發現金融 (DFS) 2015 Q1 法說會逐字稿

Good afternoon, and welcome to the Q1 2015 Discover Financial Services earnings conference call.

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

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

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

Please note that this conference is being recorded.

I will now turn the call over to Bill Franklin.

You may begin.

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 in 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, which are on our website and on file with the SEC.

In the first quarter 2015 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 today 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 will 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.

Thanks, Bill.

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

For the first quarter, we delivered net income of $586 million, earnings per share of $1.28, and a return on equity of 21%.

Our Direct Banking business continues to deliver solid results.

Discover achieved a total loan growth of 6% over the prior year.

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

Specifically, we grew card receivables by just over 5%, at the upper end of our targeted range.

Card sales volume for the quarter was up 3%.

Excluding the impact of gas prices, sales were up approximately 5%.

Our growth continues to be driven by a combination of wallet share gains with existing customers and from new accounts.

Our Discover it product continues to attract customers, as we innovate and offer new industry-leading features, such as our recently announced Freeze It capability, which allows card members to temporarily suspend their accounts in the event a card is misplaced.

In the quarter, we also launched our new Discover it Miles card.

We believe this card will appeal to a different segment of our target market: prime revolvers who value travel rewards.

This card leverages our Discover it platform, with all of its innovative customer features, to offer a unique value proposition in a crowded market.

It will take time to become a meaningful portion of our new accounts, but we're optimistic about the long-term value it will generate.

Our other direct lending products also continue to perform well.

The organic student loan portfolio increased 20%, and personal loans grew 18% over the prior year.

Focused on our payments business, total volume for the segment was flat, as increases in our proprietary volume, and growth in our business to business volume, offset year-over-year declines at PULSE.

On a reported basis, Diners volume was down 1%.

However, adjusting for impact of foreign exchange rates, Diners volume was up more than 10% year over year, driven by strong results in several regions, especially Asia-Pacific.

Overall, I'm pleased with our results this quarter.

I look forward to sharing more of our thoughts about the year ahead at our financial community briefing on May 5. Now, I'll turn the call over to Mark, and he'll walk through the details of our first-quarter results.

Thanks, David, and good afternoon, everyone.

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

Net interest income increased $66 million, or 4% over the prior year, driven by continued loan growth.

Total non-interest income increased $27 million, to $542 million, as higher net discount and interchange revenue and direct mortgage related income more than offset the continued decline in protection product revenue.

Net discount and interchange revenue was up 6%, driven by increased sales and a lower rewards rate year over year.

Our rewards rate for the quarter was 102 basis points.

On a reported basis, the rate was down 1 basis point year over year, but I would remind you that last year, we recognized a forfeiture adjustment in the first quarter.

So on an adjusted basis, the rate is actually up about 6 basis points.

Sequentially, the rewards rate was down significantly, as the rate last quarter included a one-time charge for the elimination of our rewards forfeiture reserve, as we changed our program so that cardholder rewards never expire.

Direct mortgage-related income increased this quarter, as the refi market picked up, due to the decline in mortgage rates several months back.

As we've said in the past, Discover home loans has been contributing or costing $0.01 or $0.02 of EPS most quarters, and this quarter we were on the positive side of that range.

Protection products revenue declined $12 million, as new product sales remained suspended.

Moving to Payment Services, revenue decreased 6%, or $5 million from the prior year, mainly due to the previously announced loss of the Sam's and Walmart co-brand volume and network partners.

Volume for the segment, on the other hand, was relatively flat, as growth in lower margin B2B transactions mostly offset the loss and lower debit volumes.

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

Turning to slide 6, total loan yield of 11.37% was 7 basis points lower than the prior year, primarily driven by a 9 basis point decrease in card yield.

The year-over-year decrease in card yield reflects a small shift in portfolio mix, as high rate balances are replaced by standard or promotional rate balances.

Personal loan yield decreased from the prior year, primarily driven by more customers opting for shorter term consolidation loans.

Funding costs increased 10 basis points, due to higher fixed rate debt issuances in the last 12 months.

Year to date, we've completed two debt issuances, a $500 million 10 year fixed rate senior note, and a $950 million 3 year floating rate ABS deal.

We continue to position the balance sheet in anticipation of gradually rising rates.

Higher funding costs and lower total loan yield resulted in an 18 basis point decrease in net interest margin from the prior year, to 9.69%.

Turning to slide 7, operating expenses were up $89 million over the prior year.

Employee compensation increased $24 million, due to higher head count to support growth, annual salary increases, and higher commissions associated with the increase in home mortgage originations.

Marketing expenses increased $13 million, as we invested in advertising for several products.

Professional fees increased $28 million, due in part to approximately $15 million in costs associated with anti-money laundering and related compliance program enhancements.

Other expense was up, due to a $20 million legal reserve addition.

For the quarter, our total Company efficiency ratio was 40%.

Excluding the two unusual items I just mentioned, the total Company efficiency ratio is roughly 38.5%, in line with our long-term target.

Turning to provision for loan losses and credit on slide 8. Provision for loan losses was higher by $118 million, compared to the prior year, due to higher reserves and charge-offs driven primarily by loan growth.

This quarter, we increased reserves by $30 million, while last year, we had a $57 million reserve release.

The credit card net charge-off rate increased by 14 basis points from the prior quarter, and by 8 basis points year over year, to 2.4%.

The 30 plus day delinquency rate of 1.64% declined relative to both the prior quarter and the prior year.

A portion of the drop was driven by the implementation of some payment processing changes during the quarter.

On balance, the credit backdrop continues to remain benign.

The private student loan net charge-off rate, excluding purchase loans, decreased 28 basis points in the prior year, partially due to more efficient collection strategies, as well as the introduction of several new payment plans over the last year.

Student loan delinquencies, once again excluding acquired loans, decreased 13 basis points, to 1.66%.

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

Switching to personal loans, the net charge-off rate was up 15 basis points from the prior year, and the over 30 day delinquency rate was up 8 basis points, to 76 basis points.

The year-over-year increase in the personal loan charge-off rate was primarily driven by the seasoning of recent loan growth.

One last item I will call out is on the income statement, is that we were able to recognize some prior-year state tax benefits, which reduced our effective tax rate to 35.5% for the quarter.

Next, I'll touch on our capital position, on slide 9.

Our common equity tier 1 capital ratio increased sequentially by 60 basis points, to 14.7%, due to the seasonal decline in loan balances from the fourth quarter.

As previously announced on March 11, Discover received a non-objection from the federal reserve on proposed capital actions during the five quarters ending June 30, 2016.

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

Based on the proposed capital actions, we plan to repurchase $2.2 billion of our common stock over the next five quarters.

And last week, our Board increased our quarterly common stock dividend from $0.24 to $0.28 per share.

In summary, it feels like a good start to the year, with strong loan growth and a continued benign credit environment.

That concludes our formal remarks.

So now, I will turn the call back to Bill Franklin.

Only a few people are in the queue right, now.

(Caller Instructions)

Thank you, now I'll turn it back to Mila.

(Operator Instructions)

Rick Shane, JPMorgan.

Mark, you talked a little bit about one, in the personal loans, you're seeing a pickup in losses, in terms of seasoning.

I'm really curious, if you were to disaggregate the credit card portfolio, are you seeing the seasoned portfolio -- any deterioration there?

Or is it really just normalization of the newer loans that's driving -- and again, it's a slight uptick -- but the movement in charge-offs.

Yes, Rick, I would say, as we've been telegraphing, the credit environment really does remain generally very benign.

So the seasoned portfolio is really stabilized at this point in time.

I would say the movements we're seeing are directly related to the loan growth we put on over the course of the last three to four years.

And the seasoning of that growth as it moves through the vintage curves.

Got it.

So it's basically convergence; it's not an uptick on the larger portfolio.

(multiple speakers) That's correct.

Thank you.

You bet.

James Friedman, Susquehanna Financial Group.

Thanks for taking my question.

Apologize for the background noise.

I had a couple of questions.

First, David, with regard to the new Discover it card that you're introducing into the market with miles, maybe more generally, if you could talk about the competitive environment, and how you're positioning that product?

Sure.

Of course, Discover it remains our flagship product, and we continue to enhance Discover it with the introduction of the Freeze on and off switch, which we just introduced on that this quarter.

We've continued to enhance in areas like free FICO, over time, and that's in part to basically stay ahead of competitors, in value to consumers.

And things that can be differentially marketed.

The Discover it Miles card is on the same Discover it platform, but adds a new currency, in terms of miles, for primarily positioned to people who travel, or really value free travel.

And it is, I would think about it as more as an extension.

It -- we do think it will appeal to certain segments, and directly go up against other competitors who may have Miles-type cards, whether co-brand or otherwise.

And so we think it positions us well for -- to compete in the marketplace.

And then just one quick follow-up.

I wanted to ask, have you seen the impact at all yet from the marketplace-type vendors like Lending Club?

I know it's more personal lines, and they're fixed amortizing loans.

But do you see them at all, at this point?

Or is it too early?

It's a little hard to track.

There's no doubt that we must be running up against them some in the marketplace.

Because as you say, some of them have grown, and have been very aggressive.

They tend to play in a broader credit spectrum than we do.

If you look at our 750 plus FICO score, and you compare it to those folks, there's a lot of people that they might book that we might not.

But there would no doubt be some overlap.

So we're watching what they're doing.

And if we can learn some things that can help us, we won't be shy about paying attention to them.

And Jamie, it's Mark.

I would just tack onto that that the yield compression we've seen to date in the personal lending book is really attributable to the shortening of the duration that consumers are choosing.

Going back a year or so ago, they picked a four-year average amortization period.

Today, they're picking a three-year period.

So it's -- as a fixed rate loan, it's just pricing further down the curve.

Thank you.

Bill Carcache, Nomura.

Thank you for taking my question.

Mark, can you talk about when you think we might expect to see you guys reach the point where the seasoning on new account acquisition growth rate, that stabilizes?

And with that, your provision begins to grow more in line with your loan growth, such that it's no longer a headwind to your EPS growth?

I was just wondering if maybe you could give a sense for how far we are from that point, assuming, of course that credit remains benign.

Bill, I would tell you it really depends on what happens to our growth rates, right?

So a big piece of this puzzle is if you think about, I'll visually draw you a vintage curve here, and say, now overlay four years of growth of those vintage curves.

What's driving the -- really, the reserving is the area shaded under the peaks of all four of the curves, overlaid on top of one another.

So theoretically, if you think about a vintage curve, as you do another year or two worth of growth, that really begins to stabilize, if your growth rate is really stable.

If your growth rates accelerate, theoretically, it's going to take longer for that to happen.

The good news is I think this is a really good problem to have, because we can't shrink our way to long-term success.

And ultimately, acquiring new card members and growing the book is the way we compound value over time.

So while I understand the -- obviously, the impacts in the near term, I think over the long haul, it's a -- again, a pretty high-class problem.

As far as you could tell, over the course of, call it, the next 12 months, that those seasoning effects will lead to continued reserve building, I guess at a level on par with this quarter?

Or perhaps maybe even a little bit higher?

Yes, I guess what I would say is, we don't provide forward guidance, really, on what we expect reserves.

We did, at the beginning of the year, give a sense for what we expected on the full year, in terms of provision rate, is really where we touched on it.

What I would do, Bill, is I would take you back to earlier comments, and I would just say the credit environment remains really benign.

So really, the provisioning you're seeing from us, at this point in time, is the result of that high-class problem of growth.

And not anything related to any deterioration in the portfolios.

Understood.

And then on a related point -- and then I'll drop back out.

I didn't hear any update on that [2 1/2] provision guidance.

Should we assume that that continues to hold, that you guys gave last quarter?

Maybe if you could discuss -- talk a little bit about the applicability of that?

I know the investor day is coming up, and there will probably be more there.

But anything you could say on it now would be great.

Yes, I would kick you to the investor day for a more fulsome update.

I guess what I would say, just very quickly, is I don't see any reason to change that guidance at this point in time.

Great, thank you.

Chris Donat, Sandler O'Neill & Partners.

Hi, thanks for taking my question.

Mark, I wanted to go back to the other income line that was $80 million this quarter.

And I think you said it was 90 -- or primarily from higher direct mortgage-related income.

Can you just remind us what kind of mortgages you're doing there?

And I guess we have to make our own assumptions about how those fees are likely to operate, given the rate environment we're in.

But is it all fixed rate product, like 30 year?

Or is there other types of mortgages in there?

There's a variety of product in there.

I would say it's all conforming product, and it's all being packaged for sale.

So we're not retaining any of that product on our own balance sheet.

I would say, if you look, I think, year over year, that other income item was up somewhere on the order of $29 million or $30 million, if I remember correctly.

Roughly, let's call it two-thirds of that was related to the mortgage business.

So it was the largest driver of the increase that was embedded in there.

And I think it's really a reflection that the fixed-rate volume's picked up pretty dramatically, as you saw the drop in the long treasury rates at the end of last year.

And it takes a little while for that pipeline to flow through the system.

So I think that's really the impact of what you're seeing there.

Okay.

And this is refi, or new originations?

I would say at this point in time, the vast majority of our business continues to be refi-oriented.

Got it.

Okay.

Thanks very much.

You bet.

(Operator Instructions)

Sanjay Sakhrani, Keefe, Bruyette & Woods.

Please go ahead.

Thank you.

David, I had a question about interchange rates, and I guess the discount rate for you guys.

We're seeing a decent amount of competition in the co-brands space, and I know you guys have experienced it firsthand.

I was wondering if you had just any broad thoughts on interchange rates?

And then whether or not you felt any pressure from other merchants recently, given what we're hearing?

Thanks.

Sure.

I think that the big, I guess, merchant discount interchange rate stories that I guess I've seen recently have been the two warehouse clubs that I would just say feel like more unique situations.

And I'm not -- there's not broad acceptance in either of those locations, and therefore, the competition, the rates that we've all seen printed, seem very low compared to others.

I wouldn't necessarily draw any conclusions about an impact on that more broadly.

I think they're unique.

On the co-brand, I think that's a little different, and I'm not sure it shows up in interchange.

But I just -- what we see is that the co-brand market seems to have really heated up, and it has become very competitive, in terms of terms.

And that makes me glad that we're not in the co-brand business.

Okay, great.

More broadly, I guess I haven't noticed any trends, one direction or another, on merchant discount rate or interchange in the market.

Okay, great.

And then just a follow-up question on M&A.

I guess, any updates there on opportunities that you guys might be seeing to use some of the excess capital that you guys have?

Obviously, there's a large pool of financial assets out there for sale.

Not sure if you have any interest in that.

But maybe just an update on that topic?

And then just Mark, one data point question.

The tax rate, going forward, we should just assume it reverts back to like 38%?

Thank you.

So on M&A, we may have a little more to comment on at investor day.

But in a nutshell, I'd say our primary focus is on organic growth, and I'll shoot it over to Mark for the other.

Yes, and on the tax rate, Sanjay, I would say there might be a little bit of goodness in the tax rate this year, but not anything particularly meaningful.

Okay, great.

Thank you.

You bet.

David Hochstim, Buckingham.

Hi, thanks.

I wonder, could you expand maybe on what impact you've seen from lower gas prices, aside from the -- I guess, the headwind on spending?

Have you seen any changes yet in customer spending or behavior during the quarter, gas related or not gas related?

We called out that the gas prices alone had a pretty significant impact, about -- what -- 2%, I guess, on our sales.

And I think that there would be a small knock-on effect on loan growth, as well.

There's a lot of transactor volume within gas.

But obviously, some of it would also revolve.

What is maybe a little surprising to me so far is, I might have expected some of that increase in discretionary spending that consumers have left to be -- have been spent on other things.

And I really didn't see that during the quarter.

We saw retailers broadly not have great sales.

There's some view that a lot of people are talking about the weather having an impact in the quarter.

But -- I guess I am hopeful that the broader economy, and the broader consumer spending, would pick up, even apart from gas, in the future.

But we just didn't see it during the quarter.

I guess the other question is, what are they doing with their money?

It seems to be in an increase in savings rate.

I've seen some comments about whether it's benefiting credit.

It certainly shouldn't be a negative for credit, and -- but I think it's a little early for me to conclude that lower gas prices are going to improve credit results.

And did you see any change in consumer spending over the course of the quarter?

Was February particularly weak because of weather, do you think?

March was a bit better than January and February.

But still, March wasn't -- still wasn't where I'd like to see it.

Okay.

And we've seen Moody's, and a number of people, take down their forecast for the year.

This was a broad industry kind of thing.

We've seen most of our competitors off on lower growth rate on sales, and we've certainly experienced that in our customer base as well.

Okay.

Thank you.

Bob Napoli, William Blair & Company.

On the growth in student loans, and in the consumer portfolio, they both slowed down somewhat.

The consumer was almost flat, quarter-over-quarter, from the fourth quarter to the first quarter.

That's been growing, year over year, close to 20%.

The same with the student loan XPCI.

What are your -- again, is that competition from the marketplace lenders, and student lending and consumer?

Or do you still expect to be able to grow those portfolios along the same lines that you have been the last couple of years?

I tend to look at year-over-year changes to help remove the seasonality in really all the business, but particularly in student loans.

And our origination volume in both of those businesses, in dollars, has continued to grow nicely.

And so I think what you're -- what we're seeing is percentages, even if you increase originations, and you increase dollars of loans off of a higher base, the percentages could modestly decrease.

But if anything, we're picking up the dollar loan -- dollar growth.

Yes, the other thing I would note is just that obviously, the student loan business is lumpy in terms of disbursement cycles.

So you have to take that into account, in terms of the periods you're comparing, as well.

Okay.

And then just on the B2B business, the Ariba business, and it looks like you're getting some pretty large volume.

But what should we expect from a volume perspective?

And then is there -- is the line of sight to that being material to your business, is that 12 months?

24 months?

How is that business progressing?

And when can it move the needle?

It's going to be some time before it really contributes in any meaningful way to profits.

But without forecasting exact numbers, we do expect -- we expect the volume to continue to grow.

And it seems to be very well received.

It's unique, and it seems to be very well received by some businesses, and by the partners of SAP and Ariba.

All right.

Thank you.

Don Fandetti, Citigroup.

Please go ahead.

Mark, I was wondering if you could provide some thoughts on the card yield?

And also the efficiency ratio over the next, let's say, couple of quarters?

And then David, do you think there will be any sort of impact or change to the rewards competitive environment, when short term rates rise?

So I'll tackle the first couple, and I remember the first one was card yield.

And I'm forgetting -- I'm sorry, what was the second?

Card yield, and then efficiency rate.

Efficiency rate, yes.

(multiple speakers) Yes, you got it.

So from a card yield perspective, I would say the real compression thus far has been driven, really, by more what I call portfolio mix across the card business.

So what we're continuing to see is pre-card act higher rate balances continue to run off.

And given the various positive credit environment right now, that bucket's not getting refilled quickly.

And where we are seeing greater growth, obviously, is in what I would call the standard price receivables, as well as promotional receivables, also.

So I would experiment that phenomena would continue to play out over the coming quarters.

And you would see some -- I'll call it relative stability to modest compression in card yield.

In terms of the adjusted efficiency ratio, what I'm doing, basically, on that one is, I'm just taking the reported efficiency ratio of around 40%.

I'm backing out the $20 million legal reserve addition.

And I'm backing out the $15 million related to AML/BSA remediation efforts.

Really calling them out as non-core kind of things.

And on a core basis, your efficiency ratio comes out at 38.5%.

And that is still where you're thinking?

Yes, I think what we've said for the year is that we expect we'll be slightly above that 38% target range.

And I don't see any reason to dissuade you from continuing to focus on that guidance.

And on rewards, I think, to a large degree, we're at a new normal.

Consumers love rewards; that's what's working.

And therefore, competitors have migrated to rewards generally.

Cash rewards, I think, particularly is working well.

And therefore, you're seeing competition in that space.

I think that if some issuers start getting pressured on profits, and whether that's from rates or charge-offs or other factors -- higher marketing costs, as an example.

The ones who may have gone to an unsustainably high level of rewards probably will make an adjustment.

That's what we've seen in the past.

But I'm not sure that the average rewards rate for the industry, and for us, is unsustainable in the long run, in terms of producing a good profit margin, and providing great value for consumers.

Thank you.

Ryan Nash, Goldman Sachs.

Good afternoon, guys.

Hey, Ryan.

Just a couple of questions on expenses.

First, the $20 million addition to the legal reserve.

Was that contemplated in your $3.5 billion guidance?

And on the $15 million of BSA/AML, how do you expect the remaining 60 to ramp?

Would you expect it to be front loaded?

Or would you expect it to be a little bit more evenly spread throughout the remaining quarters of the year?

So I would say no, the 20 was not contemplated in the guidance we gave, number one.

Number two, I would say I would expect you will see the expense ramp a little bit, associated with the AML/BSA remediation activities.

Okay.

And then just as a follow-up to that, has anything changed from what you told us last quarter on the expense front?

Do you continue to believe the $110 million of incremental expenses for BSA and EMB will be one time in nature?

Yes, I believe the specific expenses we called out will be one-time in nature.

I think as we think about our business planning, there will be run rate expenses that we think we can cover with other operational efficiencies, and everything else related to some of those matters.

So just to be clear, it's really the nonrecurring things where we're not changing our guidance on those things, at this point.

Got it.

And if I could squeeze one more in.

Mark, on the net interest margin, you outlined the issuance that you've done thus far.

Should we assume NIM pressure to continue in this mid-single digit level, until rates rise?

I know you've talked, in the past, about wanting to make the balance sheet rate-neutral through the cycle, which I believe you guys are at or are at least close to.

How should we think about how much more insurance you guys want to buy to protect against higher interest rates?

Sure, yes, great question.

I guess, Ryan, what I see is, yes, we guided to that modest compression quarter over quarter this time around.

And what we saw was really in line with our expectations.

Looking at second quarter, I think you can probably expect a similar or somewhat similar decline there for the second quarter, about half driven by yields and about half by funding costs, plus or minus.

Beyond next quarter, I would say the pace of the decline really begins to level off quite a bit.

It's not like we're going to pierce a [950] margin or something this year.

Got it.

Thanks for taking my question.

You bet.

Jason Harbes, Wells Fargo.

Question on EMV.

The merchant liability shift is still a few months away, but we're already hearing requests for a delay.

Can you maybe share your perspective on the EMV implementation, along with some of the potential costs and benefits?

That would be a big topic, so I'm not going to try to fully address it.

Again, at investor day, we'll try to tackle it a little more broadly.

I think that it's important that we all try to hit the October date.

This has been a long time in the works; it's been a date that was set quite some time ago.

And as an industry, we know we need to do something to better control security and fraud losses.

And frankly, we could issue all the cards we want with chips, but if there's not terminals to use them, it actually would cost us money.

There would be zero fraud savings.

And I think it's in the merchants' best interests to try to get there just -- if anything, more than it is for the issuers, when you look at some of the breaches that have happened.

I think more broadly, I expect that this is going to be a somewhat rocky rollout for the industry.

This is a huge change for consumers, for people at point of sale.

Consumers are going to have to start dipping their card instead of swiping it.

Some merchants are going to be different.

So I think that we're -- merchants, acquirers, issuers, we're all going to be having to help educate consumers on the new way it works.

And that's what we saw in other places in the world, where EMB rolled out, is that it took a while to smooth out the edges, and fundamentally change something that's been in place for a few decades.

Okay, thanks.

And maybe as my follow-up, can you remind us what are your capital deployment priorities?

And what would be a reasonable timetable for hitting your 11% target?

Yes, I would say the capital deployment priorities remain, first and foremost, continued investments in organic growth in the business.

I would say, second of all, to the extent it's permissible under the current CCAR restrictions, returning it to shareholders.

The reason those are number one and number two is because we think they have very definable returns associated with them, and make a lot of sense.

The third priority, I would say, would be what I would call acquisitions of financial assets, as opposed to operating businesses.

But those would really have to be financially motivated, by us.

Because obviously, if you buy at [attriting] book, you don't get growth.

It makes growth more challenging.

So I would say they'd have to be financially motivated by us.

And then last but not least, I would say, with respect to traditional acquisitions, I would say that's fourth of four.

There's a pretty high bar there.

I think you've got integration risks, execution risks, diligence risks, key person retention risks.

Sot the bar on traditional M&A is pretty high.

And while the BSA/AML thing is out there, I don't think that's primarily our focal area, either.

Thanks, guys.

You bet.

Moshe Orenbuch, Credit Suisse.

Great, thanks.

I guess maybe just a little bit of a follow-up on the it Miles product.

I've seen some of the solicitations coming out.

And I've seen, from the mail data, that your numbers are starting to pick up.

Could you give us a sense of the timing of that rollout?

And maybe what you think it might -- what impact it might have on spending and receivables?

Sure.

We're still in a ramp-up phase.

But A, it will be significantly smaller than the flagship Discover it card, even when it's fully deployed.

And B, you should expect that -- you should expect some substitution.

It's not pure incremental marketing solicitations or dollars.

We'll be marketing Discover it Miles where we think we can get better response rates, better returns, better activation and usage, versus the flagship.

And we may be doing alternating of products, as well.

So I think bottom line, I wouldn't think about Discover it Miles as being something that would necessarily accelerate growth.

But hopefully to help us to maintain growth.

We've obviously been growing much faster than the industry in the past several years, and we have to innovate, if we're going to keep that up.

John Hecht, Jefferies Capital.

First one is just a -- you set the commentary in the context of deposit and liability management.

You had a little bit of a step-up in excess liquidity.

We've learned, I guess, a little bit more, maybe, about the rate cycle.

What should we think about you guys, over the next few months, in terms of managing your liabilities, in terms of -- and thoughts on deposit fundraising?

Yes, I would say a couple different things there.

Number one, the balance sheet today has been positioned to be what I would call modestly asset-sensitive.

It's what's caused the margin compression, or a big part of what's caused the margin compression we've consciously taken, over the course of the last couple of quarters, to build that positioning.

So I think if you look -- if you think about not just a 1 year forward NII, but if you think about the 10 forward years, and the net interest income impacting each of those 10 years, we're managing to be net positive through the cycle, if you will, with respect to our asset liability positioning.

So we will continue to make those investments.

So if you think about the liability side of the balance sheet, and how it contributes to that, I would say a couple things.

Number one, I would say we, as a team, will always favor deposits over capital markets liabilities.

They come with customers attached to them; we can cross-sell to customers.

There's a fulsome relationship that can be built there.

So we will always lean on using our balance sheet to serve our customers, and funding it with our customers' deposits.

The capital markets -- so that being said, I think the model is such that we're not going to necessarily be the highest rate payer in town.

That's not our goal.

But we're going to be a very fair rate payer, relative to traditional banks.

I would say, with respect to the capital markets, things we've done there, I think we've gotten the balance sheet into the position we want to see it.

So I wouldn't expect a lot of fixed rate funding, from this point.

I'm not saying none, but I wouldn't expect a lot.

What we would do, from this point forward, would be to protect the positioning we've built, as the balance sheet grows and shifts in composition, as opposed to trying to structure a more asset-sensitive position.

Okay.

That's good color, thanks.

And a related question is, I wonder if you can give us an update on the rollout of the cash-back checking?

Or is that something you just keep in your pockets, as rates go up?

We are making efforts to increase the cross-sell, and we're continuing to enhance the feature functionality of the product.

And we're hopeful that by year end, we'll be ready for broad market launch.

But frankly, we're -- we -- for now, we're continuing to focus on the cross-sell.

Okay.

Thank you very much.

Ken Bruce from Bank of America.

Good afternoon.

My question really is a follow-up to James Friedman's question about the marketplace, lenders.

I understand that it may be a little early, and you're watching and learning.

But I guess there's been a lot of capital raised recently, and a lot more focus on that particular model.

So one would suspect that there's going to be more activity than less, going forward.

And they've specifically targeted revolving credit and, essentially, debt consolidation within the sector, as a primary area of growth.

So how do you think about that competitively?

Do you think that it's a real risk?

And what is -- I guess, in your early stages, what would be your response to compete against those?

I think that at the margin, our personal loans product does the same thing.

We do consolidate loans, including credit card loans.

So to some degree, it's not a new product.

It had gotten a lot smaller, as a category, after the crisis.

And to some degree, I think it's returning to where it was before, but with maybe new players and new approaches.

At the margin, it's got to have a little impact on the total card business receivables.

But I'm not -- we haven't figured out a way to measure it at this point.

We will be watching it, and -- but I think that there's origination fees.

It's -- a personal loan is very different than a credit card that tends to be a small, temporary loan, coming from spending usually.

A credit card has a lot more features than a personal loan does.

But a consolidation loan also has its place.

And I guess for a couple years now, we've been by far the leader in this space, and now we've got some company, with a different funding model.

Okay.

And maybe also another follow-up.

But Mark, you had mentioned that basically, you are, from a -- just a pure funding perspective, you're positioned where you want to be.

Do you expect durations?

Are you at target durations on the liability side of the balance sheet now, in that it would match the general growth of the business?

Or do you envision any different -- any changes, just given we keep pushing out the future rate hikes, and it feels like, as David's comments would suggest, things have softened up around the edges.

So maybe we're looking at a lower rate environment, maybe, than you expected even three months ago?

Yes, I guess I can make you happy by saying we were never expecting a rapid ramp in rates.

The activities we've undertaken have always expected a pretty gradual movement.

Now from a risk management perspective, we run lots of shocks in areas, too, to make sure we're protected.

But what we've been positioning ourselves for, really, is that principal case of a gradual rise in rates.

So our thoughts are on what's going to happen really hasn't shifted all that much, Ken, in terms of timing or magnitudes.

What I would say is, the answer to your question about duration targeting, yes, we're within a month of two of where, ultimately, in a perfect world, I'd like to see us be.

So it feels like, again, back to my earlier comment, we will do some fixed rate funding from here.

It will be characterized in one of two different ways.

Either pure optimism, because we see, for lack of a better word, an arbitrage opportunity that makes a lot of sense.

Or number two, I would say it would be in response to shifts in the composition and growth in the balance sheet.

So, if we put more fixed rate assets on, you would expect to see us look to cover that with more fixed rate funding.

Great.

Thank you very much.

Scott Valentin, FBR & Company.

Thanks for taking my question.

Just with regard to the personal loans, just curious, over the cycle, where you would see losses for that product versus the credit cards?

What I'd rather do is defer to investor day on that.

We have given that kind of guidance in previous investor days.

And Bill feels happy to get you those -- laying that out.

But generally, personal loans, the way we underwrite them, probably have somewhat better loss characteristics than, I think, credit cards.

It's very FICO scores.

Okay.

And then just a follow-up question.

In terms of the rewards programs, is there a cost benefit to the miles program versus the cash back, on the rewards side?

Yes.

The miles card is a bit more expensive, from a rewards perspective.

And we expect to see that offset by higher spending, higher balances, and engagement.

So the way we look at it is, we expect similar overall returns, even though we also expect a higher rewards cost.

Okay.

Thanks very much.

Cheryl Pate, Morgan Stanley.

Hi, good afternoon.

Just a couple follow-up questions on the net interest margin, if I may.

I guess first, on the credit card yield, I think you spoke to a bit of a mix shift, more towards standard and promotional-type balances.

Just wondering if, on the promotional balances specifically, if you can speak to the growth there?

And has that been growing faster than other parts of the portfolio, maybe, as we see some competition in the space?

Yes, we'll give some more color on that one at our investor day.

But what I would say is, the strongest growing portion of the book, by far, is the standard rate portion of the book.

So I don't think, by any stretch of the imagination, we're being undisciplined with these promo balances, or anything along those lines.

The growth is really being driven by regular way usage of the card, which feels really solid.

Okay.

And then just a second follow-up, if I might, on the personal loan side.

You spoke to consumer preference to shorter-term loans from here.

Has that been any change in pricing strategy?

Or should we think of that as getting ahead of rates?

Or is there any behavior that -- in particular, that's incenting that?

Or maybe the competitive environment that might be fueling that?

I think -- we've looked at it from any number of different angles.

We can't really discern any one particular thing, other than to say there has clearly been a shift in consumer preference.

Possibly, as we've gotten further away from the crisis, folks are feeling more confident in their financial situation, more confident in their employment situation, everything else.

They're comfortable carrying a heavier payment, and paying it down quicker.

But we can't isolate and say, definitely, it's due to that, or due to something else.

But that's the operative thesis, for lack of a better way of putting it.

Okay.

Thanks very much.

David Ho, Deutsche Bank.

Good afternoon.

Real quickly, back on the warehouse clubs.

Opening up acceptance to Visa cards, [50-some] billion of volume out of the store.

Obviously, those cards are more competitive versus yours, versus their previous provider.

I know it's early days, but -- and next year.

But any potential impact, in terms of wallet share, as you think about some of the cash-back offerings associated with the opening up of acceptance for those cards?

No.

Discover already is -- has the highest acceptance in the top hundred retailers.

And what I would expect, especially the way this is happening is, everyone already has multiple Visa cards.

And so to some degree, they'll be able to put they're spend on that Visa card, on the same Visa card they already have, versus having to put it on a different card.

So I don't see an impact on us.

Okay.

And separately, what factors are -- or might you be considering, in terms of what you plan to do with the direct mortgage business?

And when do those expenses maybe come out a little bit more out of the cost structure?

And then, how are you thinking about the home equity installment loan side of the business, as well?

On the mortgage business, while we're pleased that, as Mark indicated, it -- that given the attractive environment this quarter, it was helpful.

But we still are confident that the rate environment is going to move up, and therefore refinance volume is going to decline.

So we are continuing to look closely at options, to make sure that we can -- it not become a drag, over time.

On the home equity business, it's just early days.

And I would think about it -- we launched both personal loans and student loans in 1987, and we kept them pretty small, until we felt really good about them.

And then we started scaling them.

I think we think the same way with home equity.

We feel good about the business, but we're not to the point where we would feel like we could -- that we're ready to ramp up to any significant degree.

Next question?

Matthew Howlett, UBS.

Just on the card payment rate, I know they've been -- they've remained elevated from years past.

And we look at the master trust -- I know that doesn't represent everything -- but it appears to be picking up a bit, year over year.

Anything to say on that, in terms of the guidance for loan growth?

Do you expect payment rates to remain in this range?

Or how do you see consumer behavior changing?

I expect it to be reasonably stable.

There -- it obviously can jump around a little bit, from time to time.

But I think the big story is, credit is really good, and so that tends to correlate with high -- with relatively high payment rates.

(multiple speakers) Go ahead.

You expect them to be flattish?

I know yours is in the middle.

You're not the highest; you're not the lowest.

But in this current range, and do we see lower payment rates when credit eventually normalizes?

Is that what happens?

Generally, it will move a little bit because of that.

And I think if you think about us relative to others, we tend to be -- we tend to focus a bit more on revolvers versus transactors, which tend to have lower payment rates on revolves.

So by definition, a transactor is 100% payment rate.

And on the flip side, we tend to have better credit, which tends to drive higher payment rates.

And so those two are competing forces, and they get us to where we are.

But I think -- I'm not expecting a big trend in that number.

Great, thanks.

And then just to follow up on -- I know there's been a lot of questions on the card margin.

But you mentioned the mix shift, with some of the balance transfers coming in.

Is that just a normalization?

Or is that -- is there any of that being driven by competition?

I know one of the big money center banks guided to the low end of their revenue margin for the year.

Any pricing dynamics changing there, where more balance transfers could be introduced?

No, I would say the bigger dynamic is actually the replacement of the high rate bucket with standard rate product, is actually a bigger driver, at this point in time, than the promotional activities itself.

So we're tending to use the promotional activities more with the legacy portfolio, as opposed to the new account side of the equation.

And standard merchandise sales are really the big driver of that yield compression, sort of across both the new accounts and the portfolio.

Great, that explains it.

Thanks a lot.

Mark DeVries, Barclays Capital.

Yes, thanks.

First questions are on non-interest income.

Just wondering, one, if you could give us an update on where your direct mortgage pipeline is shaping up for the quarter?

And also whether you can provide us an update on where you stand on re-launching your protection products?

So on the second question, we're -- we are -- have no current plans to relaunch protection products.

We'll continue to evaluate.

And I'm sorry -- the first?

And on the mortgage pipeline, Mark, what I'd tell you is, we haven't traditionally disclosed our pipeline.

I guess what I would say is, you know, what we have said is, it tends to flip between accreting a penny and losing a penny a share a quarter.

And I would just say, it's going to be in that range again this next quarter, based on everything I see right now.

Got it.

And then another question on your student lending credit.

I think, Mark, you indicated that it's seasoning, as you expected.

But both charge-offs and delinquencies were down pretty substantially year over year.

Is there anything to call out there?

Are you seeing credit improve on that book?

I'd say we were generally pleased with the numbers this quarter.

That business, partly because of its size and maturity and seasonality, does tend to fluctuate a lot more, quarter to quarter, than our other businesses.

One of the things that we have done is put in place some programs to help students who might be struggling.

And we feel like we might be getting a little traction on some of those programs that's good for both consumers and us.

But I think we need a few more data points to see how material or immaterial those can be.

The other thing I would just say is, I think the employment market for graduates has continued to improve a bit.

So I'm certainly hopeful that that will be -- portend good things for credit, over the long-term.

Thanks.

Jason Arnold, RBC.

Just another quick follow-up on the airline rewards card side.

I was just wondering if there's any way you can size the broader industry opportunity set in airline rewards focused customers, versus those that are more cash-back or points reward focused?

And then if you could comment on the incremental opportunity for growth that you mentioned for Discover, if that's more of a product of that balance of focus there?

Or if it's just your focus on cash-back reward, and this being incremental?

So, by far and large the largest airline rewards cards, as you know, are co-branded rewards cards for people that frequent a certain airline, and are really heavy travelers.

And that's a very sizable market.

It's also one that -- there's some very significant co-brand payments associated with it.

And I would say that's generally not what we're targeting with this product.

I'd say this product is also -- is targeting people that maybe like the idea of earning travel rewards.

They may travel some, but they're not the global travelers who are being reimbursed by their company, or just traveling very extensively on business.

So I would think about it as a somewhat smaller market than either the traditional airline co-brand card or the cash back -- traditional cash back category, which we are a leader in.

And that will continue to be where our flagship card is.

So I feel like this is a bit more of an important niche, and an important second product for us.

Super, thank you.

Good, thank you.

And thank you.

We have no further questions.

At this time, I will now turn the call over to Bill Franklin for final remarks.

We'd like to thank everyone for joining us.

If you have any other follow-up questions, feel free to give us a call tonight.

Have a good night.

And thank you, ladies and gentlemen.

This concludes today's conference.

We thank you for participating.

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