Buy 'High-Quality' Card Stocks Discover, AmEx: Nomura

NEW YORK ( TheStreet) -- In a shrinking market for credit card lenders, Nomura analyst Bill Carcache on Monday said that investors should focus on "issuers focused on the high quality side of the credit divide."

Through the credit crisis, American consumers have been deleveraging, with credit card loan balances totaling $820 billion as of April 30, "down 19% from their December 2008 peak of just over $1 trillion," according to Nomura, with JPMorgan Chase ( JPM), Bank of America ( BAC), Citigroup ( C) and Capital One ( COF) seeing their card portfolios shrink by 25% or more, while American Express ( AXP), Discover Financial Services ( DFS) and Wells Fargo ( WFC) "have seen their portfolios shrink by nearly 18%."

Carcache on Monday upgraded American Express to a "Buy" rating from "Neutral," while downgrading Capital One to a "Buy" rating from a neutral rating, and sticking with his "Buy" recommendation for Discover.

On the card space in general, the analyst said "while we'd like to be more bullish, we see the decline in balances as structural in nature (driven by regulatory changes and unbreakable consumer de-leveraging)," and that in light of "an uncertain environment where the risk of another recession is elevated," Nomura was "cautious on lend-centric businesses that derive most of their profitability from spread."

Shares of American Express closed at $58.41 Monday, returning 25% year-to-date, following a 12% return during 2011.

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The shares trade for 3.4 times tangible book value, according to Worldscope data provided by Thomson Reuters, and for 12 times the consensus 2013 earnings estimate of $4.78 a share, among analysts polled by Thomson Reuters. The consensus 2012 EPS estimate is $4.33.

Based on a 20-cent quarterly payout, the shares have a dividend yield of 1.37%.

Carcache on Monday assumed Nomura's coverage of American Express and upgraded the name to a "Buy" rating, while increasing Nomura's price target for the shares to $69 from $52, saying the company's "elevated levels of investments in fee-based businesses during 2010 and 2011 have placed it at the forefront of the digital transformation that is shaping the payments industry."

The analyst added that "AXP's spend-centric business model has also been producing healthy billings and revenue growth through what has been a low-growth recovery period, as the company's core affluent customer base (the envy of the industry) has continued to spend."

Nomura also expects American Express to have continued success in cutting its expenses, with "another $0.34 of potential upside to EPS to the extent management achieves its target" during 2013.

American Express is continuing to make investments to grow its non-credit fee-based payment businesses, and Carcache expects "the contribution from fee-based business revenues to grow from less than 3% in 2008 to ~8% in 2014," contributing to "to the evolution of Amex into a lower-risk, higher-return business."

The company was very strongly capitalized as of March 31, with a Tier 1 common risk-based capital ratio of 13.4%, and it generates significant capital from earnings, with a first-quarter return on average equity of 27.1%, compared to 27.9% a year earlier. American Express received Federal Reserve approval in March to return up to $4 billion to investors through dividends and share repurchases during 2012, with another $1 billion approved for the first quarter of 2012. Carcache said that Nomura's "model suggests that AXP will have ~$2.7bn in excess capital, after paying out $12.5bn in dividends and repurchases over the next three years."

American Express will report its second-quarter results on July 19, with analysts expecting a profit of $1.09 a share, increasing from $1.07 in the first quarter, and also in the second quarter of 2011.

Carcache estimates the company will post second-quarter earnings of $1.08 a share, and estimates full-year EPS of $4.38 for 2012, followed by EPS of $4.96 during 2013.

Interested in more on American Express? See TheStreet Ratings' report card for this stock.

Capital One
Shares of Capital One closed at $54.23 Monday, returning 28% year-to-date, following a flat return during 2011.

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The shares trade for 1.4 times tangible book value, according to Thomson Reuters Bank Insight, and for eight times the consensus 2013 EPS estimate of $6.83. The consensus 2012 EPS estimate is $6.52.

Capital One will report its second-quarter results on July 19, with the consensus among analysts being earnings of $1.35 a share, including one-time items springing from the company's purchase of HSBC's ( HBC) U.S. credit card portfolio in May. The company earned $2.72 a share during the first quarter -- including a bargain purchase gain of $1.16 a share from its February purchase of ING Direct -- and $1.97 a share during the second quarter of 2011.

Carcache on Monday assumed Nomura's coverage of Capital One and downgraded the shares to a neutral rating from a "Buy" rating, while lowering Nomura's price target for the shares to $54 from $60. The analyst said that "COF generated just north of $6 in EPS back in 2004 before doing any 'transformational' deals," and with consensus 2012 and 2013 EPS estimates "just north of $6," said "in other words, we've yet to see EPS accretion from COF despite the billions spent to acquire Hibernia, North Fork, Chevy Chase, ING, and HSBC's U.S. credit card portfolio."

Carcache added that "roughly 89% of COF's earnings during its existence as a public company have gone towards acquiring goodwill and other intangibles." Goodwill represents the premium paid for acquisitions, which companies generally "test" once a year, to see if write-downs are needed.

Saying that the ING Direct and HSBC card acquisitions "look good on paper, but so did past deals," Carcache said that Capital One's risks from the purchases include loan portfolio runoff, margin pressure, "as cash proceeds from COF's runoff portfolios grow more quickly than the company is able to originate new loans," and higher spending on card rewards programs.

Nomura expects Capital One to achieve 4% annual growth in its domestic card business in 2013 and 2014, although total loans are expected to increase only slightly. Carcache expects Capital One's returns on tangible equity to decline from an estimated 15.4% this year to 15.1% in 2013 and 13.7% in 2013.

Carcache estimates Capital One will earn $5.71 a share this year, followed by 2013 EPS of $6.63, and said "while COF shares look cheap on paper at ~8x next-twelve-months (NTM) EPS, we believe they are cheap for a very good reason," and that "a healthy dose of professional skepticism and a cautious outlook are warranted at this time given the company's poor track record."

Interested in more on Capital One Financial? See TheStreet Ratings' report card for this stock.

Discover
Shares of Discover Financial Services closed at $35.01 Monday, returning 47% year-to-date, following a 31% return during 2011.

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The shares trade for twice their tangible book value and for nine times the consensus fiscal 2013 EPS estimate of $3.99. The consensus fiscal 2012 EPS estimate is $4.18. Based on a quarterly payout of 10 cents, the shares have a dividend yield of 1.14%.

For its fiscal second quarter ended May 31, Discover reported net income allocated to common stockholders of $532 million, or a dollar a share, declining from $624 million, or $1.18 a share, the previous quarter, and $593 million, or $1.09 a share, a year earlier. The fiscal second-quarter results included a release of loan loss reserves totaling $110 million, declining form a reserve release of $226 million during the fiscal first quarter, and a release of $401 million in reserves during the second quarter of fiscal 2011.

For the fiscal second quarter of 2012, Discover reported a strong return on equity of 24%.

Carcache on Monday assumed Nomura's coverage of Discover Financial Services, while maintaining Nomura's "Buy" rating on the shares and raising the firm's price target for discover to $41 from $38, while calling Discover "one of the most successful stories within the consumer lending space in recent memory, with its share price more than tripling over the last three years."

The analyst expects continued outperformance "to be fueled by a combination of the following: low-to-mid single-digit card loan growth, stable net interest margins, healthy student and personal loan growth, and share gain opportunities across its network businesses."

Discover's board of directors in March authorized a $2 billion share repurchase program, and Carcache estimates the company will make "repurchases of $1.0bn in 2012 (including the ~$450mn already repurchased in 2Q12) and $1.6bn in 2013," also estimating that "this level of buyback activity would still leave the company with $2.7bn of capital in excess of its 9.5% tier 1 target ratio by the end of 2013."

The analyst said that Discover's "ability to close the merchant acceptance gap with Visa and MasterCard in the U.S. has been an important selling point," and that "Merchants are also responding positively to DFS's promotions and are increasingly participating in rewards offers. Merchants are now contributing ~$0.15 for every $1.00 that DFS pays in cash rewards."

Carcache estimates that Discover will post operating earnings of $4.32 for fiscal 2012, followed by operating EPS of $4.05 in fiscal 2013, and $4.32 in fiscal 2014.

Interested in more on Discover Financial Services? See TheStreet Ratings' report card for this stock.

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-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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