EUR 850.00 For Business Accounts Only

Morningstar | Discover's High Returns Enable Substantial Repurchases and Dividend Increases

Over the long run, Discover Financial Services’ unique role as a credit card lender focused on Middle America, operating a proprietary payment network, puts the company in an interesting strategic position. In the short term, we view Discover’s prospects less favorably as the heated rewards environment means customer acquisition costs will weigh on margins. In addition, as competition intensifies, Discover's larger rivals can exploit their scale on national advertising campaigns and technology spending. Despite rivals' size advantages, Discover is consistently one of the most profitable banks on the basis of return on equity. This is largely attributable to two advantages. Because Discover isn’t a systemically important financial institution, it can hold less capital than its larger rivals relative to its loan book composition. Discover’s assets stand at more than 9.5 times equity. The second-biggest contributor to the company’s outsize returns is business mix. Credit card loans account for nearly two thirds of the bank’s total assets. These high-yield loans drive the bank’s exceptional net interest margins, which routinely exceed those of money center banks by 600 basis points. These advantages have routinely enabled Discover to earn ROEs near 20% and repurchase more than 5% of its shares each year. Over the long run, it will be interesting to see how Discover exploits the advantage of being an issuer while operating a payment network. This position means Discover can more easily offer cash-back rewards debit cards, which could help it build a cheaper source of deposits. Currently, Discover’s funding depends heavily on CDs and money market accounts and competes for deposits primarily on rates, which means the bank is at a disadvantage when it comes to funding. The bank talks at great length about its direct banking model, but so far, we haven’t seen this enable Discover to lower its customer acquisition costs. If the bank is serious about building a digital bank, it must be willing to make the investments that could weigh on its margins. Thus far, we have seen only limited evidence that the bank is making these investments.