The economy has been running strong, thanks in part to the strength of consumer spending. But in recent months, that consumer strength has begun to show cracks.
Discover Financial Services (DFS 1.62%) recently reported higher-than-anticipated loan losses in the third quarter, dragging down the consumer finance company's bottom line. Delinquencies on credit cards picked up as incremental stress from inflation and lower savings weighs on consumers. If you're considering buying the dip on Discover today, here's what you need to know first.
What affected Discover in the third quarter
Discover's top line rose 17% in the third quarter, with $4 billion in revenue, just above analysts' estimates. Its total loans also increased nicely, up 17% from last year. However, the company's bottom line was a point of concern. Diluted earnings per share (EPS) in the quarter were $2.59, well below analysts' expectations of $3.17.
The company's bottom line suffered, however, because of increased net charge-offs and higher provisions to account for potential credit losses. Its net charge-off rate on credit card loans of 4.03% in the third quarter represented the fourth consecutive quarterly increase.
Its provision for credit losses of $773 million was up from $549 million in the second quarter and $185 million in the same quarter last year.
Data source: Discover Financial Services. Chart by author.
Loan growth was strong in the quarter, but Chief Financial Officer John Greene said that "changing macroeconomic and household liquidity conditions" drove the reserve increase. The company expects a modestly deteriorating outlook amid declining consumer savings and increased debt burdens.
Here's when Discover expects net charge-offs to peak
Delinquencies and charge-offs have gradually risen from their generational lows ever since the Federal Reserve began raising interest rates in early 2022. As measured by the personal savings rate, consumer savings have dropped below pre-pandemic levels. And consumers face headwinds from the resumption of student loan payments and the lingering effects of inflation.
One area where Discover is seeing higher stress is in consumers with FICO scores on the lower end of the credit spectrum. These consumers are experiencing increased pressure compared to others and will be important to watch in the coming quarters. According to Greene, the company expects net charge-offs to peak in mid- to late 2024.
Discover's earnings disappointed compared to its peers, and its net charge-offs continue to run above its peers. According to the St. Louis Federal Reserve Bank, the charge-off rate on credit card loans at all commercial banks in the second quarter was 3.15%. American Express, which has a more-premium customer base, saw credit card write-offs of about 2% -- half that of Discover.
Discover stock is priced cheaply amid this uncertainty
Investors appear to be pricing this uncertainty into consumer finance stocks. Discover is trading at 1.6 times its tangible book value and 1.4 times sales, valuations not seen since the pandemic-induced sell-off in March 2020. Before that, you have to go back to the years after the Great Recession to see the stock priced so cheaply.
Data source: YCharts.
Is Discover a buy?
The next several quarters could be a challenge for consumer finance companies. Despite the third-quarter uptick, Discover expects 2023 annual net charge-offs to be between 3.4% and 3.6%. The company sees some incremental stress on consumers into 2024, with delinquencies peaking in the middle to the end of the year.
Given the backdrop, there is much uncertainty about consumer finance stocks. Discover is priced at an attractive valuation, but how consumers fare in the next several quarters is a big question mark.
The company is also dealing with the recent abrupt exit of its chief executive officer. For that reason, I'd avoid the stock for now and go with a company like American Express, whose premium customer base could better weather a potential downtrend.
