Although Discover Financial’s (NYSE:DFS) credit card business is by far its most well-known, the company has diversified its offerings to include prepaid cards, student loans, personal loans and other deposit and lending products. This expansion in business operations has coincided with a steady rise in the company’s stock since the turn of the year. We have recently revised our price estimate for Discover Financial’s stock to $38, which is about 10% ahead of the current market price, and below we discuss a few key trends that have influenced our valuation.
- What Will Drive Discover’s Top Line Going Forward?
- How We Expect Discover’s Direct Expenses Composition To Change Going Forward
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Direct banking is a key focus area for Discover, as the company last year acquired a $2.5 billion student-loan portfolio from Citigroup (NYSE:C) that has since grown to $2.9 billion. Aided by focused marketing, personal loans offered by the company saw $703 million year-on-year growth in the second quarter of 2012.
Discover has also recently made a foray into the residential mortgages business with the acquisition of the Home Loan Center business from Tree.com and will originate loans to be sold in the secondary markets. The incursion comes at just the right time, with mortgage delinquency rates in the U.S. hitting a low of 7.4% and demand rising once again after the 2008 crash. (See Discover Financial Enters The Mortgage Business At Just The Right Time for more details on our stance on Discover’s venture) We forecast a steady growth for Discover’s loans business fueled by innovations like the fixed-rate private student loan product which has seen a good response in the first few months since its launch.
Larger Share Of Debit Card Market To Come
The Durbin amendment to the Dodd-Frank bill, which came into effect last October, requires debit cards to carry two unaffiliated networks. This initiative by the authorities is primarily focused on ending the duopoly currently held by Visa (NYSE:V) and MasterCard (NYSE:MA), and will benefit Discover, which is relatively small compared to the big two. Discover issues debit and ATM cards through its electronic funds transfer network, PULSE, which the company acquired in 2005. PULSE observed a massive 25% year-on-year growth in revenue in the second quarter of this year and has added around 130 card issuers to its network since 2010, increasing acceptability to over 85% of ATMs in the U.S. 
Revenues are likely to increase further, as the Durbin amendment requires banks to use separate payment processing networks for signature authorized and PIN authorized debit card transactions.  We expect a migration from Visa and Mastercard’s PIN transaction volume to fuel a growth in transaction volumes.
This growth will further be supplemented by a rise in prepaid debit products. Prepaid debit cards are gaining increasing popularity amongst banks and issuers as they are exempt from the 50% reduction in interchange fees, which was also imposed by the Durbin amendment. Interchange fees were a huge source of profit for banks, which used the revenues to offer reward program incentives. These institutions are now disinclined to offer traditional debit cards, and are shifting focus to their prepaid counterparts.
Core Business Doing Well
Discover continues to innovate to promote its flagship credit cards. The company recently launched its first affinity card, in partnership with wetlands and waterfowl conservation group Ducks Unlimited, (See New Alliance Between Ducks Unlimited And Discover Financial), targeting the group’s 600,000-plus members as a customer base. The cards business has been performing strongly, with a 5% year-on-year increase in card sales volumes, observed in the second quarter of 2012. (See Discover Financial Is Geared Up For A Lending Recovery)
However, a recent survey by Discover’s U.S. Spending Monitor indicated some negative trends regarding consumer spending with more than half (53%) of the company’s consumers in the U.S. maintaining flat spending intentions for the next few months due to a negative view of U.S. economic conditions.  Despite this apparent pessimism among consumers, we maintain a positive outlook for Discover’s credit cards business, which accounts for more than half of our price estimate for the company.
You can gauge the effect of a change in forecasts on Discover’s valuation by modifying the interactive charts above.Notes:
- Durban Exclusivity Rules To Benefit Discover Financial’s PULSE Network, iStockAnalyst, March 5th, 2012 [↩]
- The Durbin Amendment Explained [↩]
- Consumer Confidence Declines in June, According to the Discover U.S. Spending Monitor, Press Release, Enhanced Online News, 3rd July, 2012 [↩]