Discover Financial Services (DFS +0.00%) recently surprised investors with its guidance for 2023 when it said net charge-offs would move above pre-pandemic levels and exceed what Wall Street had expected. Investors were left questioning whether this was a sign that consumers were struggling and if it spelled trouble for the broader economy.
Four-out-of-five economists believe the U.S. will enter a recession within the next 24 months, so the uptick isn't too surprising. However, with the threat of a recession and a slowing economy, should investors be concerned about Discover stock? Let's take a look and find out.
NYSE: DFS
Key Data Points
A solid year of growth, but credit deteriorated slightly
Discover reported a solid fourth quarter, with net revenue up 27% year over year while diluted earnings per share grew 4%. Its results got a boost from record loan growth; credit card loans grew 21% year over year while personal loans were up 15%.
It also benefited from higher interest rates. Its net interest margin, or the difference between interest collected on loans and interest paid out, increased from last year, helping net interest income grow by 24%. On the flip side, net charge-offs (NCOs), or the amount of debt unlikely to be paid off, rose to 2.13%, up from 1.37% the year before.
Overall, its performance was solid, but investors were surprised when the company provided its guidance for 2023. Discover projected that its full-year NCO rate would be between 3.5% and 3.9%, exceeding analysts' expectations of 3%. The stock dropped following the announcement but quickly rebounded in the following days.
Why Discover sees delinquencies rising above pre-pandemic levels
When considering Discover's projected NCO, investors must understand that delinquency rates across the lending industry were coming off unusually low levels. Delinquency rates remained low as consumers were flush with cash following pandemic-era stimulus programs and ultra-low interest rates.
However, portfolio loss rates began normalizing in 2022 and are slowly returning to pre-pandemic levels -- although they aren't quite there yet. According to Discover, trends are within its expected risk tolerance, and its portfolio is normalizing as "we're coming off an abnormally low base," according to CFO John Greene.
CEO Roger Hochschild told investors that the increase in early-stage delinquencies is primarily inflation driven. The continuing uptick in delinquencies comes as the lender sees a potential recession in 2023, resulting in a rise in U.S. unemployment. The company projects unemployment rates to be somewhere between 4.5% and 6.5%, which is roughly in line with what other banks are expecting.
In 2019, Discover's NCOs on its credit card portfolio were between 3.32% and 3.5%. Many other lenders forecast an increase in NCOs, but their projections remain below pre-pandemic levels, which is likely another reason Discover's guidance initially spooked investors.
Should investors be concerned?
Historically, inflation affects low-income earners the most. Discover has slightly more loans to this population segment than a bank like JPMorgan Chase, which is why its projected NCO is higher.
Investors shouldn't be too concerned, though. The credit card company began tightening its lending standards in the second half of last year as its near-prime customers (those with scores just under 660) began feeling the effects of inflation. Discover doesn't see evidence of broader stress on consumers among its core prime revolver customer segment.
Its capital position is strong, and it has more than enough funds set aside to cover its projected losses. That, and growth this year is expected to remain solid. The company forecasts loan growth to stay in double digits in 2023, with its net interest margin expanding as interest rates move modestly higher during the year.
Discover also plans to resume a massive buyback plan that could see it purchasing $2.2 billion in stock in the first half of this year. These buybacks should support the share price further and come at a time when Discover has a dirt cheap valuation of 7.5 times earnings, making it a solid value stock you can buy today.
