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 had shares surge this year as loan losses remain at historic lows and it has made 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, beating analysts' estimates of $1 per share.
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 down 1.9% at $32.20 in premarket 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.
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."
