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Discover Financial Services (DFS - Analyst Report) reported fourth-quarter 2012 earnings per share of $1.07, lagging the Zacks Consensus Estimate of $1.13. However, earnings per share surpassed the year-ago quarter’s earnings of 95 cents.

Moreover, net income improved 7.4% year over year to $551 million from $513 million. Net income allocated to common shareholders also increased to $541 million from $508 million in the year-ago quarter.

The improvement in net income was due to revenue growth and improved interest income. Strong operating results in the Direct Banking segment overshadowed the decline in pre-tax income of the Payment Services segment.

Total revenue, net of interest expense, increased 11% year over year to $2.0 billion. Net interest income also improved 11% year over year to $1.39 billion.

Moreover, total other income increased 11% over the prior-year quarter to $604 million. However, total other expenses jumped 20% year over year to $800 million.

Direct Banking Segment

The Direct Banking segment reported pre-tax income of $827 million, reflecting a 7% increase from the year-ago quarter. Discover card sales volume grew 6% year over year to $26.5 billion.

Total loans improved 6% year over year to $61.0 billion, boosted by a 6% increase in both credit card and private student loans and a 24% surge in personal loans. Other income increased 11% year over year, primarily due to higher interchange revenue owing to improved sales, additional revenues from Discover Home Loans, launched in June 2012, and gain on sale of minority investment.

Expenses in the segment surged 18% year over year on increased marketing expenses and elevated headcount along with higher employee compensation and marketing expenditure related to the Home Loan Center acquisition.

The credit card net charge-off rate declined 14 basis points (bps) sequentially to 2.29%. However, the over-30-days delinquency rate increased 5 bps over the prior quarter to 1.86%, reflecting a reversal in the constantly improving credit trend since the fourth quarter of 2009.

Besides, the provisions for losses hiked 6% or $19 million year over year to $338 million, reflecting higher loan loss reserves, which was partly offset by lower charge-offs. Reserve created during the quarter was $38 million, against reserve release of $68 million in the year-ago quarter.

Payment Services Segment

The Payment Services segment’s pre-tax income fell 21% year over year to $33 million. Revenues were up $8 million, reflecting an increase in point-of-sale transactions on the PULSE network, which carry a higher margin. Meanwhile, expenses increased $17 million from the year-ago level as a result of a surge in marketing and employee expenses due to the recent partnerships and other expansion initiatives.

Payment Services dollar volume accelerated 13% from the year-ago quarter to $49.0 billion, reflecting higher volume from PULSE and Network Partners.

Financial Position

Discover had total assets worth $75.24 billion as of Nov 30, 2012, increasing from $68.78 billion as of Nov 30, 2011. Total equity stood at $9.73 billion at the end of fiscal 2012, up from $8.24 billion at the end of fiscal 2011. Book value per share was $19.55 at the end of November 2012, compared with $15.59 as of Nov 30, 2011.

Share Repurchase Update

During the reported quarter, Discover repurchased 10 million shares for $401 million under its $2 billion share repurchase program.

Dividend Update

Concurrently, Discover announced a quarterly cash dividend of 14 cents per share, payable on Jan 17, 2013, to shareholders of record as of Jan 3, 2013.

Zacks Rank

Currently, Discover caries a Zacks #2 Rank (Buy). We maintain a long-term Neutral recommendation on the stock. Visa Inc. (V - Analyst Report), which closely competes with Discover shares the same Zacks Rank, while MasterCard Incorporated (MA - Analyst Report) carries a Zacks #3 Rank (Hold).

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