Discover Financial Services (NYSE:DFS) is primarily known for its credit cards, but the company has been expanding its direct banking business with the acquisition of the student loan portfolio from Citigroup (NYSE:C) in September, 2011 and the acquisition of the Home Loan Center business from Tree.com, in June last year. Although the company still earns around 80% of its revenues from credit cards, we believe that the direct banking segment holds tremendous potential that the company can capitalize on in the coming years.
The Discover Bank subsidiary of the business offers student loans, personal loans and deposit products while the Discover Home Loans subsidiary offers prime variable, fixed-rate conventional and Federal Housing Administration (“FHA”) mortgage loans. In our last article, Looking At The Value Of Discover Financial’s Credit Cards Business, we analyzed the company’s credit card business in detail. In this article, we focus on its direct banking potential, in particular the student loan business.
Discover had around $10.7 billion in receivables (excluding credit card receivables) at the end of 2012. Of these, around $7.6 billion were student loan receivables, $3 billion were personal loan receivables and the rest were mortgage loans.
Discover offers fixed and variable rate private student loans to students planning to attend non-profit four-year undergraduate and graduate schools. Although the company began providing both federal and private student loans in 2007, the Healthcare and Education Reconciliation Act enacted in 2010, stipulated that all new federal student loans be originated by the federal government. As a result, the company has sold most of its federal loan portfolio, but has gained market share in private student loans through the acquisition of the Student Loan Corporation (SLC) in 2010 and Citibank’s private student loan portfolio in 2011. Discover markets student loans through direct email to potential customers and working with financial aid offices in schools.
According to the Federal Reserve Bank of New York’s quarterly report, the country’s student loan balance outstanding was around $1 trillion at the end of the first quarter of 2013. Of this, around $150 billion was outstanding private student loan debt.  With $7.6 billion in private student loan receivables, Discover has a market share of 5%.
There are currently around 37 million student loan borrowers in the U.S., of which 40% are under the age of 30, and 27% are between 30 and 40. Student borrowers under the age of 30 account for 34% of the country’s loan balance.  With 15% of the student loans falling in the private loan category, the private student loan balance per student under the age of 30 is around $3,500.
According to the last U.S. census, there were around 42 million U.S. citizens between the ages of 10 to 19 years in 2010. This populace will be eligible for attending college in this decade. The Bureau of Labor Statistics has reported that nearly 66% of high school graduates enroll in colleges or universities in the U.S. Extrapolating this figure to the end of the decade, we can expect around 28 million enrollments in universities in this decade. Around 60% of Americans attending college apply for student loans to help cover costs, giving us a base population of close to 17 million. With $3,500 in private student loans per student, we get a total $57 billion in private student loans to be borrowed in this decade. If Discover maintains its 5% market share then it can add close to $2.8 billion to its student loan portfolio, giving us a balance of around $10 billion by the end of the decade.
In the last two years that it has expanded its private student loan portfolio, Discover has maintained an interest yield of 6.4%. If the company maintains this rate, we expect the revenue contribution from the direct banking segment to go up from 10% to 17% by the end of the decade. Federal student loan rates are expected to double from 3.4% to 6.8% from July 1. Although the Obama administration is contemplating strategies for preventing the rate increase to curb expenses on students, it is likely that a Federal rate increase would be mirrored by an increase in private student loan rates.  We will closely monitor the situation and update our model as it develops. You can modify the interactive chart below to gauge the effect a change in forecast would have on our price estimate for Discover’s stock.Notes: