Seeking Alpha
Profile| Send Message| ()  

Electronic payment processor in the US, Discover Financial Services (DFS) is scheduled to release its second quarter results before the market opens on June 23, 2011. The Zacks Consensus Estimate for the second quarter is 66 cents per share, representing about 100% growth over the year-ago quarter.

Following the first quarter trends, higher consumer spending and gradual rise in merchant acceptance along with improved credit quality and The Student Loan Corp. (SLC) acquisition are further expected to boost volumes and rev up company’s position. However, increased expenses, primarily on marketing and advertising, and regulatory provisions may continue to limit the desired upside.

Previous Quarter Performance

Discover’s first quarter earnings came in at $465 million or 85 cents per share, dramatically ahead of the Zacks Consensus Estimate of 52 cents per share. The prior-year quarter posted a net loss of $104 million or 19 cents per share.

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

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.

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. 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.

Agreement with Analysts

Ahead of the earnings release, we see some upward movement in analyst estimates over the past 30 days. A similar trend has been noticed over the past 7 days. Hence, the estimate revision trends and the magnitude of such revisions justify a positive sentiment on the street.

In the last 30 days, 4 of the 16 analysts have revised their estimates upward for the second quarter of 2011, while three of the 15 analysts increased their estimates for fiscal 2011. However, no downward revisions were witnessed, overall reflecting a slight movement towards positive direction. This implies that the analysts do not foresee any significant downward pressure on the results.

Meanwhile, the positive approach towards Discover also gives scope for some positive surprises in the first half of 2011, particularly, on achieving better clarity on the potential effects of the ongoing regulations, primarily which requires reduction in interchange fee that are paid on debit transactions.

Moreover, the recent 200% dividend increment along with the authorization of the new $1.0 billion share repurchase program reflects Discover’s efficient capital deployment strategies, healthy balance sheet and strong cash flows.

Magnitude of Estimate Revisions

In the last 90 days, there have been significant revisions in the earnings estimate following the first quarter results. As a result, earnings per share increased by 13 cents to the current level of 66 cents for the second quarter, while the same grew by 63 cents to $2.75 for 2011.

Furthermore, earnings per share surged by 34 cents to the current estimate of $2.55 for 2012. However, this trend, negative earnings growth projection for 2012 over 2011, reveals a cautious outlook in the analysts’ opinion given the lack of clarity once the regulation will be in full implementation by the next fiscal.

Surprise

Going by past trends, we have a slightly mixed opinion on Discover exceeding estimates, given the uncertain regulatory environment hanging around Discover and its peers. The company’s reported earnings per share exceeded its expectations in all of the last four quarters and has a positive four-quarter average surprise of 86.29%.

Our Take

Since its inception in 1986, Discover has grown to become one of the largest card issuers in the US and a leading innovator and initiator of change in the credit card industry. Discover has also experienced continued growth in its direct-to-consumer banking business by leveraging its low cost infrastructure, brand, credit management and marketing capabilities.

Moreover, the SLC acquisition is expected to shore up the bottom-line from the first year of purchase, carrying an earnings increment of at least 9 cents per share in 2011 itself.

While the acquisition marks the company’s strong financial and capital leverage, it also coincides with Discover’s long term goal of bolstering its private student loan portfolio, which recorded steady growth over past three years when many others fizzled out. We expect these positives to continue and aid the company to improve its top line.

Discover has not only been growing steadily but has also been returning incremental wealth to its investors by deploying its capital resourcefully, which again reflects its growth potential going forward.

However, the prime reason of concern hovers around the regulations that limits the desired upside. The CARD Act of 2009 requires the company to make fundamental changes to many of its current business practices, including marketing, underwriting, pricing and billing.

Further, the Dodd-Frank Act that was enacted in July 2010 has finally axed the card companies by slashing the interchange fees on debit card transactions by about 72% over 2009 prices. Particularly, card giants such as Discover, Visa Inc. (V) and MasterCard Inc. (MA) are reported to be the wary victims of the interchange fee cuts.

We expect the implementation of CARD Act provisions in 2011 along with an anticipated increase in the volume of promotional rate offers to unfavourably impact credit card yield, although we believe it will be partially offset by continued improvement in interest charge-offs.

Nevertheless, the company’s extensive network, improved credit quality, sound capital position and cost containment initiatives will help accentuate growth over the long term.

The quantitative Zacks Rank for Discover is currently #3 with a short-term Hold rating, indicating no clear directional pressure on the shares over the near term.

Source: Discover: Earnings Preview