Growing Card Sales, Loss of Network Merchants Impact Discover’s Earnings

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DFS: Discover Financial Services logo
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Discover Financial Services

Discover Financial Services (NYSE: DFS) announced its fourth quarter and full year 2014 earnings on Wednesday, January 21. The company reported a 33% year-over-year decrease in net income to $404 million for the quarter. [1]. The decline in net income was partly due to changes in the structure of the company’s customer rewards program, though they benefited from a modest increase in credit card loans, credit card sales and payment services transaction volume. [2]

The quarter also saw an 11% year-over-year increase in expenses, primarily due to increased marketing expenses, a 14% year-over-year increase in the card and personal loan segment. The company also incurred higher professional fees of $128 million and an increased investment in web and mobile technology. Overall, 2014 total expenses increased by 5% compared to 2013.

Our price estimate of $64 for Discover’s stock, which is little over 10% higher than the current market price. We are in the process of updating our model to reflect the reported earnings.

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Growing Loans Drive Direct Banking

Discover’s Direct Banking business includes credit cards, student loans, personal loans, home loans and deposits. In the last quarter, this segment saw a 29% year-over-year decline in pretax income to $646 million. The decrease in income over the last quarter was the result of a one-time elimination of $178 million of credit card rewards forfeiture reserves. For 2014 as a whole, pretax income increased by 7% to $3.6 billion as compared to 2013.

Credit Cards

In the fourth quarter, Discover’s card sales volume increased by over 4% compared to the prior year.  During the same period, credit card loans grew by 5.6% year-over-year. The net charge-off rate increased by 17 basis points to 2.26% which is still below the industry average. [3]

Going forward, Discover plans to invest $35 million in 2015 to introduce chip-enabled credit cards, as a part of its enhanced security features.  [4] The company is expected to shell out an additional $75 million in the same year to meet regulatory requirements pertaining to anti-money laundering programs and the Bank Secrecy Act.

Student and Personal Loans

In the last quarter, total loans grew by 6.5% to $69.9 billion, while personal loans grew by 19.5% and private student loans grew by 4.4% over the prior year. Non-card receivables grew by approximately 10%. This was driven by an increase in private student and personal loans.

Loss Of Co-Branded Merchants Hits Payment Services

The Payment Services segment is comprised of PULSE, Diners Club International and cards issued by third-party networks. In the last quarter, Payment Services witnessed a 92% decrease in pretax income. This was largely because Diners Club Italy was held-for-sale during the period.

Payment Services revenues declined by $6 million in the last quarter compared to the previous quarter of 2014 as the company lost Sam’s and Wal-Mart (NYSE:WMT) as network partners to MasterCard. [5] In total, the total volume generated by network partners was down by 13% year-over-year to $350 million. This was partially offset by the volume generated by AribaPay, a cloud based service formed by Ariba and Discover to digitize Business-to-Business payments. [6]

Payment Services transaction dollar volume increased by 2% to $51 billion when compared to the prior year. The transaction dollar volume of PULSE transaction increased by 4% year-over-year and the volume of Diners increased by 2%, largely driven by growth in Asia-Pacific and Latin America.

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Notes:
  1. Form 8-K, SEC Filings []
  2. Discover Financial Services’ (DFS) CEO David Nelms on Q4 2014 Results — Earnings Call Transcript, Seeking Alpha []
  3. Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks, Board of Governors of the Federal Reserve System []
  4. Discover to spend $35M next year on credit, debit cards with microchips, Chicago Tribune []
  5. Discover Financial Services’ (DFS) CEO David Nelms on Q4 2014 Results — Earnings Call Transcript, Seeking Alpha []
  6. Ariba and Discover to Transform B2B Payments with AribaPay, BusinessWire []