Discover Beats Estimates by a Mile (Update 1)

Discover reports fiscal third-quarter EPS of $1.21, blowing past the consensus estimate of $1.03.
Average loans grow 3% sequentially, and 9% year-over-year.
Net interest income and margin increase; payment services income continues rapid increase.

Updated with market reaction and comments from Nomura analyst Bill Carcache.

NEW YORK ( TheStreet) -- Discover Financial Services ( DFS) on Thursday reported that is average loans grew by 3% during its fiscal third quarter, and 9% year-over-year.

The Riverwoods, Ill., card lender reported earnings of $627 million, or $1.21 a share, for its fiscal third quarter ended Aug. 31, soundly beating the consensus estimate of a profit of $1.03 a share, among analysts polled by Thomson Reuters.

In comparison, the company earned $537 million, or $1.01 a share, the previous quarter, and $642 million, or $1.18 a share, a year earlier.

Discover's shares were up 5% in afternoon trading, to $38.87.

The sequential earnings improvement reflected a $182 million release of loan loss reserves during the fiscal third quarter. During the previous quarter, the company released $110 million in reserves.

While earnings were down slightly from a year earlier, EPS was up, because of the company's share repurchases. Discover bought back roughly 10 million shares for $350 million during the fiscal third quarter. Total shares outstanding declined by 1.9% during the quarter.

Net interest income increased to $1.37 billion during the fiscal third-quarter, from $1.32 billion the previous quarter, and $1.24 billion a year earlier. The fiscal third-quarter net interest margin -- the difference between the average yield on credit card loans and investments -- was 9.44%, increasing from 9.31% the previous quarter, and 9.26% a year earlier, as declining funding costs more than offset a decline in portfolio yield.

Discover's credit card yield was 12.27% during the fiscal third-quarter, declining from 12.35% the previous quarter, and 12.46% in the year-earlier period.

The company reported that its payment services pretax income rose to $49 million in the fiscal third quarter, from $47 million the previous quarter, and $38 million a year earlier, "driven by an increase in higher margin point-of-sale transactions on the PULSE network."

Discover's revenue improvements were partially offset by an increase in expenses, which were up by $178 million or 29% from the prior year, "primarily due to a $94 million year-over-year increase in expenses for legal reserves," after the company agreed with the Federal Deposit Insurance Corp. and Consumer Financial Protection Bureau to issues refunds of up to $200 million to customers, related to the telemarketing of credit protection products, along with $14 million in fines.

Discover CEO David Nelms said the company "demonstrated solid performance," and that "Card sales and receivables grew in a challenging environment while credit quality continued to improve."

Nelms added that the company "successfully launched Discover Home Loans in June, which expanded our direct banking product suite. In payments, we signed agreements with PayPal, Industrial and Commercial Bank of China, and most recently Russian Standard Bank to enhance our global presence and leverage our existing infrastructure."

Discover's deal with eBay ( EBAY) unit PayPal will allow the online payment service's customers to make purchases at the 7 million retail locations that currently accept Discover, beginning in the second quarter of 2013.

Discover said that its fiscal third-quarter return on equity (ROE) was 28%, which is a very solid number for any financial institution in any market. According to Thomson Reuters Bank Insight, the company's operating ROE ranged from 24.41% to 33.42% over the previous four quarters.

Discover's shares closed at $37.02 Wednesday returning 55% year-to-date, following a 31% return during 2011.

The shares trade for 2.1 times their reported Aug. 31 book value of $18.02, and for nine times the consensus fiscal 2013 Earnings estimate of $4.06 a share, among analysts polled by Thomson Reuters. The consensus fiscal 2012 EPS estimate is $4.24.

Earlier on Thursday Morning, Sterne Agee analyst Henry Coffey said his firm was expecting operating earnings of about a dollar a share, and was "assuming no reserve release in our estimates," but also said a reserve release "would not be surprising."

Regarding Discover's $200 million settlement and $14 million in fines over the market of credit protection products, Coffey said that "the company has set aside reserves in past quarters related to state based lawsuits and other related items tied to these products in past," and had recognized litigation related expenses of $90.8 million," during the fiscal second quarter.

Coffey rates Discover a "Buy," with a $40 price target.

Nomura analyst Bill Carcache also rates Discover a "Buy," with a $41, and said after the earnings announcement that the company's "3Q12 core EPS of $1.10 (excluding $0.23 of reserve releases and $0.12 of non-recurring litigation charges)" beat his estimate of $1.07, although it was "unclear how much of one-time litigation charges and reserve releases were incorporated in the consensus GAAP EPS estimate of $1.03."

Carcache said that Discover's fiscal third-quarter loan growth suggests "that the company continues to gain share in the total revolving credit market, which is growing at ~1% on a YoY basis."

Regarding Discover's net interest margin improvement and the inevitable end to the declines in funding costs, with the Federal Reserve's target federal funds rate in a range of 0 to 0.25% since the end of 2008, Carcache said that "Our analysis suggests that the company's NIM can remain relatively stable over the next several quarters even as credit-related and funding cost tailwinds moderate, and we believe there may be upside to next year's guidance as a result."