Discover Financial Services (NYSE:DFS) turned in a mixed fourth quarter earnings report. Income was up - though this needs a closer look. Card sales volume was higher, but other revenues as well as loans and fees were down.

IN PICTURES: 6 Major Credit Card Mistakes

Discover's Report
Net income applicable to shareholders was up from a loss of $77.8 million, 14 cents per diluted share, in last year's quarter, to a gain of $346.5 million, 64 cents per diluted share, in this year's. The release of a $414 million provision for loan loss reserves contributed to this quarter's income. Income for last year's quarter included $285 million after tax, related to a Visa (NYSE:V) and MasterCard (NYSE:MA) antitrust settlement.

For the full fiscal year, Discover's net income attributed to common shareholders was $667.9 million, $1.22 per share, down from $1.21 billion, $2.38 per share, last year. Last year's results included a gain of $1.2 billion after tax, related to the aforementioned antitrust settlement with Visa and MasterCard.

Total Discover Card sales volume was $23.2 billion for the quarter, up 6% from $21.9 billion in last year's quarter. Consumers have edged up their spending, though they've edged down their debt. Credit Card loans stood at $45.2 billion, down $2.3 billion from the year ago quarter. Fee income fell by $20 million, while marketing expenses grew 32% to $149.9 million. Revenue net of interest expense declined to $1.6 billion from $1.7 billion in the year ago quarter. Rising costs with flat or diminished revenue should be watched. The concerns here would be for the card and loan business, as Discover's payment processing is doing better.

Unpacking The Numbers
The credit card loan amounts and fees indicate that the loan business is not growing. Even the company predicted only modest gains for credit card growth in 2011. Although Discover expressed cautious optimism about the improvement in credit quality, it expected the increased spending with cards - card volume sales - to continue.

Earnings Quality
The quality of earnings this quarter can be questioned, too, as the profits were largely fueled by the release of the $414 million loan loss provision. If you strip out last year's settlements and this year's large chunk of loan provision modifications, it gives a truer indication of real cash earnings: meager. Discover's lack of real cash earnings and its flat loan business are signals for caution on the part of investors.

Discover's Business Ahead
Discover is buying the Student Loan Corporation for $600 million. Discover will also acquire $4.2 billion in loans and related assets from Citigroup (NYSE:C), after Citi acquires $28 billion in assets from Sallie Mae - SLM Corp. (NYSE:SLM). This will make Discover the third largest provider of student loans in the United States. With the concerns over the student loan industry growing louder, including suggestions that it's already a bubble, it looks as though Discover is moving more deeply into a high risk segment to keep its business growing. (Extending your principal repayment date can increase your chances of fighting off default. To learn more, check out Student Loan Deferment: Live To Pay Another Day.)

On another note, Discover has agreements with AT & T (NYSE:T) and Verizon (NYSE:VZ) which will develop ways for consumers to make purchases with smartphones. This could be a more promising business in the much longer term than the brittle student loan business.

The Take On Discover
It's hard to see the credit card loan business as a great growth business anymore. There are others that do it more profitably right now. At best, investors might want to monitor this for awhile. Some of Discover's ancillary businesses seem more attractive, but they are a smaller percentage of what it does. Most of all, keep a careful eye on the company's real cash earnings. Maybe Discover will have mad growth in 2011, but somehow I don't think so.

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Tickers in this Article: DFS, V, MA, C, SLM, T, VZ

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