Discover Financial Services (DFS) reported a fiscal first quarter loss as the company bolstered its loan loss reserves. However, the company has received the regulatory approval to payback the $1.2 billion bailout money.

For the fiscal first quarter (ended Feb 28, 2010), Discover reported a loss of $104 million or 22 cents a share. The figure includes a pre-tax addition to loan loss reserves of $305 million ($185 million after tax). This brings its reserve coverage to approximately a year of losses. This compares with the Zacks Consensus Estimate of earnings of 4 cents.

The company reported a profit of $120 million or 25 cents per share in the prior-year period. However, that result included an approximate $297 million after-tax gain related to the Visa/MasterCard antitrust litigation settlement.

Discover’s banking unit, Discover Bank, will offer $350 million in the form of subordinated debt prior to the redemption of the $1.2 billion of preferred stock it issued to the U.S. Treasury under the TARP Capital Purchase Program. The offering is expected to be completed during the second quarter. The company does not expect to make any equity raise for the repayment.

Discover’s deposit balances originated through direct-to-consumer and affinity relationships were $14.8 billion, an increase of $2.3 billion from the prior quarter.

Segment Results

The Direct Banking segment reported a pre-tax loss of $208 million, reflecting a $135 million improvement from the prior-year period on an adjusted basis. Loans declined 2% year-over-year to $50 billion. Though student loans increased $2 billion to $2.8 billion, this was offset by a decrease in credit card loans, which decreased $3 billion to $45.8 billion.

Decrease in credit card loans reflect the decline in balance transfer volume, which was down 53% from the prior-year quarter as the company reduced its marketing of promotional rate balance transfer offers. However, it was partially offset by a 5% year-over-year increase in Discover Card sales volume.

The net charge-off rate rose 8 basis points (bps) sequentially and 203 bps year-over-year to 8.51%, reflecting higher levels of consumer bankruptcies and unemployment. However, the higher mix of student loans, which have a lower charge-off rate, provided some relief. Management expects a second-quarter charge-off rate of between 8% and 8.5%.

The over-30-days delinquency rate was 5.05%, an improvement of 26 bps from the prior quarter and 21 bps from the prior-year quarter, reflecting better overall credit trends. Provisions for losses declined to $1.38 billion from $1.48 billion in the prior-year quarter. The allowance for loan losses increased $805 million from the prior year and $305 million from the prior quarter on an adjusted basis to $4.2 billion.

The company also reported a 15% year-over-year decline in expenses to $446.3 million. The decrease resulted from the implementation of the cost containment initiatives and lower marketing expenses. Additionally, the company experienced a $23 million benefit from the settlement of the Morgan Stanley (MS) special dividend agreement dispute.

The Payment Services segment’s pre-tax income grew $8 million or 28% year-over-year to $37 million. Revenues rose $5 million or 8% year-over-year to $65.5 million, reflecting an increase in transactions and higher margin volume on the PULSE network and lower incentive payments. Expenses were also down $3 million or 10% from the prior-year period $28.5 million.

Payment Services dollar volume increased 2% from the prior-year period to $36 billion. Third-Party Issuer dollar volume was up 15% while Diners Club dollar volume increased 4% from the prior-year period. Dollar volume on the PULSE network increased 1% while the number of transactions on the PULSE network increased 5% year-over-year to $720 million due to increased transactions from new and existing clients.

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