By any reasonable measure, Discover Financial Services (NYSE:DFS) has come back strongly from the worst of the credit crunch - having broken $5 in the spring of 2009, this stock has very nearly reached $35 in the past couple of months. The company has certainly made progress getting more merchants and shoppers to use its cards and network, and it also seems to be picking up a little debit card share in the wake of new regulations. While these shares aren't overpriced, investors may want to ask themselves how much better they think a business can get before they buy shares.
Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers
A Noisy, but Basically Good Second Quarter
Discover's second quarter results take a little bit of explanation, but they were basically solid.
Gross revenue rose about 6%, with net revenue (after provisions) up a bit more than 4%. Card loans rose almost 4%, with a 5% increase in card sales volume. Discover is also seeing strong net interest margin (NIM), with NIM improving almost 20 basis points to 9.31%. Loan fee income was weaker, though (down almost 5%) from the previous year.
Discover saw substantially lower net card charge-offs compared to last year (2.79% versus 5.01%), though this number did tick up from 2.64% in the prior quarter. All in all, pretax operating income fell about 6% on a reported basis.
Some analysts are going to adjust this number. During the quarter, Discover took a $90 million additional litigation reserve and that took out about 11 cents of earnings (and adjusted operating income would have otherwise been up 3%). Keep in mind, though, that the company also released about $110 million of reserves (or about 13 cents per share), so I would argue that it largely nets out.
Can Durbin Drive Debit?
Since the Durbin Amendment went into effect, it has had a definite impact on the debit card network business. To make a complex topic simple, new rules have cost Visa (NYSE:V) some of its market share in debit card processing. Now Visa is trying to fight back by exploiting what appear to be loopholes in the new system, but it looks like some of that share in the U.S. is gone for good. MasterCard (NYSE:MA) has picked up most of the benefit, but Discover is getting some of it - dollar volume in payment services was up 12% and pre-tax profits rose 10%.
SEE: Investing In Credit Card Companies
How Much Better Can It Get?
If there's a cogent bear thesis on Discover, it may well center around the notion that this is about as good as business can get - at least in the near-term. Yes, the company is trying to grow its international business and build up other operations outside of its closed-loop card network, but those are all long-term plans.
As seen in this quarter's charge-off data, credit quality is pretty good and may not get substantially better. Likewise, while Discover has seen improved acceptance of its card, further penetration is likely to require heavier lifting (promotional spending, incentives, etc.) that will compress margins. Last and not least, Discover is still a long way from matching American Express (NYSE:AXP) when it comes to building a profitable enterprise from fee-based revenue as opposed to the more volatile spread on receivables.
All of this may well prove true, but it's a question of magnitude and timing. True, there may not be much room for credit quality to improve, but a nice sustained plateau of low charge-offs would certainly be good for the business, the return on equity (ROE) and the stock. Nevertheless, investors should at least consider the risk that this may be as good as the ROE can get.
SEE: How Return On Equity Can Help You Find Profitable Stocks
The Bottom Line
That outlook for ROE is certainly important if you want to value Discover with an excess returns model. While the trailing ROE here is around 30%, most analysts believe this will drop to the mid-to-high teens over the next five years.
If that happens, these shares are probably worth something in the high $30s - not bad relative to today, but not terribly exciting either. Push that long-term estimate up to 20% and the fair value jumps to nearly $50, but then the implied earnings growth rate rises to nearly 10%. That number may be doable, but it's going to take an above-average performance in a very competitive market.
At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.
Mutual Funds & ETFsLearn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
Investing NewsWill Ferrari's shares move fast off the line only to sputter later?
Stock AnalysisHere are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
InvestingThe further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
Fundamental AnalysisOptions market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
Stock AnalysisCan these two oil stocks buck the trend?
Investing NewsAlcoa plans to split into two companies. Is this a bullish catalyst for investors?
Stock AnalysisIf you want to buck the bear market trend by going long on consumer stocks, these three might be your best bets.
Investing NewsA rate hike would certainly alter the investment scene, but would it be for the better or worse?
InsuranceRead about the top life insurance companies in the United States as measured by written premiums and learn a little more about their business operations.
An insurance company can find out about driving under the influence (DUI) or driving while intoxicated (DWI) charges against ... Read Full Answer >>
When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>