Discover Financial Services: Corporate Governance Has Room For Improvements

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About: Discover Financial Services (DFS)
by: Joseph Allan Sinay
Summary

10 out of 11 board members are independent. Audit committee likely to benefit from more technical accounting and auditing members.

Short-term and long-term incentives rely on earnings before tax and provisions; we prefer a returns-based metric.

Long-term incentives vest over a three-year period; we prefer specific incentives for long-term (more than three years) employee retention.

Corporate governance and management incentives are critical in financial services: Discover Financial Services' is adequate but could be better.

In this article I plan to discuss the corporate governance situation at Discover Financial Services (DFS). This is in response to requests by my readers of additional coverage in the consumer credit space. In most companies the management team plays a critical role in determining the expected level of shareholder returns. Among firms in the financial services industry management plays an even larger role as these companies typically run with a high degree of operating and financial leverage. Put in another way: a small loss that puts a minor dent in the balance sheet of a manufacturing company can be enough to wipe out the entire market cap of a financial services company. Hence, I would say that an analysis of corporate governance and management incentives are a first stop in determining the risk-reward opportunity for a financial company. Only after that step can an analysis of business quality, competitive advantage, and valuation be made.

I have published a similar piece before on Seeking Alpha with respect to corporate governance. In the spirit of brevity I will not re-introduce the framework I use for this analysis. Enterprising readers can follow the link to the prior article published instead. With that said I believe that this piece will provide potential investors a decent starting point in determining whether further analysis of DFS is warranted.

As i did in my prior article on corporate governance, let's start with the board of directors.

Independent board of directors and a qualified audit committee

Take a look at the graphic below. First, we see that ten out of the eleven board members of DFS are independent and the only non-independent board member is the Chief Executive Officer Roger C. Hochschild. Next, we highlight that board members are elected annually (rather than staggered) and each director faces annual performance evaluations.

(Source: DFS 2019 proxy statement)

Next of importance would be the composition of the audit committee. Financial services companies like DFS are very reliant on management estimates, including those relating to provisions (e.g., loan loss provisions) which directly impact earnings. Note the disclosure in DFS' 2018 annual report:

In preparing our consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”), management must make judgments and use estimates and assumptions about the effects of matters that are uncertain. For estimates that involve a high degree of judgment and subjectivity, it is possible that different estimates could reasonably be derived for the same period. For estimates that are particularly sensitive to changes in economic or market conditions, significant changes to the estimated amount from period to period are also possible.

Consequently, the importance of a strong audit committee is accentuated to said financial services companies. We are inclined to believe that the audit committee of DFS (described below) will deliver on the objectivity and competence required.

(Source: DFS 2019 proxy statement)

Our personal preference is for more accounting and audit professionals in the audit committee (with at least one member being a Certified Public Accountant). Financial services companies face a constantly changing set of financial reporting and regulatory requirements. Most of the changes are technical in nature and require a deep understanding of (potentially arcane) accounting concepts. Furthermore, we believe that critical estimates (specifically those related to fair value of financial assets or loan loss reserves) require industry-specific accounting knowledge (second only to companies operating in the insurance industry).

Nonetheless, the audit committee (as a whole) bring a wealth and diversity of experience to the job. For example, Candace H. Duncan has a exceptional qualifications in auditing while Cynthia A. Glassman has a 40 year track-record in regulatory and public policy issues related to financial services. On the other hand we see the experience of Mr. Weinbach in private equity and Mr. Eazor in management consulting as less relevant for the audit committee. On balance, we are confident that this team can deliver above and beyond the needs of the shareholders with respect to the audit committee function.

(Source: DFS 2019 proxy statement)

(Source: DFS 2019 proxy statement)

(Source: DFS 2019 proxy statement)

(Source: DFS 2019 proxy statement)

Management incentives are aligned for the most part

Next, we'll discuss the top management compensation and the different aspects of the compensation program that lead us to believe that management incentives are (mostly) aligned with shareholder interests. In order to facilitate this discussion, we will be referring to the table below which summarizes the 2018 compensation of the Chief Executive Officer and the Named Executive Officers ((NEOs)).

(Source: DFS 2019 proxy statement)

The first compensation component is the salary. According to the proxy statement the function of the base salary is to attract and retain the right caliber of talent for each role. The proxy statement also notes the use of a compensation consultant and that changes to the base salary is not intended to made frequently. For example, we were impressed to find out that the former Chairman and Chief Executive Officer David W. Nelms's base pay had been the same from 2008 to 2017. We believe that this sets the right tone for the rest of the NEOs and the employees of DFS with respect to the meaning of pay for performance. While we are not particularly fond of compensation consultants, it seems that the compensation committee have managed to reign in the impulse to race for higher and higher base pay to the top management team.

The second compensation component is the short-term incentive program (NYSE:STI). According to the proxy statement the function of the STIP was:

The STI opportunity is provided to motivate executives to achieve our annual business goals and to attract and retain an appropriate caliber of talent for the position, recognizing that similar annual STI opportunities are provided at other companies with which we compete for talent.

Furthermore the proxy states that the primary driver of STI is profit before taxes and reserves (PBTR):

PBTR is derived by adding changes in the allowance for loan losses to pretax income. PBTR is a non-GAAP financial measure that should be viewed in addition to, and not as a substitute for, the Company's reported results. The Committee believes that PBTR is a better measure of the core operating performance of the business and is consistent with the evolution of our STI program in recent years to increase focus on factors the Company's incentive-eligible employees are most able to directly impact and influence and controls for variability in significant macroeconomic impacts.

While we applaud management for using a somewhat 'objective' measure in determining STI, we think that PBTR is an inferior measure to the GAAP measure of net income. Removing the impact of loan loss reserves may incentive management to pursue high credit-risk opportunities that bear high profit opportunities in the short-term at the expense of the long-term. Moreover, the shift in recognition of provisions from the incurred loss model to the expected credit loss model removes the need to adjust earnings for provisions: timing differences are essentially removed from the equation. Recall the following description of the expected credit loss in the most recent 10-K:

For loans carried at amortized cost, the allowance for loan losses will be based on management’s current estimate of all expected credit losses over the remaining contractual term of the loans. Upon the origination of a loan, the Company will have to record its estimate of all expected credit losses on that loan through an immediate charge to earnings. Updates to that estimate each period will be recorded through provision expense.

The third compensation component is the stock awards. According to the proxy statement the intent of said stock awards is to focus top management on DFS's long-term interests (and balancing those with imprudent risk-taking).

We note that the restricted stock units ((RSUs)) vest pro rata over a three-year period and the at-risk performance stock units ((PSUs)) are tied to a three-year company performance and vesting method. We generally don't like the idea of a pro-rata vesting period for long-term incentives (vis-a-vis a cliff vesting method). We think that this vesting approach creates less retention incentive. Nonetheless, we think that the amounts involved are meaningful enough to achieve the intended benefit of long-term alignment.

The total value awarded is determined by the board and is split between RSUs and PSUs as seen in the graphic below. We note that the total value awarded is primarily determined by the PBTR (similar to the STI) and other factors considered are only secondary to the PBTR. Said factors include company financial performance metrics, key focus areas, relative performance, and risk performance.

(Source: DFS 2019 proxy statement)

Regarding PSUs (from the proxy statement):

PSUs will generally vest and convert to shares of Common Stock if and to the extent the Company achieves specific cumulative earnings per share (NYSEARCA:EPS) performance goals over a three-year performance period and the executive remains employed by the Company for the three-year period (with exceptions for certain termination events), and are subject to an evaluation of compliance with the Company's risk policies over the three-year period prior to vesting.

We don't like the vesting mechanism for the PSUs.

First, we think that EPS is a poor indicator of long-term performance especially for financial services companies. Financial services companies are primarily constrained by capital such that more capital will always lead to more earnings (e.g., therefore management can improve earnings per share metrics by retaining capital or buying back shares regardless of the return on capital employed). We would have preferred that management use metrics such as return on equity, return on capital employed, or return on invested capital as the primary basis for awarding long-term compensation.

Second, we think that a three-year performance measurement period is too short. Financial services companies are cyclical: mistakes made in 2002 could only begin to surface in 2008. An especially long economic cycle (such as the one we are experiencing now) may provide an unusually strong tailwind to current management (which will eventually reverse and provide an equally strong headwind to future management). Furthermore, a three-year retention period is too short especially for strategic pivots into new businesses or the integration of acquired companies. Top management may not feel responsible for the repercussions of decisions made now in relation to tail risks beyond three years out.

Third, we would have liked to see long-term incentives specifically related to employee retention (beyond three years). A strong management team that sticks together is invaluable especially during times of financial distress.

In sum, we find that management incentives are aligned with 'best practices' at the surface level: a high degree of at-risk compensation, a mix of short-term and long-term incentives, and a set of objective and quantified performance targets to which incentives are tied to. However, a closer inspection reveals that the mechanisms for awarding the different incentives leave much room for improvement. We would ideally want to see a more return-oriented metric as the primarily basis for compensation and a shift towards management retention beyond three years. Nonetheless, none of the incentives stand out as particularly unacceptable - but the weaknesses observed mean that the other aspects of the investment must be compensatory (e.g., valuation, business quality, etc.).

(Source: DFS 2019 proxy statement)

Conclusion

We find that corporate governance and management incentives are adequate in the case of DFS. Consequently, investors should take a closer look at the other aspects of the investment: balance sheet strength, business quality, and valuation.

Unlike our finding for Raymond James Financial (RJF), DFS would benefit from meaningful changes in its corporate governance and management incentive program: we advise potential investors and current shareholders to call for changes in line with our suggestions. A more technical (in relation to financial services audit and accounting) audit committee, a more robust quantitative metric as the basis for long-term and short-term incentives, and a more active retention incentive will go a long way. We believe that doing so will only strengthen the investment case for DFS.

Look out for our future articles on DFS and other companies in the financial services industry. Don't forget to like our articles and follow us to get the latest on these under-covered equities.

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.