Trade of the Day: Discover Financial Services (DFS)

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Discover Financial Services (NYSE:DFS) has broken through a short-term resistance level at $72 on the news from Thursday evening that the company’s board of directors has approved both a new $3 billion share-buyback program during the coming five quarters and a $0.05 increase in the quarterly stock dividend — raising it from $0.35 to $0.40 per share.

First, the share-buyback program is music to investors’ ears because DFS has a current market cap of just over $25 billion. If the company were to buy back $3 billion worth of its own shares at their current value, it would amount to a 12% reduction in the company’s float, which all on its own would amount to a 13.6% bump in earnings per share (EPS), simply by reducing the number of shares across which current earnings would need to be divided.

That doesn’t even take into account the expectations that DFS is going to continue growing its revenue and earnings organically.

Second, the dividend increase will increase the company’s dividend yield from its current level of 1.96% to a new level of 2.2%. This will make the stock more attractive as a potential income-generation trade, and it shows investors that management is looking for ways to return value to shareholders.

One of the concerns that has pushed DFS lower than some of its peers has been the company’s rising net principal charge-offs (the loans Discover assumes it will not be able to collect from its card holders). According to Discover’s first-quarter earnings announcement, charge-offs increased by 30% year over year, which has forced the company to set aside $751 million for potential loan losses — a 28% increase from the previous year.

However, while all of this might look worrisome, it’s important to keep in mind that Discover’s revenues have grown by 10% and earnings per share are up 27% during that same time frame, which should more than offset the increased charge-offs. For a company like Discover that is involved in issuing credit cards and student, personal and home-equity loans to consumers — some of whom have weaker credit scores — this is all part of doing business, and we think DFS is doing a great job managing it all.

We expect the recent bullishness for DFS to continue through the week as the company prepares to release its second-quarter earnings data on July 26, after market close. We are looking for DFS to continue climbing up toward $74 (the resistance level the stock hit in late April) in the run up to earnings, which could provide some solid profits before the actual announcement, but we would feel comfortable holding through earnings if the stock doesn’t bounce high enough beforehand.

‘Buy to open’ the DFS August 17th $72.50 Call (DFS180817C00072500) for a maximum price of $2.00.

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