Diving Into Discover Financial Services
Summary
- Discover Financial Services is down approximately 25% since the release of its 4Q19 and FY19 earnings, that featured a sharp uptick in the expense line for 2020.
- A focus on building brand awareness and upgrading technology were cited for the disappointing results.
- An upward revision to loan loss provisions caused by modeling tweaks spurred by a new accounting rule effective January 1, 2020 did not help matters.
- The stock like almost every equity has been hit hard by fears of the coronavirus outbreak in recent weeks.
- Significant insider buying after the selloff merited further inquiry. A full investment analysis follows in the paragraphs below.
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You know your children are growing up when they stop asking you where they came from and refuse to tell you where they're going."― P. J. O'Rourke
In today's 'deep dive' we take a look at a well-known financial name. The concern saw some significant recent insider buying in late January and is down approximately 25% from recent highs.
Company Overview
Discover Financial Services (NYSE:DFS) is a Riverwoods, Illinois direct (branchless) banking and payment services concern that offers its customers credit card loans, private student loans, and deposit products. In addition to its namesake credit card, the company also operates Diners Club International and the PULSE network of ATM cards. The Discover Card was first introduced by Sears in 1985 and was the first service to offer cash rewards for purchases. The company - after several corporate metamorphoses - was eventually spun out of Morgan Stanley (MS) in 2007. Its stock currently trades in the mid-70s, equating to a market cap near ~$23.5 billion.
The financial services provider has two reporting segments: Direct Banking, which generates the vast majority of its top line; and Payment Services. Direct Banking includes Discover-branded credit cards issued through its Discover Network/Bank, private student loans - it is the second largest generator of private student loans - personal loans, home equity loans, as well as other consumer lending and deposit products. Most of the top line is generated from interest earned on its $95.9 billion loan portfolio. Credit card discounting and interchange - paid between banks for the acceptance of card-based transactions - protection products and loan fees comprise the other revenue sources in this division. Payment Services principally includes PULSE ATM transaction fees and royalties from Diners Club card licensees.
Discover and the entire consumer financial services industry have been the beneficiaries of a U.S. economic expansion that is currently in its eleventh year. During the past decade, real personal consumption grew steadily every year at a 2.5% CAGR annually to ~$13.5 trillion. With ~$1.5 trillion in bank excess reserves, government deficit spending eclipsing $1 trillion in 2019, and interest rates exceptionally low, American consumers seem poised to emulate their habits of the prior decade - at least until rates move meaningfully higher.
2019 Performance
At the onset of 2019, Discover forecasted - based on range midpoints - 7% loan growth with operating expenses rising 6%. Net interest margin was expected at ~10.30%, while the net charge off {NCO} rate was anticipated to rise from 3.06% to 3.3%.
By the close of 2019, Discover delivered net revenue expansion of 7% on loan growth of 6% to $95.9 billion, which was technically at the low end of its 6-8% range with operating expenses rising 7% to $4.4 billion. Net revenue expansion above loan growth was accomplished through an improvement in net interest margin from 10.27% to ~10.41%, while the NCO only rose to 3.2%. The company's Payment Services segment generated a 24% increase in pretax income, primarily driven by strong volume gains from its PULSE business. Discover achieved a 26% return on equity while its Common Equity Tier 1 Capital Ratio essentially remained steady, rising from 11.1 to 11.2 (minimum requirement is 4.5).
Source: Company Presentation
These loan and segment metrics carried Discover to 2019 EPS of $9.08 a share, up 17%, from the prior year and 5% better than analysts' consensus forecast at the start of 2019. The company bought back 23.1 million shares yet lowered its TTM payout ratio from 93% to 77% while raising its dividend 10%. Owing to this performance, investors were rewarded with share price appreciation of 47% in 2019.
However, when the company reported 4Q19 and FY19 earnings on January 23rd, 2020, it provided its first forecast for 2020 that included an increase in expenses between 7% and 11%. The higher than expected spend will go towards enhancing brand awareness, collections, and an aggressive cloud buildout to improved analytics and marketing. Also, Discover's 4Q19 30+ day delinquency rate for credit card loans increased 19 basis points to 2.62% while its 4Q19 NCO rate grew 18 basis points from the prior year to 3.41%, prompting management to forecast the NCO rate to grow to 3.3%-3.5% in 2020, up ~20 basis points over FY19. With 2020 loan growth slated at only 6%, expectations for its aggressive share buyback program - which has seen Discover repurchase 8% and 7% of its shares outstanding each of the past two years (respectively) - waned.
Also fueling concern was a $1.1 billion increase in troubled debt restructurings (TDRs) from $2.3 billion at YE18 to $3.4 billion at YE19. Discover's accounting for TDRs is very conservative and has generated confusion amongst the analyst community. The release of its 10-K in late February is expected to clarify any ambiguity regarding this issue.
CECL Uncertainty
Not helping matters is the uncertainty surrounding a major change in the way lenders measure the expected losses on their loans for accounting purposes. The change was done in response to the banking crisis of 2007-2010 and will compel lenders to forego a backwards looking approach - known as incurred loss - for a forward looking measure called current expected credit loss {CECL} starting January 1, 2020. CECL requires a bank to increase its loss provisions starting in the quarter the loan is made. Ceteris paribus, a rise in a bank's loan losses will result in it reporting lower regulatory capital ratios, which reduces its capacity to lend while remaining in compliance with regulatory capital rules. In addition to front-end loading loss reserves, CECL has forced banks to create complicated models to forecast future provisions.
During 2019, Discover initially guided the Street to a 55%-65% increase in loan loss provisions owing to CECL; then on its 3Q19 earnings call, it directed to the higher end of that range. On the 4Q19 call of January 23rd, the company revised its loss provisions for January 1, 2020 to $2.5 billion, representing a 75% increase over its YE19 incurred basis. A tweak in the model's assumption was cited, causing further consternation.
Either way, the higher-than-expected technology, collections, and brand awareness spend coupled with a late upward adjustment to its loan loss provisions forced Street analysts to revise earnings estimates, moving their consensus from $9.47 to $9.05, essentially reflecting no growth in 2020. The stock sold off more than 12% in the following trading session. The current median EPS forecast for FY2020 has fallen to just under $9.00 a share.
Balance Sheet & Analyst Commentary
On the bright side, Discover's consumer deposits grew 22% to $53 billion and now account for 55% of its funding, up from 47% at YE18. This is a positive development, as consumer deposits are a cheaper funding method than its other financing vehicles. Management did not provide its liquidity portfolio balance at YE19. As of September 30th, 2019, it stood at $56.1 billion, up 6% from $52.9 billion at YE18.
Source: Company Presentation
The appeal of Discover has been its aggressive share buybacks and annual dividend increases, which reached nine consecutive years in 2019. In total, Discover returned ~$2.35 billion to its shareholders last year, consisting of $1.8 billion in repurchases and ~$550 million in dividends. Its quarterly dividend is $0.44, for a current yield of 2.3%.
On the back of Discover's disappointing 2020 outlook, two Street analysts were compelled to downgrade the stock, and several revised their price targets lower. The recommendation landscape is relatively bearish. However, both Credit Suisse ($94 price target) and Morgan Stanley ($87 price target) have reiterated buy ratings over the past couple of weeks. The median twelve-month price target is currently just under $90 a share.
With that said, the CEO, CFO, and the recently hired CIO all used the recent weakness to purchase shares of DFS around $74 late in January. Together, they invested over $1.6 million.
Verdict
Their purchases send a pretty strong signal that the market is misinterpreting Discover's outlook. Make no mistake: between the significantly higher technology, collections, and marketing spend and provisions for CECL, any earnings growth has likely been wiped out for 2020. Although CECL impacts loss provisions, which impact income, there is no hit to cash flow, meaning its string of dividend increases is likely safe, albeit at a higher payout ratio. And buybacks will continue, but at a more moderate pace.
Discover currently trades at seven times trailing FY2019 earnings, which is in line with its peers such as Capital One (COF) and Synchrony Financial (SYF). They all trade at a significant discount to approximate 13 times trailing earnings American Express (AXP) trades at with its higher quality loan portfolio. Management wouldn't commit to a spend level for 2021, meaning that it is still uncertain if the marketing and technology initiatives of 2020 are the shape of things to come or simply a temporary hit to margins.
Current shareholders will have to endure another quarter before additional clarity on spend and CECL provisions is provided. However, with consumer spending likely to stay solid in 2020 after panic around Covid-19 recedes, the downside would appear limited for Discover. Worries about increasing loan delinquencies and lower net interest margins (on the recent fall in interest rates) seem mostly baked into the stock price after the stock has fallen a quarter from recent highs. The shares also sport a near three percent dividend yield after their recent decline.
I just took a small buy-write position in DFS as between the option premium and the dividend payouts, I expect to capture a return in the mid teens when the near the money option expires in October. Outside a long lasting recession (which I don't see on the horizon), there appears to be little risk to longer-term downside at current trading levels.
Giving money and power to government is like giving whiskey and car keys to teenage boys."― P.J. O'Rourke
Bret Jensen is the Founder of and authors articles for the Biotech Forum, Busted IPO Forum, and Insiders Forum
Author's note: I present an update my best small and mid-cap stock ideas that insiders are buying only to subscribers of my exclusive marketplace, The Insiders Forum. Try a free 2-week trial today by clicking on our logo below! 20% Off 1st year of membership for a limited time only.
This article was written by
We are a team of analysts led by Bret Jensen, Chief Investment Strategist at Simplified Asset Management.
We run the investing group Learn MoreAnalyst’s Disclosure: I am/we are long DFS. 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.
I have a small position in DFS via recently initiated buy-write aka covered call orders
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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