EP94: Pick A Card
Stock Ideas From Investment Professionals
Welcome, subscribers!
This week, we’re happy to share another big batch of stock pitches.
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Keep reading as we share 7 new ideas, including:
Oil Revival: A dormant California oil field could deliver massive cash flow as regulatory hurdles clear.
Pharma Play: A specialty drugmaker leverages a blockbuster transition and strong pipeline for growth.
Healthcare Comeback: A neonatal care leader stabilizes operations and looks primed for growth.
Retail Gamble: A struggling retailer offers high-risk, high-reward potential amid a turnaround effort.
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Let’s get to it.
In their most recent client letter, Bronte Capital outlined a very thorough thesis for their holding in Discovery Financial (DFS), which is soon-to-be-acquired by Capital One (COF) for $35 billion…if COF can secure regulatory approval.
Appendix 1: Capital One and the Discovery merger
US Credit cards have become a concentrated business. The leading players in order are Chase, a part of JPMorgan, American Express, Citi, Capital One, Bank of America and Discover. A combination of Capital One and Discover will become the number two player.
A book of old and stable credit cards is a good business. You almost certainly have a card in your wallet (or embedded in your phone) and you transact on it a lot. The bank makes good coin from that card – and given your financial circumstances and long history of paying – your bank can be reasonably assured that you will never default on that card.
Many Americans however have two cards. The number two card in the wallet is a problematic business. If you have two cards in your wallet there will typically be one on which you do most transactions on and which earns most the revenue.
The main reason for calling on the second card is that you are financially stressed, and the first card has gone beyond its limit. Being the “back of wallet card” is not a good business as you get a full share of the credit losses and little of the revenue.
Originating new cards is also difficult. The average American is inundated with offers for credit cards – and prime customers mostly file those invitations in a cylindrical filing cabinet. However, a financially stressed customer may accept a new card – and they will of course be far more likely to default. Originating cards is costly.
The difficulty (and loss expense) of stealing customers from other issuers (that you preferentially get customers more likely to default) makes market shares in this business hard to shift. It gives banks some pricing power.
Of direct consequence banks have pricing power – and credit cards have remained profitable for existing but not for new players.
For this note we need to explain Capital One’s business and then why Discover’s business is different – and what makes the merger with Discover transformative.
Capital One – the math/computer science led giant
Capital One is not like the other companies on this list. Capital One was a scrappy startup which originated cards by scoring people with computers and accurately offering pricing to good customers largely to get them to switch. The company is still in the hands of its founder (Richard Fairbanks) who has made dozens of major and correct calls over the history of the firm. The most important of these was buying regional banks and ING Direct to get an online and small customer banking presence to make themselves largely free from wholesale funding markets.
The early part of John’s career involved much shorting of subprime credit card companies who were intent on stealing the low-end of Capital One’s credit card base. Most of these failed in some way and Capital One emerged the unequivocal winner.
If it were not for the Discover merger we would not be buying Capital One because – frankly – even the best run subprime credit card issuer in the world is a subprime credit card issuer. This is a difficult business for which bad outcomes are possible.
Capital One’s business is two-peaked with respect to the cards they issue. They are the super-champion at “good subprime”. These are people who have difficult finances and may have defaulted in the past but have realised that you need a credit card to survive in American society (to rent a car, to buy things online for example) and are determined, within their means, to try and fix their credit. These people still have a high default rate, are economically sensitive and will have rising losses when unemployment goes up. Issuing cards to them can be a difficult business.
They are also champions – along with American Express – in super-prime cards used by people who do all their transactions on the card, have a high spend including on travel but pay their balance every month. They are usually interested in the airline points. Think of an upper-income family that travels a lot but has and intends to maintain pristine credit.
These card holders are hard to find (you have to offer them very good terms and lots of points to get them to change) but they are very profitable once found. Many of our readers fall into this bucket.
What Capital One has mostly avoided is issuing to the vast collection of what America calls middle class and the rest of the world calls working class families. Think a family with household income of 60-80 thousand and a couple of kids, but with a credit record that is mostly clean but with some inevitable live-frompaycheck to paycheck financial stress. Their view – these customers want pricing that looks close to super-prime but with a credit profile that can (and unfortunately often does) go pear-shaped when unemployment or other stress such as a medical emergency hit. Their view is that business is mostly mispriced (at least for them).
The great era of profitable growth for Capital One ended at the financial crisis – and the company has – with a banking licence – has had to build up a large capital buffer. The stock is about 50 percent higher than its pre-financial crisis peak – but traded sideways with volatility for about a decade. The derating back to a low-teens price to earnings ratio has been sharp.
We think the capital buffer problems have largely been solved the right way (by earning the money needed to meet larger capital requirements).
American Express and Discover
Most credit cards transact on the Visa/Mastercard networks. As noted in the main letter Visa is an enormously powerful company. There are however two independently owned networks. One is owned by American Express and the other by Discover.
American Express have competed with Visa by charging more than Visa. The idea was that by charging more than Visa you could offer more services (such as very good service if your card is lost overseas) or more airline points or both to customers. The cost for these were carried by the merchants who accepted the card. This made merchants reluctant to accept the card – with the reluctance offset by high value customers American Express brings.
For years we thought this was a losing strategy. We could not imagine many customers who thought it prestigious to pull a “Centurion Card” from their wallet – as if carrying a black American Express card was a symbol of their prestige and status. We noted that there was at one point a Harvard Alumni Association co-branded VISA which seemed to have more status, or at least loudly announced you went to Harvard.
We were wrong. American Express has grown for decades with a charge-morefor-more-services and prestige pricing strategy.
Discover competed with American Express the more logical way – by charging less. This makes merchants very willing to accept the Discover Card and Discover has near universal acceptance in the United States.
The problem is the lower take means that Discover cannot compete for high value customers on airline points. Instead, they took a different tack.
Discover is the king of the American lower-middle class. The typical customer is precisely the customer that Capital One avoids – the family with 60-80 thousand household income that mostly lives from paycheck to paycheck, but which has and tries to maintain good credit.
The way Discover attracts these customers is with a cash-back card. They give back to the card holder 50 cents per hundred dollars spent. The families that hold this card really value that 50 cents, and they know that if they default on Discover this perk will go forever. They do not value fancy airline points or travel benefits because mostly they are not rich enough to travel except by car.
Capital One has experimented with marketing to Discover’s customers and has found that Discover customers will default preferentially on the Capital One card. They like that 50 cents.
Capital One is buying Discover
The news that made us interested in Capital One is that Capital One is buying Discover.
This is a transformative acquisition. What it gives Capital One is a network with near universal North American coverage. These are truly rare assets – and it will allow Capital One to compete with Visa rather than be just another captive of Visa’s near-monopoly network.
Capital One are appropriately blunt about Discover’s card business. They do not love it. They would not be buying Discover for their book of business. But it is profitable, and they will leave it alone. They will not be changing the branding or anything like that. Discover customers will – if all is right – not realise that anything has changed. (Alas Discover Cards will need to say that they are issued by Capital One Bank in small print.)
There are however enormous synergies from moving Capital One cards to the Discover network. Capital One will look far more like American Express, except that it will be larger and with wider acceptance.
The guidance given by the company for post-merger earnings do not include all of these synergies. The only cards that will – at least in the guidance – be moved to the Discover network are debit cards. This should be easy to do. As noted in the letter Visa is currently being sued by the Justice Department for using their network power to illegally monopolize debit cards. Under these circumstances it is highly unlikely that Visa can or would offer any obstruction to moving the business.
That limited amount of synergy gets Capital One earnings in 2026 to about $18 a share. (Current share price about $150.)
The big driver however is getting the vast book of high-end transactors off Visa’s network and into Discover’s cheaper network. The savings from that will make earnings grow sharply for many years without requiring more regulatory capital or without accepting more credit risk.
The company however cautions against shareholders putting this in any shortterm company model. The problem is that Discover’s network is under-invested. When I touch my phone on a Visa network the payment typically clears in under a second. The network rarely (but still occasionally) rejects the payment not for credit reasons but simply because network connectivity is not perfect.
Discover’s network by contrast is far clunkier. Payments clear slower and network problems blocking payment are more frequent. Capital One will have to spend a few hundred million bringing that network up to scratch, decentralising data to solve connectivity problems and just making it faster.
Capital One will not transfer high value transacting customers to the Discover network until the network quality is the match of Visa. This will happen – it will just take time. But when it happens earnings should rise fast – and Capital One will be able to compete for these high value customers with a competitive advantage over their most important competitors – the competitive advantage will be that they are less beholden to Visa’s near-monopoly.
Our holding
We hold Discover Financial Stock rather than Capital One because it trades at a discount to the Capital One stock it will convert into. However, what we are really doing is holding Capital One stock for what we think will be almost a decade of earnings growth. It is also the best kind of earnings growth – it comes without requiring substantial additional regulatory capital and without taking substantial new credit risk. It comes from disintermediating Visa.
The problem with this position is that it is levered to a large riskier subprime business. This means that the position has been started around 3 percent rather than the 6-8 percent we are comfortable with when holding robust and unlevered business models.
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