Discover Financial Earnings Preview: Focus On Loans, Losses And Direct Banking

Discover Financial (NYSE:DFS) is scheduled to report earnings for the first quarter of 2014 on Tuesday, April 22. ^[1] The company 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 beat market estimates for the December quarter, with an 11% increase in net income helped by a 6% growth in revenues. The loan portfolio grew 5% while the sales volume increased 3% over the prior year. We expect slightly lower growth this time around.

Our $46 price estimate for Discover Financial implies a discount of 20% to the current market price.

See our complete analysis of Discover Financial here

Loan Growth Will Be Important

Like American Express (NYSE:AXP), Discover operates a closed-loop network, issuing credit cards directly to consumers and allowing them to maintain revolving credit card balances on which the company earns interest. This interest income accounts for more than 60% of Discover’s revenues. Discover’s business is not volume driven but is more reliant on the loan balance that the company is able to maintain and the interest it can earn on this balance.

Discover was able to maintain a 4% card receivable growth rate through 2013, higher than the overall market growth of 1%. ^[2] The company’s share of the total outstanding revolving consumer debt went up from 5.3% at the end of 2011 to 6% in the December.

The U.S. unemployment rate was around 7.9% at the start of 2013 but has dropped to 6.7%, suggesting that the economy is improving. ^[3] Americans are also more inclined to spend now; personal savings as a percentage of disposable personal income dropped from 6.6% during the fourth quarter of 2012 to 4.3% in the December quarter of 2013. ^[4] Discover’s competitor American Express recently reported a 4% increase in its U.S. loan balance. Given Discover’s historical performance, we expect to report a growth rate at the top end of the 2% to 5% range provided by management during the last conference call. ^[5]

The Company Will Have To Manage Reserves

Discover has to bear credit risk on the loans it issues to cardholders. This risk can be measured in terms of the delinquency rate, or the percentage of total loans that are past due date and the charge off rate, which is the percentage of loans that are considered unredeemable.

Discover has maintained a good risk profile and its credit card net charge-off rate was 2.09% during the fourth quarter of 2013, while the 30-day delinquency rate was 1.72%. This was lower than the 2.3% delinquency rate on credit card loans for all commercial banks in the U.S. ^[6] and the 3.28% charge off rate on credit card loans for the top 100 banks ranked by assets in the country. ^[7]

Discover did not sell off any of its charged-off accounts after the 2008 financial crisis and was able to record strong recoveries on its inventory of charge-offs as the U.S. economy recovered. As a percentage of average credit card loans, the provisions for loan losses were around 2.76% in 2008 but increased to 6.63% in 2010. In 2011 and 2012, the company benefited from the recoveries and its provisions as a percentage of average credit card loans fell to 1.54%. 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 will monitor this figure through the coming quarters. You can modify the interactive chart below to gauge the effect a change in forecast would have on our price estimate.

Expansion In Direct Banking Services

Discover’s Discover Bank subsidiary offers student loans, personal loans and deposit products. In 2013, the company originated around $2.5 billion in personal loans and over $1 billion in student loans. Student loans grew 5%, accounting for 13% of Discover’s loan portfolio while personal loans were up 27% over the prior year, accounting for 6% of the company’s portfolio. Discover accounts for 5% of student loans in the U.S. and can achieve more growth in this area. ^[8]

In 2012, Discover the Home Loan Center business from Tree.com following up the acquisition of Citigroup’s (NYSE:C) student-loan portfolio in 2011. 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 for future prospects.

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1. Discover Financial Services Announces First Quarter 2014 Earnings Release and Conference Call, Investor Relations [↩]
2. Consumer Credit Outstanding (Levels) [↩]
3. U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]
4. Table 2.1. Personal Income and Its Disposition (A) (Q) [↩]
5. Discover Financial Services Management Discusses Q4 2013 Results – Earnings Call Transcript [↩]
6. Delinquency Rate On Credit Card Loans, All Commercial Banks, Board of Governors of the Federal Reserve System [↩]
7. Charge-Off Rate On Credit Card Loans, Top 100 Banks Ranked By Assets, Board of Governors of the Federal Reserve System [↩]
8. Consumer Finance Protection Bureau [↩]