Discover financial stocks: buy the instinctive reaction of the market (NYSE: DFS)
Earnings season is a good time to have some dry powder on hand, as market reactions to quarterly earnings can lead to big buying opportunities. This could be due to perceived short-term weaknesses causing short-term investors to bail out, thus creating “time arbitrage opportunities” for those with a longer investment horizon.
This brings me to Explore Financial Services (NYSE: Homeless), which has seen a significant decline in its share price since the release of its second quarter results. In this article, I highlight what makes DFS an attractive stock to buy on the downside, so let’s get started.
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 most 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.
Unlike some banks, such as Bank of America (BAC), which have a credit card business on the side, Discover generates the bulk of its revenue (around 70%) from credit cards. This highly focused approach results in efficiencies for the business, as it is able to focus its energy and resources on a more singular goal. This is reflected in Discover’s A- rating for profitability with a net profit margin of 44.5%, well above the industry median of 29%.
In addition, DFS generates an excellent return on equity of 42.7%, thanks to its aggressive share buybacks. As shown below, DFS has removed an incredible 23% of its exceptional float in the last 5 years alone.
DFS recently reported Q2 earnings that beat Wall Street expectations, with EPS of $3.96 versus consensus $3.77. Its non-interest income also improved to $614 million from $423 million a year earlier, and net interest income rose a respectable 14% year-on-year to $311 million. dollars.
These results were driven by robust growth in total loans, which ended the second quarter at $99 billion, up 13% year-on-year and up 6% sequentially. This was led by credit card loan growth of 15% year-over-year, followed by personal and private student loan growth of 4% and 2%, respectively.
However, all is not well, as current macro conditions have led to a slight increase in losses, while delinquencies are stable, reflecting a slower-than-expected credit normalization. Net write-off rate of 1.8% was 32 basis points lower than a year ago, and management increased the provision for credit losses to $549 million from just $154 million in the quarter previous.
Clearly, DFS is setting aside a substantial amount of capital to hedge against a possible economic downturn. In addition, management has just announced the suspension of its share repurchase program due to an internal investigation by an independent special committee appointed by the board of directors on student loan management issues.
Still, I don’t see these factors as a deal breaker for the stock, and robust loan growth has resulted in a larger base of credit card receivables against which it can spread its losses. Additionally, Discover continues to differentiate itself from the pack with award-winning customer service that builds customer loyalty. This was emphasized by management during the recent conference call:
In our Digital Banking segment, our combination of industry-leading customer service and compelling products continues to differentiate us in the marketplace. JD Power recently gave us the highest rating for customer satisfaction across mobile apps, credit card apps, and websites.
We also achieved the highest level of customer satisfaction and JD Power checking accounts for direct retail banks. This recognition underscores our customer service model, which, combined with our attractive Cashback rewards and no-fee products, creates a value proposition that we believe others will struggle to match.
For this reason, we believe we are well positioned to generate substantial long-term growth and shareholder value. Despite our strong performance, we continue to closely monitor developments in the current economic environment.
Meanwhile, DFS maintains a BBB-investment grade rated balance sheet and pays a dividend yield of 2.4% which comes with a very low payout ratio of 15% (based on Q2 EPS of 3.96 $). The dividend also comes with a respectable 5-year CAGR of 11.8%.
I see the stock value at $100 with a forward P/E of just 6.8, well below its normal P/E of 10.9 over the past decade. Sell-side analysts have a consensus Buy rating on the stock with an average price target of $128.58, implying a potential total return of 31% over one year, including dividends.
Key takeaway for investors
With shares of Discover Financial Services down significantly following the release of its second quarter results, I believe the stock presents an attractive entry point for long-term investors. The company is a well-oiled operation that continues to deliver solid loan growth with industry-leading customer service. Although there is some uncertainty surrounding its near-term outlook, I think the stock is a good deal at current levels for long-term investors.