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We have upgraded our recommendation on Discover Financial Services (DFS - Free Report) to ‘Outperform’ from ‘Neutral’ based on its exceptional card sales volume, strong balance sheet and rapidly expanding acceptances. Besides, steady inorganic growth is also a long-term positive.

Discover reported fourth-quarter earnings per share of 95 cents, 4 cents ahead of the Zacks Consensus Estimate but way ahead of 64 cents recorded in the year-ago quarter. Net income spiked 46.4% year over year to $508 million from $347 million a year ago.

Discover’s credit card sales volume reached an all-time high of $100 million in 2011 owing to improved consumer spending and credit quality trends. High card sales coupled with increasing fund transfers have also contributed to growth in credit card receivables. Additionally, improved credit trends have led to substantial releases of credit loss reserves, part of which has been reinvested for growth operations.

Moreover, a strong cash position and future outlook influenced management to increase Discover’s dividend twice in 2011. Besides, the proficient cost containment measures aided substantial reduction in loan loss provisions, improvement in delinquency and net charge-off rates and moderation in interest expenses. This is amply reflected in bottom-line growth over the past several quarters.

Discover continues to explore healthy opportunities for inorganic growth as well. The acquisition of Student Loan Corporation (“SLC”) from Citibank and HomeLoan Center (“HLC”) from Inc. (TREE - Free Report) expanded the company’s private student loan portfolio and added a residential mortgage component to its direct-to-consumer banking business.

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

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

Nevertheless, we believe that the company’s extensive network, sound capital position and cost containment initiatives will help accentuate growth over the long term. The Zacks Consensus Estimate for the company’s first-quarter 2012 earnings is currently 88 cents per share, up about 4.2% year over year. For full year 2012, the Zacks Consensus Estimate stands at $3.39 per share, down 16.6% from 2011.

Currently, Discover carries a Zacks #1 Rank, which translates into a short-term ‘Strong Buy’ rating.

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