(DFS) Discover Financial Services’ Profit Rockets Up

Discover Financial Services’ (DFS) second quarter earnings per share of $1.09 came in dramatically ahead of both the Zacks Consensus Estimate of 72 cents and 33 cents recorded in the year-ago quarter. Net income spiked substantially by over 132% year over year to $600 million from $258 million.

Net income allocated to common shareholders also surged to $593 million from $185 million in the year-ago quarter. Results included contributions from The Student Loan Corp (SLC) acquisition.

The surge in profits was due to strong volumes complemented by lower interest expense, dramatic decline in provision for loan losses and delinquency rates based on improved credit quality, as well as escalated income from both direct banking and payment services business, which also drove the book value per share. However, these were partially offset by higher-than-expected operating and tax expenses.

Total revenue, net of interest expense, increased 4.6% year over year to $1.74 billion, also exceeding the Zacks Consensus Estimate of $1.23 billion. Net interest income increased 4.0% year over year to $1.19 billion.

The growth resulted from higher loan balances from SLC acquisition and lower funding costs, partially offset by lower yields on credit cards. Net interest margin remained flat year over year at 9.15%.  However, total operating expenses also increased 23.5% year over year to $635 million.

Direct Banking Segment

The Direct Banking segment reported a pre-tax income of $833 million, reflecting a 116% year-over-year growth from $386 million in the year-ago quarter. The pre-tax income in the reported quarter included $25 million from SLC. Discover card sales volume grew 9% year over year with $25 billion in volume, primarily due to improved consumer spending and merchant acceptance.

Total loans improved 5% year over year to $52.5 billion, driven by an increase of $3.7 billion in private student loan portfolio and $640 million in personal loans. This was partially offset by a decline of $367 million in credit card loans from the prior-year quarter. Alongside, the increase in student loans included $3.1 billion from SLC acquisition.

Other income also improved 5% year over year to $22 million, primarily due to transition services revenue related to the SLC acquisition. This was partially offset by a decline in late fees and the discontinuance of over-limit fees beginning in February 2010.

The credit card net charge-off rate declined 355 basis points (bps) year over year and 95 bps from the prior quarter to 5.01%. Moreover, the over-30-days delinquency rate was 2.79%, substantially improving by 206 bps year over year and 80 bps sequentially, reflecting an overall better credit trend since the fourth quarter of 2009.

Provisions for losses dramatically declined $548 million year over year to $176 million, reflecting lower charge-offs and a reduction in the allowance for loan losses. The trend also contributed to a reserve release of $401 million in the reported quarter, against the reserve addition of $277 million in the year-ago quarter.

Additionally, expenses in the segment soared 25% year over year to $119 million based on higher litigation, marketing, advertising and compensation expenses along with higher costs for recovering charged-off accounts and expenses related to SLC.

Payment Services Segment

The Payment Services segment’s pre-tax income grew 19% year over year to $43 million. Revenues were up $9 million, reflecting an increase in transactions and higher margin volume on the PULSE ATM/Debit network coupled with increased volumes from new and existing clients.

Payment Services dollar volume accelerated 24% from the year-ago quarter to $45.9 billion, reflecting higher PULSE, Diners Club International and third-party issuer volume. The number of transactions on the PULSE network increased 25% year over year due to increased transactions from new and existing clients.

Business Update

On May 12, 2011, Discover announced a definitive agreement to acquire substantially all of the operating and related assets of Home Loan Center, a subsidiary of Tree.com Inc., for approximately $55.9 million. The acquisition will add a residential mortgage component to Discover’s direct-to-consumer banking business.

The company intends to initiate eligible consumer mortgages to sell in secondary markets, primarily on a servicing-released basis. The acquisition is expected to culminate by the end of 2011, subject to closing conditions and approvals from regulators and investors of Tree.com.

Share Repurchase Update

On June 15, 2011, the board of Discover approved and authorized a two-year share repurchase program worth $1 billion with an expected expiry on June 14, 2013. Although the approval is effective immediately, the buyback of its shares will be held from time to time through open market operations, depending on the market conditions.

Dividend Update

On June 15, 2011, the board of Discover declared a quarterly dividend of 6 cents per share on its common stock, payable on July 21, 2011, to stockholders of record as on July 7, 2011. During the first quarter, the company had increased its dividend from 2 cents per share, paid until the fourth quarter, in order to restore its dividend payout to the pre-financial crisis level.

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