DISCLAIMER: I do not own stock or bonds of Discover Financial Services. This article is not a recommendation. I am not a financial advisor. This article is merely an observation regarding the first quarter results of DFS.
On April 8th, I wrote an article – which you can find here - on four of the largest credit card issuers in the world: VISA (V), Mastercard (MA), American Express (AXP) and Discover Financial Services (”DFS”). Last night, DFS was the first of these four credit card issuers to release their financial results. I have been over them quickly and wanted to offer some insights. Just to refresh your memory, both DFS and AXP are credit card issuers and lenders (and therefore own regulated banks), whilst V and MA are credit card issuers only, meaning they process transactions but take no consumer loan / credit risk.
Before I discuss DFS’s results, the other three credit card companies release their earnings as follows (consensus earnings are from Yahoo Finance):
American Express (AXP): April 24th before market opens, consensus $1.48/sh (1Q20)
VISA (V): April 30th after market closes, consensus $1.35/sh (2Q20)
Mastercard (MA): April 29th before market opens, consensus $1.74/sh (1Q20)
Summary View
I believe that DFS represents a good value play for those investors that are not faint-of-heart. The losses could get significant at DFS in coming quarters due to the COVID-19 inspired recession, but it has shown in the past that it can survive a severe economic downturn. It is one of the few value plays I can find at the moment. As the graph below shows, DFS has significantly underperformed the S&P 500 this year as concerns about the COVID-19 recession came into focus starting in early February.
DFS: 1Q2020 Results
DFS reported their 1Q2020 financial results last night. You can find the company’s press release here. The company lost $0.25/share, versus analysts’ consensus (profit) of $0.72/share. For context, DFS made $2.15/share in the same quarter in 2019. Net interest income was modestly better, but the company swung to a loss because of the significant increase in provisions of circa $1 billion, from $0.8 billion in 1Q2019 to $1.8 billion in 1Q2020. The company announced the day before releasing its 1Q2020 results that it would maintain its dividend of $0.44/share payable June 4th. The company has increased its dividend every year since 2010.
Some High Level Observations
DFS provides high level segment results in its financial release, providing figures for net interest income, provisions, and transaction processing revenues. The first two figures – net interest income and provisions – allow DFS’s lending results to be compared to other banks that have reported, e.g. JP Morgan, Bank of America and Wells Fargo, all of which reported last week. The last figure – transaction processing revenues – might provide some insights into the pending results specifically of the “pure” payment processors, Visa and Mastercard. Let’s look first at the provisions.
The Lending Business
Banks do have flexibility to size their provisions based on a reasonable and fair expectations of current and future portfolio losses. If you want to drill into this, you can find out more about how provisions now work for U.S. banks under the Current Expected Credit Loss (CECL) Accounting Standard in this video on the American Bankers Association website.
There is little doubt that banks around the world will experience higher losses due to the COVID-19 crisis. Therefore, provisions for all banks – including DFS – will increase to reflect this expectation. JP Morgan, Bank of America and Wells Fargo are all substantially larger and operate more diverse businesses that DFS, which is principally (although not exclusively) focused on credit cards. Nonetheless, these three large money centre banks do break out their consumer businesses from their commercial, trading, wealth management, asset management and other businesses unrelated to consumer lending, of which credit cards are a part. My conclusion looking at their provisions is that DFS took a conservative approach in sizing their provisions. These provisions are relatively high, probably reflecting the fact that DFS’s client base is middle market focused, so less affluent and therefore subject to higher potential losses. DFS provisioned $1.8 bln on net interest income of $2.4 bln in 1Q2020, which is a sizeable reserve in my opinion, but accurately reflects the uncertainty that may lie ahead. The company’s provisions in 1Q19 for comparison purposes were $0.8 bln, so they more than doubled their provisions QoQ. Here’s how DFS’s provisions compared to the three other banks (consumer lending businesses segment) I mentioned above:
JPM - $5.8bln provisions on $13.2bln net interest income; provisions 1Q19 were $1.3bln on net interest income of $13.5bln
Wells Fargo - $1.7bln provisions on $6.8bln net interest income; provisions 1Q19 were $0.7bln on net interest income of $7.2bln
BofA - $2.3 bln of provisions on $9.1bln of net interest income; provisions 1Q19 were $1.0bln on net interest income of $9.6 bln
Both Wells and BofA doubled their provisions QoQ, similar to DFS The provisions represented 25% and 18% of NII for BofA and Wells, respectively, both much lower than DFS’s ratio of provisions to NII (circa 75%). JPM, on the other hand, is an outlier in that it increased its reserves substantially more than the other two banks and DFS (by circa 4.5x QoQ), but its provision is still only 44% of NII. The substantial increase in provisions is a conservative gesture by JP Morgan most likely because the bank can afford it given their strong capital base. In addition, JP Morgan probably has the highest quality consumer loan business of any of its peers. Net-net, compared to the other three much larger banks, I think DFS has probably provisioned fairly in the context of its loan book, although this would need to be looked into much deeper than I have done.
For further context, I also took a quick look at how DFS’s net interest income, provisions and – importantly – actual charge-offs worked during the Great Recession. I cannot say with 100% confidence that the business was the same then, but I do believe it was very similar. DFS results in 2008 and 2009 were of course both severely affected by the Great Recession. In both years, the company took provisions that were higher than its net interest income (greater than 100% in other words), so even with the large provision the company just took, the situation could worsen. However, my expectation is that this downturn will likely be severe but quick compared to the 2007-2009 period, which was a very deep and protracted recession. DFS also appears to have over-reserved during the 2007-09 period, which is a conservative approach and reasonable. Net charge-offs in 2009 were 7.45% of total loan receivables, which for DFS today - should history hold - mean charge-offs of $6.4 bln (against accumulated provisions of $6.9 bln) should loan losses ultimately prove to be around the same figure.
There is one more interesting thing to note regarding DFS. The company’s net interest income actually increased modestly QoQ by 4% (1Q20 vs 1Q19), whilst the three other larger banks experienced declines in net interest income. Lastly, I would expect that since credit cards have the highest interest rate of almost any consumer loan product, DFS will have more cushion than many banks do which do not rely as heavily on credit cards to generate interest income (circa 80% of DFS's lending assets).
Transaction Service Revenues: Parallels with Visa and Mastercard
Still looking back to the period of the Great Recession for a moment, and turning to transaction services revenues where there are parallels with Visa and Mastercard, DFS experienced a roughly 10% decline in $ volume of transactions between 2008 and 2009, although the number of transactions modestly increased. For 1Q2020 (the most recent quarter), $ volume of transactions decreased from $46 million to $44 million QoQ (-4.5%), but the number of transactions actually increased by 4%. I would venture to say that VISA and Mastercard should have similar trends. It would seem that the accelerated move away from cash in general, and to on-line for e-retail (shopping and food delivery, for example), would both help propel growth, although I doubt that this will fully compensate for $ volume of transactions lost in the form of a decrease in travel (hotel, airlines, cruise ships, casinos, etc). But it should be far from a disaster.
Liquidity
Since DFS maintained its dividend, the company must be reasonably comfortable with its liquidity position. At the end of the quarter, DFS had $18 billion of cash and (non-restricted) liquid securities on its balance sheet. The company has CET1 capital ratio of 1.3%. According to the cash flow statement, the net need for debt (mainly refinancings I would guess) looks to be $3 bln to $5 bln per year, so the company will likely continue to need to access the capital markets for funding but not in the near term given its cash balance (meeting minimum CET1 ratio TBD). Recall that DFS is rated Baa3/BBB-/BBB+, so barely slips into the investment grade category, not necessarily a good place to be for a bank.
Conclusion
The EPS vs consensus for financial companies is tricky now because of the requirement that banks take provisions to reflect future losses, although there is latitude and therefore a qualitative element to this. It looks like DFS has been conservative in this respect, and I imagine the shares have been oversold if they fall deeply at the open this morning. As a sidebar, I think the news here for the pure payment companies is not as bad as expected. I suppose we’ll have to wait and see on VISA and Mastercard, but I personally expect that there is a higher probability of a surprise on the upside than the downside, although at the P/E multiples at which both are trading, they risk being sold off if earnings are not significantly above expectations anyhow (a la Netflix). There is little doubt that for those investors which want to take bank / consumer credit risk in this environment, DFS represents good value at the moment (5.2x P/E and dividend yield of just above 5%). The great unknown though is just how long this recession and pandemic will last, and what will be the end effect on the performance of its consumer loan - mainly credit cards - portfolio.