Discover Downgraded to Neutral

We have downgraded our recommendation on Discover Financial Services (DFS - Analyst Report) to Neutral based on a weak momentum in the earnings outlook. The company reported third-quarter 2011 earnings per share of $1.18, significantly ahead of both the Zacks Consensus Estimate of 91 cents and 47 cents recorded in the year-ago quarter.

Discover’s credit card sales volume has been witnessing modest improvement owing to improved consumer spending and credit quality trends. In the first nine months of 2011, card sales volume climbed 8% year over year to reach $75.1 billion.

Improved credit trends have helped in substantial release of credit loss reserves, a part of which has been reinvested for operational growth. Recently, the company has been focusing on increasing its card acceptance through various alliances.

The agreement with Banco Popular de Puerto Rico commercial bank is likely to expand Discover card acceptance through millions of card members and billions in spending on the Discover and Diners Club International networks. The deal with WorldPay is also expected to augment the acceptance of Discover and Diners Club cards, while the agreement with NETS Inc. will not only increase the usage of the PULSE network for PIN debit transactions, but also substantially increase the acceptances of Discover’s PULSE, Diners Club and Discover Cards in the U.S.

Additionally, Discover continues to explore healthy opportunities for inorganic growth as well. The Student Loan Corp. (SLC) acquisition comes in line with the company’s long-term goal of bolstering its private student loan portfolio, which has grown steadily over the past three years when many others had to discontinue the business altogether. Furthermore, the agreement to acquire Home Loan Center, a subsidiary of Tree.com, Inc. (TREE - Snapshot Report), has added a residential mortgage component to Discover's direct-to-consumer banking business.

Discover has also implemented several capital bolstering initiatives, including equity and debt offering, which have supported the company in achieving a strong capital base. Besides, the proficient cost containment measures have aided substantial reduction in loan loss provisions, improvement in delinquency and net charge-off rates and moderation in interest expenses, thereby prompting significant enhancement in bottom-line growth over the past several quarters. In fact, in the third quarter of 2011, Discover’s credit card delinquency rate hit the lowest in 25 years and the charge-off rate fell below 4% for the first time since 2007.

However, Discover’s competitors in the credit card business such as MasterCard Incorporated (MA - Analyst Report) and Visa Inc. (V - Analyst Report) have substantially larger scales of operation than the company, thereby posing ample risk on the operational front. Not only do the arch-rivals have relatively stronger global presence and brand names, but they also own exclusive contracts with many financial institutions, thereby limiting Discover’s business opportunities with such institutions.

Moreover, we expect continued adverse impact of the implementation of CARD Act provisions along with an anticipated increase in the volume of promotional rate offers to unfavorably impact credit card yield in 2011, although we believe that it will be partially offset by continued improvement in interest charge-offs. A decline in credit card yield, together with the addition of lower rate student loans from the acquisition of SLC would lead to a further reduction in the net interest margin.

Moreover, Discover incurs considerable expenses in order to compete with other credit card issuers to attract and retain customers and increase card usage. Discover’s profits are largely tapered due to the company’s higher-than-expected advertising and marketing expenditures.

Besides, employee compensation and benefits expenses are showing an increasing trend, on the back of theSLC acquisition and staff additions. Additionally, in June 2011, the company agreed to settle eight class-action lawsuits related to its marketing policies, which is likely to considerably add to expenses, although the settlement is yet to be approved by the court.

The Zacks Consensus Estimate for Discover’s fourth-quarter 2011 earnings is currently 90 cents per share, up about 40% year over year. For full year 2011, the Zacks Consensus Estimate stands at $4.02 per share, up by a substantial 230% from 2010.

The company currently caries a Zacks #3 Rank, which translates into a short-term Hold rating.