Shares of Discover Financial Services (DFS 3.11%) took a major hit after the company reported its first quarter earnings. While revenue, earnings per share, and its loan portfolio all showed mid to high single digit percentage growth, mounting evidence that the company is facing higher loan default risk seemingly spooked investors. For the quarter, Discover's loan loss provisions increased 38% to $586 million and net principal charge-offs grew 31% to $489 million.
While increased credit risks cannot be ignored, it should be noted that Discover did grow each of its different loan portfolios when it reported its quarterly results. So, while the company's well-known credit card portfolio realized 7% growth, its lesser-known personal and student loan portfolios grew as well. In fact, its organic student loan portfolio has now grown at an average of 20% over the past five years, a truly remarkable feat! But Discover isn't done. The company's management believes there could be plenty of opportunities ahead in this much-overlooked space.
Student loan debt is exploding
What cannot be denied is that student loan debt has exploded in recent years. A recent NerdWallet study showed that by the end of 2016, Americans owed an incredible $1.3 trillion in student loan debt; more than they owed on auto or credit card loans. While more than 90% of current student loans are currently handled through the federal government, the current environment would seem to be ripe for change.
Besides the massive amount of student loan debt, many of these loans are now in default. According to the Consumer Federation of America, there were more than 1.1 million federal loan defaults in 2016. Meanwhile, in a report issued this past March, the Consumer Financial Protection Bureau stated there was a whopping 325% increase in consumer complaints on student loans during the previous twelve months. For better or for worse, these problems, coupled with a new administration in Washington, could mean the federal government takes a step back from being directly involved in such a large percentage of student loan originations.
Discover has kept just such a scenario in mind and believes it is poised to capitalize on such a transition. In its 2016 fourth quarter conference call, CEO David Nelms responded to a question on this very topic:
"...the private student loan market has become pretty small, and I think that's one reason a number of people exited from it and why there's only a couple of people left in it. And I think to the extent that there was a greater role for private lending, I think we would be very well positioned. And I think the fact that I think it's around 6% or something of the total market of new loans are private and the other 94% or so are federal. And so it wouldn't take much in the way of federal backing off to have a dramatically percent increase on the private origination side ... And so I think ... that we would feel really well positioned to take advantage of any possible increase in that market, which I wouldn't expect this year but maybe in subsequent years."
Discover's solutions to a difficult market
But Discover isn't just biding its time waiting for politicians in D.C. to deliver legislative change that would boost its business. The company continues to improve its student loan platform and products. For instance, in April, it introduced a new interactive tool that allows parents to compare offers from different colleges side-by-side. If designed well, this tool should be helpful for parents when different schools don't follow the same template while offering scholarships and financial assistance.
At the William Blair 2017 Growth Stock Conference last month, Nelms made it clear that the default problem with federal student loans does not apply to the smaller private student loan market and explained that Discover avoids these problems by carefully underwriting its loans. The company accomplishes this by taking several protective measures including working only with four year colleges and not-for-profit universities, focusing on higher-quality schools, disbursing money straight to schools, and securing cosigners on more than 90% of the student loans it originates.
Because the market is heavily regulated and federal student loans make up such an overwhelming majority of student loans, Discovers finds itself with few competitors in this space. Of course, if the federal government ever steps back from originating the bulk of these loans, other competitors will surely enter the space. However, Discover will have had years to continually improve its platform and take market share, giving it what should amount to a significant advantage. While there are obviously lots of other factors to consider before making an investment in the company, Discover might deserve some extra credit for its student loan business.