發現金融 (DFS) 2016 Q3 法說會逐字稿

Good day, ladies and gentlemen.

Welcome to the Discover Financial Services third-quarter 2016 earnings conference call.

(Operator Instructions)

As a reminder, this conference is being recorded.

I would like to introduce your host for today's conference, Bill Franklin, Head of Investor Relations.

You may begin your conference.

Thank you, Chantel.

Good afternoon, everyone.

We appreciate all of you for joining us.

Let me begin 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 provided 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 2016 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 would be very helpful if you limit yourself to one question so we can make sure that everyone is accommodated.

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

Thanks, Bill, and good afternoon, everyone.

For the third quarter, we reported net income of $639 million and diluted earnings per share of $1.56 including $0.07 of one-time tax benefits.

Overall, we delivered another strong quarter with EPS up 13% year over year and a return on equity of 23%.

Our direct banking business continues to perform well, accelerating the pace of total loan growth to 5% over the prior year.

In the card business, we grew receivables by 4%, once again much faster than card sales which grew by 1% over the prior year.

As I mentioned last quarter, we've remained more disciplined than certain competitors in reward spend and as a result, we have sacrificed some transactor sales volume.

We are, however, taking some actions on rewards to accelerate card sales, but we are not chasing unprofitable volume.

I'd remind you that loan growth, which drives most of our profits, is driven by revolver spend.

Our product continues to resonate well with prime revolvers, and that has allowed us to achieve loan growth in our target range.

We are focused on delivering the best products to our customers, and we are continuously innovative, testing, and implementing new features and benefits, ways to serve our customers better or more efficiently, and we offer rewards that provide real value to our card members.

Our cards continue to be well regarded in the marketplace as evidenced by MONEY Magazine naming three of our cards, Discover it, Discover it Miles, and Discover it Secured through their annual best credit cards list last month.

I'll now move to our other direct banking products, which also delivered strong performance in the quarter.

The organic student loan portfolio increased 14% with strong performance during this year's peak back-to-school period.

Personal loans grew 16% over the prior year driven by product enhancements and opportunistic marketing which took advantage of pull backs in advertising by some marketplace lenders.

Both student and personal loans are on track for record originations again in 2016.

On the funding side of our direct banking products, we increased direct-to-consumer deposits 19% over the prior year.

This was driven by some of the highest retention rates we've achieved, and we accelerated growth in new customer balances.

Though market rates have increased in the last year, our funding costs for direct-to-consumer deposits has remained relatively flat.

Moving to our payments business, PULSE volumes declined 6% year over year but were flat quarter over quarter showing some volume stabilization.

At the same time, network partners and Diners Club volume increased over the prior year with Diners Club volume increasing 12% driven by continued strong growth in the Asia Pacific region.

Finally, I'd like to talk about something we're very proud of here at Discover.

In August, J.D. Power announced that Discover ranked highest in credit card customer satisfaction for the third straight year.

I'd like to thank each of our 15,000 employees who continue to work hard to deliver the best possible value and experience to our card members.

Overall, it was a good quarter.

We achieved record EPS, even excluding the one-time tax benefits.

Now, I'll turn the call over to Mark and he will walk through the details of our third-quarter financial results.

Thanks, David.

Good afternoon, everyone.

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

Net interest income increased $140 million or 8% over the prior year driven by a combination of loan growth and a higher net interest margin.

Total non-interest income decreased $27 million to $476 million.

Net discount and interchange revenue was down 9% driven by a higher rewards rate year over year.

Our rewards rate was consistent with the second quarter and up about 13 basis points from the prior year.

The increase over last year is primarily driven by higher promotional rewards, principally our cash back match program, which helped to drive strong new account growth this quarter.

We expect to continue with focused innovations around our rewards program to drive engagement in our target segments, and as a result, we expect the rewards rate to come in around 119 basis points for the full-year 2016.

Moving to payment services, revenue was flat year over year as lower volumes at PULSE were offset primarily by lower incentives.

Overall, we grew total Company net revenue by 5% for the quarter.

Turning to slide 6, total loan yield of 11.82% was 45 basis points higher than the prior year primarily driven by a 50 basis point increase in card yield.

The year-over-year increase in yield was primarily due to a higher percentage of revolving card receivables in the portfolio as well as the impact of last December's prime rate increase.

On the funding side, we grew average direct-to-consumer deposits by $5 billion to make up 46% of our total funding.

Our funding costs increased 10 basis points driven by higher market rates, higher FDIC assessments due to large bank surcharge, and changes in funding mix as we extended the maturity profile of our brokered deposits.

Overall, net interest margin expanded 37 basis points from the prior year to 9.99%.

For the fourth quarter, we currently expect net interest margin to be relatively flat.

We may, however, utilize some of the healthy NIM toward promotional balance growth initiatives.

Turning to slide 7, operating expenses were up $13 million over the prior year.

I would remind you that last year's results had $23 million in expense associated with the wind down of the direct to mortgage origination business.

The largest driver behind the $5 million year-over-year increase in employee compensation you see in the table was higher headcount to support compliance activities.

Marketing expenses were up $27 million as we made opportunistic investments primarily in card but also in student and personal loans.

Professional fees fell $17 million primarily due to the completion of look back related anti-money laundering remediation activities in the second quarter of 2016.

Turning to provision for loan losses and credit on slide 8. Provision for loan losses was higher by $113 million compared to the prior year due to higher reserves and charge-offs primarily driven by loan growth.

This quarter, we increased reserves $75 million while last year, we had a much smaller build of only $8 million.

The credit card net charge off rate of 2.17% increased by 13 basis points year over year and fell 22 basis points sequentially.

The 30 day delinquency rate of 1.87% increased 22 basis points year over year and was up 24 basis points sequentially.

On balance, the credit backdrop continues to remain benign.

Reserving was primarily driven by the compounding effect of several years of consistent loan growth.

Looking at private student loans, the net charge-off rate, excluding acquired loans, increased 8 basis points from the prior year due to seasoning of the organic book.

Sequentially, the rate decreased 8 basis points due primarily to seasonality.

Student loan delinquencies, once again excluding acquired loans, were relatively flat.

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

Switching to personal loans, the net charge off rate was up 64 basis points from the prior year and 25 basis points sequentially.

The 30 day delinquency rate was up 18 basis points from the prior year and down 4 basis points from the prior quarter.

The year-over-year increases in the personal loan charge-off and delinquency rates were primarily driven by the seasoning of recent loan growth and are consistent with our expectations.

Next, I'll touch on our capital position on slide 9. Our common equity Tier 1 capital ratio declined sequentially.

The ratio decreased 40 basis points in the prior year due to capital deployment in the form of loan growth, buybacks, and dividends.

In the quarter, we repurchased 2.5% of our common stock including the incremental $100 million we announced in August following the Federal Reserve's non-objection to our de minimis request.

In summary, we delivered strong net interest income by growing loans and NIM, saw increased rewards expense primarily due to our match promotion, which drove more new and engaged accounts, and while provisions were a headwind, the consumer credit backdrop remains relatively stable.

That concludes our formal remarks.

Now I'll turn the call back to our operator, Chantel, to open the line for Q&A.

(Operator Instructions)

Our first question comes from Sanjay Sakhrani with KBW.

Thanks.

Just had a question on the personal loan growth.

I appreciate the color on the acceleration and the growth.

Should we expect that growth rate to sustain itself over the course of the next six to 12 months?

And then maybe you could just speak to some of the credit quality degradation and how comfortable you are with originating that growth.

Thanks.

Sure.

We feel really good about the accelerated growth we've achieved in that business, and we believe that we will be able to continue to maintain roughly that level of personal loans growth and that's helped us to bring us now right into the middle of our quarter, 6% overall loan growth target, and we feel good about the credit quality.

The FICO scores are relatively flat for new customers, and some of the initiatives we put in place like the higher loan limits of $35,000 versus the $25,000 we had before are helping us to sustain higher average balances and approve some loans that we were not able to approve in past years.

Sanjay, it's Mark.

I would kind of tack on to that just to really support the credit quality point.

I know that 64 basis point increase is a little eye popping maybe, but it is very strong loan growth.

The reserve build really reflects the seasoning of loan growth.

I'll give you a little preview when you see our Q here in a couple weeks.

96% of our personal loans continue to have a FICO north of 660, so the credit quality on that book continues to be extremely strong.

Thanks.

Sure.

Our next question comes from David Scharf with JMP Securities.

Good afternoon.

Maybe I'll stay focused on the credit side.

Just curious, you commented for the different asset classes that credit was coming in generally in line with expectation.

Should we view the magnitude of the ending allowance rate as a little bit of catch up or conservatism given how strong some other areas of the business were?

Just trying to get a feel for how much of the increase in losses and provisioning we should view as credit normalization versus seasoning?

Yes, I would say -- I wouldn't say there's any fluff in there, for lack of a better term.

I think it's a very model driven process on the front end to which we apply some judgment on the back end, but that judgment is pretty rigid.

In terms of how to think about it and parse it up, what I would say is the biggest thing that's really driving some of the increase over the course of the last couple quarters is the fact that over the last several years, you've had the back book of legacy loans, which is three years or more seasoned, so over 80% of the book.

We were getting really big improvements in that legacy back book, and it was masking the impact of the growth driven provisioning that you're seeing from those new accounts that are three years or less on book.

And as the legacy portfolio has really stabilized and isn't seeing further improvements in credit losses, that's what's really driving the impacts of provisioning.

You know longer have that muting effect, so I would echo our earlier comments.

I would say the credit environment continues to feel very benign.

We feel good about the environment and the originations we're doing in the environment today, and I would expect provisions into the foreseeable future really to continue to be driven more by the seasoning of loan growth and not by any sense of deterioration in the book.

Okay, very helpful.

Thanks.

You bet.

Our next question comes from Bill Carcache with Nomura.

Thank you.

Good afternoon, guys.

Mark, in looking back at your long-term guidance from I think it was your fourth quarter 2015 earnings call, I believe you guys were looking for a normalized SEO rate of about 3% to 4%.

And kind of thinking about your comments on continued credit normalization and credit rating benign and seasoning effects and everything still being okay, are we kind of to expect that the continued normalization of credit would likely lead your reserve rate to continue to grind its way higher towards that 3% to 4% normalized level?

I think it ended the quarter at [2.75%], up 26 basis points year over year.

Does that trajectory continue to trend towards that 3% to 4%?

Yes, I would say we would expect to continue very slow normalization in credit.

I don't see any significant jumps of any kind.

Clearly, I think we would all acknowledge we're operating below the long-term averages for card loss rates, loss rates really across all of our products quite honestly, so we would expect some normalization over time.

That being said, I'd go back to those earlier comments, Bill, and just underscore again the environment just feels very benign out there right now.

We're not seeing real significant signs of deterioration, so I think it's really more a slow grind than a steep hill at this juncture anyway.

Okay, that's great.

As a follow-up if I may, one of the things that you've expressed a little bit of concern over in the past is kind of like the trip wire effect, if you will, of from the CCAR process, particularly relating to the risk of qualitative failure, and with the Fed's decision to eliminate that now, is some of the other changes that have been proposed for financials that aren't considered GSIBs.

I was hoping you could comment on that and share broadly how we should be thinking about or how you're thinking about that from Discovery's perspective?

Sure.

I mean, I think looking at Governor Trujillo's most recent comments reading the NPR, I think we are what I would say I'd describe as cautiously optimistic.

I think it's still too early to really know what is actually going to fall out of the NPR precisely.

And the stress capital buffer that the Governor spoke of, I don't think that's even referenced in the NPR itself.

I think that was just really even in the speech, so I think there's a lot still to come out in the details, shall we say, as we get it, but we took it as a positive signal.

We have been very focused on increasing our pay outs over time, and we clearly see nothing in the guidance that we've had thus far that would cause us to think we couldn't continue to look to increase those pay outs, and hopefully, as we see more details behind this, it will give us even a little bit more runway than we would otherwise hoped to have had.

Thank you.

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

Hi.

Thanks.

Good afternoon.

I think I'll ask a question away from credit for the moment.

Looking at PULSE, it's been kind of a tough sector for quite a while for some obvious reasons.

I guess some have kind of suggested that there may be some needs for consolidation in PIN debit.

I guess my question is, how do you look at that as a strategic asset, other alternatives for it, do you see it potentially being involved in industry consolidation?

Thank you.

Sure, Ken.

I think that it has indeed been difficult not only for PULSE but the other PIN networks given in particular some of the actions that Visa took following the Durbin amendment.

And I guess that the good news is, as I indicated in my point up front, a lot of our volume lost in the last year or so was from one big customer, and we saw some stabilization of our PULSE volumes this quarter sequentially.

And so I think I feel like we are hopefully through the worst of some of that challenge but the constraints continue to be really difficult in terms of rules and how the migration to EMV cards is, what the rules are on the various issuers that the dominant players have.

I think that consolidation is certainly possible and at some point, we and First Data have by far and away the largest of the independent PIN networks, so one could argue that one or both of us might end up being in a good position to be the consolidators.

But -- and I think we have some things to offer because we do have signature debit, not just PIN debit, which is unique among all of the independent PIN networks.

But that being said, if at any point we decided we were not the best owner, we are focused on shareholders and doing the right thing to build shareholder values, so we'll continue to pursue lots of different options in the industry.

Thank you.

Our next question comes from John Hecht with Jefferies.

Thanks very much, guys.

Mark, you mentioned that your NIM benefit in the quarter because of higher amount of revolving receivables.

Is this -- would this imply that I guess maybe our utilization rates on the app in terms of customer behavior and if so, do you guys have a perspective on what's driving that?

So I would say utilization rates are -- they're relatively flat.

I think the big driver in revolve mix, quite honestly, is we are continuing to grow on our target segment, which is prime revolver customers.

And as David noted earlier, we continue to see some degree of transactor attrition in the book with some of the very lucrative, I'll call them rewards rates, that are being put out there by some of our competitors.

And in terms of consumer leverage, we don't see significant leveraging on the part of the consumer and that's part of what feeds the overall thought process about it being continuing to remain a benign credit environment at this point in our minds.

Okay, and second, just in terms of near-term thoughts for the allowance levels.

I know I look at the last couple years, there was a modest increase in allowance in the fourth quarter but it looked like maybe because of seasonality a little lower than allowance build in the fourth quarter relative to the third quarter.

Any thoughts on that and how we should think about that for the near term?

Yes, I mean we don't give forward guidance but the one thing I would say is, you are correct that there is a seasonal impact to the reserves that does come about in the fourth quarter.

We reserve for what's on the balance sheet, and card loans tend to balloon, for lack of a better term, in the fourth quarter and then pay down again as we go on into the first quarter, so that can have an impact.

Now that can also be muted and mitigated by trends we see in the portfolio itself.

But just the absolute book on which your reserving will grow and so if everything else stays constant, theoretically your provision would grow along with that as well.

Great.

Thanks very much.

(Operator Instructions)

Our next question comes from Jason Harbes with Wells Fargo.

Hi, guys.

Thanks for taking the question.

I have a question on fees.

You saw nice rebound in loan fee income this quarter.

Could you maybe comment on the drivers of that and perhaps the sustainability as we look forward within the context of the competitive threat from some new entrants that are waiving fees, particularly in the personal lending side of your business?

Hi, Jason.

It's Bill.

Most of our loan fee income is driven by late fees, and they typically have a seasonal increase in the third quarter, so that's not anything in terms of new annual fee products or anything like that but more just the trend seasonality and late fees.

Okay, thanks for the clarification.

Our next question comes from Brian Hogan with William Blair.

Good afternoon.

A question is regarding the rewards cost.

I think you increased the -- at the competitor conference in September, you kind of alluded to a 1 to 2 basis point increase over your kind of 1.15 and now you're saying 1.19.

I assume it's just relative to the competition out there and how it's intensified, but can you just comment on that?

And then as a follow-up, can you comment on spending on rewards versus marketing and how you're thinking about the two?

Sure, Brian.

The biggest factor behind our higher rewards rate is the higher -- is our double promotion for new accounts and that we're pleased with the economics and the lower cost per account and the greater number of new accounts that's driving.

And so we've continued to aggressively offer that, and it's driving the rewards rate a little bit faster than we had even anticipated a few quarters ago.

And your second part of your question was around how we think about it as marketing, and we really think about promotional rates in conjunction with what it does to cost per account and that's true with promotional APRs as well.

And we are constantly testing and evaluating what gives us the lowest all-in costs and the best long-term profitability from the combination of marketing spend, promotional rewards, and promotional APRs.

And I'd just underscore the overall objective of that program is to drive engagement in the target marketplace, so I think it's really important to point out that we don't have any desire to be a me-too in the very high-end rewards space.

And just a follow-up.

Can you comment on the competitive environment for rewards?

I know it's incredibly intensive.

Have you seen any increased incremental?

Obviously, the Sapphire Card is out there and stuff like that.

Yes, I would say there are certain offers out there that we scratch our heads about how they could possibly make anyone's potential hurdle rate, and I think one of the indicators is you go online and look at the gaming sites and there are certain card offers right now that people are saying go get this card, they've gone viral, and in my -- I'm not sure it's necessarily even the target market that may be responding to some of these offers.

And we've seen some of this in the past and we are somewhat late cycle.

People are seeing credit cards as a much more profitable product than most anything else in banking, so they are diverting resources but frankly, some of these offers I think will in the long run have to be significantly devalued because how they're used and what the interest rate is and how many people leave after the promotional time period will all drive the economics, and I would suspect that some are not sustainable.

Thank you.

Our next question comes from Chris Brendler with Stifel.

Hi, thanks.

Good afternoon.

Just wanted to ask about the margin a little bit.

Can you discuss to the extent that you're seeing a benefit from transactors essentially being pushed away by some of the increased competition?

Is that accelerating, or is it stable, is it a steady tailwind to your NIM that should continue into next year?

How should we think about that?

So it definitely does have an impact on the NIM.

It's not the largest of the component pieces that's impacting NIM.

I would say in terms of transactor attrition, it's a modest amount of it.

It has been relatively consistent in terms of that contribution.

Don't really want to forecast looking forward what's going to happen with transactor volume and transactor accounts.

Candidly, we don't want to attrite those transactors forever.

So I think there will be some element of that but really, the big drivers on the NIM expansion continues to be the card yield itself as well as that higher revolve rate, which is a component piece that you noted that really is effected by that transactor mix.

But I would also say its been very effective management on the part of the Treasury team and deposits business on our funding costs, which has been really a huge contributor to that 37 basis point year-over-year increase in NIM that you see reported.

Excellent.

Thank you, and if I could ask a quick follow-up.

There's been some discussion -- and I apologize if you actually addressed this earlier, I joined the call late, but continuing the discussion of the 2015 vintage in the credit card space not being nearly as strong as prior vintages for whatever reason, are you seeing that in your portfolio as well and is it just for the natural I think it's further and further away from the recession, or is it increasing risk appetite?

Any thoughts there would be helpful.

Thank you.

I would say if you think about it, we just contributed some new accounts to our securitization trust here a couple months back, so you now have vintage data for some of those newer originations that are there, and I would say the 2015 year for us thus far looks pretty solid.

The one thing I would caution you on in looking at those vintage curves though that I pointed out there is in adding new accounts to the trust, you don't add any charged-off accounts.

So the numbers you're going to see there for those new accounts are going to be somewhat elevated because until we actually start taking charge-offs on those -- or getting recoveries on those rather, you're really looking at gross charge off numbers.

Excellent, thank you.

The recoveries that weren't added.

Right.

Our next question comes from Jason Harbes with Wells Fargo.

Jason, did you have a follow-up question?

Sorry, I was on mute.

Thanks for taking my follow-up.

So I had another question.

One of your peers recently commented about some potential impact that they're seeing from recent regulatory guidelines around debt collection.

Is that something that you've seen any impact from or would you expect to?

So we have not seen any impact from that yet.

I think the folks who really commented on it have traditionally sold a chunk of their portfolios.

We have not in the last 10 years sold any of our portfolios, so I'd say we continue to evaluate the proposal.

It's really kind of too early for us to fully understand its implications, but it's not factored into our reserve estimates nor do we currently think it's a big issue for us.

Okay, thank you very much.

You bet.

Thank you.

We have no further questions at this time.

At this time, I'd like to turn the call over to Bill Franklin for final remarks.

Thank you, Chantel.

The investor relations team will be around this evening if anyone has any follow-up questions.

I hope everyone has a good night.

Thanks.

Ladies and gentlemen, thank you for participating in today's conference.

This does conclude the program and you may all disconnect.

Everyone have a great evening.