Wednesday, August 22, 2012

Discover Financial Services Equity Research

Discover Financial Services $DFS gave the market some positive news regarding the trend of the US economy.  The headline news (pre-tax income being down 6% due to an increase in loan loss provisions) suggests weakness, but the devil is in the detail. In fact, this report was rather bullish. In this article I want to focus on the reasons.

Loan Loss Provisions Higher, But So is Lending

Firstly, with regards to the increase in loan loss provisions from $176m to $232m for the comparable quarters, the reason is that Discover is planning on future growth. An expansion of provisions implies an increase in loans and/or deterioration in credit quality. Frankly, I am finding it hard to believe in latter. For example let’s look at credit card loans and overall net charge-offs prior to this quarter.

Indeed, quarter after quarter, analysts inquire whether the charge-off rate has bottomed. Typically, Discover’s management are cautious about this issue and tend to sympathize with the view that we could be close to a trough in this ratio. And quarter after quarter it goes lower! Perhaps management are being too cautious?

The principal charge-off rate declined to 2.79% in this quarter and, interestingly, total loan receivables were up 9% while credit card loans (81.7% of total) went up 4%. It seems that Discover is lending more but the increase in loan loss provisions seems to imply that it thinks that customers will start to not pay balances on time.  My suspicion is that Discover is ready to ramp up lending but is being overly cautious about it in its commentary.

Tier 1 Capital Ratio

Another subtle sign that Discover is seeing better conditions is in its Tier 1 capital ratio. If this ratio declines in the future (while credit quality improves) it will be a sign that Discover is more willing to extend credit.

New Product Launches

Another sign that Discover is reacting to more favorable market conditions comes with the expansion into three new product areas. Mortgages will now be offered via a home loan center platform, a fixed rate student loan product is now available and, Discover is releasing its first major affinity card.
So while credit quality is improving and loans are increasing, Discover is also introducing new product offerings to capture different sources of growth in a low interest rate environment.

Competition Coming?

The market is competitive and in the conference call, management talked of increased competition most notably from Visa $V. However credit card rewards did not increase significantly, so Discover is not having to "buy" growth at the expense of income. With regards to the payment processors Visa and MasterCard $MA they have also been sterling performers this year. Not only are they seen as a safe place to hide within the financial sector but they appear to have successfully negotiated the threat imposed by the Durbin amendment, the purpose of which was to break their duopoly in processing small merchants' debit card transactions.

Visa responded by announcing a network participation fee (NPF) and MasterCard is believed to have raised fees for small retailers. Throw in the recovery in credit issuance and the environment is set for these stocks to continue to do well. More credit equals more transactions, which in turn translates into increased revenues for Visa and MasterCard.

What Next For Discover?

The attractive thing about Discover is that the macro-economic environment looks good for the company. The diagnosis of a slow gradual recovery is a good scenario for Discover. In other words, interest rates will stay low for the foreseeable future whilst slow gains in employment and growth should translate into increased credit quality and the opportunity to expand receivables in a sustainable manner.

The financial services industry has come a long way since 2000 and is, arguably, too conservative right now. No matter, if the recovery continues then lending will come. For the wider US economy, Discover Financial's results are an indication of ongoing strength.

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