發現金融 (DFS) 2014 Q1 法說會逐字稿

Welcome to the Discover Financial Services first quarter 2014 earnings call.

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

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

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

Please note that this conference is being recorded.

I will now turn the call over to Bill Franklin, Investor Relations.

Mr. Franklin, you may begin.

Thank you, Ellen.

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 referring to 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.

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 in our 10-K which are on our website and on file with the SEC.

In the first quarter 2014 earnings materials which are posted on our website 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.

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

Thanks, Bill.

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

Since I recently presented Discover's strategic priorities and key initiatives at our annual financial community meeting, I'll keep my prepared remarks brief on today's call.

During the first quarter of this year, the actions and results that we drove helped take us a step closer to achieving the priorities that I discussed at the event.

Specifically, we grew card receivables by nearly 5%, which is at the upper end of our targeted range.

We achieved this level of growth through wallet share gains with existing customers and the continued success of Discover It where we drove a double-digit increase in new accounts.

We've added innovative features like free FICO scores on card member statements and continued to enhance our online application to drive new accounts.

Card sales volume growth at the end of the quarter was 3%.

It's important to keep in mind that the majority of sales growth in the industry at the moment is coming from high spend transactors while profitability in the industry, for the most part, is still driven by receivables, not sales.

Our card business is focused on prime revolver sales, and we've been taking share in this segment.

Furthermore, we are not sacrificing quality to achieve growth as credit in our card business continues to remain exceptionally strong.

Next, we continue to deleverage our brand, our customer base and our risk management skills to profitably grow and expand our newer direct banking products.

Private student loans, excluding purchased loans, grew by 26% during the quarter, and personal loans grew by 27%.

In these businesses we are not only driving solid growth, but we're also achieving great returns on equity.

In addition, we are piloting our student loan consolidation product which we expect to further rollout later this year, and we're making good progress towards implementing the core banking system which will better position us to more broadly launch our direct checking product later this year.

In payments, we continue to increase global acceptance, enhance security and look for ways to partner to increase volume while navigating through some clear challenges in the segment.

Despite these challenges in the payment segment, the first quarter overall was a great start to 2014.

Our core lending business drove 6% receivables growth and 4% revenue growth.

We generated $631 million in net income, or $1.31 per diluted share with a return on equity of 23%.

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

Thank you, David, and good afternoon, everyone.

I'll start by going through the revenue detail that's on slide 5 of our earnings presentation.

Net interest income increased $153 million, or 11% over the prior year due to continued loan growth and a higher net interest margin.

Total non-interest income decreased $67 million to $515 million, primarily due to lower direct mortgage-related income and an increase in our rewards expense.

Our rewards week for the quarter was 103 basis points.

Of this total, roughly 7 basis points, or approximately $18 million, was related to updating our assumptions to reflect lower reward forfeitures going forward.

Excluding this one-time adjustment, our rewards rate for the quarter would have been 96 basis points.

The decrease in forfeitures is driven by good credit performance and our efforts to increase ease of redemption like we've done with Amazon to drive customer engagement.

In terms of the more business as usual elements of the program, we modestly increased both the standard and promotional rewards over the prior quarter.

Payment services revenue decreased 9% year-over-year, mainly due to lower transaction processing margins at PULSE, which will have somewhat easier comps next quarter as pricing changes were implemented during the first half of last year.

Overall, we grew total Company revenues by 4% in the quarter.

Turning to slide 6, total loan yield of 11.44% was 22 basis points higher than the prior year, as interest yield for card, private student and personal loans all increased.

The year-over-year increase in card yield reflects a higher portion of balances coming from revolving customers, as well as lower interest charge-offs.

Higher total loan yield combined with lower funding costs resulted in a 48 basis point increase in net interest margin over the prior year to 9.87%.

Looking forward, we continue to expect net interest margin to remain elevated above our long-term target for some time to come.

Turning to slide 7, operating expenses were up $31 million, or 4% over the prior year.

The increase in employee compensation was primarily related to higher headcount to support growth and new product initiatives, as well as compliance with increased regulatory requirements.

Information processing expenses were up $6 million, or 8%, largely due to our reclassification of expenses that were previously included in employee compensation and benefits in the second quarter of last year.

Other expense was up $9 million, or 10%, due to the inclusion of a legal reserve release in the first quarter of last year.

Payment services expense increased by $9 million, or 23%, due to ongoing Diners Club costs in Europe.

For the quarter, our total Company efficiency ratio was 37.7%, roughly in line with our long-term 38% target.

Turning to provision for loan losses in credit on slide 8, provision for loan losses was higher by $113 million compared to the prior year due to a smaller reserve release.

Our $57 million reserve release for the quarter mainly reflects an improvement in both our contractual and bankruptcy loss assumptions for the card product.

The credit environment for cards to continue to remain extremely benign.

Sequentially, the credit card net charge-off rate increased by 23 basis points to 2.32%.

However, it decreased by 4 basis points over the prior year.

A 30-plus day delinquency rate of 1.72% remained at the same level as the prior quarter.

The private student loan net charge-off rate, excluding our purchased loans, increased 49 basis points from the prior-year due to a larger portion of the portfolio entering repayment.

Student loan delinquencies, excluding acquired loans, increased 31 basis points to 1.79%.

Overall, the student loan portfolio continues to season generally in line with our expectations.

Switching to personal loans, the net charge-off rate was up 7 basis points sequentially and the over 30-day delinquency rate was down 2 basis points to 68 basis points.

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

Next, I'll touch on our capital position on slide 9. Our tier 1 common ratio increased sequentially by 60 basis points to 14.9%, this despite deploying $400 million of capital through buybacks and dividends.

As was previously announced on March 26, we received a non-objection from the Federal Reserve on our proposed capital actions during the four quarters that will end on March 31 of next year.

We were pleased with the outcome and how we lined up versus other banks in terms of our capital ratios and the stress scenarios.

Additionally, our board authorized a two-year, $3.2 billion share repurchase program and last week increased our quarterly common stock dividend from $0.20 to $0.24 per share.

Now that we've completed our inaugural CCAR stress test, we're updating our Basel III tier 1 common target to approximately 11%.

Our prior tier 1 common target was largely grounded in our economic capital framework.

The new target is based on an analysis of our CCAR stress test result which, similar to other large banks, has become our binding constraint.

Just a to remind you, this is largely an academic exercise at this point, as we're well above our revised target and the current CCAR framework discourages payouts greater than 100% of earnings.

In summary, this was a solid start to the year.

We once again drove better than industry receivables growth, net interest margin and credit remained strong, and we increased our planned capital deployment.

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

Thank you.

(Operator Instructions)

Ryan Nash, Goldman Sachs.

Mark, good evening.

Just on the decision to change the tier 1 common target to 11%, can you just give us some context towards how you came up with that decision?

This is obviously just your first year going through the CCAR and I would have thought, just given the experience that a lot of others have had, that they've taken a multiyear process before making a final decision in terms of the tier 1 common target.

So, should we think about this as a potential to be a moving target over time, or do you think this is something that will be more static and you'll continue to run with over the longer-term?

No.

I think, Ryan -- it's a great question.

I think it's definitely going to be a moving target over time, not something I would see as static.

I think we had historically had prior guidance out there that was based on our economic capital framework that we withdrew after last year's CCAR results when we saw how other card players had performed, and we said it looks to us like maybe in the current environment the number might be a little bit higher.

And we need to wait and see because the new binding constraint will be the stress test results themselves.

And I think the 11% number we're putting out through today is really meant to be reflective of just that, the current environment and where things stand right now.

I think it's intended to be dynamic; it should be dynamic, it should be driven by the mix of business, the business climate, the environment lots of different things.

So, I would not assume it's a static 11%.

Got it.

And then given that you're still sitting here with over roughly 400 basis points of excess capital above and beyond that level, and given the fact that it appears that the payout ratio will be south of 100%, this time it looks like you're probably going to continue to accrete capital from here.

Just given that framework, is there any chatter going on across the industry potentially with regulators about the ability to increase your capital returns above 100%?

And if so, if you were able to do so, what would be the method of preference?

Would be for incremental buyback, or would you potentially think about something such a special dividend?

I'll defer to the regulators, the Fed, in terms of what they're thinking about in terms of the payout ratios over the long haul.

There's always speculation in any industry from time to time, and I hear some of it from my peers, I'm sure you're hearing a lot of it around the horn too.

But I'll defer to them over what -- as to what their thought process is.

I think the CCAR process itself is designed to be a horizontal review.

And at such point in time as the regulators deem capital to be rebuilt in the industry, it would be our clear hope that the process could change somewhat in that regard.

But at this point in time, the rules, as we understand them, still are what we've laid out there, and that is that payouts greater than 100% are really discouraged in the current framework.

Got it.

And if I could squeeze in one last one, just on the updated forfeiture costs, is this something that we should think of as being one-time in nature, i.e.

the 7 basis points as one-time?

And how do we think about it in the context of a 1% targeted reward wait that you've talked about for the full year?

Yes, great question.

I would say the forfeiture rate, we impairment test, or we test that forfeiture assumption, is a better way to describe it, every six months, Ryan.

And what we've seen is in particular, some of the popularity, the pay with cash back bonus at Amazon and a few of the features like that, have driven a much higher propensity to utilize the cash back rewards.

So, we're not seeing as much forfeiture.

In addition to that, they have the really high-quality credit environment right now is meaning folks aren't forfeiting their cash back balances due to delinquency.

When we looked at that, there was a, basically a catch-up adjustment we made to reflect those things.

So, I would say yes, I view them as one-time in nature.

Now again, six months out we'll look at them again, but my crystal ball doesn't say some other giant adjustment six months from now as we sit here today.

What I would say is that in terms of the 100% full-year total rewards rate, I would say yes, that still feels like about the right general ZIP code for where we're standing, maybe 2 or 3 basis points above or below that number, somewhere in that general ZIP code is the way I'd think about the full year.

So, yes, I'll stand behind that one.

Thanks for taking my questions.

Mark DeVries, Barclays.

First question is a follow-up on Ryan's first question.

Mark, is the -- I believe it was the 9.5% economic capital target you had.

Is that still longer-term where you would hope that standard would converge on when the Fed starts to get a little bit less conservative as far as what they want relative to what they -- the theoretical goalposts are?

Yes.

The 9.5% we withdrew about a year ago, and yes, that was based on the economic capital, that's correct.

I would say, look, based on an analysis of our economic capital position, it still strikes us that that would be a reasonable place to operate a the Company over the long haul.

I would say that process is obviously -- at this point in time includes the Federal Reserve in the process, and they have a process that has imposed the binding constraint we've got today.

I want to be respectful of their role, the tough job they've got to play in rebuilding capital in the system post the crisis and everything else.

I think it's a tough job and the horizontal review process is not easy for them.

They've got to do it under Dodd-Frank.

It's not an option.

Again, our hope would be over time, as capitals rebuild, the process will liberalize a little bit.

I think it's here to stay, but our hope would be it would liberalize.

And that 9.5% economic capital number still doesn't feel entirely wrong to us.

Okay.

That's helpful.

And then on a separate note, my sense was from the investor day that you're still getting really good responses to the offers you're sending out on the Discover It card.

I think you also alluded to a benefit to the yield from a slightly higher propensity to revolve.

If you get a continued increase in that propensity to revolve along with strong response rates, could we see card loan growth in excess of that 5% high-end of your targeted range?

Well, as I mentioned, Mark, there -- we have achieved double-digit new account growth in the first quarter of this year compared to a year ago.

So, we're continuing to see good responses.

And I would say that the pickup that we saw in year-over-year growth from around 3% to between 4% and 5% I think already reflects that success.

And so we are very focused on trying to put in additional things that will help keep us near the high end of that 2% to 5% range, and I'm just really pleased that we achieved that high-end this quarter.

Okay, great.

Thanks for your comment.

Bill Carcache, Nomura.

Mark, I was hoping that you could talk about the dynamic that we're currently seeing in consensus expectations which have your provision expense increasing 58% between 2013 and 2015, but your loans only growing by 9% over that time frame.

Is it reasonable for growth in your provision line to outpace your loan growth by that much, particularly given that the reserve building that you've been doing has been growth driven and this quarter you actually had another release?

As we look ahead, how should we be thinking about the pace of reserve building in relation to your loan growth?

I would say there's a lot in that one, Bill.

I'll try and hit it all.

If I don't, feel free to come back at on me at some piece of it if I missed it.

I guess what I would say is with respect to how consensus is looking at it, I'll defer on that one because that's obviously how you guys are looking at it, so you probably have a better sense on that one than I do.

I guess what I would say is that the crystal ball right now gives us pretty good visibility into the 12 month forward lost emergence period.

In that window, we do not see any type of deterioration in the consumer credit markets in which we play at this point in time.

The environment continues to be very benign.

We'd expect provisioning to be largely a function of growth going forward to the extent that there is adds to provisions.

To the extent there's releases, we'd expect them to be from continued surprises to the good.

This most recent quarter, both our contractual and our bankruptcy loss assessments and our modeling improved.

I think that affected both, not only the number of accounts, but also the average balances.

It's pretty broad-based improvement we saw across the board.

Relative to the $1.6 billion allowance or so that we've got on the books, a modest release, a modest build, I view it as variability around a flat reserve, more or less, over the course of the last quarter or two.

But I don't see anything over the course of the next 12 months beyond growth in loans that would be a sizable driver of provision expense.

To the extent that maybe you had a little bit lower recoveries, that could be something that contributes to the provisioning maybe exceeding loan growth a bit?

But by and large, provision growth should roughly be similar to loan growth?

Is that reasonable to expect, at least for the next year or so?

I think I've got to be a little careful with that one because obviously, the provision growth's going to be driven by what our models show, and those models get updated every quarter.

But I would say as a general process, I think the framework for thinking about it that you're expressing is not a bad one.

Okay, great.

And then separately, as a follow-up, there's been some commentary during this quarter's earnings calls suggesting that there are issuers out there who are willing to raise rewards to levels that are basically wiping out any interchange revenues that they generate.

I wondered if you could comment on the extent to which you're seeing any competitive pressure from these types of aggressive reward campaigns.

And maybe more broadly, if you guys could talk about how sustainable these elevated rewards are that we're seeing today across the industry?

Particularly some of the relatively high cash back rewards offers that are out there.

Well, I think that there's -- we've seen over many years where players will come in with high rewards and then we'll pare them back.

I don't know that that's very different.

And I think you see people come in and rotate in and out, so I don't -- I wouldn't characterize now as having an unusual number of people coming in with higher rewards cost.

I think some people are getting more aggressive and some people are backing off because they're running the numbers from last year's programs.

I think if you look at what we're doing, apart from the one-time adjustment, we still were just under 100 basis points we've been around 100 basis points for a while.

That was sufficient to drive industry-leading growth and receivables and growth in revenue.

Actually, an expansion in net interest margin, so we are very focused on growing total profitability and profitable loans, not just short-term throwing rewards expenses out.

That's very helpful.

And if I may, just the last one very quickly, what kind of ROE does your 11% common equity tier 1 target represent?

And that's it.

Thank you.

Yes, I'd say we haven't specifically translated that one publicly before, but certainly well north of that 15% number that is our threshold level we put out there in our guidance previously.

Thanks.

David Ho, Deutsche Bank.

I was looking at your expenses, seems pretty clear this quarter outside some seasonal decline in marketing and maybe a little bit of Diners costs.

If I annualize that run rate, I'm still getting maybe 3.1, if I add a little bit of marketing, it's still relatively large scale versus your $3.3 billion end of year target.

I know you're building in some compliance regulatory costs and maybe some technology investments.

How much are those in the run rate, and what's the timing on that throughout the course of the year?

I would say it's going to ebb and flow, David, a little bit quarter-over-quarter.

I think I'd probably point you back to the investor day commentary where I said $3.3 billion felt like the right number for full-year expenses.

I would say based on everything I know right now, I wouldn't revise that guidance if it were investor day today.

I'd still pretty much think that felt pretty good.

I think we feel pretty strongly that the last two quarters we've flipped to flat to positive operating leverage with revenue growth in line with our exceeding our expense growth, which feels very good to us.

We remain committed to consistently delivering positive operating leverage and that's the direction we're headed.

Okay.

And another one loan growth, it seems like some competitors are increasing credit lines or adjusting those for some of their customers.

Is that something -- you guys have relatively been stable in your credit line increases, but is that something you could use as a lever for loan growth going forward?

I think we've been pretty consistent on that.

Right after the crisis, we curtailed a lot of line increases, but at this point, we've restored things and we're a couple years into a fairly stable situation of raising lines when appropriate.

Okay.

That's helpful.

And one more on the CCAR results for the loss rates.

Seems like 15% obviously the high-end of the industry, but versus your internal projections, was there a large delta there, and can you comment on the difference?

I think, David, you can see our -- we published our forecast for the losses and the supervisory stressed scenario on, I think it was March 26.

So, you can see that the difference is there.

We can't explain the differences between the two because there is not really that much insight that's given to how the Fed comes up with their loss estimates.

Okay.

Thanks for the questions.

Sanjay Sakhrani, KBW.

I guess I've got one on capital and one on the network business.

Assuming the bulk of the excess capital is trapped, how aggressively are you looking for alternative uses?

Secondly on the network business, intra quarter we found out who the third-party issuing client was that left.

Could you talk about the prospects for that third-party business and broadly the -- I'm sorry, the third-party issuing business and maybe the third-party segment broadly as well?

Thank you.

I'll tackle the how aggressively part, and then I'll pass it to David to talk about the network piece.

I would say, Sanjay, we're always actively looking for ways to put capital to work to the benefit of our shareholders.

You should, I think, safely assume we're always scanning the horizon for ways to do just that.

I think organically, we're already outgrowing our key competitors out there in all of our core product lines, and it feels like we're doing a very good job of that.

I'd say when it comes to the inorganic opportunities in that front too, we're also always very actively scanning and looking for the right opportunities.

Balancing that against wanting to make sure that the capital doesn't burn a hole in our pocket, so to speak.

I think the phrase I've used before is, if the deal doesn't make sense, we won't try to make it make sense.

And I think there's things shown around on the Street from time to time, but there's disconnect between value in buyers minds and sellers minds.

And I'm not going to be something that doesn't make sense for my shareholders just to do it.

But rest assured, we clearly understand we have more capital that is sitting around than our shareholders would like us to.

We remain committed to our prioritization, which would be organic redeployment, returning it and in organic redeployment that order.

And we are going to stay diligently focused on that.

And Sanjay, obviously the one agreement represented the lion's share of the network partner volume and profits, but that was an immaterial benefit before or currently to EPS overall.

But frankly, we had to look at the renewal, and the renewal structure simply didn't meet our profit hurdle, so it would have gone from a positive to a negative.

And so that obviously didn't make sense for our shareholders.

If you look at where we've been focused the last couple years, it's actually been not on deals like that, but on nontraditional deals.

I'd point you to the various network to network deals, the various deals like Ariba and PayPal and others with some of the emerging partners and as well as continuing to focus on debit where we've got a strong market position in terms of market share.

And so we're pleased with the deals there, but it takes a while for volume and profits of new deals to take the place of something that's a much more mature deal that's going to be going away later this year.

One follow-up, if I may, to Mark's comments.

Just in terms of places where you're looking at where the prices might not make sense, could you just talk about what those areas are?

That would be helpful.

Thank you.

Sure.

I guess, Sanjay, the way I'd think about it is you're talking the balance sheet business, you're looking at assets that are consumer-oriented assets in nature.

Assets that are actuarially, I would say for lack of a better term, underwritten and managed as opposed to big, lumpy exposures.

So, I wouldn't expect to see us run out and start doing C&I lending or commercial real estate lending next quarter.

I think I would stick to more granular consumer or consumer-like type portfolios, would be the way I'd think about that.

And obviously, I think my earlier comment, I think our crystal ball shows an ability for us to keep driving great ROEs right now as we look forward, and rushing out and trying to make one of those work when it's not the right strategic fit and/or the pricing isn't right in this environment, I think we want to be responsible stewards of our shareholders' capital and we're going to do the right things.

Great.

Thank you.

Don Fandetti, Citigroup.

Yes, David, I was wondering if you could talk a little bit about spent during the quarter and into April and then also briefly on the CFPB, if there's anything going on there, or is it fairly stable?

Well, on spend volume, we have seen some pick up the last several weeks.

And I think we're going to have to see some more data points to see if that's sustained or not, but at least maybe as the weather finally gets better -- a little better, that is potentially helping.

In terms of the CFPB, there's really nothing new.

There's always reviews, there's the one -- we continue to maintain a good working relationship.

There's the one matter that we disclosed that we're still working our way through.

We don't really know exactly where that will come out, but we look forward to resolving it as soon as we can.

We'll let you know as soon as there's more that we can say.

Thanks.

Brad Ball, Evercore.

Mark, really two questions on the margin.

One, over the nearer term, is there room for further funding cost benefits as you continue to drive more direct to consumer and affinity deposits?

And could that drive the margin even higher again?

And then secondly, longer term, what is it that keeps you locked on your long-term margin guidance, which I think is 8.5% to 9%?

What gets us back to that level?

Is it higher funding costs or is it competition depleting asset yields?

How do you foresee -- and I know you can't really give us timing, but how do you foresee getting to that lower level?

I appreciate your addition of the timing point there.

I appreciate that one very much, but I'm happy to tackle it.

I guess I would say in the near term, Brad, what we're doing is two different things.

We're capturing and taking advantage of refinancing, albeit at lesser volumes, but still not immaterial volumes, of fundings that were put on place several years back, refinancing those at current lower rates in today's environment.

What we're also doing though is we have begun to really extend out the duration and the maturities of that funding.

For example, we did about $400 million worth of 12 year bank notes in March at a very attractive fixed coupon.

Some of what we're doing will actually benefit margin, some of what we're doing will actually modestly take away from that benefit to margin.

On balance in the near term, is there some potential modest upside to margin yet?

Yes.

There is some potential modest upside to margin yet in the near term, I would say.

But we're not letting -- it would be greater, for lack of a better way of saying it, if we weren't positioning ourselves to perform well in all environments.

From an asset liability perspective, we're making sure that we're not being pigs at the trough and taking advantage of it all today, but there is opportunity for some more expansion there.

In terms of longer-term guidance, I think there's any number of things.

Credit normalization, increased interest rates, at some point in time, even if we are extending out the duration of maturities of the funding, if and when that matures in a higher rate environment.

I would say the biggest reason though, that I've kept that guidance and we've not been comfortable moving off of it is, David's been pretty clear about our goal to become the leading direct consumer bank in the country.

And I think part -- what comes with that is diversification.

And the other consumer asset classes we're not playing in today have lower yields than several of the ones we are playing in today.

The good news is, they also have lower loss rates.

On a risk adjusted basis, the returns they drive are very, very similar, but they would -- that further expansion would be dilutive to margin.

That's the biggest reason we've kept it intact.

Okay.

That's great.

And then my one quick follow-up is on the Diners expense this quarter, are we getting to the tail end of that incremental Diners cost in Europe, or are we looking at that likely to continue over the next few quarters?

I would say you should expect it will continue over the next couple quarters.

It's really being driven by the business we acquired in Europe, the Italian Diners franchisee and the processor related there too.

I'm not so sure I would take that number and make that number our run rate.

I'd give you that guidance, but I would also expect there will be some drag that comes with that business for the foreseeable future.

Okay.

Thank you.

Craig Maurer, CLSA.

Would it be correct to assume that if you're seeing increased spend volume over the last few weeks as the weather improved, that's coming with increased demand for lending or accelerated loan growth?

And secondly, with respect to PayPal, considering that they are yet to show any understanding of what a value proposition would need to be at a physical point of sale, would it be fair to characterize that your belief in their growth is now switched to a hope for growth?

(Laughter) well, I think on the second one, you need to talk to PayPal.

I wouldn't comment.

We value PayPal as a partner.

We still are very optimistic in the long term.

But what I would say is that they're going to continue to test and learn and develop and where we exactly start and where we exactly end, as you would expect, it will change.

And you're seeing that with all the other players in the space as well, whether it's Amazon or Google or Apple or they're all changing as time goes past.

In terms of the first question, sales, I would say we already feel really good about our loan growth accelerating to nearly 5% this quarter.

I would -- if I can keep it at that level, I'd be thrilled.

I would not get ahead of myself and say it's going to necessarily accelerate from here.

I'd love to see a little more acceleration in sales growth -- in our sales growth.

And while I feel really good about it, if we continue to see a little pickup in retail sales more broadly in the economy, it may be that our sales and our balance growth move closer to being in alignment versus sales being a little bit below.

Thank you.

Betsy Graseck, Morgan Stanley.

Couple of questions.

One was on follow-up to the NIM discussion.

I know you've had some high APR balances that have been attriting down, but very, very slowly.

I'm just wondering, A, what's driving -- why is it so slow, but B, are you assuming in your normalized NIM outlook that -- or your long-term NIM outlook, I should say, that those high APR balances have already attrited?

Betsy, if you look at the higher rate buckets, it's down to somewhere on the nature -- I may have this a little wrong, but I am really close, think it's about 16% of the total book, give or take, somewhere in that neck, maybe 15%.

A big chunk of that is cash advance balances which -- the rate on which is not covered or regulated under the CARD Act.

So, the amount of high rate balances left to attrite is relatively modest.

And I'd be honest and tell you that the bucket is getting replenished somewhere near about as fast as it's attriting.

So, it seems to be approaching a point of stability.

It will decline from here a little bit more, but relative stability in that regard.

So, I think the high rate balances that are attriting are not having the same diluting effect that we were fighting here a year or two ago.

Because of replenishment?

Yes.

Exactly right.

It feels like we're approaching a point of stasis there, at least for now.

I wouldn't say we're all the way there yet necessarily, but it feels like we're getting somewhere close to that.

And I apologize, I've forgotten the second part of the question.

The long-term target, do is do we assume more runoff now?

Same thing.

It basically assumes we're reaching a point of stasis there, more or less.

But it projects that there will be some continued runoff from here.

Got it.

Okay.

Not of any -- again, that longer-term NIM target is really driven by the mix shift that we anticipate seeing over time as we broaden the base of assets.

Okay.

And consumers are interested in the product and it grows as they seek that type of financing, then it could go up as well?

That's not in your base case?

Correct.

Okay.

Then second question, just on the other income line, could you help us understand how much of that is mortgage related revenues, and could you speak to the thought process around portfolioing mortgages, and is there an acceleration coming?

Sure, I would say with respect to the portfolioing of mortgages, I would say don't see that any time in the near term in our current business plans.

I think our cost of capital is in a particularly efficient place to hold a market priced asset, shall we say, of that thin a spread.

We probably aren't the most efficient holder for portfolio mortgages.

We do from time to time contemplate whether we should service our own product.

Don't read that as me telegraphing or going into servicing next week by any stretch of the imagination.

It's just something we do consider to control the experience the customer experiences.

I think we're very proud of the customer service we provide, and our ability to keep driving at forward is something that's very important to us.

With respect to the decrease in other income and how much of it is related to the mortgage business, I would say the mortgage business is the biggest single component of that decrease in other income.

Year over year.

Year over year, it's about, probably plus or minus, call it -- let's call it between $30 million and $40 million year-over-year decline in that line item as driven by the mortgage business.

So, as I've guided and as David has guided you all to historically, I would say we bought the business because we wanted to be in the asset class.

We purposely kept it small, so in the good days maybe we were accreting $0.01 or so a share to income over time on a quarterly basis.

And maybe today we're taking away $0.01 a quarter per share, give or take something like that.

So, it's not really a material driver of the earnings stream today and feels like a place we want to be playing some type of a role as part of our goal to become that leading direct to consumer bank.

But growing it before we figured out the right formula for it doesn't make sense.

Okay.

So that too is steady-state in terms of the investment that you want to make there?

I think if we saw the right opportunity to penetrate more deeply the purchase mortgage market, I think as a team we'd be prepared to make the investment for the right opportunity.

But I think, again, in this environment, we need to see the clear path to doing that.

We're not just going to throw money at it to see if it works.

We have to see a clear path of that being a good investment decision.

Okay.

Thank you.

Chris Donat, Sandler O'Neill.

Wanted to ask on the marketing side, as I look at the last three quarters, you're basically flat year on year with marketing spend, and this is at the same time as you're launching some new products.

I'm wondering, has there been some shift in your marketing spend, either call it classic marketing versus branding?

Or maybe some shift in the channels where you're advertising, that you're finding more efficient ways to do your marketing like the Internet versus direct mail?

Just curious on how you're keeping your marketing so steady here year on year.

We're certainly trying to be efficient with our marketing, and in terms of the first part of your question, we've had a series of new products.

We launched Discover It last year, we recently added free FICO scores on statements.

We're continuing to have, maybe you wouldn't call them total new product launches, but significant product development that are newsworthy and frankly, that's one of the reasons that our ad dollars and our marketing dollars go further because we have real news to tell consumers that's resonating, and we're going to continue to do that.

At the same time, we are getting better and better at Internet and direct digital marketing, and you're seeing us do more and more in that space, a very high percentage of our new applications are coming there.

And we're continuing to fine-tune, I mentioned the new application that is having a better click through and completion rate.

We continue to try to take steps to make our marketing dollars go further.

Okay.

One thing I would add to that, just to make sure we're all level set, is if we saw the right opportunities that were going to drive the right kind of returns, this is the team that will invest behind the right opportunities, right?

I think certain of our competitors have basically pulled way back on marketing spend.

That's probably, unless we saw diminishing returns from it, not somewhere we'd be right now.

Okay.

And then shifting gears to something else that had been disclosed in your 10-K about some -- the FDIC notification about potential program deficiencies on AML, BSL, BSA, any update there or anything to say?

No.

There's not an update.

We're continuing, much as I mentioned with the CFPB, to have a very collaborative working relationship.

And we'll let you know more if and when we get to the point where we can reach closure and let you know how things turn out.

Got it.

Thanks.

Brian Foran, Autonomous Research.

I guess just on -- most of my questions have been asked, but maybe on deposits, can you remind us as we've been flat for a while, how much of that is just choosing to let legacy higher rate stuff go versus how much of that is increased competition in the marketplace?

I'd say it's all the former, from our perspective.

There's -- while we have been reasonably stable after a period of very rapid growth within that, when we talked about this some at investor day, we've significantly remixed and have gotten -- have carefully gone through the portfolio and have been maybe less aggressive on pricing and more aggressive on the most profitable parts of that to position ourselves for a rising rate environment, to make sure we're with core customers.

One of the most important factors is that it's heavily cross-sell, and I think last year, about 50% of that total book is -- actually came from cross-sell as opposed to new customers.

To the franchise last year was about 70% cross-sell.

And so we think that turning this into really all core deposits is very important.

I think going forward, the big thing is checking account.

That's not going to change the mix dramatically or add to balances dramatically in the near term, but in the long term, that is very strategic for us because that is very relationship-driven.

We think we have a very differentiated product with no fees, rewards, and mobile capabilities that are unmatched.

But it will -- these are sticky.

It will take time, but that in the long term is where we'd love to see some growth.

Maybe one follow-up or separate question, I feel like I'm asking some that's already been asked, but as I look through these loan yields, I keep waiting for the mix shift in competition to bring them down.

And if anything, they keep going up.

You touched on a couple different things happening in different products, but are you surprised by how well the loan yields overall have held up the cycle?

And is there anything identifiable in the near term that would change that?

Well, you remember there's an interaction with loan losses, and so low credit losses means fewer charge-off interest.

And so to some degree, a new normal in credit will be a new result in some new normal in NIM.

The second thing I'd point out is that things are a bit different from -- as a result of CARD Act.

And as you know, one of the key attributes of CARD Act is you really can't change.

And I think -- change rates down the road.

And so I think people maybe are a little more careful about going in with too love of a rate upfront, and so it's keeping the competition much more disciplined.

And maybe in past cycles there might have been rate decreases now, but once you decrease, you can never go back up.

And so I think that is keeping a certain amount of discipline in the marketplace, and I think that will be here to stay.

Thank you.

Appreciate it.

Bob Napoli, William Blair.

I just wanted to clarify I think you said that the new accounts in credit card were up 10% year-over-year.

Is that right?

I said double-digit.

Double-digit?

I didn't say the exact percentage.

Okay.

And then maybe, what drove -- you had flat marketing that was earlier pointed out.

What drove the double-digit?

And is the Discover It at all changing the demographics of the customer base, and what's driving that growth?

Is it continuing, is it sustainable, is that product changing the demographics of Discover customers somewhat?

Well, I would point back to my earlier comments about getting incremental improvements in our marketing effectiveness, in the digital space, as well as the introduction of the free FICO scores, which is resonating well, as well as our great service.

And I think we're doing a better and better job of getting the word out that we have a fantastic service.

I think that we're seeing on balance a slightly younger attraction, and I think that would be consistent with being a digital kind of focus.

And frankly, people that are a bit younger probably have greater appeal to the free FICO scores because they may still be noting their credit scores aren't as locked in after decades of behavior.

So, on that, we're pleased with making our money go a bit further.

And then on your redemption rate, I guess are taking the charge this quarter, I think American Express has given out numbers, they're probably in the mid-90s on the redemption rate.

What is the redemption rate for Discover?

Is it similar to American Express?

Is it much lower?

We're looking at each other across the table right now.

I'm not sure we publicly disclose that one.

What I would say is our goal would be to make sure our customers have the opportunity to avail themselves of that cash back bonus to the greatest extent possible.

We are -- we take actions on a regular basis, we like to pay with cash back bonus at Amazon and other features to try and make that redemption very easy for the customer.

We found it's driven dramatically increased engagement on the part of our customers.

If you look at the receivables growth we've had vis-a-vis our competitors, it's pretty significant, and I think there's a reason they're choosing to build those receivables with us.

And I would say if you look at the components of that 5% receivables growth, when you look at the first quarter, look, basically all of that growth was standard merchandise sales, right?

There was not a significant amount of BT in the component, there was not a significant amount of promotional merchandise component, it's basically standard merchandise.

We're getting this the old-fashioned way, and that's the best, most profitable kind.

So, it feels really good.

And it's it is in that general ZIP code.

And it's been high for quite some time, and that's partly how we designed it, it's cash, it's not points.

We tried to have -- make it -- as a competitive advantage, make it easier to redeem.

We tried to have minimal breakage.

What we see as the payback is not in the breakage, but in increased usage.

And so it's a high percentage.

Last question.

If I could sneak in on the leading direct consumer bank focus, is there a -- to accelerate the [view], you were trading at 11 times earnings.

It's been a great stock and earnings have gone up, and I'm sure investors aren't complaining about the stock, but regional banks are trading at 15 times earnings.

And you're really in a sweet spot of banking.

People are closing branches, not opening branches, and have a good brand and position.

Is there a way to accelerate that view to grow the checking -- the deposit?

Is there some M&A that possibly would fit with your franchise that maybe accelerated the checking account, the growth of checking accounts or other products for Discover?

Well, I think checking in particular, I'm not sure who one would acquire, because I think we're at the leading edge there.

Arguably, I think there are some that have done a good job.

USAA is one I would point to with a more focused customer base, but they've done a great job on service and actually getting people to use that as their checking -- having a primary checking account.

But there's -- I think generally, we would consider other ways to accelerate our growth.

But there's frankly not a lot of direct players out there in any of our asset classes that one would think about being able to acquire.

Student loans would certainly fit that criteria a few years ago when you saw us take action, so we have done things to accelerate where appropriate.

We always look, but we would have to make sure it was something that fit the strategy.

Most of what would be out there would be branch banks, which isn't, and as you said, direct banking.

Thank you very much.

Sameer Gokhale, Janney Capital.

To start off, I'm trying to go back to your commentary, Mark, about the loss reserves and where they should be expected to trend and then also the provisions.

And I'm trying to frame this in my mind to help me better quantify the thinking around provisioning would be related to growth.

But if I look at your -- I go back to Q1 of 2012, I annualize your charge-offs, say in the credit card business, and then I subtract from that what you had in reserves associated with the card portfolio and divide that by the average loan balance in that portfolio.

There's a gap of about -- it comes out to be -- the math works out to be 100 basis point.

And I call that cushion, if you will, for lack of a better word.

And then if you look at the same calculation of Q1 of 2013, that was about 60, 62 basis points, and then in the most recent quarter, about 32 basis points.

Am I correct in, A, just running that calculation thinking that, okay, if you were to use the term cushion for lack of a better word, that cushion is thinner now, clearly, as you've drawn down reserves and that's why you're going to be having more provision related to growth as opposed to having any additional opportunities to release reserves?

Is that the right way to think about it?

No, I wouldn't think about it in terms of that cushion -- in terms of that thought process.

We don't -- GAAP doesn't allow you to keep a cushion per se.

GAAP basically requires you to be pretty darn transparent about where you think losses are actually trending.

And I can promise you there are regulators from multiple different regulatory bodies and an external auditor who crawls all over those loss reserve models on a regular basis, so I wouldn't think about it in terms of there being some cushion put in there.

I think, Sameer, in terms of where the trending goes from here, I would say loan growth is going to cause -- I can give you the components of it, what I can't do is tell you every quarter exactly how they're going to swing.

But the components that would cause us to have to have a positive provisioning would be, at least in the near term, those that are related to loan growth.

Growth in the balance sheet, growth in assets.

Because we don't see any significant turn in the overall environment for credit anytime soon, okay?

Another factor that would cause positive provisioning would be the student loan business, right?

Our organic student loan business,only 36% of that at this point in time is in repayment.

So, as that portfolio continued to season, that one will be driving modest additions.

I think this last quarter the student loans was $9 million of loan loss reserve addition, if you will, in the total calculation, something like that.

Those would be the two big factors that would cause positive provisioning.

On the flip side of the equation, what in a stable credit environment or a nearly stable credit environment would cause you to have releases?

I would say it would be, for both bankruptcy and contractual accounts, what our experience and hence our revised forecast based on that experience is for both the average balances that will impacted,as well as the number of accounts that will be impacted.

If you have a situation where you see average balances are going down, and you have a situation where you see the number of accounts being impacted going down, that obviously helps.

That would be the component parts and pieces of the puzzle.

Last couple quarters, we thought we saw a slight increase in some of those numbers; this quarter, we saw a decrease.

Hopefully that's helpful.

No, that's helpful.

I was looking only at your card business and I was just going on the baseline assumption that you have about 12 months of reserves -- of charge-offs in your reserves.

And then looking at your run rate of charge-offs, I was trying to extrapolate from that.

But your color is very helpful.

The other question is on a different note.

Your personal loan product, clearly you've had a lot of growth there, have been very successful.

Now, the other day in one of the newspapers, there was some discussion about a company called Lending Club which seems to target prime customers specifically for purposes of refinancing on a higher cost credit card debt and other types of debt.

I was curious, it doesn't look like you felt -- clearly, the portfolio's far smaller than the card portfolio, but it seems like you're generating pretty healthy growth rates there.

But do you come across this company?

Is it a different demographic from what you usually target?

Because it seems like the demographic is pretty similar.

I was trying to reconcile your fast growth rates with the fact that there seems to be other competitors coming in specifically targeting that customer base.

Well, from what I can tell, I would say the P2P companies are probably the leading competitors to what we're doing, and so we certainly are taking notice.

From what I can tell, some of them tend to be a little broader in their credit than we are.

We are quite focused on prime and -- as opposed to full-spectrum lending.

But nonetheless, I think some of them are doing some interesting things.

And one of the things that we have done historically has been by invitation only kind of marketing.

And we are testing into this year, at least content considering the applications of people that are coming to us through the Internet site from broad market and may benefit from debt consolidation product.

And that may bring us a little bit closer to some of the things -- that space that they're in.

Okay, great.

That's helpful.

And just one quick on, I'll sneak it in their just to make sure.

It doesn't sound to me like you're opposed to buying portfolios of private student loans.

Clearly, Sallie Mae Bank will be a standalone entity.

They've said they want to sell -- roughly about half of their production would be $2 billion in loans.

Is that something you would be interested in, or should we assume that for now, unless you get a really compelling price, you're just going to focus more on your organic growth?

I think if it were a portfolio, if a portfolio was available, we would simply run the numbers and decide if it was a good thing for shareholders and met our old hurdles or not.

I'm not familiar with what Sallie may or may not do.

I suspect that you're talking more about what they'll securitize versus keep on their balance sheet, which is probably something a little different than buy and hold loans, but --

Actually these would probably be hold loans sales, they originate about $4 billion a year and they plan to sell $2 billion to one of their other entities that's being spun out.

But presumably, they could also offer these up to the open market for other bidders to bid for these loans, so I was just curious if you'd be interested in that, or philosophically for now, you just want focus on organic business?

Sounds like if the price is right you might probably be interested.

I would say the primary focus across all of our businesses is organic growth and we're really pleased that we're achieving good organic growth.

We would be open to things that fit the strategy and could accelerate that growth, but Sallie hasn't called me yet, so I couldn't comment on that specifically.

All right.

Okay, great.

Thank you.

Rick Shane, JPMorgan.

When we look at the backdrop on what's happened in mortgage, I think it's fair to say that you caught a tailwind in the beginning that you didn't probably necessarily expect and that drove profitability a little bit quicker.

You caught a headwind over the last couple of quarters, and I think the expectation is once you turn profitable in that business, it would have been steadily profitable.

Two questions here.

One is, you talked about the revenues.

Can you talk about the expense controls that you've seen associated with mortgages you've seen the slowdown?

And following that, do you believe at current run rates, which I think are probably a realistic expectation going forward, that that business can at least be modestly profitable?

Well, I would say that you characterized it right.

Things did better than expected initially and a little worse than expected recently.

I read somewhere that we're in a 17-year low on mortgage originations in total.

And I'm not sure I agree with your characterization that that business is steady because it by nature tends to be cyclical, and I think we're in a particularly unusually tough cycle right at the moment.

I think that the direct part of that business has tended to be more refinance-focused, so it tends to be even more cyclical.

And so I think in our long-term view, what we want to do is generate more first mortgage production, which would be more stable during the quarter.

You saw us make at least one announcement on relationships with realtors and search properties that would help actually generate direct first mortgage origination, and I think that's indicative of some of what we want to do over the long term, is move to that more stable production model.

We have also taken steps, as everyone else has done, to rationalize the excess capacity in the industry out to take expenses out.

In the near term, our objective is probably simply just to get back to breakeven.

It's not costing us huge money right now, but we do see a path to get to breakeven fairly quickly.

And then after that, the question is, can we move it up to a long-term contributor and eventually to grow it to be a more substantial contributor?

Got it, great.

Thank you very much.

Actually, can I circle back on that?

Can you talk a little bit about how much of the cost -- you basically showed a 50% year-over-year compression of revenues and again, totally understandable, given where we are in the cycle.

What do you think on an apples to apples basis the expense ratio's done there?

It's just not material enough to break out.

As we said, we took costs down as well, so that whole revenue didn't come off the bottom line.

But it was enough of a swing to swing us from a modest profit to a modest loss.

And I would just (multiple speakers).

No, I would say, look, from my perspective, the expense cuts probably hasn't been as deep as the revenue loss, just to be intellectually honest with you guys in pure.

I think it would be one thing if we had a big stable business that was operating at giant scale.

Yes, you'd take out all the expenses and you'd be ready to rock 'n roll.

We're actually trying to figure out what the right role for us in this business is and how to play it the right way.

We're looking for opportunities to penetrate the purchase money mortgage channel, as David alluded to earlier, a number of different things.

We're not going to cut to the bone, but by the same token, again, we're not going to be imprudent in terms of how we manage the business, either.

We're going to be smart about it.

But we want to find a way to make this a contributing business that really adds value to our customer relationships going forward.

So, yes, we've taken a red pencil to it, but we are also not focused on just slashing it.

We want to find a way to make it work.

One other thing I would add is that we have diverted some of the resources in that business into our new home equity product that we launched late last year.

And I think we've got some early months of optimizing the process and so on before we really start to think about scaling that business.

But that's a business that I think is going to -- tends to be countercyclical with the core mortgage business.

And as rates rise and as home equity rates -- home equity starts to recover, I think there's going to be some very nice growth and in contrast to the mortgage business, that very much lends itself to direct marketing.

There's not a first mortgage versus second -- versus refinancing issue.

It's -- we think we can compete robustly for a large percentage of that market.

Terrific.

Thank you, guys.

Scott Valentin, FBR Capital Markets.

David, you mentioned double-digit account growth with Discover -- overall double-digit account growth for credit cards.

Just wondering how that's progressed over time.

You mentioned you launched the Discover It campaign about a year ago, wonder if it's been consistent, if you've seen acceleration in the pace of account additions?

Well, we had increased our accounts from when we launched Discover It.

And we're now on the one-year anniversary of really launching Discover It broadly.

So, when we talk about double-digits, that's lapping the increases that we had from the initial launch of Discover It.

Okay.

And then just a final question, you mentioned as more loans enter repayment, losses will go up in the student loan portfolio.

Where do you see -- if you were to stabilize the portfolio, where would you see losses over, say lifetime of a loan percentage-wise?

Well, I think as we've talked about a few years ago, we project lifetime losses at somewhere around 10%, roughly at 10-year life on average with prepayments.

And so you'd expect it to be a little bit north of 100 basis points.

But as we've described to you before, the first two years of repayment, typically you see half the total lifetime losses occur as people have to start in repayment and they're at the early part of their career and therefore have the lowest income generally.

And so as one would expect, as we get more and more people that bubble going through the first two years of repayment, we would expect it to be well north of that 100 basis points.

And you're seeing that in our numbers, and it's tracking pretty much according to our expectations

Okay.

Thanks very much.

David Hochstein, Buckingham Research.

Just had two really short follow-up clarification questions.

David mentioned before that the loss of that third-party issuing relationship would be immaterial, but is that immaterial to payment services income or to total Company income?

And when could that start show up?

The total Company income.

Obviously, the volumes and the profits on the much smaller base of the third-party payments business.

It's the lion's share of the one that's a third-party.

Right.

Do you have a sense of when those de-conversions could start?

We expect them later this year.

Okay.

And we're saying the lion's share of the network partners volume.

Correct.

And payment services income then is affected as well?

Payment services income also has PULSE and Diners contributing to it.

Just remember that network partners is the third component with the smallest portion of volume.

Right, thanks.

And then wonder if you could tell us how much lower you think protection products revenue can go?

Are we getting close to trough dealing?

Well, we have not restored marketing, and so you're going to see continued attrition.

It may be attriting a little bit slower than we might have anticipated.

We're seeing some very nice loyalty and customers.

It may be the things like the Target breach may be helping because the security attributes can be pretty valuable to people.

But it's going to continue to attrite until we restore marketing.

Okay.

And then I might have missed it, but Mark, did you give an estimate of what you think your tier -- your Basel III tier 1 common ratio is at March 31?

No, we didn't, but it's only off by maybe 10 or 12 basis points from our current stated tier 1 common equity level.

It does not -- implementing Basel III does not have a material impact on us.

Just wanted to clarify that.

Thanks a lot.

That was the final question, ladies and gentlemen.

I'd like to turn the call back over to Bill Franklin.

Thank you for joining us this evening.

If you have any follow-up questions, Investor Relations will be around this evening.

Have a good night.

Thank you, ladies and gentlemen.

This concludes the Discover Financial Services first quarter 2014 earnings call.

Thank you for participating.

You may now disconnect.