Despite a strong third quarter, challenges loom for Discover

Despite growing profit and share price, industry-wide concerns are worrying Discover shareholders.
Despite growing profit and share price, industry-wide concerns are worrying Discover shareholders.

By Megan Hart

Profit and share price for Discover Financial Services have surged over the past year, but analysts worry that increased expenses, a foray into riskier investment streams, and competition from alternative payment options may interfere with growth.

The stock has risen 19.8 percent in the past year, compared with 11.9 percent for the Standard & Poor 500 Index. It closed Wednesday at $62.96, just 4 percent below its record-high of $65.59 set on Sept. 18. But the Riverwoods, Ill.-based company’s most recent quarterly earnings released last Tuesday raised concerns about its future growth.

 

In the eyes of investors, an 8.8 percent increase in net income was not enough to offset a major hike in expenses related to customer rewards and banking regulations.

Increased expenses

Analysts expect Discover's expenses to continue to increase.
Analysts expect Discover’s expenses to continue to increase.

While many analysts, including Morningstar’s Jim Sinegal, have offered positive views about Discover, Sinegal also wrote in a research report that the leap in expenses has “overshadowed positive developments.”

In the third quarter, Discover’s rewards-related expenses rose 11 percent from the year-ago quarter, totaling $304 million. This upward trend in rewards expenses is likely to continue, according to Sinegal.

Across the industry, credit card companies have ramped up their rewards programs. Discover customers have earned over $750 million in cash-back rewards this year, by earning 1 percent on every purchase and an additional 5 percent at certain retailers. Through year-end, Discover customers earn the 5 percent reward on charges made at department stores or online.

These rewards costs are adding up. The company expects to incur a one-time charge of as much as $185 million in the current quarter as it makes it easier for customers to turn rewards points into cash. It also expects to spend an additional $60 million on rewards in 2015, according to Discover’s third-quarter Securities and Exchange Commission filing.

Analysts expect the revised rewards program to cost Discover between 7 and 8 cents per share in 2015, signaling that costs could take a major chunk out of profits.

Despite the costs associated with the program, Guggenheim Securities analyst David Darst wrote in a report that the revamped rewards system “will drive greater loyalty and extend the lifetime of an account.”

Sinegal said that like many banks, Discover faces a growing regulatory burden which is “taking a toll on the company’s ability to limit the growth of expenses.” In the third quarter, that came in the form of employee salaries and benefits for new workers hired to meet compliance standards.

Analysts expect these expenses to dull the company’s efficiency ratio, or the metric that measures a bank’s revenue against its overhead. In the third quarter, Discover had 37.8 cents of overhead expenses for every $1 of revenue it earned. In 2015, Napoli expects overhead to cost Discover 38.1 cents per $1 of revenue.

According to Graf, one of the major expenses the company will encounter over the next year relates to launching EMV, a more secure payment system that’s commonly used throughout Europe. With EMV, credit card information is transferred by computer chip rather than by magnetic strip, and each transaction creates original data so stolen information is essentially worthless. Discover plans to complete its EMV liability shift by Oct. 1, 2015. Costs associated with EMV will affect the entire industry as Visa, MasterCard and American Express are also making the transition.

Riskier revenue streams

While credit cards account for about 80 percent of Discover’s revenue, it is rapidly expanding its student loan business. It currently services $8.5 billion worth of student loans, and William Blair’s Napoli expects Discover’s student loan portfolio to reach $15 billion in the next four to six years.

While other banks were exiting the private student loan business, Discover was entering it. In 2010i, it acquired the Student Loan Corporation. A year later it purchased Citi Bank’s $2.5 billion student loan portfolio.

A year ago, America’s largest bank, JP Morgan Chase, stopped offering student loans. This followed the passage of a new law allowing the government to offer a greater volume of loans, which hurt many private loan servicers. Since then, the government has provided the vast majority of student loans.

Discover grew its student loan portfolio 11 percent in the third quarter, but the competitive student loan market has caused the company to offer expensive incentives. Discover’s 5.99 percent APR fixed interest rate for student loans is lower than the industry’s largest player, Sallie Mae, which offers fixed interest rate student loans starting at 6.41 percent APR. Discover also offers students who earn a 3.0 GPA a cash reward equal to 1 percent of the loan amount.

“Private student loan is a source of risk,” Sinegal wrote, as student loan delinquency rates have doubled over the last year, which could mean more credit write-offs for Discover.

Discover acknowledged the risk that new legislation being drafted by the Consumer Financial Protection Bureau and the Federal Deposit Insurance Corporation could pose to its profits.

“Legislators and regulators may take additional actions that impact the student loan market in the future, which could cause us to restructure our private student loan product in ways that we may not currently anticipate,” the company said in its third-quarter SEC filing.

Earlier this year Discover announced that it was under investigation for its student loan practices by the CFPB. According to its third quarter filing, it’s complying with the investigation which “could lead to supervisory actions.”

The CFPB announced last week that consumer complaints filed against Discover’s student loan branch were down 5 percent this year from 174 to 165.

Alternate payment systems

Currently, Discover is not participating in the Apple Pay program. Photo courtesy of Apple, Inc.
Currently, Discover is not participating in the Apple Pay program.
Photo courtesy of Apple, Inc.

New payment systems are also creating more competition for Discover. The most notable new system is Apple Pay, which allows customers to link their credit or debit cards to their iPhones. They can then simply tap their phones to pay at participating retailers, which include Walgreens, McDonalds and Whole Foods.

While Visa, MasterCard and American Express are currently participating in the program, Discover is not. Discover’s chairman and CEO David Nelms said he expects the company to join Apple Pay, but he’s unsure of the timeline.

“We certainly do expect to be participating in Apple Pay,” Nelms said. “We don’t know when that will be, but we’ll be actively working to be included over time.”

While credit card companies earn a lower than average fee on Apple Pay transactions, analysts expect Apple Pay to grow in popularity to the point that additional transactions will allow credit card companies to make up the difference. According to Apple, its new payment system will also be more secure. This will allow banks and credit card companies to significantly reduce their fraud-related costs.

Other alternative payment methods, however, could cut into profits.

Walmart spearheaded the creation of Merchant Customer Exchange, which is developing CurrentC, a system that will allow users to attach their bank accounts or load cash to an app that they can use to pay at participating retailers. In addition to Walmart, those retailers will include CVS, Best Buy and Target. The goal of CurrentC is to allow large retailers to eliminate the 2-3 percent transaction fees they pay to credit card companies.