Check out financial stocks: If you like total returns, you’ll love this stock (DFS)
It has been 3 months since I last visited Discovery Financial Services (DFS), and the stock has remained relatively stable, offering a total return of -1.3% since the end of October.
Everything is relative of course since this performance is even better than the return of -5.1% of the S&P 500 (SPY) over the same period. In this article, I revisit DFS and highlight what makes it a strong, ongoing buy for potentially strong total returns, so let’s get started.
DFS: If you like total returns, you’ll love this stock
Discover Financial Services is a digital banking and payments company that was founded in 1986. It pioneered the credit card cash rewards that are ubiquitous with credit cards today. Its offerings include its widely used namesake card and PULSE, which is America’s leading ATM/debit network. In addition, DFS also provides lines of credit and banking services to individuals and businesses, and is the headquarters of Diners Club International.
DFS has just released strong fourth quarter results, with net earnings per share up 40.5% year-over-year to $3.64. This was driven by the strength of the Digital Banking segment, with pre-tax profit growing $467 million to $1.5 billion. In addition, DFS experienced total loan growth of 4% year-on-year to $93.7 billion at the end of the fourth quarter, driven primarily by credit card loans, partially offset by a single-digit decline in personal loans, as shown below.
I am also encouraged by the decline in the total portfolio charge rate of 1.37%, a reduction of 101 basis points from the prior year period. Reflecting the improved economic situation for consumers, Discover’s provision for credit losses was halved by $268 million from the fourth quarter of 2020 and currently stands at $263 million. Additionally, the net interest margin has improved and has held steady since its plunge in early 2020.
Discover maintains strong margins against the financial industry due to the inherent efficiencies of the digital banking space and the fact that it generates most of its interest income from credit cards. As shown below, its net profit margin of 38% is well above the industry median of 30%, earning it an A rating for profitability.
Going forward, DFS should benefit from higher interest rates and its sound management of consumer credit. Management expects strong portfolio performance heading into 2022 and anticipates a slow credit normalization this year.
DFS also benefits from lower fixed costs due to the lack of a physical presence like traditional banks. This allowed it to set interest rates on deposits 45 basis points higher than those of traditional banks. Morningstar sees tailwinds in funding coming from Discover’s use of online savings accounts, as noted below in its latest analyst report:
Discover’s credit card business has performed very well in recent years, with receivables growth and credit scores better than most of its peers. With the majority of its credit cards and student loans at variable interest rates, the bank will also benefit from higher interest rates, although this will be limited by the company’s reliance on online deposits. In the long term, Discover must continue to meet the challenges of being smaller than many of its competitors in size and scope.
Many traditional banks with which the company competes can offer their cardholders a wider selection of products and services. Discover’s more traditional competitors often enjoy a lower cost of funding thanks to their strong deposit bases. While Discover is unlikely to fully duplicate the product offerings of some of its peers, it has made good progress in improving its cost of funding through the use of online savings accounts. We’re encouraged by its early forays into checking accounts, as it should help Discover further reduce the cost of the funding gap.
– the morning star
Meanwhile, DFS remains a compelling total return story as management has been aggressive with share buybacks. This is reflected in the 44% reduction in the number of shares outstanding over the past decade. DFS currently has $780 million remaining on its current stock repurchase authorization expiring in March, and management expects to announce a new stock repurchase authorization in Q2’22.
It’s a factor that has helped DFS easily beat the S&P 500 in terms of total returns over the past decade with a total return of 413% compared to the S&P 500’s 303%.
DFS also maintains a well supported Tier 1 capital ratio of 14.8% and an investment grade rating of BBB-. Although the dividend yield of 1.8% is not high, it comes with a very low payout ratio of 10.6% and a 5-year dividend CAGR of 10.1%. The low payout ratio also leaves plenty of room for future increases and ongoing redemptions, as mentioned above.
Risks to DFS include its sensitivity to consumer credit and macroeconomic conditions. Additionally, the credit card space is competitive, with larger banks having more financial muscle. As such, heightened competitive pressures could force DFS to increase cash rebates, which could put downward pressure on interest income.
Given all of the above, I see value in DFS, especially after its recent price decline from the ~$130 level to $113 currently, with a forward PE of just 8.1, well below its normal PE of 11.7 over the past decade, as shown below.
Analysts on the sell side have a consensus buy rating, with an average price target of $143.79. This implies a potential total return of 29% over one year, including dividends. Additionally, Seeking Alpha’s Quant has a Strong Buy rating, with A+/A for growth and profitability, and B- for valuation and analyst upgrades, as shown below.
Key takeaway for investors
Discover Financial Services is performing well with strong business performance in its latest quarter. It continues to see loan growth and its net interest margin continues to improve on a year-over-year basis.
Going forward, Discover’s online savings accounts are expected to continue to fund its credit card services, and management maintains a robust capital return program to shareholders. I see value in DFS after the recent decline for potentially strong returns.