Discover Shares Fall After Reporting Weaker-Than-Expected Earnings

   By Andrew R. Johnson 
 

Discover Financial Services (DFS) shares fell as much as 5% early Thursday after the credit-card lender reported a smaller-than-expected profit as the costs of new partnerships weighed on results.

The Riverwoods, Ill.-based company continued to post solid loan growth, though, as it received a boost from the early holiday shopping season, and loan quality remained strong.

Discover, the sixth-largest credit-card lender based on loan balances, said Thursday it earned $551 million, or $1.07 a share, up from $513 million, or 95 cents a share, a year earlier. Revenue, net of interest expense, increased 10.6% to $1.99 billion.

Analysts polled by Thomson Reuters were expecting on average earnings of $1.13 a share on $1.97 billion of revenue.

"Our strategy and business model are working as we achieved organic growth in all of our lending products," David Nelms, chairman and CEO of Discover, said in a statement.

Discover's stock has risen more than 65% so far this year through Wednesday's close as it generated loan growth outpacing its competitors, expanded into new businesses such as mortgage lending and struck a major deal to bring eBay Inc.'s (EBAY) PayPal online service to brick-and-mortar merchants.

Its shares were down 1.9% at $39 in pre-open trading after falling as much as 5%.

The company said its credit-card portfolio grew 6.4% from a year earlier to $49.6 billion. Discover and American Express Co. (AXP) are among the only credit-card lenders experiencing loan growth, which has been fleeting for the industry since the financial crisis as many consumers have reined in their use of revolving credit, opting instead to pay their balances off each month.

To supplement its growth, Discover has ventured into new lending areas in recent years, including student loans and personal loans. Both portfolios also grew in the most recent quarter, Discover said.

This summer Discover also began offering mortgages, hoping to ride the wave of refinancing that has boosted loan originations for the industry.

Discover said its expenses increased $114 million, or 18%, from a year earlier, due to higher employee compensation and marketing costs tied with its acquisition of the mortgage platform of Tree.com Inc. (TREE) in June, increased credit-card marketing and higher headcount. It also said pretax income in its payment services division fell 21% to $33 million, as expenses roses $17 million for the unit, which it attributed partly to new partnerships.

In August, Discover announced a deal with PayPal to expand acceptance of the online-payments service in to brick-and-mortar merchants who accept Discover cards.

Discover was to begin roll-out of the service late this year and helps process the transactions that PayPal customers make at its merchants, potentially expanding its network revenue.

Discover's credit quality remained strong in the quarter, though it showed signs of moderating.

Its delinquency rate for credit-card loans was 1.86%, down from 2.39% a year earlier but up from 1.81% in the previous quarter. Its net charge-off rate was 2.29%, an all-time low that was down from 3.24% a year earlier and 2.43% in the previous quarter.

Over the last two years credit quality has improved significantly after surging during the financial crisis as borrowers fell behind on their payments, and lenders had to write off billions of dollars of bad loans. The improvements have allowed credit-card issuers to release back on to their income statements money set aside to cover future loan losses, boosting their earnings at a time when many have struggled to increase revenue from lending.

But analysts say delinquency and net charge-off rates can't get any better, and thus say the release of loan-loss reserves has run its course, putting pressure on the industry to find new sources of revenue.

"We expect credit performance to be stable, remaining at historically strong levels, but the credit improvement that drove reserve releases in 2012 has ended, and therefore, credit costs will be a headwind for 2013," Scott Valentin, an analyst for FBR Capital Markets, wrote in a research note on Wednesday.

Write to Andrew R. Johnson at [e-mail]

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