Discover Earnings: Compliance Issues Mar Decent Earnings As Share Repurchases Paused

Narrow-moat Discover Financial DFS reported solid results in line with our expectations. However, the bank’s generally decent results were overshadowed by news that Discover has been overcharging the merchants who accept its cards by misclassifying card types. The affected amount of revenue is limited, less than 1% of cumulative transaction fees since 2007, and the firm has set aside $365 million for estimated merchant compensation. However, Discover has once again paused share repurchases as it reviews its corporate governance and compliance policies. Discover also announced it has received a proposed consent order from the Federal Deposit Insurance Corporation in connection with customer compliance, which is a separate matter from the card misclassification issue.

Discover’s net revenue increased 21% from last year and 3.6% from last quarter to $3.9 billion. EPS decreased year over year to $3.54, which translates into a return on equity of 26%. As we incorporate these results, we maintain our $146 fair value estimate. While Discover’s governance problems are concerning, the scale of revealed issues in terms of affected revenue and estimated losses is not sufficient to materially alter our projections. That said, the level of uncertainty around Discover has increased and the bank’s discussions with its regulators will need to be monitored.

Discover’s revenue growth was driven by net interest income growth, which increased 22% from last year to $3.2 billion. Net interest income benefited from strong loan growth and wider net interest margins. Average loans grew 20% from the prior-year quarter, while Discover’s credit card receivables increased 21% to $92 billion. The bank’s NIM expanded from 10.94% last year, but decreased sequentially from 11.34% last quarter, to 11.06%. While Discover has benefited from rising interest rates, increased competition for deposits has led to higher funding costs and we do not expect further NIM expansion.