Discover Financial Post Strong Earnings in Major Turnaround From 2010

| About: Discover Financial (DFS)

Yesterday, Discover Financial Services (NYSE:DFS) reported fiscal first quarter earnings of $465 million or 85 cents per share, dramatically ahead of the Zacks Consensus Estimate of 52 cents. The prior-year quarter posted a net loss of $104 million or 19 cents per share.

The reported quarter included a $23 million benefit related to the settlement of an antitrust litigation with Visa Inc. (NYSE:V) and MasterCard Inc. (NYSE:MA).

Net income allocated to common shareholders also surged to $459 million or 84 cents from a loss of $122 million or 22 cents per share, during the reported quarter. Results included contribution from The Student Loan Corp (SLC) acquisition.

The surge in profits was due to higher loan loss reserve release by the company, dramatic decline in provision for loan losses and delinquency rates based on improved credit quality, as well as gains from the payments business driven by strong volumes. However, these were partially offset by higher-than-expected expenses.

Total revenue, net of interest expense, increased 2.5% year over year to $1.73 billion, also exceeding the Zacks Consensus Estimate of $1.06 billion. Discover’s deposit balances originating from direct-to-consumer and affinity relationships increased $7.0 billion from the year-ago quarter to $21.8 billion.

Direct Banking Segment

The Direct Banking segment reported a pre-tax income of $677 million, reflecting a $885 million improvement from the year-ago quarter on an adjusted basis. The pre-tax income in the reported quarter included $30 million from SLC.

Total loans improved 3% year over year to $51.7 billion, reflecting an increase of $3.1 billion in private student loan portfolio from SLC acquisition. This was partially offset by a decline in credit card loans $44.3 million from the prior-year quarter.

An increase in the payment rate was partly offset by a 7% year-over-year increase in Discover card sales volume, which improved due to higher consumer spending and merchant acceptance.

Other income also declined 1% year over year to $6 million, primarily due to a purchase gain of $16 million and transition services revenue related to the SLC acquisition. This was partially offset by a decline in late fees and the discontinuance of over-limit fees beginning in February 2010.

The credit card net charge-off rate declined 304 basis points (bps) year over year and 99 bps from the prior quarter to 5.96%. Moreover, the over-30-days delinquency rate was 3.59%, improving 180 bps year over year and 47 bps sequentially, reflecting an overall better credit trend since the fourth quarter of 2009.

Provisions for losses dramatically declined $969 million year over year to $418 million, reflecting lower charge-offs and a reduction in the allowance for loan losses. The trend also contributed to a reduction in reserve release of $271 million in the reported quarter, against the reserve addition of $305 million in the year-ago quarter.

However, expenses escalated 26% year over year to $115 million, resulting from increased advertising and promotional marketing spending, along with the costs related to the acquisition of SLC.

Net interest income increased $46 million from the prior quarter, primarily driven by an increase in total loan balances related to the SLC acquisition. As a result, net interest margin improved 21 bps over prior-year quarter to 9.22%, principally attributable to decline in funding related costs, which resulted in a $25 million increase in net interest income.

Payment Services Segment

The Payment Services segment’s pre-tax income grew $6 million or 16% year over year to $43 million. Revenues were up $11 million, reflecting an increase in transactions and higher margin volume on the PULSE ATM/Debit network coupled with increased volumes from new and existing clients.

Payment Services dollar volume accelerated 21% from the year-ago quarter to $43.2 billion, reflecting higher PULSE, Diners Club International and third-party issuer volume. The number of transactions on the PULSE network increased 29% year over year due to increased transactions from new and existing clients.