Discover Financial: We Have ‘Discovered’ Compelling Return Potential Here

By Jonathan Weber

Discover Financial Services (DFS) is a credit card and financial services company whose stock has the potential to produce compelling total returns throughout the coming years.

Discover Financial Services should see solid earnings per share growth going forward, and on top of that this cheap dividend stock should benefit from multiple expansion, which could further boost shareholder returns. Combined with a solid dividend yield, Discover stock could provide strong total returns over the next five years.

Company Overview

Discover Financial Services is a holding company that offers financial services to its customers through two business units: its Direct Banking unit and its Payment Services unit.

These offer credit cards under the Discover brand, the Diner's Club brand, as well as credit card services for credit cards that operate on the Discover Network but that were issued by third parties. Discover Financial is focused on providing its offerings to consumers as well as to small and medium-sized businesses.

Discover Financial Services was founded in 1986. The company is headquartered in Riverwoods, IL. It is trading with a market capitalization of $24 billion right now.

Recent results and growth outlook

Discover Financial Services has reported its most recent quarterly results on January 24. The company reported that its revenues rose by 7.7% compared to the prior year's quarter, to $2.81 billion. The company was able to generate earnings per share of $2.03, which was 31% more than the earnings that Discover Financial Services generated during the previous year's quarter, on a per share basis.

The outsized earnings per share growth rate, relative to the significantly lower revenue growth rate, was made possible by operating leverage, a lower tax rate, and the impact of share repurchases that have lowered Discover Financial Services' share count over the past four quarters.

We believe that the company will be able to grow its earnings per share at a solid rate over the coming years, although our forecast is not as high as the earnings per share growth rate of 9.8% that it has achieved between 2011 and 2018.

Going forward, Discover Financial Services' earnings per share growth rate will rest on several pillars. The first one of these is steady growth in the company's loan balances:

Source: Discover Financial Services earnings presentation

The company's ending loans have grown every year between 2014 and 2018, and the average growth rate of 7% is compelling. This loan growth, in turn, has been based on a growing number of customer accounts primarily. It seems likely that this trend will remain in place, although loans will not grow at a high single digits pace forever - it seems likely that the growth rate will slow down a bit, as interest rate increases could lead to lower spending growth.

Discover Financial Services does not have high proportional costs - rising loan balances will lead to rising net interest income, which, all else equal, should lead to operating and net income growth that is steeper than the company's revenue growth rate (on a relative basis).

Another factor that has positively impacted the company's earnings per share growth in the past are its share repurchases. Discover Financial Services has reduced its share count from 544 million shares in 2009 to just 331 million shares at the end of 2018, which equates to a reduction of almost 40% during those nine years. This, in turn, means that Discover Financial Services has bought back a little bit more than 5% of its common stock every year, which would have resulted in a mid-single digit earnings per share growth rate all by itself, even if there had not been any growth in the company's net income.

We believe that Discover Financial Services will continue to return a large amount of cash to its owners going forward, and as the dividend yield is not overly high, the majority of that will come from share repurchases. Since its current valuation is not high at all, the company can easily reduce its share count at a meaningful pace as long as share prices do not rise massively.

All in all, Discover Financial Services has several levers through which the company should be able to generate compelling earnings per share growth over the coming years. We forecast earnings per share will rise by 7-8% a year going forward.

Valuation and dividends

Discover Financial Services will earn about $8.50 during fiscal 2019, we believe. Based on a share price of $72, it is thus trading for just 8.5 times this year's earnings right now. This is a quite low valuation in absolute terms, and it is also a relatively low valuation compared to how the company's shares were valued in the past.


Data by YCharts

The company has mostly been trading for 10-12 times net profits during the last decade, which means that shares trade substantially below the long-term median valuation right now. Even if Discover Financial Services' valuation expanded to just 10 times net profits, its shares would still see considerable multiple expansion tailwinds throughout the coming years. Together with the solid earnings per share growth rate that we forecast, it could easily generate share price gains in the low double digit range annually.

Discover Financial Services offers a dividend that yields 2.2% on top of that. It is not a high-yield investment by far, but shares nevertheless provide an income yield that is higher than that of the broad market, while also offering considerable share price gain potential. The combination of ~7% annual earnings growth, P/E expansion, and dividends could result in annual returns above 10% over the next five years. As a result, Discover Financial Services looks like an attractive investment from a total return perspective.

The company has increased its dividend steadily after the financial crisis (when it cut the payout), and the relatively low dividend payout ratio of roughly 20% makes the dividend look safe for now. Another major economic crisis such as the one ten years ago that led to rising credit defaults could hurt Discover Financial Services' profitability enough to jeopardize the dividend. But outside of another major Great Recession, the dividend appears secure.

Investor Takeaway

Discover Financial Services' earnings growth outlook is not bad at all, and on top of that the company offers a dividend yield that is slightly higher than that of the broad market and a valuation that could allow for considerable multiple expansion during the next couple of years.

It thus provides a good total return outlook of 10%+ annually, although investors should note that the company was not an overly stable investment during the last financial crisis.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.