Discover Financial Services (DFS)

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Discover Financial Services (DFS)

F3Q2010 Earnings Call Transcript

September 20, 2010 11:00 am ET

Executives

Craig Streem – VP, IR

David Nelms – Chairman and CEO

Roy Guthrie – EVP and CFO

Carlos Minetti – EVP and President - Consumer Banking & Operations

Analysts

Craig Maurer – CLSA

Ken Bruce – Banc of America/Merrill Lynch

Sanjay Sakhrani – KBW

Mike Taiano – Sandler O'Neill

Matthew Kelly – Morgan Stanley

David Hochstim – Buckingham Research

Jason Arnold – RBC Capital Markets

Chris Brendler – Stifel Nicolaus

Bill Carcache – Macquarie Research

Bruce Harting – Barclays Capital

Scott Valentin – FBR Capital Markets

John Stilmar – SunTrust Robinson Humphrey

Drew Dampier – Meredith Whitney Advisory

Presentation

Operator

Welcome to the 3Q 2010 earnings release conference call. My name is John, and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session (Operator Instructions).

I will now turn the call over to Mr. Craig Streem. Mr. Streem, you may begin.

Craig Streem

Thank you very much. Good morning, everyone and we want to welcome you to this morning's conference call, and as always we appreciate your joining us and participating with us. I want to begin by reminding everyone that the discussion today contains certain forward-looking statements about the company’s future financial performance and business prospects, which are subject to risks and uncertainties and speak only as of today.

Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today’s earnings press release, which was furnished to the SEC in an 8-K report, in our Form 10-Q for the second quarter ended May 31, 2010, and in our Form 10-K for the year ended November 30th, 2009, both of which are on file with the SEC.

In the third quarter 2010 earnings release and financial supplement, which are now posted on our website at discoverfinancial.com and have also been furnished to the SEC, we provided information that compares and reconciles our non-GAAP financial measures with the relevant GAAP financial information, and we explained why these presentations are useful to management and to investors and we urge you to review that information in conjunction with today’s discussion.

In addition, to make comparisons more meaningful, we are providing historical results on a basis that excludes income statement impacts of the Visa/MasterCard settlement and the Morgan Stanley special dividend agreement dispute, and also adjust for the effects of FAS 166, 167 this as-adjusted information was made available in today’s earnings release and in an 8-K filing on March 1st.

Our called this morning will include comments related to the announcement we made on Friday concerning our agreement to acquire The Student Loan Corporation, as well as our customary remarks on our results for the quarter. The call will be led by David Nelms, our Chairman and Chief Executive Officer, and Roy Guthrie, Executive Vice President and Chief Financial Officer will also have some comments on our third quarter results.

Joining David and Roy for the question and answer period will be Carlos Minetti. Carlos is President of our Consumer Banking and Operations unit to whom our Student Loan business reports. Before I begin, I also want to remind you or ask you to limit your questions to one with one follow-up. We anticipate a lot of interest this morning, and if you have additional questions please requeue.

I also want to call your attention to a brief series of slides that have been posted to our website this morning and filed on a Form 8-K that provide a summary of the terms of the acquisition of the Student Loan Corp along with our perspectives on the financial and strategic rationale. We will not be addressing the slides specifically during this call, but I do want to mention that for your reference.

And now it's my pleasure to turn the call over to David.

David Nelms

Good morning and thanks for joining us. This morning, we were pleased to report another very solid quarter with earnings per share of $0.47 and return on equity of 17%. Once again this quarter, the most significant factor in our performance was the improvement in credit. I was also pleased with the 5% growth in Discover card sales volume and the stabilization in our credit card loans this quarter, which were essentially flat from last quarter.

I also want to highlight the record transaction volumes in our third party credit and debit network businesses. These important trends reflect the loyalty of our Discover card members, as well as the solid fundamentals of our third party issuer relationships. But before I go on further about this quarter’s results, I would like to discuss our agreement to acquire The Student Loan Corporation announced last Friday.

At our Investor Day meeting back in March, I spoke to you about our goal of becoming the leading Direct Banking and Payments Company. We have been very pleased with our progress, not only in payments but also in Direct Banking, and this transaction will allow us to accelerate our strategic plan in private student lending with attractive returns and risk characteristics from day one.

Because of the complexity of the series of transactions that will occur before we close on our planned acquisition of SLC, I want to begin by reviewing those elements for you, then spend some time discussing the opportunity and rational for acquiring SLC with select private student loans.

We plan to acquire The Student Loan Corporation for $600 million or $30 per share, subject to a post closing adjustment pay between Citi and Discover. Immediately prior to the closing of Discover’s transaction, SLC will sell $28 billion of assets to Sallie Mae and $9 billion of assets to Citibank. We will then acquire $4.2 billion of private student loans and related assets at an 8.5% discount, along with assuming $3.4 billion of SLC’s existing asset-backed securitization debt funding against these private loans.

We expect to receive approximately $150 million from Citibank under the purchase price adjustment agreement. The ABS funding has had attractive rates and maturities represented by the trust identified in our 8-K. So funding is largely in place. Approximately 65% of the loan balances are in repayment, and greater than 70% of the loans are insured against loss. The transaction is expected to provide meaningful EPS activation of about $0.09 per share in 2011.

Moving on to the characteristics of the acquired portfolio, the planned acquisition has desirable credit attributes, including cosigners on 74% of the loans and weighted average FICO scores of 724. The percent of repayment is also very appealing as it will give us additional portfolio performance data. In my earlier comments I noted that the majority of loans are insured, which helps to significantly derisk the acquisition. The average variable APR in these loans is currently just about 4.5% with established funding attached, and this along with the discounted purchase price is expected to generate attractive returns.

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