Discover’s Push In The Payment Industry Justifies $83 Fair Value

by Trefis Team
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Discover Financial Services (NYSE: DFS) reported a lukewarm performance for the fourth quarter of the year late last week, as the card-focused bank met revenue expectations for the seasonally strong period, but stumbled on higher-than-expected costs to report an earnings miss. While the increase in card usage over the holiday season translated into higher card balances as well as increased transaction fees for Discover, the company had to hike its marketing expenses considerably to grow its customer base. We capture key trends from the full-year 2018 earnings and also highlight our forecasts for full-year 2019 in our detailed valuation dashboard for Discover, key parts of which are captured in the charts below.

The current economic conditions in the U.S. are well-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. At the same time, Discover is poised to potentially unlock considerable value by tweaking its end-to-end payment platform to make the most of the ongoing evolution in the global payments industry. We maintain an $83 price estimate for Discover’s stock, which is about 20% ahead of the current market price.

See our full analysis for Discover Financial here

Net Interest Income Gains Will Continue To Boost The Top Line

The rate hikes implemented by the Fed have helped the interest rate environment in the country recover steadily from the record lows seen over 2014-2015. Notably, Discover’s interest income is less sensitive to interest rates compared to larger U.S. banks because of the significantly larger proportion of credit card loans in its total loan portfolio (which are essentially fixed interest-rate loans). At the same time, rising interest rates result in a faster increase in interest expenses on deposits held. Taken together, this has weighed on Discover’s net interest margin (NIM) figure over recent quarters. But the bank has done well to grow its interest-earning asset base (primarily its card balances as well as private student loans). This has helped its net interest income grow steadily over recent years – a trend we believe will continue in 2019.

Discover’s Emphasis On Increasing Card Acceptance Will Also Drive Growth

Discover’s long-term growth rate remains tied to its efforts on its cornerstone cards and payments business. This is particularly true because Discover is one of just two card issuers (along with American Express) that has its own proprietary network to process card payments. Over recent years, the company has done well to focus on international partnerships. In the last four months alone, the bank has entered into card acceptance agreements with a global payment service provider (Oceanpayment), two payment providers in the EMEA region (PXP and 3C Payment), and one provider each in Mexico (Prosa), and the Nordics (Nets).

Increasing card acceptance, coupled with agreements with banks outside the U.S. to issue Discover-branded cards, should help volumes for its payment services business.

Increase In Operating Costs Is Understandable, But Will Have To Be Monitored

While Discover’s revenues increased by 8.2% in 2018 compared to 2017, its total operating costs also rose by 7.8%. This growth in expenses can be attributed to a sizable increase in each of the three key expense streams for the company: compensation expenses (which increased 7.6%), marketing expenses (which swelled 10.4%) and information processing & communications cost (which jumped 11.1%). The increase in marketing expenses has been seen across banks over recent quarters, as they spend more to keep new payment processing companies at bay. At the same time, the need for added security on payment networks has forced incumbents to increased their IT spends. While its revenues still grew faster than its expenses in 2018, Discover will have to monitor costs closely to ensure that these trends do not weigh on profits.

We expect Discover to report EPS of over $8.70 for full-year 2019. Taken together with a forward P/E ratio of 9.5x, this works out to a price estimate of $83 for Discover’s shares, which is about 20% ahead of the current market price.

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