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Discover Profits Slip on U.K. Unit Sale

Debra Borchardt

Credit card provider Discover Financial Services(DFS Quote - Cramer on DFS - Stock Picks) managed to beat analysts' first-quarter earnings estimates, even though it took a huge hit for selling its U.K. credit card business.

The Riverwoods, Ill.-based company reported earnings of 50 cents a share for the first quarter of 2007, a drop from the 54 cents a share it earned in the year-ago period. According to Thomson Financial, analysts had been expecting 40 cents. Excluding items, profits were $239 million, vs. $260 million for the prior year, but net income plunged to $81 million when the $158 million loss of its U.K. Goldfish business was factored in.

"Goldfish was a money-losing business for Discover, with limited prospects for near-term improvement," wrote Goldman Sachs analyst James Fotheringham. "The sale should free up [about] $400 [million] in capital for Discover, which we assume will be used for share repurchases. Discover is selling Goldfish for $70 million, less than 5% of the price paid to acquire it back in 2005."

Discover completed the acquisition of Goldfish for $1.4 billion in February of 2006.

It was just last June that Discover was spun off from Morgan Stanley(MS Quote - Cramer on MS - Stock Picks) and became an independent company. Since then, the stock has been on a downward trajectory. Shares posted a high of $32.17 in June, but were lately trading at $16.49, losing 91 cents after releasing the earnings.

The company's timing for independence comes as the U.S. economy is entering a recession. The weakening economic landscape is also contributing to an increase in delinquencies and charge-offs. Card users more than 30 days late numbered 3.9%, an increase of 34 basis points sequentially and 62 basis points year-over-year. The company also had to set aside more money for loan losses with the provision increasing 54%. This was only partially offset by an 11% increase in interest income.

One shining area was third-party payments, up 24% from last year. This segment includes fees from PULSE ATM withdrawals. There are roughly 260,000 machines.

Fotheringham currently has a sell rating on the stock and a $12 target price. "We worry about the negative impact of falling home prices on U.S. consumer credit quality; we believe that management's recently-revised guidance for U.S. net charge-offs (to 475-500bps from 425-475bps) is still too optimistic," he wrote.

Similarly, Standard & Poor's analyst James Braden has a "hold" rating on the stock but places his target price at $20. "We see credit quality slowly deteriorating, and expect consumer spending to feel the pressure of rising energy prices and increasing adjustable rate mortgages," he wrote.

Braden sees other pitfalls. "We believe increasing regulatory pressures on the credit card industry will hamper future fee income," he said.

Discover shares were sinking 8.7% to $15.88.

The company announced results on the same day Visa(V Quote - Cramer on V - Stock Picks) began trading as a public company, selling 406 million shares at $44 each. Visa shares were soaring more than 30%. MasterCard(symbol Quote - Cramer on symbol - Stock Picks) also was up $5.85 to $216.10 in recent trading. Unlike Discover, Visa and MasterCard only process transactions and do not assume cardholders' debt.