Discover’s Shares Look Undervalued Despite Mixed Q1 Results

by Trefis Team
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Discover Financial Services (NYSE: DFS) reported mixed performance figures for the first quarter of 2018 late last week, with the cards and payments company marginally beating investor expectations for a seasonally slow period. We have summarized Discover’s Q1 2018 earnings and also detailed the major takeaways from the announcement in our interactive dashboard for the company, the key parts of which are captured in the charts below.

The first quarter is seasonally a slow period for the payment industry (and for retail banking operations as a whole), and the impact of this is evident from the sequential reduction in loan balances as well as payment volumes for Discover. However, the company did well to grow its card balances by 10% year-on-year – well above the figure of 7% for the U.S. card industry as a whole according to data compiled by the Federal Reserve. The company’s payment volumes have also been on an uptick over recent quarters, with volumes for its network partners in particular growing substantially compared to the year-ago period.

The single biggest concern investors have expressed with Discover’s performance over recent quarters is the steady increase in loan charge-off rates, which have forced the company to set aside more cash as loan provisions. While increasing charge-off rates present a sizable downside risk to Discover’s value, it should be noted that this trend is not specific to the company and has been observed across the industry due to a normalization in loan charge-off rates from the record low levels seen in late 2015. We believe that loan losses will stabilize for all lenders in the near future. Accordingly, we stick to our $88 price estimate for Discover’s stock. Our estimate is almost 25% ahead of the current market price.

See our full analysis for Discover Financial here

Net Interest Margin Fell In Q1, Weighing On The Top Line

The rate hikes implemented by the Fed process has helped the interest rate environment in the country recover steadily from the record-lows seen over 2014-15. However, a faster increase in interest expenses compared to interest incomes resulted in a reduction in Discover’s NIM figure to 10.23% for Q1 2018 from 10.28% in the previous quarter. There were two key reasons for this trend: seasonality, which results in a notable reduction in card loan balances over the first quarter, and normalization in loan charge-off rates, which reduced the interest income.

Total Volumes Seasonally Lower, But Payments For Partner Networks Jumped In Q1

The first quarter of a year is seasonally the slowest period for the cards and payments business, with the fourth quarter being the strongest period. Taking this into consideration, there was a smaller-than-expected reduction in total card payment volumes for Discover in Q1 2018 compared to the prior quarter. Discover’s growing list of network partners had a visible impact on payment volume, as network partners contributed more than 5% of total payments for the first time ever.

Margins Have Shrunk, But Trend Should Reverse 

Although revenues have remained under pressure over recent quarters, Discover has continued to incur higher operating costs to ward of competition. Q1 2018 was particularly bad on both fronts, as revenues were seasonally lower although compensation expenses were seasonally higher. Taken together with a steady increase in loan provisions over the last five quarters, this has led to a reduction in EBT margin for the company from over 37% in Q1 2017 to 33% now.

Going forward, as the provision figure normalizes and as Discover leverages its strong card loan portfolio to grow revenues, margins should improve considerably.

We expect Discover to report EPS of $7.65 for full-year 2018. Taken together with a P/E ratio of 11.5 (which we believe is appropriate for the card lender), this works out to a price estimate of $88 for Discover’s shares, which is almost 25% ahead of the current market price.

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