Discover Gets a Boost From an Old Friend

Discover Financial Services(DFS Quote - Cramer on DFS - Stock Picks) surged nearly 9% on Friday morning after the consumer credit card company got a rating boost from its former parent, Morgan Stanley(MS Quote - Cramer on MS - Stock Picks).

Ken Posner, an analyst at Morgan Stanley, raised his rating on the Riverwoods, Ill.-based company to the equivalent of a buy from the equivalent of a sell.

Posner is increasingly optimistic about Discover's outlook. He expects the company to beat the average analyst earnings estimate this year, "thanks to more prudent underwriting [lower credit losses], more leverage in the net interest margin to Fed rate cuts, and limited vulnerability to gapping spreads in the unsecured funding markets," he writes in an industry note Friday.

Analysts on average expect Discover to earn $1.40 a share for its fiscal 2008, which ends in November. Posner is much more bullish -- he estimates the company would make $1.74 a share this year.

In addition, Discover's spinoff from Morgan Stanley -- completed last June -- as well as the possibility of a sale makes the company more valuable over the long term.

"Spinoff transactions often increase shareholder value, because the management of the newly spun-off company is exposed directly to the influence of the capital markets, as opposed to being sheltered under the umbrella of a conglomerate organization," Posner writes. "In 2009, [Discover] will be under pressure to demonstrate growth in its payments strategy or consider other options to boost shareholder value."

Posner says Discover's ability to limit its loan exposure in high-risk markets like California and Florida has mitigated higher loan losses, "even if that meant growing more slowly."

"More aggressive firms, like American Express(AXP Quote - Cramer on AXP - Stock Picks) and Capital One(COF Quote - Cramer on COF - Stock Picks), appear to have put too much weight on sophisticated underwriting models, and now their credit quality is deteriorating sharply," he writes.

Still the analyst retains a "cautious" rating on the overall consumer finance sector and expects both American Express and Capital One to disappoint on earnings estimates this year. Posner reiterated his "underweight" rating on both companies.

"We regard [Capital One] as exposed to subprime card and auto loans," Posner writes. American Express "may be in for further problems as prime mortgage troubles spread through its card portfolio, and it is also heavily reliant on unsecured debt, where spreads are now widening. Longer term, we see value in the [Discover] spinoff story, which has yet to play through to its conclusion."

Posner raised his price target over the next 12 to 18 months on Discover by $9 to $24. He also upped Capital One's price target by $6 to $40, but trimmed American Express by $2 to $42.

But analysts are generally concerned about the outlook for consumer finance companies, such as Discover, that hold consumer loans on their balance sheets.

Two weeks ago, UBS analyst Eric Wasserstrom slapped sell ratings on American Express, Capital One and Discover. Fears of an impending U.S. consumer-led recession this year and rising unemployment sparked Wasserstrom to lower his outlook on the companies.

Credit card growth is likely to remain low, "given high levels of consumer leverage and the potential impact from additional government rebates," Wasserstrom wrote in a note. "Hence we expect higher losses, limited balance sheet growth, and lower margins to result in lower earnings through 2008-09."

Michael Taiano, an analyst at Sandler O'Neill & Partners, said Friday that while Discover has managed to avoid large credit issues in the more risky parts of the country, "as we move through the course of 2008, the credit issues are to become more widespread geographically, therefore Discover's losses will move to be more in line with their peers." He rates the company at sell.

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