Discover Financial Services Ventures Deeper Into the Profitable (But Risky) Personal Loan Business

Discover Financial Services first quarter results revealed modest growth across most business segments but personal loans grew at an astounding rate.

May 26, 2014 at 8:00AM

Source: Wikipedia / Rama.

Five years ago, Discover Financial Services (NYSE:DFS) was so singularly focused on being credit card lender and payment processor that it didn't even break out the other types of loans on its quarterly results because the "other" loan book was so small .

Today, Discover provides an array of consumer banking services including checking and savings accounts, home equity loans, student and personal loans in addition to its ubiquitous credit card business.

However, the growth most of these segments is stagnant except for one of the company's riskiest businesses: personal loans.

Lack of growth in a financial company isn't always a red flag. But Discover growing its riskiest loans at such an astronomical clip while the rest of the business creeps along should be a big concern for investors. 

The Q1 earnings highlights
Discover's Q1 results were decidedly mixed. Discover showed anemic growth in the number of payment services transactions with only 2% growth from the first quarter of last year. Total non-interest income acutally came in lower than 2013 . On the positive side, the company reported an 11% increase in net interest income. This quarter's growth came entirely from increasing loans and balances, so I wanted to take a closer look to see which segments were growing the fastest.

Dfs Loan Balance

So where is the growth coming from?
While credit card loans are by far the lion's share of Discover's loans, that book of business grew at a relatively small 4% year over year. In fact, the only lending segment that reported double digit loan growth was personal loans at an eye-popping 27% from the previous year.

The fast growing personal loan segment does generate strong returns when times are good, but a negative shock to the economy or employment could put these loans in danger of delinquency and default. But the growth in personal loans was not an accident. In Discover's Shareholder Day presentation, the company presented the following graphic.

Dfs Pl 

Discover clearly intends personal loans to be a big part of its future and it will be up to management to maintain disciplined lending practices. So far Discover has done just that; Discover's charge off rates for personal loans have stayed within a narrow range just above 2%. 

Is there cause for concern with Discover?
Yes and no. I'm uncomfortable with the explosion in personal loans. Is the bank pursuing a growth-at-all-cost strategy to hide problems elsewhere in the business? Investors are being asked  to trust that it will continue to price the risk correctly. So far the company has done that, but it has been in an environment of a strengthening economy and employment picture. How will these loans perform when the economy inevitably worsens sometime in the future?    

Discover is also clearly lagging in the number of transactions processed. The king of payment processing, Visa (NYSE:V) came in at strong 8% growth over last year in its first quarter report. In 2011 and 2012, Discover's payment volume grew at rates north of 10%. 2013 was flat and 2% growth for Q1 is disappointing as well. Payment processing provides a revenue stream that isn't subject to repayment risk and is one of the aspects of the business that got me interested in Discover in the first place. 

However, I will continue to hold Discover. There is still the very long term tailwind of more and more transactions taking place without cash, and payment processors and prudent lenders stand to benefit. While I'm nervous about the high growth in high-interest loans, the bank was one of the best performers during the Fed stress tests and is well capitalized in case there is some negative shock to the economy. 

At over two times book value, the stock isn't cheap, but Discover has been putting up the returns to justify the price. As with all businesses there are risks, but this stock can continue to be a market beater.  

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Chris Walczak owns shares of Discover Financial Services. The Motley Fool recommends Berkshire Hathaway and Visa. The Motley Fool owns shares of Berkshire Hathaway, Discover Financial Services, and Visa. 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.

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