Discover Financial Services (DFS 0.87%) has flown under the radar compared to other banks and credit card companies, particularly in the past year. But the company posted strong fourth-quarter and year-end earnings on Jan. 19, and investors should pay attention to this.
There are some numbers and trends in that report showing that this stock could be poised for a bounce-back year. Let's examine why this wildly undervalued stock may be ready for the start of a bull run in 2023.
Strong loan and revenue growth in 2022
Discover Financial Services is often seen as the other credit card company, next to its much better-known competitors Visa, Mastercard, and American Express. But it is different from its competitors in some important ways. It's a closed-loop network, meaning it issues the cards, lends the money, and processes the transactions all on its network. American Express is also a closed-loop network, but Discover's model is different from American Express's -- and that difference proved key to its success last year.
While American Express makes most of its revenue from fees, Discover generates most of its revenue from interest income through its loans. In 2022, that helped Discover immensely, as it generated $3.8 billion in net interest income (NII) in Q4, up 41% year over year. NII excluding interest expense was $3.1 billion in the quarter, up 23% year over year. Net interest margin was 11.3% -- up 46 basis points year over year.
Revenue in the quarter was fueled by a 20% year-over-year increase in loans, to $112 billion. Loans were up 7% over the previous quarter. Credit card loans accounted for most of that, about $90 billion, up 21% year over year. Roger Hochschild, chief executive officer and president of Discover, expects that momentum to carry into 2023.
"Our outstanding results in 2022 were driven by record loan growth and margin expansion, factors that should sustain strong revenue growth into next year," Hochschild said in the Q4 earnings report. "This revenue momentum, our disciplined approach to credit management, and our capital generative model position us to generate shareholder value through a range of economic environments."
Credit quality concerns
Discover's revenue and earnings growth, with diluted earnings per share up 4% in the quarter year over year, got overshadowed by some nearer-term warnings on credit quality and delinquencies.
Specifically, the overall net charge-off rate climbed to 2.13%, which was 76 basis points higher than the same quarter a year ago. The credit card net charge-off rate was 2.37%, up 87 basis points from the prior-year period. The company said it was due to credit normalization as we move out of the pandemic. The total net charge-off rate was 3.19% in Q4 2019, pre-pandemic, and the credit card rate was 3.41%, so it is still below that.
The 30-plus day delinquency rate for credit card loans was 2.53% last quarter, up 87 basis points from Q4 2021 and 42 basis points from the third quarter of 2022. That is slightly below the 2.62% pre-pandemic rate.
Cheap stock with great long-term potential
These are obviously numbers to watch because they will rise given the expectation of a challenging macroeconomic environment. On the Q4 earnings call, Chief Financial Officer John Thomas Greene said he expects the net charge-off rate to be in the 3.5% to 3.9% range in 2023, but probably closer to the lower end.
He also expects low double-digit percentage revenue and loan growth in 2023, driven in part by a surge in new accounts in 2022. New credit card accounts jumped 23% in 2022 and 17% in the fourth quarter, year over year. Greene also expects the NII to be higher in 2023 than it was at the end of the last quarter, buoyed by loan repricing benefits.
Ultimately, this stock remains dirt cheap for the type of growth and earnings power it has exhibited in a challenging economic environment. It has a price-to-earnings ratio of just 6.9, with a forward P/E of 7.8.
There could be a few volatile quarters to start the year, but by the second half of the year, when consumer spending tends to surge, and the economy hopefully improves, it should start to generate positive returns.
The consensus price target among analysts is about $120 per share, which would be about a 13% increase over current levels. And while it's impossible to know where the economy will head in the long term, the stock should be even stronger once we emerge from this economic malaise.
