At first glance, nothing seems wrong with Discover Financial Services (DFS).
The bank, best known for its credit card products, is one of the fastest-growing financial services companies. Revenues are projected to increase 7% this year, supported by healthy consumer spending and improving net interest margin. EPS is forecasted to climb even further, up 12% on increased operating efficiency and share buybacks. Return on equity reached an impressive 26% in 1Q19, in an improving trend.
Credit: American Banker
But despite what seems to be optimistic expectations about the company's near-term financial performance, Discover's business model leans heavily towards consumer lending - credit card represented four-fifths of ending loan balances last quarter. The lack of diversification is concerning, in my view, given a credit landscape that I find unsettling.
The problem is not company-specific, to be clear. U.S. consumer debt has risen consistently since the mid-2013 trough to surpass Great Recession levels. Some may reasonably argue that, in inflation-adjusted terms and relative to GDP, household debt still looks much less menacing than it did circa 2008. But a closer look into debt composition and delinquent balances raise a yellow flag.
The chart below, on the left, depicts how certain debt categories have seen balances skyrocket in the past several quarters, namely student and auto loans - not necessarily breaking news for those paying attention to debt trends in the United States. The latter was up a cumulative 67% in 1Q19 since the first quarter of 2009, while the former (a debt type that cannot be easily discharged, even in case of bankruptcy) has more than doubled over the same period.
Source: New York Fed
The problem is that student and auto loans make up more than half of all debt balances held by a younger demographic group. These 18 to 29-year olds are the same consumers who are, in theory, most likely to (1) provide the lion's share of future growth opportunities to financial services companies, yet (2) suffer the brunt of stagnant wages and fast declining labor-force participation early in their careers.
It is not hard to see a domino effect potentially playing out over a multi-year time frame, in which a heavier debt load and increasing delinquency rates (see chart above, on the right) could at best slow down the growth pace of consumer banking institutions or, at worst, cause a serious deterioration in credit quality. Credit card delinquency rates at smaller commercial banks (usually associated with having a lower credit quality client base) have already surpassed 2008 numbers in a sharply increasing trend, suggesting some trouble has already started to unfold on the fringe.
On the stock
DFS is certainly not priced for perfection. The stock trades at a forward P/E of 8.9x that looks modest, certainly given Discover's earnings growth expectations. However, I believe that a valuation discount on the stock of a company that lacks diversification across commercial, investment banking and wealth management is appropriate.
|Discover - DFS||8.9x||2.4x||5.7%|
|Capital One (COF)||8.1x||0.8x||4.2%|
|American Exp. (AXP)||15.2x||4.6x||7.5%|
I would not bet against DFS necessarily. But at the same time, I see enough long-term risks associated with owning a company operating primarily in the consumer credit card business. Among financial service names, I continue to favor high-quality, well-diversified market leaders like JPMorgan (JPM) that seem like a more cautious play in the current macro environment.
I do not own DFS because I believe I can create superior risk-adjusted returns in the long run using a different strategy. To dig deeper into how I have built a risk-diversified portfolio designed and back-tested to generate market-like returns with lower risk, join my Storm-Resistant Growth group. Take advantage of the 14-day free trial, read all the content written to date and get immediate access to the community.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.