Discovery Beats Estimate

Dec.16.10 | About: Discover Financial (DFS)

Discover Financial Services (NYSE:DFS) reported a fiscal fourth quarter earnings of $346.5 million or 64 cents per share, well ahead of the Zacks Consensus Estimate of 42 cents.

The prior-year quarter posted a net loss of $77.9 million or 14 cents per share, excluding an after-tax gain of approximately $285 million related to the settlement of an antitrust litigation with Visa Inc. (NYSE:V) and MasterCard Inc. (NYSE:MA).

Discover also posted net income of $765 million in the fiscal 2010, as against the $1.3 billion in the prior year, which included an after-tax gain of $1.2 billion related to the Visa/MasterCard antitrust litigation settlement.

The surge in profits was due to significant improvements in the credit quality, as well as gains from the payments business driven by strong volumes. However, these were partially offset by higher-than-expected expenses.

Discover’s deposit balances originating from direct-to-consumer and affinity relationships increased $1.5 billion from the year-ago quarter to $20.6 billion.

Direct Banking Segment

The Direct Banking segment reported a pre-tax gain of $554 million, reflecting a $681 million improvement from the year-ago quarter on an adjusted basis.

Total loans plummeted 4% year over year to $48.8 billion, due to a decline in credit card loan to $45.2 million from the prior-year quarter as well as the previously disclosed $1.5 billion sale of federal student loans.

Discover has classified the remaining $800 million in federal student loan balances as held for sale in the fourth quarter of 2010 in anticipation of selling them in 2011

The decrease in credit card loans reflects reduced promotional rate offers for balance transfer against an increase in payment rate. 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 merchant acceptance.

Other income also declined 18% from the prior-year quarter on an adjusted basis, primarily due to lower late fees, the discontinuance of overlimit fees beginning in February 2010, as well as the $28 million charge related to federal student loans classified as held for sale.

The net charge-off rate declined 185 basis points (bps) year over year and 60 bps from the prior quarter to 6.58%. Also, the over-30-days delinquency rate was 3.89%, improving 142 bps year over year and 27 bps sequentially, reflecting an overall better credit trend since the fourth quarter of 2009.

The trend also contributed to a reserve release of $414 million in the fourth quarter, against the reserve addition of $195 million on an adjusted basis in the year-ago quarter. Provisions for losses declined 70% year over year to $383 million on an adjusted basis.

However, expenses escalated 9% year over year, resulting from increased advertising and promotional marketing spending, as well as costs related to the acquisition of The Student Loan Corporation (SLC).

Net interest margin decreased 10 bps to 9.28% from the prior-year quarter, as adjusted, while increased 12 bps from the prior quarter. While the decline was due to the impact of legislative changes on credit card yield, partially offset by lower interest charge-offs.

The upside from the prior quarter was attributable to the impact of the sale of lower rate federal student loans partially offset by the impact of legislative changes and a higher level of promotional rate balances.

Payment Services Segment

The Payment Services segment’s pre-tax income grew $8 million or 32% year over year to $31 million. Revenues were up $9 million, reflecting an increase in transactions and higher margin volume on the PULSE ATM/Debit network along with increased volumes from new and existing clients.

Payment Services dollar volume increased 21% from the year-ago quarter to $40.4 billion, reflecting higher Third-Party Issuer and PULSE dollar volume. The number of transactions on the PULSE network increased 33% year over year due to increased transactions from new and existing clients.

Financial Update

As on November 30, 2010, Discover’s total assets stood at $60.8 billion, while total equity was recorded at $6.5 billion.

Business Update

On September 17, 2010, Discover announced that it has reached an agreement to acquire SLC for $600 million or $30 per share. The transaction is expected to be closed by December 2010, subject to regulatory approvals.

Prior to closing of the deal, SLC will sell $28 billion of assets to SLM Corporation (NYSE:SLM), known as Sallie Mae and $9 billion of assets to Citibank, a unit of Citigroup Inc. (NYSE:C). Discover will acquire $4.2 billion of private student loans and related assets at an 8.5% discount, along with $3.4 billion of SLC’s existing asset-backed securitization debt funding.

The amount to be paid by Discover for the private student loan assets is subject to a post-closing purchase price adjustment between Discover and Citibank, which owns 80% of SLC’s outstanding common stock.

Dividend Update

During the fourth quarter, the board of Discover announced a regular quarterly dividend of 2 cents per share on its common stock, payable on January 20, 2010 to stockholders of record as on December 29, 2010.