The Long and Short
An improving credit profile, attractive spreads on Discover Financial
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The credit profile for Discover Financial Services has improved markedly over the past few years despite the obvious operational challenges posed by the pandemic. DFS saw improved lending growth in the third and fourth quarters of 2021, and management is anticipating further normalization for the current year. With mid-to-high ‘BBB’ ratings at the bank operating company, the issuer offers attractive relative value and a good overall balance of risk and reward within the peer group and against the broader financial segment.
Graph 1. IG Consumer Lenders and Credit Card Processors
Source: Amherst Pierpont, Bloomberg/Barclays US Corp Index
DFS 2.7% 02/06/30 @ 113/10yr, G+113, 3.18%, $96.67
Issuer: Discover Bank (DFS)
Parent Holding Company: Discover Financial Services
Bank Ratings: Baa2/BBB/BBB+
Holding Co Ratings: Baa3/BBB-/BBB+
Amount Outstanding: $500 million
Discover Bank is the bank operating company of parent holding company Discover Financial Services (DFS). DFS is one of the nation’s largest standalone consumer lenders and credit card issuers with $108.5 billion in total assets, $89.5 billion in total loans and $72.7 billion in total deposits. Approximately $70 billion of the total loan balance is in credit cards, with an additional $10 billion in student loans, and the remainder in other direct consumer loans. The bulk of credit cards are issued under the well-known Discover franchise.
DFS is in an excess capital position as of the third quarter of 2021 with a Tier 1 Common (CET) ratio of 15.52% versus an internal target range closer to 10.5%. That number has increased from 11.23% at year-end 2019. The current total risk-based capital ratio is 18.52%. The additional capital provides plenty of capacity for the bank to fund shareholder incentives such as increased dividends and share repurchase programs. The bank paid $474 million in dividends and $1.5 billion in share repurchases in the first three quarters of 2021 under the current authorization for $2.4 billion through the first quarter of 2022.
DFS has vastly improved to a more stable funding profile over the past several years. The loan/deposit ratio has decreased to 123.25% as of the third quarter of 2021 from nearly 139% in 2017 as the bank has reduced its reliance on wholesale funding. Reliance on wholesale funding now stands at just under 35% from nearly 60% in 2017. Furthermore, emphasis on consumer deposits means the use of higher risk brokered deposits as a percentage of all deposits has decreased to 18% from just under 30% in 2019 and over 40% in 2017.
The bank’s credit quality in the existing loan book has improved significantly over the past several years, and management has set aside more reserves for loan losses. NPAs/Total Assets is roughly half the amount it was at year-end 2019 at just 1.93% as of the third quarter of 2021, down from 3.19%. The Texas Ratio, which measures total NPAs plus 90-day past due loans versus Tangible Equity and Loan Loss Reserves has improved substantially to its current level of 11.10% from a recent peak of 31.35% as of year-end 2019. Reserves held versus non-performing assets has quadrupled over that time to its current rate of just under 400%. Allowance for credit losses of total loans was approximately 7.7% as of the third quarter.
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