Discover Financial Services (DFS -0.55%) is a credit card company, but it's also an online bank with about $112 billion in assets. Either way you classify it, it has been a strong performer over the past decade. Discover's stock has returned about 13% on an annualized basis for the past 10 years through the end of the second quarter of 2020. That makes it a top performer among banks; as a credit card company, it has trailed the major players, Visa and Mastercard, but it is different from them in several key ways.
This year, Discover's stock has been hit hard by the coronavirus pandemic, down about 45% year to date. That's worse than the average return for bank stocks and far worse than Visa and Mastercard, which are both relatively flat for the year. Why is Discover underperforming, and is it a buy?
To understand why Discover is lagging behind its competitors, it helps to know how it differs from them. Visa and Mastercard are payment-processing companies that facilitate the movement of money and collect a fee for their services. Their credit cards are issued by other banks, like Citigroup (C -1.70%) and Bank of America (BAC -1.50%), among others.
Discover is a payment processor as well, but unlike Visa and Mastercard, it is also a lender, loaning money through its own bank. The company generates revenue from the interest on its credit card balances. So, while all credit card companies were hurt by a sharp drop in consumer spending over the first two quarters due to stay-at-home orders and layoffs, Discover will take a hit from lower card balances as well as a likely surge in defaults and credit losses.
Also, because Discover is a bank, it suffered from lower interest rates and a decline in net interest margin. In addition, it had to set aside $1.8 billion for provision of credit losses as a result of the pandemic. As a result, Discover posted a net loss of $61 million in the first quarter. Other credit card companies don't have to worry about provision of credit losses or other issues specific to banks.
Rockin' the plastic?
Discover's credit card balances were actually up slightly, 4%, after the first quarter, but as the recession continues, look for that number to decline. In the first-quarter earnings call in late April, President and CEO Roger Hochschild said the company was already seeing it:
So far in April ... everyday sales are down 14% year over year as increased spending on groceries is more than offset by a 60% reduction in spend in petroleum. Discretionary spend is down 33%, driven by the travel category, which, although only 8% of cardholder spending, is down 99%, and by retail, which is down 11%. As long as stay-at-home orders remain in place and many businesses remain closed, we expect the weak sales volume trend to continue, and future trends will depend upon the pace of the recovery.
Less spending, of course, means less borrowing and credit card use. The company is also at a higher risk for defaults and credit losses as more people struggle to pay their bills during a recession.
There are some bright spots for Discover. It has good liquidity, with about $19 billion in liquid assets at the end of the first quarter and $23 billion as of the April 23 earnings call, according to Hochschild. In addition, the company announced plans to reduce spending by $400 million by the end of 2020.
But given the economic outlook, it's going to be a rocky time for banks and credit card companies, even one like Discover that has delivered consistent earnings over the past decade. I'd look elsewhere for buys in the financial sector right now.