While both PayPal Holdings Inc (PYPL -1.67%) and Discover Financial Services (DFS 0.33%) operate in the broader payments space, the two business models are vastly different. PayPal can probably best be thought of as a digital wallet platform that enables account holders to make purchases and send money to peers via digital and mobile means. Discover Financial is a credit card issuer that makes its money from operating a payments network and collecting interest on the consumer loans it makes.
Both companies stand to benefit from macro trends. In 2016, U.S. credit card payments rose to $5.98 trillion, a 5.8% increase year over year, according to the Federal Reserve Payments Study. In the fourth quarter of 2017, e-commerce sales grew to $119 billion, a 16.9% increase year over year. Those are movements that should benefit both PayPal and Discover. So, which company makes for a better buy for investors right now?
Customers are finding ways to pay besides using cash, a trend that should benefit both PayPal and Discover. Image source: Getty Images.
The case for PayPal
In what is becoming standard operating procedure, PayPal Holdings reported an excellent fourth quarter. During the quarter, net revenue grew 26% to $3.74 billion and non-GAAP EPS rose 30% to $0.55. Driving this top- and bottom-line growth is the way the company is growing its active accounts and increasing user engagement. At the end of 2017, PayPal reported having 227 million active accounts, a 15% increase year over year. And account holders are using the platform more and more: Over the prior 12 months, active accounts averaged 33.6 transactions on the platform, good for an 8% increase year over year.
Even better, these record numbers of new accounts are using the platform more than account holders from previous years. During the company's fourth-quarter conference call, transcribed by S&P Global Market Intelligence, CEO Dan Schulman said:
Importantly, engagement was once again higher at 33.6 transactions per active account. And I think it's instructive to note that our accelerating net new active growth hides the true underlying growth of engagement. If our total net new adds had grown at the same rate as last year, our growth and engagement would have increased 11% to approximately 34.5. It's particularly encouraging that our net new active cohorts acquired in 2017 are showing an acceleration in engagement versus similar cohorts from 2016. The net takeaway is we're bringing on record net new actives with higher engagement than ever before, and that obviously bodes well as we look ahead.
PayPal's growing number of increasingly engaged users is creating a real network effect moat for the company. A network effect moat is built when the value of a service increases as more people subscribe to that service. With PayPal, the more people who use the service, the more likely it is that merchants will accept PayPal as a method of payment. The more merchants that accept PayPal, the more customers will sign up for its services. These actions build a virtuous circle, as one action feeds the other and vice versa.
Of course, all this growth does come at a price. Based on the midpoint of its full-year 2018 guidance for adjusted earnings per share, PayPal's forward P/E ratio is just a shade over 35. The company did repurchase approximately $1 billion of shares in 2017 and expects to increase that total in 2018. PayPal does not pay a dividend.
The case for Discover
For the most part, Discover reported a solid fourth quarter. Net revenue rose to $2.6 billion, an 11% increase year over year, and adjusted earnings per share grew to $1.55, also an 11% increase year over year. Discover's three different loan portfolios all saw solid growth: credit card, personal, and student loans. Its credit card portfolio, by far the largest of the three, rose 9% to $67.3 billion.
The problem with this loan growth is that it was accompanied by a surge in the company's net charge-off rate -- the percentage of loans unlikely to be paid back. This quarter, the charge-off rate rose to 2.85%, a substantial increase over 2016's fourth-quarter charge-off rate of 2.31%. The charge-off rate for the full year was 2.7%, far higher than in the previous four years.
Given the company's full-year adjusted EPS of $5.98, shares trade at a more than reasonable P/E ratio of 13.53. The company also has a history of shareholder-friendly policies. In the fourth quarter, Discover repurchased approximately $555 million of outstanding shares. On the last conference call, CFO Mark Graf reiterated the company's desire to become a dividend achiever, which requires 10 consecutive years of dividend hikes. Discover currently pays a $0.35 quarterly dividend, giving it a 1.76% dividend yield and a low payout ratio of 24%.
Final verdict
Discover trades at a much better valuation than PayPal and seems committed to returning capital to its shareholders. It's hard to argue against a stock with those characteristics, and I imagine Discover shareholders will do fine. That being said, even if there is no underlying concern with its rising charge-off rates, the market will still assign it a much lower multiple as long as the rate is increasing and not decreasing.
PayPal's shares immediately dipped at news that eBay Inc would not be renewing its payment processing contract with it when their current contract expires in 2020. But that reaction seemed overdone, especially as PayPal maintains its medium- and long-term guidance. Even without eBay, what cannot be ignored is PayPal's growing user base, which is more engaged with the platform than ever before.
That's why, given the choice, I would invest in PayPal. While Discover is an attractively valued stock that treats its shareholders well, PayPal just plays into too many macro growth trends, like m-commerce, and is growing active accounts at a pace too rapid to ignore.
