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Quick Take

  • Discover Financial earns more than 80% of its revenues from its propriety credit cards.
  • Interest income on credit card loans accounts for 66% of the revenues, while discount and interchange fees account for another 16%.
  • The company managed to stay ahead of industry trends in the post financial crisis period, and saw an increase in average loans outstanding in 2012.
  • Discover is also looking to expand its direct banking business with the launch of home equity loans.
  • Non-credit card loans currently account for 10% of the company’s revenues.

Discover Financial (DFS) is expected to report earnings for the first quarter of 2013 on Monday, March 18. The company, best known for its credit cards, is looking to expand its direct banking business. Discover acquired the Home Loan Center business from Tree.com in June last year to complement the student-loan portfolio it acquired from Citigroup (C) in September 2011. The Discover Home Loans branch originated over $2 billion in loans from its inception to the end of the fiscal year in November. Following the success of this venture, Discover is also looking to branch out into home equity loans.

Our $38 price estimate for Discover Financial is in-line with the current market price.

Credit Cards Are Still The Key

Plastic is still the biggest source of income for Discover. The company earns more than 80% of its revenues and gross profits from its propriety credit cards. Interest income from credit card loans accounts for two-thirds of Discover’s revenue, while non-interest income from discount and interchange fees accounts for 15%. The interest income is largely dependent on the loan portfolio. The company earns a yield of around 9.4% credit card loans, which averaged $47 billion through 2012.

Discover saw a decline in average loans outstanding through 2010 and 2011, mostly affected by macroeconomic factors. The total revolving credit owned and securitized, outstanding across the U.S. fell from over $1 trillion in 2009 to $840 billion in 2011, a 16% decline. Discover managed to stay ahead of the market trend through prudent risk management, and reported a 7% decline in average credit loans outstanding during the post-financial crisis period.

The revolving credit outstanding stabilized around $850 billion in 2012 as the U.S. economy showed signs of recovery. Discover reported a 4% increase in average credit loans outstanding through the fiscal year ending November. We expect it to build on the momentum gained in the last year. The Discover U.S. Spending Monitor showed an increase in economic and financial confidence among customers through the first two months of 2012, with an increase in spending intentions. The recently released “IT” was well received during the trial phase last year, we will keep a close eye on the performance this quarter and through the year.

How Far Will Discover Take Its Banking Segment?

Apart from credit cards, Discover also offers personal loans, student loans, home mortgages and deposit products through its Discover Bank subsidiary. Interest income from these loans currently accounts for just 10% of the company’s revenues, but the management has stated its intent to expand horizontally. The launch of home equity loans is another step in this direction. The company plans to offer fixed-rate, closed-end loans worth $25,000 to $100,000, primarily to its existing credit card holders. Around 80% of its customers are homeowners, and will provide it with a marketable demographic.

We expect a steady growth in Discover’s direct banking portfolio, and expect the non-credit card segment to account for nearly 20% of the revenues by 2019. This estimate is based on the results we have seen so far, but Discover has the potential to take the banking segment much further in the coming years. We will update our model as per future developments. You can modify the interactive chart below to gauge the effect a change in forecast would have on our price estimate.

See our complete analysis of Discover Financial here

Disclosure: No positions.

Source: Discover Financial Earnings: What We're Watching