DBRS Morningstar Confirms Discover Financial at BBB (high); Trend Revised to Stable from Negative

DBRS, Inc. (DBRS Morningstar) confirmed the ratings of Discover Financial Services (Discover, or the Company), including the Company’s Long-Term Issuer of BBB (high). At the same time, DBRS Morningstar confirmed the ratings of its banking subsidiary, Discover Bank (the Bank). The trend for all ratings has been revised to Stable from Negative. The Intrinsic Assessment (IA) for the Bank is A (low), while its Support Assessment is SA1. The Company’s Support Assessment is SA3 and its Long-Term Issuer Rating is positioned one notch below the Bank’s IA.

KEY RATING CONSIDERATIONS
The ratings confirmation and revision of the ratings trend to Stable reflect the Company’s demonstrated earnings resiliency and solid credit performance despite the significant economic headwinds resulting from the coronavirus disease (COVID-19) induced downturn. Additionally, Discover’s credit card portfolio largely fared better than the industry’s sharp contraction in card spending and outstanding balances. The ratings also consider the Company’s solid franchise as a credit card issuer, payment network owner and private student lender, its proven credit risk management, good funding profile, and sound capitalization. Lastly, the ratings contemplate the intensely competitive landscape in the card issuing business, along with the near-term challenges surrounding the pandemic-related limitations that inhibit discretionary credit card spending and card loan growth, both key contributors to the Company’s concentrated revenue streams.

The Stable trend reflects our expectation that Discover’s balance sheet fundamentals will remain solid while its operating results will gradually improve as the vaccinations become widely available, pandemic-related restrictions subside and consumer confidence and spending recovers. The Stable trend also considers a further, yet manageable, deterioration in credit performance over the next several quarters.

RATING DRIVERS
Over the longer term, if the Company were to grow its fee-based businesses resulting in further revenue diversification while maintaining similar risk-adjusted returns, the ratings would be upgraded. Conversely, a sustained weakening in the Company’s profitability, or a meaningful deterioration in credit fundamentals, would result in a ratings downgrade.

RATING RATIONALE
The Company has a solid franchise as the fifth largest U.S. credit card issuer, payment network provider and second largest lender in the private student loan market. Discover’s franchise is supported by its loyal cardholder base, consistent industry outperformance in customer satisfaction surveys and historically innovative approach for product enhancements and value proposition. The Company’s closed-loop network enhances its competitive advantage by the embedded flexibility and adaptability that allow better monitoring of cardholder spending patterns, swift implementation of new products and offerings, competitive pricing, and brand reinforcement as a merchant accepted card payment network. Nonetheless, third party credit card issuing on Discover’s payment network remains limited given the entrenched market positioning of the other top payment networks, even though the Company endeavors to expand its network adoption for B2B payment capabilities and has made significant strides in broadening its network acceptance globally by partnering with numerous local payment networks.

Discover’s earnings power is solid stemming from its highly profitable business model and demonstrated resiliency in adverse economic environments. Indeed, the Company remained profitable on an annual basis in 2020 despite the significant earnings headwinds. For 2020, Discover generated net income of $1.1 billion, substantially lower than the $3.0 billion earned in 2019. A substantial increase in loan loss provisions and a 4% decline in adjusted (excluding one-time items) net revenue was partially offset by a 2% decline in adjusted operating expenses. We expect future earnings improvement to mirror growth in loans and card spending, both of which should benefit by the growing U.S. economy. Discover’s bottom line could also be bolstered by reserve releases due to the improving economic outlook. With that said, the Company’s earnings power is constrained by its narrow revenue diversification and reliance on spread income with fee-based income accounting for just 17% of total income. Discover has historically maintained a disciplined cost control culture. Notably, in response to the pandemic, the Company implemented and successfully completed a $400 million expense reduction initiative (approximately 9% of 2019 operating expenses), despite ongoing investments in technology and analytical capabilities.

The Company’s good risk profile is supported by a conservative risk management culture with consistently low exposure to riskier segments of the credit spectrum. Discover’s credit performance has remained strong in the current downturn, aided in part by the swift risk management initiatives it undertook at the onset of the pandemic, as well as significant government stimulus that has helped mitigate the negative impact of the pandemic. The net charge-off (NCO) rate of the credit card portfolio was 3.41% in 2020, down slightly year-over-year and in-line with the industry average, while the 30+ day delinquency rate at YE20 was at the lowest level of the past three years. The credit performance for the rest of the portfolio has also remained solid. Nonetheless, some manageable credit deterioration is expected to materialize in the second half of 2021 with credit metrics likely remaining elevated into 2022. The latest direct stimulus payments to consumers by the U.S. government should be beneficial for credit trends in the near-term, although a lack of continuing momentum in the labor market recovery could partially diminish this positive impact.

Discover has a good funding profile benefitting from diverse sources and a strong liquidity position. The Company has maintained a meaningful presence in its primary funding channels, including deposits, asset-backed securitizations and senior unsecured debt. Over the past year, direct-to-consumer deposits grew further, becoming a major component of Discover’s funding profile at 62% of total funding in 4Q20, up from 55% in 4Q19, providing it with a lower cost of funding relative to brokered deposits that accounted for 13% of funding, down from 19% a year ago. The Company has strong liquidity to meet its funding needs and debt obligations. At YE20, Discover’s primary liquidity sources included a liquidity portfolio of $24.4 billion, comprised of cash and liquid investments and $6.0 billion of undrawn credit facilities through private asset-backed securitizations. Additionally, the Bank has another $32.9 billion in borrowing capacity at the Federal Reserve Bank (Fed)'s discount window. These liquidity sources compare to long-term debt maturities of $4.2 billion and certificates of deposit maturities of $17.9 billion for 2021. Of note, in September 2020, the Bank became a member of the Federal Home Loan Bank (FHLB) of Chicago, which provides an additional potential source of liquidity for the Company.

The Company’s sound capitalization is bolstered by its dependable organic capital generation and strong profitability. At YE20, the Company’s common equity tier 1 ratio (CET1) ratio was 13.1%, higher than its long-term target of 10.5% and comfortably above the regulatory requirement of 8.0%, including the Fed’s capital buffer requirements. Discover has historically applied a prudent and flexible capital management policy. In March 2020, like most banks, the Company suspended its share repurchase program. Reflecting an improving economic outlook, in 1Q21 the Company authorized a new share repurchase program of $1.1 billion.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at: https://www.dbrsmorningstar.com/research/373262.

The Grid Summary Grades for Discover Financial Services are as follows: Franchise Strength – Good; Earnings Power – Strong/Good; Risk Profile – Good; Funding & Liquidity – Good; Capitalization – Good.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 8, 2020), which can be found on our website under methodologies and criteria: https://www.dbrsmorningstar.com/research/346375/
global-methodology-for-rating-banks-and-banking-organisations. Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021): https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The primary sources of information used for this rating include Company Documents and S&P Global Market Intelligence. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did not participate in the rating process for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

This is an unsolicited credit rating.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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