Shares of Discover Financial Services tumbled as much as 8% on Thursday after the credit card lender reported a 33% decline in fourth-quarter profit. But things are no way near as bad as they may seem.
Yes, maybe there’s some (temporary) egg on my face after I called Discover DFS, -6.34% your best bank-stock bet for 2015 late last month. And my colleague Jeff Reeves included Discover on his list of three financial stocks that will soon be trading at higher prices, published on Wednesday.
What went wrong for Discover during the fourth quarter? First, the numbers: Net income was $ 404 million, or 87 cents a share, down from $ 602 million, or $ 1.24 a year earlier. But excluding $ 226 million in non-recurring charges for the simplification of its credit card rewards program, to eliminate redemption thresholds for customers, as well as impairment of its home-loan business and Diners Club Italy, adjusted earnings were $ 553 million, or $ 1.19 a share. That’s still below the consensus EPS estimate of $ 1.30, among analysts polled by FactSet.
The other major item affecting Discover’s performance was an increase in provisions for loan-loss reserves to $ 457 million from $ 354 million a year earlier. That provision is the amount added to loan-loss reserves each quarter, and over the past several years, as banks’ loan quality has improved, reserves were released, which boosted net income.
But that couldn’t last forever. During the fourth quarter, Discover’s annualized ratio of net charge-offs to average loans — excluding “purchased credit impaired” loans, or PCI, which are written down when purchased — was 2.06%, rising from 1.90% in the fourth quarter of 2014.
For a bank that is primarily in the business of making credit card loans (80% of total loans as of Dec. 31), that is a healthy charge-off rate. Loan-loss reserves covered 2.59% of total loans (excluding PCI) as of Dec. 31. Discover said the increase to reserves and a $ 51 million increase in quarterly net charge-offs from a year earlier was “due to several years of consistent loan growth and declining recovery dollars on aged charge-offs.”
The main reason I have been so optimistic about Discover’s stock is the company’s long-term track record of returns on equity well above 20%, its rapid pace for growing the most lucrative loan type and the stock’s low valuation to peers.
Excluding the one-time items, the company’s fourth-quarter return on equity would have been just under 20%. Discover swelled its credit card loan portfolio by an impressive 6% during 2014, while total loans increased by 7%.
The company bought back $ 400 million in common shares during the fourth quarter and lowered its share count by 5% during 2014. A lower share count pushes up EPS, which tends to help stocks quite a bit over time.
The stock closed at $ 60.84 Wednesday and traded for 10.7 times the consensus 2016 EPS estimate of $ 5.70. That compares to an average forward P/E ratio 11.5 among the 24 components of the KBW Bank Index BKX, +2.17% none of which have performed nearly as well as Discover on a return on equity basis over the past three years.
Among the 30 largest U.S. banks, only American Express Co. AXP, -3.23% which trades for a much higher 13.3 times its 2016 EPS estimate, tends to outperform Discover’s return on equity, and its loans are growing at a slower pace.
The total return for Discover’s stock over the past five years has been 352%, with dividends reinvested. Among the 30 biggest U.S. banks, the second-best performer has been Huntington Bancshares Inc. HBAN, +2.87% with a return of 137%.
So Discover certainly had a bad fourth quarter, but it continued to enlarge its loan portfolio, while achieving a return on equity of 14%, which would have been close to the magic 20% without the one-time items.
“One quarter does not make a soft trend,” Oppenheimer & Co. analyst Ben Chittenden said on Thursday, although he lowered his 2015 EPS estimate for Discover to $ 1.30 from $ 1.43 and his 2016 estimate to $ 5.38 from $ 5.58. He stuck with his “outperform” rating on the stock but lowered his 12- to 18-month price target by a dollar to $ 72, which implies 18% upside from Wednesday’s close.
Chittenden said the bank’s core return on tangible common equity was “24.2% in 2014 vs. 24.5% in 2013 and 24.1% in 2012.” Those numbers explain the stocks’s long-term outperformance.
Janney Capital Markets analyst Sameer Gokhale maintained his “buy” rating on Discover, while sticking with his EPS estimates of $ 5.27 for 2015 and $ 5.83 for 2016. He said on Thursday he believed the bank’s explanation that the rising provision for loan losses was “a function of portfolio seasoning rather than fundamental credit-quality deterioration.”
Gokhale is confident the “noise” from the higher provision will “abate over time” and that earnings “should resume a more normalized growth trajectory.” His 12-month fair-value estimate for the shares is $ 70, implying 15% upside from Wednesday’s close.