發現金融 (DFS) 2014 Q2 法說會逐字稿

Good evening, and welcome to the second quarter 2014 earnings call.

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

(Operator Instructions)

Please note that this conference is being recorded.

I will now turn the call over to Bill Franklin.

Bill Franklin, you may begin.

Thank you, Bakiba.

Good afternoon, everyone.

We appreciate all of you for joining us.

Let me begin as always with slide 2 of our earnings presentation which is on the Investor Relations section of our website.

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 in an 8-K report and in our 10-K and 10-Q which are on our website and on file with the SEC.

In the second 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 afternoon 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.

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

So now it is my pleasure to turn the call over to David.

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

After the market closed, we reported second quarter net income of $644 million or $1.35 per diluted share, up 13% over the prior year.

This was driven primarily by profitable loan growth and share repurchases.

We also continued to deliver strong performance with a return on equity of 23%.

Our direct banking business continues to deliver solid results, and slide 4 of the earnings presentation shows Discover's total loan growth of 7% over the prior year.

This was driven by strong growth in card, personal loans, as well as student loans.

Card receivables growth of 6% this quarter continues to outpace our peers.

We are achieving increased wallet share with existing customers and adding loans from new accounts as well.

Our Discover card sales growth also accelerated to 6%.

The overall value proposition of Discover It continues to resonate with customers as evidenced by another quarter of double-digit new account growth year over year.

Additionally, we added some new designs for the card and we rolled out a new cash back rewards card primarily to appeal to students.

Speaking of students, during the second quarter, we enhanced our student loan products by introducing a 1% cash reward for students who achieve good grades.

Additionally, in the quarter we announced new lower rates for students applying for loans.

We launched an in school repayment product and we began testing a consolidation student loan product, all of which are showing positive results to date.

Shifting gears, Discover was recently named the winner of three Call Center Excellence Awards by the International Quality & Productivity Center for demonstrating superior thinking, creativity, and execution across the full spectrum of call center functions.

I think this service excellence is one of the reasons why we have some of the lowest customer attrition in the industry.

And to further enhance the customer experience, we implemented our new core banking platform over Memorial Day weekend, which supports all of our deposit products.

The flexibility and the operational efficiencies that we expected to provide are fundamental to our vision to being the leading [direct] bank.

Moving to our payment segment, volume increased by 3%.

During the quarter, two of our newer emerging payment partners went live with transactions.

However, I'll remind you that it will take some period of time for partners to achieve scale.

As we have previously discussed, PULSE continues to deal with pressures on volume and margins due to competitive challenges in the debit industry.

Despite two consecutive quarters of positive growth, we learned that we will likely lose significant volume from a large debit issuer beginning in 2015.

While the prospect of losing some business down the road is disappointing, this loss is not material relative to the profitability of the total Company.

With that said, we are very pleased with the branding and superior returns that our network helps drive for our card business.

And we do remain focused on improving third-party volume over the long term.

Lastly, as we previously discussed in the second quarter we entered into a consent order with the FDIC related to our AML and BSA compliance programs.

The order does not include any civil money penalties but provides for program enhancements.

In addition, the Federal Reserve has recently notified us that it also intends to enter into a supervisory action with the Company regarding our enterprise-wide AML and BSA compliance programs.

We are committed to resolving these issues with the regulators in a timely manner.

Before I turn the call over to Mark to walk through the details of our second quarter results, let me say that I'm proud of our record EPS, card loan sales growth, and our ability to continue to drive solid revenue growth with expense discipline.

Mark?

Thanks, David.

I'll begin my comments today by going through the revenue detail on slide 5 of our presentation.

Net interest income increased $159 million or 11% over the prior year due to continued loan growth as well as a higher net interest margin.

Total non-interest income decreased $28 million to $583 million primarily due to lower direct mortgage related income and lower protection product revenue.

Given our suspension of protection product sales, revenue related to these products continues to decline, albeit at a slower pace than initially expected.

These items were partially offset by higher net discount and interchange revenue, which increased by $19 million or 6% year over year driven by higher Discover card sales volume.

Our rewards rate for the quarter was 91 basis points which was higher than last year due to greater standard and promotional rewards but down from last quarter which included a decrease in the expected forfeiture rate.

Payment services revenue for the quarter was flat year over year.

Overall, we grew total Company revenues by 6% for the quarter.

Turning to slide 6, total loan yield of 11.42% was up 18 basis points over the prior year driven by higher card and private student loan yields.

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

The year-over-year increase in private student loan yield is the result of better than expected performance in certain acquired pools of loans.

As we discussed on our fourth quarter earnings call under PCI accounting, favorability is recognized over the life of the underlying loans via an increase in yield and that's what's happening here.

Overall, higher total loan yield combined with lower funding costs resulted in a 40 basis point increase in the net interest margin over the prior year to 9.84%.

Turning to slide 7, total operating expense decreased by $23 million or 3% over the prior year mainly due to a decline in other expense, which was somewhat offset by an increase in headcount and professional fees.

The decline in other expense was caused by the absence of $40 million in Diners Club charges which we incurred last year.

For the quarter, our total Company efficiency ratio was below 37%, more than 1% lower than our long-term target due in part to the timing of certain expenses throughout the year.

Turning to provision for loan losses and credit on slide 8, provision for loan losses was higher by $120 million compared to the prior year due to a $23 million reserve build this quarter compared to a $78 million reserve release during the second quarter of 2013.

The reserve build mainly reflects our continued card loan growth.

Sequentially, the credit card net charge-off rate increased by 1 basis point to 2.33% and a 30-plus day delinquency rate decreased by 9 basis points to 1.63%.

The private student loan net charge-off rate, excluding purchased loans, was down 1 basis point sequentially to 1.3% and the 30-plus day delinquency rate decreased by 13 basis points to 1.66%.

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

Switching to personal loans, the net charge-off rate was down 12 basis points sequentially to 1.95% and the over 30-day delinquency rate was down 2 basis points to 66 basis points.

Overall, we remain pleased with our strong credit results.

One last item I would call out on the income statement is that during the quarter, we had a favorable resolution to some outstanding tax matters and as a result, our 36.6% effective tax rate for the quarter was lower than anticipated.

Next, I'll touch on our capital position on slide 9. Our Tier 1 common ratio increased sequentially by 30 basis points to 15.2% due to solid earnings.

During the quarter, we repurchased $177 million of common shares.

One of our top priorities is to drive shareholder value through effective capital management.

To that end, we still plan to repurchase a total of $1.6 billion of common shares for the four-quarter period ending March 31, 2015, the same amount as our CCAR capital action submitted to the Fed.

Also on slide 9 is our outlook for 2014, which I would simply say remains relatively unchanged from the guidance we gave back in February at our financial community briefing.

So to summarize, during the second quarter, we continue to build on our momentum established at the beginning of the year.

Discover drove better than industry loan growth, net interest margin continues to be above our long-term target, the credit environment remains benign, and we are effectively controlling our expenses.

That concludes our formal remarks today.

So I'll turn the call back to our operator, Bakiba, to begin our Q&A session.

Thank you.

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

(Operator Instructions)

Mark DeVries, Barclays.

Question, David, to what do you attribute the 6% card loan growth of above the high end of your guidance?

Is that -- are you actually seeing signs of acceleration in spend across the industry or is it better than expected traction from the marketing of the Discover It card?

And then could you actually see it potentially remaining above that rate for a period or is that a level of growth that you at some levels would think might outstrip your desire to grow here?

Well, to answer your second question, we're not prepared to revise our 2% to 5% long-term target.

I'm certainly pleased that we actually were a bit above that target this quarter.

And you've just seen our various competitors announce and I'd say generally, I certainly didn't see that much signs of acceleration across the industry.

So I think we continue to gain market share.

So I would say that you mentioned the success of Discover It.

That is certainly contributing, but some of the other things that are contributing are lower charge-offs, less attrition, some wallet share build with existing customers as they react -- respond to many programs and higher levels of service, as well as I mentioned putting on more new accounts.

We're getting loans from the new accounts, so I think we're hitting on all cylinders and it's showing up in loan growth.

And we also saw our sales growth accelerate to 6% this quarter, which is the best in a number of quarters.

Okay.

Great.

And just a follow-up on the guidance around rewards expense.

Mark, I think you indicated you're still at assuming 100 basis points for the year.

I think the first half of the year has only been about 95 bps.

Should we assume that there's going to be greater promotional activity in the back half of the year that's going to bring you closer to 105 for the back half of the year, or should we consider this conservative guidance here?

I would not interpret as conservative guidance.

I would say it's -- I feel really good about that guidance.

The area of 1% is the right way to think about it.

If anything, Mark, for the full year it may trend a basis point or 2 higher than that.

So I would say it remains good guidance.

Okay.

But to answer your seasonal question, you've seen this in form.

A year ago, this was a fairly light quarter and then we tended to pick up more moving into the holidays.

And we'd expect to do the same this year.

Got it.

Thank you.

Sanjay Sakhrani.

I guess you guys built reserves this quarter and I was just wondering as we look out, should we just expect that you guys will continue to build reserves?

And maybe just on a related note, when we think about the seasoning process from the growth that you've booked over the course of the last year and a half, where are we with that process?

When do we start seeing that actually be somewhat of a headwind in the face of stabilization in credit?

Thanks.

Sanjay, I'll try and touch on both of those and do them justice here.

I would say from a reserving perspective, reserve trajectories still feel like they're being driven by growth.

The credit environment, the backdrop itself stills feels relatively benign.

We don't see any fundamental turns out there at all.

So quarter over quarter, there may be some variability in that.

I think as we've said before, GAAP is pretty prescriptive in terms of how you actually set the reserve, so on $1.6 billion we may build 20 one quarter; we may release 20 the next quarter.

The way I think about it, we're just kind of sitting flat bumping along the bottom with those kind of relative numbers.

In terms of seasoning and where things are going to come out, what I would say is we've been generating real strong loan growth now for over three years.

And in light of that, if you think about the way a card loan seasons, you typically tend to see peak charge-offs somewhere between month 18 and month 30, so we're already well into the seasoning process on the first two years of those vintages of growth, which I think really speaks to the quality of the loans we're attracting and really underscores that we are operating, first of all, in a benign credit environment, but then really with respect to us I think really underscores the fact we focus on a prime borrower and the quality of that portfolio that we're building.

Okay.

Great.

I'm sorry.

One quick follow-up.

Has the profile of the accounts you've booked changed over the course of time?

Have you guys tried to broaden it out a little bit more?

I'd say overall, the quality is quite consistent.

Okay.

Great.

Thank you.

Eric Wasserstrom, SunTrust Robinson.

Just a follow-up on the growth, how should we think about the sequential growth, David, just given the trend that you have mentioned which is sort of above standard growth for three years in a row is starting to lead to disinflating sequential growth rates?

So how should we think about that dynamic?

Well, I'm not sure I follow exactly your sequential question.

I guess if you --

So for example in credit card, the sequential growth was about 3.5% versus the 6% year-on-year growth, right?

Yes.

Well, obviously, the card business is seasonal.

And so I personally think the better way to do it is to look at it year over year which removes that seasonality.

And we've been operating near the high end of the 2% to 5% target for a while now.

And I guess this is the first quarter that we've actually broken through that and are above that.

I wouldn't promise that we're going to remain above it, but I certainly would suggest that we're going to be at least at the high end here for a while because I don't see any of the positive trends that we're achieving reversing in the next quarter or two.

Thanks.

Mark, if I could ask one quick follow-up question.

Do you happen to know the dollar amount of the tax benefit in the period?

I don't have it at my fingertips.

We can follow up and get that to you.

Thanks very much.

Don Fandetti, Citigroup.

David, you had made some comments about the loan growth.

As we look at some of your competitors, it looks like there's a fairly consistent -- I guess you could call it an uptick in loan growth.

But it sounds like maybe you're saying that you're not really seeing that or is it more you just want to be cautious because it's a small uplift?

Are you seeing any increased demand for credit from customers or is it -- and we understand that you're definitely gaining market share.

Just trying to parse it out a little bit more.

Well, I'm not exactly sure what you're looking at, but from our biggest competitors, what I'm seeing is that American Express is the only really large competitor that's growing close to our levels.

And the other largest issuers are sort of plus or minus 2% ranges.

So I'm not seeing an overall industry pickup to our levels of growth.

So it looks -- the industry as a whole looks pretty flat.

Maybe the industry has moved from minus 1% to plus 1% or something, but it's still darn near flat.

And so I'm very pleased with our 6% growth with a flat industry.

Got it.

And then into July, the spend, has that held relatively steady?

It has.

The last two months of the quarter and then continuing into this month are pretty consistent with that 6% overall quarter year over year.

So feeling good about seeing a little higher growth sustained for now.

Got it.

Thanks.

Ryan Nash, Goldman Sachs.

Mark, when I think about the trajectory of the net interest margin, just thinking back to last year, I think there was some expectation of a decline in the first half and then improvement in the back half of the year, so while your starting base obviously is a lot higher at this point, just given the seasonal tailwinds that you sometimes see in 3Q, should we expect to see the margin begin to expand again from its current levels?

Yes, Ryan.

I would say I would expect flattish is the right way to think about it from where we sit right now for the remainder of the year.

I think there's some puts and takes in there.

I think from a loan yield standpoint, I think flattish is the way to think about that one.

I think we have a little bit less funding cost tailwind, if you will, in terms of the maturities that are rolling off and a little less pickup on some of those going forward but I would say we actually would have had some margin expansion this quarter just to be transparent with our investor base.

I think we had three basis points of sequential contraction.

That's because we chose to take some of the goodness we're seeing right now and use that to position ourselves to perform well when the environment turns and you have a rising rate situation as well.

So we consciously did some of that and I would expect you might see us do a little bit more of that as the year goes on.

So I would stick to the flattish NIM guidance as you look to the year.

And is that driving higher sensitivity to rates when rates do eventually rise?

Over time, yes, it will.

Okay.

And then, Mark, if I could just ask one unrelated question.

On credit, when I look at the recovery numbers, it looks like we're seeing no signs of slowing.

I guess relative to your initial guidance from last year, are you seeing any changes?

Obviously, the recoveries look like they're coming in better and if they do continue to come better, is it safe to say that we could actually see credit improving over the next couple of quarters?

I would think about recoveries in two different buckets, Ryan.

The first bucket is what I'll call the recoveries on the pool of charge-offs from the recession, right?

As we've said before, we have continued to realize that recoveries off that bucket for a much longer period of time than you would following a normal downturn.

Usually by the time you're 24 months past a charge-off, your recoveries have really peaked and they tail off pretty quickly thereafter.

We're five years past that point in time.

And recoveries are still coming off that book, and I would say they're coming at a -- they're attritening at a much slower rate than we would have guessed, as you pointed out.

So over time, clearly that's a finite book.

It will attrite, right?

So I would say over time, it's happening slower than we expected but that attrition will take place.

Then you have to look at the new charge-offs that are flowing into the pipe, if you will, to refill that bucket.

I think it's a really good thing that we don't have many of them today.

So the fact that we're just not charging off a lot gives you limited potential for recoveries against a much smaller book of charged-off accounts so the recovery rate itself when you parse it up on the new charge-offs is every bit as good as it's ever been.

The recovery rate on that static pool from the crisis will attrite over time.

Got it.

Thanks for taking my questions.

David Ho, Deutsche Bank.

Quick question on expenses.

You reiterated the guidance for the year for $3.3 billion of expenses.

If I take the first half run rate, it seems to imply that the second half will be up about 6% year over year.

Is that just kind of the timing of marketing and a little more build and other expenses and comp?

And how much has the mortgage business been right sized as costs come out of that business as you've seen a big takedown in revenues there?

I would say, $3.3 billion still feels like a good number on the full year.

There is definitely some seasonality in the expense base.

There's no question about that and there is some back-end load.

I would say with respect to the mortgage company specifically, I feel like we've taken the right actions there at this point in time to position that business well.

It's still burning a little bit of money, but not a real measurable amount, to be honest, at least not anything that shows up at the top of the Company in a meaningful way.

And we are continuing to work on positioning the longer-term strategy with respect to that business within Discover, but I feel like we've taken the action that needed to be taken there.

Thanks.

Just following up on Ryan's question about asset sensitivity increasing, can you remind us what percentage of the book is variable-rate loans and of that, how much do you expect to be able to reprice or realize the rate changes in the higher rate environment?

I think there's a bunch of moving pieces in there, David.

What I would say is I think an immediate parallel shock of 100 basis points to rates produces something on the order of $130 million roughly was our last quarterly disclosure.

We'll obviously update it in our new Q as well.

The vast majority of the loan book is floating.

The card book floats at this point in time.

Some of the student loans are fixed and the personal loans as well.

So I don't have the exact breakdown at my fingertips, but the vast majority of the book is a floating-rate book.

Right.

You assume that will probably rise with deposits being a little more sticky and assets being able to reprice?

Yes.

I think the one thing we've talked about and I think we just need to continue being transparent about it is if you want to continue driving sales growth, at some point in time, there probably is a cap on some of your floating-rate loans, some other card, right.

If you're going to charge 40% for cards you're probably not going to get a lot of sales usage, but we're far, far, far away from where we think that begins to kick in.

Great.

Thanks for taking my question.

Bill Carcache, Nomura Securities.

I had a follow-up question on expenses in particular, your revenue growth outpaced your operating expenses by over 9% this quarter.

I know you guys have an operating efficiency ratio target, but I was hoping that you could discuss how you guys are thinking about positive operating leverage as we look at the business beyond this year and into next?

Is there any kind of a commitment to growing revenues faster than expenses at this point in the cycle or is it really all about the efficiency ratio and expenses over time will go up or down with revenues?

The way I would think about it is to really look at the fact that we've been investing pretty heavily over the course of the last couple of years to take advantage of the goodness in the environment.

So part of some of the negative operating leverage you've seen over the course of the last couple years has really been driven by that fact.

I can assure you that David is laser focused on positive operating leverage and making sure that revenue growth outpaces expense growth over the long run.

I think there's quarters where we will; there's quarters where we won't, by virtue of what's taking place in that given quarter.

So I would say we will anchor to that efficiency ratio, but we are always striving for positive operating leverage in the business model.

So then just mathematically to the extent that over time revenues are growing faster than expenses and there could be over time some potential for that efficiency ratio target to move lower?

Yes.

I might just comment that we expect some positive operating leverage, but probably more modest than what you just cited.

And I think that one of the things that Mark just talked about, taking expenses down in, for instance home loans, and that's sort of a one-time event that's impacting us -- benefiting us, if you will, this time.

But on the flip side, we've got higher regulatory related costs, and so I think the way to think about it is we've established a 38% efficiency margin, and we expect to roughly maintain that.

It could possibly go the other way at some point because if we see great marketing opportunities, we might choose to go the other way.

So we're not promising positive operating margins or operating leverage forever, but if we get off that track, it will be for a good reason.

And for a limited period of time.

Understood.

Thank you.

If I may, on a separate note, you guys haven't added any new receivables to the trust in a long time.

You've talked about this in the past, but I think in looking at it, I don't believe that any of your originations from 2009 to 2014 are in there, so the balance has been gradually decreasing.

I was just hoping you maybe you could briefly touch on how you're thinking about the trust and how it fits into your pecking order of funding preferences here.

Thanks.

It's great cost-effective funding for us, issue card ABS.

What I would say is we have a significant excess of receivables in the trust over what we need for the planned issuances at this point in time, and that's why you haven't seen us contribute any new assets to the trust in an extended period of time.

So should we get into a situation where we would be running up against capacities, we'd obviously be willing to consider putting more receivables in.

Great.

Thank you.

You bet.

Moshe Orenbuch, Credit Suisse.

I was intrigued, David, by a statement you just made about if you found great marketing opportunities here.

You're at a point where you've -- you aren't materially increasing marketing spending yet you're outgrowing the industry, your sales volume growth's accelerating, and your rewards costs not certainly well within the range of what you'd set out.

I guess to turn that question around, what could you be doing to make it even better?

Is there anything that could be done here and maybe just if you could tack on how you assess the current competitive state in your market?

Well, I think we have a disciplined approach to thinking about marginal cost and marginal benefit.

And we look at that across all of our businesses and across all of our programs.

And so we think that we're at a pretty optimal point here.

And so at the margin, we think we'd have diminished payback from incremental investments.

And yet, we've actually been able to focus as much on efficiency and effectiveness to outgrow the industry, not doing it by outspending the industry.

And I think what you spend in marketing, maybe it's important, but what your product is, the service that backs it, the rewards program, how good you are at direct marketing, and of course we focus all of our efforts on direct.

We don't have channel conflict with branches and all that.

Those things are just as important.

So we're constantly evaluating incremental opportunities and killing things that aren't getting the payback and adding things that do.

Just to follow up, if you were to do something, where would it fall short?

Would it fall short on terms of the cost to produce it or the credit or the spending performance?

Where would you think that would be?

It's typically in the cost per new account or cost per incremental marketing effort relative to the loan balances and spending and credit performance that you get.

Thanks very much, David.

Chris Donat, Sandler O'Neill.

I had one follow-up on the rewards spending.

Just the seasonality with the second quarter this year being lowest so far and as I look back on the last -- really over the last three years, second quarter's been the lowest quarter as a percent of card sales volume.

Is that solely a function of the quarterly cash back bonus programs or is there something else going on in that seasonality?

It's primarily related to the 5% and other promotional programs.

And the biggest single factor is what categories are we promoting?

And we tend to -- you saw last year, we promoted online and big categories like online and department stores during times when people are doing their holiday shopping and such.

And then we'll typically do things like gas programs during the summer and so on, but that still tends to be a smaller overall category.

Okay.

And then just to follow-up on a comment that Mark had made, sort of tacking on an answer to a question there, that additional spending if you were to do it would be for a limited period of time.

Like as I think about the run rate you're on for this year at 3.2%, so the things you're looking at to spend on to get you to $3.3 billion of annual spending or operating expenses, that's on the variable side, right?

It's marketing.

It's not like you're looking to hire a whole bunch of new people or anything that would recur immediately in 2015, right?

Yes.

I think you should rightly assume the vast majority of it is variable.

That's the right way to think about it.

Got it.

Thanks, Mark.

Bob Napoli.

Question on capital.

I know you said you're going to buy back the same amount of stock but I was curious why you didn't buy back as much and just as you look at your capital level, a way to use that capital, I guess the Fed is more comfortable with is some M&A.

And I just don't know, you guys have been, as you've mentioned, time -- and have rewarded investors with discipline.

Are there opportunities to use that capital in a strategic manner that would add additional growth -- long-term growth opportunities that you're comfortable with and are you looking hard, I guess?

Why don't I start the answer to that one then I'll pass it over to David for more specifics.

First of all, why we ended up buying a little bit less this quarter, I would say, Bob, we haven't gotten in the habit of talking about when we're in the market, when we're out of the market, why, or how much.

So I prefer not to get selective on that.

I'd rather just say we're going to -- our plan is to take out the $1.6 billion over the course of the four quarter rolling period.

I would say with respect to our approach and our appetite for M&A, I would just remind you before I pass things to David, our capital prioritization stack, it's first and foremost organic growth.

It's secondly returning it to shareholders, which as you rightly point out under the current CCAR process is somewhat constrained these days.

Third, it would be financially attractive for portfolio acquisitions.

They've got to be financially attractive because by definition they attrite at their portfolios, so I'd say that would be a piece of the puzzle.

And then fourth, on that prioritization list would be M&A because you introduced the key man retention risks, the diligence risks, the integration risks, all those other different pieces of the puzzle that the others don't bring forth, so that's why we're pretty disciplined around the way we look at M&A.

In terms of what we might be willing to consider, David, I'll pass that to you for --

Well, I would just reinforce that we're primarily an organic growth story.

And the reason for that is there's a -- I think a limited set of opportunities that would directly fit with our direct banking and payments partner strategy.

Secondly, we have achieved very strong returns in our business.

And therefore, the hurdles as we think about where to put our incremental shareholders' capital, we've tended to find more opportunities to actually grow organically and build shareholder value in that way.

And thirdly, we do -- while we've done some M&A over time, we do approach it with a fair bit of skepticism.

And there's a lot of cases where it has -- M&A has detracted from shareholder value versus building it and so we're going to be very cautious in approaching that.

I guess the final thing I'd say is that I do think that we're playing a long-term game here.

And I think that it's likely that as regulators and institutions get more comfortable with the new approach and the new levels of capital and the processes in place, that some of the sort of constraints may loosen up over time.

And so it's important not to have money burn holes in our pockets because we may be able to return more of it over time.

Great.

And just a quick follow-up on the credit card business.

Have you been adjusting credit lines?

One of your competitors has moved to credit line increases and I think we've seen some of that in the Fed data.

Given the strong credit, is that a way to get growth?

Have you been adjusting credit lines or anything else on the credit side?

Yes.

Our line increase strategy hasn't changed material over the last couple years.

Great.

Thank you.

Appreciate it.

Brian Foran.

I guess on loan yields, I kind of asked the same question last quarter and you gave a pretty decent detailed answer on kind of the broad industry dynamics.

But I guess when I look at it, you've got a banking industry where loan yields are 4% and falling fast.

You've got you guys where loan yields are 11.4% and not falling at all.

Is there anything you're seeing on the horizon that would lead to increased competition for those loan yields?

It's just you're in a remarkably good spot where you're actually able to grow revenue as you grow loan balances so obviously the risk is that changes.

Well, I think that it's more a factor of the fact that we focus on direct banking and on more profitable products.

And so, I think that if you compare our card yield to other card yields, we still look attractive for one reason, we don't charge off as much interest as competitors with higher loan losses, but it's a lot closer.

And as we have expanded into other businesses, student loans is a lower yield than other unsecured loan types.

But it's still above secured loan types, such as mortgages.

Personal loans also tends to be below card but still it's a lot closer to card than other banking products.

So the direct banking strategy has a lot of benefits, picking and choosing which products you offer and which you don't is one of those.

And we have been judicious in that.

I guess the final thing I'd say is we've been disciplined.

We're disciplined on our use of promotional rates.

We're disciplined on focusing on revolvers.

And if you have a lot of transactors in your book, you tend to suppress the yield because you have zero earning assets in there.

And we've been judicious on credit because written-off interest also deducts from that yield.

As an unrelated follow-up, there's a lot of changes going on in private label card.

Can you just remind us how you think about that business long term as something that potential part of the roster, so to speak?

I think we've said over time that that could fit the strategy if we ever found an appropriate entry path.

But the entry paths are very limited and we have not seen any to date.

So I would think about that as opportunistic.

Could it happen someday?

Yes.

But it may never happen.

And it's not a critical product in the way that direct checking or even some of our mortgage products are to thinking about being a leader in direct banking.

It's more of a nice-to-have if an opportunity ever happened.

But private label has had a rebound of late, but still if you look at the long term, it's not necessarily growing relative to general purpose cards.

And it's a more limited market size than general purpose cards.

And so I think there's only room for a more limited set of competitors to offer that kind of product.

Thank you very much.

Craig Maurer, CLSA.

At the Investor Day, you had talked about looking to significantly enhance your portfolio of spend-centric products to try to leverage your network.

And I was just wondering where you stand in that thought process?

Thanks.

I actually don't remember that comment.

I think we certainly have talked about continuing to enhance and differentiate our core card products.

And I feel very good about Discover It, which is our flagship product.

The free FICO scores have been very well received by consumers and not widely copied by competitors.

In fact, I think we're still the only ones who offer it on the statements.

We've added some security features that are somewhat unique in the industry.

As an example, we've put in the ability for a consumer to turn their card on or off with the flick of a button online if, for instance, they misplace their card, which I'm not familiar with other competitors having that.

We've continued to enhance the rewards program as well.

So I think what you heard at the Investor Day was us talking about our focus on good credit quality revolvers.

And that one of the things that differentiates us is it seems like a number of our competitors are really chasing transactors that look good in today's rate environment, but is not typically driving the revenue.

And that's one of the reasons you're seeing our revenue go up and other card companies go down in revenue because transactors simply don't produce as much revenue.

Okay.

Thank you.

David Hochstim, Buckingham Research.

I wondered, David, can you give us a sense of the mix of the contributors to loan growth?

You mentioned new customers and existing customers, and have you done anything with -- is there any change in teaser rates and promotional rates this quarter?

I'd say our loan growth continues to be quite balanced.

We're getting loan growth from new customers.

We're also retaining customers and getting higher level of activation and engagement out of existing customers.

So we have not done anything dramatically differently in teaser rates.

One way you can see that is you haven't seen a big change in yield.

And so pricing has held up even as growth has held up and even accelerated a bit.

So we are constantly testing, adjusting, but retaining a very disciplined and balanced loan growth.

And we've not -- in our opinion, the quick change your credit or change your pricing could drive a spurt of growth but is not -- is easier to execute, but the executing a differentiated strategy with all of our customer service onshore, inside their company, better service levels that drive better retention of balances is the way to get both good credit results, good yield, and loan growth over time, which ultimately leads to profits.

Okay.

And then, Mark, could you just tell us are there any tax benefits coming in the second half or what's a good estimate for the effective tax rate in the second half?

I would use 37.5% as a good estimate for the effective tax rate in the second half.

We always have, as any large company does, open matters before various taxing authorities and so the possibility always exists, but I'm not banking on any.

How about that?

Okay.

Thank you.

Jason Arnold, RBC Capital Markets.

I was just curious if you could comment a little bit further on a competitive side.

Are you seeing any competitors doing anything kind of more aggressive or out of the ordinary versus prior periods at all?

I would say that different players are coming in and out in terms of aggressiveness.

The general trend in recent years is there's been a huge shift towards everyone focusing on rewards and in particular, cash rewards.

But that's partly because it's working.

Consumers love it.

They've seen competitors see our success and want to get some of that, if you will.

But that's not -- it's not a new trend.

What we've seen is in this year, one or two competitors that have picked up their marketing intensity on that.

And there's one or two players that have actually reduced their marketing intensity on cash kind of rewards.

It is expensive to offer.

It is what we focus on.

And we focus on delivering great value at affordable cost to the Company, which allows us to sustain it over the long term.

And I think one of the things I'm really proud of is how well our top line advertising is working.

Our consumer testing shows that we're getting some of the best results in years.

And our marketing campaigns are more effective for a given level of spend than our competitors, so our commercials and sponsorships like the NHL are working harder for us, and that is really helping.

Great.

Good to hear there.

And just one other unrelated item.

I know we're still somewhat early on but can you give us an update on the cash back checking product and how things are going there?

Sure.

I mentioned -- we launched cash back checking last year in a limited cross-sell.

And what we told everyone at Investor Day is that we really wanted to get our core banking system in place before we started to really scale that.

I mentioned that we put that in successfully during Memorial Day.

So we really feel good that it's gone in well.

And so we are just about at the point that we'll start ramping up but we'll be ramping up in a cross-sell manner.

We've -- the new system has allowed us some new capabilities to make it easier to offer to our -- to most of our current base.

And obviously, with a large customer base that represents about a quarter of the US households, that would be the place that cross-sell would be the most cost-effective way to expand it from this point.

We have not yet made a decision as to when we're going to launch it beyond our current customer base.

It's entirely possible that the rest of this year, we're going to focus on an expanded cross-sell.

And it may be next year before we go broad market, but stay tuned for that.

Terrific.

Thanks a lot.

Vincent Caintic, Macquarie.

On the gross interchange rate, I'm calculating a 203 basis-point rate for this quarter, which is higher than it's been at least since 2011 and despite the lower rewards expense.

I was wondering if there's any one-time or second-quarter items there that we shouldn't think about as a run rate or if this is a kind of a good jumpstart for the rest of the year?

I would say it's a couple different things taking place there.

First of all, is we did a reclass of certain merchant fees in the first quarter, so part of it is being reflective of that reclass that was done.

The second piece of the puzzle I would say is just the spend mix over the course of the quarter and the spending tilted more toward merchants with higher discount rates this quarter and away from merchants who have lower discount rates.

So I would say that tends to move back and forth quarter over quarter.

It feels like MDR's in a decent range at this point in time.

Got it.

Makes sense.

And then a follow-up actually on the loan yield questions that were asked previously and I'll take it through another tack.

You mentioned with the card loan yields that the lower interest charge-offs were a meaningful benefit to that.

Just wondering if you normalize with the credit being taken out of the equation, do yields point towards a downward trajectory or how should we think about that?

Thanks.

I was just going to say, if you take credit out of the equation, yields feel pretty stable.

You should look at the ALM positioning we've had for the Company.

We've positioned ourselves to absorb the initial phases of rate shocks to our funding cost base.

We continue, as I mentioned in my commentary, in the margin we continue to push out our funding, extending maturities, fixing rates, positioning ourselves for that so the funding cost component of the yield feels pretty good.

The actual card yield itself feels pretty good.

The actual asset yield themselves feel pretty good, the stated yields on the product.

So it's really just the interest charge-offs that are the other piece of variability, so I would say if you exclude them, feel very stable.

Remember, that's stable in the shorter term.

We still think over the longer term, we would expect credit to normalize somewhat and then that would push the yields down closer to the levels that we've talked about in the past.

But that would come through the charge-off line as opposed to the stated yield on the asset or the funding.

Got it.

Thanks very much, guys.

Sameer Gokhale, Janney Capital.

Couple of questions.

My first one was you mentioned as one other competitor who's growing faster than the market or at a decent clip, and of course that you're growing at a pretty good clip in the card business.

And it looks like most of the larger card issuers really aren't seeing that much growth on a year-over-year basis.

There is one company, Wells Fargo, which is actually growing faster than even you are.

And of course, they have a much smaller loan portfolio.

So what I'd be curious in getting your thoughts on is they're growing faster than the industry, faster than you are, smaller portfolio, but I was wondering, how we should think about the competitive landscape as they continue to grow.

They seem to be taking more share away from your competitors, but at some point, I have to believe there's a trickle-down effect to the extent your competitors are forced to spend more marketing to defend share and then you have to spend more.

So how should we think about that?

Are you in such a different target market that really doesn't affect you?

Just your thoughts would be helpful.

I think that we've typically referred to the big six because that includes us, that because there has been such a big gap between the six of us and the next one.

We have increasingly started tracking Wells Fargo to a much greater degree.

They are growing faster by rate from a smaller base.

And I would expect that to continue.

And I think over time, we may get to a point where we talk about the big seven as opposed to the big six.

That being said, it's branch driven.

I think it's probably a wider credit box than we have.

They're not national, so we're not bumping up against them in national internet and direct mail campaigns to as much degree.

We're not bumping up into them with national advertising the way we are with really, most of the big six.

But still, as they take share of the total market, they will become more of a player.

So I expect that it's likely to maybe impact the other branch banks more because they're following that strategy.

But it will also have some competitive impact on us.

Okay.

That's a very complete and helpful answer.

Thank you.

And then the other question I had was, you answered the question about industry competition and growth in several different ways.

I just wanted to -- I was wondering if you think that loan growth for the card industry will ever get to 5% plus level?

Clearly, you're there.

But you haven't raised your target range, but it seems like unless there's a significant pickup in incomes, personal incomes, or something that makes consumers more optimistic about borrowing more and lenders more willing to lend, I just can't see that dynamic ever changing with industry growth overall exceeding 5%.

So is that consistent with your view or do you feel that at some point, we really could see the industry growth overall accelerate and what would drive that?

Well, I think we could see some acceleration from the really non-growth today that we're seeing.

I continue to believe that it will accelerate to be roughly in line with GDP.

And so low double-digits, maybe not 5%, but even a couple percent growth would be a meaningful change from where this industry's been.

And I think what's driving that is I think the deleveraging is largely complete with consumers and competitive changes in the marketplace.

And then I would expect credit card to grow with the economy, with incomes, with retail sales.

And I don't see -- if you look at the times when the industry grew really fast, historically it was when balance transfer was introduced or when credit was -- standards were reduced.

And I don't see either of those trends happening to have a fundamental change going forward.

Okay.

It sounds like we're on the same page.

Appreciate your perspective.

Thank you.

Great.

Thank you.

We have no further questions at this time.

All right.

Thank you, everyone.

As a reminder, the Investor Relations team will be here this evening to answer any additional questions.

Have a good night.

Thank you, all.

Thank you, ladies and gentlemen.

This concludes today's conference.

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