發現金融 (DFS) 2010 Q2 法說會逐字稿

Good day, Ladies and Gentlemen and welcome to the Q2, 2010 Discover Financial Services earnings conference call.

My name is Deidra.

and I will be your coordinator for today's call.

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

We will be facilitating a question-and-answer session towards 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 conference over to your host for today's call, Craig Streem, Vice President of Investor Relations.

Please proceed.

Thank you very much, Deidra.

Good morning, everyone.

We all want to welcome to you this morning's call.

We certainly appreciate your interest and your joining us today.

As always, I want to begin by reminding you that the discussion today contains certain forward-looking statements about the Company's future financial performance and business prospects, which are 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 an 8-K report in our Form 10-Q for the first quarter ended February 28, and in our Form 10-K for the year ended November 30, 2009, both of which are on file with the SEC.

In the second quarter 2010 earnings release and financial supplement, which are now posted on our website at Discoverfinancial.

com, and have been furnished to the SEC, we've provided information that compares and reconciles our non-GAAP financial information with the GAAP financial information and, of course, we explain why these presentations are useful to management and to investors and we urge to you review that in conjunction with today's discussion.

In addition, to make comparisons more meaningful, we're continuing to provide historical results on a basis that excludes income statement impacts of the Visa/MasterCard settlement and the Morgan Stanley special dividend agreement dispute, and also adjusts for the effects of FAS 166, 167, and this as-adjusted information was made available in today's earnings release and in an 8-K filing on March 1.

Finally, before turning the call over to David Nelms, our Chairman and Chief Executive Officer, I want to mention to everyone that my colleague in Investor Relations, Amit Parikh, has been promoted to Director Global Business Development in our payment services business and will be leaving me at the end of next week.

I know that many of you have worked closely with Amit during his rotation on the IR team here at Discover and certainly appreciate the contribution he's made.

I know that David, Roy and I expect that he will make an even more significant contribution in his new role and I'm sure will you join us in wishing him great success.

As is always our custom, our call this morning will include formal remarks from David and from Roy Guthrie and, of course, a question-and-answer session.

Now, it's my pleasure to turn the call over to David.

Good morning and thanks for joining us.

This morning, we were very pleased to report second quarter earnings per share of $0.33.

Excluding the $0.13 per share impact related to repurchase of TARP preferred stock, which will discuss later, we earned $0.46.

The most significant factor in our performance this quarter, was the improving outlook for credit along with contributions from sales volume growth and lower expenses.

So, let me begin with credit where we did experience a substantial improvement.

It is clear that the performance of our portfolio is beginning to diverge from the national unemployment rate, which remains stubbornly high.

In May the number of long-term unemployed, those jobless for 27 weeks and over, made up nearly half of the total unemployed Americans and this ratio is now quite high relative to previous recessions.

While it is unfortunate that our economy has been very slow to create new jobs, it is the case that people out of work for an extended period have often already moved through delinquency, or bankruptcy, to charge-off.

So, we believe that at this stage in the credit cycle, the reduction in new job losses is a better indicator of future loss trends for us than the absolute level of unemployment.

We think this helps explain why our overall charge-off ratio came in at 7.97%, slightly better than the low end of the range we had expected.

Reflecting declines in both contractual and bankruptcy related charge-offs.

Delinquencies have come down, as well, with a 30-day rate falling by 53 basis points from the first quarter.

In fact, our total portfolio 30-day rate is now at the lowest level since the fourth quarter of 2008.

Looking ahead, indications are that credit will continue to improve and we now project that third quarter charge-offs will come in between 7.5% and 8%.

As the positive credit trends continue, reserve releases should also continue, providing an important contribution to future earnings and greater flexibility to invest for growth.

Now let's take a look at some of the other key drivers of our results this quarter.

Discover Card sales volume was $22.9 billion, up 6% year-over-year, and this was the strongest second quarter in our history.

We've shared with you the importance of increased merchant acceptance as fundamental to driving better card member engagement and higher spending.

Now, I do want to share some metrics that demonstrate our progress.

First, regarding acceptance, the number of active Discover merchant outlets grew 7% from last year.

This is very important because it reflects that we have more merchants accepting Discover and that our card members are using their cards at more merchants.

Similarly, we are seeing good growth in our primary card users, our most loyal card members.

Defined as those who make Discover Card purchases 15 times or more per month.

As of the end of the quarter, we had an increase of 6% in this measure of primary card users, and this group spent 11% more this quarter versus a year ago.

Clearly demonstrating that our efforts to increase wallet share are bearing fruit.

In addition to this strong performance among our most loyal card members, the growth in sales this quarter was driven by a 5.7% increase in the number of transactions on the Discover Card, demonstrating generally improved usage that extends beyond our primary card user segment.

So, to sum up on our sales performance, it is clear that we are seeing the overall spending environment continue to recover, but beyond that, we are benefiting from improved merchant acceptance and the positive impact of our competitive advantages and rewards service and value.

Turning now to receivables.

Total loans were down about 2%, year-over-year, with the decline in our credit card portfolio being partially offset by growth in student and personal loans.

Our credit card portfolio is down 7% as we continue to cut back on balance transfers, although only a more modest 1% versus the prior quarter, but our balance transfers were actually down 60% from last year.

A year ago, we responded to the Card Act by making a number of significant changes to maintain profitability, including dramatic decreases in balance transfers.

These changes are largely complete, so we expect card receivables to start showing modest sequential growth over the next several quarters.

Our direct to consumer deposits business achieved $2.7 billion of growth this quarter, including about $1 billion from the acquisition of certain consumer deposit accounts from E-trade, bringing total balances at the end of the quarter to over $17.5 billion.

If you look back one year, direct to consumer deposits were just 15% of our total funding, but they're now about a third of our total funding.

We are very proud of the tremendous progress we have made in this area, and going forward, we will look to this cost effective, core deposit channel as our largest single funding source.

Turning to our payment segment.

Pretax income for the quarter was $36 million, up 36% last year, driven by strong performance in each of the three lines of business.

Pulse generated a 6% increase in the number of transactions and based on our pipeline, we expect this to increase next quarter.

Our third-party issuing business also performed well this quarter with 25% year-over-year growth in dollar volume and in Diner's Club we also achieved growth in volume, revenue and profit.

I'm very pleased with the profits in our payments segment, given strong contributions from all three lines of business.

The credit card industry has seen a tremendous amount of activity in the areas of accounting, regulatory and legislative changes over the past year.

Implementation of the changes mandated by the Card Act is now largely behind us and, we believe, that this will prove to have add a much larger financial impact on Discover than the financial reform legislation currently being considered by Congress.

Although, the actual impact of the reform legislation will depend in large part on future implementing regulations.

The industry recently received direction from the Federal Reserve on late fees from the original Card Act legislation, and I need to remind you, that estimating the net impact is not simply a matter of calculating the effect of changing late fees from our current rates of the new safe harbor levels.

The actual impact will depend greatly on the number of incidents which should steadily diminish as credit continues to improve.

From where we stand today, once implemented, the net pretax annual impact of the late and NSF fee adjustments, we expect, to be approximately $80 million to $90 million.

Further, I want to highlight that the normalized Discover Card revenue margin, of 12% to 12.5% that we described during our recent investor day meeting, contemplated about this level of impact.

I would like to wrap up my section of the call by highlighting the key drivers to give us confidence that we can achieve the growth and return targets that we outline for you at our recent investor day meeting.

First, as I said at the beginning of my comments, we will reinvest a portion of the benefit from improving credit performance in initiatives to accelerate growth in both of our business segments.

Indirect banking, our brand promise of rewards, service and value, continues to resonate very well and is driving higher levels of card member engagement and spending.

We will enhance our card marketing efforts to build on these results and you will see that in our third quarter marketing expense, which is likely to be at its highest level since the third quarter of 2008.

The strength of the Discover brand also helps to drive growth in direct to consumer deposits, personal loans and student loans, and we will also continue to invest to grow these products.

In payments, we will continue to invest to generate increasing volume on Pulse, Diners Club, and the Discover network.

We are also investing to complete global intraoperability across all of our networks, which when completed, will offer the option of a new and flexible payments alternative for issuers around the world.

Now, I would like to ask Roy to take you through additional key elements of our second quarter financial results.

Okay, thanks, David.

Before turning to the segments, I want to give you a little color on how the second quarter results were affected by the repurchase of the TARP preferred shares.

In the quarter, we recorded $72 million of accelerated discount accretion and dividends related to the preferred stock, that was previously issued to the US Treasury which, as you know, was redeemed in the middle of April.

Of the $0.13 per share impact, $0.11 of it relates to the accretion, and $0.02 represents the preferred dividend that we owed the treasury for that stub period prior to repayment in the quarter.

Turning to the segments, direct banking earned $386 million pretax this quarter, versus a loss of $185 million last year on an as-adjusted basis.

In terms of the yield on the card portfolio, we reported an increase of 23 basis points sequentially of which 20 basis points came from the improvement in credit.

Very simply, as credit improves we see the principal benefit in lower loss provisions, but we also see a reduction in the amount of accrued interest being charged off.

This latter benefit flowed through interest income.

Looking ahead, we expect that ongoing improvements in credit will continue to benefit the yield on the card portfolio.

Although, this will be more than offset by the impact of the Card Act.on the portfolio mix.

We now estimate that in the fourth quarter this year, we will see yield contraction in the credit card portfolio of about 25 basis points from where we ended 2009, right around the low end of the guidance range that we've given you as of the end of last year.

Net interest margin for the segment, which includes cards, student loans and personal loans, was 9.14%.

That was up 13 basis points from the first quarter, essential reflecting the yield benefit I just discussed, as well as, slightly lower cost of funds offset by a higher mix of non-credit card receivables.

David already discussed the trends in card sales volume, receivables and aggregate credit.

So, I'm going to move on to discuss credit performance by product.

Turning to delinquency and charge-offs, let me first focus on the card portfolio, excluding student and personal loans, since the card trends really account for the vast majority of our overall credit performance.

The 30-day delinquency rate for credit card loans was 4.85%, an improvement of 54 basis points from the first quarter.

Again, looking at that the card portfolio alone, charge-offs declined 44 basis points sequentially to 8.56%.

This reflects fundamental improvement in the credit and some seasonal benefits in the portfolio.

Looking ahead to September of this year when we expect that most of our government guaranteed student loans will be sold to the Federal Government, I want to give you an early look at credit performance for the personal and student loan portfolio, which are tracking in-line with the credit metrics that we outlined for you during our investor day meeting.

We're going to continue to track these for you going forward, and we'll provide more detail on the impact of this sale this loan sale I referred to in our second quarter 10-Q.

Starting with personal loans, the 30-day-plus delinquency rate in the quarter was 2.12%, down two basis points sequentially and the charge-off ratio was 5.97%, down 82 basis points sequentially.

For student loans, the delinquency rate was just 0.85%, just one basis point sequentially and charge-off ratio was seven basis points.

Turning to operating expenses for the direct banking segment, total costs came in about 8% lower this quarter year-over-year, driven by severance and other costs related to our reduction in force in last year's number, along with cost savings in this year's quarter in the area of information processing and communications.

Given the improvements in credit performance that David discussed earlier, coupled with the opportunities we see in the marketplace, we do intend to ramp up our marketing spend, and as David highlighted, you should expect to see in that our third and fourth quarter numbers.

The last thing want to cover this morning is funding.

We've talked for some time about the maturity profile for the first half of this year.

Maturities total $14 billion, with $9 billion here in the second quarter, including the TARP repayment.

I'm pleased to say, that we've successfully funded these requirements and finished the quarter with a solid cash position.

As you look forward, we have just $7.6 billion in maturities in the entire second half of 2010 and $16 billion over the next 12 months, down significantly from what we just successfully funded our way through.

During the quarter, we used our direct to consumer channel to achieve most of the funding, including the E-trade deal.

We also raised $500 million in sub-debt at the bank bolstering our tier two capital levels.

The liquidity investment pool on the balance sheet, was about $15 billion at that time beginning of this year, this fiscal year, and we've drawn that down now to $10.9 billion at the close of the second quarter.

Still somewhat elevated, and we expect to finish the year with about $8 billion to $9 billion in cash liquidity given the forward maturity profile we see at the end of our year.

As of the second quarter, contingent liquidity aggregated $23 billion, including the cash I just mentioned, conduit capacity, the bank revolver and Fed discount window access.

So in closing, we have a good foundation for growth in all of our businesses, and I feel really good about where we stand at this point in the cycle.

With that, I'm very pleased to turn it back over to you, Deidra, and move to our questions and answer period.

(Operator Instructions) Your first question comes from the line of Bill Carcache from Macquarie.

Please proceed.

Good morning.

Can you talk about the sales volumes trends for each month within the quarter?

Then if you could also, discuss what June trends look like so far that would be helpful.

Well, we've actually seen some very nice stability, and it appears that we're hanging on to the strong momentum that we had during the quarter.

The month of May, our sales were up about 6% year-over-year, and that's also continued for the first couple weeks in June year-over-year.

So, it really matched the 6% that we saw for the entire quarter.

Deidra, next question, please.

Yes, and your next question comes from the line of Brian Forth.

Please proceed.

Good morning.

When we think about charge-offs long term, I guess historically your charge-offs did tend to be around 1.2 times your delinquencies.

So, if I go back to '04 delinquencies were at a similar level, but we had a 6% charge-off ratio versus 8% today.

So, I guess, the two questions I have are, first, is there any structural shift in bankruptcies or roll rates or recoveries that would make the charge-off versus delinquency ratio different going forward or, and then secondly, when you gave guidance for 3Q, any assumptions or color on how you're thinking about the path of bankruptcies and role rates?

I think, as you kind of alluded to, the mix of bankruptcy versus contractual charge-off can certainly impact that overall relationship.

But beyond that, I don't think they will move in lock-step, but I would expect them to have a fairly strong correlation as delinquencies fall, so should charge-offs.

If I could ask one follow-up, how should we think about CD repricing as a potential NIM tail wind?

Is it a NIM tail wind, or does it get offset by other things like, full quarter impact of the sub-debt or using less floating rate ABS funding?

Hey, Brian, I think it is, right now, it is a tail wind or good guy.

Just to be clear, which I talk about a tail wind on an expense line.

But the reality is, that maturities that we have always played out the curve and so what you are seeing mature are deposits issued two, three, four and five years ago.

And so the rate at which those carry, and are being sort of displaced by today's issuance, which by the way, you can see on Discovercard.com or at Discoverbank.com, basically are giving us a tail wind.

We did have in this quarter, I mentioned, large maturities, five of which came out of the asset-backed trust.

Those were also issued in legacy periods and had very low rates associated with them.

So, we've got a blend of things that are coming due that the deposit channel is replacing.

But, if you were to isolate deposits maturing and deposits being issued, it is a big plus for us.

Your next call comes from the line of Don Fandetti.

Please proceed

Hi David.

Quick question on the Pulse business.

I was just curious to get your thoughts on the exclusivity provision and the Durbin act and some of the other folks in the business have suggested that there could be some risks to some of the other networks, including yourselves, in terms of priority of routing.

Can you comment on sort of your view on this?

Well, Dan, the first thing I would say is that the bill is not even yet passed, and there still could be changes.

And secondly, even once it's passed, the specific regulations that the Federal Reserve will have to make over the next year regarding pricing and specific rules could have a lot to bear on exactly how this plays out.

With regard to exclusivity, some of the current proposals are to, designed , I think, to encourage competition.

Recognize today, that if you think about a debit card, Visa could have exclusive contracts today where they have both interlink and signature debit, and there's no competition on that card.

Where as virtually 100% of the other networks, like Pulse or the other PIN networks, almost always share and are competitive on that card with signature networks.

So, I think there's some scenario that the people that have, if competition is introduced to that card, and we're able to compete, that could be a favorable outcome and we would certainly look to aggressively pursue higher level of competition if that's how it

That's very helpful.

So, I think what I'm hearing is that there's not really any sort of risk, per say, to your current volume?

It would be more of a neutral to positive type scenario.

I think it's really that early to tell.

These things are fairly far reaching and a lot of changes, and I would certainly hope that given that the intent is to open up competition, if that's how it plays out that would be very good.

But, we have to wait to see the specific regulations before we can definitively say whether it's a positive, neutral, or negative.

Your next question comes from the line of David Hodgson from Discover.

Please proceed

Hi.

I'm not from Discover.

But, anyway, wonder if you could just speak to the prospect for growth in cards and loans and the credit card business?

Now that you've substantially reduced balance transfers, are we kind of at a more normal level and as you see spending growth are we likely to see loan balances increase?

Maybe, you said how much you had in new cards over the last quarter, but I'm not sure.

Well, as I kind of mentioned, we do think we're at a bit of an inflexion point.

This quarter our balance transfer volumes were off 60% year-over-year, but we're right now at the anniversary of when the big changes were made on our balance transfer programs.

So, both from much easier comparisons starting next quarter on balance transfer, as well as, increased growth initiatives, both for new customers and existing customers.

I expect that balance transfers will actually start growing modestly from here.

You've seen sales growing and so those things, two trends, we expect will lead to gradual sequential gains in card receivables over the next few quarters.

And we're going to -- especially as we see our strategies working, regarding cash rewards and our service, better service, that we're providing customers, and our product set, as well as an improving credit environment and a little more stability on the new regulations, that gives us confidence to start gradually growing the business again.

And have you had growth in new account or cards, net growth?

Or is that also declining?

You know, we don't disclose an exact number of quarterly new accounts.

But I would say, we expect to put on more new accounts this coming quarter than we did the quarter that we just reported.

Just as a follow-up Roy, is there any way you can give us an idea how big the gain on the student loan sales would be before the new quarter?

I think it it's -- I wouldn't -- de minimis .

Okay, thanks.

Your next question comes from the line of Sanjay Sakhrani from KBW.

One question for Roy and then one for David.

Roy, I was wondering if I could drill down on the net interest margin trajectory for the remainder of the year?

I had two questions around that.

One is the yield guidance you gave for the 25 basis point decline does that include the benefits of lower suppression?

And then just on expense side, the interest expense side, I was wondering if you could just help us think through the tail wind, the maturities in the second half are as far as interest expense?

Sure.

The answer sequentially is yes.

So, I think we've tried to -- I think we've sort view pushed that to the low end of the range based on some favorability that we've seen in the actual level of charge-offs.

So, it is incorporating estimates of a degree of suppression that are resident in that.

It's a rubric, right?

So, it's obviously got the yield itself, it's got mix, which includes default balances and promo balances, which are the two things that we're seeing moving now.

We are talking a lot about promo balances maybe flattening, if not growing, in the discussion we're having here about growth.

So, that's going to be a constructive move.

We'll see sequential decline in the default balances and we should see lower charge-offs.

Those are all resident in that expectation.

In terms of the interest expense, I think when Brian asked the question, I tried to make sure that we don't go deposits for deposits, because in this first half we've seen, out of that $14 billion of maturity I talked about, about $8 billion came out of the asset backed program, and the asset backed program maturities are LIBOR plus a handful, 15 or 20 basis points.

You can see that detail in master trust and so you know that we are paying off things that were issued during a time when the risk profile of those were measured quite differently.

But from the deposit standpoint, and I think what we're seeing for the rest of this year importantly, moving forward, it's going to be deposit maturities and deposit issuance.

So, the relevant discussion we had about the deposits being a good guy is probably more relevant in the third and fourth quarter than it was through the first half, given that deposit maturities and deposit issuance will be at the margin what's happening in our second half.

Okay, so those $7.6 billion in maturities, what are the deposit rates on those?

Well, those were deposits that were issued two, three, and four years ago.

So, they would be materially higher than the 2% percent yields that are being written now and materially, I would say a multiple of that.

All right, thank you.

Then, I guess, the second question for David was just on capital, and maybe even you Roy, but the TCE ratio very, very strong.

I was wondering how you guys are thinking about capital on a go forward basis?

Is there an expectation to implement some kind of shareholder friendly action at some point later this year?

Thanks.

Well, everything we do is designed to be shareholder friendly.

I would say our number one focus will be on growing our business and putting capital to work to earn strong returns.

And I'd say, obviously, if at some point we feel like we've generated more capital than we can put to work, then the Board would obviously consider the other alternatives.

But, I would say it would really be premature to do anything more in terms of capital at this point.

Okay.

Thank you.

Your next question comes from the line of Jason Arnold from RBC Capital Markets.

Please proceed.

Good morning, guys.

Your card outstandings declined only very modestly this quarter, as compared to a lot of the peers you have, judging by their trust data, very strong performance there.

I was just curious if you could comment on what's really key to your ability to keep loans at Discover versus what the peers are doing?

Well, I would say there's a couple of components.

This is been true for the last six quarters where we've had much more stability in our loans and sales than our Visa, MasterCard competitors, the other issuers.

Certainly our credit has performed better.

So, right off the top we're not writing off some of those -- as many of those receivables.

Secondly, with the things I talked about with broader acceptance and the appeal of our cash reward program, our sales have outperformed.

So, we've gained market share relative to US credit card sales and some of that turns into balances and more stability of balances.

And finally, I think we, given that we have been conservative on credit for the last five years, we didn't have to take as dramatic of actions to clamp down on credit as some of our competitors did.

So, I think all of those factors have helped our receivables and our sales and this quarter was really more of the same.

Great.

And then, I guess I was just curious, you spoke about, of course, upping the marketing expense here going forward as well.

What are you really seeing as the greatest impact in adding new members?

Is it the direct mailing?

Is it TV, radio advertisements?

What are you going to generally tend to focus on?

The biggest opportunity, clearly, is from our current card member base because we've got about a quarter of the US households who have a Discover card and we don't have a quarter of the market in spending and loans.

Activation and expanding usage across the 5% get more programs to get our card members to use their card in more categories and use it as their primary card, would usually get first funds, because there's a very high payback there.

But beyond that, it will be spread across the areas that we think have the best bang for the buck.

A little more direct mail, more internet, more TV advertising for the brand and more in some of the other direct banking product as well.

Student loans, personal loans, and deposits.

So, there's not going to be any one things but just a gradual return to more normal levels of marketing.

Okay, terrific.

Thank you for the color.

Your next question comes from the line of John Sillmar from SunTrust.

Please proceed

Good morning.

David, a quick question for you.

Thank you, for the color on some of the spending trends especially at the customer level.

But, I would like to start there with what are you seeing, obvious it's very controversial, with regards to certain mortgage holders who are walking away from their homes or staying in the homes and not paying rent.

There's argument that that is contributing to consumer spending, and that's been argued that that's one of the differences and credit card spending versus maybe what we're seeing in retail sales.

The question is what are you starting to see at the customer level?

Is that really something that is driving this increase in spending or is this really just a consumer who is money good on their mortgage, who is basically coming back to spending?

If could you kind of characterize some of those demographics, or some of the trends that we read about, and what you are seeing underneath in terms of the composition of spending is patterns in your portfolio I would be appreciative?

I would say it's the second of the scenarios you just laid out.

What we are seeing is, it's the -- all of the growth is coming from high FICO score customers and from our lowest risk customers.

So, someone walking away from a mortgage, would by definition, be in the low FICO score range and we are not seeing growth in those areas.

So, my interpretation of our data is that the -- is that we have a large number of customers who were not underwater with their house, who didn't lose their job and are now feeling a little more confident spending money again.

They've now had a year or two to maybe de-leverage, pay off a little debt and they're feeling a little more confident about the economy.

They don't feel like -- they're feeling like they're not likely to lose their job and that's where we're seeing the spending increase from.

Great.

Really appreciate.

That then if I could, also circle back to marketing expense this quarter.

Obviously, you signaled in the third quarter for a pretty sizable increase.

But to be frank with you, I had expected it to be a little bit higher this quarter and without being petulant with regard to timing, what are you seeing today that allows you to spend more in the third quarter versus prior to the analyst day when you could have made marketing decisions?

Seems like you were pretty bullish there, too.

I'm curious what you are seeing out in the market and really your approach to dropping mail?

Is it prudence?

Is it a cautiousness?

Is it response rates?

Can you just provide a little bit of color of segment and areas that you see as opportunities, and really, and the timing of marketing expense relative to certainly your commentary about improving credit optimism for growth?

Well, I'd say a couple things.

First, we have been very focused on making the dollars we are spending go further, and so we were able to produce the 6% growth in sales with the level of marketing expense that you saw in the quarter.

So, it's not just about money, it's also about effectiveness.

Secondly, I would say that the delinquencies dropped more this quarter than we expected.

We certainly saw some of that benefit in the first quarter.

But first quarter was the first time we really saw credit start -- our credit start to diverge from the unemployment rate and I think having a few more months under our belt to make sure that wasn't just a one quarter aberration that it was going to continue.

I think gives us a little more confidence and the last thing we wanted to do was falsely call the top.

Last quarter, we said, we thought it peaked in the first -- delinquencies peaked in the fourth quarter.

Now, we had another data point to prove that that was, in fact, the case.

And so, I think we're just a bit more confident now than we were even in investor day.

So, it's more of what you are seeing in the portfolio rather than the competitive landscape that's driving your marketing expense.

Yes.

Okay.

Then a final housekeeping item.

Just a point of clarity with regard to Sanjay's question.

This quarter, I believe, your credit card revenue yield was 12.7% and your guidance is for it to the come down by 25 basis points.

But implicitly 20 of that -- is 20 of that already including the fee suppression, such that you are really talking about 12.5% guidance for the near term, or should we be stripping out the fee suppression number and that's another 25 from there?

Just a point of clarification.

sure.

John, I'm looking at just reading off the statistical supplement, the credit card yield in the second quarter was 12.93% and the guidance refers back to the fourth quarter of last year, 12.75%.

We're expecting, all in, that to close the year 25 basis points down.

So, 12.%75 end of next year, down 25 basis points, would indicate something around 12.50% by the end of the fourth quarter.

Wonderful.

Thank you, guys, appreciate it.

Your next question comes from the line of Scott Valentin with SBR Capital Marketing.

Good morning.

Thanks for take may question.

With regards to merchant acceptance, just curious, you said sales volume was up 6% year-over-year.

Just curious, maybe if you could, break out the lift that's provided from merchant acceptance versus increased card spend?

And secondly, just how much more opportunity is in merchant acceptance?

I know you guys have been working on getting more merchants turned on to accept Discover, as well as, just increasing awareness at those merchants to take Discover.

Well, I think that the measurement, the statistics that I said, was 7% increase in active merchants, is indicative of the fact that we're broadening the acceptance.

They tend to be the smallest, very small merchants that we're adding.

So, you are seeing that grow even faster than sales dollars in total.

And so, the strategy is working.

We have signed with over 100 of the acquirers.

So, virtually all of them are on the program.

Not all of them have implemented all the stages of our new strategy.

And so, I would say through this year, and even into next year, this should continue to be a nice tail wind, because not all of the small merchants are turned on as we sit here today.

Okay.

And just a comment earlier about Pulse.

I think you mentioned the pipeline looked very good for Pulse, and therefore transaction volumes should go up.

I was just curious if anything had changed, with regard to Pulse, as to why maybe the pipe line is what it's historically been.

But sounds like you were more positive on the Pulse pipeline.

Well, I am more positive.

We've gone through a few quarters here where our growth in Pulse has been below our historic levels and would be below our target.

And I had previously cited the loss of one large customer.

You come up to the one-year anniversary so that, alone, helps.

And to some degree, the last few quarters, that one has masked all the other really strong sales gains that we've made with lots of other customers, both new and existing.

And so, that's helpful.

But, we look to basically accelerate our volume gain.

The profits have been great.

Transactions have continued to grow.

But, we would like to get that dollar volume also in the positive territory, which I expect to do next quarter.

Okay.

One final question.

On third-party issuance, I guess Diners Club intraoperability and how you think that will impact.

Will that improve the odds of signing large third-party issuers once you have global intraoperability?

Then maybe the timing on that?

Well, certainly we were pleased with how the high growth rate that we had this quarter in our third-party Discover network business.

So, I think, that's to some degree that might partly benefit from our international prospects and the fact that we are, in fact, turning on countries.

We saw some nice gain from inbound Japanese volume because of our JCB deal that benefited this quarter, and I think, that going forward certainly being one of, the only one besides Visa and MasterCard who actually have a global network with credit and debit, provides opportunities to appeal to really provide an opportunity to both US issuers.

We want international acceptance but also international or global issuers who could look to Diners Club and Discover and Pulse as a strong alternative to Visa and MasterCard.

Okay, thanks very much.

Your next question comes from the line of Brad Ball from Ladenberg.

Please proceed.

Sounds like Brad may have dropped off Deidra.

Let's go to the next question please.

Yes, and your next question comes from the line of Henry Coffee from Sterne Agee.

Please proceed.

Yes.

Good morning everyone and congratulations on a great quarter.

In terms of trying to understand some of your guidance, the lower expected net charge-offs, how is the sale of the student loan portfolio -- the government guaranteed portion of the student loan portfolio impact that number?

And in terms of the yield forecast that you have given us, that obviously doesn't include loan fees.

But did you give us some indication of where those should be going on an annual rate.

Then if you have a minute, if you could kind of give us some sense of -- or a deeper sense of the -- the securitizations that you paid down and the costs there versus the deposits you replaced them with.

Okay.

Henry, I'm giving you -- we're talking about that sale now, because I really wanted to give you a heads up.

We are going to be putting a lot more detail in the queue that will give you lots of transparency into how to think about that.

It will not occur, though, until the fourth quarter.

So again, transaction is expected to actually be effective in the fourth quarter.

Therefore, I think across most of those issues that you talked about, it's a fourth quarter issue.

We'll have good clarity on that in terms of where the real trends are going so, I'll wait for the queue.

Fair enough.

And then in terms of, there's obviously more than just cost savings that go on as you move from securitization funding into deposits.

But can you give us some sense sense of what those numbers look like this quarter?

Well, we would have been paying down legacy.

We issued, if you go back into 2005, 2006, 2007, we would have been issuing three to five year asset backs at LIBOR plus five to 20.

That's what you saw mature here.

There's $8 billion of them in the first half.

You can see our deposit rate.

Those are resident on Discoverbank.com.

Please, everyone listening in, please pre-print that and use it at your leisure because I think it's a good reference point and great value.

You can see where we're issuing based on that and I gave you guidance as to what the asset backs are now.

So, you've got a zip code on that.

The legacy deposits, which also were issued, I think prior to the crisis, because most of these are long dated deposits that are maturing, would have been prior to the Fed relaxing targeted rates much higher than the 2% plus we're issuing at right now.

So, there's a big win on the deposit for deposit, deposit issuance, deposit maturities.

But a little bit in the first half, head wind from the maturities of those asset backs.

As we look forward into the second half, it's going to be lined up deposit maturities for deposit issuance.

We'll begin to see the value of that accrete into the cost of funds more readily than you might have seen it in the first half.

If I have time for a related question on that, as you grow the network into a real channel, are you able to pick up benefits by grabbing shorter maturity CD's and more conventional money market like products?

So, is there always mix dynamic that's going on here, too?

We have maintained about a third of the portfolio is indeterminate maturities.

The other two-thirds is out the curve.

We have strong renewal attributes and we've talked about those.

We've talked about those in-depth on analyst day.

For those of you listening in that haven't seen the material, it's available on our website.

But, we do tend to issue in the 18 to 36 month window.

I think an aggregate duration in the two-year area.

So, no, we do do not go short necessarily.

Over time you might say, yes, there's opportunity there, but at the present time we're focusing on term liquidity and renewal attributes and a combination of those two, I think, does differentiate us from a lot of other issues in the market from a liability and liquidity standpoint.

Congratulations on a great quarter.

Sounds like everything is moving in your favor.

Ladies and Gentlemen, in the interest of time, we request that you please limit your questions to only one.

And your next question comes from the line of Rick Shane.

Please proceed.

Thanks, guys, for taking my question.

In the context of the increased marketing, is your strategy also to increase your willingness to lend?

Obviously, you've been very disciplined as underwriters throughout the cycle and that's been reflected in the steady credit performance.

As we reach a cyclical trough, in terms of credit, will you be willing to be a little bit more open to lending and is that part of the strategy with the marketing?

Well, if the question is are we going to let the -- loosen our credit standards, I'd say generally no.

We benefited during this time from having strong credit standards and we're going to remain a prime credit card issuer.

Certainly, we will continue to fine-tune our credit standards.

We can find additional places to make prime loans for cardholders and I would say, even during the last two years, we did not -- while we closed some inactive account and took some actions, we have been there for our customers who remain credit worthy during this time period.

Got it.

And then just one other follow-up.

I apologize.

When we compare the 6% increase in spend and the runoff in the portfolio, the initial conclusion was that that has to do with backing away from balance transfers and that makes sense.

But, you made a very interesting comment that really the surge in your spend is being driven by your high FICO customers.

Are you seeing any change in payment rates associated with that?

Is this going to become a little bit more of a transactor model?

Well, I think you have already seen that over the last year.

Our payment rate has risen, and part of the -- a couple of the reasons, fewer balance transfers and balance transfers have a bit lower average payment rate than the retail only part of the portfolio.

And secondly, yes, more sales growth on transactors means a bit higher payment rate.

You have seen that.

If you look at our trust data, we're definitely up versus a year ago on payments.

Terrific, guys, thank you for taking my questions.

And your next question comes from the line of Chris from Stifel Nicolaus.

Please proceed.

Thanks.

Good morning.

On the -- quick follow-up on the margin guidance.

You mentioned you are getting a 20-basis-point lift from credit.

You also clarified on the late fee guidance.

Is it safe to say the late fee guidance, or the late fee impact from the new rules, was already in your 25 to 50 basis point guidance?

I guess, the latest is the 20 basis points you got from improving credit quality this quarter basically continue to roll forward in the second half of the year as long as trends stay the same?

Hey, Chris.

Yes, the late fees are recorded in other revenue in our business model.

So, you will see that the yield guidance we're giving you on that credit card book would not include that aspect.

Initially and yes, I think it's cumulative.

So, you look at the yield suppression that is involved with charge-offs within the interest income line and that will move down, station itself and then continue to improve sequential quarter from where we landed here.

So, I think it is a new beginning point for sequential quarter impacts looking forward.

So, I guess you would take that suppression.

You'll get a lot of transparency into this because you'll see the actual number in the queue.

And then, I think, what you want to do is that's your baseline and then apply the guidance we're giving you on charge-offs representative to it going forward.

Okay.

Different question on different topic.

The 7% increase year-over-year in active merchants, I'm assuming, that an active merchant is one you are defining, some have made a Discover purchase.

That's correct.

Given the fact with this acquiring strategy that's been successful in growing your merchant outlet and you have gone from roughly three-quarters to close to 95% to 100% merchant coverage, shouldn't that number be up a lot more?

And, I guess, the point here I've actually tried myself to use Discover Card at merchants where they don't have Discover signage yet, thinking that might be a new Discover merchant, and I get a lot of push-back in some of these tests.

They don't even want to try to take Discover.

I am wondering if that's part of the reason why you are not seeing a bigger increase in the number of active merchants, and if so, is there something you are planning on doing about in the also, just along those lines is any of the marketing spend you're planning for the second half of this year going to try to increase consumer awareness of your increased merchant acceptance?

Well, first off, I'm very pleased with the 7% increase.

It's hard to know how many merchants there are total.

But certainly, there have been a lot of businesses going out of business over the last year.

If could I measure it versus what's going on with everyone else, which I really can't, I think we'd compare very favorably.

Certainly the -- it is -- the new strategy is working.

But does it take time and there can be -- it can take some time for the acquirers to enable all the terminals and communicate with their merchants and change their systems, and some of that is still ongoing.

And then secondly, the merchants, once they've been enabled, turned on, they've got to have the signage up, the clerk at the counter has to know they take Discover now, because that's a change.

And we've been making hundreds of thousands of in-person visits to help accelerate that progress.

We do think we're on a 97% plus of new merchants who are signing up are getting Discover as part of the package.

So, this is more a matter of it takes a long time to go back and get all the legacy merchants to add Discover where, as they may only have taken Visa and MasterCard in the past.

Secondly, in terms of awareness we are -- part of the reason we're so aggressively pushing our 5% get more program, and if you look at our TV commercials, we're physically showing merchants swiping the card through their terminals.

We are encouraging our card members to use across all categories.

We think about which ones to put into the get more program, partly based on the types of categories where we're having most -- the biggest changes in acceptance, and so, we're doing, we're certainly stepping up our activity in terms of encouraging it from the card holder side as well.

I apologize, one quick follow-up.

Are you seeing any changes in response rates, any improvement?

I get the impression that card issuers are ready to start marketing again but you are not seeing much, if any, sign of life out of consumer acceptance, the balance transfer gain that was so successful in the last several years, just not, I think consumers generally may be more turned off to it.

Is that any part of your increased optimism in the second half of the year?

Are you seeing any signs of life out of consumer demand for credit?

I think there's some mixed, mix changes that are leading to reasonably stable overall response rates.

On the one hand, even with some competitors starting to come back into the direct mail market a bit, the amount of direct mail is still far lower than it was historically.

So, consumers just aren't getting nearly the number of offers, and that means that helps -- that helps us to not get drowned out as much as could have happened a few years back.

On the other side, I do think consumer behavior has changed and consumers are now using fewer and fewer cards.

They're consolidating their spending.

They're not switching around from one to another.

So, that benefits us because our retention rates are at historic lows.

But it also means you are not getting as many new customers who are switching from some other issuer on to us.

So, those are some of the cross-currents, and what I think -- I'm not seeing dramatic swings in the cost per account or the response rates as a result.

Thank you, David, appreciate it.

Deirdre, hang on a moment.

I really have to encourage all of you to hold your questions to one so we can accommodate everyone.

We don't want to end the call without everyone having had a chance to ask a question.

So, please, with respect, limit your questions to one.

Deidra, prompt for the next one, please.

Your next question comes from the line of Michael Taiano from Sandler O'Neill, please proceed.

Thanks for taking my question.

My question centers around the capital.

I think the question was asked earlier, first in terms of the Collins Amendment does that, as it is currently constituted I know it still has to pass, but in terms of the capital that would need to be held at the bank holding company relative to the banks.

Just curious, if that would affect you and just more broadly in terms of where your capital levels are?

What would it take before, maybe, you would get more aggressive on things like share buybacks and increasing the dividend?

The capital ratios that we maintain are well into the top quartile of top quartile of the banking industry, Michael.

So, it's not a part -- it's not the target, nor it will it be dramatically affected by it.

I'm more focused on the direction of (inaudible) and other aspect of capital than that.

Certainly, as we look forward these things may influence what we might view as a cushion that would be absorbed by growth or opportunities to grow inorganically before we would make decisions about other areas.

So, I think where we target is the very dynamic rubric right now, based on a lot of things going on.

I think, what we tried to share earlier, is that we're positioned to grow the business and that's what that capital is first and foremost for and that's what it is going to be used for.

As we see those opportunities not sort of pan out to absorb that, we'll make decisions in keeping from a timing standpoint with that, those insights.

Next question, Deirdre.

Your next question comes from the line of Roger Lister from Morgan Stanley.

Please proceed.

Good morning, gentlemen.

I just after quick comment.

I've been with you since day one as a card holder and a stockholder.

And I am very impressed with your -- when you call up the department, when you call up to get information on a balance or something like that, they are so nice and so helpful, more than any other card company I have ever had.

So, whatever you are doing there, keep it up.

That's my comment.

Well, thank you.

Clearly one of our three main pillars is leading service, and last year we won in the whole industry for number one on JD Power on the service aspect.

We'd love to win the overall JD Power for the industry.

We were just edged out by AmEx last year.

But, we're looking to have everyone have those kind of comments.

Next question.

Your next question comes from the line of Bruce Harting from Barclays Capital.

Please proceed.

Thanks.

David or Roy, just wonder if you could catalog the legislative changes that have passed so far and just comment on whether all of those are now in your numbers, and it sounds like the late fees we talked about the impact right from the perspective of the third quarter?

But, just wondering if you can get any more granular with the final ruling on late fees, and then as part of that one question, just discuss what's already happened and what's still pending, if you don't mind reminding us on debit exclusivity?

I just wonder if you could comment on what's still outstanding?

Granted, the bill is still being heavily debated, but in terms of the bank tax and state preemption and other things that are open, it would be really helpful, trying to navigate through these last few days of this legislative reform.

Thank you.

I would say that if you take, I think it was 1,300 pages on the Card Act, probably a similar number of pages of interpretation and something like 2,000 pages from the current financial reform, that's not yet passed, it would be impossible for me on this call to fully catalog everything.

I would say generally, as was mentioned, we have implemented most of the Card Act changes already.

There are some ongoing, sort of cumulative impact as risk based pricing gradually diminishes and we have an amortization off higher priced loans and fewer really low priced loans and more people in the middle and we talked a lot about the yield impact on that.

The late fee piece, I did quantify in my comments, as being roughly $80 million a year and that will go into effect in August.

I think it's middle of August.

So, if you look from that point forward that would come off of our, on a net basis, come out of our fee income line.

And then this current financial services reform legislation is not yet done.

So, we'll have to see what the final impact is.

But, it's much less certain how would it even impact us.

Clearly there's -- well, it appears there will be a new consumer regulator.

But, there's nothing specific and so a lot of the impact would be dependent on how that regulator promulgates rules and how those fit with us.

But, clearly we've tried to be a very consumer focused company and so we would hope or expect to have a lower impact.

But, there's uncertainty on that.

It will be at least a year before we probably see even more clarity on some of those changes.

Deidra, I'm not sure we have any more questions in the queue, so is that the case?

Yes, sir.

We have no further questions in the queue and way like to turn the call back over to Craig Streem for closing remarks.

Thank you, Deirdra.

Thank you all for your attention and your interest and if you have any follow-ups, please come back to me and we will work on that with you.

And we wish you a good day.

Thank you.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Good day.