Sept. 25 (Bloomberg) -- Discover Financial Services, the credit-card company making its first earnings report since being spun off by Morgan Stanley in June, said third-quarter profit fell as marketing and interest expenses increased.

Net income fell 16 percent to $202 million, or 42 cents a share, from pro forma profit of $241 million, or 51 cents, a year earlier, the Riverwoods, Illinois-based company said today in a statement. The average estimate was 39 cents in a survey of 10 analysts by Bloomberg. Discover owns the nation's fourth-largest payment card network.

Discover's split from Morgan Stanley, the nation's second- biggest securities firm, is raising the card company's financing costs. Interest expense increased 44 percent to $361 million as Chief Executive Officer David Nelms was stepping up efforts to attract small and mid-size merchants.

``Discover is going to have a lower credit rating than the vaunted Morgan Stanley, so financing is going to cost you a bit more,'' James Ellman, president of Seacliff Capital in San Francisco, said in an interview. ``The cost of borrowing in the interbank market has also gone up significantly in the last few months.'' Ellman declined to say how many Discover shares Seacliff owns.

Discover faces ``unusually high borrowing costs'' because of depressed demand for securitized credit card loans, Nelms said in an interview. That's forcing Discover to rely more on consumer deposits as a source of cash, he said. The company reported a $24 million loss from securitization transactions after earning $36 million in the second quarter.

Higher Costs

``We will face somewhat elevated costs until the markets return to normal,'' Nelms said. ``We think it's going to have an impact through most of the fourth quarter.''

Discover fell 54 cents, or 2.4 percent, to $21.72 in 4:04 p.m. New York Stock Exchange composite trading, leaving the shares 24 percent below where they began trading in June.

The company concentrates on middle- and upper-income customers who are less affected by the upheaval in mortgage markets, Nelms said. With housing prices declining in some regions, more consumers are letting their homes be foreclosed while keeping payments current on credit cards, he said.

``You could argue that consumers are making a strong economic choice,'' he said.

Like American Express Co., Discover is a lender that offers cards as well as a network that processes transactions for other issuers. Visa, the biggest credit-card company, and MasterCard, ranked second, just run networks. American Express ranks third.

`Abysmal' Growth

Discover boosted marketing and business development spending 12 percent during the quarter to $163 million. The loan portfolio rose 4 percent to $51.9 billion. Card volume, which represents customer usage, increased 1.9 percent over the past year.

``The growth in the network was abysmal versus other networks,'' Craig Maurer, an analyst at Calyon Securities USA said in an interview. MasterCard is growing more than four times as fast as Discover, said Maurer, who rates Discover ``neutral.''

Discover is pleased with its U.S. performance and expects growth in its payments network to accelerate as the card becomes more available to small and mid-sized merchants, Nelms said. The company announced on Sept. 20 an agreement making it easier for about 600,000 merchants affiliated with Chase Paymentech Solutions LLC to accept Discover cards. Chase Paymentech is a payment processing joint venture between JPMorgan Chase & Co. and First Data Corp.

Stable Credit

Discover's foreign operations, centered in the U.K., reported a pretax loss of $67 million, more than double the $30 million loss from a year earlier. The company expects to report a lower loss in the fourth quarter, and Nelms declined to say when he expects the business to break even.

The company announced its first quarterly dividend, 6 cents a share, giving the stock an annual yield of about 1.1 percent. Investors who own shares as of Oct. 5 will be paid Oct. 23.

Credit quality in the U.S. remained stable with 3.16 percent of outstanding payments more than 30 days late, up from 2.97 percent in the previous quarter, Discover said. Provisions for loan losses declined 9.4 percent to $212 million.

Investors are concerned about weakening credit quality, even though Discover's delinquency rates are near record lows, said Louis Meyer, an analyst in New York at Oscar Gruss & Sons Inc.

``Their credit quality is very good for their sector, but it's a time when the tides are going out,'' Meyer said in an interview before the announcement.

To contact the reporter on this story: David Mildenberg in Atlanta at dmildenberg@bloomberg.net

Last Updated: September 25, 2007 17:19 EDT