Will Slower Loan Growth Hurt Discover’s Q2 Results?

Discover Financial (NYSE: DFS) is expected to release its second quarter results on Tuesday, July 23, and Trefis expects soft retail sales growth in April and May to impact growth in its loan portfolio over the period. This, in turn, is expected to weigh on Discover’s revenues (shows key revenue components) for the quarter by negatively affecting its two revenue streams: Net-Interest Income; and Non-Interest (Fee) Income.

Credit Card Loans and Network Volume are key operational metrics that affect Discover’s valuation, and are both largely dependent on macroeconomic factors such as GDP growth, retail sales, and consumer confidence. Trefis highlights the impact of changes in retail sales for key geographies on Discover’s Network Volumes in an interactive dashboard. You can also find more of our Financial Services data here.

A brief look at the previous quarter results

• Discover’s Network Volumes slowed during the first quarter, growing by just 7% (y-o-y) – well below the strong 15% growth  (y-o-y) witnessed in Q4 2018.
• The year began with a lot of uncertainties surrounding the U.S.-China trade deal, the yield curve inversion, and a sharp drop in January’s retail sales figures.
• The FOMC maintained the target rate for the federal funds rate at 2.25% to 2.5% in its January and March meetings despite a slowdown in economic activity during the first quarter.
• Discover’s top line is largely dependent on the interest income from credit card loans, and a potential rate cut would hurt the company’s full-year results.
• Discover’s Q1’19 revenues came in at $2.7 billion, increasing by 7% over the prior year period.
• Net-Interest Income reported a growth of 10% (y-o-y), supported by higher interest rates. However, the Non-Interest Income declined 3.5% due to higher cardholder incentive.

What to expect from the second quarter results?

• After observing a significant drop in January and February, the U.S. Retail Sales recovered in March. However, a further decline was reported for April in the Bureau’s June release. (Note: Data considered is not adjusted for seasonality).
• Per the Bureau’s advance estimates for May, the seasonally unadjusted retail sales figures are expected to grow by 8% sequentially.
• Per Trefis estimates, the U.S. retail sales, ex-auto and gas, and Discover’s network volumes have a high positive correlation of +0.63. Moreover, the ratio of average credit card loans to network volume stands at 0.81.
• Considering the macro-economic uncertainty associated with tariffs against China and Europe, the Fed’s June report indicating moderate growth in economic activity, and a high possibility of a rate cut, we expect Discover to report lower network volume growth figures for the second quarter.
• Additionally, the decline in network volumes will likely hurt Discover’s loan book.

Trefis estimates Discover’s EPS for the current year to be $8.74. Taken together with a P/E of 9.5x, we arrive at Discover’s valuation of $83 per share, which is slightly ahead of the current market price.

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