How Consumer Spending Trends Will Affect Discover Financial

Improvements in the job and housing markets in the U.S. have spurred an increase in consumer spending. ^[1] According to a recent Bloomberg report, the expenditure on goods and services increased 0.3% in July following growth of 0.5% in June, marking the third consecutive month of positive growth. Personal consumption expenditures (PCE) in the U.S. have climbed 2% since the turn of the year. ^[2] Discover Financial (NYSE:DFS) is one of the companies to gain from this trend. Despite the company’s recent foray into mortgage and personal loans, interest income from credit card loans is still the most important source of income for Discover, accounting for 60% of its revenues.

Our $47 price estimate for Discover Financial is in line with the current market price.

See our complete analysis of Discover Financial here

Market Share

Discover’s share of the total revolving credit owned and securitized, outstanding grew from 4.8% at the end of 2008 to 5.5% at the end of 2012. The company further gained in 2013, reaching a market share of 5.8% at the end of the second quarter. The job market in the U.S. has shown continuous signs of improvement with the unemployment rate reaching a four-year low of 7.4% in July down from 7.8% at the end of 2012 and over 10% at the height of the financial crisis in 2009. ^[3]

PCE as a percentage of actual disposable income in the U.S. (the income available to an individual for spending after paying taxes) dipped from 96% in 2007 to 91% in 2008 and 2009 as a direct consequence of the economic downturn observed worldwide during this period. However, the percentage has improved back to 94% in the last three years as the economy has improved. ^[4] Given these positive trends, we expect a 2% growth rate in total revolving credit in the U.S. in the coming years. With Discover maintaining a market share of around 5.5%, our current forecast accounts for 2% to 3% annual growth in Discover’s credit loan portfolio through the decade. There is a 10% upside to our price estimate should Discover’s market share increase to 6.6% as our estimate for average credit card loans go up nearly 20% in this scenario.

Discover’s net interest yield from credit card loans has been around 9.5% in the last three years, and we expect it to remain around the same level in the coming years. As the loan balance increases, the net interest income will expand by around 20%.

Although recent trends have been optimistic, they must be assessed with caution. The Discover Spending Monitor, which tracks consumer spending intentions across the U.S., fell 4 points in July. The current level is down 7.6 points from the base level of 100 in May 2007. PCE as a percentage of actual disposable income in the U.S. have dropped to 92.6% — indicating that the economic recovery might not be as swift as expected. Revolving credit as a percentage of disposable income in the U.S. has been around 8.3% in the last three years. Our current forecast expects a gradual recovery in consumer loans with revolving credit reaching the pre-recession level of 9% of disposable income. However, there is 5% downside to our price estimate for Discover’s stock should consumer spending not recover as expected with total revolving credit dropping to around 8% of disposable income. This would lead to a 10% decline in our estimate for Discover’s credit card loan portfolio and a similar decline for net interest income.

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1. Consumer Spending Probably Climbed in July: U.S. Economy Preview, August 25, Bloomberg [↩]
2. Personal Consumption Expenditures, U.S. Department of Commerce: Bureau of Economic Analysis [↩]
3. U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]
4. Disposable personal income, U.S. Department of Commerce: Bureau of Economic Analysis [↩]