Discover Q3 Earnings Preview: Credit Card Income, Loans Diversification Key Focus Areas

Discover Financial (NYSE:DFS) has reached an agreement with the Federal Deposit Insurance Corporation (FDIC) and Consumer Financial Protection Bureau (CFPB) to refund customers who bought credit-protection products over the phone from December 2007 to August 2011. ^[1] Earlier this year, the company was accused of using deceptive marketing techniques over the phone to sell protection against identity theft, stolen cards and catastrophic events such as job loss as well as credit score tracking. Discover will pay $200 million to about 3.5 million customers and will pay $14 million in fine to the FDIC and the CFPB.

The announcement comes a few days before the company’s quarterly earnings announcement for the third fiscal quarter of 2012, which is scheduled for Thursday, 27^th September, 2012. The company is focusing on growth in credit card receivables while diversifying its range of offerings. We look below at a few key trends that might influence its performance.

We have a $39 price estimate for Discover’s stock, which is close to its current market price.

See our complete analysis of Discover Financial here

Credit Card Income To Increase

Credit cards issued to individuals and small businesses form the primary source for Discover’s income. More than 60% of Discover’s revenues are earned through interest on card loans outstanding, charged from customers. Discount and interchange fees charged from merchants who accept Discover-branded cards account for 16% of the company’s total revenues. Although the company is facing yield compression due to the implementation of the Credit Card Accountability Responsibility and Disclosure Act of 2009 (CARD Act), funding cost improvements and an increase in outstanding loans might help the company maintain its performance.

Credit card loans outstanding increased by $1.6 billion to reach a total of $46.6 billion at the end of the second quarter. This trend might continue as spending on essentials such as food and gas in the U.S. increases.  Discover’s U.S. Spending Monitor, which maintains an index of consumer spending intentions and capacity based on customer surveys, revealed that 44% of the respondents expect household expenses to increase in the coming months. As the national household income continues to drop in the tough economic and job environment, credit card use and loans can be expected to rise in the near future.

Discover is also looking to boost sales through affinity partnerships and rewards programs. It reported a 5% increase in card sales volume in the second quarter. The recent incursion into Russia might help maintain this trend in the future. (Please refer to Discover Enters Russia En Route To $39 for more details)

Diversification For The Future

Discover is looking to grow its direct banking business. Its foray into student loans last September with the acquisition of Citigroup’s (NYSE:C) $2.5 billion student-loan portfolio has proved successful. Private student loans grew to $2.9 billion at the end of the second quarter.  We will also keep a close eye on the Discover Home Loans, which started originating prime, fixed- and variable-rate after acquiring the Home Loan Center business from Tree.com in June this year. Our current forecast is based on an increase in Discover’s other loans, shown in the chart below. You can gauge the effect of a change in our forecast by modifying the interactive chart.

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1. Discover Announces Agreement in Principle with FDIC and CFPB Regarding Certain Marketing Practices Associated with Credit Protection Products, Press Release, 21^st September, 2012 [↩]