發現金融 (DFS) 2016 Q4 法說會逐字稿

Good afternoon.

My name is Chantal, and I will be your conference operator today.

At this time I would like to welcome everyone to the Discover Financial Services fourth-quarter earnings call.

(Operator Instructions)

Bill Franklin, Head of Investor Relations, you may begin your conference.

Think you, Chantal.

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 provided to the SEC 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 annual and fourth-quarter 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.

(Caller Instructions)

So now it is my pleasure to turn the call over to David, who will begin his comments on page 3 of the presentation.

Thanks Bill, and good afternoon everyone.

I'm going to review the full-year 2016 accomplishments and 2017 key focus areas, and then turn it over to Mark to cover fourth-quarter results.

2016 was another strong year, as we delivered 21% return on equity and we accelerated loan growth.

This loan growth acceleration, as well as net interest margin expansion, drove strong revenue growth.

Operating and expenses benefited from the completion of the AML look-back project earlier this year and the exit of the home load business last year.

Higher provisions from the seasoning of the last several years of loan growth partially offset some of this positive operating leverage, but were in line with our expectations for credit costs.

All in, our full-year earnings per share rose 12%, boasted by almost $2 billion of share repurchases.

We accomplished a great deal in 2016 against our key focus areas including, as you can see on slide 4, accelerating the pace of loan growth to nearly 7%, above the 4% to 6% expectation we set a year ago.

In total we increased loans by nearly $5 billion, our largest organic increase in loan balances in 15 years.

Our car business was the largest driver of that growth.

Reflecting on some card-specific accomplishments, we launched Credit Scorecard, which provides both current and prospective customers free easy access to their FICO score.

And we introduce the Discover it secured credit card, targeted at customers who are looking to establish or rebuild their credit history.

Our credit cards continue to resonate well with prime revolvers, as we hit a post-recession high number of new accounts for the year, which was the biggest driver of the loan growth.

We achieved this growth while maintaining our disciplined approach to underwriting, and as a result credit quality remains strong.

Our total Company net charge-off rate, excluding acquired loans, was 2.24% in 2016, 12 basis points above 2015, still very low relative to historical experience and among the lowest in the industry.

Moving to our other direct banking products on page 5, personal loans set a record with originations of $4 billion, an increase of 31% over the prior year.

Growth in originations was largely fueled by product enhancements and strong execution.

Product enhancements in 2016 included a higher maximum loan amount, an improved mobile responsive website and application, and check-your-rate functionality which allows customers to view the interest rate and estimate monthly payments without impacting their credit score.

Student loans also set a record with $1.4 billion in originations, an increase of 9%.

We expanded our student loan awareness efforts via marketing and our field sales force as well as redesign of the application experience, resulting in a higher conversion rate and more satisfied customers.

In payments, the Discover Network continues to provide significant benefits to our card-issuing business and network partners.

I am pleased that PULSE [step-up] volume is stabilizing as shown on page 6 after trending down for the last couple of years, due primarily to the competitive response related to the implementation of the Durbin Amendment in 2012.

I believe PULSE is now poised for modest growth in 2017.

Internationally, we established a new partnership with Elo, the largest Brazilian card network, to allow Elo cardholders to use their cards across our global network.

Diners Club returned to growth on an FX adjusted, or real, basis of couple years ago, but I'm happy to see volumes grew as well on a nominal basis in 2016, as several of the new partners we signed over the past few years are now growing nicely.

[Moving to page 7, we returned more than $2.3 billion to our shareholders in the form of dividends and share repurchases last year, which represents 99% of our net income.

As a result we reduced outstanding shares of common stock by 8%.

This, combined with the income growth of 4%, drove our EPS to be 12% higher.

You can also see in the chart on the right how our return on equity has remained above 20% for the last four years, much higher than other large banks.

As we look back on 2016, we feel good about all we've been able to accomplish.

Now I will spend a couple of minutes discussing our key focus areas for 2017 before I turn it over to Mark to walk through the fourth-quarter results.

First, we will be focused on sustaining profitable growth.

In card, we will continue to enhance our products by introducing innovative features and benefits, and prudently adjusting reward offerings to drive greater customer engagement.

Underlying all of our initiatives is our commitment to disciplined credit management and great customer service, which has historically served us well.

I think it's fair to say that a number of competitors are pursuing growth for the sake of growth, which is generating some transactor sales shareship, but resulting in lower revenues for them.

By contrast, you saw our loans and revenue grow at similar rates in the fourth quarter.

Our approach and execution have shown discipline, and that is our continued commitment to shareholders.

Building on our momentum in both lending and deposit products we will increase marketing to improve consumer awareness and consideration across products, as well as continue our efforts to increase product differentiation.

To do this, we will also invest in technology to enhance our products and processes so that we can offer consumers what they want most and make it simpler for existing customers to add additional products.

In payments we have a unique set of assets, which we believe offers many long-term opportunities.

Near term we are focused on getting the most from our proprietary network for our card-issuing business, including increased acceptance and brand differentiation.

Third-party volumes stabilized at the end of the year, and we continue to seek opportunities to defend and grow our PIN debit business and penetrate the signature debit market.

Additionally, we will continue to pursue new ways to partner to better leverage our network and drive volume growth.

In 2017 we will remain focused on enhancing our AML BSA compliance functions.

Continuing to invest in compliance and risk management strengthens our operations and supports our leadership position in customer service.

In closing, I want to thank our employees for serving our customers so well and producing strong financial results in 2016.

I'm excited about the momentum we have going into 2017.

And with that, I will turn the call over to Mark to cover fourth-quarter results and provide some guidance for the year.

Thanks David, and good afternoon everyone.

I will begin my remarks on slide 8 of our presentation.

For the fourth quarter we reported net income of $563 million and diluted earnings per share of $1.40.

Overall we delivered another strong quarter, with EPS up 23% year over year and a return on equity of 20%.

Turning to slide 9, card and personal loans finished the year with a strong fourth quarter, accelerating total loan growth to almost 7% over the prior year.

Current balances were driven by increased sales, which were up 3%; a higher revolve rate on merchandise sales; and higher promotional balances.

Personal loans grew 18% over the prior year, due to successful marketing initiatives and the product enhancements that David mentioned earlier.

Student loans grew 2%, as runoff in the acquired portfolios partially offset growth in the organic book.

Looking solely at the organic student loan portfolio, it increased 13% with strong performance during this year's peak season.

Moving to our payment services segment, PULSE volume and network partners were relatively flat year over year, while Diners Club volume increased 8%, driven by continued strong growth in the Asia Pacific region.

Turning to slide 10.

Net interest income increased $160 million, or 9% over the prior year, driven by a combination of loan growth and a higher net interest margin.

Total noninterest income decreased $7 million to $466 million. ]

Net discount and interchange revenue was down 3%, driven by a higher rewards rate year over year.

The rewards rate was up 6 basis points from the prior quarter and about 8 basis points from the prior year.

The increase over last year is driven by higher promotional rewards, as well as a continuing shift toward Discover it from our prior flagship cash-back product.

The increase in promotional rewards is primarily due to better customer engagement with the rotating 5% category, which was broader than last year as it included department stores, Amazon, and warehouse clubs.

The cash-back match program, which helped drive strong new account growth this quarter, also contributed to the increase in promotional rewards.

In payment services, revenue was flat year over year.

Overall, we grew total Company net revenue by 7% for the quarter.

Turning to slide 11, total loan yield of 11.88% was 39 basis points higher than the prior year, primarily driven by a 42 basis point increase in card yield.

The year-over-year increase in card yield was due to a greater percentage of card receivables being revolving in nature, higher rates in the portfolio, the impact of the December 2015 prime rate increase, and a few basis points from last month's rate increase, the benefits of which will be more fully reflected in the first quarter.

On the funding side we grew average direct-to-consumer deposits by $5 billion to make up 47% of our total funding.

Our funding costs increased 10 basis points, driven by changes in funding mix, as well as higher market rates.

Overall, net interest margin expanded 32 basis points from the prior year to 10.07%.

Turning to slide 12, operating expenses were down $36 million over the prior year, but I would remind you that last year's results had $37 million in expense related to the AML look-back project.

Marketing expenses were down $20 million due to lower deposit marketing, as well as a shift in the timing of credit card campaigns relative to last year.

Professional fees fell $18 million, primarily due to the completion of look-back-related anti-money-laundering remediation activities earlier this year.

Partially offsetting these expense reductions is a $19 million year-over-year increase in employee compensation resulting from higher headcount support compliance activities, as well as the impact of higher average salaries.

Turning to provision for loan losses and credit on slide 13, provision for loan losses was higher by $94 million compared to the prior year due to higher charge-offs and a larger reserve build, both primarily driven by the seasoning of loan growth.

This quarter we increased reserves $143 million, while last year we had a slightly smaller build of $126 million.

I would reiterate that loan growth is the driver here.

On balance the credit backdrop continues to remain benign, with a modest level of normalization continuing.

Looking at card, the net charge-off rate of 2.47% increased by [25] basis points year over year and 30 basis points sequentially.

The 30-day delinquency rate of 2.04% increased 32 basis points year over year and was up 17 basis points sequentially.

Turning to private student loans, the net charge-off rate excluding acquired loans increased 12 basis points from the prior year due to seasoning of the organic book.

Sequentially the rate increased 40 basis point due primarily to seasonality.

Student loan delinquencies, once again excluding our acquired loans, are up 31 basis points compared to the prior year and 35 basis points sequentially.

The increase in delinquencies is primarily driven by a greater portion of the student loan portfolio entering repayment and the seasoning of loan growth.

Switching to personal loans.

The net charge-off rate was up 42 basis points from the prior year and 7 basis points sequentially.

The 30-day delinquency rate was up 23 basis points from the prior year and 14 basis points from the prior quarter.

The year-over-year increases in the personal loan charge-off and delinquency rates were driven by the seasoning of loan growth and a higher mix of customers who drive strong risk-adjusted returns but have slightly higher losses.

Across all three major asset classes, card, student, and personal loans, credit performance continues to be generally in line with our expectations.

Next I will touch on our capital position on slide 14.

Our common equity tier 1 capital ratio, fully phased in for Basal III, declined 60 basis points sequentially.

This ratio decreased from the prior year due to capital deployment in the form of loan growth, buybacks, and dividends.

In the quarter we repurchased 2% of our common stock.

Moving to 2017 guidance on slide 15.

First, we have increased our loan growth target range for the next year to 5.5% to 7.5%, above our long-term target range of 4% to 6%, based on opportunities that we see to continue to drive disciplined, profitable loan growth.

In order to support that higher growth target, we expect operating expenses to rise to approximately $3.8 billion next year.

We have been saying for several quarters now that we would invest some of our NIM upside back into the business to the extent we can find profitable opportunities to do so.

And we believe we have opportunities to do just that in 2017.

Another driver of the loan growth is higher sales.

There we expect to continue with focused innovations around our rewards program to drive engagement and growth in our target segments.

As a result, we expect the rewards rate to come in between 126 basis points and 128 basis points for full year 2017.

Moving to our outlook for net interest margin, we expected it to increase slightly versus full year 2016's net interest margin.

The prime rate increase from last month is not fully reflected in fourth-quarter results due to timing, and that alone will result in NIM expansion in 2017.

Further rate increases would also result in NIM expansion due to the asset sensitive position that we have built into the balance sheet, and we are currently expecting a couple more rate increase this year based on the market implied forecast.

Somewhat offsetting the benefit provided by the rate environment will be the level of card promotional activity and modestly higher charge-offs of accrued interest.

Finally, we expect the total net charge-off rate this year to be modestly higher than the 2.16% net rate charge-off rate we delivered in 2016, due largely to the seasoning of a growing portfolio.

Let me reiterate, the overall consumer credit environment continues to feel benign.

To summarize, we will remain disciplined in our approach to loan growth focusing on our core prime customers, while also identifying and targeting new customer populations when we believe there are opportunities for incremental growth with good risk-adjusted returns.

It is the pursuit of these opportunities that is driving the higher operating expenses I discussed on the prior slide.

Payments volume is stabilizing, and we expect it to return to single-digit growth.

We have a strong capital position that enables us to both continue to invest in the business to drive growth, as well as to deliver a strong payout ratio and total yield.

Finally, our business model continues to generate very strong returns on equity.

Before I pass the call back to the operator, there is one more piece of information I would like to share with you.

For the past four years, Bill Franklin has done a great job at the helm of our investor relations function, but now it is time for him to take on new responsibilities.

Effective February 1, Bill will be assuming a role as our Assistant Treasurer, responsible for funding and rating agency relationships.

Stepping into Bill's shoes will be Tim Schmidt, who's done a great job serving in that Assistant Treasurer role that Bill will be assuming.

Tim is well known among debt investors, and I'm looking forward to introducing him to the equity community as the conference and roadshow season kicks off.

That concludes our formal remarks.

Now I will turn the call back to the operator, Chantal, to open the line for the Q&A session.

(Operator Instructions)

Your first question comes from the line of Ryan Nash with Goldman Sachs.

Your line is open.

Good evening, guys.

Hey, Ryan.

Hey, Mark.

I was wondering if you could give us a little bit more clarity on the expense guidance.

Mark, you made some reference to potential for higher marketing in your remarks.

I know David had made some comments about investing in some technology.

So can you contexualize how much of the spending you are doing is to drive new growth versus core infrastructure build?

And how should we think about the ongoing core growth rate?

Is this an elevated year just because of the fact, like you said, you are going to be reinvesting in the NIM and we should see expense growth eventually come back down?

Ryan, I would say absolutely the driver of the expense growth this year is the investment in continuing to drive stronger growth rates across the portfolio.

If you think about it on a core basis where you really pull out the look-back out of prior year and compare it norm to norm, I would say core expense growth is somewhere on the order of 2.5%, plus or minus.

So it feels very well controlled from my perspective.

The remainder of that expense growth is discretionary investment that is directly related to driving stronger production where we found opportunities to do just that.

Big chunk of it is very aggressive marketing.

We can always adjust that if our returns don't come and as we expected them to on those investment dollars or if the environment were to turn on us.

We see great opportunities right now building off of the strength in the fourth quarter, and we feel really good about making that investment.

Got it.

And just on your comment regarding the 5.5% to 7.5% loan rate, you talk about new opportunities for customers with good risk-adjusted [return].

Can you maybe expand on that point?

Are you dipping down below the historical levels of where you played in the card business, and how should we think about the longer-term impact on charge-offs related to that?

I would say, Ryan, I'd think about these things as really incremental where we are seeing great opportunities.

For example, if you think about a secured card, for example, that's somewhere where you're going to have a lot of those customers no FICOs or very low FICOs, but because you are holding collateral, the risk-adjusted return on that doesn't look radically different than our traditional portfolio.

That is just one example.

We always look for opportunities where we can expand the box a little bit.

But I would say this really reflects more a deepening of the existing strategy than it does expanding the box and really going significantly down market in any way.

Got it, and congrats to Bill in the new role.

Thanks, Ryan.

Your next question comes from Sanjay Sakhrani with KBW.

Your line is open.

Thank you.

Congrats, Bill.

I guess my question is around the NIM outlook assumptions.

Mark, could you just talk about how much of this last rate benefit you are actually incorporating into this guidance, up slightly higher, and then the subsequent rate rises that might occur in the future?

Sure.

Last year, if you think about it, we had a very similar situation where you had a December rate increase.

And in Q1 that resulted in about 10 basis points of improvement in NIM.

We actually saw a 20 basis points of Q1 improvement last year.

About 50% of that was due to portfolio mix, the other 50% of it was due to the actual rate move.

I think it will be rational to assume that, that same 10 basis points, plus or minus, flowing through from the rate move we saw in December is not out of the realm of rational -- would not be out of the realm for a rational person to assume, is the way I'd think about it.

As we move on through the year, I think that kind of a cadence would hold, based on the current curves and the current expectations for promotional activity in the portfolio and the current expectations for interest charge-offs.

If you think about it, the factors that are really going to influence it going forward are going to be what happens to market rates, what happens to the mix in the portfolio, both with transactors as well as with promotional balances, and then obviously charge-offs of accrued interest flow through NIM.

So that is a piece of it.

The other piece that probably kicks in at some point, Sanjay, and I don't think I am smart enough to tell you exactly when it happens, but at some point in time deposit betas will come back into existence.

These first two rate moves, we have not seen -- we've seen essentially deposit beta essentially zero.

At some point in time that will creep in a little bit.

But I feel really good about the NIM positioning for the year ahead.

And maybe just one follow-up to a question was asked previously.

I mean, Cap One just talked about how the competitive intensity of domestic card lending is probably the highest it's been, yet you guys are accelerating your growth expectations.

Can you just talk about why you are so successful?

I think if you look at our fourth-quarter results, we fairly matched the increase in loan growth with increase in revenue growth.

And I think that is, as I mentioned in my comments, pretty different than what we're seeing in some other places.

It's really easy to give away your product in terms of rewards to transactors that doesn't produce revenues or to dipping down in credit that just gets eaten up in charge-offs.

But that is not our focus.

Our focus is on getting more of our products into the hands of our prime revolvers and getting more usage in our portfolio.

I mentioned that a greater number of new accounts last year was a big part of the increase in growth rates.

And that is everything from the new features, the advertising, the digital marketing, the new products like the secured card or expansion in student cards.

So as I think about this coming year, I think it will be more of the same.

We are putting in more money for more marketing for more new accounts, as an example.

Thank you.

Your next question comes from the line of John Pancari with Evercore.

Your line is open.

Good afternoon.

Hello, John.

On the expense front, and I know you had indicated that the higher expense expectation is driven by the higher revenue growth opportunity.

So on that, can you just give us your thoughts around where you think the efficiency ratio could go over time and how you may be looking at it for 2017?

I know we're coming off a level of about 40% for 2016.

Do think it remains around there, or do think you could actually see some improvement?

Thanks.

Yes, I think you'll see some improvement as you head into 2017.

My current thought process is we wouldn't get all the way to the 38% target, given the level of investment we're talking about driving this year.

But I do think you get to a 39% handle next year based on where I see the crystal ball right now.

Don't take that as guidance.

Throughout the year that will change, and our expectations there and everything else.

But I think it is a reasonable expectation to have as we sit here at this point in time, and we will obviously keep you posted as we go through the year.

The other thing I would really reinforce to support that is that a big chunk of this increase in expenses is directly related to aggressive marketing dollars.

And if we don't see the returns on that investment that we expect again, or if the environment turns on us, we won't hesitate to pull that back.

And that would obviously have a positive effect on the near-term efficiency ratio.

Okay, great.

Related to that, the increase in the rewards cost that you see for 2017, does that imply any abatement in the level of marketing spend, or are you going to lean on the accelerator there as well?

Thanks.

Well, I would say that if you look at the past year, we had a similar order of magnitude increase in rewards cost.

And that is part of what produced the higher growth rate that we achieved this past year.

I think what we are anticipating is some continuation of that trend.

Some of it is just going to tend to happen as we get more of our customers converting into Discover it, which has a higher average earn rate than our previous flagship product.

And part of it is the continuation of our very successful promotional double match program and the 5% program that we are continuing to aggressively market, and is still a very good headline rate and a very good value to consumers who take full advantage of that.

Yes, and even though rewards is not an expense it shows up as a contra-revenue.

We view that and the expense side as flip sides to the same point.

They're both really about driving customer awareness, customer engagement.

So we the marketing and rewards investments as interchangeable to a degree.

Okay, great.

Thanks, Mark.

And Bill, congrats again.

Thanks.

Your next question comes from the line of David Ho with Deutsche Bank.

Your line is open.

Good evening, everyone.

Just want to talk about where the growth may be coming from a vintage standpoint.

I know you have done a lot of new customer acquisition with Discover it, been very successful for you.

Just want to understand the mix of growth as it relates to that and the implications on some of the seasoning of that growth in your guidance for credit for 2017.

Thanks.

Yes.

David, if you think back a few years ago when we were talking at conferences and on conference calls, we were talking about roughly 50% of loan growth coming from new accounts and roughly 50% coming from the legacy back book, defining new accounts as on the books three years or less for this purpose.

I would say today that mix looks more like, let's call it 75/25, 70/30, something in that range, skewing towards the new accounts.

So new accounts are a greater portion of the loan growth at this point in time, and that does have some affect on the provisioning guidance.

That said, I view it as thinking with an intermediate and a longer-term mindset, a very positive thing because in a lend-centric business model, the way you compound the value of the business is to actually grow loans.

I think the seasoning of loan growth that comes from new accounts is just a natural function of the business.

The attraction of new customers into the franchise is a natural function of the business.

I think I tried to really emphasize at the end of -- in my comments that what we see is growth driven provisioning as we look ahead, growth driven credit drivers as we look ahead in the coming year, and not something that reflects any type of at turn in that credit environment.

That's helpful.

And then switching gears a little bit.

Back to the 5% rewards category, it's been very successful.

You guys started that category really, and the others have copied.

But do you think the value prop could get diluted a bit by some of the categories like Amazon and department stores essentially having some of the private label players and co-brand players provide ongoing rich rewards in those categories and some of those customers rotating out of your 5% into those ongoing categories that they provide?

Certainly we continue to evolve exactly what is in the various categories, how we market it, and we are going to continue to keep this program fresh.

It has changed a lot from when we originally launched it a number of years ago with the 5% program.

I would say that it feels to me like not withstanding a few examples like you mentioned, more of the competitors seem to be moving to the flat 1.5% than anything else.

There's a few outliers, a few 5%, in one or two cases there's was a 2%.

But mostly it seems like it's the 1.5%.

And our 5% program works well there.

And I think the proof is in the results.

If you -- certainly the competition got a lot tougher last quarter, and yet we accelerated growth.

We are going to continue to have that kind of focus to thrive in this competitive environment, which I think is here to stay.

We are very focused on an overall value proposition as opposed to competing on the basis of headliner and rate.

It is also about ease of redemption, dollar thresholds to redeem.

We removed all those things.

So it is not just about what is the headliner, and it's can you actually use it.

We also have merchant funded rewards as a result of having our own network to sit in there where we drive some incremental value that's funded by the merchants that doesn't flow through our P&L.

We feel the bias is fully going to be upwards; hence our guidance that we gave.

But we feel really good about our ability to compete in that space without chasing headliner or rates.

Great, thanks.

Congrats, Bill.

Next caller.

Your next question comes from the line of Eric Wasserstrom with Guggenheim Securities.

Your line is open.

Thanks very much.

Two quick questions, please, Mark.

I know historically you guys have pointed to about half your growth coming from new accounts and half your growth coming from incremental lending from existing accounts.

I'm wondering with the investment and growth in new accounts that you've seen over the past recent periods if that ratio has changed at all?

Yes, it's running right now somewhere's 75/25, 70/30, somewhere in that range.

I don't have the exact number at my fingertips but it is in that general range.

As we continue to invest in and drive growth we would expect it to continue to remix toward the new account side of the equation as well.

Great.

And then just one question to follow up on NIM.

How should we think about the sustainable NIM with respect to the current forecasted fed funds, et cetera?

I know that in the past you've pointed to a 9%-ish handle.

Has that moved sustainably higher in your view?

I would say the nature of the business model, we did not move our long-term targets on any of our longer-term stuff in our call today, including that margin guidance.

The real reason there is because I don't think we can lose sight of the fact that we are a cyclical business, and as we go through cycles we will see NIM look different than it does today.

That notwithstanding, I would say absent a cycle triggering, it would be a long path from here to that 9% longer-term guidance.

Got it.

Thanks very much.

You bet.

Your next question comes from the line of Chris Brendler with Stifel.

Your line is open.

Hi.

Thanks.

Good evening.

A question on the NIM guidance again.

Noticed that it looks like the cash advance volume was up significantly quarter to quarter.

Just want to know how much of the reinvestment in marketing is going to be on teaser rate marketing in the card business?

And then also, I guess I would think that the personal loan portfolio doesn't really get the benefit of higher rates and with the growth there.

Is that also a drag on the NIM going forward?

Thanks.

Yes.

I would say you are correct in the assumption that you had some higher promo rates in -- promo in the mix in the fourth quarter, but it was really more balance transfer than cash advance is what you saw coming in there.

And I would say we pulled back significantly on our balance transfer programs early in last year, it's part of what pulled back our growth rates because we were not finding the right kind of engagement out of those programs.

I think we have cracked the code, or at least we believe we have cracked the code at this point in time to be able to come back into market with a more robust balance transfer offering, but I would say balance transfers are far from the linchpin associated with the growth strategy we have laid out.

They are a component of it, but really focusing on merch sales, merchandise sales, building balances the old-fashioned way of customers engaging with the card and using products remains the core piece of the puzzle.

As it relates to NIM, I would say the current level of promotional activity that is contained in our plan and that we are moving forward with, I would say is more robust than what we have had years past, but that is fully contemplated in the NIM guidance that we gave in the earlier thoughts on this call that I provided in response to an earlier question about the trajectory.

I continue to feel very good about the way our NIM is positioned to be able to support both our growth initiatives as well as accrete further value to our shareholder.

And the personal loan side?

The impact there, is that meaningful enough?

Can you repeat it again, Chris?

Cards are mostly variable rate.

I would assume that personal loans are not variable rate so you don't get --

Correct.

-- benefit of the NIM.

You are also growing the portfolio, it looks like pretty aggressively.

Is that a rate based strategy, or is there (technical difficulties) in the competitive environment that caused a spike in growth?

It sounded like there was some strategic changes and some -- a breakthrough maybe that helped as well but it sounds like (multiple speakers) the guidance that, that's going to continue in 2017.

Yes.

We do intend continue growing the personal loan book as well.

I think that is fair.

It is a fixed rate book, but it is a very short duration book.

It is somewhere two- three-year horizon, if you will.

And we tend to -- while we don't match fund to loan by loan, we do think about our businesses holistically as we fund the balance sheet.

And I would encourage you to think of us as really kind of match funding that personal loan book is the way we think about it.

Given the short duration and the quick turn in that book, it really doesn't have a deleterious effect on NIM to any significant degree.

So I would say that again is contemplated in the guidance that we've got out there.

In terms of where the growth is coming from, no, it is not a rate driven game.

I would say it's coming from some product enhancements that David alluded to in his earlier comments, and I would say it is also coming from the fact that we have increased the maximum loan size we are willing to do there modestly, up to $35,000.

That is a modest driver as well, but it is really more the features and benefits and some of the product enhancement that has been the driver there.

Great.

Thank you.

Your next question comes from the line of Bill Carcache with Nomura.

Your line is open.

Mr. Carcache, good evening.

Good evening.

Guys, the 10% year-over-year decline that we saw this year in marketing and business development expenses, that certainly supports that you guys have indeed been more judicious with your investment spending relative to some others who have been stepping on the gas on marketing spend and perhaps not been getting as much return on that spend.

But now as we look ahead at 2017 and thinking about now this increase that you guys are talking about in marketing investments that you have planned, how do you insure that you are getting an acceptable level of bang for your buck on your spending?

Maybe are there any principles underlying your investment spending that you could parse out for us?

And I'll my second question because it is related.

Maybe if you can share any data points on how the cost per account acquired at Discover is trending versus the rest of the industry, that would be great.

Well, on the first part of the question, and Mark I'll let you do the second part.

We are very judicious in terms of looking at what the expected marginal return is for every effort we do.

And whether it is segments that we are targeting in direct marketing or decisions that we're making in promotional rate duration or rewards investments, we evaluate those and we do a lot of tests and control, we back test to see how things are working, and we decide whether to modify or extend things or curtail them.

I think that the thing that I am noticing, and I'm sure other people do the same, some of the mistakes that I think sometimes people make is they assume a certain mix, and if in fact what they do is attract a lot more transactors than expected, then the interest income doesn't come through as expected and you've still got the expenses in terms of marketing or rewards cost.

And what I'm thinking from a lot of experience, I think that is some of what I'm observing elsewhere, where they are driving volume but not revenue.

And with respect to CPAs, what I would say is we've seen very, very modest increases in CPAs, maybe 1.5%, 2% over the course of the last 12 months, let's call it.

We are very focused on CPAs.

We've deemphasized some of the aggregator channels because we saw some real run there, shall we say.

So I think in that basis, if you think about a card account when you are booking at and the long-term value of the card account, think of it like an NPV stream, and that CPA that you're booking upfront, the value of that, the net present value of the card account is highly dependent upon what you've paid to acquire it.

We're laser focused on CPAs and actively finding ways to drive growth in fashions that does not cause us to make crazy terminal value assumptions to make the NPV on these card account acquisitions work.

That's excellent, guys.

But can you give the color on how that is trending versus the rest of the industry, because in particular, given the comments that you guys made, maybe there are some cases where the cost per account could be elevated but the retention of the customers is not there.

And so any color relative to the industry that you can give?

I would say we don't disclose our CPAs, so I have to be really careful in terms I of how I answer it.

What I would say is, looking at Argus and certain other data providers who try and triangulate on this and guesstimate, I would say if you exclude subprime where the CPAs are very low because these are very active credit seekers, so exclude subprime for a second and focus on prime borrowers, the data that I have seen out there anecdotally would say other CPAs are considerably higher than ours.

But that is anecdotal and I would not encourage you to rely on that.

That's very helpful.

Thanks very much.

Appreciate it.

You bet.

Your next question comes from the line of Mark DeVries with Barclays.

Your line is open.

Yes, thanks.

I was just hoping you could provide a little more color on what you mean by modestly higher in terms of total net charge-offs?

Should we expect something along the lines of the 30 Bps year-over-year increase we saw in the fourth quarter?

I gave a lot of thought on how to answer this question because we figured it was coming.

I guess I would say, Mark, is your bunny seems to have pretty good nose.

The way I was going to describe it was to say that last year we described, we expected a slightly higher increase and it ended being 15 basis points year over year.

And the way I was proposing to answer this question was to say modestly higher probably means slightly higher than slightly higher.

I would say you are probably in the right relevant range, somewhere in that neck of the woods is, based on everything we see right now, the right way to be thinking about it; maybe just a tad higher than that.

But on balance, again, it is driven by the seasoning of the growth and not by a deterioration in the fundamental environment for credit that we see out there.

Okay, great.

Thanks.

Your next question comes from the line of Moshe Orenbuch with Credit Suisse.

Your line is open.

Great, thanks.

I guess, David, most of the industry is actually growing spending volume several percentage points, 2, 3 percentage points, faster than balances, and you have the opposite.

Can you talk a little bit about actually how you are achieving that?

Is that likely to continue over the next couple of years?

And how do you sort of think about that?

And I have a follow-up.

You know, we look at -- you would understand a lot more in the industry if you could really see what's going on with transactors versus revolvers by issuers, because if you could look at our sales growth in our revolving base, the sales growth is actually very similar to the loan growth in our revolving base.

What's happening is there some people out there with very rich rewards that are attracting transactors.

And that's why you're seeing it not cost us revenue and not build revenue where that's anywhere proportional to the sales growth that they are achieving.

It is a remixing and it's a purposeful strategy on our part to focus on profitable business.

Just a follow-up.

When you look at those 5% categories, I think there are some people particularly on our side of the world here, who think of that as an area in where cardholders tend to game that and focus their spending in those categories.

Are you saying that you do not actually see that?

That isn't an source of excessive transactor activity?

Well, I would say that we have had a 5% program for a number of years and have good experience with it.

I think we would find it problematic to give 5% on everything without restrictions because the economics just would not work.

We have been -- we have used it to help engage our customers, to give rewards in rotating categories.

It has helped to encourage our customers to use their Discover card across many categories versus just being concentrated in one, or versus just gaming it, as you are saying.

I think that, look, we started -- we were the first rewards card there was back 30 years ago.

And so I'd say we have the most experience of anyone in the industry.

We've seen people introduce things and then have to pull them.

The original 5% program was actually, if you go back, the General Motors program, which is not around anymore.

You've seen some things that work for a while in terms of volume but did not work from a profitability perspective and then they were curtailed.

You have not seen the from us.

You have seen us be able to maintain a viable program.

Even with the higher rewards cost that we have been talking about last year, we grew earnings a lot.

So we're balancing a great value for consumers and profitability.

The final thing I would say is, you need to be careful, as Mark mentioned earlier, not to get hung up with just rewards.

It is more than just the rewards.

It is great service, it is other features, it is how you work with credit and make sure you are going to people that don't get overextended.

There are a bunch of pieces here, and rewards is an important, but just one piece of the puzzle.

Thanks very much, and congrats Bill.

Your next question comes from Don Fandetti with Citigroup.

Your line is open.

Yes.

Mark, I was wondering if you could talk a little bit about how you are thinking about capital return this year going into CCAR.

I think you've made some comments about the debt rating agencies or debt markets being a binding constraint, or the new binding constraint.

Seems like investors are a little cautiously optimistic that you could get a higher payout ratios.

Can you talk a little bit about that?

Yes.

I think last year again we had one of the highest total payouts, and I think the highest effective yields among the CCAR participants.

So we feel very good about the fact that we've been prudent stewards and are driving responsible loan growth, and also trying to return excess capital that we don't need as effectively as we can.

We have taken up our payout request to the CCAR process every year we have participated in it so far.

I think it would be reasonable for one to expect we would not want to break that trend.

So I think you should look for us to get more aggressive again this year.

We take with great happiness some comments that Governor Tarullo has made over the course of the last several quarters where he really talked about differentiating between the [GSIB]s and the, what I will call, the mid-tier CCAR participants in terms of the expectations there and some thoughts around the qualitative process.

I feel really good about what we've done in the past.

And I think we would look to get progressively more aggressive this year as well, consistent with prior years.

Your next question comes from the line of John Hecht with Jefferies.

Your line is open.

Evening.

Thanks very much guys, and congratulations Bill.

Question.

Just the ending payout of rewards, 1.27% is pretty consistent with the overall guide for this year.

So I'm wondering, number one, do you think at least in terms of incremental changes the worst is behind you with respect to rewards expense, or is there some seasonal element we need to think about with respect to the guide?

There is definitely a seasonal element associated with it.

I would say a big piece of it is what is going on with our 5% rotating categories and what we what we choose to include in those categories.

So we chose to include warehouse clubs, for example, in our fourth-quarter program that haven't historically been there in the fourth quarter in the past.

We will make decisions around engaging the customer to drive the kind of behaviors that build the loan volume that kind of drive the profitability in the long run.

So that piece of the puzzle definitely flows through.

So you will see variability based on that.

The other big drivers really are going to be obviously the Cashback Match program we have running on new accounts is a piece of that.

I would say that would be really more consistent with the growth in new accounts really, just as we have every month another vintage that laps that one year in the process and another vintage that is larger than the one that is leaving coming on because thus far every year the vintage of new accounts has been larger than the ones that preceded it.

And then the last driver is really going to be our legacy More card product.

When we launched Discover it, all the new account acquisitions since that point in time have come on it.

So you also have a natural migration in the portfolio, a greater portion being it cards as opposed to more cards, and they have a slightly more lucrative reward proposition position associated with them.

Those are really the drivers.

I would echo David's comments that the increase on a full-year basis this year is about right in line with the increase on a full-year basis last year, significantly below the headline earned rates that you are seeing from others.

And we like that, we're choosing to compete on our terms.

Okay.

And then second question.

Mark, I think you have referred to long-term loss rates in the 3% to 4% range in the credit card portfolio.

And we're talking about moving -- it seems like that might move it towards 2.3% to 2.5%, or some modest increase from last year to this year.

Do you think long-term rates, loss rates have changed because of certain factors in the business, or is it just going to take a long time to get to the long-term range based on a benign credit environment?

Well, I think that we specifically didn't update our long-term guidance.

And I think this has been a struggle for a while because there were definitely some factors that changed after the Card Act, after the consolidation, after a number of structural changes in the industry.

We kind of gradually took down that long-term expectation.

Frankly, until we see a couple of cycles, we are not going to really know.

And so we are hesitant to say what will the next cycle bring.

We are seeing this normalization that we have been talking about for a while.

It is slow and we continue to characterize it as a benign credit environment.

And I think as long as unemployment rates stay very low and housing prices improve and the economy does well, you are going to continue to see below whatever that new peak is.

There will be another turn, and when it turns then we will see what losses go to in the industry.

I don't think it will be the previous peaks at all, but you'd almost have to see it for anyone to really know how it's going to behave.

Great.

I appreciate the perspective.

Thanks.

Your next question comes from the line of Betsy Graseck with Morgan Stanley.

Your line is open.

Hi.

Good evening.

Hi, Betsy.

Hey, Betsy.

Hey, a couple of follow-ups.

One is on, you talked about the payout ratios, capital distribution.

Could you remind us of what the capital ratio is that you think that you could operate at if you didn't have the CCAR telling you which needed to do?

I thought it was in the 10% range, but maybe remind us of that.

And is that something as a goal you think you can hit over the medium term?

The second question was just around mix between dividend and buyback, and does your skew change at all given how the stock's performed recently?

Sure.

I would say with respect to target capital ratios, historically you are correct in that the binding constraint has been CCAR.

And that was on the order of 11% tier 1 common.

I would say an economic capital analysis would show you we need more on the order of, let's call, it 9.5% tier 1 common.

I think the ultimately binding constraint probably lies somewhere between those two extremes, Betsy.

And I don't have a sniper rifle estimate for you today.

But I do think it is really rating agency and debt investor driven in terms of where that settles out.

I think somewhere ultimately with some kind of a 10%-ish handle does not feel altogether -- maybe somewhere around 10% does not feel altogether wrong, but it is premature for us to really revise guidance or kind of put that out there.

But I kind of say that is the way to generally think about it.

And obviously we will be working with rating agencies as our crack investor relations executive moves over to tackle that challenge and try and move their perspective on us as well over time.

The other piece of the puzzle I would say with respect to the mix between buybacks and dividends, I would say we run a pretty rigid analysis of our buyback program on a monthly and on a quarterly basis, really building on an efficient frontier and making sure the returns on the buybacks look solid.

I think given where we are right now, we continue to feel good about a healthy buyback program.

That said, we have said we do want to be a dividend achiever over time.

So I think you would expect to see us, to the extent the economics allow for it, we would look to consistently increase that dividend on an annual cadence, again to the extent the economics allow for it.

Okay, thanks.

You bet.

Your next question comes from the line of Bob Napoli with William Blair.

Your line is open.

Thank you.

Good evening, and congratulations, Bill.

On the regulatory costs, I was wondering if you could give us some feel for how much those regulatory costs have increased from pre-recession levels and how much they could decline if you were to remove from regulatory cost those costs that you view as probably not being beneficial incrementally, beneficial to the regulatory side or to Discover?

I would -- I think we are not prepared to give any kind of specific guidance on this.

I would just say I would characterize it is it I feel like a lot of the build has occurred, whether it's AML BSA specifically or regulatory CCAR, whatever.

It feels like this year is going to be a little more annualization of some of those expenses as we continue to ramp up very quickly this past year.

I would caution on thinking that it is going to go back to anything close to what it was pre-downturn for -- at least for us, and I think for anyone.

And frankly, I believe that some of it is going to be a big payoff for us because if we can have better quality controls to put in projects right the first time, to have things work more perfectly for customers every single time, to have better, more scientific understanding of our capital and what's important and what are the different scenarios.

We have become much more sophisticated than we used to be.

And I think we focus on the costs and yes, you have to do it because you have to do it.

But I think what we need to do is pursue efficiencies but also pursue the -- even more importantly, pursue the benefits that come from better controlled process.

In much the same way, it is almost like think about Six Sigma in manufacturing.

There's benefits that can come from this and we need to focus on that.

Okay.

Thank you.

And just on your student lending business, obviously -- and any thoughts on your discussions with your contacts in Washington, DC on the potential dramatic expansion of the TAM available to you in that market or potential for that to happen?

You've seen obviously the student loan stocks go through the roof and continue to do so, and some of your competitors.

You guys would obviously be a beneficiary if those stock moves are indicative of the opportunities to come.

To be clear, you are talking at the student loan business, the addressable market?

That's right.

Yes, that's right.

Well, I would say that if there is more room -- I mean, the private student loan market has become pretty small.

And I think that's one reason a number of people exited from it and why there's only a couple of people left in it.

I think to the extent that there was a greater role for private lending, I think we would be very well positioned.

And I think the fact that I think it is around 6% or something of the total market of new loans are private and the other 94% or so are federal.

So it wouldn't take much in the way of federal backing off to have a dramatically percent increase on the private origination side.

It is a very specialized business.

From a credit perspective it is unique.

From an operational perspective it is unique because it is distributed through schools with tight controls for it being used for educational expenses.

There are a lot of regulations specific to it.

And so, I think it would be hard.

I think that we would feel really well positioned to take advantage of any possible increase in that market, which I would not expect this year but maybe in subsequent years.

I guess the final thing I would say is, we have been investing a lot in the infrastructure.

We are converting to a new system a little later this year in that business, which I think would be very scalable and flexible to be able to take advantage of whatever opportunities may come in future years.

Thanks.

Just a quick follow-up.

It wasn't clear to me, do you think rewards competitions, do see signs of it peaking or do you think it is another -- there is another step up from here?

Obviously, Sapphire cut their rewards pretty dramatically on the origination on the new account side.

I am seeing -- for every sign of someone cutting back, I am seeing something else that goes the other direction.

I would just say some of these programs, whether you are paying out a flat 2%, which uses all of the interchange, or you're paying out a flat 5%, which uses over double what your income coming in is, some of these programs just don't seem to make a lot of sense in the long term to me.

So I think the economics are going to cause this to be a peak.

Maybe we are around peak now.

I just feel like it has already gone further than I would think that the economics really support for some of these programs.

I think it is going to be a while before people cut back.

Part of it, as rates go up and cost of float for transactors becomes non-zero, and as people see that what the actual mix coming in, in transactors versus revolvers and what's cannibalization of their own portfolios versus really new, people will then start to adjust and probably cut back some of their programs to more reasonable levels.

Great.

Thank you.

Appreciate it.

Your last question comes from the line of David Scharf with JMP Securities.

Your line is open.

Good afternoon, and thanks for squeezing me in.

If I heard correctly, it sounded like your NIM guidance is factoring in the expectation of more rate hikes later in the year.

I am just wondering, switching to the regulatory side and as we think about your loss rate forecast, are you building in any expectations of using regulatory easing on the collections front?

And how should we think about some of the developments there?

The simple answer to that question is no, we are not billing in any expectations there at all.

I think we tend to be a pretty conservative, straight shooting bunch.

And at the end of the day I wouldn't know how to create those expectations that I would feel comfortable laying into a loss forecast.

So I think as we get more clarity on some of the proposals that are out there in terms of regulatory reform and everything else, we will obviously be reviewing them and looking at them and trying to process where they all come together.

But I think we need decidedly more clarity on where all those type things ends up before we can rely on them, let's put it that way.

Got it.

And along those lines, from a strict operational standpoint one of the likely areas of change we seem to be hearing more and more about is with the new FCC nominee is that the TCPA may reverse its ban on auto dialing, predictive dialers, any automated technology for reaching cellphones.

I know some of the debt buyers and collection agencies tell us that, that represents a much greater sea change to collection productivity then anything the CFPB has been weighing on them.

Since all of the -- you don't sell any charge-offs.

Since you are operating, I assume, all of your collection activities in-house, if you were -- if the FCC were to allow the use of auto dialers and other automated technology for reaching cellphones, is that something that can be implemented rather quickly, or is that more along the lines of, let's say, a year-long project?

I think that could be implemented fairly quickly and easily.

In fact, we have to had to spend a lot of money and go to a lot of trouble to restrict the normal operation of these things.

And so it is a lot easier to take that out.

I would say that one of the things we have been doing is moving very heavily to digital collections.

So that is less impacted by some of this, but it is definitely hard to -- so many people are using their cellphones as the primary phone.

They don't have land lines anymore.

And the fact that we are required to have consent and then the fact that we have had to turn off our auto dialers has introduced inefficiencies which is driving up our expenses, and is also frankly caused some of our customers to not be able to get into payment programs we may offer or the assistance we can provide to get them -- help them get back on their feet.

I think it would be a great thing to consumers if we were able to reach them to help them stay current or get current.

And it would be a great thing for our operating costs and our collection results.

That would be a positive.

Got it.

Thanks very much.

All right.

That concludes our call.

We would like to thank everyone for joining us.

And I have enjoyed working with all of you.

If you have any follow-up questions, feel free to call the investor relations department.

Have a good night.

This concludes today's conference call.

You may now disconnect.