Hey Investors, Discover These Possibilities

They often say it takes a strong man to admit when he's wrong. I'd hardly call myself a strong man, but boy, was I wrong about Discover Financial (NYSE: DFS  ) .

Back in December, I highly doubted that Discover could sustain its earnings momentum. Compared with peers Visa (NYSE: V  ) , MasterCard (NYSE: MA  ) , and American Express (NYSE: AXP  ) , Discover often found itself at the back of the line, feeding off the Big Three's scraps. At the time, Discover was facing the uncertainties of new credit card legislation, and it was priced for perfection based on its five-year growth projections. Yet the company still proved me wrong.

Discover this
Discover's second-quarter earnings report yesterday revealed little reason to fear the earnings momentum fueling its growth.

To say the company surpassed analyst expectations would be a monumental understatement. Analysts were calling for earnings per share of $0.75 on revenue of $1.70 billion; Discover delivered a quarterly profit of $1.09 on revenue of $1.74 billion. Higher card usage and lower delinquency rates primarily drove the company's growth.

Sales volume for its Discover card jumped 9%, while the company expanded the number of merchants accepting the card by 8%. Even the company's Pulse network saw a rapid jump in usage, with debit transactions jumping by 25%.

Possibly the most impressive aspect of Discover's report -- and my main concern with the company back in December -- was the credit quality of its customers. In the year-ago period, 4.85% of all accounts were delinquent in their payments by more than 30 days, compared with just 2.79% in this past quarter -- a 25-year low for Discover. In addition, charge-offs, the uncollectible write-offs of credit card companies, dropped by more than $570 million to just 5.01% of all balances, from more than 8.5% one year ago. Fewer delinquencies and charge-offs mean lower loan loss reserves, and more money for marketing.

The nitpicker's guide to exercising caution
If I had to nitpick one or two negatives from this report, I'd cite the company's rising expenses and the realization that the U.S. economy remains less sturdy than Discover would like.

Because of higher marketing costs and integration costs associated with the company's purchase of Student Loan last year, shareholders witnessed a 25% jump in expenses. Considering that Discover absolutely killed estimates this quarter, I'd call this jump more than forgivable, but let's just say that my worries about the quality of student loans persist. The U.S. unemployment rate remains historically high at 9.1%, and with Discover now the third-largest holder of private student loans, I wonder whether graduating students will be able to secure a job and make timely payments.

The conference call also highlighted comments from CEO David Nelms that the U.S. economy is still on shaky ground. While he pointed to Discover's strength in the wake of a weakening economy, I'm worried Discover may not be able to keep up its torrid growth if the things really begin to take a turn south.

Cautiously optimistic
My own worries aside, Discover bulls are being rewarded, and I was wrong, wrong, wrong to doubt this credit and loan powerhouse. I'm not sure I'd take the plunge into Discover here with the company showing the slowest earnings growth estimates of the four leading into 2012, but given a pullback in the stock, it could be worth reconsidering.

What's your opinion on Discover Financial? Share your thoughts and feel free to rib my prior prediction in the comments section below. Also, consider adding Discover Financial to your watchlist to keep up on the latest news in the credit sector.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong. Motley Fool newsletter services have recommended buying shares of Visa and Discover Financial. 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 that's free of charge but full of interest.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 29, 2011, at 1:01 AM, DEBBIEM55 wrote:

    What Discover has done is business outside of the US. They got involved with China Union Pay as well as other foreign chargecards.

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