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Morningstar | Discover Enjoying Best of Both Worlds: Higher Yields and Muted Credit Losses

Narrow-moat Discover Financial Services had a strong second quarter, generating earnings per share of $2.32 for year-over-year growth of 21%, ahead of our expectations. Much of this was driven by an improving net interest margin, which has expanded 26 basis points over the past year to 10.47%. Total loan growth was 6.4%, a 230-basis-point deceleration from the previous year. Discover’s total purchase volume grew 4%, suggesting that increasing purchase limits are contributing to the company’s overall card growth. Though Discover’s loan growth is slowing, it is still modestly elevated. We would expect to see some pressure on margins resulting from higher credit losses, but thus far, Discover has seen a minimal impact on credit losses. Currently, Discover is enjoying the best of both worlds: elevated growth and higher loan yields without a proportional increase in credit losses. Though we’ll be making some adjustments to our model to reflect Discover’s outperformance, we do not expect a material increase to our fair value estimate of $84 per share.

Last quarter, we said that higher credit card yields caused by an increasing percentage of cardholders carrying balances is a good forward indicator for higher credit losses. So far, this has not happened. Charge-offs were flat with the previous quarter at 3.5% and only 15 basis points higher than the previous year. Management’s commentary on the economy was positive, suggesting to us that higher credit losses are not imminent. Though we did not anticipate a significant increase in credit losses, we have been surprised at how good credit performance has been throughout the entire industry.

Possibly the biggest positive for Discover during the quarter was that spending on rewards was flat with the year-ago second quarter, as rewards to total purchase volume declined 6 basis points to 1.25%. We continue to forecast that rewards will eat into Discover’s margins. However, if Discover continues to hold rewards at current levels, then we’d probably have to raise our fair value estimate by at least 10%. This is probably the biggest upside risk to our current valuation.

Offsetting some of the improvement in rewards was higher spending on technology. Spending on information processing and communications grew 17% from the previous year. We believe investors should expect this to continue. Though these costs account for only 3.5% of net revenue, we think they’ll take on growing importance and an increasing percentage of Discover’s net revenue over the next five years. According to LinkedIn’s insights page, Discover’s total employee count has grown 1% from the previous year. However, employee growth by job function suggests a 28% increase in engineering roles at Discover. Though Discover may be playing catch-up to Capital One and maybe American Express, the company does appear to be ahead of most other financial institutions that are still debating what to do.