Discover Upped to Outperform

Today, we upgraded our recommendation on Discover Financial Services (DFS) to outperform from Neutral. The company’s fiscal third quarter earnings came in substantially ahead of the Zacks Consensus Estimate given the combined effect of higher margin payment service volumes, lower loan loss provisions, higher interest yield, improvement in credit card usage with reduced defaults and gains from the direct-to-consumer deposit business that drove the bottom-line. However, this was marginally offset by higher interest expenses and tax rate.

Moreover, the recent agreement to acquire The Student Loan Corp. (STU) has also enhanced optimism since this should augment its already strong student loan portfolio. This also marks the company’s strong financial and capital leverage. The acquisition also meets with the company’s long term goal of bolstering its private student loan portfolio, which has grown steadily over the past three years when many others had to discontinue the business altogether. This also helps in accentuating Discover’s competitive strength in the market.

While the deal is scheduled to be culminated by the end of 2010, upon certain debt-asset agreements, it is expected to shore up the bottom line from the first year of purchase, carrying an earnings increment of at least $0.09 per share in 2011 itself.

Further, Discover has also witnessed increase in merchant acceptance of the Discover Card and experienced continued growth in its direct-to-consumer banking business by leveraging its low cost infrastructure, brand, credit management and marketing capabilities. We expect these positives to continue and aid the company to improve its top line.

Credit quality metrics, although still high, continued to show improvement. Charge-offs and 30-day plus delinquencies at Discover are improving compared to the peer average. Going forward, we expect the improving credit trends to continue with the gradual economic recovery.

Discover has implemented several capital bolstering initiatives, including equity and debt offering, which have supported the company to achieve a strong capital base. Moreover, the repayment of its $1.2 billion government bailout loan in April 2010 has not only eliminated debt but has also freed the company from government intervention and pay restrictions. With repayment of the TARP investment, Discover can divert its focus on consumers and businesses, hence achieving financial success.

However, risks related to the imposition of the CARD Act regulation, now that it is being implemented in full force and rating downgrades continue to scare the operating leverage of Discover. Overall though, the company’s extensive network, sound capital position and cost containment initiatives will help accentuate growth once the markets rebound to its historical highs. Going forward, we expect healthy growth opportunities with limited downside to the stock, which also justifies the upgrade in our recommendation to Outperform from Neutral.

DISCOVER FIN SV (DFS): Free Stock Analysis Report

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