Please ensure Javascript is enabled for purposes of website accessibility

Discover Financial's Quarter Hurt By Credit Card Loans Gone Bad

By Matthew Cochrane - May 4, 2017 at 1:09PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Discover Financial reported higher revenue and EPS for its latest quarter year over year. But shares sank on news that its loan risks might be taking a turn for the worse.

The past six months have taken investors in Discover Financial Services (DFS 3.29%) on a roller coaster ride. Heading into last year's presidential election, shares of the credit card company were trading at just a shade over $56. Following the election, shares surged to a 52-week high of $74.33 in early January, an approximate 32% gain in just two months' time! Yet following Discover's first quarter earnings reported in late April, the stock price has dropped to the low $60s.

On the surface, there wasn't much not to like in the company's earnings report as the company once again showed increased earnings per share, revenue, and total loan growth. Revenue net of interest expense grew 5% to about $2.34 billion. Earnings per share grew a modest but healthy 6%, coming in at $1.43. Total loan growth sported an 8% growth rate. Even better, the loan growth was powered by growth experienced across its different loan portfolios: credit card loan growth was 7%, personal loan growth saw 20% growth, and private student loan growth was 3%.

DFS Chart

DFS data by YCharts

So what spooked investors in the company's earnings report? Perception that the company faces an increased credit risk.

Discover's charge-offs and loan loss provisions rise

What alarmed the market the most about Discover's quarter was its increases in net charge-offs and provisions for loan losses. Unfortunately, these were not just marginal increases.

Discover's net principal charge-offs increased to $489 million, a 31% increase year over year. A charge-off is essentially any money Discover loans to borrowers that the company deems is now unlikely to be collected. This can happen for a variety of reasons including the borrower declaring bankruptcy or renegotiating debt payments.

Discover logo.

Image source: Discover Financial Services 2017 Q1 Earnings Presentation.

Discover's loan loss provisions increased 38% to $586 million. This was primarily driven by the increase in charge-offs and is basically money Discover sets aside for loan payments it has yet to receive. More than anything else, these two numbers from Discover's quarter seem to have spooked Wall Street and sent shares sliding downward.

Discover recommits to prime borrowing

Prime borrowers are borrowers who are generally considered to have good credit scores and long track records of paying their bills on time. Sub-prime borrowers generally have lower credit scores and/or little to no credit history. Thus, sub-prime borrowers must pay much higher interest rates as they are considered far greater lending risks.

During the conference call, Discover CEO David Nelms emphasized Discover was not going to the subprime borrowing market to look for new customers and that the company was committed to finding opportunities with prime borrowers. According to the S&P Capital IQ conference call transcript, he stated:

"I would also note that we have established a long-term track record of managing our credit risk in a disciplined fashion. With our focus on consumer lending, asset quality has a large and direct impact on our bottom line. That's one reason why prudent risk management underlies all we do. [...] We continue to focus on attracting prime borrowers and achieving strong risk-adjusted returns."

Later, Nelms added for emphasis:

"...we see great opportunities in the prime credit card market. And I'm not sure, the fact that we're not a sub-prime player, in my observation, is that market has gone through a lot more gyrations, and some people that are exposed to that may have bigger swings than we have. But in the prime space, we're pleased with the opportunities."

Just noise or a substantial concern?

Discover CFO R. Mark Graf emphasized that a lot of the increase in charge-offs and loan loss provisions are just a normal part of the "seasoning" of Discover's loan portfolios. Graf stated that as new accounts are opened these will naturally experience higher delinquencies of existing accounts and, since it's been eight or nine years since the financial crisis, "folks have had the ability to encounter life events or get overleveraged or whatever the case might be."

Graf emphasized, however, this did not feel like a cyclical turn in the economy and that the macro factors still felt strong. Management did not feel the need to change its full-year guidance on charge-offs or loan loss provisions.

If Discover can continue to grow revenue, earnings, and its loan portfolios, the stock price might very well represent a good long-term value at its current levels. But investors beware: If loan delinquencies continue to rise, the market can continue to punish the stock for a long time to come. It has not yet been a decade since the financial crisis and the market remains extremely skittish with stocks that are exposed to credit risks, likely for good reason. 

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Discover Financial Services Stock Quote
Discover Financial Services
$97.69 (3.29%) $3.11

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 07/03/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.