發現金融 (DFS) 2012 Q4 法說會逐字稿

Welcome to the Q4 2012 Discover Financial Services earnings conference call.

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

At this time all participants are in 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. Bill Franklin, head of Investor Relations.

Mr. Franklin, you may begin.

Thank you, John.

Good morning, everyone.

We appreciate all of you joining -- for joining us on this morning's call.

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 fourth within today's earnings press release which was furnished to the SEC in an 8-K report in our Form 10-K for the year ended November 30, 2011, and in our Form 10-Q for the quarters ended August 31, and May 31.

2012, which are on our website and on file with the SEC.

In the fourth quarter 2012 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 investors.

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

Our call this morning will include formal remarks from David Nelms, our Chairman and Chief Executive Officer and Mark Graf, our Chief Financial Officer.

After Mark completes his comments, there will be time for a question and answer session.

I would encourage you to limit yourself to one question and one related follow-up.

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

Thanks, Bill.

Good morning, everyone, and thank you for joining us today.

This morning I'm going to start off by discussing the fourth quarter and then walk through some highlights of our full-year accomplishments.

Before the market opened, we reported quarterly diluted earnings per share of $1.07, up 13% over the prior year, driven primarily by loan growth and share repurchases.

During the quarter, we generated return on equity of 23% and returned approximately $451 million of capital to common shareholders through repurchases and dividends.

Our robust results, strong capital position and positive outlook lead us to announce a 40% increase in our dividend to common shareholders.

This quarter we accelerated our organic growth to 6% on total receivables.

Card receivables growth for the quarter was the highest at in over five years, driven by spend from the revolver segment of our card base.

Our strong receivables and sales growth results demonstrate the effectiveness of our marketing programs, consumers' preference for cash rewards and our acceptance and awareness initiatives.

For the fourth quarter, our non-card assets, specifically our personal and private student loans, achieved a combined 11% year over year growth as we broadened marketing and added new schools and a fixed rate product in student loans earlier in the year.

Our payments segment experienced 13% year over year purchase volume growth driven, largely by PULSE.

Volume processed on our networks achieved all-time high for the fourth quarter.

We also increased our level of investment to drive future growth and achieve the full potential of our banking and payment strategy.

Important new initiatives included new domestic and global payments partners a new core banking system, our first checking product which we expect to launch in early 2013 and Discover It, our new credit card product that is testing successfully in select markets and will be launched nationally next month.

Our card net charge-off rate had another record low, but our over 30-day delinquency rate ticked up slightly due to seasonality.

While the continued improvement in credit appears to be nearing an end, we don't believe we are at a point where charge-offs are poised to rise significantly.

Now I'd like to share some thoughts on how we performed against our 2012 priorities.

We had two principal priorities for our direct banking segment.

First, we wanted to build on our momentum from 2011 and grow card sales and receivables.

Second, we wanted to grow our non-card product offerings.

During the year, we successfully grew card sales and receivables in a challenging environment by increasing our marked wallet share and achieving double-digit new account growth.

We increased customer engagement through our rewards programs, marketing initiatives and by expanding online and mobile capabilities.

We increased merchant participation in our rewards program, which also enhanced the value for our card members.

For the full-year, card receivables grew by $3 billion, or 6%.

In our direct banking segment, we grew non-card assets and launched new products, including home loans and student loans focused on graduate and professional programs.

By leveraging our expertise in unsecured underwriting and maintaining the customer centric focus, we disbursed over $1 billion in private student loans and grew personal loan originations to $1.8 billion.

Additionally, we originated over $2 billion in home loans since June.

In payments, we continued to build on the domestic and international acceptance and successfully grew our network volume while dealing with competitive challenges.

For the full-year, volume for the payment segment grew by 12% and we achieved a record number of active merchants.

Further in payments, we positioned ourselves as a flexible and innovative partner for payment solutions with a number of new agreements.

Domestically with PayPal and internationally with new network and issuer partnerships.

Lastly, one of our top corporate priorities was to drive shareholder value through effective capital management.

During the fiscal year, we returned a little over $1.4 billion through share repurchases and common dividends.

Our fourth quarter provided a strong finish to a record year.

As we enter 2013, I'm looking forward to maintaining the momentum in our direct banking segment and executing on our recently formed network partnerships as we continue to leverage our network assets.

We look forward to providing you with an update on our 2013 priorities at our annual financial community briefing in March.

Now I'll turn the call over to Mark.

Thanks, David, and good morning, everyone.

Let me start by reminding you that as of January 2013, Discover will be converting to a December fiscal year end.

We'll provide you with historical calendar year data in early March in advance of our financial community briefing.

That said, I'll begin my remarks on this quarter's performance, starting with the direct banking segment which earned $827 million pretax this quarter versus $776 million last year.

Net interest income increased $134 million, or 11% over the prior year, driven by both asset growth as well as a net interest margin which was 34 basis points higher than the prior year end at 9.44%.

Lower funding costs and lower interest charge-offs more than offset a 17 basis point compression in total asset yield from the prior year.

Specifically, card yield declined 20 basis points from the prior year to 12.16% due to more promotional balances and a decline in higher rate and default price balances.

Interest expense as a percentage of average receivables was down 49 basis points over the prior year to 2.11% due to the continued benefit from refinancing maturing liabilities at lower rates.

We expect to continue to benefit from this funding cost tailwind through 2013.

Over the next year, the combination of yield and funding cost trends should keep net interest margin above our long-term target of 8.5% to 9%.

However, we do anticipate some compression driven largely by card yield, which should continue to decline.

Other income for the direct banking segment was $50 million higher than the prior year, mainly due to the inclusion of revenue from Discover Home Loans, our mortgage business that we launched in June of this year as well as a $26 million gain on the sale of a minority investment.

The mortgage business was profitable for the quarter; however, I would remind you of my comments from last quarter's call that we continue to expect it to remain relatively immaterial to earnings for some time.

Continuing with other income, our rewards expense, a contra revenue item, increased to 106 basis points on card sales during the quarter due to what was in retrospect a richer than expected 5% cash-back promotion that generated very strong card-member engagement.

We do not expect this elevated rewards rate to persist into the calendar first quarter.

However, I would point out that the current program runs through December.

Another component of other income, protection product revenue was down from last year, and we continue to expect this line item to decrease over time.

During the quarter, we did cease marketing these products to focus on implementing changes required by our consent order.

We continue to service and maintain existing product memberships and intend to once again make these products available to new customers next year.

Operating expenses for the direct banking segment were up $114 million over the prior year, or 18%.

There are several factors contributing to this higher level of expenses.

First, we increased employee headcount as well as marketing and other expenses due to the home loan acquisition and the launch of our direct mortgage product which contributed roughly $50 million to expenses in this period.

Second, as evidenced by our strong receivables growth, we believe investments in marketing are bearing fruit in this environment and as a result, we think the timing is right for us to continue to opportunistically drive new account acquisition and card utilization.

Finally, our headcount, information processing and professional fees line items grew further as we laid the groundwork for launching several new products in the coming quarters and added resources to address new regulatory expectations.

Some of these initiatives will also result in higher operating expenses next quarter.

Turning to credit, sequentially, the credit card 30 plus delinquency rate increased 5 basis points due to seasonality, but the net charge-off rate declined 14 basis points to a new historic low.

The over 30-day delinquency rate for student loans decreased 21 basis points and the net charge-off rate excluding purchase loans increased 22 basis points from the third quarter.

The net charge-off rate reflects increased seasoning of the organic portfolio.

We would remind you that as the portfolio seasons, we will see this rate rise past 1% and come back down over the long-term.

The credit performance of both our organic and purchase portfolios remains in line with our expectations.

The personal loan over 30-day delinquency rate was up 2 basis points and the net charge-off rate was up 22 basis points sequentially as the portfolio continued to season.

Over the course of the year, we have said that loan growth will eventually lead us to build reserves.

This quarter's $38 million reserve build reflects the strong asset growth that we have realized.

One last thing I want to mention is that effective November 30, the Company began including confirmed card transactions as part of loans in process, which resulted in a $365 million increase to ending card receivables for the fourth quarter.

This will have no impact on historic or future income statement items, including earnings per share, but will lower some ratios which use average card or total receivable balances in the denominator such as card yield and net interest margin.

Turning to the payment services segment, pretax profit decreased 21% over the prior year to $33 million.

The decrease resulted primarily from higher expenses at Diners, which included marketing and incentives related to several new issuing relationships.

Expense increases were partially offset by increases in higher margin point-of-sale volume for our PULSE debit network and higher network partners volume.

Network partners is our new name for what we formerly referred to as third-party issuers.

We've changed the name to better reflect our strategy of partnering to drive volume growth.

However, the composition of the business has not changed.

Segment volumes were up 13% driven by strong increases in PULSE and network partners volumes.

Next, I'll touch on liquidity, funding and capital.

Our on balance sheet liquidity portfolio at quarter end was $9.6 billion.

Total available liquidity was $27 billion, a decrease of $2.4 billion over the prior quarter.

We opportunistically executed a $575 million, 6.5% perpetual preferred stock issue and a $500 million debt exchange offer that allowed us to broaden our regulatory capital mix.

Also, in November, we issued $250 million of three-year class B asset-backed securities with a floating-rate coupon of one month plus LIBOR plus 45 basis points.

This is Discover's first class B issuance since 2007.

As we've said before, we'll continue to opportunistically fund our business by accessing all available channels.

We ended the quarter with a 13.6% tier 1 common ratio, which was 30 basis points lower than the last quarter.

Let me conclude with some full year comments.

We achieved record net income in 2012 due to improvements in credit, loan growth and a higher net interest margin.

The payments business leveraged our network and acceptance footprint to achieve record network volume and entered into several key partnerships which we expect to be drivers of future profitability.

Lastly, we continue to deploy capital as evidenced by today's announced dividend increase to $0.14, as well as our repurchase of over 6% of our shares over the course of the past year.

That concludes our formal remarks, so now I'll turn the call back the call back to the operator, John, to open things up for Q&A.

Thank you.

(Operator Instructions)

Sanjay Sakhrani, KBW.

Thank you, good afternoon.

I'll ask my two questions up front.

Just first on credit quality, I think David, you mentioned that you don't anticipate a significant rise in charge-offs.

Could you talk about the dynamics there when we look a year out from now, especially when you -- when considering how you factor it into your provision, do you assume flattish a year from now or up slightly?

And then secondarily, just on operating expenses, I was hoping to get some color from Mark, maybe.

When we look out to 2013, is $3 billion roughly a good assumption to use of as an annual budget for operating expenses?

And then maybe on rewards costs as well, is 100 basis points still a good number roughly?

Thank you.

Sanjay, on -- we're certainly in an environment that we've never experienced before on credit.

So, it is a difficult line to forecast.

But it's my expectation that we're going to see at this point some flatness and more seasonal trends occurring.

It wouldn't surprise me to see a slight increase over the coming 12 months, but as I indicated, we're certainly not expecting anything dramatic.

And so if you look at the reserving, it's largely due to our loan growth, which I was very pleased to have achieved a five-year high growth rate, and that leads to more reserving.

And that's more of a driver as opposed to expecting a big increase in credit costs.

Mark?

Yes.

I would echo David's comment on that one.

I think receivables growth is central to our business model.

And as we've been saying, that growth would at some point in time cause us to begin to build reserves, and the growth in reserves you've seen is a direct result of the growth in loans over the course of the last several years.

With respect to your expenses question, Sanjay, I would say a couple different things.

I think as we look forward to next year, that $3 billion number is a close number to utilize.

It may come in a little bit higher than that, would be my general expectation, however.

I think in terms of an operating leverage way of looking at things, if we were not investing in a number of these growth investments over the course of the next year, we would be reporting flat operating leverage for 2013.

I think we will be slightly below that because of the investments in growth we're making.

I think you all understand that when you're investing for organic growth, the expenses lead to revenues.

But given the ROIs and the opportunities we see in these products, were are very comfortable going ahead and making those investments.

With respect to the rewards rate itself, as I said in my prepared remarks, I think the 106 basis point level that you saw this quarter was higher than we expected it to be, quite honestly.

The program was probably a little bit too rich in retrospect, but it did drive fabulous cardmember engagement, which is great.

I would say going forward I would expect it to be closer to that 1% level is the right way to think about things, though again, I would point out for the month of December that higher program is still running.

All right.

Thank you.

You bet.

Mike Taiano, Telsey Advisory Group.

I guess on the volume side, I was just curious, first if you saw any impact from Sandy for the full quarter?

I know you had that impact the first week or two, but just wondering if that was anything material.

And then secondly, looking out to next year, I know there's a lot of uncertainty around the Fiscal Cliff, but it seems like -- at least one thing that seems consensus from both sides is the elimination of the payroll tax cut that's been in place the last couple years and just was wondering if you could give any thoughts as to how that might impact your volumes looking out to next year?

I would say that in terms of Sandy, we don't think it had a significant overall effect on our volume during the quarter.

It certainly had a regional impact obviously with timing.

We saw some subcomponents that changed around event.

For instance, home-improvement had been softer before Sandy and post-Sandy.

There has been enough rebuilding needs that we've actually seen that component drive higher.

So, there have been some ins and outs maybe from Sandy, but I think the overall volume, not too affected.

I think in terms of Fiscal Cliff, we don't have a separate plan, as I've heard some companies have.

And we think that -- I don't expect a big impact.

I do expect something to get resolved.

I think the big wild card is what happens to consumer confidence.

And I think as long as consumer confidence doesn't take a big nosedive, I expect our sales volume and so on to continue doing just fine.

If consumer confidence for whatever reason went down significantly, then that's what would probably start affecting sales volume.

Great.

And one follow-up, CFPB put out a notice yesterday saying they're going to look at the impact that the card has had over the last couple of years.

Just curious to see if you had any thoughts as to whether that could be either positive or negative, just given it seems like there's been restriction in credit as a result of that and I wonder if they may decide to make some changes.

Just any thoughts you might have there.

I hadn't seen that.

We'll have to wait to see.

I'd be surprised if there was a big impact as a result of a study like that, just from what you're saying.

But I'll have to wait and see.

Thanks.

Bill Carcache, Nomura.

David, on the rewards front, it seems like you guys are taking advantage of the spending growth and the loan growth that you've been generating and continuing to invest for growth and offering more attractive rewards.

Can you share your outlook for investment spending for the new year, both for you and the industry?

And specifically, do you expect some of your competitors to have a tougher time maintaining investment levels, given that many of them are still not seeing loan growth?

Well, certainly I think it's a very good opportunity for us to continue to invest in growth.

We've been gaining share in loans over the last couple years, and that's accelerated this quarter.

And so in direct banking, we're investing to continue to gain and accelerate loan growth in cards to broaden our other direct banking offerings in student loans, personal loans and other products.

And then obviously in the payments area, we're investing for -- we've just got many more opportunities in front of us at this point, and we think it's time to really grab some of those and invest in that business, which will be great for the long-term.

I think in terms of the competition, I think that's part of why investing is looking better for us.

We have seen some competitors pulling back on, for instance, direct mail volumes and advertising.

And I think we'd be foolish not to take advantage of that kind of opportunity.

Okay, that's really helpful.

Thank you.

And finally my last question is on your partnership with PayPal, it shows how you guys are using your network in a way that's disruptive to how the payments ecosystem has traditionally worked.

Is it reasonable to expect that we'll see more deals like that?

You mentioned there's some things in the works.

Without obviously commenting on anything specifically, but just wonder whether a similar kind of partnership to what we saw with PayPal where you turn on acceptance for them at all of your merchant locations is something that we could expect with say, like an MCX or others that are entering the industry and trying to be disruptive themselves?

Thanks.

I'd say yes and no.

I certainly -- I think PayPal is in a fairly unique position, and I'm really excited about that opportunity.

There is no one else in the market that's exactly positioned the way they are.

What I expect is not other PayPal-like deals, but other deals that are also disruptive in different ways.

And we are talking to a number of partners who see our flexibility and unique assets as a big opportunity.

And so I am certainly hopeful that as we get into next year, that we'll have additional partners to be talking to you about.

Okay, thank you very much.

Jason Arnold, RBC Capital Markets.

You've seen strong loan growth in 2012 and particularly good performance here this quarter, clearly a rarity in the financial sector, so keep up the good work.

But just curious if you could give us an update on your loan growth outlook for the year ahead and perhaps also update us on the card side in particular with respect to how you're progressing on the card acceptance awareness translating into more lending volumes?

Thank you.

I think that -- I'm really pleased with the 6% this quarter.

Significantly higher than the 2% to 4% that we had targeted in our investor day discussions.

And certainly, it's nice to see this kind of growth when the overall industry continues to decrease, so significant share gain.

It's going to be tough to maintain it at quite this 6% level, so I'm not sure we'll be able to maintain that throughout the year, but I'm certainly hopeful to at least be at the high end of the range that we've targeted in cards.

And I mentioned Discover It, I think a lot will ride on how successful that is.

We've seen good results in the test markets, but we really have to push hard to have this kind of growth in a non-growing card overall market.

I think the acceptance that you mentioned is part of what's allowing us to achieve this kind of growth combined with the higher level of investment spending, cash rewards programs, new products, all the other things.

It's hard to disentangle everything, but I'm certainly pleased with the growing acceptance, the awareness of acceptance, the deals we're doing with acquirers and that is paying fruit for us, resulting in some of this growth.

Excellent.

Thanks.

Could you expand on the Discover It, compare and contrast with your typical card offering as well?

Well, I won't go into a huge detail on this because there's too many features to fully talk about, but I'm very -- it's a cash back, no fee card with an extremely high level of service and unique features that are designed to save customers interest and fees.

And also has a different look and feel in terms of the card itself and how we're delivering it to the customers.

So, we're -- we'll look forward to briefing you more at our investor day about it, and you're likely to see some stuff -- some marketing of it show up next month.

Perfect.

Thank you.

Mark DeVries, Barclays.

I've got a follow-up on credit.

I don't know if this is a fair way to frame it, but how do you think about the level of reserves relative to charge-offs going forward?

I guess, Mark -- this is Mark -- I would say that from my perspective, I would echo David's earlier comments in that the reserve build you see this quarter is largely due to the growth in loan outstandings.

We don't see a fundamental inflection point in credit here, I guess is what I'd say, just to be clear about it.

Going forward, I think as we continue to grow our balance sheet, there will likely continue to be requirements for provisioning associated with some of that growth.

You think about it, we've been generating strong growth for a while now, and I think David indicated we continue to expect to see good solid growth going forward and so that will force us to continue to provide.

The way we look at things is we use a forward loss emergence period.

Currently it's at 12 months.

So, that's kind of how we're looking at a forward window of what we see coming at it.

And the growth that we have been generating over a period of time has reached a level to the point where we're providing for it a little bit.

But we do not see a fundamental inflection point in credit here.

Okay.

And what loss rates are you assuming on new receivables you are adding?

I don't think we've provided that information historically as part of our underwriting models, but I would say we are not underwriting to current loss rates.

I would say we are underwriting to what we believe to be more normalized loss rates.

Okay, thanks.

I just had one question about the mortgage business.

What should we be looking at as far as when we're going to see that become a more meaningful contributor to profitability?

Is it an issue of market size or is there just more work that you have to do to integrate that and right size the expenses?

I think it's a couple different things, Mark.

I think first, foremost and fundamentally it's a new business for us.

And consistent with the way we like to do things, we're going to test drive it a little bit before we jam on the accelerator, so I would say that's a piece of the puzzle.

I would say another piece of the puzzle would be, we've said all along there's some optionality there.

We wouldn't make any broader commitments to the business until we had further clarity around how some of the capital treatment and some of the GSEs, some of that was starting to evolve.

I think we're starting to get some clarity there, but we're probably not all the way to the full clarity we want to see to really move things forward.

That not withstanding, I would say we don't enter things with an idea of playing at them, so my perspective is there's a great opportunity for us in the mortgage business.

And as we get more comfortable with it ourselves, make sure we understand the various levelers and all the risks, it probably will -- you should look for it to become a more significant contributor going forward.

Okay, that's helpful.

Thanks.

Scott Valentin, FBR.

Just quickly on the networks, you've mentioned you've signed a number of agreements with -- that are unique and just wondering, when will we expect to see some type of a bottom-line impact on some of those agreements?

It seems like some of them could be pretty sizable, like [Chinee and pay] or the PayPal or even, I guess in the media you've seen Google Wallet Association.

What I would expect is that --we just signed a bunch of deals and next year is going to be a lot of implementation and costs related to that and getting going.

And so I would probably think more like in the 2014 and then certainly into the 2015 period to see some much more serious volume from those new agreements starting to hit and generate profits.

Okay, thank you.

And then just to follow-up on the expense line, you mentioned investing now to drive growth later on the marketing side.

You also mentioned some employment expenses associated with the mortgage bank.

In the context of the $3 billion give or take number that Mark, you kind of referenced before, was mentioned before, how much of that is due to that kind of employment line?

How much is due to the marketing side?

I would say it's a combination of both.

At this point in time, marketing will be a big driver of the launch of a lot of these new products, some of which we've talked about and some of which we haven't.

So, that will be a big piece of it.

Headcount expenses have been part of the equation, but they have not been the lion's share.

Okay.

Thanks very much.

You bet.

Ryan Nash, Goldman Sachs.

Mark, when you think about capital, you bought back $1.2 billion of stock, grew loans 6% year-over-year, increased the dividend, yet your capital levels are up 40 basis points year-on-year.

Can you talk about your outlook and priorities for capital returns into 2013?

Could this be the year that we actually see a decent dent made in bringing down the capital levels?

We would love to see that be the case.

I'm happy to talk about capital.

We are currently in the throes of our annual capital planning activities, both internally and with our own Board of Directors and also preparing for submission in the first couple days of January to the Fed as part of the CCAR [CAP] process, our annual capital plan as well.

I think you all know that any capital actions we propose to take need non-objection on the part of our regulatory body.

I guess I'd say a couple things.

Number 1, I don't think we feel that we were necessarily aggressive enough in our ask last year.

I think you should expect our ask to be somewhat more aggressive than it was last year, that was not objected to.

I think the other thing I would say in this regard is we remain committed to being responsible stewards of that capital.

And fulfilling that mission is going to be a combination of deploying it at ROE levels above our threshold 15% that we have talked about to you in the past and finding ways to get that capital returned to our shareholders to the extent we don't have the ability to do that.

So, it's not lost on us that you guys would love to see an increase in the returns of capital, and we are working toward that end.

Okay, and just -- Mark, as a follow-up, on the comments on the potential for negative operating leverage, can you talk about how you're thinking about that?

Are you looking at it as including gross revenues or are you thinking about rewards as a contra revenue or actually as an expense?

I'm including it as a contra revenue, but it's going into the calculation in the way I'm thinking about it, Ryan.

Okay.

All right, thanks, guys.

You bet.

Moshe Orenbuch, Credit Suisse.

David, I was really struck by the 6% growth in receivables.

You had mentioned that that was being driven by increased spending on -- from revolving customers, and yet the quarter doesn't really include the bulk of the holiday spending period.

And by the same token, I didn't notice that your payment rates had declined or anything.

Could you talk about -- it feels like it should persist then.

Is there something I'm missing?

Of course, we are comparing like time periods.

So we're looking at the same time period prior year in terms of the percentage of the holiday season.

I would say that we saw probably higher sales growth during year-over-year in November than we're seeing so far in December.

And we saw this last year as well.

And I think that one of the things that's happening is that more and more of the retailers are having bigger sales around Thanksgiving and accelerating some of the holiday spending into that month.

So, that is a likely kind of thing.

And I guess the second thing is we did get -- we have been getting some extra pop from the higher rewards investments and other investments we've made.

And while that will likely carry through this month, if I think about full year, we're going to be pulling back a bit to more normal levels of promotions, and that can also affect that growth throughout the year.

And just to follow-up is there anything you're seeing from the consumer side in terms of their willingness to actually carry some more debt?

Because that would be obviously a positive, and can you talk about that and maybe what you're seeing into December?

Yes.

I would say I haven't seen a big change this quarter, but for the last few quarters, I've been saying that we've seen sales in receivables growing at about the same pace which suggests to me that a lot of the deleveraging that has taken place over the last several years has run its course.

And so I just think this quarter it was more of the same.

Great.

Thanks so much.

Don Fandetti, Citigroup.

Yes, David, more of a business type question.

On your marketing, how much of your marketing is mailing today versus, let's say some of the newer channels like online, as a percentage today, let's say versus three or four or five years ago?

Can you talk specifically about how that might have changed or not changed?

It certainly changed dramatically over the last several years, and Internet and online has become a very significant part of the marketing mix, and I think that will only continue to grow.

Direct mail is easier to track and so sometimes when we look at level of marketing intensity, it's a little easier for us to compare statistics on mailings being up or down and relative mail share.

But we see more and more of our business moving online because it's very cost-effective.

We already get -- the majority of our applications come in through online as opposed to all other channels combined.

Okay.

And it sounds like you're pretty constructive on payments and opportunities for investment.

You have a lot of capital.

Would you make any type of decent sized acquisition in payments and would be more likely domestic or international?

If we saw the right opportunity that gave us the right returns and fit with our strategy, I would love to be able to bulk up in payments.

Obviously, if you look over the longer time period we bought Diner's and PULSE, so we have made payments-type of acquisitions.

We've made some smaller investments in this space.

But -- so I think it could be, for the right deals, it could be a great way to deploy some of this capital.

But that being said, the prices of properties tend to be pretty high.

Our assets are quite unique.

And so I think that what we have been finding is there's a lot more opportunities to partner with others as opposed to buying others, and that's been true both the domestically and internationally.

And so I think that that is a more likely scenario is to see more partnerships as opposed to acquisitions.

Thank you.

Rick Shane, JPMorgan.

When we look at your card growth, it's starting to break even more from the pack, and I think we really want to understand what's going on there.

When -- I know you don't provide account numbers, but when you look at the drivers of this, can you give us some sort of sense of a ratio between how much of it's being driven by existing customers increasing balances and how much of it is being driven by net new accounts?

I would say that it's been pretty balanced growth, and we've both balanced between new accounts and more usage from existing accounts.

We've got more from sales as well as more from balance transfers.

And I would say we're getting impact from growing share within existing merchants as well as the new acceptance that we've been able to put in is also giving us -- so each piece may be a percent or so and you have to add it up to get to the 6% loan growth that we're seeing in total.

The one thing that I would say is that we are not sacrificing credit quality.

And if you look at where the growth is coming from, it is coming from the medium to the high FICO score bands as opposed to from low FICO score bands.

So, the one thing that's consistent across all these channels is that it's good prime credit.

Great.

Thank you very much.

Bob Napoli, William Blair.

The acceleration in growth on your proprietary card this quarter, 3.5% last quarter, 6% spend growth this quarter, is that primarily driven by some of the new incentives, David?

Then you mentioned teaser rates product as it relates to the margin in the quarter.

What are you doing in teaser rates today?

I would say there is some promotional aspects.

We had, as Mark mentioned, more aggressive promotions this year than last year.

I'd say that was more to do with -- the difference between this year and last year during the quarter was much more the rewards program than the fact that we were offering up to 5% on both Internet and department stores than it was pricing -- promotional pricing.

So, I think it will likely pull back a little bit as we get into next year, just as we go back to more normal promotional promotions.

Okay.

And then the investment that you made -- the incremental investment in payments, there was a big jump in the payments sector and your operating expenses, I think $12 million quarter over quarter, is that primarily -- should we expect to see those expense numbers stay around that level?

And is that primarily being driven by PayPal?

Or what else -- what specifically are you doing in that sector that's driving up those expenses?

Bob, I'd say that there's a couple things going on in the payment space.

Specific to the quarter, Diner's expenses were responsible for about two-thirds of the year-over-year increase, and they were primarily related to several new issuing relationships that we have talked to you guys about in the past that we established in the last quarter or so.

And you should think about them more as one-time oriented in nature.

I would say that being said, as David noted, we're looking for a number of other opportunities in this space and actively engaged in those, so there's possibilities as you look forward of other one-time expenses creeping in as a result of that.

So, the way I would think about the payments business in 2013 is I would think about it as a year of investments in building to reap real returns down the road.

Don't read that as a big backpedal, but also, I wouldn't expect the payments business to be the primary driver of growth in revenues and earnings over the course of '13.

Thank you.

Chris Brendler, Stifel.

Just wanted to hit on the growth questions a little bit more and the promotional activity.

Can you talk at all about the interim month trends in spending?

Once the promotion kicked in, I believe it was in October, was there a several hundred basis point acceleration in your spending growth number?

And more broadly, do you think with the loan growth you're seeing this quarter, are we seeing any early signs of a pickup in consumer demand in terms of response rates to mail and the willingness to revolve?

Is there any of that going on, or do you think at this point it's mostly just the promotional activity you've had, both teaser rate and also on the Internet purchases that is causing the balance growth to also tick up?

Thanks.

I think I've already discussed the intra-quarter volume with November being the strongest year-over-year month of the year and then less so in December, but I think that's not so much related to any promotions we're doing.

But related to pull forward of retailers broadly, sales into earlier in the holiday shopping season.

And I think in terms of the promotion, we've got a promotion that ran the fourth quarter of -- fourth calendar quarter, so it runs through December.

There's nothing intra-quarter.

March and August and September -- September relative to October, was it like a couple hundred basis points of spending acceleration you got from that program, or was it just a minor impact?

I think at that point, minor.

Okay.

I guess another question I have on that topic was, in terms of response rates, I have a follow-up question that would be, on the fee income side, the fee products you saw I think a sequential deceleration in the fee products, the revenues falling a little faster this quarter.

Does that 7% or so decline, does that continue into 2013 as you wind those down, or are you mostly through the wind down at this point?

Thanks.

Yes.

As you look at the fee products revenue line going forward, as I mentioned, we did cease marketing the products during the quarter.

We took a hiatus here to make sure we have everything in place to comply with our consent order.

It's our intent we will begin reissuing -- or re-offering those products to our customers, but in terms of from a guidance standpoint, I would say you had, what, a $5 million roughly sequential decline in revenue related to those products?

For now I would say that's probably a good way to think about the continued impacts going forward.

All the way through 2013?

$5 million a quarter?

Yes.

I think that's probably a good way to be thinking about 2013 on protection products at this point.

Okay, and then lastly circling back, any pickup in demand, David, you're seeing at the consumer level in your -- beneath the service analysis?

I would say that we have seen some good results from our Discover It product, which is why we've made the decision to roll it out next month.

And so we're looking forward to that launch.

Okay, great.

Thanks, guys.

James Friedman, Susquehanna.

I'll ask both my questions up front.

There was a slight deceleration in PULSE volumes this quarter.

Still good numbers.

Was wondering if that's the mix shift of debit and credit or if there's something more profound related to FANF for the competitive environment?

That was my first one.

And then Mark, you had mentioned at the outset that you had $26 million gain on the sale of minority investment.

I was wondering if you could share more details as to what that might have been.

Thank you.

Yes.

I think in terms of PULSE, I would expect a further deceleration in the next quarter.

While I was pleased with the overall growth rate we experienced this quarter and the last few quarters on PULSE, it would have been even higher without some of the competitive challenges, I'll say.

And one of those competitors is the Goliath in the industry and as they continue to roll out some of these new hijacked transaction actions, a lot of those are just being rolled out now and will have an increasing effect on all the other competitors in the market, including PULSE.

And then with respect to the $26 million gain, we don't disclose the specific names, but we do have a small portfolio of what I would call strategic minority investments that we make as part of our payments business where we see opportunities to either be able to acquire or more ultimately partner with these folks going forward.

We sometimes take a stake in those opportunities.

And when the strategic value either does not pan out the way we thought it would or for other reasons we determine it's just not the right direction for us to head, we typically look to monetize those investments.

And I think this one falls into that latter category and shows that we do know what we're looking at in the payments space, even though it didn't end up working out right for us.

Thank you.

I appreciate the color.

You bet.

Sameer Gokhale, Janney Capital Markets.

I had a couple, the first one is on your private student loan portfolio.

You show great credit numbers, but loans in forbearance, do you know what the statistics are if you compare them year-over-year for the private student loan portfolio, and do you foresee making any changes to your forbearance policies as you look through the portfolio and credit quality in the economic environment?

And then I have a follow-up.

Sameer, I think that our forbearance policies are pretty much dictated by what's allowable in terms of regulations, which have not changed year-over-year.

And I think that the big effect for us is that we are going to be going through a seasoning where we have a lot of growth and we're going to have more of the students that we booked who will be entering repayment for the first time.

And most of the losses -- about half of the losses that occur over the life of a student loan occur the first two years after repayment.

So as we get more of those people, we're going to end up having more people in forbearance, more losses and then you get a maturing over time.

I would say that business continues to perform on a vintage basis as we had anticipated.

Okay.

And then you talk quite a bit about credit card loan growth and given some helpful commentary on that, but that's something which I think is kind of an obvious question, but it would be helpful to get additional perspective on that.

When you look at the credit card business and the fact that there are of course a few small -- a small number of large competitors in the business, and you are investing in rewards and trying to gain share or you are gaining share of receivables, how do you think of it from a game theory perspective?

Because it strikes me that you invest in rewards, you get some share, then somebody else invest more in rewards and they take away some of the share from other folks.

In terms of the natural growth rate, underlying growth rate of the industry, doesn't it make sense to dial back on investments just because if everyone starts doing that everybody loses?

How do you think about that at a high level?

I think from a high level I think of cards as being a slower growth business.

And so if you think about it as a little bit more of a zero sum game, our goal is to continue to gain share.

So, you've seen us gaining share in loans for now a few years, and what I see is that while it's a smaller number of sizable competitors today than in the past, the good news is they are more rational competitors, so I think they're not going to be dropping credit standards to reach for growth, which is always the biggest concern you've got.

And so what it comes to is us using our competitive advantages to gain share.

So, our advantage in service, our advantage in rewards, our advantage in growing acceptance, our advantage on differentiation including with new products.

And so we're going to be focused on, from a game theory perspective, using all of those competitive advantages to gain share in credit card market.

Okay.

Thanks, David.

Chris Donat, Sandler O'Neill.

Two quick questions on the checking product.

I thought that was something that you had intended to launch in fiscal '12, and I'm just wondering first if there's anything with the timing that's related to the conversion of your core banking system.

And then secondly, if it does launch and does scale significantly, could it also be another tailwind to your cost of funds in '13?

Thanks.

Well, I would say that our core banking system's on track.

I would have loved to have gotten the checking product out this year, and it looks like we're going to miss it by a couple months -- by one quarter.

But I think what I would attribute more of that to is that it is a more -- it's probably a much more robust product and a better product than what I might have anticipated a year ago.

And so we wanted to really get it right from a consumer value proposition, and so I am really excited to be able to launch it early next year.

In terms of the impact on cost of funds, that is our reason for launching it.

We don't expect this to necessarily make money as a product except it's going to be over time a good low-cost, stable source of funds and an additional important core relationship.

And I expect it to not have a material impact in the near term because it's going to take some time.

By definition, these are the sticky bank deposits, and so it's going to take some time for us to pry those sticky relationships into a direct banking relationship.

But I'm excited about the technology and the value that we can offer to, over time, have that start to become a tailwind on cost of funds, but I think realistically, you'd have to look more in the 2014, 2015 and beyond that to really start seeing some movement.

Okay.

Thanks very much.

Daniel Furtado, Jefferies & Company.

This is Martin Kemnec in for Daniel Furtado.

Quick question on the promotional balances.

I assume that in the low rate environment is still positive from an NPV perspective, but curious, when these eventually start to come off their promotional periods, is it reasonable to expect that we could see maybe some stabilization in card yields as those balances start earning fees?

I think David, you may have mentioned possibly reeling in there a bit, or would that not be meaningful enough to really move the needle there?

And then on credit, Mark, your comments are very helpful.

I just -- one, a modeling question, on the reserve rate, is it safe to assume the 3%, call it 315 basis points is that correct reserve rate to model going forward until we start to see crediting inflecting?

Thanks.

Mark, we'll give you more update on the promo rates at investor day as we've done the last few years.

But you're right.

We are able to maintain good NPVs with more promo balances and lower rates in today's cost of funds environment than we would in different environments.

And we're taking advantage of that now to be able to offer our customers some very good deals, cost effectively.

I guess I tend to think about it as a little bit of a wash that more -- less of being an opportunity, but more, if the rate environment changes, then you have to look at your promotional rates and what percentage are at promo, what's the duration and all that?

Is one way to help mitigate some of the less benign rate environment over time.

And as far as the reserve coverage ratio is concerned, it's -- we don't really track the reserve coverage ratio.

We do follow-up, we don't manage to it.

It's a rearward looking metric, and we look forward.

I'd say there's a bunch of factors that can affect it, so not prepared to give specific guidance on what that rate should look like going forward.

What I would do is echo our earlier comments that we don't see a fundamental turn in credit at this point, and any reserving that takes place will really be driven in our view at this point based on the seasoning of that account growth.

Got it.

Thank you both.

Yes.

David Hochstim, Buckingham Research.

I wonder if you could share some additional thoughts about the dividend.

You had a big increase this quarter, but it's been years a year since the last one.

And you payout ratio is still quite low relative to other very large well-capitalized banks.

I wondered if you could share your thoughts about payout ratio and how soon you might look to make another change to the dividend, assuming the Fed signs off on what you'd like?

Thank you for the qualifier at the end there.

That's helpful.

I guess from our perspective, it's pretty straightforward.

We definitely see room to take our dividend payout ratio higher than it is right now.

And I would also say that as we change our fiscal year, we may change our quarterly dividend payment dates to correspond a little bit to those of our peers.

I would also say that we've been saying for a long time we'll revisit our dividend no less frequently than annually.

I would specifically reiterate that statement to you today.

Would you consider reevaluating it more often than annually?

I don't think I'm prepared to give any further guidance than I did right now while we're in the preparation of capital plan.

Let's just say we see room to take that dividend payout ratio higher, and one should not assume we're going to stay on a December cadence.

How about that?

Okay, thanks a lot.

Ken Bruce, Bank of America.

I think when you look at credit over the last few years, it's been a tremendous positive driver for Discover.

And I think it's understandable why you don't expect it to get any better and I also understand why you'd expect provisions to go up as balances grow, and that obviously was very encouraging in the quarter.

But what I'm interested in knowing is what do you think it -- what will drive the loss rates or delinquency rates and ultimately loss rates higher on a percentage basis?

Is it just a macro environment?

Is it the seasoning that, Mark, you just touched on?

Is it lower recoveries?

What is it that you think is going to drive delinquencies and losses higher?

Well, I would say a couple of factors.

One is seasoning of the book.

If you looked at how much everyone pulled back during the financial crisis and very few new accounts were booked, we are now back into a more normal time period.

And so as the new accounts that are now being booked start to season, that will tend to increase the loss rate a bit to more normal levels.

I'd say a second thing is that as we get further away from the very large spike in charge-off rates, to some degree, people that were close to the edge all got recognized in a short period of time.

So, much like the bankruptcy law change from a number of years ago where there was a trough afterwards and it took a few years but eventually you get back to more normal levels.

I think as we get away from the spike, you're going to eventually start to normalize.

And so those are two macro factors.

Then you start getting back into the normal unemployment, healthcare costs, divorces.

These are the kinds of things that in prime business tend to drive charge-offs and you get back to more normal levels of all those kind of life events.

Okay.

That's helpful.

And could you remind us what the timeframe of seasoning typically would be within your portfolio?

Yes.

Typically, one thinks about 2 years, maybe 2.5 years as being a peak charge-off and then coming down after that point.

Okay, great.

Well, that was it.

Thank you very much.

I thought it was a very good quarter.

Appreciate it.

Thank you.

We have no further questions at this time.

All right.

Thank you, everyone, for joining us.

I hope you all have a happy holiday, and feel free to reach out to Investor Relations if you have any follow-up calls.

Thanks.

Thank you.

Ladies and gentlemen, this concludes today's conference.

Thank you for participating.

You may now disconnect.