Should Discover or Capital One Have a Place In Your Portfolio?

On the heels of the big banks reporting earnings last week, two of the largest credit card issuers were on deck this week. Capital One (NYSE: COF) reported earnings after the market closed on July 21. Discover Financial Services (NYSE: DFS) reports after the closing bell on July 22.

Some investors may scoff at the idea of investing in either stock. Credit card stocks are historically volatile stocks for reasons that have nothing to do with the broader economy. That’s because credit card debt is usually the debt that consumers are most likely to pay late when times get tough. They will attempt to pay their rent or mortgage and provide food and medicine.

And that means that credit card companies face a higher rate of charge-offs and defaults than other types of loans. And that’s a reality no matter how the economy is doing.

On the other hand, both Capital One and Discover are huge companies so not only will they survive the downturn, but they both have potentially long-term value.

So let’s take a closer look at the current situation for each stock.

Neither company is a pure-play on credit cards

The critical thing to understand about both stocks is that unlike MasterCard (NYSE: MA) or Visa (NYSE: V), Capital One and Discover are banks as well as payment processors. This puts them at risk for losing revenue in two ways. First, they can be hurt by lower card balances and defaults. And second, they can suffer a loss of revenue from lower interest rates and a decline in net interest margin.

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In fact, both companies had to set aside money to make provisions for credit losses. That’s not a situation that pure credit card companies have to deal with.

Capital One’s earnings report underwhelmed investors

COF stock climbed over 6% in anticipation of the company’s second-quarter earnings report. But when the company reported numbers that missed on the top and bottom lines, the stock went into retreat. While the stock is still up from the start of the week, it has lost nearly half of its gains.

 The reason for investors’ anxiety has to do with more than just missing on earnings. The problem according to Richard Fairbank, Capital One’s chief executive officer (CEO) said – or perhaps confirmed - that the unprecedented government stimulus is creating “a paradox of high unemployment and strong credit.” Fairbank also said an “X-factor” for the company’s short-term forecast will be whether the government provides additional stimulus.

Investors also have to be digesting what can only be described as dismal news about the company’s dividend. Based on the result of the Federal Reserve’s stress test, the company was already suggesting that it would be cutting its dividend from 40 cents  per share down to 10 cents. However, Fairbank was more frank on the earnings call and told analysts that there was no guarantee the company would be able to issue a dividend.

Here are Fairbank’s comments from the earnings call:

“So, I'm not going to give a guide on where the dividend is going to be next quarter. We're committed to continuing to have a dividend. I appreciate how important that is to a number of our owners. And then I would just say with respect to earnings, you know we do have a net loss for the three cumulative quarters ended Q2, I think that we would need to make over $1.1 billion next quarter in order to pay dividends, whether or not that's going to happen.”

Discover has a low bar to step over, but will it do it?

Like Capital One, Discover is not exclusively a credit card company. In the first quarter, Discover put aside $1.8 billion as a credit loss provision. As a result, they suffered a net loss of $61 million in the first quarter.

That loss was less than the $1.3 billion loss taken by Capital One. However, Capital One set aside a far larger amount as a credit provider and still posted poor numbers. Investors will be looking to see how Discover fares.

However, on the plus side, after the Fed performed its stress test, Discover indicated that it was confident in its ability to continue its dividend at the current level.

And the answer is…?

The short answer may be neither. But if I had to pick one right now, I’d go with Discover. This may be a case of recency bias. Capital One posted miserable earnings after taking one of the largest credit provisions of all credit card issuers. It’s given Discover a very low bar to climb over and I suspect it will.

When you factor in the idea that Discover is likely to continue its dividend, while Capital One suggests its dividend will certainly get slashed and may be even in jeopardy altogether.