Explore Financials: Leading Compound with Natural Inflation Hedging (NYSE: DFS)

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Discover financial services (NYSE: Homeless) has earned a reputation for consistent financial performance (the company has compounded EPS at a rate of 14.8% since 2006) and the past quarter has been no different. While the company’s EPS was down last year because of reserve releases the previous year, DFS still managed to beat street estimates by 16.4%. This pace was largely driven by solid loan growth, higher net interest margin (NIM) and excellent expense control. In a tough labor and cost market, the company actually improved its operational efficiency while many peers saw their efficiency ratios increase. (Efficiency ratio = non-interest expenses / total income, so a higher ratio is bad).

Since DFS is a consumer-focused finance company, it is perhaps one of the “most hated” sectors in the market today (excluding travel). Incomes are correlated to employment and inflation levels and it looks like people’s economy (and therefore employment) is slowing or shrinking in Q4 2022 or Q1 2023. In short, even though we see the economy slowing down, we still see a strong labor market and maintaining high levels of nominal consumer spending. This bodes well for DFS’ loan growth and earnings going forward and we believe that at current levels, stocks are simply too cheap to ignore.

We are long on stocks in the $105-$110 range and believe that below $100 the stock is a “book the table” buy.

Earnings

Discover’s first quarter results would indicate something other than a weakening economy. Total loans grew 8.3% year-over-year as NIM expanded, driving year-over-year (“y/y”) revenue growth (adjusted to account for market value losses on equity investments) of 10.6%. Management has almost impressively brought costs under control, with non-interest expenses rising only 4.5%. This translated into growth of 14% in adjusted profit before tax and before provisions of 14%.

Management also increased its dividend by 20% to $0.60 per share and the board approved a $4.2 billion buyout which, at current prices, is equivalent to 13% of the company’s market capitalization. society.

Credit performance trends remain strong with net charge-off (NCO) rates across the portfolio well below their long-term averages.

Credit yield

Discover the financial services first quarter 2022 results presentation

Credit performance and balance sheet

American Express (AXP) gets a halo multiple because the company generally attracts higher-income, more resilient consumers (people who tend not to lose their jobs during a recession), leading to better credit performance. However, we draw your attention to the fact that since 2006, DFS has had NCO rates that are on average only 70 basis points higher than those of DFS.

NCO to Loans

Author’s graph, Data obtained from the company’s financial statements

Discover also appears to be running its business more conservatively with NPL loan loss reserves averaging 5.7 times higher since 2008 and significantly higher in recent years.

LL Reserves

Author’s graph, Data obtained from the company’s financial statements

Discover’s management team decided a few years ago to actually reduce the company’s cost of funding by creating an online banking business that could attract customer deposits. Interest rates on checking accounts and savings accounts tend to rise more slowly than lending rates, resulting in a greater benefit to income when interest rates rise. In the chart below, you’ll see that when the Fed started raising rates, fed funds peaked at 2.5%, up 200 basis points in 24 months. At the same time, the cost of DFS deposits peaked at 2.35%, which rose only 100 basis points over the same period.

Cost of deposits

Author’s graph, Data obtained from the company’s financial statements

You can see how the growth of the company’s consumer banking business has led to improved NIMs over time. In their most recent quarter, NIM was up 64 basis points year-on-year and 4 basis points quarter-on-quarter. Management expects NIM to rise another 10 to 15 basis points this year as the Fed continues to hike rates to fight inflation.

NIm

Author’s graph, Data obtained from the company’s financial statements

Discover also has a fortress balance sheet, carrying $16.6 billion in cash, plus a revolver capacity of $39.6 billion. This represents total liquidity of $56.2 billion. You can sleep well at night, so even during an economic downturn like the one we experienced in 2020, there are no funding issues to worry about. DFS is also rated Investment Grade with a BBB- rating from S&P.

capital position

Discover the financial services first quarter 2022 results presentation

Discover is becoming more bank-like every day, and the brand is strong. Accounts receivable have consistently grown between high and double digits (up 11% last quarter).

Composition

There are really only 3 other publicly traded consumer credit card companies; American Express, Synchrony Financial (SYF) and Capital One (COF). We believe there is a strong case that DFS belongs on the same tier in terms of valuation as AXP given that DFS’s ROE, CET1 ratio are on par with the company and the historical EPS growth track record of DFS is almost double that of AXP. We also highlight management’s strong ability to control credit when prudent to do so, which led to the sell-off in credit portfolio performance, as discussed above.

The only downside we can point out with DFS is that their loan to deposit ratio is significantly higher than their peers, which means the company is required to finance itself with corporate borrowings which are more expensive.

comp

Provide

We believe loan growth can grow conservatively by 4% to 4.5% over the next two years and provisions as a % of total loans will normalize over time to historic levels over the next two years. coming years. Provisions drive earnings down after large reserve releases, but overall still very strong EPS growth considering. Using our 2024 EPS estimate, the 5-year EPS CAGR is 10.2% well above the S&P 500 long-term average of 7% to 8%.

model

Evaluation

Although we reiterate again that we believe DFS deserves a closer multiple to AXP rather than a 55% discount. The long-term average is a 34% discount, which would equate to a multiple of 10.7x. To be conservative, we apply the 10-year average P/E multiple of 10x and 2.5x for the P/E ratio for valuation purposes.

We believe the stock’s downside is limited to $100 or around 10% from recent prices and see 40-50% upside potential over the next two years.

p/e valuation
p/b valuation

Conclusion

We believe Discover Financial Services is significantly undervalued given the quality of the business and the natural inflation hedge built into their operations. Management has created significant shareholder value over a long-term horizon and we believe management will continue to be prudent with investor capital and continue to seek ways to generate greater shareholder value.

We believe the stock’s relative outperformance speaks to the strength of the company’s balance sheet and the quality of the business. However, they will still be somewhat perplexed by the low multiple achieved by the stock given the strong track record of financial performance, especially coming out of the pandemic.

We believe this stock is an excellent long-term core investment for any portfolio. The growing dividend and dividend yield above 2% provide a current cash income that many are desperately seeking today. We also believe that the massive buyback program provides good support for equities in the event of significant declines in volatile markets.

About Leah Albert

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