3 Reasons Why You'll Love Discover Financial Services

Discover Financial is a bet on stronger loan growth going forward and increasing earnings in its important credit card business.

Jul 31, 2014 at 1:32PM

Source: Company

Discover Financial Services (NYSE:DFS) delighted investors with another solid quarter that saw double-digit increases in its pre-tax, pre-provision and net interest income and solid loan growth. The financial company further convinces with a comparatively low valuation when benchmarked against its immediate credit card peers.

Discover Financial offers traditional banking services such as credit cards, home loans, home equity loans, private student loans and other core banking products such as savings and checking accounts.

In addition, Discover Financial operates PULSE, a leading ATM/debit network, and Discover Network, a secure payments network which facilitates payments for a full range of credit, debit and prepaid cards. Discover Financial currently has a market capitalization of $29 billion and is a formidable force in the credit card and loan business.

1. Solid loan growth
Discover Financial has become a formidable force in the credit card business.


Source: Discover Financial Second Quarter Earnings Presentation

The banking firm is one of the largest credit card issuers in the country and has used its strong market position in credit cards to expand into other product groups such as student loans or personal loans.

In the second quarter of fiscal 2014, Discover Financial could present total year-over-year loan growth of 7% and a loan portfolio totaling $65.9 billion.

Almost 80% of total loans are attributable to Discover Financial's card business indicating that the bank will remain highly dependent on this business segment in the future to drive company earnings.

Given the immense size of its card loan portfolio of $52.7 billion in the most recent quarter, investors are likely to see more moderate, yet attractive, growth rates going forward.

Personal loans, on the other hand, represent a much lower percentage of total loans, but exhibited the highest year-over-year growth rate of 26%.

2. Earnings
Discover Financial generally has done a good job in the second quarter. Driven by loan growth and an 11% higher net interest income, the bank also achieved healthy bottom line results: Its pre-tax, pre-provision income, a proxy for sustainable bank earnings, improved 13% year-over-year to $1.38 billion compared to last year's $1.22 billion.

Discover Financial's net income increased 7% while its diluted earnings per share grew even stronger at 13% to $1.35.

The bank's high reliance on the credit card business also raises hopes, that the bank will be able to capitalize on higher consumer spending in an economic upswing in the U.S. going forward.

Credit card players like Discover Financial should be among the major beneficiaries of an increase in discretionary income and higher consumer spending similar to credit card companies like American Express (NYSE:AXP) or Mastercard (NYSE:MA).

3. Valuation
Discover Financial compares very favorably to other credit card-focused financial firms. While most investors concentrate on traditional credit card issuers such as American Express or Mastercard, Discover Financial actually is a much better bet from a valuation point of view.

Its price to book multiple stands at just 2.6x whereas American Express trades at nearly twice this metric.

Mastercard certainly trades in a valuation league of its own with an almost indefensible P/B ratio of 13.5x.


The Foolish Bottom Line
I cannot help but like Discover Financial especially after another quarter of strong financial results in its core credit card business. Its outsized exposure to credit cards should serve the company well as consumer spending increases and demand for credit cards and transaction volumes go up.

Moreover, Discover Financial convinces with a comparatively low valuation compared to its credit card peers and should be able to catch up in terms of valuation once its credit card business really takes off.

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Kingkarn Amjaroen has no position in any stocks mentioned. The Motley Fool owns shares of Discover Financial Services. 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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