發現金融 (DFS) 2013 Q1 法說會逐字稿

Welcome to the Q1 2013 earnings call.

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

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

Later, we will take questions.

Please note that this call is being recorded.

And I will now turn the call over to Bill Franklin.

You may begin.

Thank you, Vanessa.

Good morning, everyone.

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

Please note that for the first time, we have provided an earnings presentation on our website, which we will be referencing during the call.

Let me start on slide 2. 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 in our Form 10-K for the year ended November 30, 2012, which are on our website and on file with the SEC.

As previously reported, the Company changed its fiscal year end from November 30 to December 31.

For more information, including historical calendar-year financials, please see the 8-K dated March 5, 2013.

In the first-quarter 2013 earnings materials, which are posted on our website at 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's my pleasure to turn the call over to David.

Thanks, Bill.

Good morning, everyone, and thanks for joining us.

I'll start my remarks on slide 3 of our new earnings presentation.

Before the market opened, we reported quarterly diluted earnings per share of $1.33, up 10% over the prior year, driven primarily by loan growth and share repurchases.

During the quarter, we generated return on equity of 27%, and returned approximately $310 million of capital to common shareholders through repurchases and dividends.

These positive results, our capital position, and our outlook led our Board to approve a 43% increase in our dividend to common shareholders last week.

Mark will provide you with more details about our financial performance for the first quarter, but I'd like to draw your attention to Discover's year-over-year revenue growth of 10%.

This shows how the Discover business model is working, especially since the financial industry as a whole currently is in an environment that poses challenges for achieving revenue growth.

So, we will continue with investments to drive top-line growth.

Slide 4 of the earnings presentation illustrates some of the drivers behind our revenue growth.

We achieved 7% organic receivables growth, driven by a 5% increase in card receivables, and a combined 10% increase in private, student and personal loans.

Card sales volume for the quarter was up 4%.

We do continue to focus on prime revolver sales, and we believe these results underscore the effectiveness of that strategy.

On the payment side, year-over-year total volume growth slowed down to 2% as PULSE's growth rate decelerated from 11% for the fourth quarter to 4% year over year for the first quarter.

This deceleration in growth was something we discussed in prior calls, and was mainly due to the impact of merchant routing and competitor actions, as well as our focus on profitable business rather than just volume growth.

While the environment remains dynamic, we are pursuing a number of strategies that we expect will enable us to compete for a larger share of debit transactions, and continue to grow this business going forward.

Looking beyond debit, during the quarter we signed our first net-to-net partnership in Africa, and we are making strong progress as we continue to prepare for PayPal's staged offline rollout this year.

At Diners, volumes were impacted by the continued weakness in Europe, and strengthening of the dollar versus other currencies, like the yen.

Last month, our management team presented Discover's strategic priorities and key initiatives at our annual financial community briefing in New York.

We discussed our profitable growth, the credit environment, our successful expansion beyond credit cards, and our commitment to effective capital management.

We also shared exciting new opportunities including the nationwide rollout of Discover It, which so far is driving strong response rates and an enhanced engagement from new accounts.

Discover It was not the only new product we launched this quarter.

We also launched cash back checking.

While these new initiatives are in early days, I'm very excited about how they will shape the future of Discover.

Now, I'll turn the call over to Mark and he will walk through the details of our first-quarter results.

Thanks, David, and good morning, everyone.

I'd like to start our discussion this morning by going through the revenue detail on slide 5 of the earnings presentation.

Net interest income increased $118 million, or 9% over the prior year, driven by asset growth and a higher net interest margin.

Net discount and interchange revenue increased by $23 million year over year or 10%, due to Discover Card sales volume growth and a lower rewards rate.

The timing of promotional cash back programs drove most of the sequential decline in our rewards rate from 111 to 92 basis points.

For the full year, our target rewards rate remains at approximately 100 basis points.

However, you will likely see continued quarterly fluctuations due to the timing of promotions as we look to further engage our customers and to drive profitable sales.

Protection product revenue declined by $15 million over the prior year, and $10 million sequentially, mainly due to the discontinuation of new product sales, as well as customer refunds.

We don't currently believe the sequential decline is representative of an accelerating runoff rate, but do think there may be some quarterly fluctuations going forward.

Other income increased by $59 million, primarily due to the inclusion of Discover home loans, which was launched in June of 2012.

In terms of production, we originated approximately $1 billion in direct mortgages for the quarter.

Payment Services revenue increased 6% year over year due to higher transaction processing revenue for PULSE, and higher revenue from network partnerships.

Turning to slide 6, total loan yield of 11.22% declined 17 basis points over the prior year, mainly due to card yield compression.

This compression resulted from an expected increase in promotional-rate balances, as well as an expected decline in higher-priced balances.

Lower funding costs and lower than expected interest charge-offs more than offset this yield compression, resulting in a 30-basis-point increase in net interest margin over the prior year, to 9.39%.

We continue to expect some NIM compression next quarter, and then margin should expand sequentially in the second half due to maturities of higher-rate funding.

Operating expenses, as shown on slide 7, were up $81 million, or 12% over the prior year.

Over 50% of the expense increase is due to higher employee and marketing costs associated with the Home Loan acquisition, and the launch of our direct mortgage product last June.

Marketing expense was also higher than the prior year due to investments that continue to drive new account growth, card utilization and loan growth.

Other expenses were lower than the prior year, mainly due to fluctuations in reserves related to legal and regulatory matters.

Payment Services operating expenses were up $6 million, or 18% over the prior year, mainly due to higher professional fees and marketing expenses related to new partnership and growth initiatives.

As David and I mentioned last quarter, this will be an investment year for Payments.

We're working on a number of different opportunities that will depress profits in the segment near term, but which we believe will position us for volume and revenue growth over the longer term.

As mentioned during our financial community briefing, we still expect total Company operating expenses of roughly $3.1 billion for the full year.

Turning to provision for loan losses and credit, on slide 8. Provision for loan losses increased $75 million from the prior year, driven by a lower reserve release for the first quarter, which was partially offset by lower charge-offs.

Our forward loss forecast, particularly for season credit card vintages, improved since fourth-quarter earnings.

Accordingly, the first quarter of this year had a reserve release of $154 million, which I would emphasize should not be viewed as a run rate.

Net principal charge-offs were down $45 million, or 13% year over year, due to continued improvement in credit.

Sequentially, the credit card net charge-off rate increased 5 basis points to 2.36%, and the 30-plus-day delinquency rate decreased 2 basis points to a new historic low of 1.77%.

The student loan net charge-off rate, excluding purchased loans, decreased 18 basis points from the fourth quarter, due to seasonality and growth in the portfolio.

We would remind you that as the portfolio seasons, we expect this charge-off rate will rise above 1%, and come back down over time to our normalized target of approximately 1%.

The over-30-day delinquency rate increased 26 basis points sequentially.

The credit performance of both our organic and purchased credit-impaired student loan portfolios continues to be in line with our expectations.

The personal loan net charge-off rate was down 17 basis points sequentially, and the over-30-day delinquency rate was down 1 basis point.

Next I'll touch on our capital position on slide 9. Our Tier 1 common ratio increased sequentially by 110 basis points to 14.7% due to the combination of strong earnings, sequentially lower share repurchases, and the seasonal decline in receivables from the fourth quarter.

As was previously announced on March 14, Discover received a non-objection from the Federal Reserve for proposed capital actions for the four quarters which began on April 1. Additionally, our Board authorized a two-year, $2.4 billion share repurchase program, and last week increased our quarterly common stock dividend from $0.14 to $0.20 per share.

With respect to longer-term capital planning, we anticipate being part of the Fed's CCAR review process next year.

Having compared peer-reported stress results to those calculated by the Fed in this year's process, we believe that our target capital ratio may increase as we become a part of the CCAR process.

Despite the prospects of a potentially higher Tier 1 common target, we still have more than adequate levels of capital to drive organic growth and planned capital actions in the current environment.

In summary, this was a great way to start the year.

We drove better than industry revenue in receivables growth, credit performance remains strong, and we received non-objection from the Fed on our January 2013 capital plan.

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

And thank you.

We will now begin the question-and-answer session.

(Operator Instructions)

And I do apologize for the delay.

It will be just one moment while people queue up for questions.

(Operator Instructions)

All right, we'll take the first caller, Vanessa.

Thank you.

We have our first question from Craig Maurer.

Please go ahead, Craig.

Good morning.

Great quarter, guys.

I had a question about network volume.

For many quarters, you have been talking about share gains in the network business -- not just PULSE, but Discover Network, as well.

It seems at minimum you have fallen back to the growth rates of the four-party systems and are now lagging the other major three-party network.

Do you expect that to recover with the launch of IT?

Are there other initiatives you can take?

Or should we expect more of a lagging position from Discover Network now versus some of the other networks?

Thanks.

Thanks, Greg.

Certainly, we have had a great track record over the last five years or so gaining share.

It hasn't all been even.

We've gone through some periods of gaining significant share and some much less.

And if you look what's going on, there is not a big change in the Discover side; it's primarily debit.

Where PULSE had been gaining very significant share, and as we had suggested in prior quarters, some of the trends that we were seeing were concerning -- some of the new rules and approaches coming out some of our competitors, as well as some routing changes post-Durbin.

I still do expect in the long term to be in a share gain position.

And I'm particularly excited by some of the new net-to-net partnerships, PayPal and others, as well as the actions that we're taking within PULSE to confront some of the competitive challenges.

As Mark suggested, we are in an investment mode, pursuing some of these great new opportunities, which I think will pay huge dividends over the long term.

But I'm not expecting to have big share gains -- we obviously we didn't have at this quarter; and I wouldn't expect it probably in the next quarter or two.

But would look forward to returning to gaining share again as soon as we can.

And if I could follow-up on PayPal.

Are you planning to aid PayPal in their marketing efforts?

Or will this be strictly a PayPal effort in terms of actual consumer focused marketing?

Consumer marketing will be PayPal's responsibility.

We are focused on the acceptance side.

Okay.

Thank you.

Our next question comes from Ryan Nash.

Please go ahead, Ryan.

Thanks, guys.

Mark, just on credit; and the reserve losses continue to come down nicely, I believe you mentioned due to the season loans and the reserve also came down.

Can you just help us understand the path from here?

Any changes to your expectations over the next year?

And given all the initiatives you have on the lending side, can we continue to see the reserve come down at this point?

Or is all the provision that you are going to be doing from here strictly related to growth that you are generating?

Yes, there is a lot in there, Ryan.

I'll try to touch on it all.

If I miss anything, feel free to hit me with your follow-up.

I guess what I would say is, credit continues to surprise to the positive.

And I guess that's a great thing at the end of the day.

It validates the underwriting we've done and the strength of the book.

I would say I would not take this quarter's run rate on a release, or anything even approximating it, and say that's what the future is going to look like and you should extrapolate that out.

I guess what I would say specifically is, at this point in time it's really too early to call if next quarter is going to represent a release or a build.

And I think it's a continually evolving situation, where in 50 years of the existence of a credit card as a product the models are all built off that history and we've never seen an environment like this.

So I think everybody in the industry is to some degree figuring this out as we go.

We feel good about the positioning.

We feel good about where we are.

In terms of trajectory right now, I'd say next quarter could go either way.

Great.

And then, just on the buyback, Mark -- I know that at Investor Day you talked about getting the payout close to 100%, or at least that's the cap the way that the Fed is thinking about it.

If I look at expectations over the next few quarters, it implies a buyback of something around $500 million a quarter or so.

When you think about the two-year program, given that you use 70% of last year's allotment, is it feasible that we could see greater utilization on this year's $2.4 billion plan just given the significant amount of earnings that you are generating at this point?

Yes, I don't think at this point in time I'm going to give guidance on exactly where we expect to end up.

I guess what I would say, Ryan, is we are generating great returns on that excess capital.

We don't feel like we're being irresponsible in that regard, and we bought back 6% of our outstanding shares last year and topped our dividend 43% last week.

So I think we're trying to navigate a healthy balance between deploying that capital into the business to drive compounding of value and profitable growth over the long haul, as well as making sure we don't just start building some giant capital hoard.

I guess what I would say is that it is a two-year authorization.

And I wouldn't expect we would -- over the rolling four quarters from where we sit right now, I wouldn't expect we would approach utilizing that $2.4 billion.

Great.

Thanks for taking my questions.

You bet.

We have our next question from Sanjay Sakhrani with KBW.

Please go ahead.

Great, thank you, good morning.

When I look at marketing, it seemed like it was a little bit lighter than what I had anticipated and what you guys were guiding to.

I was wondering if you could just talk about if there was any change to the competitive landscape that caused a little bit of variance there?

I think one of your competitors mentioned where the growth has really been is in the high-balance revolvers.

And I was just wondering if you could just maybe even talk about that and specifically where your growth is coming from, versus what you have typically originated in the past?

Thanks.

Sure.

First, our marketing was certainly higher in cards first quarter this year than it was a year ago.

And I think if you look around, you have seen plenty of billboards, TV spots, and so on.

I think we've really gotten the word out and we've done it in a cost-effective way.

I think during the first quarter, with the launch of Discover IT, we probably went a bit heavier on some of those broad market approaches because in the test markets they work very well.

But I'd say we're also now following up with a bit heavier mail and I would expect to see our direct mail volumes be a bit higher for Discover IT in the second quarter versus the first as we continue to make consumers broadly aware of this great product and grow our business.

In terms of where our growth is coming from, I'd say it's quite balanced.

There is still a good amount of our growth that comes from current customers in gaining market share, retaining them, not writing them off.

And so that's a big part of it.

I'd say Discover IT is attracting a slightly different usage pattern -- a little bit less balance transfer, a little bit more retail sales, higher activation, and if anything is skewing a bit better in terms of the credit expectations.

So that will take quite some time given the size of our book to work its way in.

But I guess, overall, our growth has been quite balanced and we are going to continue to ramp up our marketing on Discover IT.

Mark, you just talked about your targeted level of capital going up under CCAR.

Could you help quantify how much of a change you might be anticipating?

And could you just also talk about why that would go up under CCAR versus CapPR?

Thanks.

Yes, I would say we don't, Sanjay, definitively know that it will go up, is the key point.

I think what we've seen is we have compared the same thing you all have, and that is we've looked at in the CCAR where there is total transparency; we've looked at what that the BHCs themselves submitted as their expected losses and hits to pre-provision net revenue.

And we've seen the stress cases that the Fed came back with.

I think some of our customers have talked about -- or some of our competitors, rather, have talked about that disconnect.

I think we clearly see a pretty significant disconnect there.

We're just trying to be responsible and say -- hey, look, as we are looking at this, we feel compelled to tell the market this may impact us too.

So I think we're just trying to level set that.

In terms of what the impact may be -- I know this isn't the answer you want to hear, but it's the God's honest truth -- and that is we won't know until we go to through the CCAR process ourselves, because they don't disclose how this is being done and it changes every year.

So I think the key point to take away is -- in my prepared remarks, one of the things I was very cautious to say is we don't envision any of this impacting our current planned capital actions.

So I would say it's a bit of an academic point at some level, because getting down to that target capital ratio, as we've discussed, [either] before was going to be a multi-year process anyway, and it isn't going to impact us near term.

We just felt compelled to put it out there.

Okay, great.

Thank you very much.

You bet.

Our next question comes from Brian Foran with Autonomous.

Please go ahead.

Just as we think about that credit, you referenced the bankruptcy benefit in the press release.

Can you just talk through where bankruptcy filings are coming out?

Is it just the number of bankruptcy filings are coming out lower than you had forecast?

Or dollars per bankruptcy?

Or what exactly is happening there?

Well, I think that total bankruptcy filings in the country has been trending down a bit, which is different than what a number of forecasters externally had been predicting just a few months ago.

And within that, our share of Discover customers who are part of those bankruptcy filings has also remained quite modest.

And so it's part of the credit favorability that we've talked about earlier on the call.

And then on the net interest margin -- given the slide at the Analyst Day on the high-cost CD and fixed-rate ABS rollovers, I was wondering if you could just give us a sense of what the go-to rates are on average for CDs, and I guess on ABS -- whether you're replacing with fixed-rate or floating-rate ABS, so we can try to think about what the funding cost benefits might be over the next couple quarters?

Yes, I guess what I'd say is, from the standpoint of the deposit side, I encourage you to just go out and hit our website.

Our posted rates are out there, and you can get a good sense and a good approximation on the deposit side of the equation where we're replacing those rolls today.

With respect to the ABS market, I would point you to our most recent print, in terms of how we're looking at life, where we're doing a multi-tranched approach.

We're managing the balance sheet holistically, not incrementally.

So the asset liability position takes into account a number of different factors, obviously; and we are tranching out some of this with longer dated fixed-rate ABS.

We're also keeping some of the relatively shorter dated.

So I know that's not a direct specific answer to the question, but if you need some further follow-up, we will be happy to help you on that, as well.

Great.

Thank you.

You bet.

Our next question comes from Betsy Graseck with Morgan Stanley.

Betsy, go ahead.

Thanks a lot.

One of the questions that I keep getting is on teasers; and you did indicate, and you've talked before about the fact that you are doing teasers, ramping them up.

I guess I'm just wondering if you could give us a sense of how you are managing the credit around the teasers?

And also could you give us an update on how much of the teasers that you are bringing in you're able to transfer into multi-product or extended product type of customers that helps you get a sense of what their payment history is like?

Sure.

We are up modestly from last year.

We were around 16% last year; we're around 18% now.

And I expect it to be pretty stable from this point forward.

And I'd say we, obviously, do it because our net present value say it is the right thing to do.

We look at all the different factors -- how many stay with us, the credit aspects and so on.

From a credit perspective, generally speaking, if you offer customers a lower rate you get better credit.

A higher percentage -- and the fact that we are in the prime business means that we use it more than someone who's not fully in the prime business.

I'd say, generally speaking, what you're seeing with us is consistent with our previous guidance; is probably elevated today versus what it might be in a different cost-of-funds environment, because that, obviously, goes into all the models; and is been done to maximize returns, and is indicative of a prime faster-growing issuer -- which we are.

I guess the final point I would make is if you look at our total yield, it's strong.

And so I think that is maybe the best indication that we are balancing it all and achieving both growth and profitability.

You go ahead.

Did you have another question?

No, I was just going to say when it comes off teasers, how has the performance on the credit side been?

It has been very strong.

What I was going to say, Betsy, is that I think David covered the first half of the equation, which is really the NPVs and the come-ons and everything else.

But the second piece of the puzzle is, you start watching these vintages very early on things you bring on promotionally; and you look to see if you're getting the behaviors out of those accounts that you like to see.

For example, if you see an account that comes on and balance transferred in the first six weeks they never pull out their new card, we probably know that wasn't successful and we need to start really trying to engage the customer pretty meaningfully.

Flip side the equation -- if that card gets pulled out of the wallet 16 times in the first six weeks, we're feeling a lot better about it, right?

So you have to watch not only the cost of acquisition and what the ultimate profitability of those current balances are, but you also have to watch that customer, the behavior that customer going forward.

And I would tell you we're very happy with the results from our promos in that activity, as well.

Okay, because you been pretty active in trying to engage those customers quickly.

Can you give us a sense as to -- has that customer utilization, so to speak, that pulling out of the wallet, been pretty steady state over the past year or so?

Or has that ramped up?

And roughly what percentage of your teaser customers are you able to translate into active card users?

Well, I can't give you numbers, but I can tell you directionally -- Discover IT, we're seeing higher retail engagement, a bit lower balance transfer activity then we had before.

So we're -- than history had.

So I think the trends have been favorable.

Okay, thank you.

Our next question comes from Don Fandetti with Citigroup.

Please go ahead.

Good morning.

David, I think you had mentioned that the PayPal ramp-up was sort of a staged process.

And you may have commented on this already, but can you talk a little bit about how many merchants have agreed to accept that?

And how that staged process could work?

And then secondly, I know some of the banks have complained that these merchant-of-record models just add risk to the payment system.

I was wondering if you could sort of provide your perspective on that, as well.

Well, I would say that I'm not prepared to give specific numbers.

We are adding acquirers and, therefore, the merchants with those acquirers go to, continuously here.

We're in a very active stage.

I'm very pleased with the number.

We've press released a good number, and we are expecting to continue to add additional acquirers to the equation.

I think that what we have committed to do is to work as hard as we can to turn on our merchant acquirers and our entire merchant base to PayPal.

But that doesn't happen with a flip of the switch.

We've done this a couple times before.

PayPal as got some unique characteristics, but we've turned on the JCB and trying to UnionPay and BC Card.

We've been working -- there's no one in the industry that has turned on more new networks and a merchant base and an acquirer base than Discover, and I think that's one reason PayPal chose us.

We are going to be ramping up quickly.

But I purposefully use the word staged because it doesn't all happen in one day.

And I think for us the volume will build gradually, and I wouldn't really think about a big volume benefit this year.

In terms of your other part of the question, I'm simply not aware of any real issues.

If you look at PayPal itself having 100 million customers and merchants in the US and around the world, I'm not aware of issues that you talk about in terms of merchant of record.

Okay, great.

And just lastly -- your sense on April credit card spend trends.

Are they holding fairly steady?

Yes, I'd say April is holding steady with the second half of the quarter.

January was the strongest month on a year-over-year growth rate of the quarter.

And then it just seemed like things slowed down a bit.

We're continuing to see growth, year-over-year growth, but just not as robust as January.

It seems like that has continued so far into April.

Thank you.

Our next question comes from Bill Carcache with Nomura.

Please go ahead.

Thanks, good morning.

I was hoping you guys could give some commentary around the trajectory of capital actions for the rest of the year, in particular for the second quarter?

Last year you guys had a big spike in buybacks in Q2 from almost nothing in the first.

Wondering if it's reasonable to expect a spike in Q2 this year relative to the other quarters, at least?

Bill, I guess I would lean into my earlier comments and say we're not really prepared to provide a lot of guidance on that front today.

But the one thing I would say in response to your question -- your specific question -- is that last year's second quarter included a catch-up from our having been out in the market in the first quarter last year.

So I would say spiking was more related to that.

In terms of the year ahead, I would just point you again to my earlier comment that it's a two-year, $2.4 billion repurchase authorization, and I wouldn't expect us to approach that $2.4 billion in the next 12 months.

Okay.

And as far as the commentary that you guys have made on expenses, I was wondering if you could maybe elaborate on that a little bit?

So you made it clear that there is some opportunistic investments that you are making this year and that expenses would be elevated.

And I think everyone was expecting that update, yet they still came in a bit lower than expectations.

Wondering if, over the course of the rest of the year, is there any reason to expect there would be some lumpiness in that expense ratio from where it is this quarter?

Or how should we be thinking about the progression of that expense relative to this quarter over the rest of this year?

That's it.

Thanks.

Absolutely.

I think you raise a very good point.

It will be a little bit lumpy, Bill, is the most likely outcome.

I think $3.1 billion on the full year is the right way to think about it.

When David spoke earlier about our marketing expenses, he alluded to the fact that we pulled back on some planned direct mail for the quarter and a few other things because the response rates we were seeing on the other channels for IT were so strong.

So basically, what we did is, we've taken some dollars that we still fully intend to spend, and we pulled them out of the first quarter shock-and-awe campaign and we're spreading it out a little bit more to be maybe not a first quarter shock and awe, but an early part of the year mini shock and awe would be the right way to think about some of that.

With respect to other initiatives, I would say there aren't any that are going to be particularly lumpy through the year other than that marketing line item.

Next caller, please.

(Operator Instructions)

Our next question comes from David Hochstim with Buckingham Research.

Thanks.

I was wondering, could you tell us in the Payment Services P&L is there much in the way of PayPal integration expense?

Is that pretty much done this quarter?

Yes, I would say, with respect to PayPal, we definitely, as David mentioned earlier, are responsible for the acquisition side of that equation.

And so we are actively engaged in that and there are dollars being spent in that effort.

So what I would say is -- yes, in the Payments line item there are dollars being spent on PayPal at this point in time.

But I would say it's not just PayPal.

There are a number of different initiatives that we have talked about, I think -- and a number that we have not spoken about, if you will, that are underway in the Payment space right now that are driving some of that.

I would say it is a more broad-based approach to building out that business that is driving that expense line than it is PayPal driving that expense line.

Okay, thanks.

And then, could you just talk about the lumpiness in rewards costs?

How much lumpiness?

Yes, I would say for the full year, we still expect the rewards rate to be about 1%.

There is definitely going to be some lumpiness in that trajectory based on the timing of our 5% cash back programs and the way we are going to run those programs over the year ahead.

So what I would say is, quarter-on-quarter there's going to be some variability.

I think for the full year, though, what you should be looking for is a 1% rate is the target we're after.

Which quarter should we expect it to be substantially above 1% do you think at this point?

Well, I would think about higher amounts in the second half of the year.

So just as you saw us being -- I wouldn't necessarily expect it to be quite the magnitude of this past fourth quarter, but we tend to be heavier during the seasonal part of the year.

So I think higher in the second half than the first half.

Okay.

I had one more follow-up, above the limit.

Could you just tell us how much of a distortion there was in year-over-year growth from Leap Year day?

Was it about one percentage point, or two percentage points, do you think, in terms of --?

Yes, I think, we'll let you get away with it this time.

I would think about it as one day out of 90 days as roughly the impact.

Okay.

Thanks.

Thank you.

Our next question comes from Chris Brendler with Stifel Nicolaus.

Please go ahead.

Thanks, good morning.

Just a little more on the spending volumes.

Can you talk at all about your merchant acceptance initiatives?

Is that still -- I know you are spending a lot of time and effort in improving the virtual, the real merchant acceptance of making sure all merchants are aware that they do accept Discover.

Is that still additive to your spending growth at this point?

And then, also, if you could address PULSE?

I know you have some initiatives to re-energize the volumes there.

Should those start to kick in and help out the PULSE business in 2013?

Thanks.

I think I missed the second question, but on the first question I would think about -- well, increased acceptance is still clearly additive and a tailwind to us.

And that's true both in the US as we get the remaining merchants on board, as well as the international acceptance that has ramped up significantly in the past few years.

That being said, the remaining merchants in the US are mostly quite small, and so I think that I would expect it to, at this point, start to be really a diminishing tailwind because we, frankly, have gotten the -- we have prioritized the larger merchants and there's just not too many of them left.

Could you repeat your second question, please?

Just on PULSE -- I remember from Diane's presentation at the Investor Day she alluded to some new initiatives, some routing on Signature potentially that would help the PULSE volume, help to regain some of the market share after [recent] changes it seemed to have hurt that business starting this quarter.

Sure.

Well, I'm not prepared to talk in detail; it would be a longer conversation.

But certainly one of the things Diane pointed out is that we traditionally were a PIN debit network; and PIN was about a third of the market, order of magnitude.

And you saw us announce in a previous quarter, Cadence Bank, which was a Signature issuer, so we are clearly starting to add some Signature issuers.

We are also -- have taken close notice to what some of our competitors are doing and we're putting in appropriate responses to really try to provide options across our network for the full range of debit types, including, as you mentioned, Signature, not just PIN.

We are actively working with acquirers banks, making technological changes to pursue everything that we possibly can to get back into the share gain that we had, had for many years.

And I'd like to squeeze in one more, if I could.

Just on the Home Loans business.

It seemed to accelerate pretty meaningfully this quarter.

Is that business already profitable?

And can you expect the high volumes and the profitability to continue even under the potential that refis could start to slow down.

I imagine it's mostly refi at this point?

Thanks, and I'll stop there.

No problem.

We've said before that it is profitable, but it's a pretty small part of our profitability.

And like other loan origination businesses, we are certainly benefiting from the current significant refinance volumes.

And we do expect those to slow over time.

So we saw a slight slowing this quarter, maybe not as much as some others have so far.

But we are taking a lot of steps to get stronger in the initial purchase part of the market to enhance our cost structure and ability to remain profitable through other parts of the lending cycle.

Thank you.

Our next question comes from James Friedman with Susquehanna.

Please go ahead.

Thanks.

Mark, I wanted to ask also about some of these Payment Service investments, like 7 in your presentation.

A housekeeping question -- as we see return on those investments, should we be watching -- will it show up in Payment Service revenue?

Or is it in that network partner line item that you have in that separate disclosure?

Jamie, you are going to see it in both of those line items, is the way to think about it.

We are investing pretty heavily in initiatives that run through both of those items.

So what I would say is, without really talking about what they are, and given that a number of them are in the works and not yet public, I can't really do that.

I can't give you the breakdowns for how to look for it, but I'll tell you what -- as this starts to roll forward and as we talk about it in new initiatives that we make known, how about if we just go ahead and let you know where those are going to be reflected going forward?

Yes, that would be helpful.

We'd appreciate the disclosure.

And then, David, maybe if you could just talk in more human terms about the partnership with PayPal.

What are they like to work with as human beings, as technologists, as payments professionals?

Observations in that direction would be helpful.

Sure.

Well, just one follow-on to your earlier question.

One thing that helps us is that in the network business a lot of it is fixed cost and fixed infrastructure that we are leveraging.

And so that is one of the reasons that getting additional volume on it over time is helpful, and why you are not seeing much more massive investments despite some of these big opportunities that we have.

PayPal has been great to work with.

One of the things about them is that they are a payments company and we deal with a lot of partners.

But they are a strong technology company and they have been in payments for quite some period of time, and I think our teams have really enjoyed working with them.

I think one of the things that has been great is the fact that they have really recognized that we are experts at point of sale; and we are experts at a offline network, having built it over the last 27 years.

And we recognize that they are very nimble and they have some attributes that, together, I think, is helping us to really do some great things for consumers and merchants.

And so I think they are one of our most important and great partners to work with.

Okay.

I appreciate the commentary.

Thank you.

Sure thing.

Our next question comes from Moshe Orenbuch with Credit Suisse.

Please go ahead.

Great.

Thanks.

I was just wondering if you could talk a little bit about -- you mentioned a few things about marketing, saying you pulled back a little on mail because the other stuff is so good.

Could you talk about the efficiency of your marketing in this program, and what you see going forward, compared to what it's been in the past?

Because I think what stands out to me is that everyone else is making excuses as to why they're not seeing the growth.

Could you talk a little about what it is about marketing programs that you find successful and how they have compared to others?

Well, I would say that we are seeing better efficiencies both on the direct-mail side and the non-direct mail side, all the others on this.

And I think it starts with having just a great product.

And we believe that Discover IT is second to none in terms of consumer value proposition -- the rewards, the service, the fees, the services that IT provides.

And you see that in some of our marketing, where we are doing much more than we have in the past -- direct comparative charts that point out the fact that we think it's the best in the market.

And we're seeing customers respond to that and prospects respond to that.

So I'm very happy that I'm not in the position of having to make excuses.

I've been in the position of working really hard to deliver results.

Great.

And if you could follow up -- any metrics that you could share with us as to what the typical customer looks like when they come on, in terms of the credit line or balance of spending volume -- if you could frame that for us?

Well, as I told Betsy, I'm not prepared to give any specifics, but I would just repeat that, directionally, whether it's credit or usage or spend, we are seeing better performance with Discover IT than we did with the previous More card.

And I'm not so sure that it's as much getting a different customer base as it is getting more usage from these new prime customers.

So we're really excited about it.

And, Moshe, I would just kind of add to that, I guess.

The growth is not coming from issuing bigger credit lines.

Just to be abundantly clear, we continue to be real conservative in our credit-granting activities, and we tend to start customers out with a smaller line than most of our competitors would, to be honest.

Perfect.

Thanks, Mark.

Thank you.

Our next question comes from Mark DeVries with Barclays.

Please go ahead.

Yes, thanks.

First, I just wanted to clarify the comments around the margin.

Given the strong margin this quarter and the expectation for declining margin in the second, but then rising margin in the second half of the year, is it reasonable to expect, Mark, for us to see a margin at the end of 2013 that is higher than where it ended in 2012?

I'm not prepared to call that yet, Mark, but I would say it's a possibility.

I think the trajectory of credit from here and the interest charge-off impact on that will have some degree of bearing there.

Funding costs are rolling along a little bit better than we expected the funding costs were going to be rolling on at, quite honestly.

So let's just say it is a possibility.

Okay, great.

And then, on your Personal Loan segment.

Can you talk about how credit there, delinquencies and charge-offs are kind of tracking relative to your expectation?

And what impact, if any, the growth in that segment is impacting growth in your card business?

I'm sorry, that was a Personal Loan segment specifically, Mark?

Yes.

Exactly.

Yes, I would say, growth there right now is tracking in line with our expectations.

I think it's a business that managing prudently for profitability with moderate growth as opposed to managing with a key emphasis on growth is the key to success in that business over the long haul.

And that's indeed what we are doing.

I would say with respect to credit costs and performance, I would say it's a little bit better than last year.

And also probably a tad bit better than our target, as well.

Okay.

And then, any kind of cannibalization effects from that on your card business?

No.

You can't say there's not any, because certainly some of the people who consolidate their debt may have some Discover debt.

But what I'd say is that there is not a change, because we've been at this for now a number of years, and we've been growing it for a number of years.

So it's pretty steady state and the vast majority of the balances do come from external balances that consumers are consolidating to us, getting to not only a lower APR, fixed repayment term, paying their debt down over time to deleverage.

And that's what the product is designed to do and it's working well.

Okay, great, thanks.

Thank you.

And our next question comes from Jason Arnold with RBC Capital Markets.

Please go ahead.

Hello, guys.

Great job this quarter.

Just a follow-up on the Home Loan side of the equation.

I know that you talked about expanding into home equities, so I'm just wondering if you could update us there?

And then, also maybe comment on if you are seeing other mortgage opportunities, perhaps maybe more of an opportunity on the jumbo side, [with subs] still it seems to be some dislocation in that market.

Thanks a lot.

Yes, well, I would say that it's still our intent to expand into home equity later this year.

However, there are a lot of new rules of that have just come out that were focused on home loans but have some bearing on home equity, as well.

So we're continuing to go through there, look at the risk/reward; and there has been no change in plans.

But we haven't actually launched anything yet, so we are continuing to evaluate.

In terms of jumbos, that is also something we could certainly consider long term, but certainly would not expect anything on that this year.

I'd say our big focus in home loans is on the business that we've got -- the conforming Fannie/Freddie FHA; how do we best serve customers and grow that business; maintain -- or improve profitability -- and that is our biggest single focus.

Okay, great.

Thank you.

Thank you.

Our next question comes from Bob Napoli with William Blair.

Please go ahead.

Thank you, good morning.

Question on marketing.

I was wondering if you could give maybe a little bit of a better feel for the spread of the budget there?

How much of it is allocated to Discover IT versus, say, the mortgage business?

Are most of your originations on the card business now coming on the Discover IT product?

Bob, I would say, yes, most of the originations are now indeed coming on the Discover IT product.

And I would say the lion's share of the marketing dollars that are going out the door are going specifically to support the Discover IT product.

I think the answer to both those questions is yes.

There are some dollars being spent around some of the other products, as well.

But I would tell you they are not the drivers of the marketing expense line item and they're not going to be the drivers of getting to that $3.1 billion total OpEx for the full year.

And the one thing I would add is that what Mark said is actually true with the acquisition side.

There's also a substantial part of the marketing dollars that are targeted to our current customers.

As we offer cash back bonus programs, we have activation, balance transfer programs.

So that would go across primarily our credit card base.

Okay.

And then on the student lending business, do you remain confident in being able to replace the volume that you lost from the Citibank relationship?

Well, this was the first quarter that we were marketing entirely with our own brand, and I think you saw some pretty good originations doing that.

So I would say, I'd let the results speak for themselves.

We feel good about having maintained our volume with the Discover brand only.

Thanks.

And then, Mark, just a clarification.

You had said -- I wasn't sure; it sounded like you had said earlier that the credit outlook had improved and I'm not sure what you meant?

This was in your opening, part of your opening remarks.

If it had improved from the Investor Day or from year end or what you were referring to?

I would say the answer to that question is both/and.

I would say it has improved since fourth-quarter earnings and it has continued to improve post-Investor Day.

Thank you.

Yes.

Thank you.

Our next question comes from Rick Shane with JPMorgan.

Thanks, guys.

Two questions, one on marketing and one on credit.

First, on the marketing side -- I think that there has been a perception, and I'm sure you guys receive these questions about the pickup in intensity of marketing efforts that didn't necessarily, as we now see, translate into expense.

I'm curious if, with the Discover IT product, and the slight shift in that product, is there a greater geographic focus on the Northeast corridor?

And is that driving some of this perception?

No.

I think if you talk to folks in San Francisco or Miami or Atlanta they are going to also say they have seen a lot more of us.

It has not been focused on any particular part of the country.

It's been very much a national launch.

I think what's different is that we have been using much more -- number one, we have a great message to tell, so I think whatever ads you do get noticed a little more when you are saying something new and different.

And we've got specific news on billboards talking about late fee forgiveness or other things, they get noticed more.

But secondly, I think that lends itself to more the non-traditional media, some of the top line media like TV; and our marketing has been moving towards the Internet for years and so Discover IT works well there.

But I would in no way think that we blitzed New England or something on that.

It was very spread.

It's funny, because we have noticed a lot more radio and a lot less TV.

In terms of the credit, one of the -- it was in response to Brian's question, I think this is very interesting -- you basically suggested that the frequency of default is decreasing.

And so if you look at any individual consumer, basically what that suggests is that the probability of default, regardless of the severity of default, is falling.

Given that there is an optimal loss rate within the portfolio and it seems like you're below that, is there any shift in terms of risk profile?

Are you comfortable taking a little bit more risk if you think that systemically the frequency of default is lower?

Well, it's a good question, and certainly we have seen significantly lower delinquency rates and default rates.

And as you say, the frequency of both of those has come down a lot.

I would say that we have continued to try to refine our models to identify other people that would have prime-type behavior and would have low frequency of default.

And so to the extent that we can identify such enhancements in our models we will put them in place.

One of the things that Mark said in the text is that we have seen probably more of an improvement off of the base, and this may be partly because of the maturity of the base, the fact that we've held onto the customers, and the fact that the people that are at the margin were riskier may have already written off during the difficult times a few years back, and what we are left with is people that have extremely low default probability.

That doesn't fully translate into new accounts, because I don't think we've seen quite the same reduction in that for new accounts.

And, therefore, I think we have remained fairly cautious on trying to expand.

We're going to be careful not to expand too much for new customers based on the behaviors that we have seen with customers that have been with us for 5, 10, 15 years.

David, that's very helpful.

I appreciate the distinction.

Thank you.

Our next question comes from Scott Valentin with FBR Capital Markets.

Thanks for taking my questions.

The first question revolves around student loans.

The CFAB has put out for comment, I guess, some comments or request for comment on servicing.

I understand they have been out talking to all the major student lenders.

Just wondering if you have any initial thoughts on whether it will have any impact on servicing?

Whether it may drive expenses for servicing a little bit higher?

And I have a follow-up.

I really don't have a comment on that.

Certainly, student loans is one of the important areas that the CFAB is looking at and we would be fully cooperative, and I haven't seen anything that would guide me one way or another on what it will mean down the road.

Okay, and just to follow up on the transaction volume.

I think you pointed out in the fourth quarter you had a higher rewards level versus the first quarter.

Just wondering if maybe that's a real part, if you think that's a real part of the slowdown in spending over the course of the quarter?

Or whether you think it was more macro driven?

Our large fourth-quarter promotions actually ran through December; and, I guess, the fact that our sales continued to be very strong in January after we were into the first quarter promotions would suggest to me that the change is more macro than it was with our programs.

Okay.

Thank you very much.

Our next question comes from Sameer Gokhale with Janney Capital.

Sameer, please go ahead.

Thank you.

Most of my questions have been answered.

I guess a couple of them -- number one, I just wanted to get a sense for how actively or aggressively you might be marketing the Discover IT card to your existing customer base?

I know you said there were more positive responses and dynamics associated with that product maybe relative to your other products.

So it seems like Discover has been a leader in terms of brand loyalty and I've had my Discover card since 1995.

One of the issues used to be, you have the long tenure, but you need to stimulate spending.

Clearly, you focused attention on that.

But it seems like marketing the Discover IT card aggressively to your existing customer base may make sense.

So just wanted to get a sense for that.

And then I just had a separate question.

Well, first, thank you for being a loyal customer since 1995.

I would say that our primary focus has been on originating new to Discover customers.

We certainly make it easy for anyone who wants to switch to do so.

But, frankly, our More customers, like you, have been really happy.

We just won the Brand Keys Award for customer loyalty for the 17th year in a row for our industry.

And so our current customers are quite happy generally.

And I think we see our bigger opportunity to attract some of the other consumers who may not have experienced the service and rewards that Discover offers to the Company.

And that's where we are focusing our marketing efforts on Discover IT.

But, David, just along those lines, there is a difference between having the card for a long time and using it for spending.

So over time, have you seen a significant improvement in stimulating spend for those folks?

Can you give us some striation for people who've been with you for15 years, 10 years, what the incremental lift in spending has been over time?

Because I think that was one of their areas you might have been focused on.

So is there any data you can share with us to show if there's been an improvement in actual usage among those longer-tenured customers?

Well, absolutely, we've had improvement in usage, activation, balances from long-time customers; from lots of different activation efforts as well as from their experience with us.

As an example, customers -- when you came on in -- a number of years back -- at that time we didn't have the broad acceptance we have now.

So you have probably increased your usage just because of acceptance.

Our rewards -- we've added the 5% program and many other things.

We've chosen to keep all of our customer service in-house, onshore, unlike other competitors.

So we've had lots of activation efforts.

Over time will we -- if we see a way to stimulate more usage from current customers by cross-selling IT or what have you, we will do that.

But right now the IT is really focused primarily on new customers, and the current customers would probably be a potential incremental opportunity down the road.

But we're pretty busy with new customers right now on that part.

We've got lots of other efforts for current customers.

Got it.

And then, just the other question that I had was on student loans also.

I know that we simply, you have basically said that on new student loans you're not going to be charging any late fees or returned check fees.

And, clearly, that seems to be consumer friendly, but was that something done on the prompting of the CFPB?

And when you think about it competitively, there are only you and a couple of other guys who are really players of any given size in the student loan business, so why reduce some of your fee generation opportunities when your competitors will likely match that, and then you're just reducing profitability?

Why not just leave the model as is?

If you could talk to that, that would be helpful.

Sure.

Well, that was purely our decision.

There was no external prompting whatsoever.

But we, obviously, did it because we felt that it would be good for our business going forward.

I don't know whether competitors will match it or not.

But we certainly think it makes our product even more attractive to students and parents.

And with pretty low delinquency rates anyway, with the way we underwrite, it wasn't -- it's just not that big -- it wasn't a big revenue producer anyway.

So we felt like it was a good business decision for us to do it.

So we're excited about it going forward.

Got it.

Thank you.

Our next question comes from Chris Donat with Sandler O'Neill.

Please go ahead.

Good morning.

Thanks for taking my call.

Just one quick question on the reward spending, which was -- or the rewards as a percentage of sales.

Since it was elevated in the fourth quarter, you commented at the time that, that was something that was positive in the sense that it drove higher customer engagement.

And then, as was commented earlier in this call, was how sales drop off a bit, but like David said, it was strong in January.

I'm just wondering how we think about this going forward as a way -- do you feel like you are being gamed by customers at times?

Or does it -- is the engagement really sticky there for these 5% quarterly programs as you rotate through sectors?

What I would say -- I never think about things as gamey, and I think about things as customers taking advantage of great things we have to offer.

And we are constantly evaluating how much usage, how many enrollments, what it does to behavior within the category we are stimulating.

What it does to behavior after the category.

What it does both during the time of promotion and after the time of promotion.

And so I would just say -- generally, we've been incredibly happy with the 5% program that we pioneered and have offered and enhanced over the years.

And we're going to continue -- it is a promotional program, so we change it every quarter, and every year.

And we are constantly evaluating how to make it more effective and even better and easier for customers.

And a lot of it is not about the rate, it's also how easy is it to redeem, how can you redeem with various partners, what categories is it in during what type of the year.

We've got customer service people that actually work with our customers to help them maximize the benefit.

And so it's kind of an all-encompassing program that we will continue to refine and enhance.

Okay, so if I thought -- and I could be wrong here -- but if the reward program was maybe too rich in the fourth quarter, you've got a number of dials besides -- a number of dials you can turn to adjust it if that's your perception too?

One of the unique things in the fourth quarter, we usually do a program by category and we had two huge categories.

We had stuff you buy on the Internet and stuff you buy in department stores for 5% during the holiday season.

And so that was probably by far the richest program we had offered.

I think more normally we would offer one category, not two at a time.

But we were in a big push in the fourth quarter and we got even more take-up than we originally expected from it.

And, Chris, I would say -- look, from the very heart and specific point of your question, yes, there is a group of customers who do -- who will tend to game this process.

All the spend, if you will, on the card that quarter is in the 5% category that quarter.

It's a very small percentage of the overall base.

Got it.

All right.

Thanks very much.

Thank you.

Our next question comes from Daniel Furtado with Jefferies.

Good morning, everybody.

Just a quick question.

What is your gut telling you is the root cause of the moderating spend we've been seeing over the last couple months?

Well, my assessment is that it is in line with what I'm seeing retailers generally report.

So I think our spend is market environment.

And so if you go from that, okay, is it taxes, sequester?

I don't have any additional data to say what exactly is causing consumers to spend a little less.

It's not huge moderation, but it definitely seemed to be a little bit lower, as I said before, later in the quarter versus earlier.

You've seen a bit of consumer confidence drop off and certainly there have been a number of negatives from a consumer perspective.

But how much is the news about Cyprus impacting how consumers feel versus the taxes is a little hard to parse out.

Even lower gas prices is a good thing for consumers, but actually causes a bit of a downtick in spending.

Understood.

Thanks for the commentary.

Thanks, Daniel.

Our final question comes from Ken Bruce with Bank of America.

Please go ahead.

Thank you.

Good morning.

My question relates specifically to the balance transfer part of your business.

You clearly have had a lot of success in terms of growing balances using this particular product, and you provided some good context for how you are filtering on credit.

I think I'm really interested in what your success is in actually retaining those balances as you roll off the teasers.

If you can talk about retention and attrition and specifically what your strategies are to improve that as you go through, please?

I'm not going to be able to give you specifics; and, frankly, there's lots of segments.

There's new customers, current customers, there's different durations, different rates, and we're looking at every cell to understand whether it is adding value or not.

And then we're making adjustments.

And so we feel good about the efforts.

One thing to recognize, Ken, is that while the majority of the 18% is balance transfers, as you think about them, there is a non-trivial part that is actually retail promotional rates and we do add those two together when we give you the 18%.

It's really total promotions of BT plus retail promotions.

But there is significant financial discipline around the planning, the administration and the analysis.

And, frankly, it also is changing over time.

We see consumer behavior change a bit, depending on what's going on in the environment, the interest rate, the competitive environment.

So even if I could give you something for a given cell at the current time, we may find in six months that we're seeing a bit different behavior.

And are you able to react to how these consumers behave, so when you see certain behavior, whether that be good or otherwise, you can effectively create a campaign that effectively uses that behavior to your benefit?

Or is this something that you can observe it and, I guess, make some general changes over time, but you just have to see how things manifest themselves over time?

Well, I think there's not a lot one can do for something that's already out there.

But I think when we observe behavior and measure it, it feeds directly into all of our new offers.

So every month and every week we are determining who to offer what to.

And so it affects the incoming volumes and terms based on the learnings of people that went before them.

We do an awful lot of testing, too.

We'll do testing control and some of the things we try work, and some of the things we try don't work.

The reason we offer promotional rates is to get people to try our product and then use our product on an ongoing basis.

If we're getting trial but no usage that's not what we want to do.

We want long-term loyal customers.

Right.

Okay.

Thank you very much for your comments.

Great, thank you.

All right, thank you, everyone, for joining us this morning.

Feel free to call Investor Relations if you have any follow-up questions.

Take care.

Thank you, ladies and gentlemen.

This concludes today's conference.

Thank you for participating.

You may now disconnect.