Discover Is an 'Underappreciated Growth Story': Analyst

NEW YORK ( TheStreet) -- Discover Financial Services ( DFS) has managed to diversify its lending during a period of slow credit card growth, which is just the right formula, according to Oppenheimer analyst Ben Chittenden.

Chittenden on Wednesday initiated his firm's coverage of Discover with an "outperform" rating and a 12-18 month price target of $55.00. The target implies a potential gain of 16% over the stock's closing price of $47.47 on Wednesday.

In a difficult growth environment for credit card loans, Discover managed to grow its average card loan portfolio by 6% year-over-year to $49.3 billion during the first quarter.

"Starting with personal loans and private student loans, Discover has identified four product types to grow into," according to Chittenden. "The common thread among all of these products is that they all offer similar risk-adjusted returns to credit cards and leverage the company's analytical underwriting style," he wrote in a note to clients.

While credit cards still make up the bulk of Discover's portfolio, student loans and personal loans contributed 19% of the company's earnings during 2012, increasing from just 9% of earnings during 2010. Private student loans contributed 4% of 2012 earnings, while purchased credit impaired (PCI) student loans contributed 9% and personal loans contributed 5% to the bottom line.

Capital One made its own move to expand its student lending activities through acquisitions from 2004 to 2006 at which point student loans made up 50% of the McLean, Va., lender's total portfolio, according to Chittenden. But Discover "doesn't want branches," and is not expected by Oppenheimer to do a "transitional deal."

"What's left is a steady methodical year-in, year-out organic growth plan," Chittenden wrote. "This is part of the reason we think we're only about halfway into a much longer-term trend in diversification for DFS."

Discover has outperformed most other large financial firms, with a first-quarter return on equity (ROE) of 27%, following ROE of 26% in 2011 and 30% in 2011.

Diversifying away from credit card loans may initially appear to be a recipe for lower margins, Discover is "doing so with products that are earning a similar revenue margin," according to Chittenden.

Discover "remains compelling to us," because of its diversification into other unsecured loan types, Chittenden wrote, adding "data-dependent analysis and underwriting of unsecured credit to consumers is really DFS's bread and butter."

Oppenheimer estimates Discover will earn $4.79 a share this year, with EPS growing to $5.01 in 2014.

Chittenden expects Discover, over time, to "trade in line with other financial services firms," at a multiple of 11 times forward earnings, supporting his price target.

DFS Chart DFS data by YCharts

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

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

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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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