Shares of Discover Financial Services (DFS +0.00%) have lagged the S&P 500 index year to date, dropping by about 6%, while the index has gained 5%. Yet, when the company reported its second-quarter earnings late last month, investors were once again treated to mostly good news -- with a few nagging concerns.
First, the headline numbers: Net revenue rose to $2.6 billion, an 8% increase year over year, and diluted earnings per share (EPS) grew to $1.91, a 36% increase year over year.
Of course, there is a lot more to the story than just the robust top- and bottom-line growth, so let's take a look at some of Discover's biggest quarterly highlights.
| Metric | 2018 Q2 | 2017 Q2 | Change |
|---|---|---|---|
| Total loans | $84.8 billion | $78 billion | 9% |
| Credit card loans | $67.8 billion | $61.8 billion | 10% |
| Personal loans | $7.3 billion | $7.0 billion | 5% |
| Student loans | $9.1 billion | $8.9 billion | 2% |
Data source: Discover Financial Services.
Total loan growth remains solid
Hearteningly, Discover's loan growth remains solid. In Q2, total loans increased to $84.8 billion, a 9% increase year over year. This growth was led by growth in its credit card portfolio, by far its largest loan category, to $67.8 billion, a 10% increase year over year. The credit card portfolio now makes up about 80% of Discover's total loan portfolio. Student loans and personal loans, Discover's two other loan categories, grew a much more modest 2% and 5% respectively.
With loan-loss provision growth on the decline and the company showing decent top- and bottom-line growth, Discover Financial shares are beginning to look like a real bargain. Image source: Getty Images.
Finding the right balance in its personal loans segment continues to be the problem giving the credit card issuer headaches. Last year, the company reported that a specific subset of personal loan consumers had caused an uncharacteristically high amount of charge-offs. This quarter, management stated that, due to increased competition, there was less opportunity for profitable growth, and said it would intentionally "cut back on origination activity."
Still, the star of the show remains the credit card portfolio. Card loan growth was robust, something management credited to "a balanced mix of new accounts and existing cardholders." Discover continued to see strong engagement in its rotating 5% cash-back categories, which management said was particularly high this quarter as the reward category rotated to supermarkets and groceries.
Loan-loss growth tapering
The primary issue that has plagued Discover for the past several quarters continued: growing loan-loss provisions and charge-offs. Loan-loss provisions, money the company has set aside for loan losses, increased to $742 million, a 16% increase year over year. While this growth is slower than previous quarters, it is still easily outpacing loan growth.
Still, management pointed to a relatively flat sequential growth in credit card loans' net charge-off rate as evidence the trend might be improving, and attributed it to several factors. In the company's second-quarter conference call, transcribed by S&P Global Market Intelligence, CEO David Nelms stated:
Turning to credit, performance remains strong with charge-offs flat and delinquencies down 15 basis points on a sequential basis. This reflects a number of factors: First, we've maintained our disciplined approach to underwriting. Second, we've seen meaningful benefit from our investments in advanced analytics, modeling and machine learning. And finally, the strength of the U.S. economy has certainly helped.
Management remains shareholder-friendly
Discover remains a company interested in returning excess capital to shareholders via buybacks and dividends. During the Q2 conference call, CFO Mark Graf said the company authorized a new $1.85 billion share repurchasing plan -- and that's after the share count decreased by 2% since the previous quarter's earnings release.
In addition to the new buyback plan, the company also raised its dividend to $0.40, a 14% increase. Based on its trailing-12-month EPS of $6.83 (adjusting for the Tax Cuts and Job Act), Discover stock sports a decent dividend yield of about 2.2% and a low payout ratio of only 24%. Such a low payout ratio means Discover's dividend is not only exceedingly safe, but also gives the company plenty of room to raise it in the years ahead.
Discover a decent value stock
It cannot be denied that Discover's stock sports an attractive valuation. Based on its EPS, its price-to-earnings ratio is 10.5, much lower than its credit card peers such as American Express. For a company growing revenue by the high single digits -- and its bottom line at a much higher rate -- this makes shares look fairly cheap, in a bull market getting long in the tooth.
When you consider the company's other qualities, such as organic loan growth and shareholder-friendly management, its value appears even more striking. For now, value investors would be wise to place Discover on their watchlists, or even in their portfolios.
