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Discover Financial Services (DFS): New Analyst Report from Zacks Equity Research – Zacks Equity Research Report

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Summary:

Discover Financial’s strength lies in its strong inorganic growth story and solid cash position that also enables efficient capital deployment. However, weakness prevailing in the Payment Services segment and escalating expenses raise caution. Its third-quarter earnings surpassed the Zacks Consensus Estimate on lower share count and card loan growth. Moreover, the company’s quality services keeps it cushioned against high customer attrition. An extensive student loan portfolio, global expansions, prudent capital management and increased card sales position it well for long-term growth. Additionally, implementation of the core banking platform supports all the deposit products, thus accelerating customer service. However, competition, lawsuit damages and regulatory challenges remain headwinds. We maintain our Neutral recommendation on the stock.

Overview:

Founded in 1986 and based in Riverwoods, IL, Discover Financial Services is a direct banking and payment services company in the United States. The company offers credit cards, personal, student and home loans as well as deposit products. In Mar 2009, Discover Financial became a bank holding company under the Bank Holding Company Act of 1956 and a financial holding company under the Gramm-Leach-Bliley Act in connection with its participation in the U.S. Treasury’s Capital Purchase Program.

Discover Financial offers its products and services with acceptance in more than 185 countries and territories. The company operates through three networks:

The Discover Network Discover Financial’s credit card payment network.

The PULSE network Discover Financial’s ATM, debit and electronic funds transfer network.

Diners Club International Discover Financial’s global payment network.

Discover Financial manages its business activities in two segments:

The Direct Banking segment (accounted for 96% of total revenue in 2013), formerly referred to as the U.S. Card segment, includes Discover card-branded credit cards issued to individuals and small businesses in the Discover Network. The segment also offers personal loans, student loans, home loans, prepaid cards and other consumer lending and deposit products.

The Payment Services segment (4%), formerly referred to as the Third-Party Payments segment, includes PULSE, Diners Club and its network partners business (previously referred to as the third-party issuing business), which includes credit, debit and prepaid cards issued by the third parties on the Discover Network.

Discover Financial continues to grow inorganically through acquisitions. In Dec 2010, the company acquired The Student Loan Corporation (SLC) in a merger transaction for $600 million and received a purchase price closing adjustment in a cash payment of approximately $234 million from Citibank, the 80% owner of SLC before the merger, resulting in a net cash outlay of approximately $366 million for the acquisition of SLC. In the transaction, Discover Financial acquired SLC’s ongoing private student loan business and approximately $4.2 billion of private student loans and other assets, along with approximately $3.4 billion of SLC’s existing asset-backed securitization debt funding and other liabilities. It also acquired the loans and other assets at an 8.5% discount. SLC is now a wholly owned subsidiary of Discover Bank.

In June 2012, Discover Financial announced the completion of the purchase of almost all operating and related assets of Tree.com Inc.’s subsidiary Home Loan Center. The company has already paid $49 million for the deal, including payments made prior to the closing. Another $10 million was paid on the first anniversary of the closing date, that is, June 2013. Home Loan Center originates and processes residential mortgage loans across all 50 U.S. states as well as the District of Columbia.

Following the acquisition of Home Loan Center, Discover Financial expanded its product portfolio to include residential mortgage with the launch of Discover Home Loans in June 2012. The company now offers commercial and Federal Housing Administration loans with both variable and fixed rates.

In Dec 2012, Discover Financial’s board approved a change in its fiscal year to Jan 1 Dec 31, effective from Jan 2013. Earlier, the company’s fiscal year ended on Nov 30. Due to the change, Dec 2012 was a transition period and was reported separately with the financial results for the first quarter of 2013 and full-year 2013.

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