How Discover's Tax Benefit Helped Make Up for Pricey Card Rewards
This article, originally published at 5:17 p.m. on Tuesday, July 19, 2016, has been updated throughout with comments from analysts and executives.
Discover Financial (DFS) - Get Report posted higher quarterly profit after a tax benefit helped make up for costlier reward programs designed to boost cardholder spending.
Net income rose 2.8% to $616 million as lending increased during the spring and shoppers pushed up credit card balances. Excluding a $44 million tax benefit that boosted profit by 11 cents, Discover earned $1.36 a share, trailing the average estimate of $1.38 from analysts surveyed by Bloomberg. Revenue increased almost 2% to $2.22 billion, the Riverwoods, Illinois-based company said in a statement.
"The reason they beat earnings is they had a much lower tax rate this time," Erik Oja, an analyst with S&P Global said in a phone interview. The gain was artificial, he said, since Discover usually has a tax rate of 37% had one of 31% rate in the three months through June. The cost of rewards programs, meanwhile, increased 18% to $371 million, which would have dragged net income lower, he explained.
"It's a very competitive environment and all the card companies are definitely having to enhance their rewards costs," Oja said.
Discover said lending increased 4% from last year to $71.9 billion while credit card balances rose by the same amount to $57.2 billion. "We achieved loan growth within our target range and delivered strong profitability," said CEO David Nelms.
BMO Capital, which has a "market perform," rating on Discover, with a target price of $63, is content with consumer credit quality and said the firm should "grow loans at a faster pace."
Part of what's driving the increase in rewards costs is a permanent shift to 1% cashback bonuses for customers, a 5% cashback program on certain purchases each quarter, and double rewards with new accounts, the company said.
"We set a post recession record for new accounts during the quarter, demonstrating that our brand, rewards and overall value proposition continue to resonate with our target customers," Nelms said on an earnings call.
Interest income was up 7% year-over-year, to $1.8 billion, mostly due to loan growth and a higher margin, the company said.
Discover, American Express (AXP) - Get Report , Ally Financial (ALLY) - Get Report , and Capital One (COF) - Get Reportwere among 30 bank holding companies with more than $50 billion in assets that passed the Federal Reserve's 2016 annual review, the regulator said last month.
That enabled Discover to boost its quarterly dividend 7.1% to 30 cents a share and initiate a $2.5 billion share repurchase program, generating "one of the highest total yields" among finance companies that require Fed approval for such spending, Nelms said.
Keefe, Bruyette & Woods analysts rate Discover as a "outperform" with a target price of $62.
"Discover reported a good quarter, driven by stronger than expected net interest margin and a slightly lower tax rate on an operating basis," Sanjay Sakhrani, a KBW analyst, wrote in a note.
The company's shares dropped 2.8% to $55.40 in after-hours trading Tuesday, paring gains to about 5.1% this year, slightly lower than the broader S&P 500.