- Delinquency rates and charge-off rates have been declining
across the U.S. since the recession.
- Discover has benefited from this trend, maintaining both
parameters below the industry average.
- This has led to a huge reduction in provisions for loan
- We expect the trend to reverse in the coming years as
consumer spending improves.
An industry wide decline in delinquency and charge-off rates
through the last few years has helped card companies like
), which earn income from revolving credit loans provided to
customers. Interest income from credit card loans is important for
Discover since it accounts for 60% of its revenues. In contrast,
American Express is less reliant on interest income transaction.
The company earns 65% of its revenues through transaction fees from
merchants and banks, and 15% through interest income.
In this article, we will focus on Discover Financial. A strong
performance on credit card loans led to a 65% increase in market
price through 2012. However, we believe that the stock is
overvalued according to our
$36 price estimate for Discover Financial
, which is at a discount of 10% to the current market price.
See our complete analysis of Discover Financial
The Industry Trend
The delinquency rate is the percentage of total loans that is
past due date while charge-off rate is the percentage of loans that
are considered unredeemable. Both parameters have been declining
steadily in the U.S. since the recession. The delinquency rate on
credit card loans for all commercial banks in the U.S. dropped from
6.76% in the second quarter of 2009 to 2.73% in the fourth quarter
of 2012. In the same period, the charge-off rate on credit card
loans for the top 100 banks ranked by assets in the country dropped
from 9.59% to 4.08%. This trend was influenced by the recession as
customers started paying off their loans in time in order to avoid
staying in debt during the financial crunch.
How Is Discover Faring?
Discover has also seen a steady decline in both parameters
staying well below the industry average. In 2009 the delinquency
rate for loans over 30 days due was 4.92%, this dropped to 1.75% in
2012. The net principal charge-off rate dropped from 7.45% in 2009
to 2.29% to 2012.
The Effect It Has
Lower charge-off and delinquency rates allow companies like
Discover to cut down on expenses related to maintaining reserves to
absorb estimated losses in their loan portfolio. This expense
is termed as provision for loan losses. Discover's provision for
loan losses has been reduced significantly in the last few years
influenced by the aforementioned trends. In 2010 the related
expense was $3.2 billion while in 2012 the expense was just $848
million. As a percentage of average credit card loans, the expense
has been reduced from 6.7% in 2010 to 1.55% in 2012.
Our Take On The Future
While the post recession period has seen a record low in
charge-offs, going forward we expect both delinquency rates and
charge-off rates to increase as consumer spending improves with the
stimulus provided to the U.S. economy. This will lead to an
increase in the provision for loan losses. We believe that the
expense will rise marginally through the next few years. Our model
is quite sensitive to this parameter and there is a downside of 10%
to our price estimate should the provision for losses as a
percentage of credit card loans increase above 2.5% in the next few
years. You can modify the interactive chart below to gauge the
effect a change in forecast would have on our price estimate.
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