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Discover Financial's Unenviable, Undeniable, and Unbelievable Problem

Discover Financial Services (NYSE: DFS) recently reported its third-quarter earnings, and investors heard a familiar story: The company is seeing higher revenue, solid loan portfolio growth -- and higher loan losses. Revenue net of interest expense rose to $2.53 billion, a 10% increase year over year. Discover achieved 9% year over year total loan portfolio growth driven by growth across all of its primary loan platforms: credit cards, personal loans, and private student loans.

Unfortunately, net principal charge-offs and loan loss provisions rose much faster. Net principal charge-offs, loans that Discover categorizes as those it is unlikely to ever collect, grew to $527 million, a whopping 42% increase year over year. Provisions for loan losses, money set aside for loan payments not yet collected, grew at an even greater rate to $674 million, a 51% increase year over year. These line items noticeably impacted the bottom line, as net income declined to $602 million, a 6% decrease year over year.

Let's take a closer look at some of the company's numbers and determine what drove them this past quarter.

Investors have grown frustrated with Discover Financial's performance. Image source: Getty Images.

Discover-ing the real story behind the loan growth

Once again, all of Discover's loan portfolios showed solid year-over-year growth. The company's credit card portfolio, by far its largest, increased 9% to $63.5 billion. The private student loan portfolio grew a more modest 2% to $9.2 billion, while personal loans grew 18% to $7.4 billion. This growth was a result of a nearly even mix between onboarding new customers and increased use by existing customers.

Discover credited spending growth from existing card holders to the incredible loyalty it has earned from its customers. Management believes this is due to the innovative features it has introduced to its core products and excellent customer service. In the company's third-quarter conference call, transcribed by S&P Global Market Intelligence, CEO David Nelms stated:

For Discover, attrition has remained consistently low among prime revolvers, reflecting the loyalty of our customer base. The foundation for our strong performance is our commitment to outstanding customer service and a unique and expanding feature set in our Discover it Card. In our advertising, we remind customers that "We treat you like you'd treat you." Customers are loyal to us in part because we serve them well, which includes providing a helping hand in response to unexpected events.

One of the "unexpected events" Nelms was referring to was the huge Equifax data breach this past summer. For its customers, Discover regularly scans thousands of risky websites, and if it finds its customers' personal identification information on any of them, the company alerts its account holder. After the Equifax breach, enrollment in this free alert service spiked. It's services like this that have consistently earned Discover high customer satisfaction scores on third-party surveys.

Discover Financial Metrics Q3 2017 Q3 2016 Change
Revenue $2.53 billion $2.30 billion 10%
Net income $602 million $639 million (6%)
Net charge-off $527 million $370 million 42%
Loan loss provisions $674 million $445 million 51%

Data source: Discover Financial Q3 2017 earnings presentation.

Mo' money, mo' problems

Unfortunately for Discover, as its loan portfolio grows, so do its credit woes. The company's charge-off rate across its loan platforms was 2.63%, up substantially from last year's third quarter, when it was 2.02%. Not helping matters is that it's the personal-loan category that saw the highest loan growth across Discover's portfolio this quarter. Yet this category not only has the highest charge-off rate, at 3.19%, but it also was the very area of concern Discover highlighted in last quarter's conference call.

During the conference call's Q&A session, CFO Mark Graf did try to ease concerns about the credit concerns stemming from the company's personal loan division by saying he wasn't "overly concerned about it" and that the potential problems were limited to a very small subset of personal loans. However, management also refused to give guidance for charge-offs for 2018, and while that's fair (most companies I follow don't like giving guidance for the next fiscal year until the fourth-quarter earnings release), it also makes investors nervous, given the sizable increases in loan loss provisions and charge-offs.

Discover is in an unenviable position: It can't achieve loan growth without also growing its credit problems. While its overall charge-off rate is still a reasonable 2.63%, there's no denying that it's growing fast. As net income decreased from last year's third quarter, it's evident that the loan loss provisions and charge-offs are already acting as an anchor on earnings. With peers such as American Express, which offers both earnings growth and a much lower write-off rate, there seems to be little reason for investors to take a chance on Discover until it proves it can grow its loan portfolio and its earnings.

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Matthew Cochrane has no position in any of the stocks mentioned. The Motley Fool recommends American Express. The Motley Fool has a disclosure policy.