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Discover Posts In-Line Q3 Earnings, Beats on Rev

Zacks Equity Research

Discover Financial Services (DFS) reported third-quarter 2013 earnings per share (EPS) of $1.20, in line with the Zacks Consensus Estimate. However, EPS declined 3.2% from the year-ago quarter’s earnings of $1.24.

The decline in Discover Financial’s EPS was due to the inclusion of a large reserve release in the year ago period.

Discover Financial’s net income deteriorated 6.9% year over year to $593 million and included a $42 million reserve build whereas the third quarter of 2012 included a $167 million reserve release. Net income allocated to common shareholders decreased to $579 million from $631 million in the year-ago quarter.

Discover Financial’s total revenue, net of interest expense, increased 2.8% year over year to $2.06 billion, beating the Zacks Consensus Estimate of $1.77 billion. The improvement came on the back of Discover card sales volume growth. Net interest income also improved 8.8% year over year to $1.51 billion reflecting loan growth and higher net interest margin.

Moreover, total other income for Discover Financial decreased 10.5% from the prior-year quarter to $553 million. However, total other expenses also fell 6.9% year over year to $783 million.

Direct Banking Segment

Discover Financial’s Direct Banking segment reported pre-tax income of $918 million, reflecting a 6% decline from the year-ago quarter. Revenues, net of interest expense, for the segment increased $67 million or 3% from the year-ago quarter. The increase was due to higher loans and a decline in funding costs.

Discover card sales volume grew 3% year over year to $28 billion. Total loans improved 5% year over year to $62.7 billion, boosted by a 4% increase in credit card loans, a 5% increase in private student loans and a 26% surge in personal loans.

Other income decreased 10% year over year, primarily due to a decline in direct mortgage related income and the inclusion of a gain on sale of a minority investment in the prior year worth $26 million.

Expenses in the segment decreased 8% year over year. This was because the prior year quarter included a $96 million addition to legal reserves in other expenses. However, higher information processing expenses and growth in headcount and new product initiatives that led to higher compensation, partially mitigated the improvement in expenses.  

Discover Financial’s credit card net charge-off rate declined 29 basis points (bps) sequentially to 2.05%. The decline was primarily attributable to growth in personal loans. However, the over-30-days delinquency rate deteriorated 9 bps over the prior quarter to 1.67%.

In addition, provisions for losses increased $197 million year over year to $333 million, reflecting higher loan loss reserves slightly offset by lower charge-offs. Reserve build during the quarter was $42 million (reflecting lower expected recoveries on aged charge-offs and increase in loans), compared to a reserve release of $167 million in the year-ago quarter.

Payment Services Segment

Pre-tax income in Discover Financial’s Payment Services segment amounted to $28 million, down 41.7% year over year. Revenues in the segment during the reported quarter decreased $10 million year over year reflecting a decline in transaction processing revenue for PULSE. Meanwhile, expenses increased $10 million from the year-ago level driven by higher operating costs related to Diners Club.

Payment Services dollar volume declined 2% from the year-ago quarter to $48.5 billion. Meanwhile, the transaction dollar volume from PULSE reduced 2% year over year. Diners Club volume also showed a decline of 7% during the third quarter of 2013.

Financial Position

Discover Financial had total assets worth $75.5 billion as of Sep 30, 2013, increasing from $75.1 billion as of Sep 30, 2012. Total equity stood at $10.6 billion at the end of Sep 2013, up from $9.2 billion at the end of Sep 2012. Book value per share was $22.14 at the end of Sep 2013, compared with $18.18 as of Sep 30, 2012.

Share Repurchase Update

During the reported quarter, Discover Financial repurchased 7 million shares for $350 million leading to a sequential decline of 1% in shares outstanding.

Our Take

Discover Financial successfully met the earnings expectation, although earnings were lower than the year-ago numbers. However, the top line fared well on both counts. Higher revenues coupled with lower expenses led to margin expansion during the reported quarter.

Rapid domestic expansion and foray into new countries via alliances is boosting card acceptances and expanding the company network. Further, Discover Financial has broadened its product portfolio by launching Discover Home Equity Loans that should bridge the gap between its personal and home loans. Additionally, curbing interest rates on student loans, the acquisition of Home Loan Center and business expansions through alliances with EMVCo and Paydiant should drive numbers of Discover Financial going ahead.

However, the Payments Services segment is facing some challenges. The active debit environment coupled with the economic environment in Europe and potential pressure on Discover Network partners’ volume might mar the results of this segment in the near term. Nevertheless, the long-term prospects of the segment continue to look good.  

Zacks Rank

Currently, Discover Financial caries a Zacks Rank #2 (Buy). Other companies worth considering in the financial sector are World Acceptance Corp. (WRLD), Capital One Financial Corp. (COF) and Regional Management Corp. (RM). All these stocks carry a Zacks Rank #2 (Buy).

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