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Morningstar | Discover's Cheap, but Elevated Growth Comes With Increasing Risk

Narrow-moat Discover Financial Services finished 2018 on the right foot, generating earnings per share of $2.03 in the fourth quarter, modestly better than we had anticipated. Net revenue was $2.8 billion, up 7.4% from the previous year. Practically all of Discover’s revenue growth was derived from higher net interest margins and loan growth. In fact, yields on credit card loans advanced more than 40 basis points over the last year, driving a 7-basis-point improvement in net interest margin from the previous year. Discount and interchange revenue net of rewards declined 2.1% as a 9% increase in rewards costs pressured discount rates. This supports our long-term thesis that rewards will continue eating into interchange revenue. We’ll update our model to reflect full-year results and management’s guidance but do not expect any material changes to our fair value estimate of $81 per share. Currently, we believe the market undervalues Discover and seems to assume minimal, if any, growth over the next five years. We think this represents a fairly low hurdle for Discover.

For 2018, Discover was able to increase credit card loans 8.3% from the previous year. For 2019, management expects only modestly slower growth in credit card loans. We note that Discover’s recent and forecast growth is elevated and appears to be partly driven by higher balances as Discover card sales volume increased only 5%, slower than total credit card loan growth. So long as Discover grows at its current pace, which we find somewhat aggressive, investors should expect higher provisions. Though Discover’s card delinquencies are rising at slower rates than earlier this year, they are still rising, suggesting to us that Discover hasn’t turned the corner on charge-offs. In addition, we think we are getting closer to the end of the credit cycle. As we progress through this cycle, Discover’s elevated growth comes with increasing risk.

For 2019, management anticipates loan growth of 6%-8%, in line with operating expense growth. Information processing and communications expense provided a 25-basis-point headwind to margins from the previous year. Investors should expect this to continue as it appears management is taking technology investment seriously. As of September, Discover’s careers website had 203 open positions, and 76 were in information technology. Today, Discover is seeking to fill 358 positions, 118 of which are technology roles, indicative of management's recent commitment to improving its technology platform. We think management should be commended for this investment even if it comes at the expense of margins. Technology investment is core to our thesis for Discover and credit cards as we believe it increases efficiency in new product development and enables card issuers to more quickly respond to changes in the market.