Is discovering financial services a purchase?

Discover financial services (DFS 0.03% ) is a credit card company, but it’s also an online bank with around $112 billion in assets. Whichever way you categorize it, it’s been a strong performer over the past decade. Discover’s stock has returned around 13% on an annualized basis over the past 10 years through the end of the second quarter of 2020. That makes it a most successful player between banks; as a credit card company, it has tracked major players, Visa and MasterCardbut he is different from them in several respects.

This year, Discover’s stock has been hit hard by the coronavirus pandemic, down about 45% year-to-date. This is worse than the average return on bank stocks and much worse than Visa and MasterCard, both of which are relatively stable for the year. Why is Discover underperforming and a buy?

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Double hit

To understand why Discover lags behind its competitors, it helps to know how it differs from them. Visa and Mastercard are payment processing companies that facilitate the movement of money and collect fees for their services. Their credit cards are issued by other banks, such as Citigroup ( VS -0.23% ) and Bank of America (BAC -0.40% )among others.

Discover is also a payment processor, but unlike Visa and Mastercard, it is also a lender, lending money through its own bank. The company generates revenue from interest on its credit card balances. So while all credit card companies were hit by a sharp drop in consumer spending in the first two quarters due to stay-at-home orders and layoffs, Discover will be hit by lower card balances as well as by a likely increase in payment defaults and credit losses.

Additionally, as Discover is a bank, it suffered from falling interest rates and a decline in net interest margin. Additionally, it had to set aside $1.8 billion for the provision of credit losses as a result of the pandemic. As a result, Discover posted a net loss of $61 million in the first quarter. Other credit card companies don’t have to worry about provision for credit losses or other bank-specific issues.

Rockin’ the plastic?

Discover’s credit card balances actually increased slightly, 4%, after the first quarter, but as the recession continues, expect that number to decline. In the call for first quarter results in late April, Chairman and CEO Roger Hochschild said the company was already seeing this:

So far in April…daily sales are down 14% year-over-year as higher grocery spending is more than offset by a 60% reduction in oil spending. Discretionary spending is down 33%, driven by the travel category, which, although representing only 8% of cardholder spending, is down 99%, and retail, which is down. down 11%. As long as stay-at-home orders remain in place and many businesses remain closed, we expect the trend of weak sales volume to continue, and future trends will depend on the pace of the recovery.

Less spending, of course, means less borrowing and using credit cards. The company is also at higher risk of defaults and credit losses as more people struggle to pay their bills during a recession.

There are a few positives for Discover. It has good liquidity, with about $19 billion in liquid assets at the end of the first quarter and $23 billion at the April 23 earnings call, according to Hochschild. Additionally, the company announced plans to cut spending by $400 million by the end of 2020.

But given the economic outlook, it will be a tough time for banks and credit card companies, even one like Discover that has generated consistent profits for the past decade. I would look elsewhere to buy in the financial sector at present.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.

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