What happened
Shares of the credit card and payments company Discover Financial Services (DFS -1.31%) were trading roughly 15% lower at 10:40 a.m. ET today after the company reported earnings this morning -- and disclosed a surprising regulatory issue.
So what
Discover reported second-quarter earnings of $3.54 per share on revenue of roughly $3.88 billion, both numbers that missed consensus estimates. But the bigger issue at hand seems to be around a regulatory issue: Discover improperly priced merchant fees on some credit card accounts.
Beginning in the middle of 2007, the company grouped some credit card accounts into its highest pricing tier for merchant acquiring fees, which essentially means it charged businesses for transactions more than it was supposed to. Discover said that revenue from this mistake equaled less than 1% of its total discount and interchange fees since 2007, which it believes is immaterial.
As a result of the improper charges, Discover expects to pay out $365 million to merchants that were overcharged, although it does not yet know what the final cost of the reimbursements will be. Discover has hired a law firm to review the issue and is also in discussions with regulators. Management said it has already received a proposed consent order from the Federal Deposit Insurance Corporation and that additional regulatory actions could occur. The company is pausing share repurchases until there is more clarity on the matter.
While this is all perhaps surprising to investors, analysts seem to think the sell-off is overdone and are assigning an overweight rating to the stock.
"While we are very disappointed with the pricing issue and the consent order, and it is not without risk, we believe investors should take advantage of a potential significant sell-off and buy the shares," analysts from William Blair wrote in a research report this morning. "Historically, that has been the right decision in this type of situation."
Now what
While the issue is surprising, and there is still a lot we don't know, including what other regulatory charges may come, I'm inclined to agree with analysts and believe the risk-reward balance is still in investors' favor.
Discover is a company and bank that has been around a long time and has a strong track record, and it does seem management has gotten in front of the issue. It's probably best to start with a smaller position and build gradually as more information becomes available.
