Discover Financial Had A Good 2013, Will It Continue?

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Discover Financial ( DFS ) saw its stock gain more than 40% in 2013 helped by strong results and the expansion into direct banking services. The company acquired Citigroup's ( C ) student loan portfolio in September 2011 and the Home Loan Center business from Tree.com in June 2012. As a result of this expansion into direct banking, Discover reported a 15% increase in interest income from loans other than credit cards through the first nine months of the year.

Despite the foray into student and home loans, the bulk of Discover's business still comes from credit cards. Credit card loans account for more than 80% of the company loan portfolio. Credit cards account for  80% of Discover's revenues, with 65% of the company's  revenue coming from interest earned on credit loans and another 15% from discount and interchange fees.

Our price estimate for Discover Financial is $47 implying a 10% discount to the current market price.

See our complete analysis of Discover Financial here

Credit Cards

Discover has over 60 million cards in force with annual payment volume per card of close to $2,000 and 34 transactions per card. This is lower than American Express, which has a payment volume per card of close to $9,000 and averages nearly 60 transactions per card in a year. Discover's main strength lies in loan origination; the company reported a 4% increase in credit card loans for the third quarter while Amex reported a 3% decline in U.S. cardmember loan balance. Discover's share of the total outstanding revolving consumer debt has gone up from 5.3% at the end of 2011 to 6% in the last quarter.((Consumer Credit Outstanding (Levels)))

The U.S. economy is recovering and the unemployment rate has recovered from the peak of 10.1% observed in 2009 to a low of 7% in November. This was matched by an increase in personal income, which increased 4% during the third quarter. Wages and salaries were up 3%, with a 4% increase in the private industries sector. The Fed's decision to adopt low interest rates has promoted spending over saving. The Federal Funds Rate, the rate at which banks borrow from each other to maintain capital reserves, is currently less than 0.1%. Monthly personal consumption expenditures (PCE) in the country are up 3% over the prior year, indicating an improvement in consumer sentiment. We expect an increase in spending through 2014, with Discover in a prime position to capitalize.

Discover did not sell off any of its charged-off accounts after the recession and thus benefited as the U.S. economy improved with strong recoveries on its inventory of charge-offs. As a result, the company's charge-off rate (percentage of loans that are considered unredeemable) dropped from 7.45% in 2009 to 2% in the last quarter, much lower than the industry average of 3.5%. However, in the coming years, Discover does not expect the same level of recoveries and is making adjustments to its loan reserves.  Provisions for loan losses were around 2.7% of average credit card loans in 2008 but increased to over 6.5% in 2010 before dropping to 1.55% in 2012. We expect the provisions to reach pre-recession levels in the next three years.

Foray Into Banking

The direct banking business currently accounts for just 10% of Discover's revenue, but the potential for growth is strong. Discover's Discover Bank subsidiary offers student loans, personal loans and deposit products while the Discover Home Loans subsidiary offers prime variable, fixed-rate conventional, and Federal Housing Administration (FHA) mortgage loans. At the end of September, Discover had $3.9 billion in personal loan receivables, earning an average interest rate of 12.5%, $3.8 billion in private student loan receivables, with an average rate of 6%, and $4.5 billion in PCI student loans, earning 7%. PCI loans represent loans for which all contractually required payments might not be collected and are considered impaired at acquisition. Most of these loans were acquired from the Student Loan Corporation (SLC) in 2010 and Citibank in 2011. Discover markets student loans through direct email to potential customers and works with financial aid offices in schools.

According to our analysis, Discover has market share of 5% of the total student loans in the country.. Through the third quarter, private student loans increased 5%, coming out of the CitiAssist brand, while personal loans surged 26% over the prior year. The company also started offering home equity loans in August to capitalize on the recovering housing market.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: AXP , C , DFS , MA , V

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