Despite the overall growth in sales volume and loans, Discover Financial (NYSE:DFS) reported an 8% decline in net income for the third quarter, missing market expectations.  Revenues were up 3% over the prior year, driven by a 5% increase in total loans and a 3% rise in card sales volume. However, this growth was offset by a $197 million increase in provision for loan losses, which reached a total of $333 million for the three months ending September. While this increase in loan loss reserve was partially due to loan growth, it was also affected by lower expectations of recoveries on well-aged charge-offs (loans that are considered nonredeemable). The company 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, Discover does not expect the same level of recoveries and is making adjustments to its loans reserve.
The company’s stock dropped 4% in after hours trading following the announcement of its third quarter financial results. Accounting for the company’s policy to increase provisions for loan losses, we are adjusting our price estimate for Discover Financial to $46 implying a 10% discount to the current market price. Credit cards are the company’s most important product. Nearly 80% of Discover’s revenues and gross profits come from credit cards with interest on credit loans accounting for 65% of the company’s revenue and discount and interchange fees accounting for another 15%.
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Provisions Will Increase As The Economy Goes Back To Normal…
The 2008 recession shook consumers across the U.S. as credit card customers started paying off their loans in time in order to avoid staying in debt during the financial crunch. The delinquency rate on credit card loans for all commercial banks in the U.S. dropped from 6.76% in the second quarter of 2009 to 2.52% in the second quarter of 2013.  In the same period, the charge off rate on credit card loans for the top 100 banks ranked by assets in the country dropped from 9.59% to 3.53%. 
Discover has a reputation for effectively managing risk and has maintained lower delinquency and charge off rates than the credit card industry as a whole. Its delinquency rate for loans over 30 days due was 4.92% in 2009 but dropped to 1.75% in 2012. The net principal charge off rate dropped from 7.45% in 2009 to 2.29% to 2012. This was the primary reason for the elevated recoveries on charged-off accounts. The company’s charge-off rate hit a historic low of 2.05% in the third quarter but the credit card delinquency rate for loans over 30 days past due increased 9 basis points from the prior quarter to 1.67%.
Discover expects the recovery rate to decline in the coming years and is making adjustments to its reserves for loan losses. Provisions for loan losses were around 2.7% of average credit card loans in 2008 but increased to over 6.5% in 2010 before dropping to 1.55% in 2012. We expect the provisions to reach pre-recession levels in the next three years.
…But So Will Spending
Discover reported a 4% increase in credit card loans for the third quarter while sales volume increased 3%. Consumer spending trends have been improving through the year; consumer purchases increased 0.3% in August, the fourth consecutive increase in monthly spending reported by the U.S. Commerce Department.  This trend was influenced by a 0.4% increase in wages  as the unemployment rate in the country dropped to a four year low of 7.3%. 
Last week, Capital One (NYSE:COF) and American Express (NYSE:AXP) both reported increases in U.S. card spending with the latter reporting 8% growth in U.S. card-member spending. Discover accounted for around 1% of the personal consumption expenditures (PCE) in the each of the last five years, and we expect it to benefit from improving customer spending trends.  Discover has also maintained a market share of 5.3% to 5.5% of the total revolving credit owned and securitized, outstanding across the U.S. for the last four years and is expected to sustain loan growth in the coming years.
Direct Banking Remains On The Growth Track
Apart from credit cards, Discover also offers personal loans, student loans and home loans. The direct banking business currently accounts for just 10% of Discover’s revenue but has been expanding. The company acquired the student-loan portfolio from Citigroup (NYSE:C) in September 2011, and the Home Loan Center business from Tree.com in June last year. Through the third quarter, private student loans increased 5%, coming out of the CitiAssist brand, while personal loans surged 26% over the prior year. The company also started offering home equity loans in August to capitalize on the recovering housing market. We will keep a close eye on the performance of the direct banking segment in the coming quarters.Notes:
- Discover Financial Services Management Discusses Q3 2013 Results – Earnings Call Transcript [↩]
- Delinquency Rate On Credit Card Loans, All Commercial Banks, Board of Governors of the Federal Reserve System [↩]
- Charge-Off Rate On Credit Card Loans, Top 100 Banks Ranked By Assets, Board of Governors of the Federal Reserve System [↩]
- Consumer Spending in U.S. Climbs 0.3% as Incomes Pick Up, Bloomberg [↩]
- U.S. consumer spending rises as wages boost family income, Reuters [↩]
- U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]
- Personal Consumption Expenditures, U.S. Department of Commerce: Bureau of Economic Analysis [↩]