Earnings Scorecard: Discover

Discover Financial Services (DFS) reported its first quarter earnings for fiscal year 2011 on March 22, beating the Zacks Consensus Estimate substantially by 33 cents per share, led by strong net interest income growth and lower loan loss provisions, though partially offset by higher-than-expected interest expenses.

Nonetheless, the investors’ reactions to the better-than-expected results were quite optimistic on Wall Street. This gets reflected in the upward price movement witnessed since the earnings release. The confidence could be justified not only by the fundamental improvement in the credit and profitability metrics but also by the recent acquisition of the Student Loan Corp. (SLC).

Below we will cover the results of the recent earnings announcement, subsequent analyst estimate revisions and Zacks ratings for the short-term and long-term outlook for the stock.

Earnings Report Review

It’s always encouraging to outperform estimates, particularly when the difference is substantial enough to inject optimism into the future. A quick look at the top line reveals extensive growth across segments, including direct banking and payment service volumes, whose pre-tax operating income surged year over year.

While Discover credit card volumes grew by 7% year over year on higher consumer spending and merchant acceptance. Further, the credit quality improved on the reduction in the loan loss reserve rate, and as the credit card charge-off rate declined along with the decline in the credit card loan delinquency rate in the first quarter.

However, this significant growth was partially offset by higher-than-expected expenses that grew 26% year over year, during the reported quarter, reflecting increased marketing and advertising spending, higher compensation expense and costs related to The Student Loan Corporation acquisition.

(Our full coverage on the earnings is available here: Discover Financial Outshines)

Earnings Estimate Revisions – Overview

Estimates have witnessed significant upward movement for Discover since the earnings release. This means that analysts expect continued improvement going forward. In fact, this gives quite a valid reason to own a stock that benefits from positive results and provides a scope for a rise in the future. The earnings estimate details are deeply delved into below.

Agreement of Estimate Revisions

Given the exceptionally strong fundamentals, analysts are excited not only by the way Discover has weathered the storm of the financial downturn, but also the successful completion of the SLC acquisition. Analysts, therefore, agree with the optimistic outlook for Discover’s earnings.

As a result, we see below that out of 15 analysts in the last 30 days, 13 have increased their estimates for the second quarter of 2011, while only one of the analysts has lowered the same, which is overall encouraging.

Moreover, looking into the fiscal year of 2011, all the analysts have raised their estimates over the 30-day period. Likewise in 2012, 14 analysts out of 16 have raised their estimates on the strong and improved performance in the first quarter, and better outlook for the near term. However, only one analyst has lowered its estimate over the 30-day period. This shows a positive outlook for 2011 and 2012.

Magnitude of Estimate Revisions

Overall the last 30 days, earnings estimates have shown extraordinary improvement, up from 50 cents to 63 cents in the second and the third quarters of 2011, since the earnings release. Likewise, estimates moved significantly upwards to $2.66 from $1.98 per share for fiscal year of 2011.

Further, in 2012, the estimates upped from $2.17 to $2.46 per share. This overall looks promising, particularly, when so many other stocks are experiencing a decline, analysts continue to value Discover’s earnings at a considerable premium.

Discover on Positive Side

Discover has implemented several capital bolstering initiatives, including equity and debt offers, which have supported the company to strengthen its capital base.

Moreover, with the repayment of its $1.2 billion government bailout loan in April 2010, Discover can divert its focus to consumers and business, to achieve financial success. Increased merchant acceptance, improved credit quality and continued growth in direct banking is expected to augment the top- and bottom-line growth going ahead.

Moreover, the SLC acquisition has fetched appreciation from the market for management’s decision to enhance its already strong student loan portfolio, thereby also adding to the competitive strength.

However, risks related to the imposition of the CARD Act regulation, now that it is being implemented in its totality, and rating downgrades continue to hurt the operating leverage of Discover. Overall though, fundamentally the company is poised to grow significantly with its well-diversified business model and a more favorable operating environment.

Moreover, 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 recent upgrade in our recommendation to Outperform from Neutral. Hence, we are maintaining a Zacks #2 Rank, which translates into a short-term Buy recommendation. Our long-term recommendation for the stock is upgraded to Outperform.

Discover competes with Visa, Inc. (V), Mastercard Incorporated (MA) and American Express Company (AXP).

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