Better Buy: American Express Company vs. Discover

Both American Express Company (NYSE: AXP) and Discover Financial Services (NYSE: DFS) sport remarkably similar business models and, perhaps not coincidentally, have given investors almost identical returns over the past 12 months, both returning just over 22%. Which of these iconic companies makes for a better investment today?

Let’s take a closer look at each to see if we can arrive at a reasonable determination.

Two of a kind

Both American Express and Discover are their own credit-issuing financial institutions. They differ from Mastercard Inc. (NYSE: MA) and Visa Inc. (NYSE: V) in that they both directly lend to borrowers, meaning they are liable for defaulted loans but that they also collect interest. Unlike credit-issuing peers such as Capital One Financial and JPMorgan Chase, they also operate their own proprietary payment networks — think of them as the highways money travels on when the companies’ card are used to make a purchase.

This unique business model means that American Express and Discover are virtually the only two domestic companies that earn interest on borrowings and fees for processing and settling transactions. While both companies generate the majority of their revenue from their credit card products, they also offer other financial products such as personal loans and savings accounts.

Image source: Getty Images.

Different roads to the same destination

The similarities between the two companies don’t end with their nearly identical business models. Both have consistently found ways to please their customers, with each scoring high in third-party customer loyalty and satisfaction surveys. Yet the two have taken different paths to this common destination.

American Express has found ways to leverage the unique rewards that its high-income and business clientele seem to appreciate. This includes value propositions such as increased airport lounge access, first-bag-free perks through its partnership with Delta Air Lines, and credit for Uber rides. In the company’s first-quarter conference call, CFO Jeffrey Campbell said the company’s focus on its unique reward offerings has paid off handsomely in recent years. He said:

[W]hen you look at our growth rates in every customer and geographic segment this quarter, I think you have to conclude that we have great value propositions. We have also really focused the last couple years on evolving our value propositions in ways that try to leverage the unique differentiated assets we have … [O]ur global scale, the size of our premium customer base, our brand, we closely model, all of those things allow us to do things with a variety of partners and to do things like our global lounge program that are we believe difficult for others to match.

Discover focuses on an entirely different set of customers and drives customer engagement with entirely different incentives. One strategy is to offer a Cashback Match program that offers rotating categories where consumers can get 5% cash back each quarter and, at the end of the first year, customers receive double their earned rewards. The idea is to incentivize cardholders to use their Discover Card year-round.

Crunching the numbers

In the year’s first quarter, American Express grew revenues 12% to $9.7 billion and its diluted earnings per share (EPS) rose 38% to $1.86. In Discover’s Q1, revenue increased 10% to $2.6 billion and EPS grew 27% to $1.82. Both companies trade at substantial discounts to the overall market: Amex’s P/E ratio is 15.3, and Discover’s is just 11.2. Both companies pay dividends, though American Express’ yield of 1.42% is lower than Discover’s yield of 1.88%. Both companies’ dividends are well covered by adjusted earnings, with payout ratios substantially lower than 50%.

The number that stands out the most when comparing these two companies might be the most important, even if it is not the most obvious. For any company that issues credit, it is very important to look at its write-off, also known as its charge-off, rate before investing in it. This is the percentage of loans the issuer deems unlikely to be paid back. In Amex’s Q1, the company showed a 2% write-off rate. While this is noticeably higher than the prior year’s Q1 write-off rate of 1.7%, it remains best in class among its credit-issuing peers.

Discover, on the other hand, has struggled to grow its loan portfolio without also growing its loan losses over much of the past year. In fact, last year, it particularly struggled with issuing personal loans to customers that management admitted should not have been given loan approval. In Q1, Discover’s charge-off rate increased to 3.09% a steep increase from 2017’s Q1 2.6% rate. Its net principal charge-offs rose to $635 million, a whopping 30% increase year over year, and a substantial drag on the company’s bottom line .

The final verdict

These two companies probably represent decent values at these prices and will probably appeal to many value investors. While Discover is selling at a substantially cheaper valuation, it does come with more risk. Its charge-off rates, though still lower than many peers, are far higher than American Express’ and still growing at a rapid clip. Until Discover’s charge-off rate stops its steep climb, I greatly prefer American Express. Though Amex’s shares are not quite as cheap, they are still selling at a substantial discount to the market and come with much less risk.

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Matthew Cochrane owns shares of JPMorgan Chase and Mastercard. The Motley Fool owns shares of and recommends Mastercard. The Motley Fool owns shares of Visa. The Motley Fool has a disclosure policy.

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