Discover Financial Services (DFS - Analyst Report) reported third-quarter 2012 earnings per share of $1.21, beating both the Zacks Consensus Estimate of $1.03 and the year-ago quarter earnings of $1.18. However, net income declined 3.4% year over year to $627 million from $649 million. Net income allocated to common shareholders also declined to $621 million from $642 million in the year-ago quarter.
The decline in net income was due to lower loan loss reserve releases and higher legal expenses, which offset revenue growth and reduced charge-off rates.
Total revenue, net of interest expense, increased 9.8% year over year to $1.96 billion. Net interest income also improved 11% year over year to $1.37 billion. However, total other expenses jumped 29% year over year to $826 million.
Direct Banking Segment
The Direct Banking segment reported pre-tax income of $963 million, reflecting a 5% decrease from the year-ago quarter. Discover card sales volume grew 4% year over year to $27.2 billion.
Total loans improved 9% year over year to $59.2 billion, boosted by an increase of $1.9 billion in credit card loans, $2.9 billion in private student loans (including purchase of a $2.4 billion loan portfolio in the fourth quarter of 2011) and $675 million in personal loans.
Other income increased 5% year over year, primarily due to higher interchange revenue and additional revenues from the newly launched Discover Home Loans.
Expenses in the segment surged 29% year over year on higher legal reserves related to the recent settlement agreement with the Federal Deposit Insurance Corporation (FDIC) and Consumer Financial Protection Bureau (CFPB), along with increased marketing expenses, expenditure on the Home Loan Center acquisition and higher headcount.
The credit card net charge-off rate declined 142 basis points (bps) year over year to 2.43%. Moreover, the over-30-days delinquency rate was at an all-time low of 1.81%, having witnessed a substantial 62 bps decrease year over year, reflecting an overall better credit trend since the fourth quarter of 2009.
Besides, the provisions for losses surged 26% or $26 million year over year to $126 million, reflecting lower reserve release, which was partly offset by lower charge-offs. Reserve release was $182 million in the reported quarter, as opposed to $359 million in the year-ago quarter.
Payment Services Segment
The Payment Services segment’s pre-tax income grew 31% year over year to $49 million. Revenues were up $17 million, reflecting an increase in point-of-sale transactions on the PULSE network, which carry a higher margin.
Expenses increased $6 million from the year-ago level.
Payment Services dollar volume accelerated 13% from the year-ago quarter to $50.3 billion, reflecting higher PULSE and third-party issuer volume.
Share Repurchase Update
During the reported quarter, Discover repurchased 10 million shares for $350 million under its $2 billion share repurchase program.
Discover has been generating exceptional card sales volume over the past few quarters, owing to improved consumer spending and credit quality trends. Moreover, operating performance of the Payment Services segment was impressive, which contributed to the bottom-line growth.
Besides, the company has a strong inorganic growth policy in place, which apart from boosting earnings also fosters portfolio diversification. The Home Loan Center acquisition from Tree.com Inc. (TREE - Snapshot Report) has added a residential mortgage component to Discover's direct-to-consumer banking business, thereby enabling it to launch its subsidiary - Discover Home Loans. This has also amplified the revenues of the Direct Banking segment.
However, the expenses of Discover have been on the rise due to higher compensation and benefit expenses, infrastructure development and growth initiatives. Moreover, the company is facing substantial litigation expenses and has been strengthening its reserves for the same. Reserve strengthening related to the recent settlement agreement with FDIC and CFPB has led to almost 15% year-over-year growth in expenses.
Nevertheless, the remarkable improvement in credit quality makes us optimistic about Discover’s future earnings. Additionally, the company’s extensive network, sound capital position and cost containment initiatives are expected to accentuate growth over the long term.
Discover competes with other card companies like MasterCard Inc. (MA - Analyst Report) and Visa Inc. (V - Analyst Report). Currently, the company caries a Zacks #2 Rank, implying a Buy rating in the short term.