Discover Financial Services (DFS)

[chmcnfunds]

Discover Financial: A Solid Play On The American Recovery And Oil Tax Cut

Jan. 29, 2015 1:19 PM ET | 1 comment | About: Discover Financial Services (DFS), Includes: AXP, MA, V
Disclosure: The author is long DFS, JPM. (More...)

Summary

DFS is trading at modest historical metrics following the market over-reaction to a disappointing quarter.
DFS is slowly and prudently growing its loan base while maintaining modest (and adequately reserved) write-offs.
Recent events suggest cost of funds will remain low for the medium-term.
Declining unemployment and the oil "tax cut" are both strong, positive indicators for loan growth and modest default rates.
Discover Financial Services (NYSE:DFS) is the "nice" credit card issuer and processor, often overlooked but, conservative and solidly profitable. The Company based in the friendly Midwest (suburban Chicago) was founded in 1960 and became a public company in June 2007, after being spun-off from Morgan Stanley (NYSE:MS).

Two Segments

DFS operates in two primary segments, Direct Banking and Payment Services. Direct Services includes the Discover Card credit and debit cards, held by over 50 million customers in the United States, and a consumer lending and deposit products business offered through Discover Bank. Payment Services includes the Discover network, which processes payments for merchants using the Discover Card, PULSE, an ATM network, and Diners Club (International). Unlike most credit card issuers, except American Express (NYSE:AXP), who utilize the Visa (NYSE:V) or MasterCard (NYSE:MA) networks, Discover cards are processed through the Company's network. Discover is not the largest network, but it is a consistently profitable network.

Source: Cardhub.com

The vast majority of the Company's revenues and profits derive from the Direct Banking segment.

Recent Stock Performance

During 2013 and 2014, DFS appreciated by almost 43% as the U.S. economy expanded, DFS profits grew and market concerns lifted for certain financial companies.

(click to enlarge) (click link below for tables/charts)

Source: Yahoo!

However, as evidenced by the fourth quarter income statement (and discussed later), the Company incurred several one-time charges in rewards costs and loss reserves that negatively impacted results.

Source: Discover

The market reacted negatively to the "bad news" in the fourth quarter earnings. As shown below, the negative reaction created the current opportunity. Since the beginning of the year, SFS is down almost 16%.

(click to enlarge)

Source: Yahoo!

Makes Money on Card Balances (Lending )

Direct Banking makes the bulk of its money lending money to customers through its credit cards, and to a lesser extent via direct consumer student and personal loans. Total loan receivables at the end of 2014 were $70 billion, up 6.4% during the year. Historically, 62% of Discover cardholders had a balance or loan with the Company; as DFS has become more aggressive, the percentage of new accounts with balances or loans has increased to 78%.

Source: Discover 10-K

Conservative Lender/Strong Credit Quality

Traditionally, DFS has been less aggressive in pursuing borrowers with lower credit scores and has been stingier with respect to credit limits. As a result, DFS has traditionally experienced lower charge offs than its peer group (Citibank (NYSE:C), JPMorgan (NYSE:JPM), Capital One (NYSE:COF), American Express and Bank of America (NYSE:BAC)). Charge offs varied by product, with the net principal charge-off rate for credit cards in the fourth quarter of 2014 at 2.26%, less than the 2.63% reserve rate. Overall, the net principal charge-off was 2.18%, against a reserve rate of 2.59%.

Source: Discover; the charge off rate increased to 2.2% in the quarter ended December 2014

Charge offs are a key indicator of both company credit quality and the overall strength of the U.S. economy. As DFS has grown its loan portfolio, overall charge offs increased by 15 basis points (BP) in the fourth quarter of 2014 compared to the year-ago period. The reserve rate, while still 41 bp more than the overall charge offs, fell by 4 bp.

Opportunistically Aggressive

DFS has been more aggressive in positioning itself as a consumer friendly card.



The Company has leveraged its brand and, beginning around the time of the Great Recession, as competitors pulled back, has taken a more aggressive stance than its peer group in growing loan balances.

Source: Discover; peer group also includes Wells Fargo (NYSE:WFC)

The Nilson Report estimates DFS's credit card purchase volume will increase by 35% in the 2013-2018 time period, reaching $172 billion.

Cost of Funds Modest; Expect Medium Term Declining-to-Constant

As with all financial institutions, DFS makes money on the spread between the rate at which it lends money and its cost of funds, less bad debts. The Company's cost of funds has been declining in recent years, but can be expected to increase if interest rates increase. The concern over rising interest rates was more urgent as recently as three months ago. While the timing of interest rate increases is not known, the trend has been toward even lower interest rates. On January 27, MS indicated it did not believe the U.S. Federal Reserve would increase interest rates until Q1 2016.

Source: Discover (all interest-bearing liabilities)

At the end of 2014, DFS had an "interest yield" of 11.4% (net interest margin was 9.8%), an average cost of funds related to the loans of 1.8%. As previously mentioned, the net principal charge-off was 2.18%.

Modest Valuation (though not screamingly cheap)

From a valuation perspective, DFS boasts a strong growth rate, a reasonable-to-attractive yield and a modest PEG.

Source: Yahoo!

Further, the fourth quarter earnings included a number of a one-time charges and provisions which, to me, smack of cookie jar filling. Of course I am not suggesting any wrong-doing; I am suggesting conservative reserves which have the potential to be moderated or released at a future date. In other words, a potential upside.

Why Discover?

Measured, profitable and opportunistic growth
Valuation at low end of historic 10-12x PE range
PEG of 1.2 is reasonable
DFS is a play on expanding U.S. economy and oil "tax cut"
DFS benefits from a strengthening U.S. economy, driving low write-offs and confidence to borrow
DFS benefits from oil "tax cut" as consumers spend more (though is hurt by lower gas charges)
DFS is U.S. only, unlike AXP, MA and V, and has no currency risk
Positioned as high integrity, non-gimmick company; avoids promotional price wars and avoids overly risky clientele
Continued low interest rates make cost of funds even more attractive (and likely lower than analyst have forecasted)
Risks to Consider/Watch For

A turn in the U.S. economy
Spot unemployment in the oil patch driving market defaults
Unexpected increase in interest rates (increases cost of funds)
Higher net default rates
I like the credit card sector in today's economy. The U.S. economy is strengthening and will continue to grow as unemployment stays low and consumers warm to the oil tax cut. DFS is a conservatively managed, cautiously opportunistic company that can (and is) take advantage of the good times in the U.S. It is modestly valued, sports a reasonable PEG and pays a reasonable (though not rich) dividend. Default rates are low, are adequately (or even over adequately) reserved and are being carefully monitored. The recent pullback creates an opportunity to initiate a position. DFS should help investors "get rich slowly).

This article only reflects the author's opinion. It is not designed, and should not be used as the basis of an investor's buy or sell decision. Investors should always conduct their own due diligence and make their own buy and sell decisions.
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http://seekingalpha.com/article/2864166-discover-financial-a-solid-play-on-the-american-recovery-and-oil-tax-cut?auth_param=udil:1acnir5:2b3ca76ee11e6f95e8e4b97c4fc8c847&uprof=46

DFS