Discover Beats Zacks Estimate - Analyst Blog

Discover Financial Services (DFS) reported a fiscal third quarter earnings of $261 million or 47 cents per share, well ahead of the Zacks Consensus Estimate of 35 cents. However, results dipped about 55% from the net income of $577 million or $1.07 per share in the year-ago quarter. This included an after-tax gain of approximately $287 million related to the settlement of an antitrust litigation with Visa Inc. (V) and MasterCard Inc. (MA).

The surge in profits was due to a significant rise in the use of credit cards with reduced defaults, improved credit quality, as well as gains from the payments business driven by strong volumes. However, these were partially offset by higher-than-expected expenses, primarily on higher interest expenses and tax rate.

Discover's deposit balances originating from direct-to-consumer and affinity relationships increased $1.5 billion from the year-ago quarter and $1.6 billion from the prior quarter to $19.1 billion.

Direct Banking Segment

The Direct Banking segment reported a pre-tax gain of $395 million, reflecting a $177 million improvement from the year-ago quarter on an adjusted basis.

Total loans declined 2% year over year to $50.1 billion. Though student loans increased, this was offset by a decrease in credit card loans, which declined by $2.9 billion to $45.2 billion.

The decrease in credit card loans reflects reduced promotional rate offers for balance transfer against an increase in payment rate. However, it was partially offset by a 5% year over year increase in Discover Card sales volume, which improved due to higher consumer spending and merchant acceptance.

Other income also declined by 4% to $19 million on an adjusted basis from the year-ago quarter, primarily due to lower late fees and the discontinuance of overlimit fees beginning in February 2010. However, this was partially offset by a gain from liquidation of collateral supporting Discover's previously disclosed Golden Key investment, along with higher discount and interchange revenue from higher sales volume.

The net charge-off rate improved 122 basis points (bps) year over year and 79 bps from the prior quarter to 7.18%, almost in line with the management's expectation of 8%-8.0%. Also, the over-30-days delinquency rate was 4.16%, improving 95 bps year over year and 36 bps sequentially, reflecting an overall better credit trend since the fourth quarter of 2009.

The trend also contributed to a reserve release of $187 million, against the reserve addition of $7 million on an adjusted basis in the third quarter of 2009. Provisions for losses declined 34% year over year to $713 million on an adjusted basis.

However, expenses escalated 9% year over year to $45 million, resulting from increased account acquisition, advertising and promotional marketing spending, which were partially offset by cost containment initiatives.

Net interest margin decreased 79 bps to 9.16% from the prior-year quarter, as adjusted, and relatively flat as compared with the prior quarter. While the decline was due to the increase in lower rate student loan balances, the impact of legislative changes on credit card yield and higher funding costs, these were partially offset by a reduction in promotional rate credit card balances and lower interest charge-offs.

Payment Services Segment

The Payment Services segment's pre-tax income grew $10 million or 36% year over year to $37 million, almost flat sequentially. Revenues were up $7 million, reflecting an increase in transactions and higher margin volume on the PULSE/ATM network along with increased volumes from new and existing clients. Expenses were also down $3 million from the year-ago quarter.

Payment Services dollar volume increased 8% from the year-ago quarter to $39 billion, reflecting higher Third-Party Issuer and PULSE dollar volume. The number of transactions on the PULSE network increased 17% year over year due to increased transactions from new and existing clients.

Financial Update

As on August 31, 2010, Discover's total assets stood at $60.1 billion, while total equity was recorded at $7.1 billion. However, book value per share declined to $11.22 per share against $15.45 per share in the year-ago period.

Business Update

On September 17, 2010, Discover announced that it has reached an agreement to acquire The Student Loan Corporation (SLC) for $600 million or $30 per share. The transaction is expected to be closed by December 2010, subject to regulatory approvals.

Prior to closing of the deal, SLC will sell $28 billion of assets to Sallie Mae (SLM) and $9 billion of assets to Citibank (C). Discover will acquire $4.2 billion of private student loans and related assets at an 8.5% discount, along with $3.4 billion of SLC's existing asset-backed securitization debt funding. The amount to be paid by Discover for the private student loan assets is subject to a post-closing purchase price adjustment between Discover and Citibank, which owns 80% of SLC's outstanding common stock.

During the fourth quarter of 2010, the company expects to sell approximately $1.4 billion of certain eligible Federal Family Education Loan Program loans to the U.S. Department of Education (DOE) as part of the DOE's loan purchase program.

Dividend Update

On September 15, the board of Discover announced a regular quarterly dividend of 2 cents per share on its common stock, payable on October 21, 2010 to stockholders of record as on October 7, 2010.