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Discovering Value In This Underappreciated Credit Card Company

By Matthew Cochrane - May 9, 2018 at 3:35PM

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Credit risk concerns might be overblown, making this credit card company an undervalued gem that is finding new ways to win and incentivize customers.

Over the past several quarters, Discover Financial Services (DFS 5.39%) has struggled to strike the proper balance between growing its loan portfolios and keeping its credit default risks in check. At least, that's what Wall Street would have you believe. Discover's management, however, maintains credit risk concerns are overblown. Meanwhile, the company continues to grow its loan portfolios at steady clips.

Those hoping the tension between these two camps would dissipate after the company reported its first-quarter earnings in late April were disappointed. In the company's Q1, there was certainly a lot to like. Discover's revenues rose to $2.58 billion, a 10% increase year over year, while the earnings per share grew to $1.82, a 27% increase year over year. Discover's nice top- and bottom-line growth was powered by tax reform and loan portfolio growth. The company's overall loans increased 9% to $82.7 billion, led by growth in its credit card category, which increased borrowings 10% to $65.6 billion.

Discover Metrics 2018 Q1 2017 Q1 Change
Revenue $2.58 billion $2.34 billion 10%
Diluted EPS $1.82 $1.43 27%
Total loans $82.7 billion $75.9 billion  9%

Data source: Discover Financial Services  

Let's take a closer look at Discover's real credit risk, how it plans to increase spending from existing card members, and what it's doing to acquire new customers to see if it's the bulls or the bears that got this stock right.

Customer paying for order with contactless credit card payment over table of tea and pastries.

Discover is plagued by rising net charge-offs, but it is discovering ways to encourage existing card holders to use their cards more and finding new millennial customers with sticky products like checking accounts. Image source: Getty Images.

Does Discover have a credit problem?

It's not hard to see where credit risk worries are originating. In the first quarter, net principal charge-offs, or loans that Discover characterizes as being unlikely for the company to receive payment, rose to $635 million, a 30% increase year over year. Provisions for loan losses, or money Discover sets aside for loan losses, jumped to $751 million, a 28% increase year over year. It doesn't help if investors remember that the Federal Reserve's 2017 stress tests revealed Discover would suffer the most meaningful losses in a downturn similar to the financial crisis.

The total net charge-off rate across all of Discover's loans was 3.09%, with Discover's private student loan portfolio only experiencing a 0.92% charge-off rate. Discover's credit card portfolio, by far its largest loan category, carried a 3.32% charge-off rate in the quarter.

During the company's first-quarter conference call, transcribed by S&P Global Market Intelligence, management insisted this credit performance was normal considering the increased availability of consumer credit and the seasoning of its portfolio. CEO David Nelms said that, since new borrowers now make up a larger portion of its credit card portfolio, it is expected that charge-off rates would increase. But, Nelms continued, Discover would continue to pursue these opportunities as long as they increased shareholder value. At this time, Nelms insisted, these newer account holders did just that and were performing within the company's expectations. CFO Mark Graf stated the company wasn't going to guide for provision losses but did say the company was still comfortable with its 2018 charge-off guidance of 3% to 3.25%.

Increasing card holder engagement

In the Q1 conference call, Nelms highlighted several "differentiating features" which he believed encouraged customers to use their Discover cards more. One feature he highlighted was Discover's Cash Back Match program . The unique factor about this rewards program is that it doesn't just incentivize members to use their cards in any particular quarter but, rather, all year round. While customers earn 5% in certain quarterly categories, like gas, groceries, and restaurants, at the end of the year the program doubles the rewards the member earned throughout the course of the year. Members can then redeem these points in a variety of ways such as credit card bill payments, charitable donations, and gift cards.

The strategy behind this is that using the same credit card over the course of the year will reinforce customers' habits of using their Discover cards, so that it will become customers' go-to cards long after that first year.

Other distinguishing features highlighted by Nelms included on/off freeze functionality customers can use when a card might be lost and Discover's complimentary searching of the dark web for its customers' personal identification information. These features are at least partly responsible for why Discover consistently ranks high in third-party customer loyalty and satisfaction surveys.

A new product to win millennial customers

One of the more exciting developments Discover's management mentioned in the conference call was the roll out of checking accounts. Nelms said:

In February, we announced our new debit rewards program for our Cashback Checking product. This program allows our checking customers to earn 1% cashback and up to $3,000 of eligible debit card purchases each month. Despite only minimal promotion to date, the checking product has received a positive reception in the market, particularly among millennials with an average age of 35 for new checking account customers in the first quarter. Importantly, for more than 40% of the new checking accounts opened in the first quarter, this represents the customers' first relationship with Discover. This demonstrates the checking products potential to serve as an important new entry point to the Discover franchise. 

What makes this particularly exciting is that it is a way for Discover to entice millennial customers into a long-term relationship since checking accounts are much stickier than credit card and savings accounts. Direct deposits and bill payments are often associated with checking accounts, making it much more of a hassle for customers to switch banks. Later in the call, management advised not to expect anything significant from this roll out soon -- fraud risks, credit questions, and branchless expansion were all still being experimented with -- but, Nelms concluded, " I think you should think about over, say, a 5-year period, this sort of turning into something material in terms of first-time customers, lower cost funding, stickier relationships, and we're starting off to increase the franchise."

Discovering a good value

On the surface, there are many reasons to like Discover. It seemingly enjoys a good relationship with its existing customers and is finding potentially lucrative ways to acquire new customers. The company pays a rising dividend and appears to be a good value. Based on its trailing twelve months earnings per share of $6.32 (adjusted for tax reform) and based on my own calculations, the company trades at a P/E ratio of just 11.25. While there are definite credit risks, I believe they are more than priced in at these levels. I am giving Discover a green thumbs-up in My Caps portfolio and will add the company to my watch list of ideas for my own personal portfolio.

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