Discover Earnings: Higher Credit Costs Hurt Bottom-Line Results

Narrow-moat Discover DFS reported weak third-quarter results as the bank’s credit costs rose sharply. Discover’s net revenue increased 17% from last year to $4.04 billion. Earnings per share declined 27% year over year to $2.59, which translates to a return on equity of 19%. The drop in profitability was due to higher credit provisioning costs, as the company built $601 million in reserves during the quarter. As we incorporate these results, we do not expect to materially alter our $152 per share fair value estimate. We see the shares as undervalued right now.

While Discover’s credit quality continues to deteriorate, the rate of decline was faster than we had anticipated. Discover’s credit card portfolio, which provides the bulk of its revenue and earnings, saw its net charge-off rate rise to 4.03% from 2.88% last year. To make matters worse, after a period of relative stability, the bank’s delinquency ratios also increased sharply, with the 30-day credit card delinquency rate rising to 3.41% from 2.86% last quarter. We expect net charge-offs to continue increasing—and to be elevated next year—and we note that the acceleration in Discover’s delinquency rate bears monitoring as it comes despite a surprisingly resilient labor market and may be a sign that the end of student loan forbearance is affecting credit results.

Discover’s revenue growth was primarily driven by higher net interest income, which increased 17% year over year to $3.3 billion. Higher net interest income was due to strong loan growth, with the bank’s average receivables increasing 18% from the prior-year quarter. Loan growth was partially offset by net interest margin compression, though, with the bank’s NIM falling to 10.95% from 11.05% last year. While Discover did initially benefit from rising rates, increased competition for deposits has led to higher funding costs. That said, we do not expect to see much more margin compression as we reach the tail end of the Fed’s tightening cycle.