Chit Chat Stocks - Discover Financial (Ticker: DFS) Not So Deep Dive

Episode Date: August 29, 2023

Discover Financial Services (DFS) is a financial services company that offers credit cards, personal loans, and banking products, catering to consumers and businesses, and navigating challenges from the competitive credit card industry and economic fluctuations. At the end of the month, we will publish an Arch Capital episode that will cover the company: Sprouts Farmers Market. Listen closely as Brett and Ryan go through the history, financials, and future prospects of Discover Financial. Enjoy the show! ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (2:58) Industry | (16:37) Management & Ownership | (20:13) Earnings | (28:19) Balance Sheet | (32:23) Valuation | (34:32) Our Analysis | (38:28) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is Chitchat Money. My name is Brett Schaefer, and I'm joined by my co-host, Ryan Henderson. Today is our Tuesday not-so-deep-dive episode, where we analyze one

stock and we actually ingest, perform a deep dive. It's not actually a shallow dive of research of the company, but we're going to cover its business model, ownership, financials, future growth opportunities, major risks, really how the business works, what the stock's trading at, what we think of management, what we think its future prospects could look like, hope you or help you as a listener get a better perspective on the company. And today we're talking about Discover Financial, maybe one of the cheapest looking stocks that we've looked at so far this year, but want a little bit of meat on the bone as it is a lender and some people don't like the brand. Maybe we'll probably talk about why we think the stock's trading at a low PE, or maybe

why they're over-earning, stuff like that, a little teaser. But before we get into it, I want to say that for any listener that is interested in this company or really is interested in learning more about the companies we cover, I would recommend subscribing to our free newsletter, which has a link in the show notes uh for this episode it'll give you all our basically the notes we write down for the episode we copy them over to a sub stack and we post them out for free we have charts we'll have stuff in this one like discovers total loans outstanding discovers loan credit card loans as a percentage of total u.s loans stuff like that really really interesting so that will help you i guess it really helps us digest more of the information

as we're recording the episode so i think for listeners having that visualization and the stuff to read can help you digest more of the information as well and it's a pretty quick read as well we send them out tuesday mornings along with these episodes all right ryan how are you doing and why don't you get into discover financial anything else before we get started no i'm doing well uh i think we're on the cusp of nvidia about to report as we record this our fate is being that's right uh potentially discussed right now we don't own nvidia but uh just it seems to uh determine the yeah how the entire world lives their lives for the next three months until we do it all over again but yeah let's talk about discover financial um kind of two separate

businesses here but i would say just in general it's pretty much just a bank is kind of the way to look at it and i know banks sometimes bore people but there's also basically they have a digital banking segment and then they have payment services so i'll start with the banking because it makes up the majority of their business but discover is a digital digital only bank with 115 billion dollars in total deposits most of those deposits are direct to consumers so people with savings accounts at discover people with certificates of deposits that kind of thing And there's also brokered deposits, which is basically third-party securities companies will put their customers or their clients' funds into Discover branded savings accounts or deposit accounts. And it's slightly more expensive than direct-to-consumer, but in general, it's still a pretty low-cost form of deposits.

And then the last one is just general borrowings, which come in a variety of different ways. But really, the bulk here is direct-to-consumer deposits and the broker deposits that I talked about. Those two in total make up about 83%, 85% of all the deposits that they have. But like any bank though, the objective here is to take those deposits and lend them out at higher rates and pocket the difference. The way Discover does that is primarily through credit cards, which makes up 80% of their total loan volume. They also provide private student loans, personal loans. There's even a small home loan segment, but really they are in the credit card business. And within the credit card business, Discover is a little unique in that they offer cashback credit programs with no annual fees. So a lot of companies nowadays, it feels like they're trying to go more towards the American Express style of building out a credit card program, which is you have an annual fee, which gets you access to all these really exciting cashback programs.

but really discovers trying to target more of the middle-class American. The former CEO, Roger Rothschild described it like this. He said, we might be more like Toyota and American Express, maybe more like Mercedes. So they're really kind of going wide, but offering attractive credit card programs to most Americans. Now on the loan portfolio or excuse me, the deposits, you mentioned 115 billion. Are you including just the other borrowings into that? Yeah, sorry, that's not deposits. It's total loans, but the majority of that is customer deposits.

It's liabilities, basically. Yeah, they're paying interest on all those, but that small portion, which we will have in the newsletter for anyone referencing or anyone that's interested, is basically just bonds or securitized, excuse me, I can't talk today, securitized borrowings, but continue, right?

Yeah. And I think most people probably understand how credit card programs work. You buy on credit, which is afforded to you by whoever your credit card issuer is, or the issuing bank, which in this case is Discover. They're also the payments network for the cards, which we'll talk about in a second. But they have fortune credit. If you have carried balances, you pay interest on those carried balances and credit card programs done right, from what I understand, can be very lucrative. But there's a lot of credit card programs that are apparently done wrong in the banking world. One bad year and you might blow up, right? So it can be a great business until you make a couple of mistakes that really haunt you.

Exactly. And Discover's been in the credit card business since really its inception. So they've been doing this for a long time. They have really earned high returns on equity. I mean, the fees that people pay on carry balances for credit cards are pretty high. You're paying a pretty high level of interest and the cost of deposits for Discover is pretty low. So the net interest margins or the difference there is really higher than you'll see at

a lot of banks. I think, I don't know if I've come across kind of a higher net interest spread in the banks that I've looked at. I mean, we look at Ally. They certainly don't have that high of a net interest margin. Same with other companies now, obviously. There's a little more risk in that portfolio and sort of a recession potentially, but- Yeah. That means we'll talk about this, managing the net charge off rate, which I think you were, if you didn't mention, I'll say it again, 3.2%, or excuse me, yeah, that's their net charge off rate. Managing that can be vital for them as it could rise significantly and quickly. If they don't underwrite really correctly, it can rise to

5%, 6%, 7%, 8%. Or if they do it well, it can slide down to about 3% where it is today and they can be an incredibly profitable operation. Exactly. Now on the payment services side of things discover operates really its own several of its own payments networks so sim think business model wise think visa mastercard american express it's very similar they have their own payments rails this means that they're processing and settling transactions that are made across the various networks these networks include the pulse network which is primarily for debit transactions the actual discover network which is more all transactions used by discover credit cards and then the diners club network which is just trivial and really not a large business they've

acquired both the pulse network and the diners club network in the last 10 years um in total the discover networks have about the same coverage as visa and mastercard in the united states in terms of merchants, it's really quite similar. Discover is accepted at 99% of merchants in the US. In total, they processed over half a trillion dollars in volume in 2022. However, I'm not going to go into that much detail here on the rest of that operation because it accounts for less than 10% of Discover's pre-tax profits, so it's really not that important. But it's just, I think, worth noting that like american express it's a closed loop system so they capture a lot of the value in transactions um if you want to learn more about what networks like these actually do

so what is the processing and settling of transactions um i recommend checking out our episode we went into pretty good depth on basically that entire process but as well as american express we've covered both this year yeah let's talk quickly about the history here the discover card was initially introduced by sears in 1985 which is kind of interesting which sears was at the time the largest retailer in the u.s it's kind of crazy now to have seen the demise of sears and realize all the value like they had their hands in everything and it would have been so hard to think this business is going to be worthless good lesson 30 years yeah yeah Yeah. It's a good lesson. Yeah. Yeah. 30 years from now, you had to write a lot of

wide moat businesses and you go, Hey, 30 years from now, they'll still be around. Sometimes they're not. Yeah, exactly. Anyway. So Sears, a couple of years prior to introducing the card, I had acquired Dean Witter, which was from what I understand, I think it was in that movie with Will Smith, where basically it's like a brokerage firm. Maybe there was more to it, but they acquired Dean Witter and they acquired a company called Greenwood Trust, which has now become Discover Bank. And they were trying to build out sort of this financial services division. And so Greenwood Trust at the time came up with this idea to launch a no-fee cashback credit card. I think it was mostly intended to just

spur spending at Sears. But there was kind of some early struggles. It didn't really get that big of a liftoff. And so Sears spun off Dean Witter and Discover in 1993 as its own publicly traded company. Four years after they were spun off, Dean Witter Discovering Company, which was one company at the time, merged with Morgan Stanley. The full name was Morgan Stanley Dean Witter Discovering Company. That was the full Morgan Stanley name. It's funny how much merger activity there's been in the finances world, but it continued to grow under the Morgan Stanley Brand. While it was there, DFS, which Discover had been officially its own thing at this point, acquired the Pulse Network as well. Then it was finally spun off as a separate entity

in 2007 into this is what we know as no Discover Financial Services as today. A year later, they also acquired the Diners Club International. And since then, they've added student loan student loan operations, home loan operations, maybe one other, but I want to talk more about what's really happened in the last 12 months. So over the last year, there has been a lot of change around the C-suite at DFS. And initially, it wasn't really that clear why there was this much change. Now, within the last six months, really, and really most of this quarter, Where DFS announced to shareholders that the FDIC is, I put investigating here, but it sounds, they kind of say it's a review. So I don't know what to call it exactly, but FDIC is investigating them around insufficient risk management and compliance departments and processes.

And then they also stated that they misclassified certain merchants into the wrong classification or wrong category, which made them pay more than they should have in interchange fees. And they say that they caught themselves doing this, but now the CFPB or the Consumer Financial Protection Bureau is going to be issuing them a consent order. Essentially, they're reviewing or investigating, in air quotes, Discover as well. Also, in response to these investigations slash reviews, the board elected to pause the share buyback program, which has been significant over the last decade, and remove the CEO and replace him with an interim CEO for the time being, along with a lot of other management turnover. to give some context on the shares share repurchase program not quite as high as lows or auto zone over the last 20 years but over the last 10 they've reduced share count by almost 50 percent and over the last two years specifically it's been trading at kind of this depressed multiple which has allowed them to buy back 15 of their stock in two years right now the stock trades at, well, I'll just kind of, this is, I'm spoiling Brett's segment here, but trading at six times earnings. So if they were to earn that over the next 12 months, which doesn't look like they

will, but if they were, and they still had the buyback in place, they could potentially cancel out or buy back more than 15% of their shares outstanding. So even though the share buyback program hasn't been as significant as Lowe's or AutoZone, which have been best in class really, moving forward, if it's reinstated and all things go well, it certainly could be. Yep. And I would mention that they do pay a little bit higher of a dividend than some of these other share cannibals, specifically AutoZone, which I think doesn't pay one. If I remember correctly, they're at about a 3% yield. I think that sets us up nicely for the rest of this episode. The two most important things we're going to be discussing, maybe debating,

maybe deciding how positive or negative we think it is, are one, the recent investigations, and the investment and compliance stuff that they need to make, as well as the CEO leaving abruptly, which as of our recording on August 23rd, that was barely a week ago. So it's really fresh. They just had an analyst call that we'll probably discuss as well. And the second that we're going to discuss is how much are they over-earning, if anything, right now? Today's episode is presented by the Science of Hitting Investment Research Service.

The Science of Hitting was founded by Alex Morris, who spent a decade working as a buy-side equities analyst before launching his own service in early 2021. You've heard him here on the show a number of times, but Alex produces really, really high-quality equity research. And in addition, he provides 100% transparency into all his portfolio decision-making. we were early subscribers to the science of hitting research service. And we genuinely believe that Alex produces research that is on par with top wall street analysts at a fraction of the costs. I mean, the fact that you also get complete portfolio transparency and a hundred percent accountability is just icing on the cake. Effectively, you're outsourcing a full-time equities analyst role for just $349 per year. Brett and I both pay for the service on our own,

and we can tell you that it's honestly worth the money. Some of the companies that Alex covers includes Microsoft, Netflix, Meta, Roku, Costco, Match Group, Berkshire, tons of others. So if you're interested, check out the TSOH Investment Research Service today at thescienceofhitting.com. All right, let's go into industry and competition. This is a very simple one. I think people understand this one, especially in the United States. And this is a US-centric company, but they do have operations around the world where they let people pay with Discover cards. They operate in the credit card issuing business and the payment processing business, as Ryan mentioned above.

Listeners are going to be well aware of the main competition in payment processing, that is Visa, MasterCard, and American Express in that order. And then you're also going to be well aware of, since these are very consumer-facing products, of the credit card issuing companies, which are American Express, Chase, Bank of America, Capital One, the airlines, hotels, et cetera, et cetera. Well, the airlines and hotels are partners. in payment processing discover is a very distant fourth in process volumes they're much lower than visa much lower than mastercard and even much lower than american express which does serve

sort of a niche but they're high spending niche last quarter discover processed a total of 146 billion dollars which seems high but when you look at visa which processed 3.8 trillion dollars You realize that they are much, much lower on process volumes. And as Ryan mentioned above, their main business model is not, and this is different than American Express. American Express makes a lot of money on discount revenue, which is just how they describe the payment processing revenue that they make. Discover doesn't make much money on that.

They make a lot of money basically as a bank, earning the net interest margin on their credit card loans, focusing on high FICO score consumers. But looking at those high FICO score, consumers that need some loans, the main way they make money is, again, actually making the credit card loans and not on the process volume. If we look at their market share within US credit card lending, I took basically their loan receivables at the end of the year and then at the end of last quarter and divided it by the St. Louis, whatever that website's called, Fred's in total estimate of credit cards outstanding in the United States. And I got their market share and it's been very steady at

just under 10%, right around 9% since 2018. So their market share there has been steady and it's much, much higher than on the payment processing side. Now, here's a discussion question I have. We can look at their compliance stuff. We'll talk about that. We'll talk about management. We'll talk about whether they're over-earning, but is there any foreseeable reason why Discover's market share of credit card loans is going to change over the next decade? Do you think anything from 2018 to 2022 was a strange period where something's changed and now they're going to start losing market share? Do you have any thoughts on that by now pay later all right i i'm saying it in jest but it's like i guess maybe i'd probably

say no but maybe there are a lot of companies that seem to be getting into card programs um maybe the airline cards seem to be doing very well maybe that could apples tried to push into it too um yep but let me look up things haven't changed yet i don't see why they would let me yeah because those i mean airlines were investing in their credit cards in 2018 i'm going to look up when the apple card is launched because it actually might be legitimately in 2018 um apple card launched let's see google yeah august 20th 2019 so i guess one year later but discovers market share has been you know been very very steady along that time period let's move to management ownership this is a very important part for this uh recording uh given the timing

it's going to be an interesting section to talk about it's probably the most important thing it's probably the biggest overhang on the stock right now so since it spun out as a public company discover has had steady management at the helm from 20 or excuse me 2004 to 2018 so 14 15 years The company was led by David Nelms, who then gave the position over to Roger Hothschild in 2018. And then he was the CEO until the summer. Both had been there since 1998. Ryan discussed how things had been running smoothly, but then there was this weird thing

that happened last week where the company announced that Hothschild had resigned and the company was appointing an interim CEO from the board of directors. Do you listen to the analyst call on that day of the announcement after a bunch of peppering questions because they're all about this right the interim ceo from the board of directors basically said that hoth child was fired for cause uh without specifically saying that but he kind of alluded to it for the recent investigations on account misclassifications and this fdsc probe i don't know if it was a you know a nice little i don't want to call it present but something to appease regulators i don't know if they forced it to happen but it was very unexpected because

hoth child has been in the company since 1998 he was the protege of nelms probably since 2004 and both those people are gone now and they're looking for a new ceo and we don't know how bad these classifications will be it seems like they're not going to be but we'll talk about that later i guess specifically on the management stuff how nervous or concerned do these make you if at all well it's kind of the thing is like when when you think about just the actual numbers so the processing volume it accounted for less than one percent of discoverer's interchange revenue the the the energy like the swipe fees that they were misclassifying so it doesn't seem And I mean, their interchange revenue is not even that big to begin with.

And they brought it up to regulators themselves. I thought that was positive. Yeah. So it doesn't seem like it'd be that big of a deal. But the fact that they've been so talkative about it, the fact that they feel the need to double compliance spend over the next two years tells me that there's probably something more going on under the hood. If they had to fire their CEO, it's not because they accidentally miscategorized less than 1% of their interchange revenue.

I think it's probably there's something bigger going on. That's my concern, is that it either feels like a massive overreaction, or I don't understand the gravity of the situation. yeah there's yeah on the one hand you're looking at you're like okay well you fire c over the stuff that's happened since he became ceo which they said they under invested in compliance stuff generally among other things since 2018 that regulators are going to look for them to invest in more and they have been over the last few years and said they will over the next couple years as well it's probably going to grow faster than their top line but on the other hand it could be a positive for the company or board of directors culture because it seems to be the reaction or

their strategy seems to be much better than say a wells fargo who got very defensive during this time period they admitted you know wells fargo obviously people or maybe obviously not but some people know the wells fargo story they were kind of i don't know they try to downplay it constantly maybe Discover's overplaying it. Maybe Discover is just taking a better route of being apologetic. They're saying we made a bunch of mistakes. I kind of like that. But like you mentioned, the CEO getting fired over this small thing does make me nervous because what else is there, if anything, under the hood? We don't know. That uncertainty is probably what's driving the stock down right now. We don't know if there's anything there. I kind of have a feeling

it's not going to be there's not going to be much but it's there's definitely a chance that there's something significant there that's going to hurt their earnings power for at least you know for multiple years yeah and if it's so insignificant like if it's not that big of a deal and why did they pause their repurchase program when they're so well capitalized so well i think they did that because the regulators get upset with financial companies buying back stock when they're under investigation and stuff like that so i think they just want to make sure that they're not angering them could be but it also i don't know that's the part where it's like they were like no we we did this all internally we chose to do all this and then it's like

were they forced to stop their buyback program or did they choose to do that because i would have a hard time believing they chose to do that when they're also bragging about how well capitalized they are i don't know it just makes it i think they chose it to make themselves look good to the regulators i don't think that's a concern to me the ceo leaving is a concern for me really the other thing is during that analyst call they asked and they said like one of the analysts kind of pressed them and said you know you're talking about how robust your ceo pipeline is your potential ceo pipeline like how it's a job that a lot of people are going to want and then it's like if that's the case then why are you here why are we talking to you an

interim ceo you know other companies were able to promote instantly after problems like this yeah i guess we don't know they could have been forced by the regulators to fire the ceo right so that probably and you can't hire the next ceo overnight even though if you have a candidate of like 10 people so we'll see but i think from our perspective i think it's probably clear that we should be looking for in the next few months a permanent hire to be made if it's a great position if there's you don't want someone right because if they can't get someone to come in that means that the ceos are doing their due diligence saying wait there's something here that we're missing they're not telling it would just be a red flag i think all right but as i mentioned

we don't know who the ceo will be now so we're in a little bit of a limbo period it's a bit strange i wouldn't expect though the board of directors to change its compensation philosophy so i'm going to look at the proxy standard from last year. It's for a lot of executives that aren't there anymore, or at least the CEO that's not there anymore. But I think they're going to do the same sort of strategy for this new one. And they have the classic trifecta of base salaries, annual bonuses, and long-term RSUs and PSUs. For anyone that doesn't know, PSUs, performance stock units, they are tied to some sort of metric and then they get vested or, excuse me, eligible to get sold, however it goes. We look at the annual bonuses. They are based on profit before taxes.

and then the PSUs are based on cumulative earnings per share performance over a three-year period. I think those are fine targets. I do worry about lending executives getting incentivized to juice kind of short to midterm profits, which I guess a three-year period or an annual period is, but it hasn't been a problem with Discover Financial before. They've been profitable throughout a cycle. I think they were unprofitable for about two quarters in 2009, but I don't have the notes in front of me. That could be wrong. But again, at least through a cycle. Humility, they stayed profitable. And I like the earnings per share number because that incentivizes them to continue the buyback. Now, lastly, on the ownership section,

they have a ton of passive ownership, which I think is a big positive because it gives the executive team virtually unlimited liquidity to continue its buyback in perpetuity. For example, if we look at just BlackRock and Vanguard, they own over 20% of the shares outstanding. and that's a great source of shares to buy back all right ryan let's hit the earnings unless you have anything else to follow up on management and ownership no i think we discussed it pretty thoroughly i mean the concern is really that it's confusing it's up in the air it's like we don't know what's going on yeah um and typically when i don't know there's just a lot of bad examples of when banks aren't necessarily clear with what's going on well there's something

really horrible going on under the scenes um or behind the scenes when we look at earnings i wanted to bring this up this is well i'm not sharing my screen but um their earnings per share which is really kind of the figurative track here um over the last 10 years net income is up 62 percent so i mean it's it's fine it's kind of meager growth a little slow now net interest margins have contracted in the last 12 months so it's kind of maybe not indicative of what they could be generating but 62 it's not bad over 10 years it's it's fine especially for a bank and and it was a mature bank like it's not like this is a small business you know 10 years ago earnings per share up 200%. So on 62% net income growth, earnings per share were up 200%. That is

really all the buyback program right there. And it shows how they have been allocating capital, not to mention there's also been dividends along the way, which is nice to see. When we look at the most recent quarter, basically what's going on right now, they're still growing their loan volume um they're you know they're they say they're tightening their credit standards but they're getting a lot of loan applications and finding a lot of ways to lend um but they're seeing net charge off rates kind of accelerate so in the most recent quarter the net charge off rate was 3.2 percent which is basically um i'm not super well versed in all the banking terms, but expected losses is maybe what you could call it, expected losses on the

loan book. Last year, it was at 1.8%. It actually accelerated quarter over quarter too, which is one of the big reasons that the stock is selling off. The other part that was talked about here is, I mean, the earnings is really a byproduct of the net interest margin, right? So if your net charge off rate is going up, it's going to contract your net interest margin, but it's also worth remembering that banks have operating expenses. And for Discover, they're investing a lot more in their compliance and risk departments, which means they're going to see pretty big operating expense growth, which is also going to further compress net interest margins. So, or not in net interest, but net margins in total. So you're going to see-

Well, maybe, unless they grow quicker, but- Based on their forward guidance, net margins will contract. So earnings per share over the last 12 months has been sort of $14, 50 cents. Today, the stock's like $88, something like that. I think there's a path to them getting back to that at some point, but over the next 12 months, it's probably going to look a lot worse. Yeah. And I think the debate is how worse, because they definitely were, as a lot of these lenders were, they were over-earning during the pandemic when a lot of people weren't spending money and then everyone could pay back their loans and

and people got stimulus checks. But now the debate is whether it's a normalization back to the pre-pandemic period, or things are going to get worse as people get concerned time and time again about a recession hurting a consumer lending business. We'll probably talk about what our thoughts are on that, on the normalization versus it getting worse than that, because that's what the companies always say. They talk about a normalization in a loan book, but then a lot of the investors, and we know this time and time again with investors, we're guilty of it. You extrapolate the last few quarters and you see that net charge up rates are growing and you go, oh, this is going to continue in perpetuity until the business loses all its money.

But I think it's probably somewhere in the middle there. All right. Anything else? Yeah. Balance sheet next. Balance sheet. I mean, really kind of with banks, earnings and balance sheet are pretty much one in the same, really. You're earning from your balance sheet. But in terms of capitalization, what's going to happen in a bad scenario. I think maybe the important thing to look at for banks is they provide that CET1, which is the common equity tier one capital ratio that's basically equity capital plus how much cash they're reserving compared to their risk-bearing assets. There's a regulatory minimum that they have to have. They're well above that. They have 11.7%, which is pretty strong from what I understand. But really what I like to keep

track of is what's their reserve rate, which is the reserve rate is just money the bank's putting aside in case some of the loans aren't paid versus their net charge-off rate. And so at Discover, the total loan reserve rate this quarter was 6.8% and the net charge-off rate was 3.2%. So it's 2.1 times it's nco or net charge off rate i think that's fairly conservative um you know there's always the risk with a bank that things hit the fan really really quickly yeah everyone goes what if it gets worse what if it gets worse and it could yeah um it's kind of you know feels pretty well capitalized it seems like they have a lot of cash reserves they're also passing the buyback program which should allow them to

add that cash buffer and invest in compliance. Yeah. And the new rules that are getting debated, we don't know what's ever going to fall off from the spring debacle with Silicon Valley Bank and First Republic Bank, but they said they're basically compliant with all the stuff that's been discussed already. So they're pretty conservative compared to a lot of the banks that failed and actually saw an influx of deposits this spring. So not a giant concern around the deposits fleeing they seem to be pretty well entrenched once you join the discover ecosystem all right let's move to valuation yeah simple very simple for a bank like this you just got to use the pe ratio but again as we talked about the business is a little cyclical and

we don't know how we know that they were over earning in 2021 and 2022 but the question is how much. And today I think investors are betting that they over-earned a lot because when we have a market cap currently of $22 billion, if we look at a PE on their trailing, I believe I used trailing 12 month basis, but it's either trailing or their 2022 numbers, we're trading at a PE of 5.7. And look, I think investors are betting that it's going to get a lot worse. Now they have a lot of room to still be profitable. So I think the question is, it's a tough one where you're kind of betting on how much on what other investors are betting and the handicapping there, which I guess is what we're always doing. But in this case, it's pretty clear cut and dry

because on the deposit side of things, on kind of just their loan book side of things of keeping it steady and steadily growing and whatever, that's not a concern really at all. It's how are these loans going to perform over the next five, six years? Or how is that engine of loans going to perform for the next five or six years as they cycle through with student loans coming up, interest rates coming up in general, all that stuff that everyone's concerned on. Yeah. I think what's interesting is you see this with Ally and you've seen it with Discover

and maybe SoFi to some extent. Capital One. I mean, there's some others out there. Yeah. But I'm talking about how throughout COVID and even before COVID, the direct-to-consumer deposits have grown as a percentage of their deposit base. But during that time, they've also seen this rise in net – at first, during COVID, they saw all their loans getting paid back. There was basically zero net charge-offs. and they – I kind of lost my train of thought there.

But basically, you have this huge – Are you about to say they didn't have to pay any interest on those because the rates were zero? Yeah, that too. Yeah. So you kind of saw this really big expansion of net interest margins. And I understand it compressed really quickly because maybe there's a higher spike in net charge-offs

due to the rapid rise in interest rates. As it becomes normalized, I think a lot of people – aren't maybe giving credit to the lower cost of deposits that they're getting now with the direct to consumer. Whereas if they're getting a consistent steady yield or net interest margin on their loan book, I should say yield, there's going to be better position than before the pandemic, but it's kind of hard to see that because there was such a big balloon in net interest margins during the pandemic. I probably phrased that really poorly, but I hope- Yeah, and it all comes down to at the end of the day, how do you think their loans are going to perform? And I think we'll get to it. But my thought is you got to look at their history of underwriting. And yes, the CEO stuff is a bit of a concern. But given the history of this company, they've been very, very conservative with their underwriting. Currently, they're underwriting 5% unemployment for the reserves. So I think people are probably overestimating.

I honestly wouldn't be surprised, and this could be a bad cold takes exposed for us, for ourselves, if I look back a year from now. I wouldn't be surprised if we don't hit that 5% unemployment. They say, oh, we over-reserved. Now we have more money to buy back stock. But let's move to anecdotal evidence. What do you think of this from a consumer side of things, Ryan? It seems steady, low growth.

They haven't really gained market share, but curious what your thoughts are. i think it's got some pretty attractive credit cards and uh credit card offerings for consumers especially for like first-time credit card users students yeah students people that don't want to pay a big annual fee maybe they don't have the income to do that yet this is a really good solution and it's a good way to get started into the credit card universe and if you find that it works really well for you and you're getting good rewards, then they're probably pretty sticky, those credit card borrowers or credit card users. Yeah. That kind of leads to another anecdotal thing I'm feeling with this company. And that is if we see, and again, recent example is the UPS

contract negotiation. If we see the middle-class to lower wage to upper middle-class wages rise at a significant rate over the next five to 10 years, I think that'll be a definite tailwind for Discover. That's something they can probably take advantage of. Now, for me, I think with their consistent advertising over the years, I generally understood Discover's value proposition for consumers. Even before researching this episode, I'm not a user of the card, but I could see us looking at it for our small business if they offered us the best cashback rewards for all purchases. Obviously, they're not going to be the one you go for for a travel or entertainment card, that's going to be Amex or the airline and hotel cards that, you know, some are powered by

Amex, some are powered by Visa and MasterCard, but that's not their niche and they don't really need to go into that. And I think they have that clear customer value proposition. They're probably the leader for that standard cashback card. I would think there's some competition there, but a lot of companies, I mean, you look at the Chase Sapphire Reserve, you look at so many cards are going after those airline points, which I'm guilty of it. I go up to those airline points for those deals right and a lot of people go after those but i think that leaves an opportunity open for discover to go after its niche that might not be growing that much but can still be profitable that's just the travel boom talking that's true they could be they said

that they over indexed to gas so they've been uh gas which i mean like you know paying for gasoline purchases maybe electric vehicles are the downside for them but no uh that would be a very obscure bear case for everyone with gasoline prices down generally across the country that hurt them a little bit. And I think like you mentioned there, the focus on travel and entertainment over the last 18 months for people, especially in the United States was probably a headwind as well. So I think that's something for anyone to consider when they compare them to Amex, Visa, MasterCard, payment volume growth. All right. Future growth opportunities ryan we mentioned that the payment stuff network isn't that important to their

business but potentially they're investing in it to make it more important in the future so what do you got for us yeah i don't know i mean for i put the cash back debit card here but really i think with get more customer deposits make make good loans like that's that's the recipe for growth here and then buy back stock with the cash you get. Maybe the other thing right now is to invest in compliance. Obviously, that's kind of a growth opportunity to maybe appease regulators or actually improve your systems. But the cashback debit card, I think this is maybe a good way to start a relationship with customers without having them risk hurting their credit score. So if you're a high schooler or maybe you're in college or something like that,

and you don't necessarily feel ready to get a credit card yet, getting the cashback debit card is a good program where you can earn, I think it's 1% back on up to $3,000 or something like that. So it's not huge, but most people don't do that for a credit or a debit card program. So I think it's a good way to get an account open and get a relationship with a lot of people while having it be lower risk in their eyes. Yeah. And they're not going to make much money on that given the spread on the debit card fee or whatever that tends to be. We don't have the exact number. They don't give it to us, but yeah, it's definitely good. And they said they're going to be investing marketing into this in the fall, so over the next few months, and then they're

already seeing strong growth from it. I believe they said they're gaining like 2,000 accounts per day, which is good, but it's not going to have a material impact on their earnings. I think it's more of the success of this over time will show up in the loan book steadily growing. yeah and that leads into my future growth opportunity which again i have something it's hard to pinpoint a new thing that's going to move the needle outside of the loan book so you really just look at it and they got to grow accounts grow the loan book and underwrite good loans but i think at the edges there's things they can do to widen their competitive advantage and improve their consumer value proposition and some people might not might

argue that they don't have a competitive advantage. I would say it's clearly not as strong as someone like Amex or Visa or MasterCard, but it's not there. It's just a moat that's not extremely strong because if you kind of look at it, I kind of invert and say, if someone tried to be the fifth payment network, would that have any success in this country? I don't think so. I really don't. It seems like it would be impossible. But one of the ways for them to widen the moat and kind of increase that value proposition for their customers is to see increasing international acceptance they're not going to make that much money on it because as we mentioned they don't make much money on their payment volume but the more places that accept

discover the greater value they can provide to customers the greater the better i guess mind share they can have where a lot of people get concerned about the amex and discover cards because of the acceptance rate which is actually a little bit of a misnomer and not as as we talked about in the amx episode they provide they've fixed those issues and discover has fixed those as well so they continue to do that over the next decade i think that can be a really strong customer value proposition to lock in their existing customers and make a better pitch to convince these new customers to join them and say look it doesn't matter if you're on discover or visa you're going to have basically the same acceptance in the united states okay highlights

lowlights it's a simple business but also one with some hair on the bone so ryan what do you like just like here i mean obviously we like the buybacks but i think that's a given yeah i would i would like for them to continue hopefully at some point but uh i mean highlights just kind of thinking of discover overall it is a solid business right i mean they have really high net interest margins relative to a lot of banks they earn great returns on equity which is a very important kpi for banks um i mean you know it's it's capital light you're earning money with money you're earning money with other people's money really i mean done well it's a great business model on top of that they also are kind of like ally financial in the sense that they're on the

right side of the innovators dilemma same thing with companies like sofi being a digital only bank, they don't have to staff as many branches, so they can save on costs there and can invest those, or they can pass those cost savings in the form of higher interest savings accounts, which should attract more and more deposits, which, I mean, that's just kind of a winning formula there. Lowlights for me though. Let me, I'll give context for listeners on the deposits just because I don't think we've given any numbers on that. So since 2018 to Q2, 2023, three interest bearing deposits have grown at a 9% compound growth rate. So pretty strong growth there. Yeah. And then on the low light side, it felt like there was a lack of transparency around

the recent issues. They tried to be transparent. They had this public call that if you look on quarter, it just says status update. I think it was meant to be like, let's clear the air here with analysts but in reality it kind of i mean judging by the stock price reaction it's made things worse um it doesn't feel like there was a lot of clarity here and maybe it's because they can't say everything you know they can't say or maybe they didn't want us to fire the ceo or regulators told us we couldn't you know buy back the stock or we wanted to please them so but it like for investors that just leaves us in a black box like we don't know how big this problem really is it sounds pretty big when you pause the buyback and you fire your ceo

um so that concerns me obviously and then the other one is just the you know the uncertainty around when the buyback program will be back and maybe this is kind of the other frustration i have is that with banks they're when you want them to capitalize on bad times like when the buyback is the most opportunistic is when they need to reserve the most cash. When the economy is doing poorly, their valuation comes down substantially, they could be having the most accretive buyback program yet. That's when regulators crack down and say, let's start reserving more. But it's happening across the board, right? It's happening with all banks right now. Yeah. I think, yeah, that's going to happen because they wouldn't stop the buyback if

their reserves were extremely high. And the reason their reserves aren't extremely high because they did the buyback beforehand. So, and then I don't think the stock would be down if the reserves were extremely high. No, but I mean. I think it's just, I think I like their strategy of basically when we have excess cash from our reserves, based on our numbers that we like to run with

and we don't have any of this regulatory overhang, which again, I guess is the bigger question. They're just going to put a buyback stock consistently, indiscriminately, it doesn't matter what the price is. And luckily for them, they've generally had a low valuation when they've done it. The thing for me is that, and we've seen this across the board, the economy starts to worsen relative to 2020. Net charge-off rates rise.

Suddenly, they have to reserve for more. They can't use as much money on their buyback program at a time when, ideally, that's when they'd be spending more. So it's just part of the nature of being a bank. But the stock wouldn't be down if they over-reserved before and didn't do the buyback. So if they didn't do the buyback before, right? Because the stock wouldn't be down. I think if net charge-offs are rising, the stock would still be coming down. Maybe.

But if they aren't buying back stock beforehand, it's just a little bit of a catch-22. If they aren't buying back stock, okay, then they're going to be way over-reserved, and then people are going to be playing, why aren't you buying back stock? And then maybe the stock will get- I get it, but it's the negative of being a bank is that you have to be cautious at the times when it would be most advantageous to potentially press your advantage. That's fair. It's a cyclical. Yeah. All right. What about you? Well, highlights consistent track record of profitable

underwriting with the credit card business. It's been years and years and years, decades of, well, I guess we didn't know the exact numbers before they went public in 2006, but since then, it's been very, very consistent, very, very good. They haven't made any really terrible mistakes on the underwriting side of things. I don't see, famous last words, but I don't see any reason this will change in the immediate future. Makes me much more comfortable with the lending operations compared to, say, a fintech upstart, which they're pun intended. It's just much more comfortable. They have a formula. It works. I don't see any reason why it won't work in the future. Second one, they're generally inflation protected. Third, they

consistently use the excess cash to return to shareholders. They even said on one of the recent calls. And again, this was the old CEO that was fired, but it was recent. And they said that, look, we have our first priority when we get cash is to see where we have to invest in the business. And again, right now they've harped on saying that we got to increase our spending on compliance. Regulators want that. And then they say, second, when we have excess cash there, we're going to buy back stock and increase the dividend. And then they say a distant, distant third, which I like, is bolt-on acquisitions. So I think they've been very smart without destroying much capital. I mean, you look at that Pulse acquisition, probably a waste of money.

Some of the other stuff, probably a waste of money. And I like that they're not going crazy with the $1 billion acquisition that they could use to buy back shares. And I think the fourth one, and this is more of a meta one from the investor perspective, is that I think investors constantly get scared of the lending operations presenting potential buying opportunities and a cheap stock to repurchase shares. I think a really fascinating thing to go through is there's been like five value investor club write-ups on Discover since 2010, maybe, or I know they actually had one before the great financial crisis. And almost all of them to a T said something along the lines of, well, people are nervous about Discover right

now because with the recession looming and it would be like 2016. They'd be like, oh yeah, but once once the recession hits next year so i i think that can present obviously there could be recession next year they're letting operations could get hit but i would say that they usually have reserved themselves well for through recession to be fine to be unless we hit a great depression they'll be okay and just to be clear if there is a depression banks inherently are screwed like yeah that is that you know go revisit the great depression how many banks closed if everyone yeah if people can't pay back their loans they're they're gonna they're gonna do poorly but i think what presents an opportunity is that everyone worries about this constantly

and that's what lets them have a pe under 10 and buy back stock now my low lights we talked about the misclassification and the fdic compliance stuff uh like i mentioned i did like that they aren't kind of talking about it like wells fargo and deflecting blame and all that stuff that got Wells Fargo in trouble and compounded that mess. On the call with the analyst, which is not the one with the interim CEO, but the one, the earnings report, the CEO that got fired seemed to be very apologetic, admitted that it was his mistake. I guess that's why he got fired. But famous last words, I think it's not a giant low light. I think there's some highlights here on their corporate governance that they were trying to be accountable. They're not just defending

their executives to keep them in line. They're thinking about the shareholders from that perspective. And as Buffett once said, there is fraud likely going on at his company, Berkshire Hathaway, constantly. They just don't know where it is. There's going to be fraud going on and mistakes are going to be made. Some people you're not going to have, if you have 20,000 people at your company, they're going to be someone that's a bad apple. It's going to happen from time to time and really the only thing that you can control is your reaction to it so i don't know all the moves behind the scenes but it seems like discover is acting at least from the information we have now as best they can i think the big concern that me and ryan have talked about is

we don't know what else is there or if they don't know what else is there but that's true with every company so i feel like that's a tough low light yeah i mean that it's like we don't know what fraud could be going on at microsoft yeah it's true well and part of the thing now is like there's kind of this interesting situation where it's like okay i wish the regulatory stuff wasn't going on so this would be a cleaner situation but i'm also times earnest yeah yeah but i also want to buy it cheap so this is where kind of you make your money is can you parse through how relevant this really is. Difficulty for me is, do we have enough information to do that? It's kind of hard to tell. Yeah. And sometimes what's that famous quote, which probably gets people in trouble

sometimes, but also can lead to good opportunities is sometimes you got to go in with 70% of the information confirmed. Now, this kind of relates to my second low light, which is there are unknowns around the pandemic bullwhip for the consumer economy. I think there are few historical presidents for consumer lending operations here. We have the strange mortgage auto loan payment stuff right now, the affordability being off the charts, student loans starting up again, interest rates rapidly rising. Discover seemed well-capitalized, like we discussed. They're prepared for a lot of this stuff. If some stuff hits the fan, they are assuming, like I mentioned, unemployment hits 5% or higher at some point soon for the reserve book. But given that this is a

road that the economy really hasn't gone down before, there could definitely be some unforeseen circumstances. And I think that's a low light that keeps me concerned right now. And you can say that anytime, but I think it's especially- Set every value investor club right up for the last two years. No, that's what I mean. But especially this time, it's either positive or negative. There was nothing, like the great financial crisis and the recovery out of that, there's nothing abnormal from a credit perspective. It was a very bad one, but it was a credit cycle. This one was extremely unique. We've done things that have not happened ever, really. And the bullwhip effects, there could be some stuff that's very, very unpredictable here that no one's even

looking at, which could provide an opportunity or can really hurt these businesses for years to come. Now let's move into the bull case. I think any listeners will know with this one, these are going to be simple, but what are some numbers you have for us, Ryan, for why the stock would work? So in the bull case, let's say the regulatory concerns get sorted out in the next 12 months. Compliance costs jump, but then kind of stagnate. So they bolster their compliance department, but then don't have to continue increasing costs, double digits. And we don't get into a massive recession. If those things happen, they should generate similar net interest margins to what they've done historically. And if they reinstate the buyback program at the current valuation, you're looking at greater than 20% earnings per share growth.

I mean, you're almost looking at 20 – if they bought back with all their net income today, you're almost getting 20% earnings per share growth without the earnings even growing. So you're going to make money. And if there's any sort of multiple rewriting, right now it's trades at six times trailing earnings. The average since 2013 has been basically 11 times. if you get anywhere near that, this is going to be a phenomenal investment over the next five years. Yeah. I think the bull case is so easy to see. If they're trading at six times earnings and five years from now, earnings have compounded at 20% a year, well, the stock's going to work. Now, the bear case though, I'm pretty sure we've talked about all these and there's not

many numbers you can put in. For Discover, it's not much of, yeah, their operating margin like a retailer is going to compress significantly because of wages or there's going to be a transition to Amazon or something like that. It's more of, okay, the loans kind of blow up on them. Yeah, which is, you know, I mean, that is the problem with banks, you know, if there's a really, really bad economy. Or a dumb manager. And credit cards, I mean, there's a reason the yields are so high on those.

It's kind of a higher risk lending asset. So I don't know. Do you want to go bear case? I mean, my bear case is really just the loans continue to underperform. The compliance stuff, they'll be fine unless something else comes up, right? that's an unknown thing what if a bunch of vcs tweet to pull your deposits pull your money out of discover yeah i'm not thinking about that you're not thinking about that bear case i'm not concerned about that but with the compliance stuff with the the expenses there and the

regulatory stuff i think they'll be fine they've had some stuff like this come up in the past and basically they just have to spend and have the workers in there and the expertise to make sure the compliance around risk management, blah, blah, blah as a bank is good. And I don't think that's a big concern for me, but the biggest concern is just the loans underperforming. And there's no evidence that I should think that they will because they've been so good historically at being prudent with their loans. I don't know. It just makes you nervous every time though. I think that's why the stock's cheap, but it's never not going to make you nervous with a bank like this now or banking like they're a bank essentially um but people think of them as

the credit card company yeah i think for me the the so there is the downside is zero right with any bank like if if there's a run on the bank obviously the equity gets canceled essentially but i think and the loans yeah like that side that side of the balance sheet too yeah the i think the more likely bear case is that maybe they're downplaying the regulatory issue and like it's not super clear to investors and maybe things get worse um they aren't able to reinstate their buyback program for a while we're looking at tighter net interest margins for a few years any sort of worsening in the economy you know they're it's it's cyclical like you said so

that you know you're gonna get lower earnings over the next years if the economy's worse but i think it kind of leads to the more or less interested which is that it always seems it has a cheap valuation for a reason it doesn't just get there because people start selling the stock like there's there's a reason that stocks like this get cheap and it's typically because things like regulatory issues things where there's a valid reason to believe things could get worse for them which i'm more interested because it's incredibly cheap more than anything else i mean it's just super cheap yeah yeah now i will say trail in eps maybe isn't the number to look at here if they're it's kind of like ally if they're

able to thread the needle over the next 18 months you're gonna make a lot of money yeah yeah the i think yeah we don't definitely don't look at the trailing pe in a vacuum i think with these really tough it kind of comes into the the bullwhip effect of the pandemic financial disruptions where I think you kind of look at a combination of pre-pandemic earnings during the pandemic earnings. And then what you think maybe they could have post-pandemic, because I think it should be higher in a normal environment because of the inflation, right? And the pre-pandemic numbers, but it's definitely not as good as when people were having the stimulus checks and not spending money on anything else. But I'm definitely more interested. I think this is a clear example.

And now this is the first time we looked at it. So it's going to take us a little bit longer to research. But it seems like unless we find anything else or whatever, it seems like one of those opportunities where people are overrating the news in the short term. And if the franchise is still intact, which I saw no indications that I think it wouldn't be, and the business model is not broken, which I didn't see any indications that it is, you're getting a company that has a strong track record of growing its earning per share at a PE of six. And they can probably earn that in the top of the cycle or the middle of the cycle for that earnings ratio, yeah, during the bottom of the cycle, during a tough period for a consumer lending business, they're

not going to earn that money. But through the cycle, if we look at the last, let's give another context for the listeners, from 2018 to 2022, so five years, they generated a cumulative $16.4 billion in net income. I think they could do higher the next five years. And given the buyback program that makes me definitely more interested in this stock because it seems like a good business maybe not as good as american express probably not as good as american express but a good one trading at a very very cheap valuation with low expectations from investors what would you rather own this or amex at the same man no not at the same price that's what i mean yeah that's a tough one i think

so for context for listeners amex is probably trading around given their guidance around 14 times earnings discover here i think is around six but probably gets a little bit higher given seven or eight seven or eight times forward maybe maybe yeah and again it's very uncertain they don't really give out guidance for a reason i would lean discover but it's pretty close yeah yeah i mean i'm definitely more interested well what about you the only problem is it's just like i sometimes worry we haven't really owned banks or we haven't had that much interest in banks and maybe it's just been kind of like our evolution as investors until maybe now and i worry that we're like getting interested in these banks at potentially like we're interested in

discover right when we figure out there's a bunch of regulatory issues maybe that's not like the best time to invest in a bank you know but you'd be wrong yeah if it's a wells fargo situation it definitely isn't solomon brothers i guess that wasn't really back but sort of yeah i mean kind of yeah not the same at the same type yeah i'm definitely more interested there is that concern For any listener, don't just look at the PE and say, earnings per share have grown like this. If you just look at those two numbers in a vacuum, yeah, it's obvious buy, but everyone can look at that. So there are clearly reasons people aren't buying the stock and you kind of got to decide whether you believe in them. Okay. I think that's it for this week. Next week, we're going to be

covering Sprouts Farmer's Market. We're going to be doing the monthly Arch Capital episode. So we're going to go through why we own it, risk, all that good stuff with kind of that unique format, but similar stuff going over the business, all that. So yeah, that'll be a fun one next week. We've owned that for a long time now. Let's get the disclosure though. As a reminder, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you everyone for tuning in. Next week, a little teaser. We'll have a sub on the power hour so for for me so that could be exciting i guess for anyone that maybe everybody everybody

wish brett a fun vacation on his european cruise that's right that's right i will be on vacation so don't tweet at me okay thank you everyone for listening again and we'll see you next time you