Earnings Preview: Why We Expect Discover To Under Perform

Discover Financial Services (NYSE: DFS) is set to report its earnings for the second quarter of the fiscal year 2016 on Tuesday, July 19th. The company’s two most valuable business segments are related to the sales of Discover’s Credit Cards and the origination of loans, especially Student Loans. The former segment generates revenue by two means: 1) the discount and interchange fee and merchant fees charged by Discover for access to its payment network; and, 2) the interest charged on outstanding credit card loans. The latter is by far the biggest source of revenue for the company. As a result, the company’s biggest focus in recent years has been on increasing the number of Discover credit cards in circulation and offering incentives to try and increase the average spend per customer on credit cards.

Over the past four years, the growth in the number of transactions on Discover’s card network has been declining. The number of transactions has grown from 1.72 billion in 2011 to just over 2.03 billion in 2015, but the growth rate has declined each year- from 7.3% in 2011, 7.1% in 2012, 5.6% in 2013, 3.8% in 2014 and just 0.6% in 2015. This puts downward pressure on the outstanding credit card loan amount on Discover’s credit cards and hence its interest income. One of the factors that has been suppressing the number of transactions has been the high amount of household indebtedness in the U.S. A combination of mortgage debt, student loan debt and high rental payments have put downward pressure on average consumer spend and the limited amount of reprieve given by low oil prices over the past 18 months have been funneled into short term consumables, as evidenced by the increase in e-commerce sales in recent months. Since, oil prices have started to increase again, we expect the same sluggish growth in number of transactions and hence outstanding credit card loans to continue through 2016. One thing that could offset these trends is the increasing adoption of mobile payments in the U.S. economy. This is one reason why we project EPS for 2016 to be below consensus levels.

Mobile phone payments are rapidly gaining popularity, coinciding with the surge in smartphone sales. The global volume of money spent using mobile phones is expected to grow to about $617 billion by the end of 2016 from around $490 billion in 2015. As most mobile payments are linked to credit or debit cards, this should drive volumes. Also, it has to be noted that Discover’s pre-tax earnings have fallen in recent quarters, but it has still reported increases in EPS, a result of high share buyback activity. This is another factor that could offset the impact of rising oil prices and low growth in consumer demand.

Have more questions about Discover? See the links below:

• How Much Did Discover’s Revenue & Net Profit Grow In The Last Five Years?
• How Much Can Discover’s Revenue Grow In The Next Five Years?
• What Is Discover’s Fundamental Value Based On Expected 2016 Results?
• How Has Discover’s Revenue Composition Changed In The Last Five Years?

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