Morningstar | Discover's Growth Persists While Management Lowers Net Interest Margin Outlook
Narrow-moat Discover Financial Services produced few surprises in the third quarter. Total loans grew 2.4% from the previous quarter to $83.9 billion, representing year-over-year growth of 7.8%. Revenue net of interest expense climbed 4.7% as Discover benefited primarily from higher loan balances and stable credit provision. Despite this quarter’s loan growth, credit provisions were flat with the previous quarter, enabling Discover to increase earnings faster than revenue. For the third quarter, Discover generated earnings of $2.05 per diluted share, a $0.14 improvement from the previous quarter.Despite this quarter’s decent results, Discover lowered its guidance and said it now expects full-year net interest margin to be "modestly below our prior guidance of 10.3%-10.4%." The small decrease in guidance doesn’t come as a surprise to us; we were already forecasting net interest margin declines over the next five years. Given this, we’ll be maintaining our fair value estimate of $78 per share. We’ll take a closer look, but currently we are at a loss to explain the stock’s negative reaction to third-quarter results.
Given this quarter’s results, our only other concern is that delinquencies (the best forward indicator of credit losses) keep increasing. At the end of the quarter, total loan delinquencies stood at 2.22%, 17 basis points higher than a year ago. However, charge-offs on receivables did fall from the previous quarter, and it does appear Discover has built reserves ahead of potential losses. Through the third quarter, Discover’s allowances stood at 3.37%, comparable with the previous quarter but still 22 basis points higher than a year ago. Given this, we’re not 100% confident that Discover won’t need to add to its reserves. The company’s loan growth continues to be elevated. The longer this continues, the more likely Discover will need to build additional reserves. In addition, in our opinion, we are later in the economic cycle, and it worries us whenever loan receivables growth this fast this late in the cycle. However, our concerns are partly soothed since management mentioned seeing lower monthly revolve rates. After delinquency rates, revolve rates are probably the next best indicator of future credit quality.
Discover Financial Services is a bank holding, as well as a financial holding company. The company manages its business activities in two segments: Direct Banking, which includes consumer banking and lending products, specifically Discover-branded credit cards issued to individuals on the Discover Network and other consumer banking products and services, including student loans, personal loans, home equity loans, and deposit products; and Payment Services, which includes the PULSE network, Diners Club International and its Network Partners business, which provides payment transaction processing and settlement services on the Discover Network.
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Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.
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