Discover Financial (NYSE:DFS) reported an 11% increase in net income for the fourth quarter of 2013, beating market earnings estimates.  Net revenues were up 6%, driven by a 5% growth in the loan portfolio and a 3% increase in sales volume. Low interest charge-offs allowed for a 42 basis point net interest margin expansion as the net interest income grew 10% over the prior year. Discover has been expanding its direct banking facilities, offering personal, home and student loans but credit cards remain its most important business; credit card loans account for 80% of the company’s loan portfolio.
Discover was able to maintain a 4% card receivable growth rate, higher than the overall market growth of 1%.  The company’s share of the total outstanding revolving consumer debt has gone up from 5.3% at the end of 2011 to 6% in the last quarter. Discover has been able to maintain growth through lucrative card schemes such as 0% introductory APR on purchases for 15 months along with 5% cash back on quarterly rotating categories and 20% cash back bonus on online shopping.  Management expects future growth to be at the top end of the targeted 2% to 5% range. Discover’s historical performance suggests that it will be able to achieve this target as the U.S. economy improves.
Our $47 price estimate for Discover Financial implies a discount of 15% to the current market price. We will update our model shortly to reflect the reported earnings.
- Discover Beats Expectations In Q3; Charge-Off Rates, Account Growth At Record Levels
- Q2 2015 Banking Review: Credit Card Payment Volumes
- Q2 2015 Banking Review: Credit Card Charge-Off Rates
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- Discover’s Net Income Declines Due To One-Time Expenses, Portfolio Reshuffle To Boost Margins
- Q1 2015 Banking Review: Credit Card Charge-Off Rates
Americans are coming out of the recession shell and are once again looking to spend rather than save; personal saving as a percentage of disposable personal income has gone down from 6.6% in the fourth quarter of 2012 to 4.9%.  This trend has been supported by improvements in the job market, which saw the unemployment rate dip below 7% in December.  Wages and salaries increased 4% in the third quarter of 2013 with a 5% increase in service-producing industries.  This growth in income was one of the reasons for the 3.9% increase in 2013 holiday retail sales, despite the adverse weather conditions. 
We believe Discover should be able to maintain loan growth as consumer confidence improves in the coming years.
The high loan growth rate might suggest that Discover has been willing to offer loans without prudence, but this is not the case; the company’s credit card net charge-off rate was 2.09% during the fourth quarter and the 30-day delinquency rate was 1.72%. Both these rates are much lower than the industrial average.  The charge-off rate on credit card loans for the 100 largest banks in the U.S. is around 3.3% while the delinquency rate is around 2.5%. Low charge-offs have helped the company’s yield, which improved 6 basis points in the fourth quarter to 12.08%.
Discover did not sell off any of its charged-off accounts after the recession and thus benefited as the U.S. economy improved with strong recoveries on its inventory of charge-offs. However, in the coming years, the company does not expect the same level of recoveries and is making adjustments to its loan reserves. Provisions for loan losses increased 27% through 2013. We expect the provisions to reach pre-recession levels in the next three years.
Expansion In Other Areas
Discover’s Discover Bank subsidiary offers student loans, personal loans and deposit products. The company originated around $2.5 billion in personal loans and over $1 billion in student loans through 2013. Personal loans were up 27% over the prior year, accounting for 6% of the company’s portfolio. Student loans grew 5%, accounting for 13% of Discover’s loan portfolio. The student loan net charge-off rate increased 41 basis points over the prior year while delinquencies were up 6 basis points to 1.66%. Discover accounts for 5% of student loans in the U.S. and can achieve more growth in this area. 
Discover acquired the student-loan portfolio from Citigroup (NYSE:C) in September, 2011 and the Home Loan Center business from Tree.com, in 2012. The company now offers prime variable, fixed-rate conventional, and Federal Housing Administration (“FHA”) mortgage loans through its Discover Home Loans subsidiary. In 2013, Discover originated $4 billion in mortgages and management has suggested that it will scale up marketing and operations in 2014. We will keep a close eye on this segment going forward.Notes:
- Discover Financial Services Management Discusses Q4 2013 Results – Earnings Call Transcript [↩]
- Consumer Credit Outstanding (Levels) [↩]
- Cash Back or a Low Interest Credit Card, Which is Better? [↩]
- Table 2.1. Personal Income and Its Disposition (A) (Q) [↩] [↩]
- U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]
- Holiday Retail Sales Come in at NRF Expectations, Press Release, January 14, 2014 [↩]
- Charge-Off Rate On Credit Card Loans, Top 100 Banks Ranked By Assets, Board of Governors of the Federal Reserve System [↩]
- Consumer Finance Protection Bureau [↩]