Discover financial services (NYSE: Homeless) is a company with a strong overall value proposition based on its business performance and shareholder return. We appreciate the company’s history of growth and improvement in key areas of its business. However, in our first hedge of this stock, we recommend a “HOLD” as we believe that the current economic uncertainties call for caution. We believe that waiting to see the real impact of interest rate hikes and tightening monetary conditions is favorable at this time. We will update investors as earnings results are released or the macroeconomic environment changes significantly.
Discover Financial Services is a company that provides digital banking and payment services to consumers and businesses. The company issues credit cards including the Discover card but also offers other services such as lending services such as private student loans, personal loans, home loans and other banking services. Year-to-date, the company has tracked the performance of the S&P 500, down -19.02% versus the S&P 500 down -21.99%. As of this writing, Discover Financial Services has a market capitalization of $24.97 billion.
Solid track record of dividend growth
Discover Financial Services has experienced strong dividend growth over the past 10 years, regardless of share price movements. The company currently pays $0.60 per share at an annualized return of $2.40. Based on the current share price, the current quarterly dividend translates to an annualized dividend yield of 2.63%. This dividend rate is higher than the S&P 500’s meager 1.69% yield. Also, compared to 10 years ago, the quarterly dividend has tripled, from $0.20 per share to $0.60 per share. stock. Such an increase represents a solid dividend CAGR of approximately 11.6% over the past ten years. We believe that the dividend yield and the growth of the company are among its main merits.
Modest growth in key metrics
In the company’s second quarter earnings report, the company showed solid growth in key areas. As a digital banking and payments company, the company’s bottom line is closely tied to payment volume. The higher the payment volume, the more money the company can generate on these volumes. Purchase volume in 2Q22 increased 10% YoY with outsized growth in key segments such as Discover Network and Diners growing 18% YoY and 37% YoY, respectively.
Stable asset performance
The company’s lending performance last quarter remained strong, with stable default rates across all lending segments. Despite the economic turmoil of the past year, it’s good to see that metrics have held steady in recent quarters. Net write-offs have also remained stable over the past few quarters, although it should be noted that net write-offs have increased significantly for the private student loan segment. Either way, we consider past loan performance to be a good sign for the company’s underwriting standards, and the company has approximately $6.76 billion in provisions for credit losses. .
Despite strong past performance, our bearish view stems from deteriorating economic fundamentals. As the Federal Reserve continues to raise rates at a rapid pace and the risks of a major recession mount, Discover Financial Services’ fortunes may turn around quickly as credit losses mount and consumers stop to spend. In our view, we remain vigilant on high yields in the short-term Treasury market, as they signal tighter monetary conditions in the near term. Of most concern is the fact that the loan reserve rate currently stands at 6.80%, compared to 8.01% in the second quarter of 2021. We believe that the decline in the loan reserve rate while that the economy is about to deteriorate is not a good situation. for shareholders.
In terms of the downside, we believe the crash during the pandemic may be a good example of what the stock price will be in the event that a worse than feared recession becomes a reality. In March 2020, Discover Financial Services was trading at nearly ~$25 per share, or 72% below the current share price. While we wouldn’t expect such a large crash as a base case scenario, we believe the stock’s previous declines may demonstrate the company’s downside potential when the market thinks we are headed for a major negative equity event. credit. Based on this downside potential, we believe the risk/reward ratio is on the downside, given that the stock is only 32% below its November highs of last year.
Although Discover Financial Services has performed well over the past few years, driven primarily by shareholder-friendly policies and solid growth across many segments, we believe the risk of recession remains too high for us to recommend the stock. . We think investors should wait for upcoming earnings reports before taking a position on the stock. We will monitor this stock and update investors as further news is released and/or economic uncertainties diminish.