On June 24, Discover Financial Services (DFS) reported a fiscal second quarter profit of $258 million or 33 cents per share. The earnings were well ahead of the Zacks Consensus Estimate at 11 cents. The surge in profits was due to a significant rise in the use of credit cards with reduced defaults, as well as gains from the payments business driven by strong volumes.
The company reported a loss of $132 million or 31 cents per share in the year-ago quarter. However, results in the year-ago quarter excluded an after-tax gain of approximately $295 million related to the settlement of an antitrust litigation with Visa, Inc. (V) and Mastercard Incorporated (MA).
Also, Discover made the Troubled Asset Relief Program (TARP) repayment of $1.2 billion of preferred stock. This resulted in lower earnings by 13 cents per share in the reported quarter.
Card sales volume spurred 6% year over year to $23 billion in the second quarter of 2010, while net interest income declined to $1,147 million against $1,192 million in the year-ago quarter.
Discover’s deposit balances originating from direct-to-consumer and affinity relationships increased $9.5 billion from the year-ago quarter and $2.7 billion from the prior quarter to $17.5 billion. The deposit accounts of the second quarter of 2010 included an acquisition of $1 billion.
Direct Banking Segment
The Direct Banking segment reported a pre-tax gain of $386 million, reflecting a $571 million improvement from the year-ago quarter on an adjusted basis.
Total loans declined 2% year-over-year to $50 billion. Though student loans increased, this was offset by a decrease in credit card loans, which declined by $3.6 billion to $45.3 billion.
The decrease in credit card loans reflects the decline in balance transfer volume, which was down 60% from the year-ago quarter as the company reduced its marketing of promotional rate offers for balance transfer. However, it was partially offset by a 6% year-over-year increase in Discover card sales volume, which improved due to higher consumer spending and gas prices.
Other income also declined by $7 million on an adjusted basis from the year-ago quarter, primarily due to the suspension of overlimit fees effective February 2010. However, higher discount and interchange revenue from higher sales volume provided some relief.
The net charge-off rate grew 18 bps on a year-over-year basis to 7.97% in the reported quarter, almost in line with the management’s expectation of 8%-8.5%, reflecting consumer bankruptcies and unemployment, offset by the higher mix of student loans with a lower charge-off rate. However, the net charge-off rate fell 54 basis points (bps) sequentially, primarily due to the continuous improvement seen in credit performance of the portfolio. Management expects a third-quarter charge-off rate of 7.5%-8.0%.
The over-30-days delinquency rate was 4.52%, up 56 bps on an year-over-year basis and up 53 bps sequentially, reflecting an overall better credit trend since the fourth quarter of 2009. The trend also contributed to a reserve release of $277 million in the second quarter of 2010, against the reserve addition of $299 million on an adjusted basis in the second quarter of 2009, due to worsening credit trends at the time.
Provisions for losses declined to $724 million on an adjusted basis from $1,302 million and $1,387 million in the year-ago quarter and prior quarter, respectively.
Discover also reported an 8% year-over-year decline in expenses to $44 million, resulting from the implementation of cost control initiatives. Additionally, the second quarter of 2009 witnessed a $20 million charge from the reduction in force.
Payment Services Segment
The Payment Services segment’s pre-tax income grew $10 million or 36% year-over-year to $36 million. Revenues were up $6 million, reflecting an increase in transactions and higher margin volume on the PULSE network and lower incentive payments along with higher Diners Club revenues. Expenses were also down $3 million from the year-ago quarter, due to cost reduction initiatives related to transaction processing.
Payment Services dollar volume increased 1% from the year-ago quarter to $37 billion. Third-Party Issuer dollar volume was up 25% while Diners Club dollar volume increased 7% from the year-ago quarter. Dollar volume on the PULSE network decreased 2% while the number of transactions on the PULSE network increased 6% year-over-year to $805 million due to increased transactions from new and existing clients.
As of May 31, 2010, total assets decreased to $62.1 billion, from $66.8 billion as of February 28, 2010 and $62.8 billion as of May 31, 2009. Total equity was $6.0 billion compared to $7.0 billion in the prior quarter and $6.3 billion in the year-ago quarter.
On June 15, the Federal Reserve ordered new guidelines under The Credit Card Accountability, Responsibility and Disclosure Act of 2009, known as the CARD Act, which will be implemented from August 22.
Accordingly, the credit card penalties will be limited to $25 and fees for customers who don't use their cards will be eliminated. Also, consumers will not bear multiple penalty fees, even after violating a single late payment. The Federal Reserve also ordered to review of all credit card interest rate hikes imposed since January 2009.
Since February 2010, the reforms are totally in favor of the credit card users. The issuers are prohibited from hiking interest rates on existing balances as long as customers paid their bills on time. They also have to notify customers at least 45 days in advance of interest rate increases and most fee changes.
Discover anticipates shedding $80 million to $90 million of annual fee pretax income after August 2010, even after reviving earnings.
While the regulations under the CARD Act is expected to make credit cards costlier and its restrictions on finance charges and fees will result in lower interest income and loan fee income, we believe that the company is headed upward and will be able to overcome the losses caused by the Act.
As the cards segment forms the key source of income for Discover, we expect the company to work on expanding the use of cards and gear up to maintain the credit performance improvements. Consequently, earnings will continue to perform and encourage investments in the stock over the longer term.