Following the release of Discover Financial Services’ ( DFS - Analyst Report ) second quarter 2012 earnings last week, Fitch Ratings reaffirmed the long and short-term Issuer Default Rating (IDR) of the company and its subsidiary - Discover Bank at “BBB” and “F2”, respectively, with a stable outlook on both.

The affirmation of the ratings came on the back of Discover’s well-established card franchise, high liquidity, substantial capital balance and high-quality assets. However, non-diversified revenue sources, limited flexibility in borrowing capacity and a highly regulated environment prevented a rating upgrade.

Besides, Discover has been witnessing record low charge-offs, while the losses on its credit card portfolio in the first half of the year have been substantially lower than the average loss rate of the five industry leaders during the first quarter of this year. However, Fitch expects the loss rate to rise in the later part of 2012, although credit metrics are still expected to outshine the last year levels.

Discover’s outstanding credit trends, higher processing volumes, improving consumer spending and expanding portfolio have driven its earnings in 2011 and so far in 2012. However, high operating expenses emerged as a spoiler.

Further, Discover has strong capitalization with a Tier 1 common ratio of 14% in the second quarter of 2012, which is more than both the company’s long-term target as well as the capitalization of peers. Nevertheless, Fitch expects the ratio to come down to the long-term target of 9.5% with time.

Overall, stable earnings, modest portfolio expansion, high-quality assets, substantial liquidity and strong capitalization support the stable outlook on the ratings. Going ahead, Fitch can upgrade the ratings on increased diversity in revenue sources, stronger competitive position and credit performance in the non-card loans, higher flexibility in funding sources and increased clarity in regulations.

On the other hand, lower earnings, driven by a decline in credit performance or market share, reduced liquidity, substantial deterioration in capitalization, adverse legislative or regulatory changes and reduced competitive strength can also lead to lower ratings.

Within the industry, recently, Standard & Poor’s Rating Services (S&P) raised the long-term issuer credit rating (ICR) of the operating subsidiaries of American Express Co. ( AXP - Analyst Report ) , a rival of Discover, to “A-” from “BBB+”. Additionally, the rating agency affirmed the ICR of the holding company at “BBB+/A-2” and the short-term ICR of its operating subsidiaries at “A-2”. The outlook for all ratings remains stable.

We maintain a long-term ‘Outperform’ recommendation on the shares of Discover. Currently, the company caries a Zacks #2 Rank, implying a short-term ‘Buy’ rating.