What happened
Shares of Discover Financial Services (DFS -1.31%) sank this week, falling about 10% as of noon on Thursday, according to data from S&P Global Market Intelligence.
On Monday, the company announced its CEO Roger Hochschild was resigning as CEO and stepping down from the board, following a discussion with the company's board of directors. Board member John Owen will be stepping in as interim CEO as the company looks for a replacement.
While the company didn't disclose the exact reason for the departure, it is likely related to an issue brought up during the last earnings call, when Discover announced it was suspending its buyback program amid an internal investigation into a compliance matter. That could mean Discover may have made a mistake that could potentially result in fines, other regulatory actions, or higher ongoing compliance costs.
So what
In the second-quarter earnings release, Discover disclosed the company had discovered it had been overcharging certain merchants on swipe fees for years, putting certain merchants into its highest pricing tier that didn't belong there. The press release said: "Beginning around mid-2007, Discover incorrectly classified certain credit card accounts into our highest merchant and merchant acquirer pricing tier."
While that doesn't sound great, it should be noted that the potential affected revenue amounted to less than 1% of Discover's interchange revenue and less than 0.2% of total revenue since then. Also of note, Discover makes the overwhelming majority of revenue and profits on loans, particularly credit card loans, not interchange fees.
It appears Hochschild's departure is most likely related to this matter, as the press release announcing his departure said, "The Board is continuously focused on Discover reaching its full potential across the business, including our commitment to enhancing compliance, risk management and corporate governance."
It's an unfortunate turn of events for Discover and its shareholders, especially since the error will affect so little of its revenue. Yet, there could be regulatory penalties in terms of reimbursement and fines for a matter like this. And of course, we don't know whether other compliance errors were discovered in the internal investigation or if Discover will need to take on higher compliance costs going forward.
In addition to the C-suite shakeup, more credit card data came out this week, showing an uptick in delinquencies. That probably didn't make investors feel great, but it is to be expected, given that higher interest rates and delinquencies previously were at very low levels following the pandemic stimulus.
Now what
Discover did rebound somewhat on Thursday after the interim CEO and his team held a conference call. Yet, on that call, no specifics were given about the investigation or increased future costs.
While it was not a great week, Discover does look cheap at just 6.5 times earnings on both trailing and forward bases.
Discover typically generates very high returns on equity, thanks to its high-interest credit card loans; however, it typically trades at a very low earnings multiple, given the perceived risks around unsecured high-rate loans, especially in an uncertain economic environment. And as we saw this week, compliance and regulatory risks are also a factor that affects Discover's multiple. With the buyback suspended until the issue is resolved, it's no wonder investors are headed to the sidelines for now.
