November 23, 2010



Discover Financial Services |(DFS – NYSE) |$43.73* | |

Note: This report contains substantially new material. Subsequent reports will have changes highlighted.

Reason for Report: 1Q13 Earnings Update

Prev. Ed.: 4Q12 and FY12 Earnings Update, Jan 14, 2013.

Brokers’ Recommendation: Positive: 77.8% (14 firms); Neutral: 22.2% (4); Negative: 0.0% (0) Prev. Ed.: 14; 5; 0

Brokers’ Target Price: $49.44 (↑ $3.81 from the last edition; 16 firms) Brokers’ Avg. Expected Return: 13.1%

*Note: Though dated Jun 6, 2013, share price and brokers’ material are as of Apr 26, 2013.

Note: The tables below (Revenue, Margins, and Earnings per Share) contain material from fewer brokers than in the Valuation table and PMES section. The extra figures in the Valuation table and PMES section come from reports that did not have accompanying spreadsheet models.

A Flash Update on 1Q13 Earnings was done on Apr 23, 2013.

Portfolio Manager Executive Summary

Discover Financial Services (DFS), a payment card issuer and card network operator (both credit and debit), has two segments – U.S. Card and Third-Party Payments. The U.S. Card segment includes Discover Card branded credit cards issued to individuals and small businesses on the Discover network and other banking related services through Discover Bank. Substantially all of Discover's revenues and income come from its U.S. Card operations. Third-Party Payment comprises Discover's PULSE network (for debit card transactions), Diners Club International (purchased on Jun 30, 2008) and the company's third party issuing business, which allows Discover Cards issued by third parties to be utilized on the Discover Network.

Almost 77.8% of the firms in the Digest group covering the stock had a bullish outlook on Discover, while the remaining 22.2% rated the stock neutral. None of the firms rated the stock negatively. Of the 18 firms covering the stock, 16 brokers provided target price ranging from $40.00 (8.5% downside from the current price) to $57.00 (30.3% upside from the current price).

Positive or equivalent outlook – 14/18 firms or 77.8% – The bullish firms expect Discover Financial’s earnings to continue growing, thus enabling it to return ample capital to shareholders. They appreciate that the company’s earnings is improving due to higher revenues, effective risk management and capital deployment, rather than cost cutting and declining credit costs. Moreover, they believe that the marketing of the Discover It card is expected to boost receivables.

Moreover, the bullish firms expect strong growth in transaction volumes, driven by the continued transition of payment transactions to plastic and electronic from cash and check, along with increasing acceptance of Discover’s cards at merchant locations. Strong credit trends, impressive loan growth and a strong asset position also provide optimism.

These bullish firms believe that Discover’s valuation is attractive and appreciate its strong fundamentals and sturdy capital base. They believe that Discover is one the few companies among its peers that will witness better earnings per share and ROE growth in the high-teens. Moreover, they expect the price-to-earnings ratio to grow, driven by the company’s operating strategies. They believe that Discover will continue to generate growth at a faster pace than its peers in the industry. Moreover, these firms expect the credit trends to remain at the current historically low levels, unless a substantial negative macroeconomic event, such as a significant decline in the unemployment level or an economic downturn, takes place. These firms are of the opinion that Discover’s foray into businesses such as student and personal loans will drive growth in the upcoming years, although growth in the credit card loan portfolio is expected to slow down. Nevertheless, they expect even small increases in the company’s share of credit card expenditure volume to boost its earnings substantially. Moreover, the Payment Services segment is anticipated to become a larger contributor to earnings as it generates comparatively higher return than Discover’s other businesses.

Furthermore, the Student Loan Corporation acquisition as well as the new debit rules should aid Discover as these offer scope for gaining additional issuers' PIN debit business, which will boost PULSE network volumes. Moreover, the student loan business is expected to grow rapidly due to the increasing tuition fees that are driving more and more students to avail student loans.

Neutral or equivalent outlook – 4/18 firms or 22.2% – The cautious firms believe that the current economic environment is not conducive for rapid earnings growth or inorganic expansion. These firms are concerned about Discover’s plans of increasing its operating expenses, as they are unsure about the company’s ability to generate adequate revenues to offset it. However, the company enjoys a strong customer loyalty, which helps it sustain and grow consumer spending. These cautious firms favor companies such as Discover that are poised to benefit from the growth of electronic payments worldwide. They are also optimistic about the company due to its strong management team, impressive credit performance, sturdy margins and higher card loan growth compared to peers. However, they are of the opinion that the strong operating performance of Discover is driven by exceptional credit performance, which is expected to return to a more normal level in the future, thereby slowing down growth. Nevertheless, the downturn is expected in the long term and the credit quality is expected to continue to improve in the near term. Net interest margin is also expected to soften in the near future as a result of low-yielding student loan and credit card portfolios, both of which are growing significantly. Overall, they believe that Discover has a limited growth potential in the absence of any significant macroeconomic improvement.

Jun 6, 2013

Overview

Founded in 1986 and based in Riverwoods, Ill., Discover Financial Services (DFS) is a credit card issuing and an electronic payment services company in the United States. It offers credit cards, personal and student loans and deposit products. In Mar 2009, Discover became a bank holding company under the Bank Holding Company Act of 1956 and a financial holding company under the Gramm-Leach-Bliley Act in connection with its participation in the U.S. Treasury’s Capital Purchase Program. The company offers its products and services with acceptance in more than 185 countries and territories.

Discover Financial manages its business activities in two segments:

• The Direct Banking segment, formerly referred to as the U.S. Card segment, includes Discover card-branded credit cards issued to individuals and small businesses on the Discover Network. The segment also offers personal loans, student loans, prepaid cards and other consumer lending and deposit products through its Discover Bank subsidiary.

• The Payment Services segment, formerly referred to as the Third-Party Payments segment, includes PULSE, its ATM, debit and electronic funds transfer network; Diners Club, its global payments network; and its third-party issuing business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties.

Additional information is available at .

Analysts identified the following factors for evaluating the investment merits of Discover:

|Key Positive Arguments |Key Negative Arguments |

|Operating Leverage: Analysts anticipate strong economies of scale with|Pricing Pressure: The company could face increased pricing pressure from |

|significant investment spending for the company. |member banks and merchants. |

|Global Payment Processing: The company provides a good opportunity for|Macroeconomic Risk: Discover is exposed to a weak global economy with low |

|the investors, looking for exposure in the global payment processing |spending, which could meaningfully affect earnings. |

|universe. |Litigation and Regulations: Any unfavorable result regarding litigation and |

|Stronger Customer Base: The company has a solid and loyal base of |regulatory issues could adversely affect Discover’s profits. |

|customers. |Financing Risk: In the near term, the company could face financing risks. |

|Credit Quality: The company has satisfactory credit quality trends. |CARD Act: The company expects pressure on both its credit card yield and |

| |other income due to the CARD Act. |

| |Credit Risk: The growth of student loans and unsecured consumer loans is |

| |increasing Discover’s credit risk. |

Jun 6, 2013

Long-Term Growth

Discover is a unified global organization and has a unique structure as a franchisor, processor, and advisor. The company has been focusing its efforts on delivering value-added products and services that enhance the profitability of customers’ businesses, and provide innovative programs that meet and exceed their cardholders’ and merchants’ needs.

The company has invested heavily in its global brands and payments network, and believes that merchants, consumers, corporations and governments recognize the convenient and secure electronic payment solutions, which were enabled by the investments. Management expects credit card loans to generate growth toward the higher end of its long-term target of 2%–4%.

Management has plans of increasing expenditure on various initiatives such as the launch of new cards, alliances, and organic growth. These initiatives are expected to boost revenues by the second half of 2013 and in 2014.

The bullish firms believe that the discontinuation of network exclusivity will be beneficial for Discover’s debit card business and drive transaction volume on its PULSE network. Additionally, they foresee substantial growth potential in the prepaid and mobile payment markets. These firms believe that Discover will be able to accomplish its long-term growth target of 2%–4% for its credit card business. The long-term consumer lending growth is expected to be around 10%–15%.

Moreover, they expect the company to continue returning wealth to shareholders via share repurchases and dividend payments, even as it takes advantage of suitable acquisition opportunities. These firms believe that Discover has the capital flexibility to generate both organic and inorganic growth as the company’s capital ratios are among the best in the financial sector. The company is also fundamentally strong and has a limited exposure to the European debt crisis.

These firms believe that Discover can generate long-term EPS growth of about 10%–15%, driven by substantial organic growth and considerable amount of deployable capital.

Meanwhile, the cautious firms believe that Discover needs to generate strong operating results in its card portfolio. They believe that growth in the credit card business will remain limited but expect the company’s debit card business to benefit from the Durbin Amendment. Further, these firms believe that the company has a loyal clientele, which ensures low customer attrition and will help in maintaining a strong spending trend.

Moreover, the shift from the traditional forms of payment to cards and electronic payments is expected to generate strong volume growth in the payment services segment. Additionally, the increasing tuition fees are expected to raise the number of students requiring loans. This is expected to boost the student loans business.

The cautious firms anticipate a slowdown in delinquency and charge-off improvements, which will likely lead to reserve building. They expect the company to build reserves over the next three years and attain a reserve ratio of about 3.9% by 2015. Moreover, high competition is expected to generate yield compression and reduce operating margin.

These cautious firms believe that the deals with both Global Payments and Vantiv will boost the acceptance of PayPal at Discover’s merchant locations. They are of the opinion that PayPal will play an integral role in converting customers from the old methods of payment to newer ones, and hence the agreement with the company will be a major advantage for Discover in the upcoming years.

Jun 6, 2013

Target Price/Valuation

|Rating Distribution |

|Positive |77.8%↑ |

|Neutral |22.2%↓ |

|Negative |0.0% |

|Avg. Target Price |$49.44↑ |

|Digest High |$57.00↑ |

|Digest Low |$40.00 |

|No of the analysts with target price/ Total |16/18↓ |

Risks to the target price include higher-than-expected credit costs, a slowdown in card spending, increased regulatory scrutiny of the credit card industry, compression of interchange fees prompted by regulatory intervention, and economic cyclicality.

Recent Events

On May 30, 2013, Discover Financial Services announced that it expanded its business alliance with Japan Credit Bureau (JCB). The expanded relationship will allow the U.S. ATM acquirers to route all JCB transactions over PULSE – Discover Financial’s ATM, debit and electronic funds transfer network.

Earlier, the cards of this Japanese company were accepted only for point-of-sale transactions over the PULSE network.

On Apr 23, 2013, Discover Financial reported first-quarter 2013 earnings per share (EPS) of $1.33, surpassing the Zacks Consensus Estimate of $1.12. EPS also surpassed the year-ago quarter’s earnings of $1.21.

Moreover, Discover Financial’s net income improved 3.5% year over year to $673 million from $650 million. Net income allocated to common shareholders also increased to $659 million from $644 million in the year-ago quarter.

Discover Financial’s total revenue, net of interest expense, increased 10% year over year to $2.0 billion, beating the Zacks Consensus Estimate of $1.64 billion. Net interest income also improved 9% year over year to $1.41 billion.

Financial Position

Discover Financial had total assets worth $76.14 billion as of Mar 31, 2013, up from $71.19 billion as of Mar 31, 2012. Total equity stood at $10.3 billion at the end of Mar 2013, up from $8.7 billion at the end of Mar 2012. Book value per share was $20.90 at the end of Mar 2013, compared with $16.41 as of Mar 31, 2012.

Share Repurchase Update

During the reported quarter, Discover Financial repurchased 6 million shares for $238 million under its $2.4 billion share repurchase program.

Discover Financial has changed its reporting period from this quarter. As a result, the company’s fiscal year now ends on Dec 31, rather than Nov 30.

Revenues

Total revenue, net of interest expense, increased 10% year over year to $2.0 billion in 1Q13, beating the Zacks Consensus Estimate of $1.64 billion.

Total revenue, as compiled by the Zacks Digest Model, is shown in the table below:

|Revenue (In $M) |1Q12A |4Q12A |1Q13A |2Q13E |2012A |2013E |2014E |

|Digest High |$1,803.0 |$2,016.0 |$1,992.0 |$2,036.0 |$7,690.0 |$8,391.0↑ |$8,789.0↓ |

|Digest Low |$1,803.0 |$2,016.0 |$1,992.0 |$1,984.0 |$7,690.0 |$8,067.0↑ |$8,310.0↑ |

|YOY Growth |6.9% |7.8% |10.5% |7.9% |8.3% |6.7% |4.1% |

|Sequential Growth |-3.6% |0.5% |-1.2% |1.1% | | | |

|Zacks Consensus | | | |$1,646.0 | |$6,619.0↑ |$6,613.0↓ |

Revenue components, as compiled by the Zacks Research Digest, are shown in the table below:

|Revenue Components |1Q12A |4Q12A |1Q13A |2Q13E |2012A |2013E |2014E |

|Net Interest Income |$1,292.0 |$1,428.0 |$1,410.0 |$1,409.8 |$5,421.0 |$5,774.8↑ |$6,067.2↑ |

|Total Revenue |$1,803.0 |$2,016.0 |$1,992.0 |$2,013.8 |$7,690.0 |$8,208.1↑ |$8,547.3↑ |

Segment Update

The company manages its business activities in two segments: Direct Banking and Payment Services.

Direct Banking

Discover card sales volume grew 4% year over year to $24.9 billion in 1Q13.

Other income increased 15% year over year in 1Q13, primarily due to higher interchange revenues owing to improved sales and additional revenues from Discover Home Loans.

Net interest income increased 9% year over year to $118 million in the reported quarter, boosted by loan growth and reduced interest expense, partially offset by lower total yield.

Payment Services

Revenues were up $5 million and expenses increased $6 million from the year-ago level because of a surge in professional fees and marketing expenses due to the recent partnerships and other expansion initiatives.

Payment Services dollar volume increased 2% from the year-ago quarter to $48.8 billion. Meanwhile, the year-over-year growth rate of transaction volume from PULSE has reduced to 4% due to increased competition and merchant routing.

Please refer to the separately published spreadsheet of Discover for additional details and updated forecasts on revenue.

Margins

Total expenses, other than interest expense, jumped 12% year over year to $753 million in 1Q13.

As per the Zacks Digest model, pre-tax margin in 1Q13 was 54.2%, down from 58.1% in 1Q12 but up from 41.8% in 4Q12.

Margin, as compiled by the Zacks Research Digest, are shown in the table below:

|Margins |1Q12A |4Q12A |1Q13A |2Q13E |2012A |2013E |2014E |

Pre-Tax Income/Expense as reported by the company

Direct Banking

The Direct Banking segment reported pre- income of $1 billion in 1Q13, reflecting a 3% increase from the year-ago quarter. Expenses in the segment surged 12% year over year on higher employee compensation and marketing expenditure related to the Home Loan Center acquisition, increased card marketing initiatives and elevated headcount.

Net interest margin was 9.39%, up 30 basis points year over year. The year-over-year increase reflects lower funding costs partially offset by reduced total yield.

Payment Services

The Payment Services segment’s pre-tax income fell 2% year over year to $47 million. Meanwhile, expenses increased $6 million from the year-ago level as a result of a surge in professional fees and marketing expenses due to the recent partnerships and other expansion initiatives.

Outlook

As per the Zacks Digest model, total non-interest expense is expected to grow at a slower rate than total revenue in 2013 and 2014. Margin is thus expected to expand in both the years.

Please refer to the separately published spreadsheet of Discover for additional detail and updated forecasts on margins.

Earnings per Share

Discover reported first-quarter 2013 earnings per share (EPS) of $1.33, surpassing the Zacks Consensus Estimate of $1.12. EPS also surpassed the year-ago quarter’s earnings of $1.21.

Moreover, Discover Financial’s net income improved 3.5% year over year to $673 million from $650 million. Net income allocated to common shareholders also increased to $659 million from $644 million in the year-ago quarter.

The improvement in Discover Financial’s net income was due to revenue growth and improved interest income. Strong operating results in the Direct Banking segment overshadowed the decline in pre-tax income of the Payment Services segment.

EPS, as compiled by the Zacks Digest, is shown in the table below:

|EPS (in $ per share) |1Q12A |4Q12A |1Q13A |2Q13E |2012A |2013E |2014E |

|Digest Low |$1.21 |$1.06 |$1.33 |$1.11 |$4.49 |$4.49↑ |$4.57↑ |

|Digest Avg. |$1.21 |$1.06 |$1.33 |$1.14 |$4.50 |$4.76↑ |$4.86↑ |

|Digest YoY growth |42.9% |1.7% |9.7% |14.8% |8.8% |5.8% |2.0% |

|Sequential Growth |16.5% |-14.5% |25.6% |-14.3% | | | |

|Zacks Consensus | | | |$1.14 | |$4.70↑ |$4.81↑ |

Highlights from the EPS table are as follows:

• 2013 forecasts (total 6) range from $4.49 to $4.94; the average is $4.76.

• 2014 forecasts (total 6) range from $4.57 to $5.17; the average is $4.86.

Outlook

Few bullish firms raised its 2013 and 2014 EPS estimates to account for the strong 1Q13 earnings beat, ongoing strong credit trends and expectations of lower expenses, lower loss provisions and operating expenses in 2013.

However, the firm reduced the 2014 EPS estimate to count for lower non-interest income from mortgage banks and lower-than-expected share buyback.

As per the Zacks Digest model, the firms expect the share count to decline 6.4% y/y to 484.0 million by the end of FY13 and 7.4% y/y to 448.4 million by the end of FY14.

Please refer to the separately published spreadsheet of Discover for additional details and updated forecasts on EPS.

– The Online Stock Research Community

Discover what other investors are saying about Discover Financial Services (DFS) at:

DFS profile on

|Research Analyst |

|Sweta Goenka |

| |

|Copy Editor |

|Neelanjan Barua |

| |

|Content Ed. |

|Tanuka De |

| |

|Lead Analyst |

|Meenakshi Sharma |

| |

|QCA |

|Tanuka De |

| |

|No. of brokers reported/Total brokers |

|18/18 |

| |

|Reason for Update |

|Earnings |

| |

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June 6, 2013

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