Discover Financial Services - Strong Underlying Performance, Despite A Drop In Net Earnings

| About: Discover Financial (DFS)
This article is now exclusive for PRO subscribers.

Shares of Discover Financial Services (DFS) ended the week with gains of 3%. On Thursday, the financial firm reported its third quarter results, which beat analysts' consensus.

Third Quarter Results

Discover Financial Services reported third quarter revenue of $1.96 billion, up 9.8% on the year. Revenue beat analysts' consensus of $1.90 billion.

Net income fell from $649 million last year to $627 million in 2012. Earnings per share rose from $1.18 last year, to $1.21 in 2012 as a result of a sizable share repurchase program. On average, analysts expected Discover to earn $1.04 over the quarter.

Despite sizable revenue growth, net profits fell on the back of lower loan loss reserve releases and increased legal expenses associated with the Federal Deposit Insurance Corporation (FDIC) and Consumer Financial Protection Bureau (CFPB).

The company repurchased roughly 10 million shares during the third quarter, for approximately $350 million.

CEO and Chairman David Nelms commented on the results:

"Our business segments demonstrated solid performance during the quarter. Card sales and receivables grew in a challenging environment while credit quality continued to improve. We successfully launched Discover Home Loans in June, which expanded our direct banking product suite. In payments, we signed agreements with Paypal, Industrial and Commercial Bank of China, and most recently Russian Standard Bank to enhance our global presence and leverage our existing infrastructure."

Segmental Information

The direct banking division remains responsible for the majority of Discover's financial performance. Discover card sales volume was up 4% to $27.2 billion. Credit card loans were up 4% as well to $48.1 billion. Total loans rose by 9% to $59.2 billion, driven by the acquisition of a $2.4 billion student loan portfolio in the fourth quarter of 2011.

Despite a 19 basis point decrease in credit card yields to 12.27%, net interest margins rose 18 basis points to 9.44% as a result of lower funding costs.

Despite the solid growth in loans and increasing net interest margins, pre-tax income for the direct banking division fell by 5% to $963 million. The main reason behind the fall in pre-tax profits is the $94 million increase in legal expenses reserves.

The payment service division reported pre-tax income of $49 million, up 31% on the year. The division handled sales volumes of $50.3 billion, up 13% on the year. Growth was driven by higher PULSE and third-party issuer volume.


Discover Financial Services ended the quarter with $73.9 billion in total assets, up from $65.7 billion last year. Total equity rose from $8.0 billion to $9.1 billion, boosting the equity-to-assets ratio by 20 basis points to 12.4%.

The company's loan book continues to show improvement in performance. 30-day delinquency rates fell by 64 basis points on the year to 1.71%, while 90-day delinquency rates fell 36 basis points to 0.81%.

For the first nine months of 2012, Discover Financial generated revenue of $5.7 billion. The company net earned $1.8 billion, or $3.39 per share. At this rate, Discover is on track to report annual revenue around $7.6 billion, on which the company could earn $4.50 per share.

Currently, the market values Discover Financial at roughly $20 billion. This values the company at roughly 2.6 times annual revenue and 9 times earnings.

Discover Financial Services pays a quarterly dividend of $0.10 per share, for an annual dividend yield of 1.0%.

Investment Thesis

Year to date, shares of Discover Financial Services have risen an incredible 65%. Shares started the year at $24 and steadily rose to the low thirties in March. Shares steadily kept on gaining ground during the summer, now exchanging hands at $40 per share.

Over the past five years, shares of Discover have almost doubled in value. Shares rallied from lows of $5 in 2009 to new highs of $40 at the moment. Since 2008 and now, Discover Financial boosted its total balance sheet from $40 billion to $74 billion at the moment. Net income rose from $928 million in 2008, to $2.2 billion in the meantime.

Last March, I argued that shares were fairly cheap, then trading at $32. Unfortunately, I did not act upon my own advice, missing out on a 25% return in just half a year.

Shares are still fairly cheap at the moment, valued at merely 9 times earnings. Given the strong momentum recently, I do not expect very strong performance in the short run, unless the company significantly boosts its dividend payout. The long-term bullish investment thesis, however, remains intact.

Disclosure: I 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.