New Trade $DFS – Slow and Steady Wins the Race

by Enis March 5, 2013 2:54 pm • Commentary

Discover Card is the ugly red-headed stepchild in the credit card business.  Its network is not as widely accepted as Visa and Mastercard, and since it actually makes its own loans as opposed to partnering with banks, its marketing reach is more limited as well.

But the company has executed exceptionally well in the past 3 years, riding the improvement in the credit markets while growing its loan book in a prudent fashion.  Here is the lifetime chart:


6 year weekly chart of DFS, Courtesy of Bloomberg
6 year weekly chart of DFS, Courtesy of Bloomberg

The stock plummeted after its IPO as the financial crisis took hold.  However, the stock has since massively outperformed most other financial stocks, as it had a cleaner balance sheet and simpler business, simply extending credit card loans for the most part.

The company has had 2 main drivers of a much improved earnings base (it earned $4.46 per share in 2012 vs. 1.22 in 2010).    

1)  Credit card delinquencies have declined to historic lows.  From the company’s most recent release:

We believe that we are experiencing generally historical lows in our delinquency and charge-off rates and that they are likely to increase at some point. In addition, if economic conditions worsen, these rates may increase more than expected. The over 30 days delinquent rate was 1.75% at November 30, 2012, down from 2.29% at November 30, 2011 and 3.87% at November 30, 2010. The full-year net charge-off rate was 2.29% for 2012, down from 3.97% for 2011 and 7.53% for 2010. Growth in our loan portfolio led us to increase our allowance for loan losses in the fourth quarter of 2012. We expect further increases in our allowance for loan losses in 2013, which will negatively impact our net income compared to 2011 and 2012, when reserve releases significantly contributed to our net income.

In other words, the company’s earnings was significantly buffered by reduced delinquencies in its credit card portfolio.  But going forward, the company had this to say:

Credit performance continued to improve through 2012 as we reached historical lows in net charge-off rates. Reserve releases contributed to our overall profitability, but we do not expect to receive a similar benefit of reserve releases in 2013.

2)  Robust loan growth.  The company almost doubled the size of its loan book between 2009 and 2012.  However, the reduction in rates in that period has hurt the earnings prospects for the loan book going forward.  Again, from the company’s release:

Our net interest income from credit card loans was $5.8 billion for the 2012 fiscal year, which was 75% of revenues (defined as net interest income plus other income), compared to $5.7 billion for the 2011 fiscal year, which was 80% of revenues.

Net interest income was essentially flat in 2012 vs. 2011.  Low rates and historically low delinquency rates make it difficult for Discover to continue earnings growth going forward, and analysts have only modeled 1-5% earnings growth over the next 3 years as a result.

Against that, DFS is not rich, trading at 9x earnings, which seems fair for a credit card business that is not likely to grow gangbusters in the next few years (but has a better quality loan book and better execution than a comparable name like COF, which also trades at 9x).

Finally, DFS has been stuck in a tight range over the past 6 months, despite the market’s volatility.  Here’s the 1 year chart:

[caption id="attachment_23296" align="alignnone" width="635"]1 year daily chart in DFS, Courtesy of Bloomberg 1 year daily chart in DFS, Courtesy of Bloomberg[/caption]

I’ve drawn the support at 37, and the 200 day ma comes in around 37.60, so the 37-38 area is strong support.  The all-time high is 42.08, and I’ve drawn resistance at the 42 level.  DFS seems neutral for now, stuck between those two areas, and fundamentally fairly valued.


TRADE: DFS ($40.60) Bought Apr 42/40/38 put fly for $0.50

-Bought 1 Apr 42 Put for 2.35

-Sold 2 Apr 40 Puts at 1.235

-Bought 1 Apr 38 Put for 0.62

Break-Even on Apr Expiration:

Profits: Up to 1.50 btwn 41.50 and 38.50, max profit of 1.50 at 40

Losses: Losses up to 0.50 btwn 41.50 and 42, and btwn 38.50 and 38, with max loss of  above 42 and below 38

Trade Rationale: I want to target the midpoint 40 level, which I anticipate will continue to be a magnet for the stock over the next month, particularly if earnings are not a surprise either way.  The company reports earnings on Mar 21st, so the trade should appreciate only a bit before then if the stock remains stable.  I will re-assess the trade before earnings and provide an update trade at that point.