Discover Keeps Cooking With 27% Return on Equity (Update 1)

Updated from 9:40 a.m. ET, with late morning market action, information about Discover's share buybacks, and comment from FBR analyst Scott Valentin.

NEW YORK ( TheStreet) -- Discover Financial Services ( DFS) continues to bring home industry-leading earnings, and investors looking for long-term growth should pay attention.

The credit card lender, based in Riverwoods, Ill., on Tuesday reported a first-quarter return on equity of 27%, which is a fabulous number, underlining the case for a long-term commitment by investors.

Discover's first-quarter net income allocated to common stockholders of $659 million, or $1.33 a share, increasing from $530 million, or $1.06 a share, in the fourth quarter, and $644 million, or $1.22 a share, in the first quarter of 2012. The main factor in the sequential earnings improvement was a decline in the quarterly provision for loan losses to $158 million in the first quarter from $370 million in the fourth quarter. The first-quarter provision was up from $84 million in the first quarter of 2012.

A major highlight for Discover during the first quarter was the continuing growth of its credit card portfolio, which runs counter to the industry trend, as U.S. consumers continue to deleverage. Average card loans were $49.3 billion in the first quarter, increasing from $49.2 billion the previous quarter, and $46.6 billion a year earlier.

That's a 6% year-over-year growth rate for credit card loans, which is better than the growth rates for most other major card lenders. Looking past sequential growth rates because of seasonal declines in the first quarter, here's how other big credit card lenders have fared:
  • Bank of America's (BAC) credit card loan balances averaged $91.7 billion during the first quarter, declining from $98.3 billion in the first quarter of 2012
  • For JPMorgan Chase (JPM), average credit card balances declined to $123.6 billion in the first quarter from $127.6 billion a year earlier
  • U.S. Bancorp (USB) reported first-quarter average credit card loans of $16.5 billion, declining from $16.8 billion a year earlier
  • Wells Fargo (WFC) reported first-quarter average credit card loans of $$24.1 billion, increasing 9% from $22.1 billion in the first quarter of 2012
  • For Citigroup (C), average card loans increased to $146.2 billion in the first quarter from $141.7 billion in the first quarter of 2012, for a year-over-year growth rate of 3%
  • American Express (AXP) reported average loans of $62.8 billion in the first quarter, increasing 3% from $60.7 billion a year earlier
  • Capital One's (COF) average portfolio credit card loans increased to $78.4 billion in the first quarter from $61.5 billion a year earlier, however, the company acquired roughly $27 billion in card loans from HSBC last year, and transferred its $7 billion Best Buy card portfolio to held-for-sale in the first quarter. The sale of the Best Buy portfolio to Citigroup is expected to be completed in the third quarter.

Among the seven companies listed above, the only one with first-quarter performance coming close to Discover was American Express, with a return on average equity of 23.2%.

Why is Discover's credit card loan growth so important? The biggest reason is that credit card lending is so profitable, because of the higher net interest margins. Discover's first-quarter net interest margin -- the spread between the average yield on loans and investments and the average cost for deposits and borrowings -- was 9.39%, compared to 9.40% in the fourth quarter and 9.09% a year earlier. It's not a fair comparison, because of Discover's focus on credit cards, but the Federal Deposit Insurance Corp. reported that the consolidated fourth-quarter net interest margin for all U.S. banks during the fourth quarter was 3.32%.

Investors should also consider Discover's forward earnings multiple. The company's shares closed at $44.33 Tuesday, trading for 9.3 times the consensus 2014 earnings estimate of $4.77, among analysts polled by Thomson Reuters. That is a pretty cheap forward P/E, when considering the company's return on equity and continued growth.

KBW analyst Sanjay Sakhrani rates Discover "outperform," with a $48 price target, and said in a note to clients late on Tuesday that "following 1Q13 results, we came away incrementally positive on Discover given the solid underlying operating trends and multiple avenues of earnings upside."

"While probably not having the longest runway to the upside of our outperform-rated names to its shares, trading at less than 10x our 2014 EPS estimate, we believe that current levels discount the quality of the company/earnings as well as the multiple-enhancing traits of the network," Sakhrani wrote.

KBW estimates Discover will earn $4.66 a share this year, with EPS declining to $4.50 in 2014.

Discover's shares were down slightly in late morning trading, to $44.26. The broad indexes were all down slightly, after the U.S. Census Bureau reported that durable goods orders declined 5.7% in March after rising 4.3% in February. Orders excluding transportation were down 1.4%. The average estimate among economists polled by Thomson Reuters is for durable goods orders to fall by 2.8% in March, with core durable goods orders rising 0.5%.

FBR analyst Scott Valentin on Wednesday reiterated his "outperform," rating for Discover, with a $48 price target, saying in a note that the company's growth in card balances was mainly due to the success of the Discover "It" card, which, he writes, "was marketed heavily in 1Q13 and 4Q12."

"Discover is taking market share as evidence by stronger-than-peer average receivable growth," Valentin wrote, adding "we expect Discover to continue to gain share due to continued Discover "It" marketing." FBR estimates that for all of 2013, the company's card balances will grow by 4.5%.

Valentin expects Discover's net interest margin to remain "relatively stable," in a range of 9.3% to 9.4% through the end of the year, because of "general pricing discipline" and declining funding costs. When discussing the prospects for success of several growth initiatives, the analyst wrote "at present, payment services account for only 5% of income. If Discover were to grow these businesses, we believe it should trade above 10x earnings."

Discover repurchased 6 million common shares during the first quarter, for $238 million. The company said its share count was reduced by 1%. The company has a $2.4 billion buyback plan in place.

"We believe the combination of stable credit, high ROE (~20%), large return of capital (~100% of earnings in 2012), and increasing receivables market share makes Discover an attractive investment at current valuations," Valentin wrote.

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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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