The Outlook for US Financials in 2013

Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The year of our Lord 2008 happened. No it really did. And in that year many people learnt something about investing that they might not have realized before. They learnt that investing isn’t just about looking at numbers and assuming that their quantum represents the best measure of risk. Sometimes it is about their quality and how they are being affected by the economy.

The banks may well have felt that their capital-asset ratios and other measures were in good shape but they failed to understand the effects of leverage on (and off) their balance sheets or how exposed they truly were. These thoughts came to mind when considering Discover Financial Services (NYSE: DFS) latest set of results.

The Good News

They came to mind but in more of a positive fashion! In fact over the course of the year conditions have been getting better and better for US lenders and I would argue that it’s now time to look at the underlying metrics and consider them in a favorable way.

Let me put it this way. Provided the US economy continues its trajectory of slow gradual recovery and the Federal Reserve keeps interest rates low for ‘an extended period’ then conditions are good for lenders. In fact they are better than good because delinquency rates are hitting new lows and individuals (if not those that are in power) do seem to have embraced a new age of austerity. Throw in a slowly recovering housing market and US household net worth should be improving and I think that this is the key metric that guides consumer spending and not bickering in Congress.

Credit Quality Improving

Indeed, we can see how credit quality is improving by looking at a couple of key metrics for Discover.

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Discover argued that the recent uptick in 30-day delinquency rates was largely due to seasonal factors and that the improvements in charge off rates seemed to be close to an end but also that it didn’t see these rates as rising significantly in future.

When pushed by analysts, Discover said that it felt the current credit situation was unusual and it expected charge off rates to rise a bit over the next year or so. No matter they are still very low historically. Charge off rates are similarly improving at the likes of Capital One Financial (NYSE: COF). Although COF’s charge off rate went up in the quarter this was largely due to the addition of HSBC’s Card portfolio which had a higher rate. In fact COF described the charge off rate as being ‘unusually low’. It is a similar story with American Express (NYSE: AXP). More on them later.

Going back to the point I made in the first paragraph, I think it is fair to say that nobody knows. The truth is that if you buy Discover you are partly buying a view on the economy. The metrics may look favorable but they will move around with the economy. Since my view is favorable I’m attracted to the stock.

I also like Discover because they are a lender that is, err, lending. Organic loan growth rose to 6% in the quarter in a marketplace described as ‘declining’. In addition net interest margin was above its long term target of 8.5-9%. This is something to note because the market has been spooked by talk of yield compression thanks to ongoing low Government rates.

Discover Discovers New Growth Drivers

The company has been busy signing network deals which it thinks will not take a couple of years to add significant volumes to its payments business. For example the deal with Ebay Inc (NASDAQ: EBAY) could be highly beneficial. The exact terms are not clear but it is believed Paypal customers will be able to use their accounts at merchants within the Discover payments network.

 In addition the deal in the summer with Google (NASDAQ: GOOG) will allow Discover cardholders to access credit on their accounts by using a smart phone with Google Wallet. Given the power of Google’s alliances in this area and its intent to expand into mobile payments this could be a powerful profit driver in a few years.

Another interestimg development is its expansion into home loans/mortgages which strikes me as very good timing although its contribution won’t be material for some time.

Macro Takeways

Discover gave a couple of interesting takeaways for the macro economy at large. Firstly it argued that deleveraging had ‘run its course’ in the US which is a sign that consumers could be ready to start spending again. The second was that retailers appear to be having bigger sales at Thanksgiving and therefore shifting some retail spending forward in the holiday season. Perhaps an indicator that the strong trends in Thanksgiving spending might not be replicated at Christmas? We shall see.

 For the record, my hunch says that this will be a good Christmas for retailers and for Discover.

Where Next For Discover?

In conclusion, the metrics look good here and the evaluations in the sector look favorable.

 

<img src="http://media.ycharts.com/charts/3909f1687ea64ce9ca0ee64f206615e6.png" />

COF Price / Book Value data by YCharts

However it is not just about the metrics. I think the economy is playing into the hands of Discover and if the age of deleveraging is truly over then we can expect still better days to come. The company has the potential to increase its dividend quite dramatically and I think it can do so as well as returning cash via buybacks. The recovery story in US lending still has room to run.


SaintGermain has no positions in the stocks mentioned above. The Motley Fool owns shares of Google. Motley Fool newsletter services recommend American Express Company, eBay, and Google. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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