Discover FinancialNYSE: DFS

Phil RosenTim TysonXiaoting YangPresented, 4-15-2008

Overview

• Macro Overview

• Industry Analysis

• Company

• Comparative and Banking Analysis

• Stock Performance

• Recent Events

• Recommendation

Macro Overview

• Unemployment

• Consumer Confidence

• Retail Sales

• Consumer Credit

• Housing Problems

Unemployment

• Upward trend since early 2007 (Current 5.1%)

http://www.forecasts.org/unemploy.htm, Accessed 14 Apr 08

Consumer Confidence

• Dropped to 64.5 in March from 76.4 in Feb

• 25.4% Business conditions are "bad“ (Up from 21.3%)

• 25.1%   Jobs are "hard to get" (Up from 23.4%)

http://www.conference-board.org/economics/ConsumerConfidence.cfm, Accessed 14 Apr 08

Retail Sales

• Declining in recent months

• Recent Bankruptcies (LIN, SHRP)

• Stimulus Checks start getting mailed in May

Consumer Credit

• Consumer credit increased at an annual rate of 2-1/2 percent in February

• Revolving credit increased at an annual rate of 6 percent

http://www.federalreserve.gov/Releases/g19/current/, Accessed 14 Apr 08

Housing Environment

• Increased mortgage delinquency

• Rising foreclosures

Industry Analysis

• Different models operate in the industry

Issuers

JPM Chase

Citi

B of A

CapitalOne

Discover

Processors

Visa

Mastercard

AMEX

Discover

Discover vs Visa/Master Card

Credit Card Company

Credit Card Issuer

Consumer Merchant

Credit Card Company

Payment Network

Credit Card Issuer$100 $98

$.25

$1.75

Monthly Fee

• Discover owns all aspects of Credit card payment operations, and thus captures all revenue points in this model

Consumer Merchant

Monthly Fee

Transaction Fee

Visa/MasterCard:

RCMP Presentation on DFS, Dec 2007

Company

• Spun off by Morgan Stanley June 2007

• Operations:– Discover Payment Network– Pulse ATM Network– Discover Bank

Discover Card

• Discover cards issued on Discover Network

– 6th largest issuer

– $47.5B receivables

– $105.9B total volume

– 3rd largest U.S. merchant network

“Discover Financial Services Financial Community Briefing Presentation”, http://library.corporate-ir.net/library/20/204/204177/items/284599/InvestorDay_032008.pdf, Accessed 14 Apr 08

“Discover Financial Services Financial Community Briefing Presentation”, http://library.corporate-ir.net/library/20/204/204177/items/284599/InvestorDay_032008.pdf, Accessed 14 Apr 08

“Discover Financial Services Financial Community Briefing Presentation”, http://library.corporate-ir.net/library/20/204/204177/items/284599/InvestorDay_032008.pdf, Accessed 14 Apr 08

Discover Bank and Insurance

• Offer typical bank savings products– CDs– Money Market Accounts

• Offer several insurance products– Auto Insurance– Homeowners– Term Life– Home Warranty

Revenue Streams

38%

37%

6%

3%7%

9% Consumer Loans

Securitization

Loan Fee Income

Insurance

Other Interest

Other Income

Problems: Securitization of loans Consumer loan defaults

“Discover Financial Services Financial Community Briefing Presentation”, http://library.corporate-ir.net/library/20/204/204177/items/284599/InvestorDay_032008.pdf, Accessed 14 Apr 08

Management’s Outlook• Continued rise in delinquencies and charge-offs (4.75%-

5.00% full year)

• Spreads should widen as cost of funds decreases

• Funding environment choppy; ABS available, but remain at wider spreads

• Maintain lower balance transfer volumes/loan growth

• Maintain prime underwriting focus

• Remain conservative on liquidity and capital

• Aggressive focus on payments opportunities

“Discover Financial Services Financial Community Briefing Presentation”, http://library.corporate-ir.net/library/20/204/204177/items/284599/InvestorDay_032008.pdf, Accessed 14 Apr 08

Comps Analysis

• Only one close competitor (Capital One)

• Hard to develop a useful model

DFS COF

Price 17.55 49.44

EPS .91 3.97

P/E 19.87 12.45

PEG 1.51 .72

Stock Price based on Comps AnalysisUsing P/E: $11.33Using P/Bv: $8.91

Banking Analysis

• Rising Delinquency Rates (Domestic)

– 30 Days – increased 7% in 2007– 90 Days – increased 10% in 2007

• Shrinking Net Interest Margin

(COF NIM: 5.3% in 2007)

Loan Loss Allowances

Stock Performance

http://finance.yahoo.com/q/bc?t=1y&s=DFS&l=on&z=m&q=l&c=&c=%5EGSPC, accessed 14 Apr 08

Recent Events

• Sold off Goldfish Division in Feb 2008

• Acquired Diner’s Club Company

• CEO Purchased 15,000 share on April 11th

Recommendation

• Sell 201 shares at the market– Securitization Problem– Rising Delinquency Problem– Shrinking Net Interest Margin– Consumer Spending

Appendix

• Diners Club– Purchased for $165m in cash– 2-3 years to integrate systems– 10-15m in annual revenue expected– DFS will not issue cards or service loans (Citi)– Will promote Discover Card internationally– Will allow use of either card on both networks

Appendix

• Gold Fish– U.K.-based credit-card business– Acquired 2 years ago for $1.7 billion– Sold in Feb 2008 for $70 million– Sold due to large loses and write downs