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Discover Financial Services (DFS) operates as a global card network company and has a market share much lower than that of Visa (V), MasterCard (MA) and American Express (AXP). Today, the company reported a stronger-than-expected performance for 3Q2012. The company reported EPS of $1.21 against the consensus estimate of $1.03. The bottom line surpassed expectations by 17.5%. This was against a 7.6% surprise for Visa when it reported its third quarter EPS of $1.56 in late July. Much of the strength in the results was associated to lower charge-offs, partially offset by higher legal expenses.

Third Quarter Performance Review

Direct Banking

For the quarter ended August 2012, the company's direct banking segment earned $963 million in net income against $1 billion in the linked quarter. This means a 5% YoY decline. Much of the decline in the segment's bottom line was associated to a surge in expenses and an increase in provision for loan losses.

Sales volume for credit cards increased by 4% to $27.2 billion, while the loans associated to credit cards swelled by 4% to $1.9 billion when compared to the same quarter of the previous year. The overall loans portfolio of the segment swelled by 9% to $59.2 billion.

Despite the low interest rate environment and a flattening interest rate yield curve, the segment was able to increase its net interest margin by 18 basis points to 9.44%. Much of the improvement was associated to a decrease in cost of funds. While the asset (credit card) yield declined 19 basis points YoY to 12.27%, the interest expense (cost of funds) decreased by 47 basis points over the same time period. Net interest income of $133 million surged 11% YoY on an improved net interest margin and growth in the segment's loans portfolio.

Provisions for loan losses increased from $26 million to $126 million. Much of this surge was driven by a lower reserve release. Other income and expenses for the segment increased by 5% and 29%, when compared to the same quarter of the prior year. Expenses related to legal reserves associated with the Consumer Financial Protection Bureau (CFPB) and the Federal Deposit Insurance Corporation (FIDC) were the reason for a surge in overall expenses for the third quarter of the current year.

Payment Services

The company's payments services segment competes with other card network companies. With a $17 million increase in revenues, pre-tax earnings of $49 million witnessed an increase of 31% from the same quarter of the prior year. Much of the improvement in the segment's results was driven by a higher PULSE network point of sale transaction margin, partially offset by a surge of $6 million in expense. The transaction volume surged by 13% as compared to the same quarter of the previous year. We believe the growth in transaction volume will have a positive impact on larger players in the Payments Industry.

Valuations

Compared to the forward P/E ratio of 12 times for American Express Company, Discover Financial Services' stock trades at a forward P/E of 9.5 times. Visa, the largest card network company, has a figure of 18.5 times. With the stock trading at $56, analysts have a mean consensus price target of $62.3 - this is an upside of 11.25%.

Source: Discover Financial Beats Earnings, Positive For Payments Industry