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We have retained our Neutral recommendation on Discover Financial Services (DFS - Analyst Report) following mixed third quarter results. This direct banking and payments services company carries a Zacks Rank #3 (Hold).

Why the Reiteration?

Although Discover Financial’s operating earnings of $1.20 per share for the third quarter of 2013 were in line with the Zacks Consensus Estimate, results declined from the year-ago earnings of $1.24 per share. Revenues, however, fared well on both counts.

Discover Financial has been launching new and innovative products to cater to the growing demand in the payments industry. The introduction of the Discover it card, Discover Cashback CheckingSM and three new loan products for law students so far in 2013 are worth mentioning. Further, the lowering of its fixed interest rate for student loans is drawing in a greater number of students. In fact, higher volumes from private and student loans are making up for the non-existence of the CitiAssist brand, which was responsible for the majority of volume for Discover Financial in 2012.

These efforts along with expansion in the international card market should be accretive to the top line going forward. The acquisition of Diners Club Italy and its wholly-owned subsidiary Dinit and the alliance with Vietnam-based Smartlink Card Service JSC so far in 2013 are worth mentioning in this regard. Strong inorganic growth potential and efficient capital management of Discover Financial also pave the way for this stock to retain investor confidence.

On the tepid side, higher expenses and a weak Payments Services segment are concerns that keep us cautious about Discover Financial. Also, the adverse impact of currency fluctuations is weighing on Diners volume. Moreover, the dynamic debit environment and fragile economic environment in Europe are expected to slow down the rate of new deals signed in the industry, thereby softening the volumes outlook for the Payments Services segment.

Although Discover Financial has a large cash balance, payments associated with the company’s agreement with the Federal Deposit Insurance Corporation (FDIC) and Consumer Financial Protection Bureau (CFPB), added to its already high expenses. Also the net interest margin has been a drag and with the decline in credit card yield and addition of lower rate student loans, margin is likely to fall further.

Other Stocks to Consider

Some better-ranked stocks within the financial services sector include Qiwi plc (QIWI - Snapshot Report), Global Payments Inc. (GPN - Snapshot Report) and Xoom Corporation (XOOM - Snapshot Report). While Qiwi carries a Zacks Rank #1 (Strong Buy), Global Payments and Xoom carry a Zacks Rank #2 (Buy).
 

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