Quick Thoughts: Discover Checking Account Offers Durbin-Advantaged Rewards

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

April 23, 2014

Quick Thoughts: Discover Checking Account Offers Durbin-Advantaged Rewards

  • DFS beat on EPS ($1.31 vs. $1.25 consensus) and continued to outpace the industry in loan growth (5% year-on-year in card and student, and 26% and 27% in private-student and personal lending respectively); with double-digit account growth in card, we expect loan growth to continue to increase and move above the high-end of the target range of 2-5%.
  • Higher provision expense (of $272mm vs. $159mm in the year-ago quarter) was due to lower reserve-release (of $57mm vs. $154mm); credit remains benign with the delinquency rate for card and the overall portfolio flat sequentially. As such, at least over the next 12-months, reserve builds will reflect loan growth and not credit deterioration (with some add-on for seasoning of the student loan portfolio).
  • DFS has ~4% of capital over its newly-announced target for a CET1 ratio under Basel 3 of 11% (vs. 14.9% under Basel 1 with no meaningful change expected under Basel 3). Given regulators discourage payout ratios over 100%, the excess capital is trapped; nonetheless, DFS expects an ROE “well north” of minimum guidance of 15% (vs. 23% this quarter) in part because the net interest margin at 9.9% will remain “for some time” above the long-run target of 8.5-9% (which reflects an expected mix-shift over time from card).
  • Management commented that while the cashback checking account is not going to change the deposit mix dramatically in the near term, it is very strategic; as noted in our full research reports, DFS is not subject to the Durbin cap on debit interchange and so has a regulatory advantage over banks in offering a no-fee, rewards checking account.

DFS continues to take advantage of its excess capital to grow a prime-lending portfolio while bank competitors, more constrained by CCAR stress-tests, are focusing on card products with spend- rather than lend-driven economics; and to leverage the resulting relationships to cross-sell debt consolidation (e.g. personal loan) product and deposit products (with 70% of the book coming from cross-sell in 2013). As DFS continues to diversify its loan portfolio and build a deposit franchise (including through its Durbin-advantaged checking-account products), we expect the multiple to expand over time from the current 10.2x towards the ~12x average for regional banks.

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