This banking action is up nearly 400% from pandemic lows and remains a buy
Actions of Discover financial services (NYSE: DFS) sold after the company’s recent earnings report, but it’s unclear why. The credit card company has always traded at a fairly cheap valuation, and is doing so today; Thought goes, unsecured credit card balances are risky, so Discover’s price-earnings multiple has always been low.
The stock plunged early in the COVID-19 pandemic, but almost quintupled its pandemic lows, so perhaps those lucky enough to buy near the bottom are cashing in on their profits.
However, given strong household balance sheets resulting from government stimulus measures and lack of spending last year, credit card companies in general and Discover in particular appear to be a solid bet for 2022, as growth continues to grow. economic starts again.
Growth is moderate for now, but is expected to gain next year
Although Discover exceeded earnings expectations, it slightly exceeded analyst earnings expectations, which could explain the post-earnings sell-off. Yet the reasons for the overall shortfall are misleading and growth is expected to accelerate sharply next year.
First, revenue was impacted by an unrealized loss of $ 167 million on certain investments. For some reason, this unrealized loss shows up in Discover’s overall revenue line, even though it is a non-operating item. Likely, this is a consequence of Discover’s investment in the recent fintech IPO. Marqueta (NASDAQ: MQ), which saw its shares sell off by about a third in the September quarter.
Still, remember these are unrealized losses and Marqeta shares have already rebounded around 25% since October 1 on the heels of the recently announced high profile partnerships. At current prices, Discover’s stake in Marqeta is worth around $ 750 million.
Without this loss, revenues would have increased 6% year over year, on all loans up 1%. Some might have expected a larger rebound in a financial stock as the economy reopened. However, Discover derives most of its income from loans, not fees or its rival payment network. American Express Is.
As consumers are typically overflowing with cash from the pandemic, credit card loan repayments have been high – about 500 basis points higher than normal, according to management – which has held back growth. Yet although management does not disclose the exact number of new clients, it said account acquisition was “very strong” in the last quarter during the conference call with analysts.
Customer cash balances won’t be this high forever, so as the payment rate normalizes next year or 2023, these new accounts are expected to start spinning card balances, so loans on credit cards are expected to increase next year – potentially double digits.
When lending increases, Discover is expected to record even better net interest margins than in the past. That’s because management has done a great job increasing its low-cost deposits, which now represent 68% of its funding, up from 62% last year and just 48% in 2018. These lower funding costs, combined at potentially higher interest rates as the economy normalizes, means profitable growth for the foreseeable future, barring unforeseen financial shocks.
Valuation of good business, solid balance sheet and abundant returns for shareholders
It’s not just Discover customers who are overflowing with cash; the company is too! In fact, at the end of the last quarter, Discover’s Tier 1 capital ratio was 15.5%, well above the company’s target of 10.5%. This means that Discover has excess capital, with which it can either invest in its business, make acquisitions, or return money to shareholders.
Discover primarily returned that capital to shareholders, repurchasing $ 815 million of shares in the third quarter, withdrawing 2.1% of its shares in a single quarter. A 14% rise in the company’s quarterly dividend to $ 0.50 in September, good for a 1.6% dividend yield over today’s share price, was also a welcome sign.
Despite all of this, Discover is still trading at just 7.3 times this year’s earnings estimates. Yes, 2021 profits will be above normal, due to the release of above normal credit reserves last year, but based on 2022 profit estimates, Discover is still trading below 10 times the profits.
Assuming the recovery from the pandemic continues next year and customers start taking loans again, Discover looks like a great way for value investors to play the ongoing economic recovery.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.