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Discover Soars Following Earnings

NEW YORK ( TheStreet) -- Shares of Discover Financial Services (DFS - Get Report) were up over 5% to $55.05 on an otherwise very weak Friday morning for bank stocks.

The KBW Bank Index (I:BKX) was down 1.3% early Friday to 69.35, with all 24 index components showing declines.

Investors were clearly pleased with Discover's financial results, announced after the market close on Thursday.

Discover reported fourth-quarter net income of $602 million, or $1.23 a share, increasing from $539 million, or $1.06 a share, in the fourth quarter of 2012.  Noninterest revenue was up 6% year-over-year to $2.1 billion in the fourth quarter.

While earnings were up 12% year-over-year, EPS was up 16% because of the declining share count resulting from share repurchases. Discover bought back roughly 27 million shares during 2013 for $1.273 billion.  Average diluted common shares during the fourth quarter were down 5% from a year earlier.

Discover's transaction volume rose 1% year-over-year to $80.429 billion during the fourth quarter, with volume for the Discover network up 3% to $30.622 billion.

Average credit card loans grew 4% year-over-year to $50.957 billion during the fourth quarter -- a strong showing, considering that U.S. consumers were continuing to de-leverage.  Average total loans were up 5% from a year earlier to $63.443 billion, as the company grew its personal and student lending businesses.

The fourth-quarter return on equity was 22%, matching the return on equity (ROE) during the fourth quarter of 2012.

Discover's shares closed at $52.40 Friday and traded for 9.63 times the consensus 2015 EPS estimate of $5.44, among analysts polled by Thomson Reuters.  That's a very low forward P/E ratio for a bank consistently achieving returns on equity in excess of 20%.  The consensus 2014 EPS estimate is $5.13.

During the company's earnings conference call on Thursday, Discover CEO David Nelms said "I'm expecting a pickup in loan growth. I have not very many data points that support it. If I look through our competitor results recently, I didn't see really anyone besides us and American Express (AXP - Get Report) that grew loans."

Nelms went on to say that the credit card industry "ought to return to more like at least GDP growth," during 2014. "And I think that if that happens, and that would obviously be good for us, because I would hope to participate in some of that faster industry growth, because right now all of our growth is from taking share."

Bank of America Merrill Lynch analyst Kenneth Bruce rates Discover a "buy," with a price objective of $60, and wrote in a note to clients Friday that "healthy margins and loan growth contributed to a solid Q4."

"We think Q4 will further underpin market confidence in DFS, as its relatively attractive growth prospects and strong fundamental outlook support further earnings growth, in our view, which is not reflected in its valuation currently," Bruce added.  He went on to write that "there are a number of factors that suggest further upward momentum to earnings, including additional market share gains and a rotation away from Teaser-based products that will drive a reassessment of its earnings power and likely an improvement in valuation."

This could mean fundamental market reassessment of Discover, bringing the shares up to a more rational valuation to forward earnings estimates.  After all, American Express trades for 14.8 times the consensus 2015 EPS estimate of $6.04, based on Thursday's closing price of $89.17.

The following chart shows the performance of Discover Financial Services against the KBW Bank Index (I:BKX) and the S&P 500 since the end of 2011:

DFS Chart data by YCharts


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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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