Discover Financial Services (DFS) reported stronger than expected third quarter results Thursday morning. Revenue grew 9.8% year-over-year to nearly $2 billion, which was slightly better than the consensus estimate. Earnings grew 2.5% year-over-year to $1.21 per share, which was far better than the drop in earnings the consensus was predicting.
Unlike competitors Visa (V) and Mastercard (MA), Discover assumes credit risk on the outstanding consumer loan balance of its cards. To view how we value Visa and Mastercard under our discounted cash-flow process, please click here and here, respectively. Still, the firm is benefiting tremendously from the continued shift to a cashless society, with payment services dollar volume surging 13% during the period, to $50.3 billion. This resulted in a 31% increase in payment services operating income. Credit card loan performance was also strong, with loan delinquency rates falling to 1.81% (down 62 basis points year-over-year) and net charge-off rates falling to 2.43% (down 142 basis points year-over-year). Its credit card loan portfolio grew 4% during the quarter, to $48.1 billion.
Total loans at the company grew 9% to $59.2 billion, driven by the firm's acquisition of student loans. Performance from these loans will no doubt improve as the economy strengthens, but there's still a risk of prolonged unemployment and cumbersome loans that former students won't be able to pay off. Fortunately for the owners of this debt, a defaulter simply can't walk away like a mortgage or any other personal debt in the US. As the law is currently written, it's incredibly difficult for the creditor to lose money on student loans. However, we're not sure that this law for student loans will last forever, particularly with unemployment rates of recent college graduates so high.
Overall, Discover's net interest margin, a metric used by banks and other financial services firms to gauge profitability, increased 18 basis points year-over-year to 9.44% (thanks to lower cost of funds). However, the firm's credit card yield actually decreased 19 basis points to 12.27%, as credit card users are paying down debt and carrying lower balances. This trend is positive for the state of personal finance, but it could harm Discover's profitability.
Going forward, we expect Discover to grow its payment processing business at a nice clip, though it will have to pay $200 million to cardholders who allegedly were deceptively sold products on identity theft and other items. Still, this didn't prevent the firm from repurchasing $350 million in shares during the quarter, reducing its share count 1.9% on a sequential basis. The stock isn't expensive at under 10x 2012 earnings, but we prefer Visa and eBay (EBAY) as payment processor names and hold both companies in the portfolio of our Best Ideas Newsletter (please see links in our left sidebar for more information).
Additional disclosure: EBAY and V are included in the portfolio of our Best Ideas Newsletter.