--Loan-loss provision up as balances increase
--Total loans increase 8.6% to $57.06 billion
--Expenses increase primarily due to higher legal-reserve
expense
(Updates with details about expenses in paragraph five, details
about legal reserves in paragraph six and analyst comment in
paragraph 22.)
By Andrew R. Johnson
Discover Financial Services' (DFS) profit declined 11% in the
fiscal second quarter as it set aside more money to cover future
loan losses, offsetting an increase in loan balances.
The Riverwoods, Ill., lender, known for its cash-back rewards
program and orange logo, has seen its shares surge this year as
loan losses remain historic lows and it has struck new deals to
expand its international presence.
But executives have said they expect to set aside more money to
cover loan losses, known as a provision, as customer loan balances
increase.
Discover said Tuesday its net income was $537 million, down from
$600 million a year earlier. On a per-share basis, Discover earned
$1, down from $1.09, in line with analysts' estimates of $1 per
share.
The results were also affected by an 18% increase in expenses
from the prior year, which Discover said was primarily due to the
addition of $90 million in legal reserves during the quarter.
The company did not say what drove the increase in legal
reserves, but earlier this year Discover said it expected the
Federal Deposit Insurance Corp. and Consumer Financial Protection
Bureau to file a joint enforcement action against it over its
marketing of add-on products, including a payment protection plan
it advertises as a way to help borrowers meet their debt
obligations in the case of a job loss or other hardship event.
Expenses increased 6% excluding the increase in legal-reserve
expenses, the company said.
Discover, like American Express Co. (AXP), is both a lender to
cardholders and a processor of transactions, which means it earns
interest on loan balances and fees each time a card is swiped at a
merchant. By comparison, Visa Inc. (V) and MasterCard Inc. (MA)
only process transactions and partner with banks, which issue their
cards and lend to consumers.
Spending by its cardholders increased 5.1% to $27 billion. It
ended the quarter with $46.6 billion in credit-card loans, up 3.7%
from a year earlier and up 1.5% from the previous quarter.
Provision for loan losses was $232 million, up from $176 million
a year ago and $152 million in the prior quarter.
Discover's shares were up 1.6% at $33.36 in early trading. Its
shares are up more than 36% this year.
As the sixth-largest credit-card lender by spending, Discover
has been seeking growth in new areas as it looks to position itself
as more of a full-service bank. Last week it debuted Discover Home
Loans, its online mortgage business through which it intends to
originate home loans and sell them to investors. The company has
targeted $30 billion in mortgage originations as a long-term annual
goal.
The company has also expanded into personal loans and private
student lending, an area that has attracted investor concern as
expectations for regulatory changes in the market grow.
"We believe these new products lay a foundation for additional
revenue and asset growth in the future," David Nelms, chairman and
chief executive officer of Discover, said in a statement.
The company on Tuesday reported its total loans rose 8.6% from
the prior year to $57.06 billion.
Discover ended the quarter with $7.5 billion of private student
loans, up 64.3% from a year earlier and down slightly from the
previous quarter. Personal loans totaled $2.9 billion, up 31.8%
from a year earlier and up 4.7% from the previous quarter.
Investors are also focused on how the expansion will affect
Discover's net interest margin, a measure of lending profitability.
The interest yield on private student loans is about half that of
credit cards.
However, Discover said its net interest margin increased to
9.31% in the quarter, up from 9.15% a year earlier and from 9.03%
in the previous quarter. The company attributed the increase to
lower funding costs for its loans.
The push into new areas also gives Discover another avenue for
growth at a time when credit-card borrowers are have been loathe to
wrack up new debt. Loan growth has been tepid at best for most
issuers.
However, credit quality remains strong despite growing concerns
about a weakening U.S. employment market and a deepening economic
crisis in Europe.
Its overall credit quality remained strong, with its delinquency
rate declining to 1.81%, down from 2.08% in the previous quarter
and down from 2.68% a year earlier. Its net charge-off rate was
2.42%, down from 2.64% from the previous quarter and down from
4.42% a year earlier.
Discover "posted another solid quarter that exceeded our
expectations," Sanjay Sakhrani, an analyst with Keefe, Bruyette
& Woods, wrote in a research note Tuesday. "Underlying
operating trends remain strong, with core earnings beating our
expectations, credit quality continuing to improve and a
stronger-than-expected net interest margin."
While loan quality has remained strong, industry executives have
said they expect the benefits they have enjoyed by releasing funds
set aside to cover future losses will shrink this year.
"For those investors who feel the credit-related recovery is
ending, we believe operating income growth and core profitability
warrant ownership," David Darst, an analyst with Guggenheim
Securities, wrote in a recent research note. "Additionally, we
believe [Discover] can manage risk of consumer weakness given a
quality customer base and diversification initiatives."
Saabira Chaudhuri contributed to this article.
Write to Andrew R. Johnson at andrew.r.johnson@dowjones.com