Despite 90% Jump, Discover Financial Stock Can Still Grow

Discover Financial stock (NYSE: DFS) lost close to 68% – dropping from $84 at the end of 2019 to around $27 in late March – then spiked almost 90% to around $51 now. Despite the recent rally, the stock remains 40% below the level seen at the beginning of the year.

There were 2 reasons for this:  The Covid-19 outbreak and economic slowdown meant that market expectations for 2020 and the near-term consumer demand dropped. As the company is heavily dependent on the credit card segment and other loans business, this could lead to sizable losses due to an expected spike in loan default rates. The multi-billion-dollar Fed stimulus provided a floor, and the stock recovery owes much to that.

But this isn’t the end of the story for Discover Financial’s stock

Trefis estimates Discover Financial’s valuation to be around $59 per share – about 15% above the current market price – based on an upcoming trigger explained below and one risk factor.

The trigger is an improved trajectory for Discover Financial’s revenues over the second half of the year. We expect the company to report $11.1 billion in revenues for 2020 – around 4% lower than the figure for 2019. Our forecast stems from our belief that the economy is likely to open up in Q3. Consumer spending in the U.S increased by 8.5% m-o-m in May and then 5.6% m-o-m in June (July data is not out yet). If the trend continues in the coming months, it is likely to result in higher loans and growth in transaction volume – credit card business contributed around 76% of the company’s total revenues in FY 2019. This, in turn, would benefit the revenue trajectory over the coming months. However, net income for the year is expected to drop to $1.1 billion – down 62% y-o-y, mainly driven by higher provision for credit losses, reducing the EPS figure to $3.63 for FY2020.

After that, Discover Financial’s revenues are expected to improve to $11.4 billion in FY2021, mainly driven by growth in outstanding credit card loans and higher transaction volume. Further, the net income margin is likely to improve as compared to the previous year due to a decline in provisions for credit losses, leading to an EPS of $5.94 for FY2021. 

Finally, how much should the market pay per dollar of Discover Financial’s earnings? Well, to earn close to $5.94 per year from a bank, you’d have to deposit around $650 in a savings account today, so about 110x the desired earnings. At Discover Financial’s current share price of roughly $51, we are talking about a P/E multiple of just below 9x. And we think a figure closer to 10x will be appropriate.

That said, consumer finance is a risky business right now. Growth looks less promising, and near-term prospects are less than rosy. What’s behind that? 

Discover Financial has a sizable portfolio of consumer loans – around $91 billion in FY2019 out of which close to $73 billion were in credit card loans alone. The economic slowdown is likely to harm the financial health of many customers, exposing the company to potential loan defaults. In anticipation of that, Discover Financial has increased its provisions for loan losses to around $3.9 billion by Q2 2020– around 2.4x of the year-ago period, leading to a significant jump in the total expenses figure for the year. If the economic condition continues to worsen, this figure could further increase in the coming months. 

The same trend is visible across Discover Financial’s peer – American Express. Its revenues are likely to suffer in FY2020 due to lower consumer spending and its net income margin is likely to drop due to a jump in provisions for credit losses in anticipation of loan defaults. Further, American Express’ stock currently has a stock price of over $97 but looks slated for an EPS of around $6.66 in FY2021.

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