What Did I Discover?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Discover Financial (NYSE: DFS) operates a unique business model in the credit card industry. While the company issues credit cards just like any other company, Discover has differentiated itself by being the cash-back leader in the industry. Since the company's cash-back program is very easy to understand, customers have been willing to sign up in droves to use their Discover cards. Looking at the company's most recent earnings report, shows just how strong this business momentum has been.
Headline Earnings:
The company reported total revenues of 6% year over year, and net income of $1 per share which was down slightly from last year. Total loans increased 9%, and credit card loans increased slightly as well. Most impressively, payment services income was up 10%, and transaction volume for the segment increased 12%. This trend of increased income, and increased volume, matches something that I saw recently with American Express (NYSE: AXP). In American Express' case, all four of their divisions showed revenues increasing. Ironically, both discover and American Express best-performing division was their Network and Merchant Services.
Delinquencies and Financials:
Discover shows their 30-day past due accounts at 1.91%, which was an improvement of 88 basis points from the prior year. Just for a point of comparison, American Express showed 30-day past due loans at 1.4%. In possibly better news, Discover's 90-day delinquencies dropped from 1.51% last year to 0.99% this year. Even more impressive, are Discover's financial statements. The company shows that cash and investment securities rose over 30% to $13.56 billion. In addition, total deposits rose an impressive 18% year-over-year, to a total of $41 billion. What this tells investors is, not only is Discover growing their cash and loan balances, but depositors are also willing to place their dollars with Discover, which is not a traditional banking institution. It's likely that the reason for this gain in deposits, is Discover's willingness to pay an above average interest rate on these funds.
Student Banking:
A controversial business that Discover is doing very well with is student lending. In fact, this division shows a 64% increase in balances, with a current portfolio value of over $7.5 billion. The interesting part, is the interest yield on these loans, which has been such a bone of contention in the public eye, actually dropped nearly 1% from last year with a current yield of just 6.43%. This is a case where other companies such as JPMorgan Chase (NYSE: JPM) are stepping back from student lending, which allows Discover to capture a larger percentage of the market. In fact, representatives from Discover previously said, "student lending is a good investment." Of course JPMorgan is a diversified financial institution, and Discover relies on credit cards to make their money. In addition, if investors are looking for current income, JPMorgan is the more attractive choice with a yield of 3.47% versus Discover's yield at just 1.1%. However, with JPMorgan deciding that at the beginning of July they would only issue student loans to their banking customers, this opens up even more opportunity in this market for Discover in the future.
One Troubling Statistic:
If there's one troubling factor in Discover's most recent earnings report, it's the rise in provision for loan losses. The company increased their loan-loss provision by 32% from $176 million last year to $232 million during the quarter. Investors should keep an eye on this, as American Express similarly raised their loan-loss provision in all of their divisions in the last quarter. This is a troubling sign, because it could indicate the companies expect a higher level of loss in the future.
Conclusion:
The biggest problem that I have with the Discover story at this point, is there are better opportunities in this segment of the market. While Discover and American Express fight for better acceptance, and higher earnings growth, both Visa and MasterCard are expected to grow at over 19% in the next several years. Given the choice between investing in Discover or American Express with roughly 10% growth, or Visa and MasterCard at over 19% growth, I would select either Visa or MasterCard. If investors are looking for an opportunity in this part of the market, it pays to stick with the co-leaders. Visa and MasterCard are dominant forces in payments and are more widely accepted. They also co-brand with many company cards, and their cost to merchants to accept are cheaper. In this game, bigger is better.
MHenage owns shares of JPMorgan Chase & Co. The Motley Fool owns shares of JPMorgan Chase & Co. and has the following options: short OCT 2012 $55.00 calls on American Express Company, short OCT 2012 $55.00 puts on American Express Company, short OCT 2012 $60.00 calls on American Express Company, and long OCT 2012 $65.00 calls on American Express Company. Motley Fool newsletter services recommend American Express Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
