發現金融 (DFS) 2011 Q3 法說會逐字稿

Welcome to the 3Q 2011 earnings conference call.

My name is John and I will be your operator for today's call.

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

Later, we will conduct a question-and-answer session.

Please note that this conference is being recorded.

I will now turn the call over to Mr.

Craig Streem.

Mr.

Streem, you may begin.

Thanks, John.

Thank you very much.

Good morning, everyone and welcome to today's call.

Let me 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 and our Form 10-K for the year ended November 30, 2010 and in our Form 10-Q for the second quarter 2011, both of which are on file with the SEC.

In the third-quarter 2011 earnings release and supplement, which are now posted on our website at www.discoverfinancial.com and have been furnished to the SEC, we have provided information that compares and reconciles the Company's non-GAAP financial measures with the GAAP financial information and we explain why these presentations are useful to management and to investors.

And we urge you to review that information in conjunction with today's call.

Our call this morning will include formal remarks from David Nelms, our Chairman and Chief Executive Officer and Mark Graf, our Chief Financial Officer and then a Q&A session, of course.

During the Q&A period, it would be very helpful if you limit yourself to one question and one follow-up so we can make sure that everyone is accommodated.

Now it is my pleasure to turn the call over to David.

Good morning and thanks, everyone, for joining us.

Before the market opened this morning, we reported record quarterly earnings of $649 million, or $1.18 per share.

This was driven by continued improvements in credit and positive growth trends, led by the reemergence of year-over-year growth in Discover Card receivables.

All in, we generated an ROE of 33% this quarter, but even excluding the reserve release, our ROE would have been well above our 15% ROE target.

I want to begin by commenting on two principal highlights of our results this quarter, the first of which is solid growth both in Discover Card sales volume and receivables and the second is credit performance.

Discover Card sales volume reached an all-time high of $26.3 billion, beating our previous quarterly record by over $1 billion.

This represented a 9% increase from last year and the growth came from both new and existing customers.

Importantly, we are seeing attrition rates that are the lowest we have seen in over 10 years in our cardmember base, coupled with an increase in average cardmember spending, which has contributed to the growth in cardmember sales.

Sales momentum is also being driven through the effectiveness of our rewards programs and our increased brand presence reflected in sponsorship deals such as the NHL, Six Flags, and the Discover Orange Bowl, as well as our marketing initiatives with a company like Amazon.

We did see a brief slowdown in spending just prior to quarter-end when hurricane Irene hit the East Coast, but during the first three weeks of September, we have seen volume growth return to levels that were consistent with most of our third quarter.

Year-over-year growth in Discover Card receivables resulted from strong sales volume, including spending growth from the revolver segment of our portfolio, as well as from increased balance transfers.

Sequentially, Discover Card sales grew $1.4 billion this quarter and card receivables grew by $1.2 billion, while balance transfer and cash advance volume was essentially flat.

Given our continued emphasis on increasing wallet share, we are pleased that the population of our primary card users grew 8% over last year with sales growth from this group up 12%.

Additionally, we have seen 12 consecutive months of year-over-year sales growth from our revolver segment of our base.

We believe our efforts to increase merchant acceptance have also contributed to these positive volume trends as our cardmembers are increasingly taking advantage of our growing coverage.

Our number of net active merchants grew 7% versus last year.

A second highlight this quarter is the continuing improvement in credit as our delinquency rate in card reached a 25-year low at 2.43% and for the first time since 2007, our card net charge-off rate dropped below 4% to 3.85%.

I am really proud of our efforts in credit risk management, collections and marketing that have produced such strong results even while US unemployment has remained above 9%.

Moving onto our other lending products, I'm also very pleased with the performance of private student loans and personal loans, which together now represent $7 billion in receivables.

Both continue to demonstrate very strong credit characteristics and strong organic growth.

Turning to our payments segment, total volume this quarter was up 15% from the prior year, which is among the most robust growth rates of our network peers and was driven by strong transaction growth in our PULSE debit network.

Since the Fed announced its final debit rules in June, we have been adjusting to the new environment and have been responding to a substantial number of RFPs for new business.

Our well-established national PIN debit network has acceptance parity with competitors and provides competitive pricing and outstanding service.

We are in active discussions with issuers about new PIN debit relationships to help participants comply with the final rules set by the Fed.

And we are working hard to help position issuers to be ready for when the routing rules take effect in April of 2012.

To wrap up, we are really pleased with our results this quarter, particularly with our strong sales volume growth, loan growth trends and our tremendous improvement in delinquency and charge-off rates.

While there continues to be weakness in the US economy, it is not getting in the way of our ability to deliver profitable growth and generate appropriate returns for shareholders while serving customers well.

Now I'll turn the call over to Mark.

Thanks, David and good morning, everyone.

I am fighting a bit of a summer cold today, so if I cough in the middle here, please forgive me.

I will begin my comments today by focusing on direct banking, which includes cards, student and personal loans.

The segment earned just over $1 billion pretax this quarter versus $395 million in last year's third quarter.

These numbers include reserve releases of $359 million this quarter and $187 million in the same period last year.

In terms of interest yield on the card portfolio, we reported a 40 basis point decrease from last year.

The principal components of the decrease are the CARD Act impact on higher-priced default balances, as well as a rise in promotional volumes.

These were partially offset by lower interest charge-offs.

When you look at our total portfolio yield, it decreased 33 basis points from the prior year due primarily to the card yield decline, which was partially offset by the impact of the sale of $1.5 billion in low-yielding federal student loans, as well as an increase in both loans outstanding and yield on our personal loan portfolio.

Net interest income increased $90 million, or 8% versus the prior year, driven by asset growth, lower charge-offs of accrued interest and the benefit of lower funding costs.

On a net interest margin basis, we had 10 basis points of expansion as the lower interest charge-offs and lower funding costs more than offset the yield compression that I just mentioned.

Our funding mix includes some higher-priced time deposits that will continue to roll off into 2012.

These were originated two to three years ago in a higher rate environment and are expected to be replaced by lower-cost borrowings through our three main funding channels as we expect to continue to benefit from the Fed's current monetary policy over the coming quarters.

For these reasons, the net interest margin would be fairly stable for the fourth quarter.

However, the addition of $2.5 billion in student loans from Citi will result in some margin compression.

I would remind you that while private student loans have lower yields than our credit card portfolio, they should also have meaningfully lower loss rates.

Other income was $15 million lower than in the prior period.

You may recall that we recognized a $20 million gain in the third quarter of 2010 as we exited the Golden Key investment.

Consumer fees decreased as improving delinquencies resulted in lower late fees.

Net discount and interchange revenue was higher, reflecting increased volumes partially offset by a higher rewards rate than the prior year.

Moving to other expenses, we have continued to reinvest in the business for growth on the back of substantial credit improvement in our card portfolio.

Operating expenses increased by $74 million over the prior year, but were just slightly up sequentially as I had guided on the second-quarter call.

Approximately $21 million of the year-over-year increase comes from expenses related to the December 31 purchase of The Student Loan Corporation from Citi, primarily in the compensation and professional fees line items.

Let me take you through some of the primary components of the remaining $53 million year-over-year increase in operating expense.

First, compensation costs were up as we further enhanced our underwriting and early-stage collections capabilities and made key staff additions in risk management.

These investments have been paying off for us in our credit performance and continue to provide an important competitive distinction.

We have also grown technology staff as we integrate new businesses and enhance our direct banking platform.

Second, professional fees were higher due to investments in growth initiatives and finally, other expense was higher due to an increase in fraud and network acceptance initiatives.

Total operating expenses should once again be relatively flat in the fourth quarter as compared to the third quarter.

We continue to be comfortable with our long-term expense target for the Direct Banking segment of 4.5% of average receivables.

As you can see in our numbers this quarter, even with the incremental investments for growth, we came in just above that 4.5% level.

Before I turn to Payment Services, let me comment briefly on receivables growth and credit performance for our Direct Banking segment.

David already covered card receivables growth, so I want to focus on card credit.

The over 30-day delinquency rate was 2.43%, down 36 basis points sequentially.

The net principal charge-off rate declined 116 basis points sequentially to 3.85%.

The significant improvement in delinquencies and the prospects for future credit performance led to a $359 million reserve release this quarter.

Going forward, we are unlikely to continue releasing reserves of this magnitude given the present economic uncertainty, the all-time low delinquency rate and the likelihood of continued receivables growth.

These factors suggest that we will start building loan loss reserves during 2012.

Receivables in our personal loan product were up $732 million from the prior year.

We continue to focus on thoughtful measured growth in this asset class by leveraging our established underwriting competencies.

Personal loans greater than 30 days past due dropped 11 basis points from the prior quarter to 85 basis points.

The personal loan's net principal charge-off rate decreased by 15 basis points from the second quarter to 2.73%.

The improvement continues to be driven by risk initiatives we put in place over a year ago, as well as growth in the portfolio.

We continue to achieve strong organic loan growth in private student lending, complemented by the student loan acquisition we closed last December.

Private student loans were up $3.8 billion compared to last year.

This growth is a combination of the loans acquired in the SLC acquisition and $1 [billion] of organic growth as we leveraged the acquired platform.

Turning to credit performance in student loans, the 30-plus day delinquency rate rose 25 basis points sequentially to 80 basis points, excluding the purchase credit impaired loans acquired in the SLC transaction.

The charge-off rate for student loans, again excluding PCI loans, was 62 basis points, an increase of 11 basis points from the prior quarter.

The increase in both of these metrics is due to seasonality as recent graduates enter repayment after spring graduation.

Typically, we also see a similar effect following December graduation.

The student loan charge-off rate remains below our target that we outlined in our profitability model at our Investor Day briefing in March.

You may have seen the US Department of Education data out earlier this month showing increases in student loan charge-offs.

We believe the vast majority of the increase shown in their data stems from federal student loans and loans made to students attending for-profit schools.

We do not originate federal loans and with very limited exception, we do not extend loans to students at for-profit schools because of their generally higher loss characteristics.

In addition, the vast majority of our portfolio has cosigners and we believe that our underwriting practices are more rigorous than typically seen with federal student lending.

As we discussed at our Investor Day, we feel great about the expected returns on our Direct Banking products and our credit figures this quarter continue to support those assumptions.

Turning to the Payment Services segment, we increased pretax profit by 3% year-over-year to $38 million.

Revenues increased more slowly than PULSE's transaction growth year-over-year due to higher incentives and a small write-off of a minority investment in a payments company.

Expenses are running somewhat higher than the prior year as we made a number of infrastructure investments to add capacity and functionality prior to the implementation of the new interchange and routing rules.

We achieved double-digit percentage growth in transaction dollar volume across all three of our networks year-over-year.

Diners Club grew 17% with a significant portion of the growth from the weak dollar and the third-party issuing business achieved 11% growth.

PULSE volume expressed as number of transactions was up 8% year-over-year as comparisons became more difficult with the addition of a large issuer in the third quarter of 2010, as well as the loss of volume from one customer in this quarter.

Before I discuss capital, I want to touch on liquidity and funding.

Our contingent liquidity ended the quarter at $26.3 billion.

This includes cash, liquid investments, conduit capacity, our bank credit facility and capacity at the Fed discount window.

We have increased our liquidity to accommodate the $2.5 billion in additional private student loans I mentioned earlier.

We continue to experience lower funding costs in this low rate environment and we are likely to enjoy a funding tailwind into 2012.

Direct-to-consumer deposits now make up 44% of our funding and represent a stable source of funds that comes with customer relationships.

As you know, we opportunistically access our other funding channels as well evidenced by the $800 million floating-rate three-year ABS transaction we priced last week at one-month LIBOR plus 21 basis points.

The proceeds from this transaction will be reflected on the fourth-quarter balance sheet.

Before I wrap up, I want to touch on our strong capital position.

With tangible common equity to tangible assets of 11.6%, we have a higher ratio than most large financial institutions.

Our strong capital base has allowed us to take advantage of unique opportunities for growth while beginning this quarter, we began returning capital to our shareholders through share buybacks.

During the third quarter, we used almost $200 million of our capital to repurchase roughly 1.5% of our outstanding shares.

We expect to continue to act on our commitment to deploy excess capital via a mix of dividends, share repurchases and growth initiatives.

Overall, we remain pleased with another quarter of record earnings led by credit improvement and the reemergence of year-over-year growth in Discover Card receivables.

That concludes my prepared comments.

So at this time, I will turn the call back to the operator to provide instructions for the Q&A period.

(Operator Instructions).

Sanjay Sakhrani, KBW.

Thank you, good morning.

So I have one question for David and one for Mark.

David, obviously, you mentioned there is still a lot of uncertainty on the economy.

Yet your numbers just don't seem to indicate it is that bad for you.

Could you just talk about this dynamic and specifically kind of what you have seen more recently and what you are expecting in the future just near term?

And then, Mark, obviously, the net interest margin expansion this quarter was positive and you talked about it being flat in the fourth quarter.

I was just wondering if you could just elaborate a little bit more on the funding benefits you have into next year?

Specifically how much of those higher cost deposits are refinancing in 2012?

Thank you.

I certainly remain quite concerned about the economy, and I wish we were seeing a more rapid recovery.

But as you say, if you look at our numbers, I think increasingly we are past a lot of the worst pain, if you will.

And I think one of the things that is happening out there is there is some structural unemployment and that is -- as we get further and further from when the storm originally hit, I think many of our customers who didn't write off early on have increasingly deleveraged.

They are fine with their jobs and they may not be as concentrated with the people that are most underwater on homes.

So I think that what you are seeing is a very uneven recovery and by focusing on the prime segment, and being careful over the last several years, people weathered it well and we have a few unique things with our business such as the increasing acceptance that I have (inaudible) sales and to get more of a share of sales from our customers.

Mark?

Sure, with respect to the funding tailwind, the biggest component of that is going to be in the brokered CD book.

And I don't have specifics in front of me, but for rough details, there is somewhere around, call it, $3.5 billion roughly that matures in 2012.

And the rate pick-up on that, assuming the rate environment remains relatively constant, is somewhere north of 200 basis points.

Okay, great.

Thank you.

John Stilmar, SunTrust Robinson.

Yes, good morning, gentlemen.

A quick question for you with regards to seeming activity that there has been with regard to teaser rates.

Specifically August was a pretty high month, and I was wondering if you could share with me just your experience with regards to those that have rolled out of previous teaser offers and their retention as customers as you have talked about record low attrition rates.

Does that also pertain to those customers and how does that compare to history?

And then I have a follow-up after that.

Thank you.

Well, this is David.

I can't comment specifically on attrition of expired promo rates, but I would just say, if you look at our attrition rates in total, you would have to conclude that there is -- we are doing a pretty good job of hanging onto our customers, hanging onto receivables.

And that is one of the reasons we are growing is we are not losing people out the other side.

In terms of teaser rates, I think that there are more this year than there were last year, but a lot of that is driven by the extraordinarily low cost of funds.

And so the profit breakevens for putting in place teaser rates is attractive, more attractive than it has been probably at any point in history.

So does that answer the question?

So if I was to summarize your views, it is basically the customers, especially relative to history for your channel when they roll off of teaser, you're actually able to retain them more so than you probably were in the past, is that fair?

Well, I'm only commenting on attrition rates in total, but certainly I would expect that if we had unusually high attrition rates or promo rates, that it would impact that overall attrition rate.

And as I say, we are at the best place that we have been on attrition as far as I can ever remember.

This is Mark.

The other thing I would point out is that we target a great deal of our BT activity toward our existing portfolio customers, folks who are already chosen to do business with us.

So it is not activity where we are actually trying to attract somebody new to the vein and get them to stick around after the fact.

The other thing I would say is we are pretty disciplined around our BTs.

We have got some very strong metrics around the returns ultimately on our marketing spend, of which BTs we view as one component.

And I would tell you if we didn't see the kind of returns we were looking for out of that activity, we wouldn't be following the level of BT growth you are seeing out of us now.

Perfect.

And then a follow-up, Dave, you've talked a lot about acceptance over the prior quarters.

I am wondering if you can give us any sort of numerical quantification in saying how much of growth has come from this new acceptance, at least in the top line, because your spending and balanced growth trends have both been relatively impressive and you keep pointing towards acceptance growth as being one of the primary catalysts.

I am wondering if you could provide us with a little bit more specificity around how much acceptance has really driven the top line for you.

Is it really just the 7% number and it is up to us to kind of guess how much of that is inside of the balanced growth or benchmarking it versus others?

Just wondering if you could kind of help provide a little bit more context to those statements.

Thank you.

Well, sure.

I would say it is difficult to tease out the precise impact because I think at all there are some synergies and how much of it was rewards engagement, how much of it was the service levels, how much of it was the increased acceptance.

I mean one of the things is, as our acceptance increases, it actually, we think, improves our sales of those same customers with places that we were already accepted.

So it is a very tough.

One metric that we have been giving out over time is the one I mentioned in my remarks of a 7% increase in active merchants.

And that is the best measure that we have come up with to show the improvement.

I recognize it is difficult to say how much of the 9% sales growth came from that.

We know it is having a positive impact.

Thank you.

Mike Taiano, Sandler O'Neill.

Hi, good morning.

I guess my first question is on the card business and just maybe you can give us some color on where the competitive landscape stands today maybe versus the beginning of the year.

Been hearing -- there was I guess an article in the Journal about one of your competitors substantially increasing mail volume.

Just curious to get your sense of how pricing trends are going in the card business.

This is David.

I think there was an erroneous piece of data out there for one, so I would be a little careful.

But I think that clearly marketing has picked up quite a bit this year, some even during the year.

But to a large degree, I feel like marketing intensity, pricing has returned to what I think it is likely to be a new normal.

It was very depressed for several years.

I think it is unlikely that marketing will go back to the levels we saw in the mid-2000s.

For one reason, there is just fewer competitors, it has consolidated and some changes based on the CARD Act on who is profitable and who would not be going forward.

But I am really pleased that our cost to acquire customers is actually down this year over last year despite this higher level of marketing intensity that we are seeing.

And I expect reasonable stability from this point on.

You are going to have months, higher months, lower months, competitors coming in and out, but I think we are at the new normal.

Yes, and I would -- this is Mark.

I would just add onto that.

I think this is an area where the CARD Act is clearly our friend because now, unless somebody goes 60 days delinquent, you are stuck with the rates you offer them.

You don't have the ability to keep them and modifying that go-to rate, if you will, on a regular basis.

So we have not seen competitors offer some of the extremely low initial go-to rates that we have seen in the past.

And David, the decline in the cost of acquisition, what would you say is the biggest driver of that?

Well, I would say that we have seen improvements both in response rates and in approval rates.

And on the approval rate side, I think we are seeing more stability and predictability of people that will have prime credit performance and can repay their card loans over time.

So that is helping.

And I also think that consumers are increasingly attracted to our rewards program and to our level of service.

And just one follow-up if I can on the -- just on the Direct Banking business.

Student loan volume, just curious as to how that -- given this is the peak month for that -- how that is tracking relative to your expectations?

And then also I think you guys had mentioned in the past about rolling out a checking account product for the bank and I was just wondering where that stands.

Well, I think on student loans, we are actually through peak season at this period.

I would say it was slightly below what our expectation was, but I think we are still on track to deliver over $1 billion of net growth in that channel for the year.

In terms of checking accounts, what I have said in the past is we do intend to launch a more -- a broad checking account likely in 2012.

But actually it will likely be at the real tail end as we put in place a new robust system that can offer the much more enhanced features that we intend to launch -- have when we launch the product.

Great.

Thanks a lot.

Chris Brendler, Stifel Nicolaus.

Hi, thanks, good morning.

I guess for Mark, you mentioned the impact on the card margin from the CARD Act related to default repricing, as well as the benefit from improving credit quality.

I recall at your Investor Day you threw up a slide that gave us a little more detail on that topic showing us the breakout of default rate balances and promo balances relative to the standard balances and sort of some guidance that that was going to normalize at a different place.

Can you update us at all on how far along we are on that process, particularly the default rate balances, which were at 21% and fell to 12% and your thinking -- I'm sorry -- 27% and 22% and you are thinking that that will go all the way down to 10%?

And also on the promo side, where you stand just in terms of getting up to that 15% target.

Thanks.

Yes, with respect to the default rate bucket, what I would say is we are continuing to see that bucket attrite, but at a slower rate than we initially expected to see take place there.

I am reticent to call exactly how long we expect that bucket to stay around because, candidly, all of our estimates to this point in time have been too aggressive in terms of the attrition assumptions we are making.

It has been much stickier than we assumed it would be.

With respect to the promotional balances, I think right now if you take a look, the BTs themselves are roughly 12% and total promotional balances are on the order of 15%.

Okay, so you're there.

My follow-up question is on the credit side, struck by just the amazing performance on the 25-year loan delinquency rate.

I guess at some point though it has to stop going down; it can't go to zero.

So are you seeing anything in the portfolio?

It is not the best time seasonally.

Are you starting to see any early-stage delinquencies flatten out yet?

Do you expect delinquencies to flatten out here?

And then a related question, on the revenue benefit that you mentioned and the interest charge-offs coming down, do you get a one-time catch-up to the extent that you are overly conservative on your estimates of delinquent fees and finance charges when those accounts end up curing?

Is that showing up in your margin at this point as well or is that pretty much a wash through since you have seen such a good trend for so long?

Thanks.

Yes, I would say, with respect to the trends we are seeing in the portfolio today, I would say snapshot three weeks or four weeks into the quarter here, all the major near-term indicators continue to be positive.

We continue to see declines in delinquencies.

We continue to see declines in charge-offs.

But the rate of improvement in delinquencies is slowing and if you couple that with the absolute low levels we are at right now, plus the fact that we are growing receivables, it is really not too much of a stretch to say there is a trough out there somewhere and we are probably closer to it than not.

But ultimately, at this point in time, I would say again everything continues to trend well.

With respect to your second question, no, there is no catch-up related to that, if you will.

It is all in P&I and Cs already.

Great, thanks a lot, Mark.

You bet.

Moshe Orenbuch, Credit Suisse.

Great, thanks.

I guess getting back to the commentary about acquisition costs being down, are there any other things that you are doing that are different in terms of channels that would have led to that?

Or is it just that kind of response rates and approval rates entirely?

Well, clearly more and more of our marketing and new customer origination is coming out of the Internet, but I would say even if you look by channel, if I just isolate direct mail, I would say our direct mail cost to acquire has fallen somewhat.

And some of it, I think, is us continuing to fine-tune and enhance our targeting and offering.

On a somewhat different issue, David, you mentioned being in discussions with respect to helping other issuers kind of fulfill their requirements under Durbin on the debit front.

Is that something in general?

Do you think that there are going to be situations where you replace an existing PIN debit or do you think it is going to be more of a complement to existing PIN debit programs?

I would say that we have got about 4500 issuers on PULSE and I think the smaller issuers are in a little bit different circumstance than the larger issuers in terms of some of their requirements, but I think it is probably too early to tell.

I think, as you know with the routing rules, clearly, the large issuers have to have two noncompeting networks on the card.

And I think that we are probably going to see some of each -- some people that simply add another network and some that replace a network.

Craig Maurer, CLCA.

Hi, just a quick question on the reserve.

When you think about the overall level versus either total loans or delinquencies, is there a target you have or is that even a valid question anymore and it's a constantly moving bogey?

I am just trying to understand how you think about the ultimate level when we think out to maybe 2013 or so when allowance should be growing at a rate similar to receivables.

Thanks.

Yes, great question.

The bottom line is GAAP is awfully prescriptive these days in terms of your reserving methodologies.

So while from a contextual commonsense standpoint, I would love to have a target ratio and be able to manage to it, that unfortunately is not possible in today's construct.

So all of our reserves are set consistent with GAAP.

They are set on an incurred loss basis with a 12-month forward look at expected loss emergence.

So as our viewpoint of those dynamics changes, so will our reserve coverage number change.

Okay, thank you.

David Hochstim, Buckingham.

Thanks.

I wonder if you could provide some additional color on consumer spending.

You said there was a little bit of a decline around hurricane Irene and then more recently, there was some shift in spending and how does the increase in gas prices year-over-year affect that 9% growth number I think?

Well, we think that about 2% of our year-over-year growth is related to the higher gas prices because gas is order of magnitude 10% of sales.

So we are seeing probably remarkable stability in that year-over-year growth rate in that sort of 8% to 9% range that we reported this quarter and the past few quarters.

And as consumer confidence really took a nosedive, it has been surprising to me frankly how well our sales have held up.

And so far through today, I don't see anything that changes that dynamic.

And I guess you sort of touched on this, but -- so the acceptance.

I mean you've spent a lot of money and effort building acceptance over the last few years.

Is it now that we are finally seeing that in the numbers do you think?

I think we have been seeing the enhanced acceptance in our numbers for a long time.

We have been talking about it for several years.

And I don't know whether it is good news or bad news, but it is going to continue for a while.

This is, I would say, a longer and more difficult journey than I had originally might have anticipated, but I think our hybrid model where we are outsourcing all the smaller merchants and retaining the larger merchants is the winning one for the industry and will get us to where we want over time.

So I think it is going to continue to be a tailwind for us for the foreseeable future because it is not like it is going to be done next quarter.

Okay, and follow-up, just in terms of the 40 basis point decline in card yields, how much of that is the CARD Act and how much of that is promotional rates?

And should the CARD Act effect I mean go away eventually or kind of anniversary it?

Yes, I don't have the breakdown in front of me.

I would say that the card yield -- one, I'd hearken back to my earlier answer on the attrition of that default rate bucket being slower than we expected it would be.

So clearly, that is a big component of it, but I don't have the breakdown there in front of me.

Is it possible to say that there should be less CARD Act effect do you think over the next few quarters and more of a driver would be the promotional rates?

I am not prepared to make that statement without the data in front of me.

The thing I might point back to is, at Investor Day, we talked about eventually we think that NIM will stabilize in that 8.5% to 9% kind of range for the overall.

And we are still above that.

And so I think that as we -- as the effect of having no replenishment of people who have defaulted as that continues to amortize down, then I would expect us to eventually get into that kind of a range.

But it is not -- the anniversary isn't really what drives it; it is really, as you eventually get the stability from no longer repricing delinquent accounts.

Lower funding costs, funding costs are lower today than at Investor Day.

Shouldn't that have a positive effect for a while?

Well, that is part of the reason also that we are above that target.

Low funding costs, low charge-offs and continued amortization of higher rate balances.

And the other thing to remember is that target was a range and obviously the overall level of rates impacts where in that range we may fall.

Right.

Thank you.

Jason Arnold, RBC Capital Markets.

Hi, good morning, guys.

Nice results here this quarter.

I guess this is a question for Mark.

I was just wondering if you could give us some added detail on the recent student loans acquired from Citi, specifically any purchase accounting adjustments to the price, average yield, etc.

and then perhaps the inputs on the $0.07 per share accretion.

Yes, I guess I would say that this recent tranche of student loans that we are picking up from Citi will be accounted for as PCI loans.

So they will be measured at fair value, which will obviously include their estimated credit losses to be incurred over the life of the loan.

There won't be any additional allowance established because it is obviously already in the fair value mark that we will be putting up on that.

The portfolio itself has got an average FICO of somewhere on the order of 740.

It is about 80% private student loans and about 20% private student loan consolidation loans.

And there is a high percentage of cosigners out there on the book as well.

So that would be the basics on the portfolio itself.

With respect specifically to the $0.07 accretion calculation, I would say the key things to keep in mind there are that the portfolio will -- we expect that it will earn above our 15% target ROE over the life of the portfolio.

The yield is expected to be on the order of, call it, 5% to 6% and we really won't take on any additional operating expense because we don't need to add infrastructure or headcount on that.

Okay.

And do you have the fair value mark yet that you would be expecting?

No.

Okay.

Thank you very much.

Brian Foran, Nomura.

Hi, I guess just thinking through the math of the comment that you expect to build reserves in 2012, I mean the way I am thinking about it is your charge-offs seemed to be at 3.6% in August.

Your 30 to 59-day delinquency ratio back in five months ago, what those charge-offs would reflect of around 88 BPS and they have fallen around 20% since then.

So it seems like all else equal, US card charge-offs just mathematically should roll down to 3% and then the mix effect of student loan should bring the consolidated charge-offs down to like 2.5%.

So I guess the point I am trying to get to is not to pin you to a charge-off guidance, but are we in a scenario where, even if you are building reserves in 2012, you could still have a provision rate that is below what we would all think of as a normal level just because charge-offs are lower still?

The answer to that is it is possible.

I would tell you that the nature of the metrics and the way they are performing today and the nature of the fact that models are really predictive when you're in the fat part of the curve and less so when you are in the way out in the tails of the curve.

I would be hesitant to try and mathematically give you any estimates or guesstimates around that at this point in time.

But I would say that that is a possibility.

And then in terms of rewards expense, just trying to think how to model that going forward.

I mean the rewards expense to spend volume ratio was stable this quarter after -- or I guess it was actually down slightly after increasing a couple of years in a row.

Are we at a point where rewards expense has plateaued and we should just think of it as whatever spend volume does from here or is there still upward pressure building on rewards expense?

I would say more or less that is a good way to be thinking about it.

If you look at the way our rewards expense is calculated, we have really, at our current levels, returned to a normalized level of rewards expense from depressed levels because there is a bit of -- I don't want to create a misperception here or the magnitude.

The magnitude is clearly not the same, but there is a bit of a natural hedge in our rewards expense line item in bad credit environments because if you go delinquent on your accounts, you forfeit your rewards balance.

So in periods of time when credit is getting worse, our rewards expense will go down because people will be forfeiting rewards balances that are out there in their bank so it is a bit of a natural hedge there.

And what you have seen -- I think we bottom at like 75 or 76 basis points.

What you have seen really now from us is really a return to our more normalized levels.

Although I would add I think it is probably the new normal level because certainly the higher usage per account drives people to earn more money by the fact that they are in higher tiers.

We have enhanced our program over recent years giving more value to consumers.

And then the low attrition rate also drives less breakage and therefore has higher payouts.

So it has certainly risen in recent years, but we think it is probably in the normal -- the new normal level.

Is the competitive environment not putting -- I mean just watching TV, you see all these commercials for BofA with a fairly aggressive cash back rewards as an example.

I mean I am just surprised that you are not citing the competitive environment as one of the drivers.

Are we all overestimating the competition and rewards?

I think that certainly one of the reasons we have enhanced our program over recent years is because, as the pioneer in this space, it is important for us to continue to be the best value for customers.

So I certainly wouldn't dismiss it.

But I would say that a lot of the reason you are seeing competitors be in this space is that cash rewards is what consumers most want.

Thank you.

Rick Shane, JPMorgan.

Good morning, guys.

Thanks for taking my questions.

When we go back to March during the Investor Day, you gave long-term asset growth outlook and on card, it was 2% to 4%.

Not coincidentally GDP expectations around that time were basically centered around 3%.

So right in the middle of what you guys were describing.

With GDP expectations coming down, should we start to think about recalibrating our card growth expectations for 2012 or is there reasonably you guys will gain marketshare?

I would say that, at this point, we would stand by our 2% to 4% kind of target.

And I was really pleased that this quarter we actually got into the low end of that target range.

Okay, great.

And I definitely want to acknowledge you guys are right on that path.

So that is sort of why I am asking the question.

Just as a follow-up, you've made the comment that about 10% of sales is related to gas.

Do you find that that is a product that people substitute?

As pricing fluctuates, people adjust other spending or is it more sort of inelastic?

I would say that we have not been able to observe much substitution.

And I am sure at the margin there must be some because people are spending more for gas; they have got less to spend elsewhere.

And we have done some work, analytical work to try to ferret out substitution.

We just at least haven't been able to prove it out in our numbers.

Okay, great.

Thank you guys very much.

Henry Coffey, Sterne Agee.

Yes, good morning, everyone and congratulations on -- I wouldn't say a great quarter, I'd say a great year.

Everyone seems to be trying to fret out a couple of key items here and I think in the general way to think about it is what is the split between the gains that are being created by your own efforts, whether it is on the marketing side, acceptance or credit-related and the cyclical factors that may impact you going forward?

When you look at either your delinquencies or your charge-offs and you start to analyze new entrants, is it mainly just that sort of structural bucket of people that don't have jobs and are going to stop paying or is there a new influx and if you did the same thing on spend, do you have a feeling for how much of it is just your generic cardholder kind of coming back to life?

And how much of it is people responding to the positive changes in marketing and other variables that you have worked on?

Well, I would say that is a tough question to answer.

I would say that it is certainly beyond your point of cardmembers coming back to life.

I mean our sales this quarter were $1 billion more than our all-time quarterly record.

So this is not just a return; this is growth beyond numbers that we have had ever in the past in terms of sales.

In terms of our efforts versus the industry, clearly we are in a cyclical business and particularly the earnings have become more cyclical because of the accounting change that was made a few years ago on reserves and the reserves don't change your earnings over time; they just change the recognition of when those earnings hit.

And so we are seeing, to some degree, that is in the numbers.

But if you look below the numbers at the charge-offs and delinquencies, we know that there is a large amount of who we approved, how much lines we've put in, all the payment plans we put in to try to keep customers current and not getting late fees, not falling behind.

And we also know that the whole industry is now also improving versus where it was at the peak.

So I can't give you a perfect breakout.

I guess the one final thing I would say is that I am pleased that we are still one of the leaders in credit and we were through the whole cycle.

And so I think the difference between us and the industry average is indicative, to some degree, of our controllable and individual efforts versus the competition.

So there is less sort of embedded cyclicality at least in your credit metrics because of actions you have taken probably over the last five years?

Is that a fair way to think about it?

Well, I would say that our losses have remained a certain amount below industry average, both at the worst part of the cycle and then now in a better part of the credit card cycle.

I would not go so far as to say the industry is less cyclical.

Although I mean we were hit with such a perfect storm as an industry two or three years ago, and with all the changes that have taken place, which would take me a long time to go through, structurally, competitively, I would be really hard-pressed to see our losses or the industry losses to go as high as they were at the peak.

Thank you and congratulations on a great quarter.

Thank you.

Ryan Nash, Goldman Sachs.

Hey, thanks.

I think I will go after something a little different here.

I just want to talk about the capital position for a bit.

So even after repurchasing almost $200 million of shares in the quarter, you still grew Tier 1 common.

And if you look at the target that you guys laid out at the Investor Day, it looks like you have something like $2.2 billion or $2.3 billion of excess capital and despite growing your loans and you are going to do the purchase next quarter, it looks like you will continue to outpace deployment.

So I guess the question I want to ask is can you help us understand how you are thinking about deployment from both a timing, as well as a use perspective just given the context of the current environment?

If you were to maybe finish the buyback early, can we see an increase or given what you are seeing in the economy, should we expect some sort of slowing?

Thanks.

I will do my best; there was a lot in that one.

I will do my best to tackle them all.

I would say in terms of how we think about our longer-term guidance of that 8% TCE target, I would say -- I would guide you back to that and say longer term somewhere in that range is still where we intend to end up.

Do we end up right exactly at 8.00%?

No, I don't think so.

I mean my own personal perspective, and I know David's too is riding right on the ragged edge to get a couple itty-bitty little clicks on the ROE just isn't worth the risk of riding right on the ragged edge of your guidance.

So I think we will probably end up a little bit above 8%.

And I think the SIFI buffer and the Basel III processes are still out there and that will have a little bit of bearing getting to that level as well, but very modest we think.

In terms of getting to that level, I guess we look at things a couple different ways.

Ultimately, we kind of view our shareholders as having entrusted their capital to us to grow the value of the enterprise and right now, we are driving very strong ROEs on all the capital we are bringing along and there's significant opportunity out there in the marketplace.

So we don't want to rush to return all of that capital in one fell swoop too quickly.

I think we want to retain some so that we have the ability to take advantage of those opportunities.

I would say the corollary to that though is that we do think good disciplined capital management involves a return of excess capital when appropriate to shareholders as well both in the form of buybacks and in the form of dividends.

So I would expect to see us maintain some of that excess capital for a period of time, but I would not expect to see us maintain all that excess capital for an extended period of time.

Okay.

And just if I could one quick follow-up.

Just from a technical perspective, on the other income line, it seems like the numbers bounce around.

I know there was a one-time number in the first quarter, but sequentially it looks like you fell almost $15 million.

Is there anything going through that line that would help us from a modeling perspective?

Ryan, it's Craig.

Let me come back to you on that.

Nothing is jumping out at me off the top of my head is the answer to your question.

All right.

Thanks.

Adam Hurwich, Ulysses Management.

Hi, nice quarter.

Just a quick question regarding a product that you might have commented on, but I am just curious what your thoughts are given the distribution you have got.

There has been a lot of attention given to prepaid cards with Visa and MasterCard labels on them.

Is there any way you could play in the same market?

Well, I would say that we actually do as a network.

Most of the larger -- well, many of the prepaid large issuers issue some of their cards on our network.

We also participate as an issuer mainly from rewards fulfillment for our cash rewards program because that is one of the ways you can get your redemption for cashback bonus.

More broadly than that, we could consider doing more, but the economics would have to be attractive enough to make sense.

And so far, we are playing in it the way we think works for us.

Thank you very much.

We have no further questions at this time.

Do you have any closing remarks?

Thanks, John.

I just want to thank everybody for their attention this morning and for the questions and you know how to reach us for follow-up.

So thanks again and have a good day.

Bye.

Thank you, ladies and gentlemen.

This concludes today's conference.

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