The day after Discover Financial Services (NYSE:DFS) reported its 2018 third-quarter earnings, the company's stock plunged 8% and is now off 12% since the beginning of the year. While the company's stock has certainly struggled this year, the business performance is not nearly as bleak. While a few concerns remain, Discover continues to grow its loan portfolio in a measured and balanced way.
In the quarter, Discover's total revenue rose to $2.72 billion, an 8% increase year over year, while earnings per share (EPS) grew to $2.05, a 29% increase year over year. After going through Discover's conference call transcript, there appear to be three big takeaways for shareholders: new CEO Roger Hochschild's commitment to staying the course of his predecessor, consistent loan portfolio growth, and nagging credit liability concerns. Let's take a closer look at all three of these.
Different CEO, same philosophy
Earlier this year, longtime Discover CEO David Nelms announced he would be stepping down and would be replaced by Roger Hochschild. Hochschild seems to be a logical choice; before taking the reins as CEO, he served as Discover's president and has been with the company for 20 years. While this means Discover probably won't be taking any bold steps to invest more in the fintech space, it also means the company won't be likely to stray too far from its roots of carefully underwritten loans and world-class customer service. In his opening comments on the conference call, Hochschild stated:
Even with a change at the top, our priorities remain the same. First, the Discover lend-centric business model integrated with the benefits of our proprietary network remains at the core. We will continue to invest in the brand in a differentiated customer experience and in advanced analytics. And of course, we will maintain our consistent conservative approach to credit risk management. This strategy has served us well and continues to produce outstanding results.
Steady loan growth
While Discover is best known for its credit-card brand, it also operates personal and student loans segments. To be fair, about 80% of its total loan portfolio comes from its credit-card segment, while personal (9%) and student loans (11%) make up much smaller slices of the whole pie. Lately, this has worked to Discover's advantage because the card portfolio has shown much stronger growth. In Q3, Discover's student loan and personal loan segments only grew 2%, while the company saw a 9% increase in its credit-card portfolio.
For student loans, Hochschild said the company was "seeing pressure on payment rates from student loan consolidators," which was affecting loan growth. In the personal loan business, the company continues to see a number of new competitors enter this space trying to differentiate themselves based on nothing more than price and looser credit standards (more on this below).
Yet, in the all-important credit-card category, Discover continues to see impressive growth. New accounts are already up 14% year to date, while the company is seeing increased engagement and spending from existing cardholders. When asked about the competition in the card business, Hochschild replied that the card business is "always competitive," and that the key was to offer a "great value proposition." On that note, Hochschild said, "We continue to differentiate in terms of customer experience, and the functionality we provide."
Credit concerns remain
While the headline numbers look good, there remains an undertone of caution that has been present on nearly every Discover conference call in recent quarters. This is due to the still-fresh memories of the financial crisis when credit issuers and lenders took massive losses after underwriting risky loans. In Q3, the net charge-off rate, the percentage of loans unlikely to be paid back, across its total loan portfolio was 2.97%, down from the previous quarter, but still a noticeable increase from last year's third-quarter rate of 2.63%.
By far the biggest offender in this category was Discover's personal loan segment, which sported a net charge-off rate of 4.09% -- not exactly a new development for shareholders who have been paying attention. Last year, Discover's management said it was intentionally pulling back on originating new personal loans after noticing troubling trends with respect to loan-loss rates and how these loans were being underwritten.
CFO Mark Graf maintains that the company took the necessary actions last year to stop the bleeding, but he said it was a situation that requires "continuous monitoring." He said that while there was still "a window of opportunity for personal loan growth," more competition was making it tougher, forcing the company to be "more selective" with how future loans in this sector are originated.
While potential macroeconomic concerns will always linger, Discover seems to be taking reasonable precautions by intentionally leaving some loan growth on the table by walking away from new loans too far down the credit food chain. That being said, whatever concerns that are legitimate seem to be already baked into the company's stock price -- and then some. Based on its trailing-12-month EPS of $7.29, Discover trades at a P/E ratio of just 9.25, well below the market's average. For a company consistently growing its top and bottom lines, actively buying back shares, and supporting a 2.4% dividend yield, this seems to be a decent bargain. For a bull market that's long in the tooth and showing lots of volatility, that's a value that should reward investors with a degree of safety and decent returns going forward.