發現金融 (DFS) 2014 Q3 法說會逐字稿

Welcome to the third quarter 2014 earnings call.

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

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

Later, we'll conduct a question-and-answer session.

Please note that this conference is being recorded.

I'll now turn call over to Bill Franklin.

Bill Franklin, you may begin.

Thank you, Adrian.

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 Discover.com.

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

In the third quarter 2014 earnings materials 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.

I want to thank all of you for joining us on the call today.

After the market closed, we reported third quarter net income of $644 million and earnings per share of $1.37, up 14% over the prior year, driven primarily by profitable loan growth and share repurchases with a return on equity of 23%.

Our Direct Banking business continues to deliver solid results.

On slide 4 of the earnings presentation you'll see Discover achieved total loan growth of 7% over the prior year.

This was driven by strong growth in card, personal loans and private student loans.

Card receivables grew 6.6% this quarter, which is a rate that continues to outpace our peers and indicates that we are continuing to take share.

We are driving this growth by adding new accounts and increasing wallet share with existing customers.

The overall value proposition of Discover it continues to resonate with customers as we achieved a double digit new account growth rate again in the third quarter.

We believe that the increase in wallet share and our continued low attrition, both of which benefit card loan growth, are held by our award recognized customer satisfaction.

In the quarter, Discover tied for highest in customer satisfaction with credit card companies for 2014, according to J.D. Power.

This is a first for Discover and demonstrates our continued focus on the customer is being recognized in the marketplace.

Discover received the highest rating in the area of customer interaction, which focuses on how card members perceive the service received through key engagement channels such as website, call centers, automated phone system, online chat E-mail, and mobile phone.

Our continued enhancement of mobile and digital technology includes developments that allow users to view account information more conveniently, freeze and activate cards with a single touch, and our recent release of an app that makes us the first credit card company or major bank that lets card members log into their accounts using fingerprint authorization.

These are just a few of the ways we continue to deploy innovative functionality for consumers.

Discover also ranked highly in the categories of credit card terms, benefits and services, problem resolution, and rewards.

Along these lines later in our call, Mark will give you some insight into how we are thinking about further improving ease of rewards redemption for card members.

Card sales for the quarter increased 5.8% from the prior year.

More active accounts year-over-year, driven by new accounts, higher average spend per active, reactivating existing accounts, and very low attrition, all contributed to growth beyond US retail sales.

Our second largest asset class, private student loans, grew 5%.

When you look at the organic growth, excluding the acquired portfolios, we were able to achieve 23% growth year-over-year.

June, July, and August are peak season for student loan applications.

During peak season, we experienced strong application growth of 11% over the prior year.

Although we were challenged a bit in the graduate student loan market due to previous price decreases on federal graduate student loans, this was more than offset by the gains we made in undergraduate originations.

The increase in undergraduate originations was mostly the result of our increased marketing, our in-school repayment product, and the 1% rewards feature we added for good grades on new student loans.

Moving to our Payment segment volume increased by 2%.

We shared earlier this year that we will be losing some third party volumes in network partners and at PULSE.

For example, the Synchrony issued Sam's/Walmart card volume began running off this quarter as it transitioned to another network and we expect the majority of this volume to leave Network partners' results in the fourth quarter.

That said, I believe that the value of the Discover Network to our card issuing business has never been greater in terms of acceptance, brand awareness, and economics.

We mentioned at our financial community briefing earlier this year that we would be competing for all debit.

This quarter The American Bankers Association announced their endorsement of Discover Debit.

Historically banks had only two options for their signature debit cards.

We want to give them another option.

We believe our Discover Debit product can offer superior economics, simplified rules, fee transparency and similar acceptance.

Another item we discussed at our financial community briefing when we covered our key priorities was risk management.

The regulatory environment continues to be challenging, and we, like others in the industry, are dedicating significant internal focus to regulatory and compliance initiatives.

Before I turn the call over to Mark for the details of third quarter performance, let me say that I'm proud of our operating results, great credit performance, and our ability to continue to drive solid prime loan growth.

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 $129 million or 9% over the prior year due to continued loan growth and a higher net interest margin.

Total non-interest income was relatively flat at $552 million, as several puts and takes within various line items essentially offset each other.

Specifically, net discount and interchange revenue increased by $19 million or 7% year-over-year driven by higher Discover card sales volume.

Protection product revenue continues to decline, down $12 million year over year, given our suspension of protection product sales in late 2012.

Partially offsetting this, loan fee income was up $7 million.

Other revenue decreased $15 million, mostly due to a prior reclassification of some merchant fees, now recognized in discount and interchange revenue, as well as lower mortgage related income.

Our rewards rate for the quarter was 103 basis points, which was 5 basis points higher than last year due to an increase in standard rewards, driven in part by higher Discover it sales.

Relative to the prior period, the rewards rate was up 12 basis points, a result of more 5% cash back bonus activity as the third quarter category was gasoline, as well as lower forfeitures.

Following up on David's earlier comment I want to share some of our latest thinking on the rewards program and some potential impacts to the P&L in the fourth quarter and beyond.

We've said for some time that we are focused on maintaining our strong position in a very competitive rewards environment.

As I mentioned at a recent conference, we're currently revisiting our rewards program with a goal of delivering greater ease of redemption and eliminating most or all forfeiture triggers.

To that end we are contemplating a series of changes to the redemption elements of our rewards program.

While not yet finalized we estimate these changes could result in a one-time charge of up to $185 million in the fourth quarter, due to the extinguishment of all or part of our current reserve for rewards forfeiture.

The ongoing run rate impact of these contemplated changes should be very manageable, somewhere less than 5 basis points per annum.

Continuing on slide 5, Payment Services revenue for the quarter was down slightly relative to the prior year.

But overall, we grew total Company revenues by 6% for the quarter, driven by strong Direct Banking segment performance.

Turning to slide 6, total loan yield of 11.36% was up 7 basis points over the prior year driven by higher card and private student loan yields.

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

The year-over-year increase in private student loan yield relates to the PCI accounting favorability we began recognizing in the fourth quarter of 2013, which I discussed in more depth on last quarter's call.

Overall, higher total loan yield, combined with lower funding costs, resulted in a 14 basis point increase in net interest margin over the prior year to 9.78%.

Sequentially, net interest margin was down as card members took advantage of promotional offers, which benefited loan growth.

Additionally we capitalized on the funding environment and issued two longer term deals in the quarter: $1.2 billion, a five year fixed rate ABS; and $750 million of seven year fixed rate senior bank notes.

These deals suppressed some of the funding cost improvement we would have delivered had we done shorter term floating rate issuances.

However these longer term fixed rate deals are part of our funding strategy to extend duration at attractive pricing, in order to position ourselves for a higher rate environment in the future.

Looking forward, we expect modest sequential pressure as we continue to extend the duration of our funding and card yield continues to come down modestly.

Turning to slide 7, total operating expense increased by $44 million or 6% over the prior year.

The most significant driver of the increase was increased compensation and benefits associated with higher headcount to support organizational growth and compliance initiatives.

We also invested in more marketing this year particularly in card and personal loans.

In addition we continue to enhance our technology, which contributed to higher professional fees year-over-year.

Partially offsetting these increases, other expense was down due in part to several one-time items that in aggregate were worth about a $0.01 of EPS.

For the quarter, our total Company efficiency ratio was 37.8%.

As we look forward, the expense base will have a modest upward bias based on a number of factors including additional marketing spend, regulatory and compliance staffing and technology enhancements.

All in, we expect our 2015 efficiency ratio to be modestly above our 38% long term efficiency target.

Turning to provision for loan losses and credit on slide 8. Provision for loan losses was higher by $21 million compared to the prior year.

The primary contributor was a $33 million increase in net charge-offs, driven by loan growth and lower dollar recoveries.

I would remind you the recovery dollars are declining as the available inventory from previously charged-off loans diminishes and isn't refilling as quickly with new charged-off balances.

Partially offsetting higher net charge-offs was a $12 million lower reserve build compared to the prior year, but reserves were up sequentially.

The credit card net charge-off rate was 2.16%, up 11 basis points year-over-year and down 17 basis points sequentially.

The 30-plus day delinquency rate was 1.71%, 4 basis points higher versus the prior year and up sequentially by 8 basis points.

The private student loan net charge-off rate, excluding purchased credit impaired loans, was down 16 basis points sequentially to 1.14% due to seasonality related to lower charge-offs and higher disbursements in the third quarter.

The 30plus day delinquency rate increased by 12 basis points to 1.78% as the organic book continues to come into repayment.

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

Switching to personal loans, the net charge-off rate was down 3 basis points sequentially to 1.92% and the over-30 day delinquency rate was up 9 basis points to 75 basis points.

Across all of our portfolios we remain pleased with our strong credit results.

However, we do believe our loan growth over the last several years places us on a reserve build trajectory.

One last item I would call out on the income statement is that during the quarter we were able to recognize certain prior year tax benefits which reduced our effective tax rate to 36.2% for the quarter.

Next I'll touch on our capital position on slide 9. You'll note that in addition to our traditional Basel I view we've added a new ratio, an estimated common equity Tier 1 capital ratio.

This new line item assumes fully phased-in Basel III requirements and stands at 14.7%, roughly in line with our Basel I Tier 1 common ratio of 14.8%.

During the quarter we repurchased $622 million of stock, an accelerated pace from the second quarter as we made up for lower buybacks in the prior period.

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 stock 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 the remainder of 2014.

As we look to the fourth quarter, we expect NIM to be down slightly as we continue to extend funding duration in this low rate environment and also look to continue to drive card loan growth.

With respect to rewards, the fourth quarter will reflect a broad 5% category for holiday shopping.

However we still believe the full year will be consistent with our comments last quarter, likely coming in a couple basis points north of 1%, excluding any potential redemption changes.

That concludes our formal remarks, so now I'll turn the call back to our operator, Adrian, to begin the Q&A session.

Thank you.

(Operator Instructions) We have Mark DeVries from Barclays on line with a question.

Please go ahead.

Yes, thanks.

I want to ask about kind of competitive intensity around card rewards.

I appreciate you get this question in different forms almost every quarter.

The reason I'm asking is we're starting to see some offers that just cause you to scratch your head on how the economics work for the issuer.

Without naming anyone in particular, I'll just reference the double cash rewards offer where you've got effectively 2% back from an issuer that's basically only collecting probably 2% of discount rate.

The question, David, is how much longer do you think we could see offers like this?

In your experience when an issuer tends to overshoot with an offer that seems overly aggressive, how quickly can you see a response of them dialing that back?

Well I actually think that there has been more stability in competitive intensity than one might think.

This has been an intense -- specifically rewards and cash back has been intensely competitive for many years.

And this is not the first time that we've seen issuers come out with what might look to some of us to be unsustainable.

My experience is they don't dial them back real quickly, but after two or three years they start seeing the profit numbers not hitting hurdles and then they'll dial them back.

I would also say -- and in fact in recent quarters we've seen some issuers actually dial back earlier rich programs.

So that's been a history in the industry.

The other thing I'd say is that I wouldn't over focus on one measure.

Clearly rewards are very important but service, features: there's a lot of other things that are very important to customers.

And so you don't have -- if people don't have the full package, like Discover it, we think it's got great rewards, but a lot of other things.

The full package still continues to be more resilient than just having one headline number that you're competing with.

Okay.

Great, thank you.

Our next question comes from Ryan Nash from Goldman Sachs.

Please go ahead.

Hey, good afternoon, guys.

Mark, on your comment about the modestly above 38% on the efficiency ratio can you maybe give us more context, help us understand what assumptions are going into that?

What are we assuming for interest rates, what type of loan growth, how do we think about the trajectory of the expense base that got you to that above 38%?

Yes.

There's a bunch in that one, Ryan.

I'll try and tackle the ones that really hit the 38% number specifically.

I would say there's a couple different things.

First of all is we'll be looking at a couple of one-time expenses coming at us next year such as roll out of EMV.

And then I think we're also facing a number of expenses that the entire industry is facing that David alluded to.

Really additional compliance and regulatory functions and meeting significantly higher expectations, obviously, is going to be driving some of that as well.

We do continue to invest in our technology infrastructure with a principal focus around digital; but it's broad based investing that's taking place, as well.

So those would be the really key drivers of the elements that I see taking our expenses higher as I look into next year.

Got it.

And then you noted in the release that continued growth would drive reserve actions.

Should we expect to see a change in the pace in which you're adding to reserves then?

Is it fair to assume you are starting to see some higher credit losses in the more recent vintages that is driving this comment or is it just that it's a function of growth?

I think, Ryan, it's really a function of growth.

I think the key thing to bear in mind is the vintages are generally seasoning in line with our expectations.

But I would also point out that we're coming into the period of time now -- or if you think about peak losses occurring on a card book somewhere generally between 18 months and 30 months after origination of a vintage.

We've got several larger vintages as a result of the growth we've put up over the course of the last couple years coming into the seasoning mode.

Continuing again generally to season in line with our expectations, but as the larger vintages come through it'll have a modestly larger impact on the overall totals.

Got it.

Please don't tell my wife about the broader 5% discount.

Thanks, guys.

Your next question comes from Sanjay Sakhrani from KBW.

Please go ahead.

I've got a couple questions.

Back to the efficiency ratio guidance, I was just wondering how much flexibility there might be to the extent that other metrics don't go as planned.

I mean how much discretion do you have over some of the expenses that you mentioned or other expenses in case the provision goes up more than you expect it to?

Then secondly, David, in terms of the above industry average growth that you're seeing, how long do you think that persists, given the current competitive environment?

Thank you.

So Sanjay I'll tackle the expense one and then I'll pass things over to David.

I would say there's definitely expense leverage in the model that we can avail ourselves of if we feel we need to go down that path.

What I would say is we're continuing to drive very strong growth at this point in time and feel good about our ability in the near term keep doing that.

So it doesn't feel like the time you'd want to be pulling back on those levers.

So that's why I think we're kind of indicating we expect to see some increased expenses next year, because we're choosing to keep those engines running to keep that production coming online at this point in time.

David?

Sanjay, on the growth, I think we're very pleased that again we performed well above our -- the targeted range that we had laid out a few years back.

I think one of the things that's happening -- two things are happening.

One is we're seeing good results from Discover it, the new features, free FICO, security things that we're putting in place, our advertising.

And I think we're starting to get an industry that is maybe showing a little more signs of modest growth.

We've been growing despite a shrinking industry.

So I think that if the industry itself picks up a little bit, then that obviously would be helpful for our ability to continue to grow as robustly as we are -- as we have been the last two quarters, certainly.

So probably early next year we'll be actually revisiting and trying to make a decision: do we stick with that original guidance that we gave a few years back or do we change it?

And the industry and our results will be informative in that decision.

Thank you.

Our next question comes from Bill Carcache from Nomura Securities.

Please go ahead.

Thank you.

Good evening.

Mark, I had a question on the calculus of growth driven reserve building.

So let's say that we remain in an environment where A, there's no evidence of credit deterioration and B, you continue to grow loans.

If we hold everything else constant to isolate the impact, how do you think about the interplay between the tailwind that you get from the additional interest income that you generate on your loan growth and the headwind from higher provision expense associated with the need to build reserves on a growing book?

Just factually speaking, what's the math of netting those pieces together in terms of the impact on EPS growth?

That's a really big question that can have an awful lot of calculus impacting both ends of that equation, so how about if I just tell you about the pieces of the puzzle that go into each of them?

Because we don't provide EPS guidance, I'll stay away from the specific correlation between the two.

I guess what I'd say is that provisioning itself, as I said earlier and as you noted in your question, it's really going to be dictated going forward by loan growth.

The seasoning of the new vintages, some of the vintages that are coming through are slightly larger than some of the vintages we've seen before.

So that will -- again they're seasoning generally in line with our expectations, but the vintages themselves are slightly larger.

The other things that go into the calculus on that side of the equation really are going to be recoveries.

Right?

What is the trajectory at which we continue to realize recoveries off that declining pool, but nevertheless still out there of crisis period charge-offs?

I would say the economic environment comes into it, bankruptcy filings come into it.

So I think there's a lot of different things.

I think our comments are really kind of directed at helping you kind of get the fact that the larger vintages are starting to mature.

So we do believe that growth will drive incremental provisioning expense.

But again, I would underscore we don't see any fundamental changes in the economic environment at this point in time.

On the net interest income side, again, a lot of things taking place there because it depends on the components of growth, right?

Are you bringing in lower priced tiers of new accounts, higher priced tiers of new accounts, is there a level of promotional activity taking place?

What are you doing with your funding costs, both in terms of the market rate environment as well as what the levers are that we're pulling right now to fix costs and extend duration on our funding, right?

As I said in my prepared comments, we're purposely taking our funding costs slightly higher so that we perform better in a rising rate environment, locking those in for long periods of time for tranches of the funding.

So there's a whole bunch of different pieces of the puzzle that go into that, that aren't necessarily interrelated, but those are the basic levers.

Okay.

On a related note regarding your reserving methodology, let's say that you're 100% correct in estimating your allowance today, does that mean that the sum of your net charge-offs for the next 12 months would total your current period allowance?

It would be forward-looking.

I'm trying to process the question.

If it's different -- I mean, I guess, to the extent that the sum of your charge-offs over the next 12 months is the driver of what your reserve is and you could have -- and you're 100% correct in estimating what those next 12 month charge-offs are going to be, is that what your reserve is today?

Or if it's different, then why would it be different?

Generally speaking, yes.

There is a couple little puts and takes around the edges.

But for the sake of simplistic answer to the question, yes that would be correct.

And we reserve for interest charge-offs as well, Bill.

Some of our competitors don't have it flowing through that allowance line.

So the related part of that, then, is if we look historically at that relationship between what your actual next 12-month charge-offs have been and your allowance, any differences between the two would essentially be attributable to misestimation, because the intent all along would be to set the allowance equal to what you expect that next 12 months charge-offs to be?

I would say the mathematical answer to that question is yes.

I would also point out to you though that in the history of mankind other than plain dumb luck I don't think anybody has ever nailed their reserve.

Understood.

Thank you.

You bet.

Our next question comes from Jason Arnold from RBC Capital Markets.

Please go ahead.

Hey, guys.

Good afternoon.

A couple of my questions already got taken, but I am just wondering if you can comment on your thoughts on Apple Pay and any other mobile payment initiatives you're undertaking?

Thanks.

Well I would say that we're excited about that potential prospect of mobile payments generally.

I think that it's likely mobile payments are likely to -- well we've been hoping they took off faster.

It always seems to take a little longer than you'd like.

But I think mobile payments has the prospect to have more going into our cards as opposed to cash and check, to add more features and functionality to consumers and to purchasing, which I think is good for customers and good for our industry.

So just generically we're excited about the various mobile efforts in the industry, and there's obviously a number of them going on right now.

Okay.

Thank you.

Our next question comes from Bob Napoli from William Blair.

Please go ahead.

Thank you.

Just I guess maybe a follow-up on that question, if you could.

I don't know.

Why is there -- do you expect to be in the Apple Pay?

How successful do you think the Apple Pay product will be, and what differentiates it from other things that are out there?

Was Discover's relationship with PayPal a reason why Discover is not initially in Apple Pay?

And how is your relationship with -- what are your expectations for that relationship with PayPal now that they're spinning off?

Well, look, I wouldn't want to talk specifically about any of our relationships.

We have a lot of important relationships.

Sure.

And one of our strategies is to be a great partner to a bunch of people.

And I would say that we certainly do expect to be participating in Apple Pay.

We don't know when that will be, but we'll be actively working to be included over time.

Okay.

Then let me just ask about your consumer loan business.

The growth rate there still continues to be very strong but it has slowed down a little bit.

The yield has come in a little bit on that product.

Are you seeing more competition?

And if so are you seeing any competition from peer to peer?

Or is it from other banks that are looking at that market as being very attractive?

And do you think you can continue to grow that business at rates somewhere near where you have been recently?

Yes, Bob, it's Mark.

I'll start with that and pass to David with respect to the yield question on the personal loan business.

It's come down slightly as more of the recent vintages really are coming in with shorter durations at origination than they had historically.

Okay.

Remember these are fixed rate products, so as they are on a shorter duration the yields are going to be a little bit lower.

So you get lower yields, but you also -- from an asset liability management perspective as we look forward to a rising rate environment there's some benefit to that fixed rate being shortened up a little bit, as well.

In respect to the performance of the business, I'll pass to David for that part.

I would say there is certainly more competition in that business than there was.

But I would say that we are also participating a little more broadly than we were.

We mentioned at our investor day that we previously did not even consider people that responded.

We had to give an invitation to apply to even be considered for a Discover personal loan.

And we have started testing into unsolicited applications.

Although we still are very much -- we have very strict credit criteria to manage the credit well.

So, I think that percentage growth rates in that business may decline a little bit, but the dollars I think have -- of growth have continued to be very strong.

That business is now much larger than it was for us a few years ago, so we're growing off of a lower base.

But we're still -- our business is growing north of 20% a year.

I am very happy with the growth rates while managing the credit and the yield.

Who is the competition?

Are you seeing incremental competition there?

Well you mention the P-to-P.

They started P--to P. I don't think they are any more, but there are some very fast growing and very aggressive nontraditional bank players.

And some of the more traditional banks are also perking up a bit in this space.

But generally I think the last two or three years we think we've been the number one originator of personal loans in the country.

And we continue to be a very -- it continues to be a very good business for us.

Thank you.

Our next question comes from Vincent Caintic from Macquarie.

Please go ahead.

Vincent?

Vincent from Macquarie?

Next caller.

Our next question comes from Don Fandetti from Citigroup.

Please go ahead.

David, I just wanted to ask broadly on the consumer.

I just wanted to clarify; are you seeing any type pick up in appetite for consumer credit?

If so are you noticing any differential between up and down the credit spectrum?

And are there any -- we've seen a lot of the health, at least on the spend side, it's been the affluent and trying to get a sense if you're seeing any broadening out or just a general update.

As I mentioned before I've seen a little bit of a pickup in industry loans.

I don't think I'm seeing anything real dramatic, but I would say the more middle class consumer is typically more likely to revolve some or all of their products.

And I think what we're seeing is a little bit more confidence by the consumer to revolve some of their debt.

And so I think that's leading to a percent or 2 faster growth rate for the industry.

Okay.

And then Mark, on capital, I was just curious if you think you'll ultimately need some more preferreds as you get into 2016.

I know that's further out, but I just wanted to get an update given what we saw at American Express.

Yes, we did issue about $575 million back in late 2012 because we only had common equity in our capital structure to any significant degree.

We didn't include a preferred issuance in our 2014 CCAR and we're still in the planning phases at this point in time obviously for the 2015 CCAR.

So, I can't comment on it specifically at this point in time although I would just again reiterate what we've said before.

That is, our goal in that CCAR process is to have a prudently aggressive ask, because we fully recognize that our shareholders would like some more capital returns.

Got it.

Thanks.

Yes.

Our next question comes from David Ho from Deutsche Bank.

Please go ahead.

Good afternoon.

We've talked a lot about competition in the rewards space, particularly in the prime revolvers.

How quickly does that extend into pricing and then subsequently terms and conditions?

Are you talking, David, about APR competition?

Right.

Spreads and just underlying, maybe folks moving down the credit spectrum a little more.

Well, I would say I've seen a fair amount of stability in both pricing and credit aggressiveness.

I am not seeing, with very rare exceptions, I'm not seeing people get back into subprime credit cards.

And I think that the pricing has been pretty stable for the industry, in part because post-CARD Act people know that the price they have to set they have to live with for potentially 10 years, 20 years.

And so I think people are being careful to have an adequate spread.

I would also say there's been some consolidation of the industry and the people that are left are probably not going to underprice.

And I think historically there were some that underpriced and then came back with price increases afterwards.

Okay.

And just a follow-up on the higher efficiency ratio target for 2015, how much of that would be a build in marketing spend?

It wasn't really mentioned.

Where are the different areas that you'll be investing in, in marketing?

Will it be around the cloud, the broad-based, the launch of checking, maybe some new products?

And how sticky are these compliance and regulatory costs as maybe the new run rate going forward?

Yes, I would say we aren't prepared yet to quite break down the components of that growth for next year.

I think we put them into broad categories and aren't going to attribute them yet.

But I guess, without reference to specific numbers what I would say is I think we continue to see great new account acquisition numbers and good loan growth.

So, I think some continued investment in the marketing space, additional investment in the marketing space is clearly going to make sense, both in the card space, as well as for certain other products.

The regulatory expenses, David, I would tell you bluntly, are sticky.

All right?

I think there's a new higher level of expectation to which the whole industry is being held.

I don't think this is unique to us in terms of what you're hearing on this front.

It's really across the industry that there are much, much higher regulatory and compliance expectations and those drive costs.

So I would say those are going to be sticky costs going forward.

Okay.

Thanks a lot.

You bet.

Your next question comes from Moshe Orenbuch from Credit Suisse.

Police go ahead.

Great.

Thanks.

There's a lot of talk about a more competitive environment and marketing spending and the like.

Could you just talk about trajectory of costs to put accounts on the books?

Because that's been a key competitive advantage of yours in terms of your account acquisition cost.

Moshe, I would say that's been relatively stable for us.

I think that we've continued to move more and more to online versus the traditional direct mail, and if you do that well, that can be a cost savings.

I also think that we have invested very heavily in having a differentiated product that appeals more to consumers, has a better pull rate.

So we're continuing to basically make our product more and more appealing so that -- it's not just pricing as I mentioned before.

It's service.

It's brand perceptions.

It's a lot of work to create more differentiation.

And that is helping us to, I think, sustain an average cost per account that might otherwise be under pressure if we didn't do any of those things and just watched the competition come back into the market.

Got it.

Just as a follow up, the change that you're making in terms of the rewards, the forfeiture of rewards, should we think about that cost as somewhat additive as we go as we think about the level of rewards expense, or is that baked into the numbers that you talked about?

Moshe, it's Mark.

There's two component pieces there.

The $185 million is a one-time charge to basically extinguish the reserve that's set up on the balance sheet now that's been built up over a number of years.

The 5 basis points of run rate expense, yes, I think you should think that is a marginal increase in the rewards cost.

It probably won't be quite that high.

I think I said it'll be up to 5 basis points or somewhat less than 5 basis points, I think is exactly what I said, depending upon the component parts and pieces we choose.

So it's going to be very manageable.

Got it.

Thank you.

You bet.

Your next question comes from Matthew Howlett from UBS.

Please go ahead.

Thanks, guys, for taking my question.

Just on oil prices: if they continue to tread lower or stay down here, does that have impact on spend volume?

And then I guess, no one has touched on this private student lending that appears to be flattish, just didn't know what was going on over there.

And then maybe could you just comment on the home lending segment, where you are.

It seems like margins are starting to turn there and better volume here in the back half of the year into 2015.

Well, certainly gas prices, all other things equal will depress a bit the sales gain, because order of magnitude about 10% of credit card sales tend to be gas prices.

So you can multiply through and figure out what the impact is on total sales as gas prices go up or down.

The knock-on effect is that if people are paying less on gas then it tends to be somewhat helpful for credit.

People may have more discretionary spend to put into other items besides gas.

So there may be some offsets.

But all other things equal it does suppress sales a little bit if gas prices are down.

In terms of student loans as I mentioned, I'm very pleased with the growth that we achieved.

We always do report both on the organic portfolio and the acquired portfolio.

And so, obviously the acquired portfolio, which was sizeable when we purchased it, will continue to pay down as those students finish paying their loans in full.

And so, if you look at the organic growth portfolio, we were up by more than 20% year over year.

So that's quite healthy growth.

Just real quickly any update on the home mortgage segment?

Oh I'm sorry.

You said home mortgage.

Excuse me.

Home mortgage continues to be a challenge.

I think we had a -- it is slightly suppressing our overall earnings maybe $0.01 a quarter.

So it's not a big driver of our bottom line.

It was never a big positive either.

But the combination of a difficult business environment and a difficult regulatory requirement make that business challenging.

I don't see either of those factors changing any time real soon.

You still strongly committed to growing that?

Could you look at possibly acquisitions?

Is that something you still feel strongly about when you got into it?

I would say that we are still figuring that out.

I think that if you look back from -- has it -- we would have expected from the time we bought it four years ago to today, we would have expected it to be further along.

But there's been a lot of changes, regulatory market, et cetera, since that time.

So we are looking at options of what more do we need to do to make it more significant and a contributor.

Got you.

That's great.

Thanks, David.

Our next question comes from David Hochstim from Buckingham Research.

Please go ahead.

I wonder, could you just talk about the -- is there a business benefit from eliminating that forfeiture reserve?

Are you going to have higher -- lower attrition rates, higher customer satisfaction?

We think that there is a business benefit.

That's why we would be doing it.

I think that one of the -- as we research rewards, customers are pretty focused on an easy and good redemption process.

It gives them more confidence as they earn rewards that they know they're going to be able to actually redeem it.

And historically our breakage was a much bigger savings, if you will, for the Company.

But between our card attrition, which has come down to extraordinarily low levels, our delinquency rates, which have come down to extraordinarily low levels, the ease of which we've given people -- we've made it so much easier to redeem through, for instance, Amazon Instant in any amount.

So, the breakage has come down to well below -- has come down to 5 basis points or lower, which means we have to say, well, could we cost effectively satisfy customers even more?

And we would expect that both attracting new customers to our franchise as well as not losing customers and getting more wallet share that it wouldn't take much movement in any of those levers to offset 5 basis points of higher cost.

Okay and then just update us on the rewards checking.

And do the rewards for that when they become meaningful show up in the same reward lines as card rewards?

Yes, they would.

Are they meaningful yet?

No, they are not meaningful at this point.

Okay.

Thank you.

Our next question comes from Ken Bruce from Bank of America.

Please go ahead.

Thanks.

Good evening.

My question also relates to what many of the questions are getting at as it relates to rising rewards cost and some of the other competitive dynamic that's playing out.

Many financial institutions have suggested that they're willing to erode margins, cannibalize margins in order to improve customer loyalty and growth.

And as you've noted yourself, you're seeing a pickup in that growth.

I guess I'm wondering at what -- or how much are you willing to essentially erode your own margins in order to stay on the growth trajectory that you're on?

You're operating well above your ROA hurdle so some of the concern is that this business could quickly become a race to the bottom in terms of pricing competition, not on APRs, but in terms of rewards cost.

I'm just trying to get a better sense as to how you think that the margin dynamic, the ROA dynamic plays out, how far you're willing to go in order to maintain your growth trajectory.

Well I would say generally we're seeing people copy us.

I mean, people don't have the loyalty that we have.

Historically people were not as focused on rewards as we've been.

So, I think when you look at competitors, the big switch is they've moved their marketing from a mix of rewards and non-rewards to now almost all rewards.

And that would erode their margins, whereas we have certainly invested more in cash-back bonus.

A number of years ago we were closer to 80 basis points.

We're now a bit north of 100 basis points of rewards cost.

We've put in place the 5% program.

We've got merchant funded rewards, which doesn't hit our bottom line but benefits customers.

As Mark mentioned we're considering reducing breakage, which drives up costs, but also satisfaction.

But we are being very careful do it in a leveraged and sustainable way so that we never get in the position of having to devalue rewards the way many of our competitors have over time.

And Ken, it's Mark.

I think the best fact I can point to, to kind of underscore what Dave is talking about is, if you look at year over year growth in receivables in the card space, by far the largest component of that was just regular way spending.

So as people -- building receivables the old fashioned way, going out and using their Discover card.

So it doesn't feel like we're faced with anything like that kind of a decision at this point.

Right.

And I appreciate that comment.

As you look out, your success has been tremendous in many respects and you've pointed out a number of those.

I guess it feels like the competition has maybe awoken to some of what's going on.

And I'm trying to understand if there's a backdrop for them to essentially become more competitive to the point where you all just are willing to cede some of the growth that's maybe out there otherwise?

I would say they woke up 10 years ago.

I mean before that, we were pretty much the only game in town on cash rewards and now everyone has one or multiple cash programs.

And so I'm not seeing any kind of inflection point at this point.

I just think that we are -- I think this very competitive rewards competition is not going to go away.

It's the new normal but it has been for quite some time.

Great.

Thank you for your comments.

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

Please go ahead.

Hi.

Thanks for taking my question.

I wanted to ask on the strategy you've had certainly in the third quarter, then in prior quarters also, of basically trading, call it a little bit of NIM for extended maturities.

Is that a strategy we can expect you to continue, assuming market conditions remain opportunistic?

Chris, it's Mark.

Yes, I think that absolutely is a strategy you'd expect to see us continue.

I think we're just being realists and looking and saying in the future, we're not smart enough to tell you exactly when rates change, but we're pretty confident there's really only one direction they can go.

And a balance sheet is a dynamic thing; and continuing to take the right actions as it inflows to make sure we are positioned from an asset liability and management and an earnings standpoint the best we can -- yes, we'll sacrifice some current margin right now to make sure we've got that right.

Okay.

Got it.

Thanks very much.

Yes.

Your next question comes from Sameer Gokhale from Janney Capital.

Please go ahead.

Thank you.

Just a couple of questions.

Going back to that $185 million charge and some of your commentary, David, about -- I think you referenced the 5 basis points number as the forfeiture rate currently.

And if I heard you correctly I think you had attributed part of the decline in the forfeiture rate to improvements in credit quality, fewer charge-offs so you have more redemptions.

But if you assume that right now we're at a trough in terms of charge-offs and that charge-offs while relatively stable are likely to only move higher compared to where they're at now, why eliminate all of that reserve now?

Why not wait a little bit to see how that plays out?

I'm just curious about -- again, Mark I think I heard you say all of that $185 million was just eliminating all of that forfeiture reserve.

Yes, so a couple things, just to level-set you before David answers there, Sameer, what we said is we could do up to the $185 million.

The $185 million would be eliminating all of the forfeiture reserve.

The other thing I would say is that we're considering a number of different pieces and there's still a few decisions to be made around that, but we wanted to guide you toward what it could be.

Then I think the other piece of the puzzle is the 5 basis points you're referencing.

That is the ongoing incremental costs we will incur on our rewards rate as a result of having done that.

It's not our current forfeiture rate.

So, and it'll actually be somewhat less than that 5. I think we kind of hung 5 out there and said it'd be somewhat less than that.

We think we can manage that down a little bit.

So there will be some incremental impact, but probably not that full 5.

So, that's just to align all the math there and then I'll pass it over to David.

I would say that we -- while I accept the point that delinquencies are at a low point likely now we don't expect them to go back to what they were for the industry or for us five years plus ago.

And other than that the changes in terms of our loyalty rate, as well as the changes that we've put in place like the Amazon redemption, are more structural changes that we've put in place.

If anything we would expect breakage to become less and less as we try to replicate the success of things like Amazon maybe with some other people.

So I don't think that the 5 basis points is suddenly going to grow to some higher number.

I think it would be a modest cost for an anticipated good marketing and customer gain.

Okay.

And then on a different note, just going back to your funding mix and deposits you may have talked about this a few quarters ago, but if you could refresh my memory, when you look at the direct to consumer versus broker deposits, broker deposits have been growing.

Direct to consumer deposits have been relatively flat.

And of course DTC seem to be more economical for you.

Brokerage are a little more expensive.

So how do you think about that mix going forward?

And perhaps emphasizing direct to consumer more again, or should we expect broker to continue to grow as a channel?

Sameer, it's Mark.

I would say as an organization we'd always have a decided preference for the direct to consumer, because it comes with a customer relationship and that gives us opportunities to cross sell and more effectively serve them.

If you look at the component parts and pieces, the direct to consumer business, we built up pretty quickly in the crisis, right?

And we built it by being a rate payer.

Over the course of the last three to four years we have gone through a very purposeful exercise to basically reposition ourselves in the rate tables and shake out what I would call our retail capital markets depositors sitting in the DTC space.

That's been a big part of what's driven our asset sensitivity we currently have on the balance sheet.

So while DTC looks flat over the course of the last couple years, if you'd look at the components you'd actually see good solid top line growth that isn't quite so rate driven and attrition of the folks with a beta of 1 or greater out of that book.

The DTC, it's a cost effective way for us to get some duration in the marketplace pretty effectively and pretty easily.

Brokered.

Excuse me, the brokered.

Thank you, David, I appreciate that.

It's a cost effective way for us to get some duration in the marketplace.

And the other thing is, we tend to use it as we head into the holiday season as we ramp up and see seasonality in the book as well because it's easy to flex up and run back off after that period of time also.

So we use it both for duration and we also use it for short term needs.

At what point do you think you will have that attrition done in the DTC deposit base of the folks with betas more than 1?

I think it's an ongoing process, right, because a bunch of that book historically was CDs.

As those maturities occur, and I think you get our CD maturity schedule in our annual investor day packet, you can look back on that one and kind of see what the maturities were coming at us, that will give you a good way to approximate what that rotation looks like.

Okay.

Thank you.

Yep.

Thank you.

I will now turn the call back over to William Franklin for final remarks.

Thanks, Adrian.

Thanks everyone for joining us.

As a remind the investor relations team will be here this evening to answer any more questions that you have.

Everyone, have a good night.

Thank you, ladies and gentlemen.

This concludes today's conference.

Thank you for participating, and you may now disconnect.