Discover: Earnings Blowout Winner

NEW YORK ( TheStreet) -- Discover Financial Services ( DFS) was the big winner among the largest U.S. financial names on Thursday, with shares rising over 7% to close at $39.71.

The broad indexes all rose 1% after the Labor Department reported that initial jobless claims fell 26,000 in the week ended Sept. 22 to 359,000 from an upwardly revised figure of 385,000 in the prior week. The four-week moving average was 374,000, a decrease of 4,500 from the previous week's 378,500.

Jefferies analyst Ken Usdin said that recent data offered "additional confirmation of the housing recovery, with most reports positive," and that "home pricing data is particularly encouraging as it should help banks turn the corner on mortgage and home equity charge-offs given the potential for lower severity."

Usdin said that housing market sentiment was "at pre-crisis levels." Supporting a very bright theme for bank stocks, the analyst said "the National Association of Home Builders (NAHB) Housing Market Index (HMI), a survey of housing market sentiment, is now at its highest level since June 2006," and that "expectations of future sales are climbing higher, pointing to better future activity."

The KBW Bank Index ( I:BKX) was up over 1% to close at 49.76, with all but four of the 24 index components showing gains, except for First Niagara Financial Group ( FNFG), which was down a penny, closing at $8.07.

Discover on Thursday 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.

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's average loans increased 3% sequentially, and 9% year-over-year.

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'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 the company 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.

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."

Discover's shares have now returned 65% year-to-date, following a 31% return during 2011.

The shares trade for 2.2 times their reported Aug. 31 book value of $18.02, and for 10 times the consensus fiscal 2013 Earnings estimate of $4.07 a share, among analysts polled by Thomson Reuters.

DFS Chart DFS data by YCharts

Interested in more on Discover Financial Services? See TheStreet Ratings' report card for this stock.


-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

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 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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