發現金融 (DFS) 2009 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the third quarter 2009 Discover Financial Services earnings conference call.

My name is Michaela and I will be your coordinator for today.

At this time, all participants are in a listen-only mode.

We will be facilitating a question-and-answer session toward the end of this conference.

(Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr.

Craig Streem, Vice President, Investor Relations.

Please proceed.

Thank you, very much, Michaela.

Good morning, everybody.

Want to welcome all of you to this morning's call, and we certainly appreciate your joining us today.

I need to begin by reminding everyone that the discussion today contains certain forward-looking statements about the Company's future financial performance and business prospects which are, of course, subject to risks and uncertainties and speak only as of today.

Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today's earnings press release which was furnished to the SEC in a 8-K report, and our Form 10-Q for the quarters ended February 28, 2009 and May 31, 2009, and in our Form 10-K for the year ended November 30, 2008, all of which are on file with the SEC.

In the third quarter earnings release and supplement, which are now posted on our website at www.discoverfinancial.com and have been furnished to the SEC, we've provided information that compares and reconciles the Company's managed basis financial measures with the GAAP financial information and we explain why these presentations are useful to management and to investors.

We urge you to review that information in conjunction with today's discussion.

Our call this morning will include formal remarks from David Nelms, our Chief Executive Officer; and Roy Guthrie, our Chief Financial Officer and, of course, a question-and-answer session at the end.

And now it's my pleasure to turn the call over to David.

Thanks, Craig.

Given the adverse credit environment I feel great about our results this quarter.

We achieved very strong revenues and had the lowest expenses we've had in many years.

Our results this quarter reflect the significant progress we have made against the performance priorities we laid out at the beginning of the year at our investor conference.

So with nine months of year behind us I thought we would begin with a look back at those priorities and review our progress.

The first priority we set for ourselves was to achieve superior credit performance, first as competitors.

Our third quarter managed net charge-off ratio of 8.39% reflected the challenging environment.

However, recently published securitization data and competitor guidance suggests that once again in the third quarter we expect to have the lowest charge rate among our major competitors.

We have built a loyal, prime customer base focused on rewards and that has allowed us to outperform the industry in this adverse credit cycle.

We have seen some promising trends in certain economic indicators such as fewer job losses and higher new sales and consumer confidence, but unemployment and bankruptcy rates continue to rise, so we do remain cautious about the outlook for delinquencies and loan losses.

Although loan losses in the third quarter came in a bit better than we expected, we believe that we have still not quite reached peak loan losses and we project that the managed net charge-off rate in the fourth quarter will be in the range of 8.5% to 9%.

The next priority we set for ourselves was conservative loan growth.

At the end of the third quarter, we had total managed loans of $51 billion, essentially unchanged from the previous quarter and up 1% from last year.

Our card portfolio was lower by 2% year-over-year reflecting our decision to dramatically reduce promotional rate balance transfer activity during the quarter.

In fact, during the quarter our balance transfer activity was down 84% from last year.

And we expect to continue at low levels of balance transfer originations in the fourth quarter.

While our card portfolio was down slightly during the quarter, our Discover student loan portfolio grew very nicely given that the summer is a peak funding period for this product and we had very strong demand.

I feel very good about the credit quality of the student loans we are putting on the books.

Of the new disbursements, approximately 80% was government guaranteed and of the private loans, 80% had co-signers.

Our other priorities this year included achieving higher net interest margins and revenues, reducing expenses, and maintaining a rigorous focus on capital, liquidity and funding.

Roy will take you through the specifics of these items, but if you look at our results I think you will agree that the team has done a great job this year in all of these critical areas.

The investment community continues to ask about the impact of the Card Act, focusing especially on how net interest margin will be affected.

First off, we are coming into the period of changes with a very healthy net interest margin which came in at 9.9% during the third quarter.

One reason for our margin expansion is our significant pullback on balance transfer activity, which contributed to a 25% decline in the quarter in our low rate promo balances.

Margins also expanded as we unwound risk-based pricing by eliminating our lowest rate APR's in light of the fact that the Card Act will no longer allow repricing of customers who become riskier in the future.

Another critical step in managing yield was fixing our standard retail APR's to the prime rate, which will help us maintain more consistent net interest margins in various funding environments in the future.

I am also pleased with our progress in shifting our emphasis to originating student loans versus student credit cards, and to originating personal loans for debt consolidation and debt paydown versus credit card balance transfers.

Given the current economic environment, and the needs of consumers today, I believe these shifts are good for our customers and for shareholders.

We believe some of the immediate consequences of the Card Act include far less industry focus on low initial APR's and on promo rates.

Instead, overall long-term value will again become the important differentiating factor in marketing.

I believe Discover is well positioned to capitalize on that shift by focusing on our core strengths, our brand, cash back bonus, unique product features and our superior service.

Research shows that most consumers want rewards on their credit cards and 82% of them prefer cash over miles or points.

Furthermore, the studies show that Discover has three times more household ownership of cash rewards cards than our next closest competitor.

We have just launched new advertising that reinforces our leadership and heritage of cash rewards, enabling card members to make their money worth more.

"It pays to Discover" has returned as our tag line because it is distinctive, well-recognized and helps to reinforce our brand.

Our new commercials, which will be much more prominent in the fourth quarter, also show customers using their cards across a variety of merchant categories which helps reinforce our expanding acceptance.

In terms of card sales volume, this quarter's results reflect a decline of 7% year-over-year, primarily reflecting significantly lower gas prices and a slower economy offset by the benefit of growing merchant acceptance.

Our number of active merchants at the end of the quarter actually increased by more than 5% from last year.

Despite this progress, we acknowledge there are still some small merchants that do not accept our card and signing them remains one of our highest priorities and opportunities.

In addition, we continue to work it enhance acceptance awareness among merchants, their employees, and our customers.

Not only are we focusing on U.S.

merchant acceptance, we are also continuing with our plan to expand acceptance globally.

In July, PULSE became the global ATM network for Diners Club International cards.

To further expand merchant acceptance in western Europe and India we have signed acquiring deals with SIX Multipay and Venture Infotek.

In October, inbound Diners Club International volume in the U.S.

will begin to shift to the Discover Network.

We are also making progress turning on international acceptance for Discover Card members and by the end of 2009 we expect that merchants in over 50 countries will be enabled to accept Discover Cards.

The Discover brand gives us a lot of power that we are leveraging to build our direct-to-consumer deposit business which has the added benefit of providing stable funding for our card business and enhances our relationships with our customers.

In the third quarter our direct-to-consumer and Affinity deposits program generated over $2 billion in incremental deposits, bringing the total to over $10 billion at quarter end.

We continue to focus on new product introductions and service enhancements to attract new deposits.

This year we rolled out our CD/IRA product nationwide, introduced an online savings account, and launched our no withdrawal penalty for job loss feature on 12-month CDs.

In the servicing arena, we launched 24/7 live customer service in March, followed shortly thereafter by the introduction of a new Discover Bank website.

So as I wrap up, we had very strong results this quarter, driven by better than expected credit performance, a return to the asset-backed market which resulted in some release of reserves, expansion of our net interest margin, further reductions in operating expenses and the third payment in our antitrust settlement with Visa.

Roy will go through the numbers in detail, but I feel very good that in the most difficult environment for our industry that I could imagine Discover continues to perform well.

Okay, David.

In my comments this morning I'm going to amplify on a few of the things that you heard from David and then give you an update on our funding, liquidity and the capital position of the Company at the end of the quarter.

So focusing on the Company overall, we reported net income of $577 million, or $1.07 per share, up $0.70 from a year ago.

And by my eye this is a very solid quarter which brings us positive for the year, even excluding the sum of revenues that we've recorded in each of the last three quarters.

Turning to the segments, the U.S.

card earned $913 million pre-tax this quarter, which does include the antitrust litigation revenue of $472 million.

I'll begin with the managed net interest margin, and in the third quarter, as you heard David say, it was 9.9%, up 64 basis points sequentially and 95 basis points year-over-year.

And clearly spread income remains a real bright spot for us, nominally up $78 million sequentially and $168 million year-over-year.

This increase reflects a lower cost of funds, as well as the impact of fewer low APR standard balances, and a reduction in low APR promotional balances.

This has led to the managed interest yield of 12.73% for the quarter, essentially flat there to a year ago and up 54 basis points sequential quarter.

Interest expense expressed as a percentage of managed receivables was right at 3% for the quarter, 16 basis points lower than last quarter principally due to that FDIC special assessment that we recorded last quarter.

And better than a year ago by 127 basis points due principally to lower LIBOR, but also due to the fact that newly issued deposits now are priced lower than maturities.

Other income included revenue of $472 million from the Visa antitrust litigation settlement, as well as the $69 million favorable revaluation of our IO asset.

Our fourth quarter should also include the final payment from the Visa settlement, a heads-up on that; the upward revaluation of the IO principal asset here reflects our higher yield.

In the first two quarters of this year you saw this asset being written done, so directionally this is a reversal, first quarter $98 million and in the last quarter $93 million.

So that reflects positively on where we see the revenue of the Company.

Moving to credit performance, the managed 30-day delinquency ratio was 5.10%, up 2 basis points sequentially.

Managed net charge-offs came in at 8.39%, a sequential increase of 60 basis points, clearly a more modest increase compared to the 131-basis-point increase from the first quarter to the second quarter.

And given our fourth quarter guidance, we're indicating that we expect to see this deceleration continue into the fourth quarter.

As I discuss the loss provision and reserve activity I want to note that we've introduced a new measure for our reserve rate calculation that excludes the guaranteed portion of student loan receivables because they are guaranteed by the government and carry virtually no reserve for loss.

We provided this reserve rate, excluding the guaranteed loan aspects of our portfolio, in the statistical supplement under the "managed" page for your information.

So during the quarter we recorded provision of $154 million less than charge-offs.

Our reserves declined as we had a lower level of owned basis loans outstanding, driven principal by securitizations, partially offset by a higher reserve rate on the portfolio.

ABS activity for this quarter includes a $1.5 billion TALF transaction, $1.6 billion in retained Class D series notes related to the Trust credit enhancement actions that we discussed with you in our last call, offset by $1.4 billion of maturing ABS.

The higher reserve rate, excluding the guaranteed portion of student loans, reflects continued conservatism in our outlook based on the recent delinquency trends.

Turning to operating expense, the U.S.

card expenses were down 16% year-over-year and came in at $490 million, 3.81% of receivables.

This is the lowest quarterly operating expense ratio we've achieved at the Company.

Expenses reflect the reduction in force that we executed in the second quarter and continued efforts to improve the operating efficiency of the business.

Overall, expenses also reflect importantly the continued investments in our payments and direct-to-consumer deposit businesses and, as you heard David report, moving into the fourth quarter we'll begin to see some further investment in marketing and so, as a result, you should expect to see the fourth quarter spend will be up from where it was here in the third quarter.

Turning to the payment segment, our third party payments business earned $27 million for the quarter, with total network volumes up 2% to $36 billion, which includes over $6 billion from our Diners Club International transaction.

Transactions processed on the PULSE Network were up 6% year-over-year, however, dollar volume was down 1% which was lower than expected.

In terms of funding, we grew total deposits by 10% year-over-year to $29 billion.

David mentioned that $2 billion or 26% sequential quarter growth in our direct-to-consumer program, which together with our $1.5 billion TALF issuance essentially took care of this quarter's funding.

The $2 billion of new direct-to-consumer issuance this quarter averaged 20 to 22 months in duration and by the third quarter we were pricing at rates inside 2.25.

So we remain very pleased with the progress that this product line has made.

In total maturities for all sources for the remainder of 2009 are going to be about $3 billion.

That includes $1.6 billion from our deposit programs and $1.3 billion from public term asset-backed deals.

Looking to fiscal year 2010, we have about $17.7 billion in aggregate maturities which we believe is well within the execution capacity of our deposit channels.

But having said that, we have substantial TALF qualifying capacity at $10.2 billion which is available to us through the end of the first quarter in 2010, and in addition to that I think we're beginning to see some positive signs in the non-TALF ABS market.

Our contingent liquidity at the end of the quarter included over $10 billion in cash liquidity, $1.5 billion in conduit capacity, $2.4 billion in multiyear contracted revolver and $6.4 billion in borrowing capacity at the Fed discount window.

We completed a number of capital markets transactions during the quarter.

As I said a moment ago, we did a TALF deal for $1.5 billion at one-month LIBOR plus 130 over three years.

We also issued equity amounting to $534 million and issued $400 million in unsecured debt.

Looking to the fourth quarter, we've already completed a TALF transaction in September for $1.3 billion, also at one-month LIBOR plus 130 over three years.

We finished the quarter with tangible common equity of $6.8 billion, or $12.49 a share, up $1 billion from the second quarter, driven by earnings and the equity raise.

This was equivalent to 13.8% of managed receivables, and 10.1% of tangible managed assets.

Regarding FAS 166, 167, based on expected ABS maturities between now and November 30th of this year, our current assumption is that approximately $22 billion of securitized receivables will be restored to the balance sheet on December 1, 2009 which we will reserve against.

In addition, the IO strip will be reversed and that impact along with the impact of the reserve addition will be recorded as an after-tax charge to the opening balance sheet of 2010 effective December 1, 2009.

So let me wrap up and reiterate, I think what David closed by saying is that despite what we've seen as a very difficult environment we think we've turned in a very solid quarter while actually enhancing our already strong capital and liquidity positions.

And with that, I'm going to turn it back over to you, Michaela.

(Operator instructions).

And your first question will come from the line of Bill Carcache with Fox-Pitt.

Please proceed.

Good morning.

Can you talk a bit about operating expenses, and you mentioned higher marketing expectations in the fourth quarter, and so should we expect that number to creep back up and kind of back to maybe the levels in the first quarter couple quarters or any kind of guidance you can share on what we can expect for expenses as we look ahead?

Sure, Bill.

Yes.

I think the -- I guess I would guide you to -- I mean we actually have somewhat of a seasonal low here and expect for seasonal spending to reinvigorate.

Both David and I sort of referenced that.

And I guide you probably not to something that would reference the run rate we saw in the first three quarters, but also not being as low as you see here in the fourth.

So somewhere in between those two on the marketing line and to expect to see continued improvement across the board on everything else.

Okay.

And can you talk about your decision to stop charging over limit fees and how you thought about the costs versus the benefits of continuing to charge them?

Just kind of share your thought process on that?

Well, I -- I would say that we felt like it would be a lot of work and not a lot of people would opt in to pay a fee.

And so we felt like the simpler thing was simply to stop charging the fee.

Okay.

And finally, one more, if I may, can you talk about any differences in credit performance by a geographic region, maybe any place where you are seeing delinquencies rise or notable differences in performance?

I would say that we're continuing to see a correlation between unemployment by area and asset price changes, housing asset price changes by area.

And loan losses by area.

Okay.

Thank you very much.

And your next question will come from the line of David Hochstim with Buckingham Research Group.

Please proceed.

Thanks.

Roy, I wonder if you could just clarify what we should think of as the likely dollar impact from the implementation of FAS 166 and 167, I mean, the IO strip could be written up again then in the fourth quarter and then written off December 1st and --

Well --

Yes.

Okay, sure, David.

I think the easiest way to do that is to reference the $22 billion that I talked about, let's just stay focused on where we are here without speculating on where we go, 745 reserve rate that was recorded in the quarter, reserves then, that is math, tax affected and we're -- you can see our effective tax rate here is around 39%.

So use about 60% of that.

And call that an after-tax charge associated with the reserves.

Um-hum.

The IO is sitting here at 162, so think about that in the context, subject to further changes as another 100 on top of that.

So in the $1 billion to $1.1 billion which is kind of where we're sort of always been and obviously that will be dynamic based on where we stand.

But that is a good proxy for where it ought to be based on this quarter's information.

Okay.

And then could you talk about the potential timing of paying back the Treasury?

Any closer though that?

Move forward?

Have another good quarter and the environment seems to be stabilizing?

Well, certainly I feel -- this is David.

I feel increasingly positive and the fact that we raised equity, long-term debt during the quarter, had a strong quarter in revenues and expenses and are seeing some moderation in job loss externally, those are all very good factors.

And that being said, we do have a process that we will go through with our board and our regulators and that we have not yet reached a decision that the time is right.

But I'm certainly feeling increasingly positive.

Okay.

And then finally could you just give us more detail on the pricing on the new private student loans originating and then also on the consolidation loans, what is the pricing, what are the rates like there and what do the borrowers look like?

You know, I think you can actually view some of our pricing on our website.

And certainly student loans are priced lower than credit cards because they reflect much lower levels of risk.

And in terms of the customers, I think we've been very, very selective.

We have around 600 schools that now work with us to originate these loans.

And we've tried to pick high quality institutions, ensure that the money is actually used for education and as I mentioned earlier 80% of them have co-signers, typically parents.

And so I feel we've done this in a very careful and responsible way.

And if FFELP originations are eliminated next year would you continue to originate private loans do you think or --?

Yes.

We're pretty indifferent to the proposed federal law change.

Today you really have to be meeting the demand for public loans if you are going to be in the private student loan business.

It's frankly a questionable margin that we make on those public loans, but you kind of have to be in it.

So, if they start going direct, we don't have a big infrastructure because we're pretty new to that.

And we would simply adjust.

Okay.

And just again on the consolidation loans, how do you control for credit risk because I think other lenders have had some problems with those loans and avoiding kind of being adversely selected from people who are desperate for credit and making sure that you are getting paid enough?

Sure, well, obviously, you just have to be very careful.

Most of that is cross sell business and it is to our best customers.

So the level of FICO score requirements and so on is higher than our credit cards and since they come from our current customers predominantly we've got a lot of history directly with those customers.

And that is why, while all customers, I'd say, are generally stressed in this environment, I think it's why we haven't experienced some of those same issues that have been reported by some competitors.

Great.

Thank you.

And your next question will come from the line of Andrew Wessel with JPMorgan.

Please proceed.

Good afternoon.

Thanks for taking the time to answer.

A couple of questions, just one on net interest margin growth.

If you can talk about what you're kind of projecting for NIM growth assuming your deposits as you're looking out, but also, I think, more importantly the roll off of that low rate promotional book?

What should we be thinking about for NIM growth going forward into the next quarter?

Yes, I think you're absolutely right.

We're continuing to replace maturing deposits at prices that are through it, and so there's, I think, still some upside even though I think just to reinforce the fact that we're out the curve, we're not basically shortening the curve on rate alone, so that's a good balance between liquidity and execution that's achieving that.

In terms of the top line, I think you are right.

I think that there's a lot of forces that are working on it.

And clearly I think the reduction in the lower yielding promotional rate balances has, to a certain extent, played out itself here in this first quarter, and there may be some of that to come.

But there's also some headwinds.

I would come back and reinforce the fact that we've sort of issued guidance here for charge-offs to rise modestly into the fourth quarter and clearly to the extent that's a reversal of interest income within that measure is going to be a slight headwind to it.

So I think we're constructive on where it is.

We don't necessarily think that it's unstable where it is.

But there are forces that are moving back and forth against it that could somewhat neutralize it.

So I wouldn't necessarily guide you to much higher.

You know, the one thing that I would add is that the initial Card Act restructurance that impact repricing on delinquent accounts went in place in August and so we won't see the same immediate repricing on delinquent customers that we had -- that for years have occurred and so the lack of those immediate repricings will start to stabilize things.

Great.

That's very helpful.

Thanks.

And then my other question has to do with just kind of on the outlook for loan growth.

As the Card Act comes into effect fully, possibly earlier based on what Barney Frank was saying yesterday, what is your outlook for really growing assets in this environment, ex of, obviously, increases in spending?

But putting more cards in hands and then also in terms of other lending channels, do you see -- are you seeing -- obviously student loans as being an area for growth that's going to be material or is that still just kind of going to be ancillary and it is going to be cards that really presents the challenge for asset growth?

Well, I would say that we're going to continue to be pretty conservative on loan growth.

I do expect some shrinkage in the industry to continue.

We are making room for this $22 billion plus securitized loans to come back on our books later this year, and we're partly doing that by this big pull back on balance transfers, and we're also getting ready for the Card Act which impacts low rate balance transfer act -- rates because and our desires of how many to offer because of the payment allocation which changes some of the economics there.

So, if anything, we do expect a modest decline in receivables by year end.

But I would say so far this year we think our receivables have held up better than anyone else, but it's not a time for robust growth.

And we expect the marketing -- increased marketing to help, but it's not -- we're not trying to start growing fast again.

Great.

And just as a follow-up to that, if I could, looking out into next year, do you see the economy or the economic outlook or really kind of increased competition in the industry from the Card Act to be the bigger determinant of card asset growth or card loan growth through next year and going forward?

I think that there are a lot of factors that we're going to be considering.

Certainly continued trends in credit will be very important.

How consumers react to the changes that are -- have been -- are being put in place because of the Card Act.

As you unwind risk-based pricing, some of the customers who have enjoyed very -- extremely low rates, as that has been in place the last five or 10 years, will see more normal rates that used to exist in the industry and whether they will borrow as much is an open question.

And so I think that there are just a lot of questions.

I think we feel like we're gaining market share in credit cards, both in sales volume and in receivables.

And to a large degree what happens to the industry may dictate our growth.

Okay.

Great.

Thank you very much.

And your next question will come from the line of Craig Maurer with CLSA.

Please proceed.

Yes, hi, good afternoon.

Just a couple of questions.

Just so I understand it, the provisioning was much lower than I was expecting this quarter because of the securitization so the benefit -- basically the benefit to the allowance, I mean, it sounds like that is essentially going to get reversed out but as an one-time charge in the fourth quarter.

Is that correct?

Yes, I think it all.

That's right.

In terms of off and on because of the securitization activity all -- there will be like a master catch up at the end of the fourth quarter and basically everything will have a reserve against it.

I think it is important to highlight, though, as you talk about this quarter, is that this has been an interesting year, Craig, and early in the year we saw receivables come back onto the balance sheet as we basically had maturities of bonds.

We're now back in the market and we're seeing receivables go off of the balance sheet as we see issuance of bonds.

And I think if you sort of look at it through all three quarters, those things sort of normalize or neutralize.

And that's kind of the way I think about it in the context of the year and the fact that we're in positive territory for the year.

Granted this particular quarter we have lower owned assets with reserves against them and that's why we incurred the release.

Okay.

Another question, the teaser rates and the balance transfers you were using in the first half of the year, would it be possible for you to tell us what your receivables growth or declines would have looked like ex the transfers?

I'm just trying to get an idea because very few banks were using low-rate teaser transfers during that period.

Well, I would actually disagree with that.

I think it's pretty common in the industry.

But I do -- if -- at the beginning of the year our promo rate, low-rate promo balances, were somewhere around 20% of our portfolio and I would say by year-end we're expecting it somewhere around 10% of our portfolio and probably continue to decline in the next year.

And certainly fewer offers, but also shorter durations, pretty much our offers today are six-month in duration, have a fee associated with them.

So we're being very selective on how we offer them and you're seeing that show up in the yield.

Okay.

And just one last question, just shifting to your international discussion and acceptance, I was just curious, beyond getting acceptance up is there any traction in terms of issuing cards outside the country right now?

I just wanted to know how that was going?

Meaning you still have Diners relationships outside the country for issuance and I was just wondering how that's competing with Visa, MasterCard and AMEX globally?

Well, just to be clear, we don't directly issue any cards outside of the U.S.

today.

But we --

No.

But there are partner relationships.

Absolutely.

So we have nearly 50 franchisees who issue cards.

And -- and we are actively working with those franchisees to try to issue more cards and to expand additional relationships.

Our first priority today is probably more in acceptance and turning on more and more countries for Discover Card to take advantage of the Diners Club network globally and we'll be working on that through next year.

But we also have signed -- I think we have signed over half of our top 10 customers to some new, longer term contracts that have incentives for growth.

And so we're working on that.

Diners Club is a very high-end T&E, corporate type of card, think about AMEX, and so the volumes have been tough just because corporations around the world have pulled back given the economy.

But here is what I'm trying to get at.

It seems that you are fighting an uphill battle.

I mean, you have banks that see more value because of the global acceptance in Visa/MasterCard.

So while you're trying to catch up on acceptance, they are issuing more Visa/MasterCard.

My question is what is going to be the long-term incentive to reinvigorate Diners issuance?

I would say our partners see more value on issuing on our network, particularly for the corporate business.

There are partners who have shifted their volume away from Visa/MasterCard onto our network because of our global acceptance, our strong interchange and our -- the brand is something we want to reinvigorate, and we've just started a new ad campaign that is being rolled out around the world as we speak to help reinvigorate and reinvest in the overall brand.

So it's something we are very much focused on taking advantage of the opportunity.

It's -- I view it the other way.

It is a global network.

And it needs a lot more volume.

So we're focused on that.

Thanks.

Ladies and gentlemen, in the interests of time, we ask that you limit yourself to one question and one follow-up question.

And your next question will come from the line of Jason Arnold with RBC Capital Markets, please proceed.

Hi, good morning, guys.

David, you commented on this briefly, but could you offer some additional thoughts on what you are seeing in the competitive landscape as more issuers are adapting their portfolios to the Card Act?

And, I guess, specifically what degree have you repriced your portfolio with regard to the Card Act and do you believe that your repricing is more or less than peers?

You know, we believe less than peers and we have completed our mailings of term changes so we feel that we're beyond the changes.

I would say one way or another every customer in the portfolio has been or is being affected by Card Act.

And it's been a process, really over the last two years, but we've now completed the process of moving virtually all of our loans to prime-based because that's all that really works in the new -- given the new rules.

And I would say what we've seen, while I think we've had to be -- we've been less aggressive than some competitors, generally I'm seeing people generally move away from low intro rates or low initial rates and a much tighter band of pricing, more the way it used to work.

But there's still a lot of people, I think, that are still adjusting to this new model since it hasn't fully gone into effect yet.

Okay.

Thank you.

And then this one might be better for Roy, could you offer us a little more detail on the other income line in addition to the IO revaluation, maybe you could tell us what contributed to the big sequential increase in other income, was it some security gains or more from the securitization line?

Yes.

The other income, well, obviously, the dominant piece of the other income line is, and particularly, Jason, when you are looking at it year-over-year, reflects the Visa settlement proceeds that resides inside that number, sort of number one.

Number two, I'd suggest you focus on it in the managed context, which is the, behind the GAAP page in the statistical supplement which gives you a little bit more of a pure, pure look.

That particular line also has the $69 million write-up of the IO asset that I referenced in my prepared remarks.

And I think it's important to note, as I highlighted there, is that it's been written down in the last two quarters, reflecting, I think, our forward view of the environment and now we've sort of written it back up.

And so the two big things in there that are dynamic are that settlement number, $472 million, particularly year-over-year, sequential quarter it is the same, but sequential quarter it's the fact that it was a $69 million IO write-up versus the write-down.

And you can see the trend of the change in that on the first page of the statistical supplement inside that body of allowance and IO change information.

Okay.

Terrific.

Thank you so much.

And your next question will come from the line of Don Fandetti with Citi.

Please proceed.

Hi, David, quick question, clearly there's a better feel around credit.

Does that give you more confidence in terms of potentially addressing sort of a longer term funding question or mix, I should say, and are you comfortable kind of running the Company with the current mix and relying on the ABS market?

Or do you -- could you still be looking at some alternatives?

You know, I am really pleased with the progress we've made on direct-to-consumer deposits at over $10 billion, we're now one of the top five direct banks in the country, we believe.

And there's no reason we can't continue to move up in that ranking.

And I would say that our success on both execute -- ability to grow and to do so at an attractive funding cost, given low expenses in the direct model, have given me increased confidence that direct banking is the future as opposed to branch banks.

And we -- I don't have the expenses.

I don't have the full product line you have to have with branches that bring with them, in some cases, returns and loan losses and risks that don't look as attractive to me.

So I am really focused on being the leader in direct banking, and that's going to become an increasingly part of our funding.

It's particularly displacing right now some of the brokered deposits, but I think it could displace some of asset-backed over the long period of time.

I mean that market has also been important to us right now.

It's got some good execution.

But I'm feeling better than I ever have on our future funding capabilities as a Company the way we are.

Okay, thank you.

And your next question will come from the line of Brian Foran with Goldman Sachs.

Please proceed.

Good afternoon, guys.

Hi.

I apologize if I missed this earlier, but in overall credit metrics for you and the industry, I guess the only weak spot in the recent months was the 30 to 59-day bucket and when we look at that we've got seasonality, I'm assuming some of the repricing you did in the spring and the whole industry did in the spring pushed some people over the edge and then you have the potential for core deterioration.

Is there any color, either quantitatively or qualitatively, you can give on how much of the 30 to 59-day bucket acceleration is core deterioration versus these other factors?

Well, I would not -- the pricing changes actually could be helping a bit, because, as I say, it's eliminating lower, and very low-rate APRs as opposed -- and doing less, doing levels repricing on delinquent customers, for instance.

Your next question will come from the line of Chris Brendler with Stifel Nicolaus.

Please proceed.

Hi, thanks, good morning.

Appreciate the color on the teaser rate portfolio.

I think if I heard you correctly it was 20% at year end 2008, used to be down to 10% and year end 2009 and it fell 25% in the quarter.

I guess longer term where do you expect that to go?

I was thinking that teaser rates would go away, but I've noticed that a lot of issuers, including yourself, are still mailing them today.

Is there an opportunity to put a big teaser rate portfolio on now and then hope that you don't see competitive activity take those balances away?

Just how do you think about the use of introductory rates and where do you see that going now in the near term and then next year when the rules change?

Thanks.

Sure.

Well, I think that teaser rates and balance transfers can still have a positive continued role, even after the Card Act is in place.

And, there are balance transfer fees associated with them and, done right, they can add to our profits and growth.

It may be that we're in the single digits for a while and it may stay that way.

We'll see.

But I think that generally we're likely to be doing shorter durations, higher rates than -- you are just not going to see the zeros and 1.9%'s the way you saw it for a while because the economics have changed.

But I don't -- I personally don't think that we will totally be eliminating teaser rates.

Okay.

And a follow-up question, it sounds like -- I wasn't quite sure what you -- how you felt about the sales volume this quarter.

I mean, you sure talked about macro factors in the economy, but it didn't seem like we saw that across Visa and MasterCard, the numbers they released this week, yet your numbers sort of decelerated sequentially, certainly was pretty impressive before this quarter.

Anything else that caught your eyes on sales volume this quarter?

Yes, I would not overreact to a 4% versus a 7%.

I would think about those two combined, because there was a difference in number of days, how holidays fell.

And one of the things I look at is sort of the weekly and the adjusted volumes and we saw a lot of consistency across Q2 and Q3.

And it probably -- if you adjusted for days, 4% was probably a little favorable and 7% might be a little light.

More of a decline than adjusting it.

I've seen maybe a bit of a better last couple of weeks, but it wasn't enough to affect the quarter very much.

And I'd say if you do average those two quarters, you get 6%, 7% which compares very favorably to the last numbers I've seen out of Visa and MasterCard which on average were down about 15% for U.S.

credit card.

So we think we're gaining share and hopefully the last couple of weeks' trend will continue.

And it very well could because we're going to start getting to the annualized -- the look backs are going to start to get a lot easier because right about now is when the crisis started.

Okay.

Last question, speaking of the crisis, there's surprisingly few questions on credit this quarter.

I think people are feeling a lot better given the improvement we've seen in the last several months on delinquencies, yet I think there is still a debate out there on exactly what we're seeing.

I think we talked about it on your last quarter's call when you first saw the decline in delinquencies and what's driving it.

They are starting to pick back up, as Brian indicated in his question, and how do you feel about -- about credit right now?

I mean we still have a lot of job losses out there, portfolios have stabilized, but issuers have taken a lot of aggressive action to stabilize those portfolios, can you just give me a little sense of how you feel about consumer credit right now?

Thanks.

I would say that we remain very cautious.

As you can tell from our estimate for the next quarter, we don't think that we've seen the peak yet.

Certainly the charge-offs are rising a lot more slowly than they did earlier in the year.

But as long as the unemployment rate keeps rising and people keep losing their jobs, credit's going to continue to be a real challenge.

I'd say the good news is that we're seeing a lot more mixed signs and you need a deceleration before you actually hit a peak and then start getting out the other side.

I guess the key debate is whether the losses peak in the fourth quarter of 2009 or they peak sometime in 2010 and continue to move higher.

Where do you stand on that question?

I would be delighted if that were the case, but I don't think we -- we certainly don't know that yet and it's going to depend a lot on the economy.

And I look at the most -- the average economist thinks that the unemployment rate is not going to peak until maybe the first half of next year and that tends to be correlated pretty heavily with credit card loans losses as well.

Appreciate it, David, thank you.

Yes.

And your next question will come from the line of Sanjay Sakhrani with KBW.

Please proceed.

Thank you.

Hey, Roy, I just had a quick question on the margin, just a continuation of the question asked earlier, if we think about the margin looking into kind of next year, I know you guys are pre-funding a lot -- some of the maturities that are going to happen next year.

Should we assume that there is a bias upwards looking into next year because some of that pre-funding will be used, because I saw cash increased sequentially this quarter as well?

Sure.

I think that the -- I give you a measure of that, but I think we do have a -- I mentioned $17 billion funding calendar due to maturities and we're very comfortable with that.

It really matches up with where we've been in the last couple of years, this year and last year.

It is just that it is ever so slightly front loaded.

So I think we're focused on that first six-month period and likely would come into the year with a marginally elevated level of liquidity to sort of de-risk that.

Liquidity is a factor that also is starting to lessen in its overall cost.

And one way to sort of think about it is I mentioned that we just did -- we got -- tied up three-year money for LIBOR plus 130.

If you just use the 130 as a cost to carry, Sanjay, it's basically $13 million per billion, or say a million a month.

So it really is not going to be the factor that it used to be.

If it cost you a million a month per billion, so that's $3 million per quarter per billion, even if way were to elevate it a couple of billion, that would be a $6 million cost so it's not going to round necessarily.

It's a real small number of basis points.

And I think those other factors in the margin are going to be more things that sort of really dominate the landscape and the direction of it.

Okay.

I mean, do you -- just on the asset side, are you predominantly variable now or is that something that will be achieved kind of into early next year?

No.

We've completed our changes.

It's -- we are -- our standard APR's on our accounts are tied to prime.

So it's 100% variable now?

Virtually.

I mean, we're done making the changes.

It's -- we've only been marketing variable for the last two years, so this has been an ongoing shift.

Um-hum.

But I don't expect to see fixed rates exist in the industry.

I just don't see how you can have an open-ended, unsecured loan that has -- you have no ability to change a rate in a higher inflation environment that you might not particularly -- that some day could happen.

Understood.

And then just on the liability side, I mean, is it pretty much safe to assume that most of the deposits are fixed?

Or do you guys hedge out some of that interest rate?

Most of the deposits are fixed.

We do have -- I draw this audience's attention to our new savings product.

You might want to check that out on our website.

I think it has been a real winner.

It was introduced during the course of this quarter.

So a savings and money market account is resident in that portfolio of products which I think I would characterize more as a floating, but the term certificates, yes, are all fixed.

Okay, great, and then just one final one, David, I've noticed a flurry of announcements on the acquiring side, and I think you guys alluded to it earlier, could you just talk about the goal posts maybe for this year and next as far as penetration domestically and internationally?

I know you guys have this third part acquiring relationship, probably I guess you're at the latter stages every getting it up and running.

I mean, where are we with that in terms of penetration relative to MasterCard/Visa and then maybe if you could just touch on international as well, thank you?

Well, I would say domestically we have signed the acquirers and we are still implementing the turn on of the merchants.

We believe we're on almost all new merchant signings that were included along with Visa/MasterCard and so I'd say this year and next year we'll be continuing to make sure that all of the small merchants are turned on by those acquirers and maybe more importantly that the stickers up in the merchant, the clerk knows they take Discover now and we still have a good amount of work to do this year and next to finish that.

In terms of international acceptance, I think I mentioned we'll probably be turning on up to about 50 countries globally for Discover Card holders by this year end, and by next year end is when we intend to turn on the -- most of the other countries around the world through the Diners Club.

And, of course, there's about 8 million merchants, so we've got a lot of work to do to make all those connections.

And we're still not satisfied with the 8 million merchants so we're signing new acquirers around the world in a similar fashion to what we did here in the U.S., such as TRIONIS in Europe and so on to further expand Diners Club acceptance which is very strong in some parts of the world and probably Europe is where we have our biggest opportunities to improve it.

Okay.

Thank you.

And your next question will come from the line of Rick Shane with Jefferies, please proceed.

Hey, guys, thanks for taking my question.

Most of them have been addressed.

There were some comments about the increase in delinquencies this month, and I think that that's pretty explainable.

There was also, in the chart, excuse me, in the Trust an increase in charge-offs and it was a relatively significant increase given the trends we've seen over the last several months.

Can you just give us some context for that, just like you did regarding the first-stage delinquencies and how that factors into your guidance for losses during the quarter?

I realize there's a difference between the Trust and the managed data, but the Trust is at least showing a higher loss rate than you are guiding to for the quarter at this point.

Yes, Rich.

I think the -- just for everyone's benefit, our Trust, I think, did show a tick up sequential month in terms of charge-off.

By my eye, it was pretty consistent with where you saw some of other superior performing trusts and so it was broadly an industry phenomena across, I think, the better performing trusts.

Some in there had some pretty significant rises that I think we don't really use as benchmarks.

I think this reflects delinquency patterns that go back before basically -- from a contractual standpoint you reach back six, seven months.

And I think you can see Trust delinquency levels six, seven months that do translate into these charge-offs.

I would cite that one area of focus continues to be bankruptcy, which we've seen continue to rise in terms of the national filings, and, obviously, our participation in that as well.

I wouldn't take away anything out of the (inaudible), though I think the individual month.

I would guide you more to, you can use a rolling three months or you can focus on the managed presentation, but never isolate a single month because of the nuances associated with that, at a minimum manage a couple.

And I think if you look at that number in the context of the guidance that we gave, you'll find that certainly if you look at either two months or the three-month trailing that they are pretty much in harmony with each other.

I agree with that 100%.

It is interesting because what, at least the delinquencies show is, I would agree with you, that over the next four or five months you do have favorable delinquency trends that will roll forward on a six-month basis.

But then the question is given the increase in delinquencies we saw this month, is this a temporary five or six-month event and then we see a pickup in charge-offs going forward?

Is that the conclusion you guys would draw, or should we not read too much into the one-month increase in DQ's?

Well, I think you should go back.

And I think we're seeing here, as we talked about in the earlier part of this, the seasonal patterns where you basically get stabilization that comes after, I think, delinquency affairs are brought under control following the holiday spend.

We've seen now stability across the spring and summer months, and historically and we're suggesting prospectively we're going to sees seasonal deterioration into the fall.

And whether there's fundamental deterioration at the consumer level or whether there's seasonal behavior has sort of been the [dicey] combination that's being, I think, carved up over the course of this summer and clearly is still resident.

I think just seasonal alone you should expect to see these rise into the fall and I guess our charge-off guidance sort of reflects that to a certain extent, the one wild card I would come back to mention is where bankruptcies are and how bankruptcies continue to sort of be a focus for us, and I think a focus for the industry because they continue to rise.

Great, guys.

Thank you very much.

And your next question will come from the line of Brad Ball with Ladenburg FSG.

Please proceed.

Thanks, just a couple of clarification questions, Roy.

So are you guys saying that the reserve release this quarter was entirely attributable to the securitization move off balance sheet of the $2 billion of receivables and I suppose the decline in overall managed receivables?

Or are you saying that there's some improved outlook that's baked into that reserve release as well?

Well, so I went back and, again, Brad, I think there was a reserve rate increase sequential quarter.

I think that's very harmonious with the guidance that we provided, 840, 839, into the mid-to high 8s in the fourth quarter.

So, yes, we had a rate increase in our reserve sequential quarter, that's the look-forward measure.

You saw delinquency pick up maybe a basis point or two.

The majority of the action in the reserve this quarter did come from off-balance sheeting receivables through the Trust action, the $1.6 billion of Class D, that was retained on our balance sheet and the issuance to third party investors of $1.5 billion through the TALF program.

Okay.

And you also had mentioned in your prepared remarks, Roy, that you're seeing some non-TALF backed strength in the market.

I wonder if you could just give us a little color on what you're seeing out there, and do you think that you could do a non-TALF deal over the near term with the pricing that you've been talking about, LIBOR plus 130?

Well, I think that, yes, there's been non-TALF deals done.

They tend to be short, but we've had -- the deals that we've actually done have had cash buyers in them.

So they've not been 100% taken down by investors that are using the TALF facility to leverage it.

And so we've seen cash buyers in the program.

We're reengaging with cash investors that were historically part of our program and have positions in our bonds.

And so we're feeling better and better and better about that.

But it starts slowly and it kind of continues.

Right now we've, obviously, executed with a combination under the TALF program.

If we saw for out the curve two and three-year-type issuance the ability to sort of get in and execute at comparable levels we would clearly take advantage of that.

Okay.

And then, finally, following up on the questions about your margin, could you give us a sense as to the 64 basis point linked quarter improvement, how much of that is attributable to the pricing and the reduction in balance transfers as opposed to improvement in funding costs?

Yes, very little of that was related to improving in funding costs.

I'd mentioned the number one thing was that FDIC, special assessment, that was resident in it last quarter, it's around $16 million, $15 million or $16 million.

So we had some improvement from that, plus marginal improvement in the underlying rate.

The rest of it was lower standard from -- balances and lower proportion of promotional balances.

Next question, please?

Your next question will come from the lane of John Stilmar with SunTrust.

Please proceed.

Thank you, good afternoon.

I'd like to start quickly just with revenue margins.

This quarter you had nearly a 14% revenue margin, and I would define that as net interest income plus non-interest income.

And on the back of very strong top line performance.

This is almost 200 basis points above where you guys were in 2007.

So the real question is, as we kind of move forward in this business, the retrenchment of credit, the ability to reprice, how much of that revenue margin will really stick around post legislation, post the shift in marketing dollars towards a higher end?

Can you give us some sense about how much of this current margin might stick around?

Well, I would say that a large piece of the margin increase is the low rate environment.

And so if you look at how much funding costs have come down since 2007, it's significant.

And we do -- we would expect to have higher margins and a higher charge-off environment and vice versa.

So at some point we would expect credit to start improving, interest rates to start rising and our margins to come back into a tighter level.

And certainly right now the credit has risen more than the margin has increased, which is giving us -- hurting our profits.

And at some point we would hope that losses drop faster than margin.

Okay.

Perfect.

Thank you.

And then just wanting to put a finer point with regards to this -- in terms of credit and the question of -- wanted to make sure I was clear -- is it the increase -- the little blip that we've seen, is it your guys' views then early stage delinquencies that a preponderance of that is seasonal or is it more so driven by a minor seasonality with a majority impact of the negative effects of repricing?

I just wanted to kind of make sure that I heard on a crystal clear basis which was the primary driver in your opinion of that increase?

Thank you.

Yes.

I don't -- I would not think that any of it was repricing related because, if anything, as you back off on delinquency pricing the riskiest customers are paying less than they might have in previous environments.

So I would point you back to Roy's comments that small blips from month to month, I wouldn't read too much into it and it's very tough to separate seasonality from the macro pieces.

And that's one reason we're giving you a forecast one quarter out and it's really hard for us to determine for sure even what the first half is next year.

And our final question will come from the line of Henry Coffey with Sterne, Agee.

Please proceed.

Hi, good morning, everyone.

I know in the last call you did a very good job of quantifying the impact of over limit fees with the changes that you put in place.

A whole bunch of other items get impacted, such as late fees, et cetera.

Could you give us a little more sense of what the outlook is for 2010, in terms of how the fee income line is likely to be impacted?

Well, it's not clear at this point that late fee income will be impacted.

Our late fee income was highest probably five or 10 years ago.

It has been on a long-term downward trend.

Right now it's a little elevated because of the higher delinquencies as you would expect, so I would think that late fees are most likely to fall when credit improves and you've got fewer delinquent customers.

At this point, we think that the over limit fee is the largest component on the fee line that would be impacted.

And most of the other changes impact the net interest margin line, which is kind of why we went through those various changes that we've made to position ourselves prudently for the new legislation on that.

How do you turn that into a marketing advantage?

Well, we turned it into a marketing advantage, as I said before, by less focus on price and more focus on cash back bonus, overall value and superior service and our expanding acceptance.

Thank you.

And your next question will come from the line of Scott Valentin with FBR, please proceed.

Thanks for squeezing me in there.

Just two quick questions, one in terms of risk mitigation, and maybe, modification activity.

Has there been any significant change?

Are you still actively closing accounts and reducing lines, or has that slowed down?

And then maybe in terms of modifications has that activity picked up at all?

The -- on the first question, we've pretty well completed closure of inactive accounts and for the most part customers who were inactive for more than a year we've closed rather than leave them open for years and years and years with no activity.

And, I'm sorry, I missed your second question?

I was just wondering in terms of modification activity.

So [re-aging] accounts, et cetera, if there's been any pickups there?

No, [re-aging] -- there were very specific rules that went in place, I think it was in 2001 under FFIEC, and we've religiously followed those rules since that time.

So there's been no change in our [re-age] and it's a very small part of our portfolio.

Okay.

And just on [sustation] activity, I believe Discover pulled back less than peers in terms of the amount of mailing that went out.

Can you talk about -- are you seeing a better quality customer now and maybe acceptance rates are a little bit higher given there's less competition?

Yes.

We were maybe the most -- had the highest number of mailings in the first half of the year, I think, despite us pulling back as well.

But we are seeing better response rates than we've seen in quite a few years.

But I would also say that given the economic environment, it's -- we're being very careful to pick through and make sure that we only approve customers who we're confident are going to be able to stay current on us.

Okay.

Thanks very much.

And your next question will come from the line of Eric Wasserstrom with Galleon Group.

Please proceed.

Thanks for squeezing me in but my questions have been addressed.

And our next question will come from the line of Moshe Orenbuch from Credit Suisse.

Please proceed.

Looks like we may have lost Moshe.

Do we have anyone else in queue?

Okay.

This are no further questions in the queue at this time.

I will now turn the call back over to Craig Streem.

Please proceed.

Thank you, operator.

Thank you all for your attention this morning.

We ran a little bit over because we wanted to be absolutely certain to take everyone's calls and take care of those needs.

So, again, thank you for your interest.

Any follow-up, please come back to me.

Have a good day.

Thanks.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect and have a good day.