Discover Financial Is Using A Financial Crisis Transformation To Fuel Higher Dividends

| About: Discover Financial (DFS)


Discover Financial is not the same company today as 2007: it has increased its cash on hand eight-fold, almost tripled its profit, and diversified its earnings stream away from loans.

Despite a recent dividend hike of 20%, the current payout ratio is still only 19.35% relative to last year's earnings.

This stock may not appeal to all income investors, however, as its current dividend yield is only 1.5%.

Let's be blunt: Discover Financial (NYSE:DFS) was not a good company to own during this past recession. Just about everything that could go wrong for a financial services company did seem to go wrong for Discover during the financial crisis. After reaching a high price of $32 per share in 2007, the share price decimated its investors by falling to a low of $4.70 per share in 2009.

The immediate drop in earnings power seemed to justify Discover's poor performance during the financial crisis: earnings of $1.75 per share in 2007 fell to $0.10 per share in 2009 before rebounding quickly to $1.22 in 2010. The drop in profits did not leave the dividend unscathed, as Discover's $0.24 annual dividend was cut in third to $0.08 annually. But still, Discover survived, the world went on, and by 2011, Discover shareholders found themselves in this interesting position: the profits generated by its credit card and loan products rebounded better than any other financial institution I am aware of: the $1.75 profits of 2007 quickly gave way to the $4.06 per share profits of 2011.

The company has advanced in every year subsequently, as the $4.06 per share in 2011 profits grew to $4.46 per share in 2012 and $4.96 in 2013. The Discover that exists today is much stronger than the Discover that existed in 2007. Back then, Discover didn't even have $1 billion in cash on hand. In the past few years, Discover has been building up a treasure chest without getting hardly any attention from the analysts: the $3.9 billion in cash on hand in 2012 grew to $6.5 billion in 2013, and now, Discover is sitting on $8.7 billion in cash assets.

The easy armchair analysis is to automatically discard Discover and say, "It didn't perform well in the last recession. Bzzzt! Next investment candidate, please!" The more nuanced approach, I think, is to recognize that Discover is much stronger today than in 2007, and consequently, more prepared to handle the next financial crisis. Before the last financial crisis, Discover was heavy on a toxic loan portfolio to deliver over half of its $800-$900 million in annual profits while not even having $1 billion in cash on hand.

Today, Discover has a balanced attack of credit cards, deposit products, and personal loans (so that the loan portfolio is no longer the predominant source of the firm's earnings as it increasingly relies on its credit card operations for growth) that generate $2.3-$2.4 billion in net profits. Given Discover's current market cap of $28.5 billion, the $8.7 billion in cash on hand represents 30% of its market capitalization. If another financial crisis were to hit next year, Discover would enter this one with a more diversified stream of earnings sources that are generating almost triple the amount of profit that Discover was generating on the eve of the last recession while holding over 8x as much cash on hand as in 2007.

Also, Discover has done a good job of mopping the shares that had to be created during the financial crisis to raise liquidity. From 2007 to 2010, Discover had to raise its share count from 477 million to 544 million to help ensure its solvency. Since then, Discover has gone on the buyback offensive, retiring 25-30 million shares per year, to take the share count below 465 million today. No, Discover's behavior leading up to the recession wasn't anything to emulate, but it has made amends since then: it removed all the excess shares that got created, boosted the cash on hand, and almost tripled the profits.

What is most compelling about Discover Financial is that the valuation seems particularly reasonable in a stock market that makes you sweat a little to find bargains: the current $4.96 in profits related to a $61 per share price indicate that Discover is only trading at 12.3x earnings, which seem enticing given Discover's loan portfolio that is growing at a 7% clip, coupled with credit card processing growth and stock buybacks that seem to indicate Discover is due for long-term growth in the 10-12% range.

Not only is the current stock price reasonable for prospective shareholders, but the rate of dividend growth figures to be substantial in the coming years. The most recent quarterly dividend increase from $0.20 to $0.24 amounts to a 20% hike, and offers tangible proof of what you can see by studying Discover's statements: the dividend has much room to grow. Even with the 20% dividend hike, Discover's payout ratio still sits at only 19.35% of last year's profits. Coming out of the recession, Discover has been raising its dividend aggressively, and the fact that the current payout is still only one-fifth of profits seems to indicate that shareholders may be in for a few years of 13-17% annual dividend growth before the payout ratio stabilizes and must rely on the earnings growth rate to support long-term dividend growth. Until then, though, the Discover dividend ought to appreciate rapidly for shareholders willing to tolerate a 1.5% starting dividend yield.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.