ALL Allstate Corporation

Discover has grown to become one of the largest card issuers in the U.S. and a leading innovator and driver of change in the credit card industry. The company continues to explore healthy opportunities for inorganic growth and also implements several capital-bolstering initiatives. These factors induce us to retain our Outperform rating on Discover Financial Services (DFS).

Discover has a dominant position in the credit card industry. Along with its existing Discover networks, the company gained significant international network opportunity following the integration of the Diner's Club. Discover has also experienced continued growth in its direct-to-consumer banking business by leveraging its low cost infrastructure, brand, credit management and marketing capabilities.

The multi-year alliance with The Allstate Corporation (ALL) is further expected to expand Discover’s presence in the U.S. We expect these positives to continue and aid the company to improve its top line.

Discover’s equity and debt offerings have supported the company to achieve a strong capital base. A healthy capital and cash position further prompts efficient deployment of excess capital, evident from the company’s strategy of acquisitions, share repurchases and the recent dividend increment.

Recently, the board of directors approved and authorized a two-year share repurchase program worth $1 billion.  During the first quarter, the company had increased also its dividend to 6 cents a share from 2 cents a share.

Further, the cost-containment measures have aided substantial reduction in loan loss provisions, improvement in delinquency and net charge-off rates and moderation in interest expenses, thereby prompting significant enhancement in bottom-line growth over the past several quarters. We expect the benefits from expense and capital management to continue supporting the operating leverage and earnings in the upcoming quarters.

The Student Loan Corp. marks the company’s strong financial and capital leverage. The acquisition also comes in line with the company’s long term goal of bolstering its private student loan portfolio, which has grown steadily over the past three years when many others had to discontinue the business altogether.

On the flip side, Discover incurs considerable expenses in order to compete with other credit card issuers to attract and retain customers and increase card usage. Discover’s profits have tapered largely due to the company’s higher-than-expected advertising and marketing expenditures. Moreover, the re-pricing restriction enforced by the CARD Act has resulted in reduced interest and fee income.

In June 2011, the Federal Reserve ruled out a limit on debit interchange fees at $0.21 per transaction, substantially down from $0.44 per transaction on an average in 2009. Once the proposal gets into effect in October this year, the card companies will be modestly pressurized and it will result in reduced profits.

Discover posted a solid second quarter, reporting earnings substantially ahead of the Zacks Consensus Estimate driven by lower loan loss provision, higher transaction and credit card sales volumes that also drove the loan loss reserve release growth. In addition, higher consumer spending and merchant acceptance also contributed to the substantial expansion of income across direct banking and payment services segments.

The Zacks Consensus Estimates for third-quarter 2011 is 79 cents per share. For full years 2011 and 2012, the Zacks Consensus Estimates are, respectively, $3.48 and $2.93 per share.

The quantitative Zacks #1 Rank (short-term Strong Buy rating) for the company indicates upward pressure on the stock over the near term.

Based in Riverwoods, Illinois, Discover Financial Services is a credit card issuing and an electronic payment services company in the United States. It competes with American Express Company (AXP), Mastercard Incorporated (MA) and Visa Inc. (V).

 
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