American Banker  |  Friday, June 27, 2008

Discover Financial Services' credit picture continued to deteriorate in its second fiscal quarter, which ended May 31.

The Riverwoods, Ill., company benefited once again from lower funding costs, though it said Thursday that credit is likely to be the more important factor in the future, because it has already gotten the benefits of recent rate cuts.

The company also touted growth in its third-party payment processing business, whose contribution to pretax earnings more than doubled from a year earlier, to 5.2% of Discover's total. The business stands to get a further boost from the deal to buy the Diners Club International network, which it expects to close next month and would give Discover a global reach.

Including loans other than card receivables, which make up about 1.5% of the $47.8 billion in managed receivables, Discover's chargeoff rate jumped 66 basis points from the first quarter and 102 basis points from a year earlier, to 4.99%.

In January it raised its projection for chargeoffs for the full fiscal year to a range of 4.75% to 5%, from a previous range of 4.25% to 4.75%. On Thursday, the projection rose again, to "somewhat above 5%."

Since the beginning of this year "gas prices have gone higher than we had anticipated," David W. Nelms, the company's chief executive, said on a conference call. "Unemployment just hit 5.5%, which was probably a faster increase than we might have anticipated," and housing prices slipped more quickly than Discover expected. "Nonetheless, I would not call our characterization" regarding a worsening credit outlook "a hugely significant move."

On Wednesday, American Express Co. warned, "So far this month we have seen credit indicators deteriorate beyond our expectations."

Mr. Nelms said, "We have not seen anything particular this month relative to the last several months. I would say with our seasoned base, one wouldn't expect any sudden change from month to month."

In an interview, he said the "biggest changes" in its credit picture came "back in the December, January, February time frame as gas prices started really rising." The new chargeoff projection was "a more modest increase in expectations than before."

Roy A. Guthrie, Discover's chief financial officer, said on the call that its 2% growth in receivables from a year earlier reflected a "focus on preserving yield in the portfolio during a period of economic weakness." Mr. Nelms said on the call that his company expected to continue to increase its receivables at about that rate in coming quarters.

The company's loans outside card accounts increased 47.5% from the first fiscal quarter and sevenfold from a year earlier, to $716.6 million. Most of the growth came from installment loans, as Discover has reined in balance transfers.

In the interview, Mr. Nelms said the installment loans are "often marketed to the same people" as balance transfers, and most have been extended to people who were already Discover customers, but typically the installment loans "would not have a promotional rate."

The loans are "a good product in this current environment to help consumers be able to consolidate and have a consistent rate and to actually pay down the debt," he said.

Profit almost doubled from the previous quarter and rose 11.9% from a year earlier, to $234.1 million. The results included $32.6 million of income from the troubled U.K. card business it sold to Barclays PLC at the end of the quarter. For the previous quarter, Discover had recorded a $158 million loss related to the business.

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