Capital One, Discover Are Bargains as Industry Resumes Growth

NEW YORK ( TheStreet) -- "We believe resumption of receivables growth, while maintaining strong credit performance could benefit all issuers, particularly those with low valuations which may enable multiple expansion."

Those words from FBR analyst Scott Valentin are music to the ears of investors holding shares of Discover Financial Services ( DFS) and Capital One Financial ( COF), which trade at significant discounts to other "purer play" credit card lenders.

Credit card lenders report numbers for their portfolio and securitized card loans each month. The "master trust" data for the securitized loans shows a continued significant decline in overall loan balances, as U.S. consumers continue to pay down card balances at a historically elevated rate.

But nearly all of the big card lenders showed year-over-year growth of over 1% for their on-balance-sheet credit card portfolios during October, which Valentin highlighted in a note to clients on Monday. This is a great thing for investors considering how profitable credit card lending can be, especially during a time of stellar loan quality. In addition to Discover and Capital One, this group includes American Express ( AXP), Bank of America ( BAC) , Citigroup ( C) and JPMorgan Chase ( JPM).

General Electric ( GE) is the largest private label credit card lender, with a portfolio of roughly $36 billion as of Sept. 30. But the company on Friday announced plans to spin off its consumer credit business, in a transaction that will be tax free to current GE shareholders and include an IPO of up to 20% of the equity in the new company. This appears to be a fantastic deal for shareholders, as well as for General Electric, which continues to trim away GE Capital, in order to focus more on its main industrial business. According to KBW analyst Sanjay Sakhrani, The business being spun off had a very strong 4% return on assets during 2012, with a profit of $2.2 billion on about $53 billion in total assets.

"Given the size and private label focus of GE's current operations, we feel that the implications are fairly limited to certain names in our coverage universe, namely Capital One and on a smaller scale Alliance Data ( ADS)," Sakhrani wrote in client note on Friday. "Freeing up" the consumer finance unit could unlock significant value for investors. Then again, the GE consumer finance unit's "bank funding advantage could be moderated as the business would not likely have the same access to funding as it currently has," Sakhrani wrote. So the new company may be operating on a more even playing field than it currently enjoys. It will be fascinating to see how aggressive the new company's management will be after GE completes the spinoff during 2014.

Alliance Data Systems is a relatively small pure play private label credit card lender, with average receivables of $7.425 billion during October. But that was up 14% from a year earlier.

Here are the current stock valuations to consensus forward earnings estimates, along with return on equity numbers (if available), depending on how they were reported by each company, for all the lenders listed above, except for General Electric:
  • Discover Financial: The shares closed at $52.39 Friday and traded for 10.3 times the consensus 2014 earnings estimate of $5.08 a share, among analysts polled by Thomson Reuters. The company's reported return on equity (ROE) for the first three quarters of 2013 was 24%.
  • Capital One Financial: The shares closed at $70.37 Friday and traded for 10.1 times the consensus 2014 EPS estimate of $6.96. The company reported returns on average tangible common equity (ROTCE) of 18.85% for the first three quarters of 2013.
  • American Express: The shares closed at $82.80 Friday and traded for 15.3 times the consensus 2014 EPS estimate of $5.41. The company reported an ROE of 24.3% for the first three quarters of 2013.
  • Alliance Data Systems: The shares closed at $249.11 Friday and traded for 20.6 times the consensus 2014 EPS estimate of $12.10.
  • Bank of America: The shares closed at $14.92 Friday and traded for 11.1 times the consensus 2014 EPS estimate of $1.34. The company reported a return on average tangible shareholders' equity of 6.67% for the first three quarters of 2013.
  • JPMorgan Chase: The shares closed at $54.87 Friday and traded for 9.1 times the consensus 2014 EPS estimate of $6.02. JPM reported a return on common equity of 11% for the first three quarters of 2013, even though third-quarter earnings were wiped out by $9.15 billion in provisions for litigation expenses.
  • Wells Fargo: The shares closed at $43.54 Friday and traded for 10.9 times the consensus 2014 EPS estimate of $4.01. The company reported a return on average common equity of 13.92% for the first three quarters of 2013.
  • Citigroup: The shares closed at $50.40 Friday and traded for 9.3 times the consensus 2014 EPS estimate of $5.43. The company reported a return on average common equity of 7.83% for the first three quarters of 2013.

What do all these numbers mean? Among the "big four" banks, including Bank of America, JPMorgan Chase, Wells Fargo and Citigroup, Bank of America trades highest on a forward P/E basis, in part because the shares trade low to tangible book value, and also because analysts expect a major increase in earnings over the next two years as the U.S. economy improves. JPMorgan has been a strong performer in the wake of the credit crisis, but is continuing to try and settle the majority of regulatory investigations, as well as other litigation, in order to "clean the slate" and get back to making money. Citigroup continues its long-term recovery, but the company isn't yet a strong earner. Wells Fargo is consistently the strongest performer among the group.

All of the big four could be excellent bargains for long-term investors, despite their significant political and regulatory overhang. Looking to the purer play credit card lenders, Discover and Capital One stand out as bargain stocks.

Discover reported average credit card loans of $50.1 billion during October, increasing 3.9% from a year earlier, according to Valentin. That annual growth rate slowed from an estimated 5% during the third quarter, but it was still solid for the current environment.

Capital One during September sold its $7 billion private label credit card portfolio to Citigroup, in a transaction that was completed in September. But even when adjusted for that sale, the company's average credit card receivables of $69.5 billion during October were down 4.9% from a year earlier.

Despite the decline in the credit card portfolio, Capital One has had plenty of good news this year, including a return to strong profitability after last year's transition with the major acquisitions of ING Direct (USA) and HSBC's ( HBC) U.S. credit card portfolio. The company also showed strong growth in commercial loans during the third quarter.

The bottom line is that for investors looking for financial stocks with high double-digit returns on equity while avoiding most of the regulator pressure on the biggest banks, Discover and Capital One are screaming bargains.

Discover's shares were down 0.7% to $52.03 in morning trading Monday, while Capital One was down 0.3% to $70.13.

-- 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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