Discover Financial (NYSE:DFS) enjoyed a healthy growth in card sales and loans receivables in the third quarter of 2012. The payment solutions provider reported a 10% year-on-year growth in revenues for the period when it announced earnings on Thursday, 27th October, 2012. 
The company’s efforts to diversify operations seemed to be on-track. Discover home loans, which started earlier this year, originated more than $1 billion in mortgages in the first 100 days of its launch. We discuss below the performance of some of the company’s important business divisions and the effect it has on our $39 price estimate for Discover’s stock, which is close to its current market price.
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Credit cards currently form the biggest arm of Discover’s business, accounting for more than 65% of the company’s revenue. Although low consumer confidence hindered the growth in card sales, which were in-line with the third quarter of 2011, the company reported a 4% increase in receivables as credit card loans increased by $1.9 billion over the last year. We believe that this increase can be attributed to an increase in household spending in essential items, coupled with a decline in national income, a trend observed by the Discover U.S. Spending Monitor. Despite the pessimistic consumer environment, credit card delinquency rates hit a record low as the 30-plus day delinquency rate fell by 10 basis points.
To drive further growth in the business, Discover has entered agreements with Industrial and Commercial Bank of China (See MasterCard Is Ready To Break New Barriers In China, But How Successful Will It Be? for a discussion of the state of the payments industry in China) and Russian Standard Bank (Please refer to Discover Enters Russia En Route To $39 for more details) to promote Discover branded cards and expand its global merchant acceptance footprint. The company is also looking to build on a partnership with e-commerce solutions provider, PayPal, to boost its network.
We project a steady growth in Discover’s credit card loans outstanding, reaching $58 billion by the end of our forecast period. There is a potential upside of 10% to our price estimate should the growth rate exceed our expectations driving the loans to $80 billion. With the current economic and job environment, this growth might be possible.
Discover has been expanding its direct banking business. The company acquired Citigroup’s (NYSE:C) $2.5 billion student-loan portfolio last September. This proved to be a wise decision as student loans in the third quarter increased by $2.9 billion over the prior year. Although student loans have lower yields than credit and home loans, they also have lower operating expenses and charge-offs. The inclusion of the mortgage business allowed a $25 million increase in other revenues for the direct banking segment.
Although interest expense was down 47 basis points due to benefits from refinancing maturing liabilities at lower rates, total expenses for the direct banking business increased by 29%. This was primarily due to a $94 million increase in legal reserves for the FDIC and CFPB settlement and expenses related due to the acquisition of the Home Loan Center business from Tree.com, in June this year. (For more details regarding the settlement, please refer to our article Discover Q3 Earnings Preview: Credit Card Income, Loans Diversification Key Focus Areas) We currently forecast a steady growth in average other loans through our forecast period. You can gauge the effect of a change in forecast by modifying the interactive chart below.
Transaction volume for Discover’s PULSE PIN debit network increased by over 17% whereas third-party issuing volume grew by 12%, year-on-year. This growth might be a direct effect of the Durbin amendment to the Dodd-Frank bill, which came into effect last October. The bill requires banks with more than $10 billion in assets to use separate payment processing networks for signature authorized and PIN authorized debit card transactions.  This might have helped Discover gain some market share over competitors Visa (NYSE:V) and MasterCard (NYSE:MA). The chart below illustrates our forecast for Discover’s third party networks.
- Discover Financial Services Management Discusses Q3 2012 Results – Earnings Call Transcript, Seeking Alpha, 27th September, 2012 [↩]
- The Durbin Amendment Explained [↩]