Discover Beats Expectations In Q3; Charge-Off Rates, Account Growth At Record Levels

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Discover Financial Services

Earlier this week, Discover Financial Services (NYSE:DFS) released its earnings for the quarter ended September 30th. The company managed to beat expectations for the third consecutive quarter, as spending in the U.S. continued to grow at a healthy level. [1] Earnings per share for the quarter stood at $1.38, exceeding the consensus estimate of $1.34 [2].

Key highlights from the quarter were record-low net charge-off rates (<2% vs. guidance of 2.5%) and strong growth in card receivables (4%) despite headwinds in the form of low gas prices. While credit risk remains in check, Discover seems to be shifting some of its marketing expenditures into promotional rewards to drive the addition of new accounts and payment volumes. Despite the lower marketing expense and a heightened competitive environment, the company was able to achieve the highest quarterly level of new accounts since Q3 2007. Going forward, operating costs are expected to come down as some of the expenses incurred this quarter will likely not recur, resulting in improved operational efficiency.

In this article we take a closer look at some of the trends discussed above and assess their impact on future earnings. We are in the process of updating our model after the earnings release.

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See the full Trefis analysis for Discover

Spending Could Grow In The Near Term

During the months of July and August, month-over-month growth in personal spending came in at 0.4% supported by steady wage growth of 4% [3]. This helped the company achieve solid growth of 4% in card receivables this quarter. It is important to note that Discover was able to achieve credit card loan growth despite headwinds in the form of low gas prices. Q3 had the largest impact from low gas prices, evident from a 30% decline in Discover card member gas purchases.

Going forward, the additional savings generated from low oil prices could lead to higher consumer spending on other goods and services. However, there is generally somewhat of a lag between falling gas prices and any impact on spending, and many times the savings are initially used for debt repayment rather than spending. Nevertheless, this trend should ultimately benefit Discover.

Focus On Promotional Programs Ahead Of Holiday Season

November and December are important months for players in the credit card space because of the holiday season. This period accounts for nearly 20% of the retail industry’s annual sales in the U.S., which also makes Q4 the highest in terms of payment volumes. According to consultancy firm AlixPartners, retail sales are expected to grow between 2.8% and 3.4% during this year’s shopping period. [4] While retailers try to attract customers by offering low prices, credit cards offer higher rewards on purchases. Discover seems to be moving in this direction ahead of the holiday season.

In the recently concluded quarter, the company’s rewards rate stood at 107 basis points, 5 basis points higher year-over-year and 2 basis points up sequentially, driven by promotional programs. During the earnings call, management indicated that the pressure on the rewards front is likely to continue due to the highly competitive environment, and expects the Q4 rewards rate to increase to 115 basis points. However, the level of new account additions seen during Q3 and the improvement in customer satisfaction rankings (per the 2015 J.D. Power survey for credit cards) suggest that Discover is benefiting from the promotional activity.

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Notes:
  1. United States Personal Spending, Trading Economics []
  2. Nasdaq []
  3. United States Wage Growth, Trading Economics []
  4. Reuters []