Discover’s Earnings Will Gain On Spending Recovery, Banking Expansion

Discover Financial (NYSE:DFS) is expected to report earnings for the second quarter after the close Tuesday. The company reported a 10% annual revenue growth for the first quarter and is expected to continue its steady growth.

Although the company is expanding its direct banking services, the focus will largely be on the credit card business, which accounts for 80% of Discover’s revenues and gross profits. A recovering economy and improving consumer trends are likely to help Discover, which has maintained a market share of 5.3% to 5.5% of the total revolving credit owned and securitized, outstanding across the U.S. for the last four years.

See our complete analysis of Discover Financial here

The U.S.  economy is now on the road to recovery highlighted by the remarkable decline in unemployment rate from the peak of 10.1% observed during the financial crisis in 2009 to a four-year low of 7.5% in April, staying at 7.6% in May and June. This lower unemployment rate indicates a general recovery in the job market, which will lead to higher disposable income and subsequently higher spending. ^[1] The Discover U.S. Spending Monitor has shown improving consumer trends throughout 2013. Given its market position, Discover is likely to gain from the improving economy.

Around 65% of Discover’s revenue comes from interest earned on credit loans and another 15% from discount and interchange fees. The company earns an annualized yield of 9.5% on its credit loan balance. Discover has managed to maintain this rate by staying above the industry. The delinquency rate or the percentage of total loans that are past due date on credit card loans for all commercial banks in the U.S. is around 2.62%, ^[2] Discover has stayed ahead of the market with a delinquency rate of 1.77% for loans over 30 days due. Please read Looking At The Value Of Discover Financial’s Credit Cards Business for more on Discover’s credit card business.

Expanding Direct Banking Business

Discover’s Discover Bank subsidiary 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. The company expanded the business with the acquisition of the student-loan portfolio from Citigroup (NYSE:C) in September, 2011and the acquisition of the Home Loan Center business from Tree.com, in June last year.

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.

The student loan portfolio is quite important for the company. Discover has a market share of 5% of the private student loan debt in the U.S. ^{[3] [4]} The company has maintained an interest yield of 6.4% on its student loan portfolio in the last two years. The senate has recently agreed to link student loans to financial markets, which could lead to higher yields from these loans in the coming years as the U.S. economy improves and interest rates rise. ^[5]

Discover originated close to $1 billion in direct mortgages in the last quarter. The housing market is now on the road to recovery after the 2009 collapse. ^[6] In February 2013, housing starts were recorded at 917,000, representing a y-o-y increase of 28%. ^[7] Although the U.S. housing market fell in June, ^[8] industry experts estimate housing starts to reach normalized levels of about 1.6 million by 2015. ^[9] We expect the recovery in the market to fuel growth for Discover’s direct banking segment.

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1. U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]
2. Delinquency Rate On Credit Card Loans, All Commercial Banks, Board of Governors of the Federal Reserve System [↩]
3. Consumer Finance Protection Bureau [↩]
4. Federal Reserve Bank of New York’s quarterly report [↩]
5. Senate reaches deal to restore lower college loan rates for most students in coming year [↩]
6. CSX’s Management Presents at JPMorgan Aviation, Transportation and Defense Conference (Transcript), Seeking Alpha, March 6, 2013 [↩]
7. Housing Starts, Mortgage News Daily [↩]
8. U.S. housing starts fall to 10-month low; weather blamed [↩]
9. Union Pacific’s Management Presents at JPMorgan Aviation, Transportation and Defense Conference (Transcript), Seeking Alpha, March 06, 2013 [↩]