Description

Discover has been written up on this website before – most recently by lvampa1070 in January of 2018. As a result, we will only provide a very brief overview of the business and then explain why the stock is currently an attractive investment despite COVID headwinds. We believe the stock should increase 38% to a price target of $88 by the end of 2021 based on 10x 2022 consensus earnings of $8.8, an attractive return over a little more than 1 year, or a 38% return including the $1.76/year dividend (~3%). There is also potential upside if the stock trades at above its historical multiple given the overall increase in market multiples.

In our opinion, this opportunity exists because of the market rotation to growth from value for reasons that do not apply to this investment (i.e. secular decline for B&M retail, continually declining oil prices hurting energy names, previously late cycle concerns), and credit concerns that we will address directly.

Business Overview and key statistics

Discover has two segments – Direct Banking and Payment Services. The former generates the substantial majority of pretax profits (95%) in 2019.

In 2019, Net Interest Income was $9.5 billion, Non-Interest income was $2.0 billion, and non-interest Expense was $4.4 billion for pre-provision profits of $7.1 billion, and provisions of $3.2 billion. The 2019 net income was $2.9 billion, and return on average equity was 26%. Of the $12 billion of interest income (before interest expense), $9.7 billion came from credit card, $1.0 billion from personal loans, and the remainder from student loans and liquid securities/cash. DFS currently has $89.0 billion of loans receivable, of which $70.2 billion are for credit cards, $9.7 are private student loans, $7.3 billion are personal loans, and $1.7 billion are other loans. There is currently an $8.2 billion allowance for loan losses. 81% of credit card loans have a FICO of 660 or above (defined as the prime cutoff for CFPB), 94% of student loans, and 95% of personal loans.

Its current Common Equity Tier 1 ratio is 11.7% vs. a minimum of 4.5%, and an additional stress capital buffer of 3.5%.

Thesis

The key to underwriting Discover is understanding the current credit environment and potential for losses in its loan book. Our opinion is the credit outlook is fairly reasonable vs. the current stock price, in contrast to the 2008 recession. Although we don’t precisely estimate credit losses over the next 2 years (a futile goal in our view), the important point is these losses will be non-recurring and will not impair the balance sheet, and in 2022/2023 the business will be back to normal loss rates. 

The latest industry commentary has been positive that credit is holding up well even after the end of some government stimulus.

1.      JPM’s CFO in September in response to a question on credit said “we're not seeing anything that you would typically expect to see at this point in a recession … On the consumer side … we haven't started to, really, in any meaningful way, fill up the delinquency buckets.”  

2.      Douglas E. Buckminster AXP Group President of Global Consumer Services said in September: “most issuers have seen a more modest impact than would have been implied by the end of Q1 qualitative reserves that they fill, right? I think looking at macro indicators around unemployment claims, changes in sequential GDP. If you were sitting back being an arm share credit manager, you would have expected much larger and negative impacts on delinquency and write-offs. And the fact of the matter is, as you say, we have not seen them as most issuers haven't play out by and large.”

3.      Discover CEO in September: “I think one of the biggest surprises of this downturn is how well credit has held up … it is stunning. I never would have predicted it 6 months in … I think what it reflects is that the prime credit consumer has actually held up very well. White color job losses have not been that high. And so I think that's really more the driving factor for credit as opposed to the government stimulus. Certainly, that helps. But we did not see a clear pattern when the stimulus started. And we actually haven't seen a noticeable change with the stimulus stopping.”

This sentiment is shared by other industry executives. The stimulus was very helpful but Americans also entered this recession with a much healthier balance sheet than the GFC as the following graphs show:

Discover’s high pre-tax pre provision profits help it incur reasonably sized provisions before depleting capital. As of the second quarter, its quarterly pre-provision profits are approximately $1.6 billion resulting in an ability to take ~2% of loans as a provision on a quarterly basis without depleting capital. A big risk for a financial is if losses occur very quickly but DFS’s ability to increase the loss allowance over time (and that it already has a healthy allowance) will mitigate further capital risk.

The company’s disclosed provisioning assumptions are reasonably conservative. The Company used a macroeconomic forecast that assumes a peak unemployment rate of 16%, recovering to just under 11% at the end of 2020 with slow recovery over the next few years, and an annualized real Gross Domestic Product decline of approximately 30% quarter-over-quarter or down approximately 10% on a year-over-year basis. In reality unemployment is already 7.9% in September, and the GDP decline assumption was roughly correct (actual was 32.9%). It is important to note that under the new CECL accounting rules, losses have to be estimated over the life of the loan while the previous Incurred rules delayed loss recognition until a loss is probable. As a result, a reasonable amount of losses have already been recognized under CECL.

The fed draconian stress tests results show that DFS would have little capital depletion if the macroeconomy further deteriorated. The fed in its latest stress test (https://www.federalreserve.gov/publications/files/2020-dfast-results-20200625.pdf) estimated that DFS would have about $18.6 billion in provisions in an unrealistic severely adverse macro scenario over 9 quarters, or an incremental $14.7 billion over the $3.9 billion already taken. Assuming in this draconian scenario that these provisions would take 9 quarters (marginally more optimistic than the fed at 7 quarters), they would wipe out the pre-provision profits (~$1.6 billion per quarter) over that time but not reduce capital. For context, DFS charge-offs in 2009 and 2010 were ~7.5% which would be ~$6.7 billion per year.

The company’s current credit quality is reasonably good and compares very favorably vs. pre-covid:

These numbers exclude credit card receivables enrolled in the Skip-a-Pay program for cardmembers impacted by COVID-19. However, as of August 31, 2020, only $197 million of credit card receivables were actively enrolled in the payment deferral program.

Other Points

Regulatory: The company expects a relatively benign regulatory environment even if Biden wins the election – according to the CEO “We didn't see a dramatic change with this administration in terms of our relationships with the CFPB, the FDIC, et cetera. And my view is as long as it's a level playing field, we will benefit and we need to operate the company, no matter what the regulatory environment. And just as an example, I think our practices tend to be more consumer-friendly, given how the brand is positioned. So we're the only major bank with no fees on any of our deposit products. So to the extent, the CFPB wants to be more active looking at how overdraft fees are calculated, et cetera, it will impact our competitors. It won't impact us.”

Liquidity: DFS has a reasonable liquidity with $27 billion in liquid assets. Of an average funding balance of $99.6 billion in 2Q20, $58.8 billion was direct to consumer deposits (good funding source), $16.4 billion were brokered and other deposits, $13.0 were securitized borrowings, and $11.4 billion were other borrowings. Of the $23 billion in securitized and other borrowings, $1.9 billion mature in 2020 and $4.3 billion in 2021.  

Consensus Estimates: Estimates are reasonable – to get $8.8 in 2022 EPS, we use the following assumptions:

1.      a $98 billion average loan book (2.5% CAGR from 2019),

2.      a 10% reported NIM (slight upside vs. 2Q20 of 9.81% driven by liabilities repricing lower),

3.      Non-interest income of $2.1 billion (up 4% from 2019)

4.      Non-interest expense of $4.8 billion (up 9% from 2019)

a.      The above results in pre-provision profits of $7.1 billion, less $3.7 billion in provision expense (3.75% of loans), or $3.4 billion in pre-tax profits

b.      Using a 23% tax rate, $45 million of preferred dividends, and 292 million of shares outstanding (slight decline vs. 306 million currently)

5.      The EPS of the above is $8.8.

Valuation: All else equal, lower interest rates should result in higher stock valuations. The market seems to price this in certain sectors like tech, but not in others like financials. We believe that it’s quite possible that the financial industry will rerate to higher than historical multiples post-crisis once it has a track record of doing well through a recession (unlike in 2009). We don’t see a reason why a high quality financial like DFS shouldn’t trade at 12x or 13x or 15x P/E vs. the 10x we use for our price target. An investor in DFS is getting this optionality for free. 

Management: The company is run by a credible management team. Roger C. Hochschild has been the Chief Executive Officer and President since October 2018. From 2004 to 2018, he served as President and Chief Operating Officer. Since 2006 (not an inflated year), DFS has grown its EPS from $2.37/share to $9.06 in 2019, or an 11% CAGR and also remained profitable during the financial crisis.

Catalysts

Intrinsic cheapness, low credit provisions and an optimistic credit outlook from the financial industry as provisions decline from Q2, down the line ability to return capital to shareholders as the economy improves.

Risks

Credit: Credit is always a risk for credit card lenders but we discussed above why the credit outlook is robust.

Competition: The credit card space is intensely competitive. However, a weaker macro economy and losses will likely prevent intensifying competition for the next few years.

Regulatory: as a regulated financial, regulatory risk is ever present. However DFS’ business is relatively clean, and regulatory pressures on capital distributions should ease once the current crisis abates.

Catalyst

Intrinsic cheapness, low credit provisions and an optimistic credit outlook from the financial industry as provisions decline from Q2, down the line ability to return capital to shareholders as the economy improves.