Will Higher Provisions Ahead Cap Discover’s Value?

-9.55%
Downside
128
Market
116
Trefis
DFS: Discover Financial Services logo
DFS
Discover Financial Services

Quick Take

  • Delinquency rates and charge-off rates have been declining across the U.S. since the recession.
  • Discover has benefited from this trend, maintaining both parameters below the industry average.
  • This has led to a huge reduction in provisions for loan losses.
  • We expect the trend to reverse in the coming years as consumer spending improves.

An industry wide decline in delinquency and charge-off rates through the last few years has helped card companies like Discover Financial (NYSE:DFS) and American Express (NYSE:AXP), which earn income from revolving credit loans provided to customers. Interest income from credit card loans is important for Discover since it accounts for 60% of its revenues. In contrast, American Express is less reliant on interest income transaction. The company earns 65% of its revenues through transaction fees from merchants and banks, and 15% through interest income.

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In this article, we will focus on Discover Financial. A strong performance on credit card loans led to a 65% increase in market price through 2012. However, we believe that the stock is overvalued according to our $36 price estimate for Discover Financial, which is at a discount of 10% to the current market price.

See our complete analysis of Discover Financial here

The Industry Trend

The delinquency rate is the percentage of total loans that is past due date while charge-off rate is the percentage of loans that are considered unredeemable. Both parameters have been declining steadily in the U.S. since the recession. The delinquency rate on credit card loans for all commercial banks in the U.S. dropped from 6.76% in the second quarter of 2009 to 2.73% in the fourth quarter of 2012. [1] In the same period, the charge-off rate on credit card loans for the top 100 banks ranked by assets in the country dropped from 9.59% to 4.08%. [2] This trend was influenced by the recession as customers started paying off their loans in time in order to avoid staying in debt during the financial crunch.

How Is Discover Faring?

Discover has also seen a steady decline in both parameters staying well below the industry average. In 2009 the delinquency rate for loans over 30 days due was 4.92%, this dropped to 1.75% in 2012. The net principal charge-off rate dropped from 7.45% in 2009 to 2.29% to 2012.

The Effect It Has

Lower charge-off and delinquency rates allow companies like Discover to cut down on expenses related to maintaining reserves to absorb estimated  losses in their loan portfolio. This expense is termed as provision for loan losses. Discover’s provision for loan losses has been reduced significantly in the last few years influenced by the aforementioned trends. In 2010 the related expense was $3.2 billion while in 2012 the expense was just $848 million. As a percentage of average credit card loans, the expense has been reduced from 6.7% in 2010 to 1.55% in 2012.

Our Take On The Future

While the post recession period has seen a record low in charge-offs, going forward we expect both delinquency rates and charge-off rates to increase as consumer spending improves with the stimulus provided to the U.S. economy. This will lead to an increase in the provision for loan losses. We believe that the expense will rise marginally through the next few years. Our model is quite sensitive to this parameter and there is a downside of 10% to our price estimate should the provision for losses as a percentage of credit card loans increase above 2.5% in the next few years. You can modify the interactive chart below to gauge the effect a change in forecast would have on our price estimate.

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Notes:
  1. Delinquency Rate On Credit Card Loans, All Commercial Banks, Board of Governors of the Federal Reserve System []
  2. Charge-Off Rate On Credit Card Loans, Top 100 Banks Ranked By Assets, Board of Governors of the Federal Reserve System []