Discover’s Shares Worth $75 Despite Industry Headwinds

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DFS: Discover Financial Services logo
DFS
Discover Financial Services

Discover Financial Services (NYSE: DFS) saw its stock price reach an all-time high of $74 in January before investor concerns about a jump in card charge-off rates across the industry kept it around $60 between May and September. But with the Fed’s rate hikes boosting revenues for all card lenders, and with investors recognizing the ongoing normalization in card charge-off rates, the bank’s stock has regained most of its lost value over recent months. It should be noted that Discover’s current share price of $67 is more than double its book value of $30.56 at the end of Q3 2017. However, we believe that there is still considerable upside to the financial institution’s shares, because of which we maintain a $75 price estimate for Discover’s stock. And this does not even consider the fact that Discover’s end-to-end payment processing service makes it a great acquisition target for the country’s largest banking giants. including JPMorgan Chase (NYSE:JPM) and Wells Fargo (NYSE:WFC) (see Now May Be The Best Time For Wells Fargo To Consider Acquiring Discover).

See our complete analysis for Discover

In our opinion, there are two key factors responsible for this upside: the company’s business model, which primarily relies on credit cards and personal loans; and its strong capital return plan.

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While the card and personal loan segments carry higher risk compared to mortgages or commercial loans, they more than make up for this by generating high interest yields. Discover’s card loans had an interest yield of 12.15% over Q3, while the yield figure for personal loans was 12.33%. The Fed’s rate hikes have only helped Discover’s interest revenues, as its net interest margin figure jumped from just under 10% in Q3 2016 to almost 10.3% in Q3 2017. For perspective, this compares to a net interest margin figure of around 3% for U.S. Bancorp, which relies on the traditional loans-and-deposits business model.

Over recent years, Discover has seen its bottom line benefit greatly from the unusually low card charge-off rates that followed the spike in charge-offs immediately after the economic downturn. The higher charge-off figure across the industry over the last three quarters was a largely expected correction, and does not take away from the potential top-line gains going forward. This belief is only reinforced by the fact that the Fed is taking a cautious approach towards hiking rates by closely monitoring key U.S. economic indicators – something that is expected to maintain a stable economic outlook for the country over the foreseeable future. This, in turn, should help keep loan charge-offs fairly constant going forward.

At the same time, Discover has done well since 2012 to steadily increase the amount of cash it returns to shareholders in the form of dividends and share repurchases. The company returned almost $4.6 billion to shareholders over 2015-16. This is equal to Discover’s total net income figure over this two-year period – indicating a total payout ratio of 100%. And we expect the total payout ratio to increase further to 120% in 2017 (as the company pays out ~$2.7 billion from expected net income of $2.25 billion) before gradually settling in the 70-75% range in the long run. In fact, the sizable share repurchases over recent quarters are primarily responsible for the reduction in Discover’s common equity tier 1 (CET1) capital ratio from 13.8% in Q3 2016 to 12.5% now. This decline is not a cause for concern, though, as the bank has a comfortable buffer over the minimum required level of 7%.

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