Jobs Tumble: Worry in Credit Card Sector Increases

David Nelms, Discover CEO

David Nelms, Discover CEO

Discover Financial Services Earnings Prediction

The rate of default for credit card companies is predicated by the unemployment figures, and as the jobless rate increased for the tenth straight month in October, up to 6.5 percent with 240,000 job losses reported, next quarter’s earnings for credit card companies could reflect this dire news.

The Chicago-based credit card company Discover Financial Services (NYSE:DFS) recently announced the settlement of an anti-trust legal dispute with rivals MasterCard Inc and Visa Inc. that will put $2.75 billion in the coffers, but this may not be enough to insulate the company from the contracting of the credit card industry. Discover maintains a nominal three percent of the market and the limited share of the market could be a blessing considering credit card banks are likely to write off a record amount of $96 billion, 10 percent of all credit card debt, by the end of 2009 according to Strategic Value Advisors.

Goldman and Sachs economists have predicted that the jobless rate will continue to increase and could be as high as 8.5 percent by the end of next year. In the Keefe, Bruyette & Woods research report, analysts stressed that unemployment is the largest determinant of credit card quality and coupled with the lack of liquidity for consumers could affect Discover’s fourth quarter earnings to be announced at the end of December.

The share price of Discover’s stocks has fallen forty-five percent since the beginning of the year to its current price of $10.78 per share and the third quarter filing documented a ten percent drop in net income from $202 million in the quarter a year before to $180 million.

Both the shareholders equity and the total assets were up slightly compared to the same quarter a year ago, but the balance of loan losses increased nearly 50 percent from $630 million to $960 million incurring a earnings per share drop from 42 cents to 38 cents per share.

While Discover’s revenues increased by 5.6 percent in the last quarter compared to year before, analysts at TheStreet.com concluded that “based on its current price in relation to its earnings, DFS is still more expensive than most of the other companies in its industry.”

In the fourth quarter of last year, Discover reported a net loss of $84 million due primarily to the deteriorating business, Goldfish, in Great Britain, which was sold to Barclay’s in February. The upcoming fourth quarter earnings should post significantly higher than last year, but should be tempered by the current fiscal situation.

There is increased speculation that the credit card market will implode in the same way the real estate market did. In fact, the credit card companies packaged credit card debt into securities and sold them to investors in a very similar, and now heavily criticized, process. As a result investors are now balking on credit card bonds and destabilizing the sector even further. To compensate for this loss, the credit card companies are raising their interest rates and penalty fees and tightening lending standards industry-wide.

Over the first half of 2008, lenders wrote off $21 billion in bad credit loans. Discover expects to write off $2.9 billion in the fourth quarter alone, and Discover CFO Roy Guthrie said in the third quarter earnings conference call that the company would continue to put money aside for loan losses in the upcoming quarters and acknowledged the in-house debt collection service for preventing even more defaults.

According to CardWeb.com, the average household now carries $10,678 in credit card debt, an increase of 29 percent since 2000. In this ever slippery slope of economic downturn consumers are getting anxious and cautious. The most recent Discover U.S. spending monitor concluded that 56 percent of consumers said their finances were getting worse, up 15 percent from the year before.

Keefe, Bruyette & Woods’ analysts said that Discover “is probably one of the better positioned card issuers in the marketplace,” but on a core basis they lowered the expectation for the fourth quarter earnings per share from $0.24 to $0.11 based on the increasing charge-off rate up to a current 6.73 percent.

Expert estimates from Bloomberg for the upcoming fourth quarter earnings are no more encouraging. The net income is expected to decrease to $106 million and the earnings per share are expected to wane again down to $0.21 from $0.37.

Management expressed confidence that they were better off than during the cycle one year ago due to its long-tenured and seasoned portfolio, but Discover CEO David Nelms said he expected the fourth quarter earnings to be even lower than the third quarter due to the historically tough environment and added that the company would not be active in company share purchases until they feel better about the current economic environment.

The unemployment rate and the downturn in economy will continue to be strong factors in the soundness of the credit card market, but in a year when the giants have fallen, it may be of great benefit to be the little guy in a rattled and struggling sector.

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