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

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 Negative from Stable. 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 reflects the Company’s solid franchise anchored by its core card business, its solid through-the-cycle earnings generation, strong credit risk management, good funding profile and sound capitalization. The ratings also consider the highly competitive environment in the U.S. credit card and payments space, and the Company’s product and revenue concentration.

DBRS Morningstar notes that Discover remained profitable during the Financial Crisis and has been a top performer in the Federal Reserve’s CCAR stress testing. Nonetheless, we view the abruptness and likely severity of the economic contraction caused by the Coronavirus Disease (Covid-19) combined with the uncertainty of the magnitude or duration of the downturn may ultimately have a more significant impact on the Company’s concentrated business model. This view has resulted in the trend being revised to Negative from Stable.

RATING DRIVERS
Given the Negative trend, an upgrade in the near term is unlikely. However, if the United States makes notable progress in controlling the pandemic allowing the economy to reopen, while the Company’s business model remains relatively resilient supported by actions taken by the government, the Federal Reserve and regulatory agencies, the ratings could revert back to Stable. Conversely, a severe economic downturn that is prolonged resulting in significantly weakened credit fundamentals would result in a ratings downgrade.

RATING RATIONALE
Discover has a solid franchise, stemming from its strong brand and entrenched market positioning as the fifth largest U.S. credit card issuer and the second largest provider of private student loans. The franchise is also bolstered by the Company’s historically innovative and customer focused mindset that has resulted in high cardholder satisfaction and loyalty. Discover has consistently maintained top rankings in customer satisfaction surveys, outperforming most of the other top U.S. card issuers. Indeed, for a second consecutive year Discover received the top ranking in J.D. Power’s 2019 U.S. Credit Card Satisfaction Study. Further, the Company’s closed-loop network enhances its franchise by enabling it to better monitor and quickly implement new products or partnerships while reinforcing its brand to consumers.

We view the Company’s earnings power as solid and resilient. Indeed, during the Financial Crisis, Discover remained profitable on an annual basis. Revenues are mostly comprised of net interest income, with a small contribution from fee-based income accounting for 17% of total revenue in 2019 which constitutes a ratings constraint. Discover has a sound cost control approach resulting in consistently lower operating efficiency ratios relative to the peer average. Nonetheless, in 2019 total expenses grew 7.8%, slightly faster than the 7.0% growth in revenues as a result of the Company’s investments including technology that would further enhance efficiencies. Overall, the Company delivered another year of solid profitability in 2019 with reported net income of $3.0 billion, up 8% YoY resulting in a ROA of 2.7% and an ROE of 25.7%. However, we expect the Company’s earnings to come under significant pressure from the coronavirus’s adverse impact on consumers’ abilities to spend and service their debts.

Discover’s good risk profile is underpinned by its prudent approach to risk management, which mitigates some concerns over its reliance on the health of the U.S. consumer. The Company has historically embraced a rather conservative risk management culture accompanied by disciplined and flexible credit underwriting. Discover’s card lending exposure to non-prime borrowers is low and it has remained fairly consistent over the past ten years. The overall credit performance remains sound with the gradual increase in credit losses mostly attributed to portfolio seasoning. The net charge-off (NCO) rate of the credit card portfolio was 3.43% in 2019, below the industry average of 3.6%. Nonetheless, in the event that the coronavirus triggers a protracted economic downturn with high unemployment, it will result in a substantial increase in Discover’s credit losses. The Company has well-established and defined risk policies and enterprise risk governance structure as well as sound servicing and collection capabilities.

The Company has a good funding profile supported by a strong liquidity position and a diversified funding base. Discover has a considerable presence across its three key funding channels, including deposits, asset backed securitizations and senior unsecured debt. The deposit funding accounts for nearly three-fourths of total funding. Direct-to-consumer deposits, which are viewed as higher quality deposits than brokered deposits, accounted for 55% of total funding at YE19, up from 47% at YE18. Discover’s funding sources provide ample liquidity to address its funding needs and debt obligations. The Company also has contingent liquidity capacity through its liquidity portfolio and undrawn credit facilities totaling $22.1 billion at YE19. Moreover, the Bank has access to the Federal Reserve’s discount window with an incremental capacity of $34.2 billion. This compares to long-term debt maturities totaling $5.2 billion and certificates of deposit maturities of $19.0 billion for 2020. As a bank, Discover will also benefit from various Federal Reserve programs implemented to blunt the adverse impact from the coronavirus pandemic.

Discover’s sound capitalization is driven by its consistent capital generation and high profitability. Further, capitalization is supported by the Company’s prudent and flexible capital management. As of December 31, 2019, the Company’s common equity tier 1 ratio (CET1) ratio was 11.2%, above its long-term target of 10.5% and comfortably in excess of regulatory requirements. Further, the tangible common equity-to-tangible assets (TCE) ratio was sound at 9.6% at YE19. DBRS Morningstar views the adverse impact from the CECL implementation to the Company’s tangible capital levels as manageable due to its strong earnings generation and capital accretion capacity. We note that last week, U.S. bank regulators have provided some additional flexibility to some financial institutions (if they choose to do so) that can mitigate the estimated regulatory capital effects from the CECL adoption for up to two years, in addition to the three year transition period currently in place.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

The Grid Summary Grades for Discover Financial Services are as follows: Franchise Strength – Good; Earnings Power – Strong/Good; Risk Profile – Good; Funding & Liquidity – Good; Capitalisation – 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 2019), 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.

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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