During this time of economic uncertainty, sentiment on bank stocks is low as investors are hesitant to buy such names ahead of a potential recession. However, that has left many bank stocks looking quite cheap today.
While many bank stocks have pulled back on share repurchases over the past year due to regulatory capital raises and in preparation for a more challenging economy, it appears bigger capital cushions and falling inflation have now spurred some back into the market. For instance, JPMorgan & Chase (JPM 0.42%) just announced it would resume buybacks after a months-long pause and after achieving a capital-ratio requirement of 13.2% on its way to 13.5% next year.
But if multiples remain compressed for some time, that means the cheapest bank stocks have a big opportunity to repurchase lots of their own stock over the next couple of quarters. And credit card giant Discover Financial Services (DFS 1.89%), among the cheapest of the large banks, just announced a massive buyback plan that could retire nearly 8% of its shares in just six months.
Discover's high-return model
Discover's main business is credit card loans, which account for most of its net income. The company also has its own branded card, which brings in interchange fees, but Discover's generous cash-back rewards tend to limit the amount of income it gets from card swipe fees alone. The company is also engaged in student loans and personal loans, but credit card loans made up 80% of the company's total last quarter, and credit cards also carry higher interest rates than personal or student loans.
High-interest cards are hugely profitable, but since they are unsecured loans and considered risky, investors tend not to ascribe a high multiple to banks with lots of credit card loans on their books. For instance, Discover earned a whopping 33% return on common equity in 2022 despite ramping up its provision for credit losses through 2022 as interest rates surged.
Despite that sizable profitability, Discover trades at just 6.8 times trailing earnings, good for about a 16% earnings yield. That means Discover's 2.3% dividend -- which the company raised 20% last year -- accounts for only 15% of its net income.
Buybacks are the key to Discover's success
But where Discover really shines is in share repurchases, which is a large source of the company's excess returns. Because investors ascribe a low multiple to Discover, despite its high return on equity, Discover has managed to lower its share count by nearly 50% in just 10 years!
DFS Shares Outstanding data by YCharts.
That nearly 50% reduction accounts for most of the stock's price appreciation over that time period and more than 40% of its total returns including dividends. The share repurchases have therefore played a key role in Discover outperforming both the S&P 500 and the Financial Select Sector ETF (XLF 0.16%) over that time.
DFS 10 Year Total Returns (Daily) data by YCharts.
The company is set to unleash massive buybacks in 2023
Not only are Discover's buybacks a significant factor in its success, but there's also an especially interesting buyback opportunity happening in its stock right now.
Discover announced back in July that it was temporarily suspending its buyback program as the company conducted an internal investigation into compliance practices regarding its student loan segment. However, it appears the results of that investigation were rather benign, and in mid-November, the company announced it was resuming its repurchase program. In the fourth quarter, the company got back to its ways, repurchasing $602 million worth of its stock.
On the recent Q4 earnings call, management outlined plans to buy back a whopping $2.2 billion worth of shares in the first half of 2023 alone. That's a massive amount, considering Discover bought back $2.4 billion over the entire year in 2022. Yet considering Discover earned $4.4 billion in net income last year and $5.4 billion the year prior, and considering its CET1 capital ratio of 13.3% remains well above the company's 10.5% target, Discover should have ample cash to execute the program.
Risks should be manageable
With economic uncertainty in the air and bank stocks trading at low multiples, now certainly looks like a good opportunity for Discover to ramp up buybacks. Although management did just raise its outlook for charge-offs for 2023, that rise is coming off a historically low base. Moreover, interest rate increases should lead to expanding net interest margins, offsetting the impact.
In addition, Discover has reserved 6.58% against its current loans -- far higher than expected 2023 charge-offs between 3.5% and 3.9%. For perspective, Discover's charge-offs peaked at 7.77% in 2009 at the height of the Great Recession. Operating earnings fell but remained slightly positive before bouncing back relatively strongly in 2010.
Should Discover's results stay strong through a more mild downturn, it could garner a better valuation on the other side of 2023. With its share count to be reduced further, Discover looks like an interesting countercyclical play today.
