Discover Gains From Lower Provisions But Regulations & Low Rates Are a Pain

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Discover Financial Services ' ( DFS ) stock price plummeted to about $5 during the financial crisis of 2008-09 and has rebounded sharply since then. The current stock price stands at around $21.70 which is about 10% ahead of our estimate of $19.76 for Discover's stock . Two issues we think can move the stock are lower provisions for losses, which would free up capital to lend and signal Discover's confidence in its credit exposure, and net interest yields (or net interest margins) which could be impacted by regulations and the direction of interest rates. Its main competitors are Capital One ( COF ), American Express ( AXP ), Citigroup ( C ), Visa ( V ) and MasterCard (MA).

Discover offers credit cards, personal loans and student loans as well as deposits. It operates the Discover Network, a credit card payments network; the PULSE Network ("PULSE"), its automated teller machine ("ATM"), debit and electronic funds transfer network, and Diners Club International (Diners Club), its global payments network.

18% Upside - Decline in Provision for Losses

Provisions for credit losses are charges against income that banks and credit card companies set aside in case borrowers are unable to pay. These provisions are based on the composition of the bank's portfolio, the peceived risk of default, the economic environment and the allowance for credit losses already established. For Discover, the provision for loan losses as a percent of average credit card loan outstanding was under 4% in 2006-7 but increased to over 10% in 2009 due to the economic downturn and is now turning around.

As the financial sector recovers and economic picture brightens, we expect a gradual decline in the provision for loan losses as a percent of average credit card loan outstanding because of the improvement in the economic outlook and a decline in the net charge off rate. We estimate that as of 2011, this figure is still above 10% and slowly coming down. Based on our estimates, if it declined to pre-crisis level of around 6%, our price estimate for Discover would rise by almost 18%.

10% Downside - Decline in Net Interest Yield

Several government policies have been enforced to reduce or limit the fees and charges credit card companies and banks can charge on customers. The CARD Act of 2009, imposed several restrictions on the company's ability to increase interest rates on existing balances and to extend credit to customers that have a high-risk profile. This could have a negative impact on the net interest yield, or net interest margin. The net interest yield is the interest income earned by Discover on its credit card balances outstanding minus all the interest expenses incurred on the credit card loans.

In addition to regulation the low interest rate environment makes it difficult to earn a higher net interest yield as Discover earns less on outstanding balances and the spread between the borrow and lending rate is narrower.

If the net interest yield declined to about 7% in the coming years, compared to our estimate of about 9%, our price estimate for Discover would decline by as much as 10%.

See our full estimates for Discover.



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 , COF , DFS , V

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