Better Buy: PayPal Holdings vs. Discover

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While PayPal Holdings Inc (NASDAQ: PYPL) and Discover Financial Services (NYSE: DFS) can be loosely lumped together by investors for serving the larger financial industry, the two companies easily have as many differences as similarities. For instance, almost the entirety of Discover's business model revolves around issuing credit to borrowers via credit cards, student loans, and personal loans. Meanwhile, since PayPal sold its U.S. consumer credit portfolio to Synchrony Financial last month, the company has virtually no credit risk exposure.

The two companies' stocks have performed very differently this year as well: Year to date, PayPal Holdings is up about 87%, while Discover Financial is holding on to a much more pedestrian 7% gain. Of course, past performance is no guarantee of future success, so PayPal's recent dominance shouldn't affect our decision-making process too much. Given the differences in business models, performances, and valuations, comparing these two companies to determine which stock makes for the better buy now can be difficult. Let's take a closer look at each to see if we can determine which might make for a better investment for 2018 and beyond.

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The case for PayPal

What makes PayPal's case so compelling is its positioning on the cusp of two great movements: e-commerce and m-commerce. E-commerce, the buying and selling of goods online, rose to $115.3 billion in the U.S. in 2017's third quarter, according to the U.S. Census Bureau, good for a 16% increase year over year. Over the same time period, total retail sales increased just 4%. E-commerce could still expand, too. In the third quarter, e-commerce only made up 9% of all domestic retail sales. While that number includes all retail operations, including gas stations, auto sales, and other businesses that are predominantly not online, that still leaves plenty of room for this trend to grow.

M-commerce, or mobile commerce, is the act of making purchases via mobile devices, like smartphones or tablets. As with e-commerce, m-commerce is also taking an increasingly larger piece of the overall retail pie. Business Insider believes m-commerce could rise to 45% of total e-commerce sales by 2020, good for about $284 billion.

PayPal's secret weapon in its battle to take larger market share in these two emerging trends is One Touch, the platform that allows PayPal account holders to make purchases from merchants that accept PayPal as a method of payment with literally one touch or click. Once account holders' devices are registered, users don't need to enter their billing or shipping addresses, credit card numbers, or other pieces of cumbersome information when placing orders. This is especially convenient for mobile device users dealing with small screens. Over 70 million consumers and six million merchants are currently enrolled in PayPal's One Touch program.

The proof of One Touch's success is in the pudding. In the third quarter, PayPal facilitated $114 billion in total payment volume, a 30% increase year over year. What was the force behind this growth? In the third-quarter conference call, CEO Dan Schulman said, "Mobile payments led our growth again, growing approximately 54% to $40 billion in the quarter." That's good for more than a third of PayPal's total payment volume. PayPal should have plenty of room to grow its market share in mobile payments, too, as Pay with Venmo rolls out to more than two million merchants this quarter.

This growth directly translates to the company's top and bottom lines. Revenue grew 21% to $3.24 billion, and non-GAAP earnings per share (EPS) grew 31% to $0.46. Of course, a company with this type of growth comes at a steep price. Based on its trailing 12-month non-GAAP EPS, PayPal currently trades at a 42 P/E ratio.

The case for Discover Financial

Discover remains an enigma for investors. By some metrics, the business is doing just fine. In the third quarter, the company reported total loan growth of 9% year over year to $80.4 billion. Driven by the loan growth, total revenue increased to $2.53 billion, a 10% increase year over year. Yet while its loan portfolio and revenue were growing, its net income decreased by 6% to $602 million.

So what gives? How could revenue grow and net income fall? Well, while Discover's top line increased, net principal charge-offs and loan loss provisions rose much faster. Net principal charge-offs, loans unlikely to be collected, grew to $527 million, a huge 42% increase year over year. Provisions for loan losses, money reserved for loan payments that have yet to be collected, grew to $674 million, a whopping 51% increase year over year.

Though the company has admitted to changes in its personal loan underwriting policies due to higher than expected defaults, most of the loan loss provisions are what the company refers to as normal "seasoning" in its portfolio and as a natural consequence of loan growth. In the company's third-quarter conference call, transcribed by S&P Global Market Intelligence, CFO Mark Graf described the situation and said the company was committed to responsible and disciplined loan growth:

It should be noted that Discover's 2.63% net charge-off rate across its entire loan portfolio remains quite reasonable by historical standards. If management is correct in saying that the sharp increase in loan loss provisions is due entirely to the company's loan seasoning and does not represent a sudden pivot to subprime lending by Discover, the company could be a bargain at these prices. Based on its trailing 12-month earnings per share of $5.82, Discover's stock currently goes for a P/E of just over 13.

During the third quarter, Discover repurchased more than $550 million worth of shares. The company sports a 1.8% dividend yield supported by a low payout ratio of only 24%.

The final verdict

One could defend an investment in either of these two companies. Discover's management is shareholder-friendly, paying an increasing dividend and buying back shares at a decent clip. The company is also going for a low valuation. If the growth in net charge-off rates slows just a little, the company should return to earnings growth and see inflation in its P/E ratio.

That being said, I would still choose PayPal Holdings as an investment between these two companies. Its high growth supports its higher valuation, and it stands poised to benefit from the growth in e-commerce and m-commerce. Combined with the increasing number of opportunities for Venmo, PayPal's growth should be supported by rising fundamentals and macro tailwinds for years to come.

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Matthew Cochrane owns shares of PayPal Holdings. The Motley Fool owns shares of and recommends PayPal Holdings. The Motley Fool recommends Synchrony Financial. The Motley Fool has a disclosure policy.