Discover Maintains Solid Growth On Cards And Direct Banking

Discover Financial (NYSE:DFS) reported 15% year-on-year growth in net income for the second quarter of 2013 as total loans grew 6% over the prior year to $61.7 billion. Credit card loans expanded by 5% over the prior year with 30 day delinquency rate reaching a record low of 1.58%. The card sales volume increased by 4%, year-on-year.

Credit cards account for 80% of Discover’s revenues and gross profits with 65% of the company’s  revenue coming from interest earned on credit loans and another 15% from discount and interchange fees. Discover 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, and we believe it is set to benefit from the improving economy.

To arrive at a price estimate for Discover, we have used a modification of the dividend discount model (DDM). In our model, we are estimating the total income that can be returned to shareholders – through dividends and share repurchases – and discounting this value back to the present. Earlier this year, Discover’s board approved a $2.4 billion share repurchase program and also increased te quarterly dividend from $0.14 to $0.20 per share of common stock. ^[1] Given the company’s recent performance and improvements in  the macro-economic environment, which will allow a higher rate to be returned to shareholders, we expect the company’s payout ratio to reach 72% by the end of our forecast period, implying a terminal return on equity (ROE) of 8.5%. Using this methodology, we have arrived at a price estimate of $47 for Discover’s stock.

See our complete analysis of Discover Financial here

Cards Remain Strong

Discover’s card, which was launched in the first quarter of 2013, drove strong account growth through the quarter, helping the aforementioned growth in the credit card business. However, an increase in promotional rate balances coupled with a decline in higher rate balances led to a 24 basis point decline in the credit card yield. 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%, and Discover has managed to stay ahead of the market in this respect. ^[2] We expect the company’s credit card yield to improve in the coming years.

Please read Looking At The Value Of Discover Financial’s Credit Cards Business for more on Discover’s credit card business.

Direct Banking Expansion

Discover is looking to expand 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. Discover home loans, which was launched in June last year, originated $1 billion in direct mortgages in the three months ending June. Personal loans grew from $2.9 billion at the end of the second quarter of 2012 to $3.6 billion with the interest yield improving from 6.49% to 6.52%.

Student loans are the most important aspect of the direct banking business, and the company reported 5% year-on-year growth in the student loan portfolio this quarter. The interest yield on the loans improved from 6.48% to 6.52% while the delinquency rate declined by 10 basis points to 1.38%. The senate has recently agreed to link student loans to financial markets, which could lead to high interest rates and subsequently higher yield from these loans in the coming years as the U.S. economy improves. ^[3]

Also, an increase in Federal loan rates can drive growth the private student loan domain in the coming years. Please read our article: Discover Financial: A Look At The Student Loans Business for more

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1. Discover Announces $2.4 Billion Share Repurchase Program and Plans to Increase Quarterly Dividend, Press Release [↩]
2. Delinquency Rate On Credit Card Loans, All Commercial Banks, Board of Governors of the Federal Reserve System [↩]
3. Senate reaches deal to restore lower college loan rates for most students in coming year [↩]