Discover's Financial Dilemma

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Discover Financial Services (NYSE: DFS) reported its second quarter earnings recently and, once again, the results were a bit of a mixed bag. Bulls on the stock can point to the 9% year-over-year growth of revenue net of interest expense to $2.4 billion. Discover's loan portfolio growth was also solid as total loans grew 8% to $78 billion and credit card loans, the company's largest loan portfolio, increased 8% to $61.8 billion.

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Despite these solid numbers, however, the bears had ample figures to highlight as well. Net principal charge-offs, loans that Discovers believes it is now unlikely to collect, once again increased more than expected. This quarter principal charge-offs rose to $520 million, a 35% increase year-over-year. Provisions for loan losses, money Discover sets aside for loan payments it has yet to receive, also spiked to $640 million, a 55% increase year-over-year.

These numbers are growing faster than expected and, as a result, Discover management raised its guidance for the full year total loan charge-off rate to 2.7-2.8%. Largely as a result of this increase in loan liabilities, Discover's return on equity fell from 22% in 2016's second quarter to 19% this quarter.

Discovering itself between a rock and a hard place

The problem the company discovers itself in (Ugh, sorry. Last "Discover" pun. I promise.) is that its only lever to pull for growth is by growing its loan portfolios. While Discover does boast a personal and student loan business, its credit card loan segment is, by far, the largest in its portfolio. In fact, Discover's $61.8 billion in credit card loans comprises a little less than 80% of Discover's total $78 billion loan portfolio. For this reason, it is hard for Discover to drive growth without growing its credit card loan portfolio. This growth comes with risk, however, as credit card loans are much riskier than other types of loans. It is this exact dilemma Discover disc ... er .... finds itself in. As CEO David Nelms stated in his opening remarks during the company's conference call (provide by S&P Global Market Intelligence):

Loan growth over the last few years has contributed to rising charge-offs as those loans season, but it has also generated strong revenue growth that mitigates higher credit costs. Loan and revenue growth represent our primary near-term opportunity to generate long-term shareholder value.

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In other words, revenue growth doesn't come without loan growth and loan growth doesn't come without charge-off growth. So what's a credit card company to do?

You can't please everyone

The fact remains that Discover's underlying business remains fine; it is Wall Street that has the problem. Since the financial crisis, investors have been especially finicky when it comes to credit risk. It's hard to blame anyone for wanting to avoid those horrific losses again, but investors shouldn't want to avoid companies that are being unnecessarily punished if they can be had at good enough value points for long term gains. This might be the case for Discover.

CFO Mark Graf believes the credit card charge-off increases are normal "seasoning" for the loan growth the company has experienced the past several years and states it "is consistent with ongoing supply driven normalization in the consumer credit industry." CEO Nelms was quick to point out that the company's charge-off rate "remains below the industry average and historical norms," though he also allowed that the company has tightened some of its underwriting standards in response to the growing charge-off rate. Company management maintained, however, that because of favorable macro-economic conditions, the company should be able to grow its credit card portfolio without too much further risk.

A hidden value or a value trap?

With a trailing twelve month EPS of $5.70, Discover sports a price-to-earnings ratio of 10.7. Does that make the company's stock a bargain? With only little EPS growth to show for its efforts, not necessarily. Even in a multiyear bull market, investors want to see some hint of growth or, at least, a potential catalyst in the company's future, before investing. Discover shows little of either. Given that its credit card peers, like Mastercard and Visa, show solid growth and are not exposed to credit risk, its little wonder they remain Wall Street's darlings of the industry.

That doesn't mean I don't believe management's explanations for its charge-off increases; I do. Charge-off rates should be expected to increase from the historical lows the industry has experienced during the past several years. Also, if macro-economic conditions remain stable in the coming quarters, I don't see why Discover's management should not be believed that the credit card charge-off rates will plateau soon. But, given the market's penchant for punishing credit risk and Discover's tepid growth, there does seem to be better investing prospects elsewhere. As Warren Buffet might say, Discover is a pitch you don't have to swing at.

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Matthew Cochrane owns shares of Mastercard. The Motley Fool owns shares of and recommends Mastercard and Visa. The Motley Fool has a disclosure policy.