Although Inside Value recommendation Discover Financial
In Discover's core U.S. card segment, pre-tax income grew 43%, thanks to a combination of top-line growth and reduced expenses. Sales volume and receivables growth came in at a slow but steady 5% and 6%. During the quarter, Discover charged off 3.84% of its U.S. credit card loans; that figure rose 14 basis points from last quarter, but fell 15 basis points year over year.
Discover also showed strong 28% volume growth in its third-party payment segment. Here, Discover uses its credit card and ATM network to process payments, collecting a small cut of each transaction. Like competitor MasterCard
Discover's pre-tax earnings from third-party payments are still small, at $8 million for the quarter. But they should become meaningful to Discover in a couple of years, provided it can keep growing volume and leveraging its expense base.
Unfortunately, most of Discover's solid results were obscured by the $391 million pre-tax charge taken in the U.K. credit card business. Although the charge was announced several weeks ago, it still marred the quarter, resulting in ugly news headlines.
However, the charge was a non-cash impairment -- basically Discover's way of saying, "Whoops, we paid way too much to acquire the U.K. business." Looking past the charge, the U.K. business lost $32 million before taxes.
Management sounded cautiously optimistic that credit problems in the U.K. had stabilized, but noted that "what we wanted to see is some improvement over a sustained period before I'd be ready to make the call that we are now past peak [credit losses] and we're improving."
The million-dollar question
Discover, along with competitors American Express
Discover has been preparing for that possibility by increasing its average FICO origination to 734 over the past year, and by cutting exposure to shaky geographic areas like Florida and California. Because potential investors remain skittish, the company needs to prove that it can withstand a shaky credit environment in 2008 in order to reward shareholders.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.