Discover Financial Services (NYSE: DFS) reported a loss of $1.20 per share in the second quarter, compared to a loss of $0.25 per share in the first quarter of 2020. Heightened provision expense was the major contributor to the first half’s losses. I’m expecting the bottom line to become positive again in the second half of the year, as the worst of the provisioning appears to be over.

The economic forecasts that management incorporated in the loan loss reserves for the second quarter appear stressed enough to cover loan impairments in the year ahead. Additionally, the loan balance is likely to recover from the first half’s dip in the latter part of the year. I’m expecting sales volume in the services and gas segments to gradually improve as economic activity picks up.

Overall, I’m expecting DFS to report earnings of $2.86 per share in the second half of the year and $1.40 per share in full-year 2020. I’m expecting the market to remain cautious until the bottom line turns positive; hence, I’m expecting the stock price to remain subdued until at least the next earnings announcement. As a result, I’m adopting a Neutral rating on DFS.

Provisions Expense Seems to Have Peaked in the Second Quarter

DFS reported a provision expense of $2.0 billion in the second quarter, up from $1.8 billion in the first quarter of 2020. Company management considered forecasts for unemployment and GDP to determine the provisioning requirement for last quarter, as mentioned in the second quarter’s conference call and 10-Q filing. Management assumed an unemployment rate of 16% this quarter, recovering to just under 11% at the end of 2020. Additionally, it assumed a slow recovery in the labor market over the next few years, as mentioned in the conference call. Further, management assumed a GDP decline of 10% year over year this quarter.

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The allowances for loan losses made up 9.2% of total loans at the end of the last quarter, which is quite high from a historical perspective. The chart below shows that the current allowances-to-total loans ratio is even higher than the ratio during the 2008-2009 crisis.Discover Financial Allowances to Credit Losses

As the economic forecasts appear reasonable in the current economic environment, and the loan loss allowances appear high enough from a historical perspective, I believe another sizable reserve build will not be required in the year ahead. I’m expecting the first half’s reserve build to cover most of the charge-offs in the year ahead that will be triggered by the pandemic. As mentioned in the conference call, management expects elevated charge-offs in the fourth quarter and 2021. Further, it expects the charge-offs to peak in the latter part of 2021 and then decline in 2022.

Considering the above factors, I’m expecting DFS to report a provision expense of $5.9 billion in 2020, up from $3.2 billion in 2019.

Economy Reopening to Help the Loan Balance Recover

DFS’s loans declined by 5.9% in the second quarter, following the 7.3% decline in the first quarter of 2020, on a linked-quarter basis. The plunge in sales volume amid the COVID-19 pandemic was a major contributor to the loan decline. As mentioned in the second-quarter investor presentation, total sales volume declined by 16% year over year in the second quarter on the back of weakness in the gas, restaurant, and travel segments. Additionally, network volume declined by 3% year over year in the second quarter.

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The loan balance will likely recover in the year ahead as the economy gradually recovers from the lockdown. However, consumers will likely remain cautious until a COVID-19 vaccine become widely available. Consequently, I’m expecting travel and restaurant segments to remain subdued while other categories recover. Overall, I’m expecting DFS to end the year with a loan balance of $82.8 billion, up 2.5% from the end of June 2020 and down 10.5% from the end of last year. The following table shows my estimates for loans and other balance sheet items.

Discover Financial Balance Sheet Forecast

Expecting the Bottom Line to Return to Profit

Due to the expected decline in provision expense and an increase in loan balance, I’m expecting DFS’s bottom line to become positive again in the remainder of the year. Additionally, management expects its cost-control efforts to reduce operating expenses by $400 million in 2020. Considering these factors, I’m expecting DFS to report earnings of $2.86 per share in the second half of 2020, leading to full-year earnings of $1.40 per share. The following table shows my estimates for income statement items.

Discover Financial Income Forecast

June 2021 Target Price Suggests a High Upside

I’m using the historical price-to-book-value multiple (P/B) to value DFS. The stock traded at an average P/B multiple of 2.09 in 2019 and the first half of 2020. Multiplying the June 2021 forecast book value per share of $31.9 with the average P/B multiple gives a target price of $66.6 for the mid of next year. This target price implies an upside of 33% from DFS’s August 6 closing price. The following table shows the sensitivity of the target price to the P/B multiple.

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Discover Financial Valuation Sensitivity

Apart from the upside, DFS is also offering a modest dividend yield of 3.5%, assuming the company maintains its quarterly dividend at the current level of $0.44 per share. The earnings and dividend estimates suggest a payout ratio of 31% for the second half of this year and 29% for the first half of 2021, which is easily sustainable. Hence, I’m not expecting a dividend cut.

Expecting the Stock Price to Remain Subdued

DFS’s earnings in the coming quarters will hinge on provision expense, which is difficult to forecast because of the uncertainties related to the depth and duration of the COVID-19 pandemic. If the pandemic lasts longer than expected, then the provision expense can exceed its estimate. I’m expecting the market to remain cautious about DFS until the company posts a quarterly profit and shows that the worst of the provisioning is indeed over. Consequently, I’m expecting the stock price to remain subdued until at least the next earnings release. As a result, I’m adopting a Neutral rating on DFS.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article is not financial advice. Investors are expected to consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.



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