發現金融 (DFS) 2013 Q3 法說會逐字稿

Welcome to the third-quarter 2013 earnings call.

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

(Operator Instructions)

Please note that this conference is being recorded.

I would now like to turn the call over to Mr. Bill Franklin, Investor Relations.

Mr. Franklin, you may begin.

Thank you, Robert.

Good afternoon, everyone.

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

Let me start on Slide 2 of our earnings presentation, which is on our website and we will be referencing during the call.

Our 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.

The 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 today in an 8-K report and on our Form 10-K for the year ended November 30, 2012, and in our Form 10-Q for the quarters ended March 31 and June 30, 2013 which are on our website and on file with the SEC.

In the third-quarter 2013 earnings material, 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 presentation 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.

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

Thanks, Bill.

Good afternoon, everyone, and thanks for joining us today.

After the market closed, we reported third-quarter net income of $593 million, or $1.20 per diluted share, with a return on equity of 23%.

EPS was down versus last year, as the prior period included a large reserve release.

Excluding the impact of reserve actions and one-time items, core earnings per diluted share increased by 12% over the prior year, driven by loan growth and share repurchases.

During the quarter, we returned approximately [$450 million] of capital to common shareholders through share repurchases and common dividends.

Card receivables grew 4% over the prior year, which, along with a combined 11% increase in private student and personal loans, drove total loan growth up 5%.

These results show that in a tepid economic environment, Discover continues to achieve profitable loan growth.

Card sales volume for the quarter was up 3% over the prior year, but on a day-adjusted basis sales were up over 4%, in line with card loan growth.

Increased wallet share and new accounts continue to drive card loan growth at the upper end of our targeted range, despite tougher comps.

Discover it is generating good response rates and resulting in a more purchase active card member with less reliance on balance transfers at acquisition.

We expanded our product suite by launching Discover home equity loans in August.

While it will be some time before this product contributes to the bottom line, launching the product at this point in the housing recovery makes sense.

We were also pleased with the origination volumes in student and personal loans.

Private student loan origination volume is on track to overcome the absence of the CitiAssist brand, which made up nearly half of the originations in 2012.

Through card, student loans, personal loans, home loans, and online deposits, Discover is offering consumers a broad spectrum of financing and savings alternatives to meet their needs.

In payments, year-over-year total dollar volume growth slowed as PULSE volume decreased by 2%.

Diners volume also decreased 7%, mainly due to the impact of currency exchange rates.

The debit environment remains dynamic, especially with Judge Leon's ruling which will likely slow down the rate of new deals signed in the industry.

This, combined with the economic environment in Europe and potential pressure on Discover network partners' volume as we mentioned last quarter, continues to keep our near-term outlook for payment services muted.

However, we remain optimistic about the segment's long-term potential.

Overall, our results for the quarter were positive, as we once again exceeded the industry average card loan growth, organically grew revenue, and charge-offs continued to improve, producing an outstanding return on equity.

Now, I'll turn it over to Mark who will walk through the details of our third-quarter results.

Thanks David, and good afternoon, everyone.

As I've done in the past, I'll start my prepared remarks by going through the revenue detail on Slide 5 of the earnings presentation.

Net interest income increased $122 million, or 9% over the prior year, driven by loan growth and a higher net interest margin.

Net discount and interchange revenue increased by $23 million year over year, or 9%, due to Discover card sales volume growth as well as a lower rewards rate.

The rewards rate was slightly lower compared to the prior year, but increased sequentially from 86 to 98 basis points, driven by the timing of promotional cash-back programs.

As we've said in the past, you should expect to see quarterly fluctuations in the rewards rate as we look to further engage our customers and drive profitable sales.

Protection product revenue declined by $14 million over the prior year, due to the discontinuation of new product sales in late 2012.

Other income decreased by $58 million, due to lower direct mortgage-related income and the inclusion of a $26 million gain on sale of a minority investment in the third quarter of last year.

As expected, Discover home loan originations slowed down during the third quarter, as rates increased and re-fi volumes decreased significantly across the industry.

After the quarter end, we eliminated some positions to better align our cost base with lower mortgage volumes.

As we've said before, home loans are a key direct banking product for Discover.

But, due to the relatively small size of the business, they have been and they will remain relatively immaterial to our overall earnings profile.

Payment services revenue decreased 11% year over year, mainly due to lower transaction processing revenue for PULSE.

Turning to Slide 6. Total loan yield of 11.29% declined 10 basis points over the prior year, mainly due to card yield compression.

This year-over-year compression was split between an increase in promotional rate balances and a decline in higher rate balances.

Lower funding costs, and to a smaller degree lower interest charge-offs, more than offset this yield compression, resulting in a 25 basis point increase in net interest margin over the prior year to 9.64%.

Operating expenses, as shown on Slide 7, were down $58 million, or 7%, over the prior year.

The increase in employee compensation was primarily related to higher headcount to support growth, as well as new product initiatives.

Despite maintaining higher advertising in support of the IT card, marketing expense remained flat with the prior year.

Other expenses were down $76 million, as the third quarter of 2012 included a $96 million addition to legal reserves.

Operating expenses for the payment services segment increased by $10 million over the prior year, mainly due to increased operating costs associated with Diners.

This increase in costs is primarily related to the second quarter Diners acquisitions, which will continue to have a modest ongoing operational drag for some period of time.

Overall, I remain pleased with our expense control, as we managed our expenses in line with our target efficiency ratio of approximately 38%.

Turning to provision for loan losses and credit on Slide 8. Provision for loan losses increased to $197 million from the prior year, driven by an increase in loan loss reserves.

Our reserve build during the quarter mainly reflects two things.

First, lower expected recoveries on well-aged charge-offs, and second, loan growth.

Since we didn't sell any of our charged-off accounts during the recession we experienced strong recoveries on a large inventory of charged-off accounts as the economy improved.

As we get further away from the recession, the benefit of these elevated recoveries is diminishing.

You can see this slow decline in the recovery rate in our trust filings over the last year.

So the key takeaways with respect to the reserve build in the quarter are that, first, we're growing our receivables base well; and second, we aren't refilling the charge-off bucket at a rate sufficient to maintain recoveries at the levels we have seen over the last several years.

To be abundantly clear, our credit outlook for cards remains relatively stable.

Sequentially, the credit card net charge-off rate decreased 29 basis points to a record low 2.05%, and the 30-plus day delinquency rate of 1.67% remains fairly close to the record low established last quarter.

The private student loan net charge-off rate, excluding purchased loans, increased 59 basis points from the prior year, due a larger portion of the portfolio entering repayment, and decreased sequentially by 25 basis points due to seasonality.

Student loan delinquencies, excluding acquired loans, increased 22 basis points sequentially to 1.6%.

Switching to personal loans, the net charge-off rate was down 23 basis points sequentially, and the over 30-day delinquency rate was 0.65%.

The sequential decrease in the personal loan charge-off rate was primarily driven by growth.

Moving to Slide 9. We returned $450 million of capital to shareholders, grew total loans by 5%, and ended the quarter with a strong Tier 1 common ratio of 14.7%.

Our outlook for the rest of 2013 remains relatively unchanged.

Looking forward, we expect the credit environment will remain benign, net interest margin will remain elevated, and we will continue to remain disciplined with our expenses and our investments for growth.

That concludes our formal remarks.

So I'll turn the call back to Bill.

Thanks, Mark.

(Caller Instructions)

Robert, we'll take the first call.

Thank you.

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

(Operator Instructions)

And our first question comes from Sanjay Sakhrani from KBW.

Please go ahead.

Thank you.

I was wondering if you could just talk about charge-offs.

I think it sounds like you guys expect gross charge-offs flattish for the foreseeable future, but recovery rates to decline, causing some mild pressure on net charge-offs.

Is that right?

And then on the recovery rates, could you just talk about what a steady state recovery rate looks like and how long we'd probably take to get there?

Because I look back, and it looks like the recovery rates used to be around 90 basis points versus 120 basis points year to date.

Thanks.

Yep, Sanjay.

If I don't catch all that, use your follow-up to bring me back to it.

I would say with respect to charge-offs, I would take you back to our earlier commentary.

We believe the credit environment's going to remain relatively benign.

The key issue that caused the reserve build with respect to charge-offs this quarter, again was very clearly what we perceived to be something good, and that is that our current book is not having enough migration into the charge-off buckets to replace the level of recoveries that we've been enjoying from the large block of unsold accounts post the recession.

So realistically, I would say benign credit environment with no turn in sight as we see it right now, absent some exogenous variables is kind of what I'd be thinking about.

In terms of normalized recovery rates, I would say the number you used in normalized terms is probably a pretty decent number.

I think the bigger challenge is, we obviously aren't in normal times at this point in time.

So it's kind of hard to say exactly where it's going to be.

None of us in our working lives have ever come through nor been in an environment like we're in today.

But that's as good a number as any to use on a normalized basis, I would guess.

Thank you.

You bet.

Our next question comes from Mark DeVries from Barclays.

Please go ahead.

Yeah, thanks.

Actually wanted to follow up on the charge-off question.

I'm just kind of wondering about the broader need to take up your reserve rates this quarter when, granted delinquencies were up Q over Q, but they're actually up less than seasonality would normally dictate, suggesting you still may not even have found a trough yet for charge-offs.

Could you talk a little bit more about that, Mark?

Sure.

Yeah, we -- just to remind everyone, we set our reserves on a 12-month forward-looking basis.

I know one of the key metrics you guys all have to look at is that reserve coverage ratio that's more of a rearward-looking metric.

Just to remind everybody, we don't focus on that all.

It's not a factor in our reserve setting decisions or discussions.

As we look at what's going on, I would again echo the comments that we see a very benign credit environment.

We don't see any situation where there's any type of a meaningful deterioration in credit in the near-term horizon at all.

I would say the reserve increase itself is driven again by those two primary factors I noted before, specifically just we're not refilling the recovery buckets, so the net charge-offs will increase, if you will, as opposed to the gross charge-offs because you'll lose the benefit of some of those recoveries.

But I don't think that's a fundamental turn in credit by any stretch of the imagination.

It's losing the benefit of those accounts we didn't sell at the peak of the recession.

And then I would say secondarily the other thing driving it is asset growth.

We have been the only folks driving significant asset growth in the card industry now for a period of years.

And ultimately the cumulative effect of that is you have to provide for that growth as those loans season.

Again, I think that's a good thing.

Got it.

And then I've got a follow-up on inorganic asset growth.

Sallie Mae in their earnings call last week commented that they were looking at a private student loan portfolio.

Without commenting on any specific opportunities, although feel free to if you'd like, is that something that would interest you, potentially adding private student loans that are out there to your portfolio?

Yeah, I can't comment specifically.

I guess, Mark, what I would say is that we're always on the lookout for good opportunities for our investors.

And if we saw some of those type things, we would clearly look seriously at them.

Great.

Thanks.

Our next question comes from Craig Maurer from CLSA.

Please go ahead.

Hi.

Thank you.

Speaking of good opportunities for investors, I was curious, your network for quite a while, looking at the different assets, Discover seems to be lagging the major peers we look at in terms of volume growth.

Diners is certainly lagging.

PULSE is hurting.

With it only contributing $28 million to the bottom line, I mean, what's the thought process regarding not monetizing that network through a sale and converting over a major network like Visa or MasterCard where you double your acceptance and likely increase your sales?

I'm struggling with this.

Is it the opportunity that something like Paypal brings, or what are we looking at?

Because continually it seems like in the near term or even the medium term, perspectives are kind of bleak for the network.

Well, I wouldn't go quite that far, Craig.

I'd say for a period of probably five years plus, we were gaining share if you look at what happened, what PULSE's track record was in debit and the purchase of Diners Club, but our profits have been growing quite significantly, and it's really been only the last two quarters that you've seen us really take a hit on growing PULSE, and we've talked about some of those issues before.

So I wouldn't want to take any decisions based on the business in a very short time period.

You did mention Paypal, but there's a number of other deals that we've signed, with Ariba, we're doing some interesting things with Facebook and Amazon.

We're doing other networks around the world.

We've been planting a lot of seeds for the future, and as we have built out acceptance and been extending our product line and partner set, we are very optimistic in the long-term potential for this business.

So I guess that's the short term pressures on PULSE don't change that at all.

Okay.

Thank you.

Our next question comes from Chris Brendler from Stifel.

Please go ahead.

Hi, thanks.

Good afternoon.

My question is on the Diners Club network, and can you just give us any more detail on what's going on in Europe and the Diners Club franchise as a whole?

Volumes seem to be going the wrong way, and the revenue impact seems to be even worse.

Any more you can tell us there, and how long do you expect this drive to continue?

And then just a follow-up on the charge-offs and the reserve build.

I just want to ask, is there a change in your forecast that happened with respect to recoveries on these older loans, or is just the pull?

Because it seems like when you build reserves, you're taking a forward-looking metric.

I'm wondering if there's a change in the behavior of some of these older loans, or just the fact that the portfolio of loans has shrunken enough?

Thanks.

On Diners, there's a couple factors.

The first is, the most important factor for us when we purchased Diners was it allowed us to become a global network with global acceptance, and to have -- to facilitate signing additional deals, net to net, to allow our card members to use their card globally versus just in North America, as had been the case in the past, and we're very pleased with how dramatically our acceptance has widened around the world.

In terms of Diners itself, it's relatively immaterial to the overall Company, but it's taking a number of hits.

Obviously, we mentioned exchange rates moved against us during the quarter, which was a factor.

We have a number of franchises that are struggling.

I think that's particularly the case in Europe where there's a lot of institutions struggling with liquidity issues and so on.

But also Citi has continued to divest some of their franchises that they historically issued on, and that's been a headwind.

Meanwhile, we've signed the largest issuers in China, India, and Russia in the last year, and those kinds of deals take a while to kick in.

So we're facing some headwinds and we've got some what should become tailwinds over time, not yet kicking in.

So we continue to manage that very well for both the short term, minimized any losses, but for the long term to get some of the benefits of truly having a global differentiated network that's fairly unique in the world.

In terms of the pool of recoveries, let me try it a little bit different way.

To some degree, we've been growing far faster than the industry, and so we've been having to essentially set aside loan loss reserves for growth over time.

That's continued.

We've also seen over time a gradual reduction in recoveries, and that's continued this quarter.

What those two factors had been covered a year ago by the dramatic improvement in delinquencies and charge-offs overall.

So they've been swamping those first two factors.

Remember, it's really an improvement in charge-off outlook and delinquencies that causes a reserve release.

So even if you just flat line and stop improving, or slow improving, you don't have a large release that covers the two factors that we called out this quarter.

So I would think about the lack of improvement, and when you get down to 2% charge-offs in the credit card business, it's hard -- you're just not going to improve forever.

Yep.

[Actually] that's impressive and I've been modeling reserve increases for a while.

Thank you for the color.

Our next question comes from Ken Bruce from Bank of America-Merrill Lynch.

Please go ahead.

Thanks.

Good evening.

My question relates to the what has been a very impressive net interest margin for the last several quarters.

I guess I'm trying to reconcile a couple different statements that you made, David, specifically around Discover it and the pick-up that should have, in terms of having growth without the use of teasers, yet the promotional rates are still moving higher.

Can you just kind of reconcile in terms what's driving the yield here within the credit card portfolio specifically, and how you see those offsetting aspects of promotional balances and Discover it playing out over the next several quarters, please?

Ken, it's Mark.

What I would say is with respect to NIM, specifically as it relates to those promotional balances, I would say the Discover it card member is coming on with a much lower level of promotional balances.

What's keeping the overall level of promotional balances higher is portfolio BTs and portfolio promotional activity as opposed to the new card member acquisition on the it card side.

So the it card member continues to be significantly more engaged, and continues to come on at very low CPA with much more active behavior and requiring much less promotional stimulation, I would say, than we've seen in the past.

So as I look at NIM more broadly going forward, I would tell you as we look to the fourth quarter I see room where NIM could be up slightly from the level we're printing in the third quarter.

Beyond that, I think I'll reserve judgment until our Investor Day where we'll give some broader commentary beyond the fourth quarter.

The one thing I would be remiss if I didn't do is to remind everybody that the model is built over the long haul to deliver an 8.5% to 9% margin.

We're clearly operating well north of that today, see an ability to continue doing that for some period of time.

And just as a follow-up in terms of the cost of funds, that's obviously been a big release valve for NIM as a general point.

Can you maybe discuss what your incremental funding options are and what those costs are so we can begin to factor that into our calculus, please?

Yeah.

I would say the fundamental channels we're leaning into are obviously going to be the consumer deposits channel directly.

That one is always a winner for us because it comes with a customer attached to the other side and builds synergy between the right- and the left-hand side of our balance sheets.

And it also, again, comes with a customer you can cross-sell to.

The other big channels we're using obviously are the ABS channel, as well as the bank note channel.

To a lesser degree, we use the broker deposit channel as well, really more around the edges at this point in time.

We've been shrinking that book over time.

In terms of the potential impacts and everything else, I would point you back to the schedule from our Investor Day presentation that's out there on our website.

It's got the upcoming maturities as well as the rates associated with those maturities.

And I would assume no major gigantic shifts in mix over the near term, and you can just use your market rates to plug into your models there.

Okay.

Thank you.

You bet.

Our next question comes from David Ho from Deutsche Bank.

Please go ahead.

David?

And David, your line is now open.

Good afternoon.

Can you hear me?

Yes, David.

Good afternoon.

I want to touch base on the non-card growth in personal loans, and maybe touch base on some of the early indications you're seeing on the home equity installment loan side.

What the dynamic will be with home prices increasing and personal income levels rising?

How do you see that kind of mix playing out maybe in the medium term?

Well, I think in terms of personal loans, we've seen good opportunities to have quite strong growth.

It continues.

We continue to see consumers deleveraging and wanting to pay down debt, consolidate loans and pay down debt over time, and so that product has continued to be a very big winner for us.

I'm also pleased with the growth of student loans.

It's been more modest growth, in part because we needed to replace the Citi brand.

But the fact that we've gotten the kind of originations we have while replacing that brand that a year ago represented half the originations, I feel very good about.

Home equity, it's really way too early.

I think we'll probably have a lot more to talk about at Investor Day with that because we're just out for the last two months.

We feel very good about the timing, because home equity the consumers have in their homes is now starting to grow, both from pay-downs and real estate pricing recovering.

I think that consumers are going to, in a rising rate environment, are more likely if they need home equity to take out a home equity loan versus refinancing their whole first mortgage, given that they may have already locked in at a lower rate for their first mortgage.

And it fits very well.

So we've got -- I feel very good about the launch so far, the pipeline, and where we stand, and maybe we'll have some more metrics for you by the time Investor Day comes along.

Great.

And just one follow-up, I just want to talk about competition you're seeing in card.

You mentioned before that you're seeing a lot of competition in the rewards space.

You've seen any acceleration in terms and conditions or pricing over the last couple months?

No.

We've had very strong competition in cash rewards for several years now, and I think we do see in any given quarter or year, one competitor will tend to get stronger while another one is backing off and vice-a-versa.

But I think if I think about -- as I think about overall the level of competition, it's been high.

It's been sustained.

And I expect it to continue to be sustained at this kind of level.

That's one of the reasons we're so excited to launch Discover it, is to be the best competitor out there, and we've certainly been pleased with our results.

Thank you.

Our next question comes from Bill Carcache from Nomura Securities.

Please go ahead.

Thanks, good evening.

You haven't added receivables to your trust fin some time, so it's hard for us to see how loss curves look for some of your more recent vintages.

I was hoping you could maybe share with us what peak loss rates you're seeing on, say, the 2011 vintage, which should be nearing peak levels now?

So we can get a sense of how the trajectory of your charge-off rates is shaking out.

Bill, I would say we haven't provided color on that in the past.

We'll take that under advisement as we look forward to our Investor Day coming up in the springtime.

What I would say is they are performing in line with our expectations.

We're not seeing any development, any loss development that is deteriorated from the expectation we had at the time we originated those credits.

Okay.

And can you say whether 2012 is directionally trending better than 2011?

I guess I'm trying to get a sense just directionally.

I think what I would say to kind of get back to the question again, we haven't provided color on that so I want to be careful about how and when we do that.

What I would say is that harkening back to our expectations for the credit environment, it remains very benign.

The new vintages are performing absolutely in line or better than our expectations, and the reserve actions this quarter don't have anything to do with any adverse development under any of those vintage curves.

Okay.

Thank you.

That's fair enough.

Lastly, can you talk about the 5% cash-back bonus program that you currently have in place for online shopping, how that's going?

And perhaps also talk about the change relative to last year, which also included retail?

Just trying to get a sense for what kind of impact the exclusion of retail could have and how we should be thinking about that.

Thanks.

Well, I think we're pleased and so far meeting expectations.

I think that it is more typical for us to have one category versus multiple categories.

So I'd say probably a year ago was more the aberration, and so we're comfortable that we can continue to stimulate our base with Internet.

Also, I would just say that Internet has grown a lot even this year versus a year ago in terms of how much consumers are using it.

So that's probably a more important opportunity for consumers, given the growth in the Internet space.

Thank you.

Thank you.

Our next question comes from Betsy Graseck from Morgan Stanley.

Please go ahead.

Hi.

Can you hear me?

Yes.

Hi, Betsy.

Hi.

Couple questions.

One is just on spending growth.

Came in at 3.2% year on year in third quarter, and that is a little bit different from some of the peers.

Your spending growth came down from second quarter, which was 4.4%.

I'm just trying to understand what might have driven the deceleration in the growth rate in spending.

Well, I'd say, Betsy, if you day adjust it, it was about 4% which was pretty on top of our loan growth, and that's been true for us over the last several quarters, that our loan growth and our sales growth have been similar.

And I haven't seen any particular trend.

I mean, obviously with the government shutdown and so on, we had been looking for, is there anything going on with consumers, and I really haven't seen anything.

When I look across competitors, I'm seeing some up and some down from their run rate, but as a generals prospect, we're seeing the same thing.

Competitors are not growing their loans but they're growing sales, and they appear to be to a much larger degree than we are, going after transactors.

And then on the -- okay, thanks.

The follow-up is just on the expense side on marketing, down obviously 6% Q on Q. I would -- is it fair to expect that you would be ramping that up into the fourth quarter, and looking to drive up the spending growth rates?

Yeah, Betsy, I think that's a pretty fair assumption.

We definitely tend to take them up in the second half of the year and the fourth quarter tends to be a big time on the marketing side.

What I would say is we put out some revised guidance around total expenses last quarter at $3.2 billion.

I would tell you I still feel good about that.

I don't see any reason that we won't be able to accommodate that level.

Okay.

So if you're taking up marketing expenses in one place you might be lowering it elsewhere, that's your point?

Or non-marketing expenses elsewhere, yes, correct.

Got it.

Okay.

Thanks.

Our next question comes from Moshe Orenbuch from Credit Suisse.

Please go ahead.

Great.

Thanks.

I was wondering if you could talk, Mark, about whether the reserve rate, in other words, the percentage of loans is likely to be increasing?

I understand the things you talked about, I guess, as we go forward.

Is that likely to be a higher percentage of loans as we go into the fourth quarter and 2014?

I would say at this point in time, don't see it being a meaningfully higher percentage of loans as we head on in.

Again, I would drive you back to the earlier comments that everything we're seeing in the portfolio right now is consistent with a benign credit environment, and the factors affecting the reserve this quarter are really those more exogenous factors related to the fact we're growing the receivables base well and we're getting seasoning under those curves, as well as the fact that we aren't generating enough new charge-offs to refill the bucket to be available for use in recoveries.

Got you.

As a follow-up, David, I'm sure that if you wanted to kind of spur additional volume from people that are transactors you could do it.

Could you just talk about the thought process?

What are the benefits or the risks of actually trying to do that?

Well, what I'd say is that we follow a very disciplined process to not just chase volume growth but to deliver profitable customer relationships, and that means that the best opportunities tend to be people that at least have some propensity to occasionally revolve, because the primary revenue producer in the industry and for us continues to be the net interest margin whereas the interchange, by the time you cover rewards and expenses is a much smaller piece.

We also are keeping very disciplined, because I think transactors look particularly good to some people today because we're in such a low cost of funds environment, and obviously in a different environment the cost of float is something that changes those dynamics a lot.

So we will continue to evaluate it and make sure there aren't some additional incremental opportunities to go after people that are more transactor-based, or have higher sales.

But if you look at our track record on growth on loans and return on loans, we're best-in-class on both of those two factors, and that's good because those are the two things we most try to optimize.

Great.

Thanks very much.

Our next question comes from Sameer Gokhale from Janney Capital.

Please go ahead.

Hi.

Thank you for taking my question.

I guess just one of the things I was trying to flesh out, and you did talk about it at length, but just one thing I wanted to clarify in terms of that recovery rate, should we think of it this quarter there was just kind of a one-time true-up to your recovery, [extra] recovery rate and then going forward, all else equal, it's going to be more -- provisioning is going to be more a function of your loan growth, is that the way to think about it, that there was kind of a one-timish element from a recovery standpoint this quarter as you trued-up the reserve for lower recoveries?

Am I thinking of that correctly?

I think what I would say, Sameer, is the situation obviously continues to evolve.

I'd prefer not to go into a conversation of quarter-over-quarter changes in reserving estimates specifically at this point in time.

I think we don't know what we'll know as the quarter moves forward, and we'll set our reserves based on the best information we have near the end of the quarter as opposed to trying to guesstimate what that's going to be right now.

What I would say is that recovery rate expectation, we have brought down meaningfully, quite honestly, from the level at which it's been operating.

And we continue to see good growth in the portfolio.

The best guidance I can give you I think is to take you back to the earlier comment, and that is the credit environment remains benign.

We would expect the underlying performance in the portfolio to reflect that.

Okay.

And then just another question was, in your other expenses I know last quarter you had some expenses related to Diners, but this quarter also, if you look at last quarter's numbers, strip out the Diners charges, you have maybe kind of close to $100 million-ish run rate in the other expenses.

This quarter I think you were at $118 million.

Is there anything else flowing in maybe as residual expenses from the Diners charges, or something else this quarter?

Yeah, Sameer.

We've got some Diners charges, like with the elevated payment services expenses that we called out flowing through there, and a little bit more on the global acceptance side, and I think then there's just some cats and dogs, but that makes up the delta.

Remember, we essentially purchased the Italian franchise, for instance, last quarter taking a one-time charge called out at that time that we would be then operating it.

So you've got the normal operating costs that were expected and an ongoing operating loss because we now own those.

Okay.

I got it.

Thank you.

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

Please go ahead.

Good evening.

Thanks for taking my questions.

Just with regard to protection product revenue, it was up slightly quarter over quarter.

It's been trending down for several quarters in a row.

Has it kind of reached a bottom and this should be kind of a base, and then it grows from here?

No, I'd say we are continuing not to sell that product, and so you would expect then the attrition to gradually reduce that line until such time as we should start to sell those products again.

There will be fluctuations from one quarter to the next, but I think the longer term trend for now would be a gradual decline.

Okay.

It has been slower than our expectations, to your point.

The attrition has definitely been slower than we expected.

Thank you.

And then just a follow-up on personal loans.

The yield's up about 16 basis points from a year ago.

It's up almost 16, I guess -- sorry, 6 basis points linked quarter.

Just with the growth you've had, I guess you're getting -- the competition level in that product, I would suspect that with a lot of growth you'd see maybe loan yields come down linked quarter basis, but doesn't appear the case.

I would say that that product continues to perform particularly well for us.

We're very, very happy with the yields we're seeing there.

I would say without any significant credit expansion, we're able to command some very good pricing in that marketplace right now, and we feel very good about it.

Thank you very much.

We're also seeing some payoffs as the older vintages mature which were at slightly lower rates, and newer vintages have come on over the years at slightly higher rates.

Next caller.

Our next question is from David Hochstim from Nomura Securities.

I don't think I changed --

David from Buckingham, right?

Yes, I'm still at Buckingham.

I wondered, could you talk a little bit about what we saw over the course of the quarter in terms of spending behavior and lending?

You said that loans have tracked spending, but loan balances declined in the month of September, I think, and grew nicely in July and August and for the quarter overall.

Is there some -- did you see some changes in behavior during the quarter, and how about in October so far?

I would say that I've seen a fair amount of stability, both in sales and loan growth.

Obviously, how a weekend falls or what promotions we have going on one year versus another can certainly have an impact on one month.

As I look at the day adjustments and everything, I haven't seen any particular trend in either direction for either sales or loans.

Okay.

So can we think the decline in loan balances in the month of September is kind of unusual and it's not reflective of some new trend?

Would October be -- ?

I would say that you're better off looking at the full quarter to take out that noise.

I feel good that we're continuing to be towards the top end of our 2% to 5% targeted range in credit card loan growth, and I think it's -- I believe it once again was the best in the industry.

Okay.

So September is not consistent with that as a month, but look at the quarter and think about Q4, obviously Q4 seasonally should be pretty good?

I mean, by looking year-over-year we sort of take out the seasonality, and but I would say we felt good about last quarter, and we're continuing to work hard to stay towards the top end of that range.

Okay.

All right.

Thanks.

Our next question is from Ryan Nash from Goldman Sachs.

Please go ahead.

Good evening, guys.

Just a follow-up on the credit questions.

Mark, I take your point that the credit is likely to remain benign.

Is the normalization in the recovery rates outside the master trust happening at a faster pace?

So is the actual recovery significantly lower in that part of the portfolio?

No, I would say the master trust is a pretty decent representation in that sense, Ryan.

I would say a couple different things.

Remember, we're not rearward looking on recovery rates when we're setting our reserves We're looking at what we expect those recovery rates to be over the ensuing 12-month period of time.

So we're looking at trending in that recovery rate and what we expect that trending to be going forward.

The other thing I'd really be cautious on, too, is if you're thinking about that last month in the trust, you'll note there's a footnote there noting that had we not done the account removal that we did, that recovery rate fell pretty significantly.

I think it was more like 107 bps as opposed to the 116 that got published by virtue of the math.

Recovery rates continue to decline.

I think the trust is a reasonable, not a perfect but a reasonable proxy for what we're seeing there.

Got it.

Just one quick follow-up.

On the reward cost, it seems like it came in a bit better than we would have expected again.

Given this quarter's online shopping, are you still targeting a 1% reward cost for all of 2013?

Yeah, I think somewhere in that neck of the woods is a pretty good estimate.

I think we'll probably come in a little below 1% on the full year, would be my current observation for you.

Thanks for taking my questions.

You bet.

Our next question comes from Don Fandetti from Citigroup.

Please go ahead.

I was curious what your appetite for acquisitions is currently and what areas, if you do have an appetite, where you might focus?

Well, as Mark said, we would always be open to great opportunities.

If you look at our track record, we've been selective.

We've made acquisitions where they fit both strategically and financially.

They obviously have to fit the direct banking or payments partner strategy, but I'd say we focus most of our attention on organic growth and growing the businesses that we currently have and have built, and we would be cautious but we would certainly look at opportunities.

Does that answer your question?

Yes, I'm all set, thanks.

Thanks, Don.

Our next question comes from Bob Napoli from William Blair.

Please go ahead.

Thank you.

Good afternoon.

David, I was hoping you could give maybe some thoughts on your partnerships, Paypal, Ariba, Facebook, Amazon, maybe -- you didn't give any update on Paypal.

Just maybe some thoughts around the strategy in working with those companies.

In particular Amazon payments, Facebook payments, the Ariba business-to-business.

I'd love some thoughts on those partnerships and over what time period you expect them to start generating some real numbers for you.

Well, I'm pleased with the progress that we're making.

They, as we've said in the past, there's two things that are good.

One is we are building a portfolio of partnerships, so we're not counting on any one, and not all of them will work, but we think we've got enough of a portfolio, or building enough of a portfolio that some of them will work, and hopefully some of them will work really well.

I think that these -- we're talking about some very new areas.

We are coming at them from a very differentiated approach.

For instance, no one I think has ever come at the Ariba opportunity the way we are.

And so these things will take time to get ready to launch.

Then once they launch, we expect the volume to come first and the profits will be a ways out.

So I think that one way to think about it is that it's like having a whole number of options, and those are long-term options that we think some of them will pay off really large, but I wouldn't think about them really as being that meaningful, even through next year, at least in terms of the profit side of the equation.

What is, maybe just as a follow-up, what is unique about what you're doing with these partners, and maybe using Ariba as an example?

Well, it opens up -- Ariba is business-to-business.

So it opens up a whole new category that's not -- if you think about the size of the credit card industry, it's all spend that's not even there, that's not part of the industry as we know it today, and so it's a way to leverage our existing network infrastructure acceptance capabilities in a totally new marketplace, but with -- because it's leveraging our existing infrastructure, it's a relatively low cost and is a better value and better service than companies paying other companies achieve today through other means.

And so what's, I think -- each one of these new opportunities are differentiated.

They're not copying anyone else.

They don't exist today.

Some of them are really hard.

We have to, Paypal is an example, turning on a new network for 8 million merchants is not easy, and I don't think it could be done without our help.

But the payoff we believe will be very large over time.

Great.

Thank you.

Thanks, Bob.

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

Please go ahead.

Good afternoon.

Thanks for taking my question.

Buried within the CFPB's report that they put out earlier this month on the CARD Act they mentioned that some issues and practices related to rewards and marketing promotions have become an area of concern.

I'm just curious if this is something that's come up in your conversations with regulators, and how do you feel about where you're positioned relative to peers on rewards?

Most specifically on rewards, not so much on marketing.

Well, I feel very good about our focus on consumers and disclosures.

We are looking at everything that we do, and as are regulators, and I would say that I'm pleased that most of the areas that came -- that were addressed during that study are areas that we don't have involvement with, like deferred interest cards or fee harvester cards, we're not currently marketing fee products, but obviously rewards was mentioned.

I think that you need to think about the fact that rewards are so prevalent, they're now on most cards in the industry, and so it's not surprising that that would be an area of focus.

One of the reasons I feel good about us is that cash is more straightforward than points or some other complicated programs.

They're easy to use and redeem.

We particularly put in features to make them even easier to redeem and add value when they're redeemed, and it's a great value to consumers overall.

We've got about $1 billion a year of cash rewards.

That's a huge value to consumers.

Okay.

Thanks for that response.

Our next question comes from James Friedman from SIG.

Please go ahead.

Hi.

Thanks.

Mark, on Slide 7 you call out employee compensation increases and you talk about higher headcount.

I was just wondering where that headcount is going.

David, I'll just get the two in upfront.

So with regard to network partners, how should we be thinking about, or phrased a different way, how do you measure your success in network partner initiatives so we can kind of harmonize with how you grade yourself?

Yeah, I would say, I'll start off in response and then let David take up.

If you're looking at the higher employee compensation expense, I would say the headcount is really, Jamie, in support of our growth initiatives that we have across the Company.

So that's going to be everything from the launch of the home equity product to the further build-out of a number of our other different initiatives.

There's also obviously some heads involved in the emerging payments partnerships that's the second part of your question as well.

So between our growth initiatives, new product initiatives we have, and then I would say there's obviously, just like with everybody these days, a little bit that's going to the regulatory climate, make sure that we are dotting I's and crossing T's and dealing everything that's expected of us as a responsible player in the industry.

Those would be the key drivers there.

In terms of network partners, I would divide it into three areas.

I think first I measure what are the deals that we're signing and what's our track record for signing deals with some really strong partners compared to others.

And I feel particularly good about that.

I think in the medium term, which is not yet, I would measure volume, what kind of transactions in dollars are these deals as they get implemented producing.

And then in the long term, I measure profitability.

That's ultimately what we're after.

And how much money do we make in these deals.

But that's a long term.

Thank you for the color.

Our last question will come from Daniel Furtado from Jeffries.

Please go ahead.

Hi.

Thank you for taking my question.

I just was curious if there were any changes to the way you report delinquencies.

If not, do you feel this quarter was the inflection point for the 30-day bucket?

Thank you.

Yeah, I would say there's been no changes to the way we report delinquencies.

From the standpoint of an inflection point, no.

I don't think anybody around here is prepared to say we think that's the inflection point.

We're obviously in unchartered territory.

We're not used to seeing card delinquencies in this level, and as I've said before, models are built off of history and the predictive capability of those models is driven off of that historical set they have as well.

I think it's going to be even more difficult to call a turn in this environment than it would normally be, and we would be very cautious about doing that.

I guess in response to really I think what's behind the question, I'd point you again back to my thoughts that the credit environment is definitely very benign right now.

We could see improvement from here.

We could see deterioration from here.

But what I would say is that's going to be around a mean as opposed to some giant movements based on what we see right now.

Understood.

Thanks for the clarity.

You bet.

Thank you, ladies and gentlemen.

This concludes today's conference.

Thank you all for participating.

You may now disconnect.