We are upgrading our recommendation on Discover Financial Services (DFS) from Neutral to Outperform based on the acquisition of Student Loan Corp. that would enhance its already strong student loan portfolio. Additionally, Discover's fourth quarter earnings were substantially ahead of the Zacks Consensus Estimate.
The growth in the loan loss reserve release as well as gains from the payments business drove the credit card sales volumes. In addition, higher consumer spending and merchant acceptance also contributed to the increase. However, the CARD Act and the proposed limit on debit interchange fees by the Fed, along with higher-than-expected expenses is expected to hurt the profits of the company in the future.
Nevertheless, the company's extensive network, sound capital position and cost containment initiatives will help accentuate growth over the long term. Our six-month target price of $26.00 equates to 12.9x our earnings estimate for 2011. Given the expected annual cash dividend of $0.08, this price target implies an expected total return of 20.0% over that period.