2023-07-22 03:44:56 ET
Summary
- Discover Financial Services' stock dropped by 15.92% after revealing it had been misclassifying certain credit card accounts and charging merchants higher fees than agreed.
- The company has set up a $365 million liability for refunds and compensation to overcharged merchants, and paused its share buybacks under its $2.4 billion authorization.
- This is the second compliance issue Discover has faced in less than a year, raising concerns and uncertainties that could affect the stock in the coming months.
- Competition for deposits is heating up, crimping DFS's net interest margins as it's forced to pay up for funding.
- While the stock looks cheap on forward earnings, estimates are likely to fall after earnings this week and the stock has significant downside risk to $80.
Less than a month ago on June 26, 2023, I wrote a bearish piece for Seeking Alpha covering credit card giant Discover Financial Services ( DFS ) titled Discover Financial: Goldilocks Lost .
After the market close on July 19 th , DFS reported second-quarter earnings results and the stock dropped 15.92% on Thursday, July 20 th , its first trading day after the release. That's Discover's largest single-day decline in about three years.
The company missed Wall Street consensus earnings estimates for Q2, reporting $3.54 in earnings per share against the $3.71 Wall Street had expected. However, earnings weren’t the biggest catalyst for the sell-off – DFS also revealed, starting in mid-2007, it has been misclassifying certain credit card accounts, charging merchants higher fees than agreed for processing Discover-branded cards.
As a result of this misclassification, the company has set up a $365 million liability to provide refunds and compensation to merchants overcharged on fees, has launched an internal investigation, and paused share buybacks under its $2.4 billion share buyback authorization due to expire at the end of June next year.
And while the compliance issue was the main driver of the post-earnings sell-off in DFS, and the topic of considerable discussion during the Q&A session of the quarterly call, DFS also lowered guidance for net interest margins (NIMs) for the year. That’s due, in large part, to a rise in deposit costs, which is one of the downside risks I flagged in my article last month.
After Thursday’s drop, DFS trades at about 7.7 times consensus earnings estimates for 2023, which looks inexpensive given the company’s historic valuation range. However, I see the stock as a value trap at the current time and see a downside risk to around $80.
Let’s start with this:
Compliance Issues at DFS
As I indicated above, DFS reported it started misclassifying certain card accounts in mid-2007, resulting in overcharging merchants on processing fees.
The good news is the resulting error over this 16-year period amounts to less than 2 basis points (0.02%) of sales, so it’s immaterial to financial results for all financial reporting periods since that time and won’t require the company to restate results.
In addition, the excess fees charged relate only to merchants, not cardholders.
While the $365 million liability DFS set up to reimburse merchants is a sizable sum, it’s manageable at less than 11% of the expected net income for 2023.
However, I believe this revelation gives rise to multiple concerns and uncertainties that will weigh on the stock in the coming months.
First, this is the second compliance issue DFS has faced in less than a year.
One year ago, on its Q2 2022 earnings conference call, DFS announced it launched an internal investigation into loan servicing practices and regulatory compliance related to its roughly $10 billion private student loan portfolio. Pending the results of that investigation, the company also temporarily paused its share buybacks, sending the stock down more than 7% on the trading day after the release.
In a November 2022 8-K filing with the SEC, DFS announced that it had concluded the investigation and would resume its share buybacks even though it was still in communication with staff at its regulators and might be subject to additional official reviews and investigations.
Of course, the card misclassification issue announced this month relates to the company’s much larger credit card business.
And that’s not all.
DFS also announced it has received a proposed consent order from the Federal Deposit Insurance Corporation (FDIC) tied to consumer compliance issues unrelated to this misclassification issue. Consent orders normally involve an agreement between a company and its regulator to pay a fine, step up compliance efforts or address what the regulator deems unsafe banking practices.
Sometimes consent orders even impact a company’s ability to return capital to shareholders via repurchases or dividends.
CEO Roger Hochschild had this to say during the company’s prepared remarks on the call:
While the financial impacts of this misclassification are not material, it underscored deficiencies in our corporate governance and risk management. We're in discussions with our regulators regarding these matters. We have received a proposed consent order from the FDIC in connection with consumer compliance, which does not cover the misclassification topic. We believe additional supervisory actions could occur.
Source: Seeking Alpha Earnings Q2 2023 Call Transcript
In short, it’s clear this isn’t just an isolated incident or one related solely to its ancillary student loan portfolio. Rather, the company has stated there are deficiencies in its governance and risk management practices that need to be addressed and that additional actions from regulators are likely.
Since it’s an active regulatory action, management was unable to offer much additional detail on the consent order it received from FDIC or the sort of remedies they might be forced to accept.
Also, critically, DFS was unable to offer specific guidance as to how long the card misclassification issue would take to resolve, or when it might be able to resume share buybacks. As you might expect, analysts on the call tried to tease some additional detail out of the company in multiple different ways but were largely unsuccessful.
The one comment the CEO made was that there’s a link between last year’s student loan compliance issues, the card classification issue, and the company’s broader compliance and risk management issues referenced in the quote above.
At a minimum, this revelation will act as a headwind, and a source of uncertainty, for DFS stock until there’s some concrete announcement regarding the consent order with FDIC or a resumption of share buybacks following an internal investigation of the card misclassification issue.
Last year, the company paused share buybacks for a total of about 4 months from July to November while it took steps to investigate its student loan compliance issues.
The result was noticeable but manageable:
As you can see, DFS has been repurchasing significant shares each quarter from Q1 2021 to date, but the drop in the share count slowed temporarily between Q2 and Q3 2022 due to the pause in buybacks following the student loan issue.
There’s no way to know at this time how long the current pause will last. However, according to Bloomberg, the consensus on Wall Street heading into the release this week was that DFS’s share count would drop from around 250 million today to a little over 240 million by the end of this year and 233 million by Q2 2023.
Of course, earnings per share ((EPS)) is defined as income divided by shares outstanding, so share buybacks have the effect of reducing the denominator of that equation and boosting EPS. The roughly 6% to 7% decline in the share count analysts had expected through to the middle of next year was a tailwind for EPS estimates that’s now in question.
A short pause in share buybacks like we saw last year would have only a minor impact on the outlook for EPS; however, if the company is forced to pause or slow buybacks over a longer time to address compliance issues the impact could be more meaningful.
And it’s likely to be months before we have additional clarity on this issue.
There’s an additional real economic impact in the form of higher costs. In Q2 2023, the company’s operating expenses jumped $181 million year-over-year to $1.404 billion, up 15% year-over-year and 2% compared to Q1 2023. During the call, management noted the primary driver of this increase was a jump in expenses related to its compliance management systems, a direct result of the compliance weaknesses management has identified.
Further, DFS announced it now expects operating expenses to rise in the low double-digits this year compared to prior guidance for a less than 10% increase. During the call, the company clarified that guidance saying it sees compliance and related costs up around $200 million from 2022 to 2023 with an elevated level of spend continuing into 2024.
One more exchange during the company’s Q2 Conference Call Q&A caught my eye:
Question : A follow-up just on compliance having followed Discover for a very long-time. Coming out-of-the great financial crisis, there was a lot -- big investment in compliance across the industry, including at Discover, has it become more difficult. I mean, I know there's been a number, quite a few consent orders put out by regulators, but has it become -- can you maybe give us some color on what you're investing in compliance today, if it's people or percentage of expenses versus historically and has it become a lot more difficult?
Answer from CEO Roger Hochschild : Yeah, it certainly is a challenging environment, but I'm not going to blame that. Right. As I look back, I do believe we under-invested. And that's something I take accountability for. But we are very focused on it now. And as John, I think highlight, that investment takes many forms, right from bringing in some highly talented folks within the compliance area, building out our monitoring and controls. Investments on the technology side to standardize, simplify, and automate manual processes. As you think about it, compliance and a lot of the folks, its risk management, right. And traditionally, we have been very strong around credit risk management, around liquidity risk management, but have not necessarily made the investments we needed, especially as the complexity of our business increased, as we got into more new products. I think there was a gap there in terms of our capabilities and that's what we're focused on now.
Source: Seeking Alpha Discover Q2 2023 Conference Call Transcript
This question hints at the potential for the relationship between financial companies and regulators to become more hostile as was the case following the Great Recession and financial crisis of 2007-09. Certainly, the regional banking crisis earlier this year and the associated collapse of Signature Bank and SVB Financial has prompted calls from Washington for greater regulation and higher capital requirements.
CEO Hochschild allowed that the current environment is “challenging.” He then went on to do a “mea culpa,” taking the blame for the fact DFS underinvested in technology and compliance-related systems as its business grew more complex over the years.
The current CEO, Roger Hochschild, has served in that role since 2018 and, before that, he was COO of DFS from 2004 through 2018. So, he’s experienced and, over the years, DFS has been an outstanding performer and one of the more efficient operators in the business. So, the quality of management leads me to believe the company will address compliance inadequacies over time.
However, at a minimum, DFS is looking at a quarter two of reduced (or non-existent) share buybacks, increased expenses, and potential regulatory fines or restrictions in an environment where regulators are seemingly becoming more aggressive towards the industry.
The fact this is the second time in a year DFS has opted to pause buybacks to address a compliance issue clearly raises risks.
That’s a lot of uncertainty and a significant headwind for the stock, especially at a time in the economic cycle when there are already concerns about net interest margins and credit quality. I believe these latter issues could ultimately prove more serious than the compliance and regulatory challenges DFS currently faces.
And that brings me to this:
Rising Deposit Costs
Discover is a bank in the business of taking in deposits from customers and loaning that money back out, primarily in the form of credit cards but also personal and student loans.
Net interest income ((NII)) represents the total amount of income DFS generates in interest charges less interest paid out to depositors. The Net Interest Margin ((NIM)) represents DFS’ profit margins – it’s the company’s net interest income divided by average loan balances (or average earning assets).
Here’s a look at NIMs over the past few years:
In Q4 2022 last year, DFS’ reported NIM – based on NII divided by average loans balance -- was 11.27%, rising to 11.34% in Q1 2023. Prior guidance from DFS was for NIM to be “modestly higher” in 2023 vs the full year 2022 (11.04% for the full year). As you can see, DFS NIM dropped to 11.06% in Q2, and management has adjusted its guidance to “around 11%” for full-year 2023.
There are two main drivers of NIM – the interest charged on loans and the interest paid on deposits. Both have contributed to the deterioration in DFS NIM guidance for 2023 though it seems the deposit side of the equation was the bigger mover.
Here’s the problem:
This chart shows the company’s funding mix in Q2 2023. As you can see, about two-thirds of funding came from direct customer deposits, which represents consumers opening checking or savings accounts with DFS. Three years ago, direct customer deposits accounted for just over half total funding.
This is generally the cheapest and most stable source of funding for DFS and, over time, management has said it targets 70% to 80% of its funding mix from deposits.
Unsecured borrowing represents borrowing primarily on the interbank market. Generally, this source of funds carries a higher cost and is less stable – for example, this market completely dried up at times back in the financial crisis of 2007-09 leading to liquidity issues at banks too exposed to this source of funding. Fortunately, unsecured lending only accounted for about 7% of funding in Q2.
Securitized borrowing represents DFS packaging portfolios of credit card receivables into securities for sale to other financial institutions or investors in much the same way as banks package portfolios of mortgages into mortgage bonds. Selling these securities generates capital to fund DFS operations.
Finally, there’s brokered deposits at 18% of funding. A deposit broker is a third party that acts as an intermediary between depositors and a bank. The bank generally sells large deposits to the broker who then divides these deposits into smaller chunks for resale to individuals or smaller banks.
It’s an easy way to increase funding; however, the problem is that brokered deposits are generally extremely rate-sensitive – these are individuals looking to earn a slightly higher yield on their deposits with no long-term relationship or loyalty to the bank accepting their funds. While consumers with checking or savings products are “sticky” because they’re loathe to move their money for a few basis points of extra yield, that’s not true for brokered deposits.
Two points here are worrisome in my view.
First, while DFS’ funding mix is healthy at the moment, the direct-to-consumer deposit share was 70% in Q2 2022, and brokered deposits were just 11% compared to 66% and 18% respectively today. So, DFS is clearly relying more on higher-cost deposits for funding than it was in the same quarter last year.
Further, while direct-to-consumer deposits are more stable and generally cheaper, that doesn’t mean costs aren’t rising. In Q2 2023, DFS noted its net funding rate – basically the cost of all these sources of funding – was up 39 basis points (0.39%) quarter-over-quarter primarily driven by consumer deposit pricing.
As I explained in my June 26 th article on DFS, the yield on most money market funds is north of 5% r and 3-month Treasury Bills yield 5.4% right now. That compares to less than 2.5% for both money market funds and T-Bills one year ago in July 2022, so depositors have plenty of low-risk, or risk-free, ways to generate solid yields with their excess cash.
To attract deposits banks like DFS must offer competitive yields and that spells rising costs of customer deposits and overall funding.
Here's what CFO John Greene had to say about deposit costs during the DFS Q2 2023 call:
Second, in terms of deposit competition, we had said that we thought that the beta would come in somewhere around 60% to 70%. What we've seen in late in the first quarter and into this quarter was our competitive set being more aggressive in terms of price increases. And as I've communicated in the past, we don't seek to be a price leader here. We try to compete on our brand, our customer offering, our digital assets that are first class in order to attract deposit customers. And we've been very successful as you can tell by the numbers there. But part of the proposition is also price. So what we're seeing now is betas likely to be north of 70% which is impacting net interest margin to the extent I just talked about in the guidance point. So those two factors are playing most substantially on the revised outlook.
The term “deposit beta” refers to the sensitivity of a bank’s deposit costs to short term interest rates.
As a rough example, suppose the Fed were to raise interest rates by 100 basis points (1%) over the course of a quarter and a bank raises deposits by 50 basis points (0.50%) over the same time period. That would imply a deposit beta of about 50%.
So, what DFS is saying here is that their prior guidance was for a 60% to 70% deposit beta relative to increases in short term interest rates and now they’re looking for “north of 70%.” That’s a major reason they cut their net interest margin guidance.
This is to be expected. When rates were ultra-low back in early 2022 and the Fed was creating deposits in the banking system via quantitative easing, there was little competition for deposits. Today, as the rate cycle has matured and rates are rising, consumers have begun to recognize their high-yield alternatives and banks are forced to raise rates to retain deposits.
Even JPMorgan Chase ( JPM ) recognized this risk in their Q2 2023 call on Friday July 14th:
Question : Good morning. So I mean in your camp that eventually consumers will want more deposit rate sensitivity here, but I guess what would make you change your rates meaningfully? So the top two banks have about 50% consumer market share, loan-to-deposit ratios are low, your outlook for loan growth, and I think others, it's fairly sluggish, at least outside of card. So I get that it's common sense and that's what we've seen historically, but there really is this kind of big divergence among big banks and everybody else where the big banks just don't need to pay that much for deposits for a slew of reasons. So what would make you change that?
Answer, Jamie Dimon, CEO JP Morgan : I think every bank is in a different position about what they need. And so you have a whole range of outcomes. But remember, we do this also by city. So you have different competition in Arizona and Phoenix than you have in Chicago, Illinois. And we do have high interest rate products. So it's a combination of all those things. I wouldn't call it a big bank or a small bank. And you're going to see whenever we report who kind of paid up a little bit more for things and who didn't and things like that. So look, guys, I would take it as a given. I think it's a mistake. There is very little pricing power in most of our business and betas are going to go up. You take it as a given. There is no circumstance that we've ever seen in the history of banking where rates didn't get to a certain point that you had to have competing products. And rates go from migration or direct rates or movement to CDs or money market funds and we're going to have to compete for that. You already see it in parts of our business and not in other parts.
Source: JP Morgan Q2 2023 Conference Call Transcript
Turmoil in the regional banking system earlier this year caused a shake-up in the US deposit market. While the FDIC eventually stepped up and guaranteed all deposits for SVB Financial and Signature Bank, there were fears back in March uninsured depositors – those with deposits above the $250,000 FDIC insurance cap– could lose their funds as banks failed.
Larger banks like JP Morgan are known as systemically important financial institutions (SIFIs) and are subject to much more stringent regulations and capital requirements than smaller regional institutions. They're considered “too big to fail.”
Thus, turmoil in the regional banks prompted some customers to remove deposits from regional banks and relocate their cash to SIFIs like JPM that are considered safer:
Every Friday evening after the 4:00 PM Eastern stock market close, the Federal Reserve releases its H.8 report that details all assets and liabilities held in the US banking system.
The chart above shows total deposits held at domestically chartered US banks since the end of 2020 broken down by the largest US banks and smaller institutions.
Deposits across the entire banking systems have been falling since the spring of 2022 as the Federal Reserve began quantitative tightening (QT); indeed, draining deposits is the purpose of QT. However, you can see the sharp drop lower in deposits at smaller banks in March contemporaneous with the regional banking crisis.
Deposits held by larger banks have remained relatively flat since that time because some of the deposits fleeing regionals simply was placed on deposit at larger banks like JPM.
My point is that if JPM faces rising costs to attract deposits, the situation is even worse for smaller institutions like DFS. And CEO Jamie Dimon makes it abundantly clear that’s what’s happening – he tells the analyst asking the question to “take it as a given” that deposit betas will rise as competition for deposits heats up.
Valuations, Target and Risks
DFS, like all financials, is a cyclical company with significant leverage to economic conditions and the credit cycle.
In the last cycle from roughly 2011 through 2019, DFS traded in a range from about 6.75 times to 12 times forward earnings estimates as I outlined in my June article here. As of Thursday’s close, DFS sold for about 7.7 times forward earnings estimates, near the low end of that historic mid-cycle range.
However, don’t be fooled, I believe DFS represents a value trap at the current price.
First, the pause the share buybacks of indeterminate length represents a meaningful deterioration in the outlook for earnings per share in 2023 and 2024 for the simple reason that a higher share count reduces the denominator of the net income/shares outstanding calculation. As analysts revise lower their EPS estimates for 2023/24 accordingly that will have the effect of boosting DFS's forward valuation multiple on a P/E basis.
Second, while the focus of the DFS call was the company’s compliance issues, the related duration of the pause in buybacks, and potential regulatory fines or restrictions, I believe the bigger issue over the intermediate term is likely to be the turn in the cycle caused by rising deposit costs and shrinking net interest margins.
Finally, during recessions as consumer spending slows and earnings contract price-to-book is a better metric for assessing value than price to earnings. That’s because, by definition, a cyclical stock will look cheap near the highs when earnings are inflated and expensive near the lows due to depressed profitability.
In prior economic contractions, DFS has typically troughed with a price-to-book ratio under 1.25 times. Current consensus for DFS’s year-end 2024 book value is about $64 per share, so that equates to a target of approximately $80 per share, the same target I outlined at the end of last month.
That still implies significant downside for the stock even if it's able to resolve its compliance issues on a timely basis.
For further details see:
Discover Financial: Don't Fall For The Value Trap