Morgan Stanley upgrades Discover Financial Services as company hopes to restart buyback program

Published Wed, Oct 26 20228:00 AM EDT

Discover Financial Services has excess capital that it could put to use by resuming its buyback program, lifting the stock and making it an attractive buy for investors, according to Morgan Stanley. The firm on Wednesday upgraded shares of Discover Financial Services to overweight from equal weight and boosted its price target to $116 from $104. The target price implies a 16% upside from where shares traded at Tuesday's close. The upgrade comes on hopes that Discover will resume its buyback program, which management recently stated it would like to do before year-end. "We now model $509M of buybacks for 4Q22, and an additional $3.1Bn in buybacks for 2023, adding $1.36, or 10% to our prior 2023e EPS," wrote analyst Betsy Graseck. She added that the company is in a strong position to restart share repurchases as it has significant excess capital on its balance sheet. Student loan growth strength The firm also expects stronger student loan growth, which also contributes to lifting its price target. Payments on federal student loans are set to resume next year after a lengthy pause on interest rates and repayments due to the coronavirus pandemic. "In its updated 2022 guide, DFS boosted loan growth outlook, and we expect some persistence there going into 2023," said Graseck. "We are taking 2023 average loan growth up from ~7% y/y to ~10% y/y, adding $1.36 to 2023e EPS. She sees card loans being a particularly strong driver with average loans up 11% on the year. In addition, Morgan Stanley sees personal loan growth accelerating to about 7% on the year in 2023 from about 4% in 2022. Discover also noted that they expect consumer payment rates to continue to normalize, adding "some tailwind to loan growth," Graseck wrote. Some offsets Graseck noted a few things that are set to offset earnings growth for the financial services company, including its reserve ratio. "We are holding DFS' reserve ratio flat over the next several years based on our outlook for rising credit losses," she said. "How quickly credit performance continues to normalize will be a key item to watch going into 2023, especially as delinquencies moved up another +31bp this quarter and are up +54bp y/y." The firm now forecasts a reserve build of $611 million up from $388 million in 2023, and is taking the reserve ratio up slightly to 6.76%. "This is a partial offset to the positives above, lowering 2023e EPS by 61c," Graseck wrote. Morgan Stanley also acknowledged forecasts of a recession in 2023 but said that it expects Discover to hold up. "While we are anticipating an economic slowdown and an increase in unemployment from 3.5% to ~4%, we are not expecting credit losses to come close to what DFS experienced in 2008-2010 when unemployment reached 10%," said Graseck. "As management delivers on loan growth of ~10% and dividend payout ratio of 18% over the next year, even as net charge offs rise and reserve ratio builds, we expect DFS' multiple to expand given its relatively stronger credit quality and excess capital supportive of a reinitiation of the buyback," she added. — CNBC's Michael Bloom contributed to this report.