Discover Could Sell Payment Network to Unlock Value

NEW YORK ( TheStreet) -- Some investors have been griping about the market valuation of Discover Financial Services ( DFS), despite the stock's stellar performance, according to KBW analyst Sanjay Sakhrani.

It's not difficult to understand why. Discover's shares closed at $52.42 Monday and traded for 10.3 times the consensus 2014 earnings estimate of $5.07 a share, among analysts polled by Thomson Reuters. That's a rather modest forward price-to-earnings ratio, considering how profitable Discover has been.

Many regional banks trade at considerably higher valuations despite being much less profitable than Discover. Here are a few examples:
  • Shares of Comerica (CMA) of Dallas closed at $43.30 Monday and traded for 14.7 times the consensus 2014 EPS estimate of $2.95. Comerica's return on average equity (ROE) has ranged between 6.64% and 8.49% over the past four quarters, according to Thomson Reuters Bank Insight.
  • First Niagara Financial Group (FNFG) of Buffalo closed at $11.06 Monday and traded for 13.5 times the consensus 2014 EPS estimate of 82 cents. The company's ROE has ranged between 4.79% and 6.42% over the past four quarters.
  • Shares of Zions Bancorporation of Salt Lake City closed at $28.40 Monday and traded for 15.4 times the consensus 2014 EPS estimate of $1.84. The company's ROE has ranged between 3.53% and 7.12% over the past four quarters.

Meanwhile, Discover's ROE has ranged between 22.54% and 27.78% over the past four quarters. That performance of course reflects the company's focus on credit card lending, which has been a very bright spot over the past several years, as the regional banks have worked through their nonperforming residential and commercial mortgage loans.

Unlocking Value

Discover is a unique story. The company -- originally a unit of Dean Witter when that company was held by Sears -- not only developed its own credit card brand, in the face of entrenched competition from Visa ( V), MasterCard ( MA) and American Express ( AXP), but it developed its own payment network. Sears eventually spun off Dean Witter, and Dean Witter merged with Morgan Stanley ( MS) in 1997. Morgan Stanley spun-off Discover through a public offering in 2007.

Following a payments industry conference in October, Sakhrani noted that companies in many industries, including tech giants like Google ( GOOG), eBay ( EBAY) and Facebook ( FB), were making large investments in mobile payment networks. In a note to clients on Monday, the analyst wrote "Clearly, at this point, Discover's network has been viewed as the ideal partner (and perhaps the only partner) for these types of companies given: 1) the network's solid acceptance penetration in the US (at ~98% parity to Visa and MasterCard ) and 2) its willingness to provide white label services (i.e., as it is currently doing for PayPal)."

PayPal is eBay's lucrative payments network, which partnered with Discover in April 2012 to offer merchants the ability to accept PayPal payments.

"If we assume our premise that offline penetration is important and necessary, we wonder if one of the aspiring wallets might want more control of the network," Sakhrani wrote.

A tech player looking for more control of its mobile payments business could certainly make excellent use of Discover's payment processing networks, and even cut its risk by making partnerships with payment processors unnecessary. A potential buyer could also benefit by keeping competitors from using Discover's network.

" W e do not believe there is a whole lot of value being ascribed to the Discover network when considering the valuation of DFS shares and in a takeout scenario, and we believe DFS shares at this point in the cycle are worth a lot more than current levels," Sakhrani wrote. He estimated Discover's combined payment network, including Diners Club and PULSE, to be worth $3 billion to $4 billion, or $6 to $8 a share.

The big question for Discover is whether the payment network's value will be considerably higher as the mobile payment space develops, or whether this is the ideal time to sell. "The argument could be made that you can scale that network significantly more than they have," Sakhrani says, however. "the strategy they have embarked on hasn't materialized -- maybe someone else can take that strategy further."

When asked if Discover could still achieve its high double-digit ROE without the payment processing network, Sakhrani says "A big part of their profitability comes from their lending businesses, so probably. The idea over time as they grow out this business is that they should enhance the returns. To the extent they do something with the excess capital, that could be accretive as well."

In addition to the three companies above, Sakhrani believes Apple ( AAPL) could be a potential buyer, as could Microsoft ( MSFT).

"Neither they Microsoft nor Apple have articulated a payments strategy, but the idea is that if mobile payments are the way we are going, and you own the phone or the operating system on the phone, you're a player in payments potentially.

A purchase of Discover's payment processing network by Apple or Microsoft is eminently feasible, based on Sakhrani's valuation estimate for the network. Apple reported having $40.6 billion in cash and short-term marketable securities as of Sept. 28, while Microsoft reported $80.7 billion in cash, cash equivalents and short-term investments as of Sept. 30.

Discover's shares returned 37% year-to-date through Monday's close. The shares were down 1% in morning trading, to $51.47.

DFS Chart DFS data by YCharts

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

-- 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.