Discover Needs 10% Haircut Though Declining Loan Losses Lift Profits

Discover Financial Services (NYSE:DFS) reported 133% increase in net income to $600 million for the quarter ended May 31 compared to $258 million the same time last year. Thought a moderate increase in both card sales volume and total loans supported the increase, a 76% decline in provision for loan losses helped the company report its all time record quarterly net income. Discover Financial Services is a direct banking and payment services company that offers credit cards, student loans, personal loans and deposit products. It competes with other financial firms like Capital One (NYSE:COF), American Express (NYSE:AXP), Visa (NYSE:V) and MasterCard (NYSE:MA).

We have a price estimate of $23 on Discover’s stock which is nearly 10% below the current market price.

Declining Provision for Losses

Provision for loan losses for Discover was $724 million in Q2 2010 which reduced to $176 million in Q2 2011. The 76% decline in provisions for loan losses is driven by lower charge-offs and a reduction in the allowance for loan losses. Charge-offs decreased by $424 million from the prior year. Also the improvement in credit outlook resulted in a reserve release of $401 million in the second quarter of 2011 versus a release of $277 million in the second quarter of 2010 which supplemented the net earnings.

The decline in charge-off rates and provision for loan losses is a result of conservative lending approach adopted by the industry in the aftermath of the global economic crisis of 2009. Stricter regulations on the banking industry have also caused many banks to raise their lending requirements.

We expect Discover’s provision for losses as a percentage of average credit card loans to be around 3.4% in 2011 and remain stable during the Trefis forecast period.

See our full analysis of Discover Financial Services