The past year was a rough one for Discover Financial Services (NYSE:DFS) shareholders. In 2018, Discover's stock price fell 23% and, though it has made up some of those losses this year, it is still well off its all-time high set early last year. Most frustrating for Discover shareholders, perhaps, is that the company performed fairly well throughout this period, even as its stock suffered. When Discover released its 2018 fourth-quarter earnings late last month, investors might have breathed a sigh of relief just because its shares didn't immediately drop afterward.

At first glance, the results certainly appeared good. Revenue rose 7% over last year's fourth-quarter total to $2.8 billion, while adjusted earnings per share (EPS) grew to $2.03, a 31% increase year over year. The solid revenue growth was driven by an increase in total loans to $90.5 billion, a 7% increase over 2017's fourth-quarter figure.

Discover Metrics 2018 Q4 2017 Q4 Change
Revenue $2.8 billion $2.6 billion 7%
Adjusted EPS $2.03 $1.55 31%
Principal charge-offs $686 million $583 million 18%
Total loan growth $90.5 billion $84.2 billion 7%

Data source: Discover Financial Services 

The main thing

Discover's loan totals are composed of credit card, personal, and student loans. While the student and personal loans should not be completely discounted -- both total in the billions of dollars -- the vast majority of its loans come from its credit card portfolio. At the conclusion of Discover's 2018, the company's credit card loans totaled $72.9 billion, an 8% increase year over year, good for about 80% of its total loan portfolio.

Customer reaches across table to make contactless payment with credit card as merchant's hand extends with credit card reader.

Discover's credit card portfolio growth powered the company's solid fourth-quarter results. Image source: Getty Images.

The growth in credit card loans is the most important number from Discover's quarter. Why? The company's student and personal loan portfolios are not only much smaller, but are also growing more slowly, just 2% and 1%, respectively. With credit cards making up the lion's share of Discover's loans, this is clearly the segment driving Discover's business. Let's take a closer look at the various factors powering the company's card growth.

Universal merchant coverage

Discover continues to fight for greater merchant coverage to match the acceptance enjoyed by the larger payment networks, such as Mastercard Inc (NYSE: MA) and Visa Inc (NYSE: V). This is especially true concerning overseas markets. In the company's fourth-quarter conference call, CEO Roger Hochschild stated:

In terms of global acceptance, we continue to see a great opportunity to partner with local acquirers to enhance merchant acceptance. We made significant progress on this in the fourth quarter, signing a number of agreements in a variety of markets, including the UK and Continental Europe. Universal merchant acceptance remains an important objective as we pursue our longer term vision of being a leading global payments partner.

For the money Discover is directing toward these opportunities, Hochschild cautioned that this is not something you see your return on investment on a merchant-by-merchant basis, but only after "critical mass" acceptance is reached in a given area.

A customer-centric approach

Discover management prides itself on offering value-added propositions to its account holders and its award-winning customer service. In his opening comments, Hochschild stated that customers associated Discover's brand with "exceptional customer service," something he doesn't want to change on his watch. He added:

[T]he thread that weaves all this together is our relentless focus on customer experience. We recognize that we live in a highly competitive environment, but we've been able to distinguish ourselves by introducing features and benefits that customers value. Our customer-centric approach has been fundamental to our consistently strong growth and returns.

The results appear to back this up. Later in the conference call, Hochschild pointed out that Discover enjoyed the card industry's lowest churn rate and that the company had won five consecutive J.D. Power Customer Experience Awards.

Check out the latest Discover earnings call transcript.

Responsible lending

Of course, none of this card growth would matter if Discover could not control the losses on its lending practices or limit its exposure to risky debt. This quarter, Discover's net principal charge-offs, the amount of delinquent debt on Discover's books, increased 18% to $686 million. While that's a sizable uptick, it represents an incredible slowdown from last year's charge-off growth rate of 34%. The company's credit card charge-off rate, the percentage of loans representing what Discover believes it will never collect, ticked just slightly higher to 3.23%.

Even more encouraging was that CFO Mark Graf told investors this number would continue to moderate going forward. Hochschild noted that the company had made heavy investments in machine learning to "enable faster and better decisions" that would lead to better loan growth and credit performance. Graf also shed some light on the credit quality of its card holders, saying that the average card holder had a credit score of about 730.

Why I'm more optimistic about Discover in 2019

Although 2018 was not kind to Discover shareholders, I would be surprised if 2019 treated them the same. In 2018, the company earned $7.79 per share, giving it a current P/E ratio of about 8.8. That seems incredibly cheap, especially for a lender guiding to grow its total loan portfolio by 7% this year. For a company dedicated to giving customers a superior experience and conservative lending, that seems like an especially attractive valuation for investors.