Simplifying Operations And Critical Mergers Set To Enhance Profitability And Market Share

Key Takeaways

• Disposal of the student loan portfolio and resolution of litigation are streamlining operations and boosting profitability by focusing on core areas and reducing costs.
  
• The merger with Capital One and a disciplined approach to deposit pricing are expected to enhance revenue and net margins through strategic synergies and efficient cost management.
  
• Discover Financial Services faces challenges from a merger, regulatory penalties, divesting a loan portfolio, tighter underwriting standards, and consumer spending patterns affecting revenue and margins.

Catalysts

Through its subsidiaries, provides digital banking products and services, and payment services in the United States.

• The sale of Discover's private student loan portfolio is expected to simplify operations and enhance business focus, potentially boosting efficiency and profitability. This simplification could contribute to an improvement in net margins by focusing on more profitable lines of business.
  
• Resolution of the merchant class actions associated with card misclassification litigation may reduce future legal expenses and settlement costs, improving the company's net income by decreasing unexpected operational expenses.
  
• The pending merger with Capital One is anticipated to bring strategic benefits, operating scale, and improved financial metrics, which may lead to revenue growth and enhanced net margins through synergies and increased market share.
  
• A disciplined approach to deposit pricing leading to a modest reduction in average deposit rates aligns with cost management strategies, potentially improving net interest margins by reducing the cost of funds.
  
• Discover's updated guidance, including a change in net interest margin range reflecting higher card yields and the impact of the student loan sale, suggests an expectation of improved earnings through margin expansion and effective asset management.

Assumptions

• Analysts are assuming Discover Financial Services's revenue will grow by 15.8% annually over the next 3 years.
• Analysts assume that profit margins will shrink from 25.4% today to 20.0% in 3 years time.
• Analysts expect earnings to reach $3.5 billion (and earnings per share of $13.7) by about October 2027, up from $2.8 billion today. However, there is a considerable amount of disagreement amongst the analysts with the most bullish expecting $4.1 billion in earnings, and the most bearish expecting $3.0 billion.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 13.8x on those 2027 earnings, up from 13.1x today. This future PE is greater than the current PE for the US Consumer Finance industry at 10.0x.
• Analysts expect the number of shares outstanding to grow by 0.32% per year for the next 3 years.
• To value all of this in today's dollars, we will use a discount rate of 7.54%, as per the Simply Wall St company report.

Risks

• The pending merger with Capital One introduces uncertainty around integration costs and potential culture clashes, which could affect Discover's net margins and overall financial health if not managed effectively.
  
• Regulatory penalties related to the card misclassification issue imply ongoing legal and regulatory risks, potentially reducing earnings through unexpected costs.
  
• The decision to sell the private student loan portfolio, while simplifying operations, may limit future revenue growth opportunities in the student lending sector, affecting overall revenue.
  
• Tighter underwriting standards in response to market conditions, though prudent, could limit loan growth in the near term, impacting revenue expansion.
  
• Uncertainty around consumer spend patterns, especially with lower income households being most affected, suggests potential risks to revenue growth from Discover card sales and loan products.

Valuation

• The analysts have a consensus price target of $152.58 for Discover Financial Services based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $170.0, and the most bearish reporting a price target of just $135.0.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be $17.3 billion, earnings will come to $3.5 billion, and it would be trading on a PE ratio of 13.8x, assuming you use a discount rate of 7.5%.
• Given the current share price of $147.14, the analyst's price target of $152.58 is 3.6% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.