Discover 3Q profit falls, but tops estimates

Discover Financial Services' profit fell 11 percent in the third quarter but its lucrative card processing business drove the results above Wall Street's expectations.

The profit decline reflected a big increase in its allowance for loan losses as it wrote off more loans and set aside money for loans that may go sour amid deteriorating credit market conditions.

The Riverwoods, Ill.-based company reported Thursday its net income fell to $180 million, or 37 cents per share, in the quarter ended Aug. 31, compared with net income of $202 million, or 42 cents per share, in the 2007 period.

Analysts polled by Thomson Reuters, on average, anticipated earnings of 35 cents per share.

Total revenue net of interest expense increased 8 percent to $1.25 billion from $1.16 billion.

Results were boosted by the company's third-party payments business — which processes ATM and debit transactions and other banks' cards.

The third-party payments segment produced transaction volume of $35 billion, up 48 percent from a year ago. The company said the growth was due to signing on new card issuers, as well as an increase in transaction volume from already existing issuers. Results also included $5 billion of Diners Club International volume. Discover completed its acquisition of the Diners Club brand from Citigroup Inc. in June.

Discover's U.S. card segment, meanwhile, reported a 36 percent drop in pretax income to $245 million. While total Discover card sales grew 5 percent to $24.6 billion, results were hurt by a $336 million, or 80 percent, increase to the company's provision for loan losses, due to higher net charge offs and a $113 million charge to increase its loan loss reserves.

Discover's total allowance for loan losses at period end was $959.8 million, up 53 percent from $629.5 million in the third quarter of 2007.

The charge-off rate — or the amount of loans written off as unpaid — increased to 5.28 percent from 5.05 percent in the second quarter, and from 3.67 percent a year ago.

Discover's delinquency rates, or late-payment rates, also rose.

During a conference call with investors, Chief Executive David Nelms said he has begun to see a greater percentage of delinquent accounts flow into the charged-off bucket, reflecting an increase in consumer bankruptcies and a lack of alternative forms of credit.

Nelms said an increasing number of traditionally lower-risk customers have begun to fall behind on payments.

"Part of the issue is when you get behind and have a much bigger balance, then it is harder to get back up to (being) current," Nelms said.

"We've continued to take action to reduce some exposure where appropriate," Nelms said. He added that the bank's moves haven't been "dramatic" but more on an individual basis, to ensure customers can afford the lines of credit that they have.

Total managed loans grew 6 percent to $50.4 billion from $47.4 billion in the year-ago period. Results on a managed basis are adjusted to assume loans that have been securitized were not sold.

Discover improved its liquidity position by $1.2 billion in the quarter, as deposits grew by $2 billion. The company finished the quarter with more than $5.5 billion in tangible net equity.

Discover continues to expect net charge offs to reach about 5.5 percent by the end of the fourth quarter.

Additionally, the company expects its reserve for loan losses to increase significantly next quarter, as $2.6 billion in asset-backed securities, or about 10 percent of its total ABS portfolio, matures. Executive Vice President and Chief Financial Officer Roy Guthrie said he expects some or all of the maturities to be funded through the company's deposits.

"Next quarter will likely be a fairly unique quarter," said Nelms in an interview with The Associated Press. "The level of ABS maturing is very high next quarter and pretty low all of next year." While the increase in reserves will hurt net income, Nelms said that cash flows will not be affected.

Even though Discover has been able to diversify its business, operating as both a credit lender and a card processor, it is not completely shielded from the impact of a worsening economy.

Credit trends continue to deteriorate, Nelms said, especially in troubled real estate markets like Florida and California, and that deterioration is spreading to other geographic areas. "We've not seen it peak yet," he said.

Looking ahead, consumers can expect to see the Diners Club brand on the doors of more businesses across the U.S., Nelms said. Discover expects its Diners Club business to add between $10 million and $15 million in pretax income per year.

Over the next two years, the company will work to integrate both networks, which will enable Discover card holders to use their cards at the eight million merchants that currently accept Diners Club cards worldwide, and give Diners Club members access to Discover card merchants in the U.S.

Discover shares fell 40 cents, or 2.6 percent, to close at $14.82 Thursday.

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