Better Buy: Visa Inc. vs. Discover

MarketsMotley Fool

Global credit and debit card payments are on the rise. Spurred by a rise in digital transactions and increased acceptance in emerging economies, card payments are projected to increase by a whopping 150% to $52.4 trillion by 2021, according to the Nilson Report. Even if these projections are off by a trillion or two, the overall trend is easy to see: The world is using less cash in favor of making more digital transactions.

Two companies that stand to directly benefit from this trend are Discover Financial Services (NYSE: DFS) and Visa Inc. (NYSE: V). But which of these two currently makes for a better investment? Let's take a closer look at each company's business model, growth strategy, and valuation to see if we can come to a satisfactory conclusion.

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The case for Visa

Visa makes money by operating a four-party model that includes the card-issuing financial institution, the merchant, and the acquirer (the merchant's bank). Because it partners with banks and credit unions, Visa never actually loans money to consumers. It only acts as the payments network to get the customer's money from his or her bank to the merchant. It collects fees based on the payment volume and number of transactions it facilitates. The advantages to this model are that the company will never be exposed to the credit default risk inherent in issuing debt. The market is generally more generous in valuing companies that, like Visa, are not exposed to credit risk.

In Visa's first quarter, net revenue rose to $4.86 billion, a 9% increase year over year, and adjusted earnings per share grew to $1.08, a 26% increase year over year. The robust top- and bottom-line growth was driven by a 12% increase in payments volume to $2.03 trillion and a 9% increase in total transactions to 44.6 billion.

Visa's acquisition of Visa Europe continues to delight investors with even more savings and synergies than originally projected; it remains a real catalyst for growth in the quarters ahead. In the company's first-quarter conference call, CEO Al Kelly said Visa Europe continues "to be accretive at a level above what we thought it would be when we made the acquisition in the first place." When Visa marked the one-year anniversary of the acquisition in its 2017 fourth-quarter conference call, CFO Vasant Prabhu raved, "At the end of the first year post-acquisition, Visa Europe is well ahead of our revenue projection, below our cost projection, with a lower effective tax rate."

Based on Visa's trailing-12-month EPS of $3.70, Visa's current P/E ratio is 31.6. Visa currently pays a quarterly dividend of $0.21, giving it a rather paltry dividend yield of 0.72% and a payout ratio of 23%. In the company's first-quarter conference call, Prabhu stated the company anticipated repurchasing about $7 billion worth of shares in 2018.

The case for Discover

Unlike Visa, Discover loans money directly to the consumer, making it the credit issuer and the payment network in all transactions made with a Discover account. This does expose it to credit risk but also allows the company to collect interest on all that credit card debt -- a fairly significant sum!

Although Discover issues student and personal loan debt, its credit card portfolio remains the star of the show. Credit card loans now make up about 80% of the company's total loan portfolio; in the fourth quarter, its card loan total was $67.3 billion, a 9% increase year over year. In the company's conference call, CEO Mark Graf characterized the card loan growth as "very healthy," almost evenly split between new and existing customers. Increasing its business with existing cardholders is important because these customers generally are associated with cheaper acquisition costs and less credit risk than new customers. It is thus noteworthy that Discover is consistently recognized for its customer satisfaction and loyalty.

In the company's fourth quarter, revenue grew 11% to $2.6 billion, and adjusted EPS rose 11% to $1.55. Its loan portfolio grew nicely, as did its net charge-off rate, which rose to 2.85%, a substantial increase over 2016's fourth-quarter charge-off rate of 2.31%. Based on its 2017 adjusted EPS of $5.98, the company currently trades at a P/E ratio of 11.7. The stock pays a safe and growing dividend and sports a 2% yield. During its fourth quarter, it repurchased over $550 million worth of shares.

The Foolish verdict

I wouldn't be surprised if both of these stocks beat the market over the next 12 months. Given its loan growth, Discover's valuation is awfully attractive, making me believe that the credit risk it faces from an increasing, but still respectable, charge-off rate is fully baked into the price. The company's growing dividend should also give the stock price a floor not too far below where it is now.

That said, I prefer to invest for periods longer than one year, and I believe Visa to be the superior business. The company executed its integration of Visa Europe beautifully under its corporate umbrella, and I expect its earnings to increase at a double-digit clip for years, even if growth decelerates from its 26% rate last quarter. The company comes at a premium price, but as Warren Buffett once said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

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Matthew Cochrane has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Visa. The Motley Fool has a disclosure policy.