Don't Ignore These Credit Card Stock Bargains

NEW YORK ( TheStreet) -- Heading into third-quarter earnings season, it's clear that the market is undervaluing some credit card lenders.

Over the past five years, as the U.S. banking industry has recovered from the credit crisis, lenders with the sharpest focus on credit card lending have fared quite well, with outstanding returns on equity. But their price-to-forward earnings don't reflect their earnings strength, setting up a golden opportunity for long-term investors.

Capital One ( COF) had a rocky road earlier this year, with the stock sinking in the wake of higher-than-expected costs tied to its purchases of HSBC's U.S. credit card portfolio, as well as an overall decline in credit card receivables. Part of this decline reflects the company's decision to move away from private-label card lending, including the sale of a $7 billion portfolio of Best Buy ( BBY) loans to Citigroup ( C).

But the company had a good second quarter, with a return on average tangible common equity (ROTCE) of 17.87%, according to Thomson Reuters Bank Insight.

Another challenge for Capital One is a rise in expenses, with KBW analyst Sanjay Sakhrani on Thursday estimating the company's third-quarter efficiency ratio will rise to 54% from 53.4% the previous quarter and 51.8% a year earlier. The efficiency ratio is, essentially, the number of pennies of overhead expenses for each dollar of revenue.

But Sakhrani rates Capital One "outperform," with a $79 price target and lists the company as his favorite pick among the credit card lenders and payment processors he covers. The analyst estimates the company will post third-quarter earnings of $1.78 a share, declining from $1.87 the previous quarter and $2.01 a year earlier.

Despite the expected decline in earnings, Capital One remains very attractive because the stock at Thursday's closing price of $68.78 traded for 10.1 times the consensus 2014 EPS estimate of $6.82, among analysts polled by Thomson Reuters. That's a low forward P/E for a company with an ROTCE close to 18%.

Discover Financial Services ( DFS) is a highflier, showing an annual growth rate of 12% for average credit card loans held on the balance sheet during August, and achieving an industry-leading efficiency ratio of 40.29% for the 12-month period ended June 30.

Discover's second-quarter ROTCE over the same 12-month period was an outstanding 26.4%.

The stock closed at $50.26 Thursday and traded for 10.0 times the consensus 2014 EPS estimate of $5.00. That's a lower forward P/E than Bank of America ( BAC), for example, which achieved a marginal ROTCE of 4.67% for the 12-month period ended June 30. Bank of America's shares closed at $14.00 Thursday and traded for 10.3 times the consensus 2014 EPS estimate of $1.36.

Sakhrani estimates Discover on Oct. 21 will report third-quarter EPS of $1.17, declining from $1.20 the previous quarter and $1.23 a year earlier. The analyst rates Discover "outperform" with a $61 price target, and sees plenty of room for the company to increase its share buyback.

"We believe significant earnings generation and excess capital position of the company leave room for capital management activities greater than our current expectations. For 3Q13, we estimate DFS will repurchase about $350 million of shares (vs. $340 million in 2Q13) and will repurchase roughly $1.3 billion of shares in 2013," he wrote.

American Express ( AXP) has also been showing growth, with average managed credit card receivables in August of $54.8 billion increasing at an annual pace of 4%. The company reported a second-quarter return on average equity of 23.6% for the first half of 2013, down from 26.6% a year earlier.

The shares closed at $74.02 Thursday and traded for 13.8 times the consensus 2014 EPS estimate of $5.35. This makes the shares rather pricey compared to Capital One and Discover, however, American Express has a long track record of bringing home double-digit returns on equity.

Sakhrani rates American Express a "buy" and estimates the company will report third-quarter earnings of $1.23 a share, compared to EPS of $1.27 the previous quarter and $1.09 a year earlier. His price target for the shares is $87.00.

The credit card lenders are worthy of consideration at this point in the banking industry's recovery because of their high degree of profitability and relatively low valuations. Some investors may be concerned about regulatory overhang, as the Consumer Financial Protection Bureau on Tuesday said it had several "areas of concern" for the credit card industry, including sales of add-on products, fees, and deferred interest on some private label cards.

However, the CFPB's concerns seem pretty tame when compared the onslaught the largest banks continue to face.

"Generally speaking, fundamental trends remain solid and we expect C3Q13 earnings season to be fairly constructive," for the credit card lenders and processors covered by his firm, Sakhrani wrote.

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

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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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