Discover Financial Services (DFS) failed to keep the earnings streak alive with its fourth-quarter 2014 financial results. Fourth-quarter 2014 earnings per share (EPS) of $1.19 missed the Zacks Consensus Estimate of $1.30 and decreased 3% from the year-ago quarter.
The poor results were primarily attributable to higher loan reserves.
Including elimination of credit card rewards program forfeiture reserve of 24 cents, Discover Home Loans goodwill impairment of 3 cents and Diners Club Italy held-for-sale fair value adjustment of 5 cents, net income of the company came in at 87 cents per share, down from $1.23 per share reported in the year-ago quarter.
Discover Financial’s total revenue, net of interest expense, decreased 4% year over year to $2.0 billion. The deterioration came on the back of weak performance by both the Direct Banking and Payment Services segments. However, this metric surpassed the Zacks Consensus Estimate of $1.8 billion. Net interest income on the other hand improved 7% to $1.7 billion, reflecting loan growth.
While total other income for Discover Financial suffered a 34.8% drop from the prior-year quarter to $365 million, total other expenses increased 11.2% to $932 million. The decline in total other income was attributable to the categorization of merchant fees into discount and interchange revenues. Meanwhile, total other expenses rose due to higher consultant expenses associated with technology and digital investments.
Segment Update
Direct Banking Segment
Discover Financial’s Direct Banking segment reported pre-tax income of $646 million, reflecting a 29% decrease from the year-ago quarter, mainly due to the $178 million non-recurring charge associated with the elimination of the credit card rewards forfeiture reserve and $27 million impairment of goodwill related to the acquisition of the Discover Home Loans platform. Revenues, net of interest expense, for the segment decreased 4% to $1.96 billion owing to the charge associated with the elimination of the credit card rewards forfeiture reserve, partially offset by rise in net interest income.
The company’s card sales grew 4.5% year over year to $30.9 billion, mainly stemming from increased wallet share with existing customers. Total loans improved 6.5% to $69.9 billion, aided by a rise of 5.6% in credit card loans, 4.4% in private student loans and 19.5% in personal loans.
Meanwhile, expenses rose 10% to $858 million on higher headcount and employee compensation, increased professional fees, high marketing spend and impairment of goodwill related to the home loans platform.
Discover Financial’s credit card net charge-off rate increased to 2.26% from 2.09% in the year-ago quarter. Similarly, the over-30 days delinquency rate increased to 1.73% from 1.72%.
Additionally, provisions for loan losses increased $102 million year over year to $454 million, reflecting higher loan growth and a decrease in dollar recoveries. Reserve build during the quarter was $101 million, higher than $49 million in the year-ago quarter.
Payment Services Segment
Pre-tax income at Discover Financial’s Payment Services segment was $2 million, down 92% year over year, mainly due to a $21 million fair-value adjustment resulting from categorizing Diners Club Italy as held-for-sale. Revenues in the segment declined 7% from the year-ago quarter.
Payment Services transaction dollar volume rose 2% from the year-ago quarter to $51 billion. Meanwhile, the transaction dollar volume from PULSE increased 4% year over year. Network Partners volume declined 13% year over year, mainly on account of the loss of volume from a third party payments partner. This was partially offset by the AribaPay volume.
Financial Position
Discover Financial had total assets worth $83.1 billion as of Dec 31, 2014, marking a rise from $79.3 billion as of Dec 31, 2013. Total equity was $11.1 billion at the end of Dec 2014, up from $10.8 billion as of Dec 31, 2013. Book value per share was $24.79 as on Dec 31, 2014, compared with $22.89 in the year-ago period.
Discover Financial’s weak performance was also reflected in the 14% return on equity for the fourth quarter of 2014 that declined from 22% in the year-ago quarter. Tier 1 common capital ratio at the quarter-end was 14.1%, down from 14.3% in the year-ago quarter.
Share Repurchase Update
During the reported quarter, Discover Financial bought back 6 million shares worth $400 million. This has led to a 1% sequential decline in shares outstanding.
In order to drive shareholders’ value through share repurchases, Discover Financial intends to repurchase shares worth $1.6 billion, which amounts to half of its total current authorization, in the four-quarter period beginning Mar 31, 2014 through Mar 31, 2015. Towards this end, the company expects to buy back shares worth $400 million in the first quarter of 2015.
Dividend Update
On Jan 16, 2015, the board of Discover Financial declared a quarterly cash dividend of 24 cents per share. This dividend is payable on Feb 19, 2015 to shareholders of record as of Feb 5, 2015.
Outlook
Discover Financial expects a modest decline in revenues in 2015, attributable to modest net interest margin compression, decrease in revenues from protection products, increased rewards rate and waning payments volume.
Operating expenses for 2015 are expected to hover around $3.5 billion, reflecting increased marketing, regulatory and technology costs.
Our Take
Discover Financial not only failed to meet our expectation but also deteriorated year over year. Moreover, decrease in revenues and increase in expenses for 2015 raise caution for the future as well. Additionally high competition in the debit market remains challenging which also led the company to lose some third-party volume and suffer deterioration in Network Partners.
However, Discover Financial’s share repurchases during the quarter are helping the company attain its goal of buying back shares worth $1.6 billion. Discover Financial remains financially sound and its strong cash position should enable the continuation of steady share repurchases to achieve the desired $1.6 billion buyback goal.
Additionally, the company recently entered into a partnership with The Logic Group, the payment and loyalty specialist to further expand Discover and Diners Club’s card acceptance in U.K and Europe. Discover Financial has been seeking opportunities to partner with key payment service providers so as to increase its card acceptance from leading brands. The latest endeavor of the company complements this objective.
Zacks Rank
Currently, Discover Financial carries a Zacks Rank #3 (Hold). Better-ranked stocks in the finance sector include Encore Capital Group, Inc. (ECPG), World Acceptance Corp. (WRLD) and Navient Corporation (NAVI). While World Acceptance sports a Zacks Rank #1 (Strong Buy), Navient and Encore Capital have a Zacks Rank #2 (Buy).
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