Monday, November 19, 2012

US Financial Stocks Set to Boom?

There is an odd contradiction with Discover Financial Services (NYSE: DFS). Whereas earlier in the week the Consumer Financial Protection Bureau (CFPB) and the Federal Deposit Insurance Corp (FDIC) accused Discover of deceptive marketing by encouraging customers to pay for extra add-ons, its management can be accused of anything but over-egging the company’s prospects. I have always found them to be overly cautious in guidance. Nonetheless the results in the latest earnings report suggest that Discover and the US economy are on the right track.

Key Takeaways from Discover’s Results

The company delivered a strong quarter and a host of metrics suggest that things are getting better in the US economy. I’ve listed the key points below

  • Credit card ending loans increased 4.2% from last year and 3.2% sequentially
  • Credit card net principal charge rate fell to a historic low of 2.43%
  • Total 90 day delinquency rate fell to a historic low of .81%
  • Loan loss provisions increased less in this quarter by $26 million vs. a $56 million increase last quarter
  • Payment services pre-tax income was up 31% in the quarter

Essentially Discover is in a position where credit quality is improving at the same time as consumers’ appetite for lending appears to be increasing. Whereas earlier in the year much of its growth had come from student loan lending, this report signaled a return to more cyclical credit card lending. This is a strong sign for the US economy.

In a sense it was presaged by the increase in loan loss provisions in the previous quarter. At the time I took it as a sign that Discover was going to start increasing lending and -despite the relative cautious commentary at the time- they certainly did so. The good news is that even as lending increased the 90 day delinquency rate kept falling. This is a good sign that future loan losses will be well contained.

There has been some market chatter about low rates causing yield compression amongst lenders. While this is certainly an issue investors should remember one key point. Banks and credit card companies lend money when employment is gaining and the economy is growing and low interest rates usually create economic growth. In other words don’t get suckered into the idea that just because the Federal Reserve wants to keep interest rates low for an extended period that this means yield compression will hurt lenders, on the contrary they want Discover to lend.

The string results from payment services is a good sign for future results from Visa and Mastercard. Transaction volumes were up 13% for Discover. It is particularly good news for the payment processors because not only is one of its –albeit smaller- rivals reporting good transaction volumes but if lending is picking up again it's a sure indication that spending and processing will be too. Both Visa and Mastercard were up on this news.


What Else is Going on in the Industry?

Discover is not alone in seeing favorable conditions. For example American Express Inc (NYSE: AXP) recently reported that its delinquency rate was down to 1.3% from 1.6% last year. Its write off rates were down to 2.2% from 3.1% last year and on a sequential basis as well.

Discover recently signed a deal with eBay Inc (NASDAQ: EBAY) but unfortunately its exact terms are confidential. What we do know about the deal is that PayPal customers will be able to use their accounts to purchase goods at merchants who accept Discover cards. This will surely involve driving more volume into the Discover network. As a consequence eBay will benefit as PayPal customers will be able to expand their purchasing channels.

As for Discover’s problem with the FDIC and CFPB, it is not alone! In July its rival Capital One Financial Corp (NYSE: COF) reached a similar settlement deal. Interestingly, neither development had much impact on the share price of either stock. There is a moral to the story there somewhere, but for the life of me I can’t find it. I note that both Capital One and Discover have seen next year’s estimates rising this year, despite any negative publicity from these actions. Incidentally, neither company admitted any wrongdoing but both made large settlements. Go figure.

The Bottom Line

There are two bottom lines.

The first is Discover is in strong shape and can look forward to future growth despite some pressure from yield compression. The economic recovery and ongoing improvements in loan quality are important and policymakers are committed to working to create economic conditions in Discover’s favor.

The second is that the US recovery is real and there are signs that lending is making a comeback. Investors should not discount the significance of this. The conditions look set for a strong period ahead for US focused lenders.

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