Strong Card Industry Outlook Justifies $89 Price Estimate For Discover’s Stock

Discover Financial Services (NYSE: DFS) reported a fairly underwhelming performance for the second quarter late last week, as it failed to meet investors’ revenue expectations though it narrowly beat EPS estimates. We have summarized Discover’s Q2 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.

Notably, Discover reported strong growth in card loans over the quarter, with outstanding card balances jumping 10% compared to the period a year ago. While this had a positive impact on card purchase volumes for the quarter, the company also witnessed a 14% increase in volumes for its payment services division. The only reason these trends did not lead to a sizable boost in the top line was because of the impact of a flattening yield curve on the net interest income figure, and from a jump in rewards costs (treated by the company as contra-revenue, which reduces its discount and interchange fees).

More importantly, the current economic conditions in the U.S. are perfectly suited for companies like Discover which rely primarily on short-term consumer credit to make money – specifically on card and other personal lending. A strong outlook for the economy helps individuals take on unsecured debt, while extremely low unemployment levels reduce the risks associated with the additional debt for lenders. This should have a positive impact on Discover’s profits over subsequent quarters, because of which we stick to our $89 price estimate for Discover’s stock. Our estimate is about 20% ahead of the current market price.

See our full analysis for Discover Financial here

Net Interest Margins Should Trend Upwards Going Forward

The rate hikes implemented by the Fed have helped the interest rate environment in the country recover steadily from the record-lows seen over 2014-15. However, a flattening yield curve has led to a faster increase in interest expenses compared to interest incomes for several of the largest U.S. lenders over recent quarters. This industry-wide trend hurt Discover’s revenues over the last two quarters, as its net interest margin (NIM) figure shrunk from 10.28% in Q4 2017 to 10.23% in Q1 2018 and further to 10.21% in Q2 2018.

However, an improvement in the yield curve over recent weeks is likely to help the NIM figure for Q3 2018, while strong growth in the loan portfolio over the coming months should boost interest income.

Increased Card Usage, Growing Global Network Presence Are Key Long-Term Growth Factors

As we pointed out earlier, Discover reported strong growth in its card loan portfolio for the quarter. Although its portfolio of student loans and other personal loans has seen little change over recent quarters, we believe that it makes sense for Discover to focus its efforts on its cornerstone cards and payments business – especially since Discover is one of just two card issuers (besides American Express) that has its own proprietary network to process card payments.

While the growth in its card portfolio has driven strong growth in purchase volume for its proprietary network, the company has also done well over recent quarters to focus on international partnerships – in turn helping volumes for its payment services business. As Discover continues to strengthen its payments ecosystem, we expect it to benefit from the rapid adoption of non-cash payment options globally.

Discover Will Need To Keep A Close Eye On Charge-Off Rates

One of the biggest concerns investors have raised over recent quarters is the steady increase in charge-off rates for Discover. As we have pointed out on several instances in the past, the steady increase in card charge-off rates in 2017 was expected, as the figure for the industry had been hovering at a 20-year low of under 3% over 2015-16. The card industry as a whole benefited from a recovery in credit market conditions over 2012-15, which helped banks reverse some of the loan provisions they had set aside immediately after the downturn. At the same time, card lenders like Discover relaxed their lending standards to make the most of the situation – considerably expanding their sub-prime card lending activity. However, we expect the charge-off rate to large stabilize around current levels – with a strong possibility that the figure will decline over the next few quarters given upbeat economic conditions.

That said, Discover will have to remain cautious about the manner in which it grows its card portfolio going forward, as it runs the risk of ending up with higher charge-off rates. This could potentially lead to higher loan provisions – weighing heavily on profits.

We expect Discover to report EPS of $7.74 for full-year 2018. Taken together with a P/E ratio of 11.5, this works out to a price estimate of $89 for Discover’s shares, which is about 20% ahead of the current market price.

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