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Discover a Compelling Value

Matthew Cochrane, The Motley Fool

After a rough 2018 in which its stock dropped 23%, Discover Financial Services (NYSE: DFS) is making a strong rebound in 2019. When the credit card company reported its first-quarter earnings late last month, the results propelled the stock price even further, and it's now up more than 35% year to date.

In the first quarter, revenue rose to $2.76 billion, a 7% increase year over year, and diluted earnings per share (EPS) grew to $2.15, an 18% increase over 2018's first quarter. The solid top- and bottom-line growth was driven by respectable loan portfolio growth and further evidence of responsible lending from Discover. Let's take a closer look at both of these factors and see why Discover might still make for a compelling value today, even with its rapid rise.

Man's hand holding a virtual scale with the word

Discover Financial is growing its loan portfolio while clearly practicing responsible lending. Image source: Getty Images.

Solid loan growth

Discover's total loan portfolio grew to $88.7 billion, a 7% increase year over year. While Discover's portfolio consists of credit card, personal, and student loans, the vast majority of it comes from its credit cards. Happily for shareholders, then, this is also Discover's fastest-growing category. This quarter, credit card loans rose 8% to $70.8 billion, good for about 80% of Discover's total.

In the company's conference call, CEO Roger Hochschild said Discover "continued to drive a high level of engagement from our customers," at least part of which was driven by the quarter's revolving rewards category of groceries. CFO Mark Graf called groceries the "most lucrative" reward category for card holders, adding:

"It's really easy for people to engage and max out the benefits. If you think about it, you know, to spend $1,500 in groceries in a quarter, you only need to spend something less than $125 a week. So not a lot of people spend that on gas, but a lot of people spend that on groceries."

Responsible lending

Investors will always be rightfully jittery when investing in companies with exposure to credit liabilities, which is why it's so important to shareholders that Discover practices responsible lending practices. That translates into not pursuing growth at all costs with risky loans. In the first quarter, Discover again showed that it continues to prioritize risk control with its lending. Hochschild commented:

"We continue to focus on originating loans that we expect will generate the appropriate level of long-term returns as opposed to simply targeting a higher level of growth in what continues to be a very competitive environment."

Across all loans, the net charge-off rate rose to 3.25%, about 0.16 percentage points higher than 2018's first-quarter charge-off rate. The net charge-off rate is the percentage of delinquent loans, or loans that Discover no longer expects to collect. Graf pointed out that this was the sixth consecutive quarter that the growth rate in credit card charge-offs declined.

A problem Discover experienced in the past was higher charge-off rates in personal loans accounts. While older personal loan accounts continued to show these higher charge-off rates, management noted that newer accounts in this segment were performing better. They accredited much of this success to taking fewer loans from aggregator and unsolicited channels.

Discover a good value

Discover's management also remains committed to returning capital to shareholders. Management has reduced the number of outstanding shares by about 7% since last year's first quarter through share repurchases. In 2018, the company also raised its dividend by about 14%, its ninth consecutive year of hiking its quarterly payout to shareholders. The current $0.40 quarterly dividend gives the stock a dividend yield of almost 2%. In the first quarter alone, Discover's management returned a total of $600 million to shareholders via dividend and buybacks.

The company's current P/E ratio is also just 10.25, meaning that even after its steep climb this year, shares still seem to trade at a more than reasonable valuation. Given the company's consistent loan growth, track record of responsible lending, shareholder-friendly management, and compelling valuation, this might be a stock many investors might want to ... ahem ... discover for their own portfolios.

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Matthew Cochrane has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.