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Morningstar | DFS Updated Forecasts and Estimates from 14 Jun 2019

Narrow-moat Discover Financial continues to perform well as we move deeper into the credit cycle. In the first quarter, Discover generated net revenue of $2.8 billion, representing year-over-year growth of 7%, lifting earnings 18% higher to $2.15 per share. Loan growth remains elevated, despite being nearly a decade into the economic cycle. At the end of the quarter, Discover’s credit card loans were 8% greater than 12 months ago, faster growth than we were anticipating. In comparison, Discover’s competitors are growing at low-single-digit rates. For now, this growth should continue to put upward pressure on credit losses. We are not concerned yet, but we are watching this closely, as Discover is being more aggressive than peers. With Discover, credit quality is possibly the biggest area of uncertainty affecting our fair value estimate, which we’re maintaining, for now, at $84 per share.

Bucking its peer group, Discover’s net interest margin expanded 11 basis points to 10.46%. Throughout much of our card issuer coverage, the recurring theme has been that higher deposit costs have pressured NIMs. Here, it’s a different story. Yes, Discover is seeing higher deposit rates. However, yields on Discover’s credit card receivables have more than offset the higher cost of funding. In the first quarter, yields on credit card loans rose 20 basis points to 13.4%. Some of this is attributable to higher prime rates, but much of it appears to be caused by a higher percentage of cardholders carrying a revolving balance. While this may be a one-quarter phenomenon, higher revolving balances suggest lower credit quality. Discover may be able to more than offset higher charge-offs with even higher yields, but we would urge some caution. So far, we’ll reserve determination until we can gather more data points, but we believe investors would be wise to follow this trend.

Throughout the earnings call, analysts continually referred to a “Discover competitor” exercising greater caution on credit lines and increasingly investing in technology. That competitor was Capital One. During its call, Capital One described the weakness in using FICO scores when judging an applicant’s credit. The look-back period for FICO scores is seven years, which puts consumers at 2012. Within the last seven years, the U.S. consumer has not been tested by a recession, thus people’s credit scores are artificially elevated and would explain why seemingly every credit card issuer has been able to increasingly weight portfolios toward scores above 660.

In addition, Discover was asked about its technology initiatives. During the quarter, the company spent $99 million in information processing and communications, a 21% increase from the previous year. In addition, new CEO Roger Hochschild was credited with rolling out the “Discover Management System,” which according to the company’s proxy is “a new operating model leveraging lean and agile principles.” That might sound like a lot of jargon, but we think it’s important that the company appears to already be addressing this and investing in its technology infrastructure. Discover may not be as far into the process as Capital One, but many banks are barely even discussing technology initiatives, suggesting to us Discover is ahead of the average bank in improving its technology infrastructure.