DFS: Capital, Opportunity, and Discipline
We estimate DFS has excess capital of $2.5bn (given that its 2015 Tier 1 common ratio is 8.7% under the CCAR severe-stress scenario, after the just-approved capital plan, versus a minimum requirement of 5% of risk-weighted assets that are currently $68.7bn). The firm has prioritized organic growth over buyback (notwithstanding the buyback of 5% of stock in 2013 and a 67% payout ratio), and will deploy this excess capital into prime-lending where bank competition has retrenched (because it is highly stress-capital intensive with card-lending generating, under the severe-stress scenario, almost as much loss as the $98bn modeled by the Fed for Wall Street trading operations).
DFS has already diversified into a broad-line prime lender from its legacy at the time of the June, 2007 spin-off from Morgan Stanley as an ABS-funded card business (so that non-card loans are now 20% of the book and direct-to-consumer deposits 43% of funding) by: (i) leveraging brand awareness from its payments business; and (ii) cross-selling deposit products and debt consolidation “personal” and, going forward, home-equity loans to card customers (60% of personal loan and deposit customers have another DFS product). That said, we see lending share gains by DFS (e.g. 6% growth in the prime-revolver card segment in 2013 vs. flat for the industry and leadership in personal loans with an 11% share of the $28bn market) as a function more of capital than competitive advantage:
- Capital Advantage: In the severe stress scenario, DFS generated a total loan loss ratio of over 15% compared with 12% for COF, 7% for JPM, and below 6% for BAC (see Exhibit below). Nonetheless, the trough Tier 1 common ratio (before capital payout) was 13.2% well above 6.3% at JPM, 5.9% at BAC; after the approved capital payout, the Tier 1 common ratios modeled at 8.7%, 5.5%, and 5.3% respectively for 2015 (vs. the minimum 5% threshold).
- Efficiency: The competitive advantage to DFS of “branchless banking” may be overstated. While its 37% efficiency ratio compares favorably with an average of 66% for large banks, this is largely because of business mix; for example, JPM’s card, merchant, and auto business segment has an efficiency ratio of 43%. It is true that the cost-to-serve online deposits is less than branch deposits but this is reflected in the price: in 2013, DFS paid an average rate of 1.44% for interest-bearing deposits versus 18-32 basis points at large branch-bank competitors. We expect the gap to widen as short rates increase because branch deposit customers tend to be less rate-sensitive.
While the returns from non-card prime lending are lower than those from card-lending (no merchant fees, for a start), we expect DFS to maintain a 25% tangible ROE as the dilution is offset by absorption of excess capital into the loan book. On this basis, our TBV-regression model suggests DFS is ~20% undervalued, and this excludes the optionality in the payments business from arbitrage of Durbin regulation and the emerging distribution channels with online players and retailers allowing DFS to end-around the bank channel which has been locked up by V and MA (and which, unlike AXP, DFS does not have the premium economics in credit to penetrate).
- Durbin arbitrage: As closed-loops, AXP and DFS are not subject to the Durbin interchange cap when they manage the cardholder funding account. AXP exploits this with its Serve-branded prepaid products which, because of check access and online bill pay, function as checking-account substitutes and are offered free to consumers who enroll for direct payroll deposit. DFS is exploiting it with the launch of cashback checking providing customers with a 10 cent reward for each debit, checking, and online bill pay transaction. With debit interchange capped by Durbin, and large branch networks to amortize, banks cannot match these economics.
- Emerging distribution: The PayPal partnership provides DFS with access to 60mm active Payroll accounts versus its current tally of 63mm credit card accounts; this provides DFS with the opportunity to sell physical cards, along with loan and deposit products, even if the PayPal mobile wallet disappoints and PayPal loses share online as consumers shift to identifying themselves with (tokenized) bank credentials as in “Pay with Chase”, for example.
We see the most significant (albeit speculative) opportunity for DFS being to partner with the merchants’ payments consortium, MCX. While MCX will work with FIS to process payments acquired by consortium-members, MCX is likely to want their payment products to have utility at merchants who are not yet consortium-members and this will require partnership with an acceptance brand. DFS is a natural fit because it has the acceptance footprint of V and MA (9.2mmm acceptance locations at DFS versus 9.6mm at V) without the history of antagonism and litigation.
- Indeed, customers who open a DFS cashback checking account when they enrol for an MCX card are likely to get a better debit value proposition whether they shop at MCX merchants (to qualify for premium rewards MCX members will use to steer customers to their products) or at merchants who are not MCX members (because of the Durbin-exempt character of DFS “closed-loop” cards). As in the case of PayPal, the access to MCX customers will allow DFS to sell physical cards and other product whether or not the MCX mobile wallet meets expectations.