Discover Financial Services (DFS) reported second-quarter 2012 earnings per share of $1.00, a penny ahead of the Zacks Consensus Estimate but lower than $1.09 recorded in the year-ago quarter.

Net income declined 10.5% year over year to $537 million from $600 million. Net income allocated to common shareholders also declined to $532 million from $593 million in the year-ago quarter.

The decline in profits resulted from lower reserve releases, which offset revenue growth and higher interest income. Results were also affected by higher expenses and a decline in the pre-tax income from the Direct Banking segment.

Total revenue, net of interest expense, increased 6.3% year over year to $1.85 billion. Net interest income also improved 10.2% year over year to $1.32 billion. However, total other expenses jumped 18% year over year to $749 million.

Direct Banking

The Direct Banking segment reported pre-tax income of $820 million, reflecting a $63 million decrease from the year-ago quarter. Discover card sales volume grew 5% year over year to $26.1 billion.

Total loans improved 9% year over year to $57.1 billion, boosted by an increase of $1.6 billion in credit card loans, $2.9 billion in private student loans (including purchase of a $2.4 billion loan portfolio in the fourth quarter of 2011) and $703 million in personal loans.

Other income decreased 4% year over year, primarily due to lower late fee assessment, protection products revenue as well as transition services revenue in connection with the acquisition of Student Loan Corporation. Additionally, expenses in the segment enhanced 18% year over year based on higher reserves related to litigation.

The credit card net charge-off rate declined 222 basis points (bps) year over year and 28 bps from the prior quarter to 2.79%. Moreover, the over-30-days delinquency rate was at an all-time low of 1.91%, having witnessed a substantial 88 bps decrease year over year and 31 bps sequentially, reflecting an overall better credit trend since the fourth quarter of 2009.

The provisions for losses surged 32% or $56 million year over year to $232 million, reflecting lower reserve release, which was partly offset by lower charge-offs. Reserve release was $110 million in the reported quarter, as opposed to $401 million in the year-ago quarter.

Payment Services

The Payment Services segment’s pre-tax income grew 10% year over year to $47 million. Revenues were up $10 million, reflecting an increase in point-of-sale transactions on the PULSE network, which carry a higher margin, and higher third-party issuer volume, partly offset by increased incentives.

Moreover, expenses increased $6 million from the year-ago level. Payment Services dollar volume accelerated 12% from the year-ago quarter to $51.4 billion, reflecting higher PULSE and third-party issuer volume.

Share Repurchase Update

During the reported quarter, Discover repurchased 13.5 million shares for $447 million under its $2 billion share repurchase program.

Our Take

Discover has been generating exceptional card sales volume over the past few quarters, owing to improved consumer spending and credit quality trends. Moreover, operating performance of the Payment Services segment was impressive, which contributed to the bottom-line growth. Also, the company has a strong inorganic growth policy, which apart from boosting earnings also fosters portfolio diversification.

However, the expenses of Discover have been rising due to higher compensation and benefit expenses, infrastructure development and growth initiatives. Moreover, the company expects its litigation expenses to rise, and has been strengthening its reserves for this reason.

Nevertheless, the remarkable improvement in credit quality makes us optimistic about Discover’s future earnings. Additionally, the company’s extensive network, sound capital position and cost containment initiatives are expected to accentuate growth over the long term.

Discover competes with other card companies like MasterCard Inc. (MA) and Visa Inc. (V). Currently, the company caries a Zacks #2 Rank, implying a Buy rating in the short term.

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