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Discover Financial Services (DFS), American Express Company (AXP): Staying Ahead of Warren’s Elephant Gun

“We’re prepared. Our elephant gun has been reloaded, and my trigger finger is itchy.”

–Warren Buffett, appearing on CNBC’s “Squawk Box”, Valentine’s Day 2013.

With Berkshire Hathaway Inc. (NYSE:BRK.A)‘s  mega-buyout of Heinz in January, billionaire Warren Buffett showed that he still has the tenacity and eagerness of a much younger man.  The Heinz acquisition cost Berkshire $13 billion in cash, with 3G Capital kicking in the rest of Heinz’s $28 billion takeover value.  Even after Heinz, Berkshire Hathaway Inc. (NYSE:BRK.A) is loaded with more than $35 billion in cash, which it could easily leverage into a huge deal.

Mr. Buffett has foreshadowed the potential for a very large takeover in the future, but to make money from a Berkshire buyout, individual investors will need to stay one step ahead of Buffett’s hunt. So the question is not if, but when the “elephant gun” will fire again. But where will it shoot?

Discover Financial Services (NYSE:DFS)

Undervalued in the financial services industry

With a long and storied history in the financial and insurance industries, one Berkshire target could be Discover Financial Services (NYSE:DFS) Systems.  Berkshire Hathaway Inc. (NYSE:BRK.A) is a longtime American Express Company (NYSE:AXP) investor, and currently owns a minority stake of 14% of the credit card company.  But a controlling interest in Discover Financial Services (NYSE:DFS) may be preferable to Berkshire’s current minority interest in American Express Company (NYSE:AXP).  With an expanding footprint in student loans, home loans, and credit cards, Discover Financial Services (NYSE:DFS) is well diversified and highly tied to the debt of the American consumer.

Discover Financial Services (NYSE:DFS) continues to maintain market share and receives the highest J.D. Power customer scores, reflecting consumer satisfaction scores equal to American Express Company (NYSE:AXP).  According to CEO David Nelms in its Q1 conference call, growth in prime credit and strong banking execution is allowing the company to grow faster than the competition.

But given this growth, the market still values Discover Financial Services (NYSE:DFS) (Enterprise Value of 9x EBITDA) at a steep discount to American Express Company (NYSE:AXP) (nearly 13x).  Discover generates between $3 billion and $4 billion annually in free cash flow, which it could potentially kick up to the parent company, arming Berkshire with more ammunition for future takeovers.  A rotation out of American Express Company (NYSE:AXP) and into Discover Financial Services (NYSE:DFS) would make sense given these factors.

Longshot with high valuation but big opportunities

A longshot for the elephant gun is eBay Inc (NASDAQ:EBAY).  With an enterprise value north of $69 billion, eBay would be a mega takeover, and looks quite expensive at a valuation of nearly 17 times EBITDA.  However, there are reasons to think that an acquisition would make business sense for Berkshire.  eBay Inc (NASDAQ:EBAY) has solid growth of 15% or more, and maintains solid leadership in the online auction marketplace.  But eBay’s real growth vehicle is in financial services, through its PayPal subsidiary.

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