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Stock Strategist

Discover's in a Sweet Spot

It's able to hold less capital against credit card loans compared with its larger, more regulated rivals.

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Over the long run,  Discover Financial Services(DFS) unique role as a credit card lender focused on Middle America, operating its own network, puts the company in an interesting strategic position. In the short term, we view Discover’s prospects less favorably as the heated rewards environment means customer acquisition costs will weigh on margins. In addition, as competition intensifies, Discover’s larger rivals can exploit their scale on national advertising campaigns and technology spending.

Despite the size advantages of its rivals, Discover is consistently one of the most profitable banks on the basis of return on equity. This is largely attributable to two advantages. Because Discover isn’t a systemically important financial institution, it can hold less capital than its larger rivals relative to its loan book composition. Discover’s assets stand at more than 9.5 times equity. The second-biggest contributor to the company’s outsize returns is business mix. Credit card loans account for nearly two thirds of the bank’s total assets. These high-yield loans drive the bank’s exceptional net interest margins, which routinely exceed those of money center banks by 600 basis points. These advantages have routinely enabled Discover to earn returns on equity near 20% and repurchase more than 5% of its shares each year.

Colin Plunkett does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.