Since 2011, as Discover Financial Services (DFS 4.85%) finally pulled itself out of the depths of the financial crisis, the company has raised its dividend by an incredible 1,650%, climbing from $0.02 quarterly in 2010 to $0.35 per quarter now. In 2017, Discover raised its dividend by almost 17%. Despite this growth, the stock's dividend yield still stands at about 1.8%, roughly on par with the market's average. The recent healthy increases in dividend payouts have begun to put the credit card issuer on the radar of dividend growth investors.
Beyond the dividend growth, Discover has faced its fair share of struggles during the past few years and, more recently, even the soundness of the company's loans has been called into question. The stock price is only up about 16% over the past three years, well below the S&P 500's return over the same period. With the company's recent struggles in mind, it's only natural for investors to wonder if the company's dividend payout is safe and if the healthy increases can be sustained in the years ahead. Let's take a closer look at what's ailing the company, what management is doing to correct course, and how safe Discover's dividend really is.
Discover's financial dilemma
What has seemingly spooked investors the most about Discover's financial fortunes are the sharp increases in its net charge-offs and provisions for loan losses the company has reported lately. In the company's third quarter, net principal charge-offs, loans that Discover deems unlikely to ever be paid back, rose to $527 million, a 42% increase. Provisions for loan losses, money Discover sets aside for loan payments not yet collected, grew at an even greater rate to $674 million, a 51% increase year over year.
Management points out that loan growth remains solid and that the increase in charge-offs is due to the normal "seasoning" seen in loans of a certain age. Management also insists that the company is only pursuing opportunities in the prime, not the subprime, credit market. Essentially this means Discover is only pursuing opportunities with consumers who sport a credit score of 640 or higher.
Earlier this year, however, Discover CEO David Nelms did acknowledge a problem with how the company had been awarding personal loans. Once the problem was identified, though, the company moved quickly to rectify its personal loan model. Here's what Nelms said in Discover's second-quarter conference call:
[O]ne place I'd point to is in personal loans. We've seen a lot of new players that don't have 10 years of data, haven't been through a cycle, lot of expansion in credit. And so we have a relatively small number of credit card customers, who have personal loans with someone else. But those people have tended to underperform and underperform what our expectations are, and underperform what their FICO scores would otherwise suggest. And so we've adjusted our models to help compensate for what we think is above all outside credit that is affecting us.
After the Federal Reserve's stress tests were performed earlier this year, fellow Fool John Maxfield noted that Discover, over any other domestic bank, had the highest percent of its loan portfolio that might be written off during an economic downturn.
While Discover continues to show loan growth across all of the company's loan categories -- including credit card, personal, and student loans -- the sharp spike in charge-offs and loan loss provisions led to a decrease in earnings this past quarter.
So about that dividend...
One thing investors don't need to worry about now is Discover's ability to cover its dividend payout with its earnings. Over the trailing 12 months, the company has reported $5.74 in earnings per share (EPS) and is currently paying out $1.40 in dividends per share. This gives it a payout ratio of only 24%. This means the company has plenty of room to continue share buybacks, invest in its business, increase marketing spending, and still grow its dividend comfortably into the future -- as long as economic conditions stay relatively the same.
For the immediate future, there don't seem to be any concerns for income investors. If, however, there's a severe economic downturn where Discover would have to write off approximately 13% of its loan portfolio, as the Fed's stress test cautioned, it's hard to know what would become of the company's dividend. While the dividend would almost surely be covered in all but the direst forecasts, it might be prudent for management to reduce or suspend it in such a case for a time. In the company's first-quarter conference call, management did say it was committed to sustaining the dividend, listing only organic growth as a higher priority.
Due to these concerns, income investors who are interested in financial companies offering yield might want look to other, probably safer, alternatives. American Express, which has an almost identical business model to Discover and maintains a much lower charge-off rate, sports a growing dividend with a similar yield. Similarly, JPMorgan Chase & Co. is growing its dividend and features a more diversified business model. While Discover's dividend is probably safe and its stock trades at an attractive valuation, there are simply other companies I would rather invest in, for income or value, until Discover's credit risk becomes clearer.