發現金融 (DFS) 2017 Q1 法說會逐字稿

Good afternoon.

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

At this time, I would like to welcome everyone to the Discover Financial Services First Quarter 2017's Earning Call.

(Operator Instructions) Tim Schmidt, CP of Investor Relations, you may begin your conference.

Thank you, Chantelle, and a sincere thanks to everyone on the call for joining us today.

I'll begin on Slide 2 of our earnings presentation, which you can find in the financial section of our Investor Relations website, investorrelations.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 first quarter 2017 earnings materials, we have provided information that compares and reconciles the company's non-GAAP financial measures with GAAP financial information, and we explain why these measures 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.

(Operator Instructions)

Now it's my pleasure to turn the call over to David, who will begin his comments on Page 3 of the presentation.

Thanks, Tim, and thanks to our listeners for participating in today's call.

For the first quarter, we reported earnings per share of $1.43, up 6% from the prior year, and we delivered a 20% return on equity.

Before I ask Mark to review the financial results in more detail, I'll begin with some comments on our vision, key focus areas and strategic objectives.

In 2017, we're celebrating Discover's first decade as a public company.

Throughout those 10 years, we've made great progress towards realizing our vision to be the leading direct bank and payments partner.

This vision guides the choices we make and the strategies we employ to achieve our ultimate goal of creating long-term shareholder value.

I mentioned some of our key focus areas and strategies for 2017 on our Q4 earnings call, and you can see them outlined on Page 3 of our earnings presentation.

We've organized our strategies around 2 key focus areas: achieving the strong rate of profitable, disciplined asset growth in the near term while investing on capabilities that will create a firm foundation for future growth.

Growth is an underlying theme in both of these focus areas because profitable, sustainable asset growth is essential to create long-term shareholder value in our lend-centric business model.

We have recently returned to faster growth because we deliberately slowed loan growth for much of 2015 and part of 2016 when, for instance, we curtailed our use of aggregator sites as the cost to acquire new card accounts in that channel rose significantly.

In response, we developed and implemented several initiatives to return to the higher and more profitable asset growth you see today.

These initiatives have spurred new account origination so they're responsible for most of our recent credit card receivables growth.

I would also note that we have established a long-term track record of managing our credit risk in a disciplined fashion.

With our focus on consumer lending, asset quality has a large and direct impact on our bottom line.

That's one reason why prudent risk management underlies all we do.

In managing credit risk, we stayed keenly attuned to changes in the credit cycle.

While credit fundamentals remain favorable and the lending market has been expanding, we have been making more loans.

We continue to focus on attracting prime borrowers and achieving strong risk-adjusted returns.

With that context, let's examine our recent progress in achieving the strategic objectives in these 2 key focus areas.

As cited in the highlights on Page 4, we made substantial progress in the first quarter.

In the focus area of profitable disciplined growth, we produced strong loan growth momentum across all of our primary lending products.

We achieved this asset growth without sacrificing revenue growth.

As I noted earlier, we reported a 20% ROE while growing revenue 5% from a year ago.

We demonstrated growth in our Payments business as well.

Of note, PULSE volume returned to year-over-year growth in the first quarter and is well positioned for further gains during the rest of 2017.

We also delivered on our second focus area by investing wisely for the future.

For instance, we continued to invest in our Cashback Match program, which is approaching its second anniversary.

This program has proven a worthy investment by generating sustained customer engagement beyond the promotion period.

Customers acquired through this program recognize the benefits enjoyed by all Discover it cardholders, including award-winning, all-domestic customer service, innovative security features, free FICO scores, no annual fee and a competitive rewards structure.

We also remain productively engaged with our deposit customers, many of whom have another Discover relationship as well.

We achieved strong annual balance growth while holding deposit rates steady.

Finally, to seed future growth, we continued to enhance our operating capabilities and manage our risks prudently.

Enhanced operating capabilities support features and benefits that serve our customers better, which in turn fosters growth through customer loyalty.

I'm particularly pleased that the Brand Keys Customer Loyalty Engagement Index ranked Discover Card first in our industry for the 21st consecutive year, a feat unmatched by any of the 740 brands measured in their respective categories.

With respect to risk management, we remain good stewards of our shareholder capital and submitted our most recent CCAR capital plan to our regulators in April 5. Given our strong earnings and capital position, we expect to remain among the industry leaders in total payout ratio and shareholder yield.

In summary, I'm pleased with the achievements to date in our 2017 focus areas and our profitable and disciplined approach to generating long-term value for our shareholders.

I'll now ask Mark to discuss our first quarter results in more detail.

Thanks, David, and good afternoon, everyone.

I'll begin by addressing our summary financial results on Slide 5. For the first 3 months of 2017, we reported net income of $564 million and diluted earnings per share of $1.43, up 6% from the prior year.

David noted that we remain focused on profitable, disciplined growth, and you can see evidence of that in the 20% return on equity we generated for the quarter.

Turning to Slide 6. Total loans increased 8% over the prior year, driven by 7% growth in credit card receivables, which represented nearly 80% of total loans.

The increase in card receivables was primarily driven by growth in standard merchandise revolving balances.

Loan growth remained favorable across our other primary lending products as well.

Personal loans increased 20% from the prior year as we attracted strong customer engagement with our simplified application experience and Check Your Rate feature.

Student loan balances rose 3% in total, but our organic book increased 12% year-over-year.

We continue to make investments in early-stage product awareness and marketing to promote student loan growth.

Moving to the results from our Payments network.

Proprietary volume rose 4% year-over-year, driven by 6% higher credit card sales volume.

Increased card usage and higher gas prices both contributed to this growth.

In our Payment Services segment, as David already noted, PULSE volume returned to year-over-year growth during the first quarter with an increase of 4%.

Diners Club volume rose 10% from the prior year on growth across all regions.

And finally, Network Partners volume increased 2% from net to net and B2B payments activities.

Turning to Slide 7. Net interest income increased $142 million or 8% from a year ago, driven by a combination of strong loan growth and a higher net interest margin.

On a sequential basis, our net interest margin was flat.

I'll explain this more thoroughly in a subsequent slide.

Total noninterest income decreased $27 million or 6% year-over-year.

The primary driver was a 15% decline in net discount and interchange revenue as rewards cost increased 24% from a year ago.

Our rewards rate rose 19 basis points from the prior year but declined 1 basis point sequentially.

Promotional rewards accounted for nearly all of the higher rewards rate, with higher spending in our 5% categories driving most of the increase.

At 1.25%, our rewards rate remains roughly in line with our 2017 guidance of 1.26% to 1.28%.

Loan fee income grew $9 million or 11% year-over-year.

Late fees accounted for most of the gain.

Moving now to Slide 8. Our net interest margin rose 13 basis points from the prior year but held stable from the prior quarter at 10.07%.

Relative to the first quarter of 2016, a higher prime rate and higher shares of standard merchandise balance and revolving loans contributed favorably to margin, although the pace of growth in the revolve rates slowed from the prior year.

These gains were offset in part by higher charge-offs and a more costly funding mix.

Shifting gears and looking at a comparison to the fourth quarter of 2016, a higher prime rate added to margin but was offset primarily by a combination of receivables mix, higher charge-offs of accrued interest and modestly higher liquidity balances.

Total loan yield increased 25 basis points from a year ago to 11.94%, driven by a 23 basis point increase in card yield.

The increase in card yield was primarily the result of prime rate increases and a shift in portfolio mix.

On the liability side of the balance sheet, growth in our direct-to-consumer or DTC deposits remains one of our primary objectives.

Average balances of these deposits increased $4.8 billion or 15% year-over-year.

At $36 billion, DTC deposits now funded nearly half our total loans.

We intended to -- we intend to continue to increase this share over time as DTC deposits provide relatively low cost and stable funding and are also viewed favorably by debt investors and rating agencies.

With deposit betas below historic norms, DTC deposit growth will also help mitigate the impact of rising interest rates on our funding cost, which increased 12 basis points from the prior year, driven by higher market rates and funding mix.

Turning to Slide 9. Operating expenses were flat relative to the prior year.

Bear in mind last year's results incorporated $30 million of expenses related to our BSA/AML look-back project.

We spent less on professional fees, which declined $13 million in aggregate from a year ago.

Employee compensation and benefits rose 5% from last year, mostly because of higher staffing levels, driven in part by regulatory and compliance activities as well as higher average salaries.

Total marketing expenses rose a modest $6 million or 4% from a year ago.

Increased acquisition and brand spending in card was largely offset by lower expenses in other areas.

Marketing investments to support our card business as well as ongoing investments in rewards have been drivers of our strong loan growth.

In summary, our expenses remain well managed.

After declining 190 basis points from the prior year, our operating efficiency ratio for the quarter was just below 38% and remains one of the lowest in the industry.

I'll now discuss credit results on Slide 10.

Excluding acquired loans, total net charge-offs rose 48 basis points from the prior year and 30 basis points sequentially, in line with commentary we provided on our fourth quarter earnings call and in public forums during the quarter.

Credit cards drove most of the increase as net charge-offs rose 50 basis points year-over-year and 37 basis points from the prior quarter.

Student loan net charge-offs, excluding acquired loans, declined 2 basis points year-over-year and 59 basis points quarter-over-quarter, reflecting seasonal trends.

Personal loan net charge-offs increased 71 basis points from the prior year and 46 basis points sequentially as credit performance continues to normalize from historically low levels.

Relative to the prior quarter, 30-day delinquency rates were relatively stable or declined across all of our primary lending products.

We increased provision for loan losses by $162 million compared to the prior year, including a $97 million reserve build.

While we continue to see some normalization in the credit environment, the increase in our provision is primarily the result of the seasoning of loan growth, which has been driven both by new accounts and, to a lesser extent, growth initiatives directed at legacy accounts.

On balance, the macroeconomic fundamentals underlying consumer credit performance remain favorable relative to historic norms.

The labor market remains strong.

Home prices continue to rise.

Bankruptcy filings remain relatively low.

And while rising, consumer financial obligations remain low relative to disposable income.

While charge-off rates have risen, they remain quite low by historical standards and within the context of our 2017 guidance.

Loan growth, both in recent vantages and, to some degree, in the well-seasoned portion of the portfolio, continues to be the primary driver of reserve additions, with the remainder being driven by ongoing normalization.

Once again, these trends are in line with our expectations.

As David noted, we will remain disciplined and vigilant in managing our credit risk as we take advantage of current loan growth opportunities.

On Slide 11, you'll note that we continue to deploy excess capital.

Our common equity Tier 1 ratio increased 20 basis points sequentially, driven by the seasonal decline in risk-weighted assets.

However, over the past year, it declined by 90 basis points, reflecting the impact of our strong loan growth and more than $2.4 billion of capital returned to our shareholders.

As depicted in the chart, our trailing 12-month payout ratio exceeded 100% in the quarter.

David previously mentioned that we submitted our CCAR capital plan on April 5, and I would note that we will continue to deploy shareholders capital in a prudent manner that is consistent with our priorities: organic growth, dividends and share repurchases, asset acquisitions and M&A, in that order.

To sum it all up on Slide 12, we're very pleased with our operating results, anchored by revenue growth of 5%, a double-digit margin and healthy 20% ROE.

In addition, expenses remain well managed as evidenced by a 38% efficiency ratio.

Our balance sheet remains strong as total loans expanded 8%, with significant contributions from all 3 of our primary lending products.

We continue to fund these loans with an increasing share of consumer deposits while realizing the benefits of relatively low betas.

Credit fundamentals remained favorable relative to historic standards, with provisions primarily driven by the seasoning of loan growth.

And finally, we continue to benefit from a strong capital position that enables us to simultaneously invest in profitable asset growth while delivering a high payout ratio and total yield to our shareholders.

That concludes today's formal remarks, so now I'll turn the call back to our operator, Chantelle, to open the line for Q&A.

(Operator Instructions) Your first question comes from the line of Sanjay Sakhrani with KBW.

Appreciate the comments on the NIM, but I was just trying to get a hold of more clarity.

Mark, you've talked about historically at least seeing some benefit from rate rises.

As we look towards future rate rises and one that happened later in the quarter, should we assume that, that will benefit the aggregate NIM?

Yes.

So I think there were a couple of things that saw the aggregate NIM not get a benefit this most recent quarter, Sanjay, and maybe that's a good starting place that will let me talk to the quarter ahead as well a little bit.

So if you talk about just the benefit of the move in rate, we saw about 15 basis points of goodness to NIM.

The takeaways from that really were about a 5 basis point negative based on asset mix.

Promotional balances, transactors reengaging in the portfolio, and we also had a higher percentage of student loans that drive great risk-adjusted returns but they don't have the highest yields associated with them.

So in combination, that took about 5 basis points away.

Another 5 basis points came off due to the increased charge-offs of accrued interest, due to the increased charge-offs.

Then you saw about 3 basis points come off based purely on funding volume.

We did overfund a little bit for the quarter.

We were prefunding for a potential portfolio acquisition we were looking at that didn't come to fruition.

So we're lugging around a little bit of extra 10-year money that we'll grow into here.

That was a piece of it.

And then there was about 2 basis points as well that was really just netting of a whole bunch of positives and negatives.

So on balance, that's kind of how you ended up flat on a fourth quarter to first quarter basis.

We'll still have some of the impact of that overfunding as we head into the second quarter a little bit.

But on balance, I feel really good about our margin guidance of slightly higher on a full year basis, and we do indeed remain positioned to be asset-sensitive.

Your next question comes from Don Fandetti with Citigroup.

Mark, can you clarify what your card charge-off guidance is for '17?

I think you've been sort of thinking 30 to 35.

And I could be wrong, but it looked like Q1 might have sort of trended a little higher than what you were thinking.

And just can you talk a little bit about that?

Yes.

So I think we said is we didn't clarify card, we gave total charge-off guidance, said it was on the order of 35 basis points year-over-year, something like that.

And I think it's really being driven by 2 different things, Don.

It's being driven both by a growth component and, I'll call it, a normalization component.

The growth piece of the puzzle, I would say, every year since the crisis, we've had a vintage of new accounts that's been larger than the one that preceded it.

And as you know well, new account season at loss rates, they're above portfolio loss rates, so that's part of the phenomena.

We also have engaged in some growth stimulating activities over the last couple of years in the legacy back book, so you have some seasoning of some new line availability there as well.

And then the normalization piece of the puzzle that I would say is really more just 8 or 9 years post the crisis, folks have had the ability to encounter life events or get overleveraged or whatever the case might be.

So as we've been saying, card books don't operate with low 2% charge-off handles on a normalized basis.

I think we're just seeing some degree of that normal normalization creep into the book.

But it doesn't feel like a cyclical turn.

All the macro factors continue to feel really strong and then normalization relatively modest.

In terms of the first quarter move there, I would say I think it was pretty well in line with the guidance that we gave on our fourth quarter call.

We said that it was going to look more -- in the first quarter would be lumpy, and that we expected the increase in charge-offs to look a little bit more like the increase from third and the fourth quarter than what we were guiding for for the full year.

So as I sit here right now, I don't see any reason to revise the thoughts we provided around charge-offs on a full year basis.

A 35 or so basis points directionally is correct.

It could be a smidge higher, a whisker lower, but in that general ballpark is the way to think about it.

Got it.

And just to clarify, the potential portfolio acquisition, can you talk about which product that was in?

Was it personal loans, cards?

And is that a source of potential loan growth going forward?

No.

I'd prefer to stay silent on that one, Don.

I guess the one thing I would say is given we funded it with 10-year money, it probably wasn't cards.

But I'll leave it at that.

Your next question comes from the line of Christopher Donat with Sandler O'Neill.

Just wanted to ask one thing related to the net charge-off.

As we looked at the data and looked at your roll rates from -- in card from 90-day delinquencies into net charge-offs, seems like that roll rate is increasing.

And then when we look at the data from your securitization, which I know is a well-seasoned piece of business, but it looks like recoveries are coming down a bit.

Is this -- we've talked in the past before about this, Mark, but have we finally worked through some of the recoveries related to the financial crisis.

But are we not yet picking up recoveries from some of your recent loan growth?

Yes.

So I would say on the latter point, most of the charge-offs that were generated during the crisis have now passed the statute of limitations.

So while we don't stop trying to collect at that point in time, the collection percentage does indeed decline.

So I think, Chris, yes, you definitely are seeing.

And candidly, that was the gift that kept on giving for an awful lot longer than it normally does.

Normally post a peak in charge-offs, you really have strong recoveries for 24 to 36 months.

This time, we got them for bloody well close to 7 years.

So it was definitely the gift that kept on giving.

And as far as the roles are concerned, what I'd really point you to is if you look at the trends in delinquencies in the earlier stage buckets all continue to be really favorable.

That's really more, I think, the indicator of what's coming at you to be looking at and thinking about in terms of how we came up with our thoughts and our guidance on a full year basis.

But in terms of just general loss development, it feels again, as I said earlier, like our earlier guidance from the last quarter's call for the full year still feels like it's in the relevant range.

Okay.

And then just kind of curiosity question on marketing.

When I look back a year ago, you had a pretty low number and there was some talk about the timing of it.

I don't think $168 million should be a run rate for marketing, but I mean, we should expect typical seasonal increases in that number, right?

It's not that you're not taking the foot off the accelerator on marketing, are you?

No, I would say that we're growing a bit faster as you can see.

We're very pleased with the results of the marketing dollars.

And I would guide you to look at the rewards line.

And we do kind of think about, especially when we're thinking about promotional amounts, about where we get the best investments, in marketing dollars directly or in Cashback Bonus, which attracts more customers more cost effectively.

And you can see there, we have increased our investment.

And we do expect to spend more in marketing this year than we did last year.

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

Mark, maybe I can start off with expenses.

So obviously, they came in a lot lower than I think the street had been looking for.

David just referred to marketing expenses will obviously be up from this quarter and year-over-year.

But do you still feel the $3.8 billion of expenses is the right number in terms of what you'll spend for 2017?

Yes.

I mean, I guess, Ryan, as I sit here right now, still feel good about the $3.8 billion.

We definitely have leverage over that number.

And if we see other things working against us that we feel a need to pull at, we can pull at those.

And we said all along, you've heard my 3-engine aircraft analogy or the market's heard my 3-engine aircraft analogy many times.

And we can pull back on those throttles accordingly.

There is a lag between spend and results, right?

So a lot of the growth you're seeing this quarter, yes, a lot of it's rewards, but a lot of it is also marketing dollars that were invested last year that really kind of produced the loan growth you see on to this quarter.

So I think there will be some seasonally-adjusted marketing spend as we go through the year but we will be very mindful in that expense line.

Got it.

And maybe if I could ask one for David.

Many of us just got off another call where the outlook for loan growth is lower amid increasing consumer indebtedness, higher competition.

So maybe just in both card and personal, can you just talk about the decision to accelerate growth, where you're actually seeing good opportunities for growth?

And do you think that you could actually sustain this type of growth rates in both card and personal?

Yes, well if I start with card, we were growing 2, 3, 4 years ago when the market was actually shrinking.

And to some degree, it's a whole lot easier to grow when the market's growing than when it's purely share gain because the market is shrinking.

So in some ways, the environment is better.

Now it is clearly more competitive and you're seeing us, particularly in the rewards space, invest more in rewards in order to remain competitive, and that's paying off in these results.

I did mention to you that -- in my prepared remarks that, a year ago, we were pulling back from some areas where we weren't as comfortable with the returns, specifically, some of the aggregator sites that have become very popular with some of our competitors.

And that caused us a bit of growth last year, gives us a little bit better comp for this year's growth so that's also a piece of it.

But generally, we are -- we see great opportunities in the prime credit card market.

And I'm not sure, the fact that we're not a sub-prime player, in my observation, is that market has gone through a lot more gyrations, and some people that are exposed to that may have bigger swings than we have.

But in the prime space, we're pleased with the opportunities.

More broadly in the other products, you can see personal loans continues to grow very nicely.

And when there's more loans outstanding, there's more loans to consolidate and that is heavily a consolidation product, and so we're seeing strong opportunities there.

I would expect that as variable interest, variable price interest rate credit cards reprice upwards, there may be -- that opportunity may continue as we consolidate in.

And of course, tuition continues to increase in schools, and so we continue to find good opportunities to grow in our private student loan program.

So I would say all in all, while it's more competitive than it was, there's more opportunities than there were.

And I would just pile on to that quickly with one little comment, and David noted that we did pull back on growth last year or the year before when we saw that we weren't meeting our return thresholds.

We wouldn't hesitate to do that again, just to be clear.

I mean, right now, we are getting good solid growth.

If anything, we've tightened credit recently, and we're still getting this kind of really good solid growth.

I think that's a key point.

And I would also point out that as long as that's the case and we can make rational assumptions and drive good credit, loan growth is the key to compounding shareholder value in that lend-centric business model that we really feel good about the growth we're putting up right now.

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

Mark, just on the rewards costs.

Typically, there's a decent amount of seasonality in that, and yet, this first quarter comes in more or less in line with the full year guidance.

So is this a change in the marketplace?

Or is there something else occurring relative to the historical pattern?

No, I think a big piece of it, Eric, really is the cadence on the rewards stuff, unlike a lot of the seasonality in the industry, is really under our control, right?

So we can choose what programs we want to run for the 5% program and at any given quarter, we can -- it's really it's a management set rate, for lack of a better term, as opposed to cyclical or seasonal factors that affect it.

So really, it was conscious decision more than anything else.

So does that suggest that at this moment, your outlook is for more or less a sustained level of rewards expense?

Yes, I would speak specifically because there will be peaks and valleys.

So I'd speak specifically to the full year guidance of 1.26% to 1.28% -- 1.26% to 1.28%.

Still feel good about that guidance as we sit here right now.

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

Mark, you talked about how the rewards expense payout was consistent with guidance.

But looking at historical patterns, it looks like your rewards in Q1 is seasonally a little lower than any other quarter.

So I'm wondering, is the seasonality changing or we're just kind of keeping our eyes open to what might come of the reward expense ratio?

No, again, I would say it's really a management set rate.

It's not really a seasonal rate historically like last year, sometimes gas is in there, sometimes, gas isn't.

So I feel good about the full year guidance of 1.26% to 1.28%.

And first quarter was really again just conscious decisioning.

Okay.

And then all else equal on credit, with call it an even economic backdrop, unemployment and kind of wage expansion and borrowing rates where we are, would you think that '17 -- 2017 represents kind of the normalization year?

Or would you expect loss rates to kind of accumulate into '18 before they flatten out?

It's David.

I would -- I think that we're likely to see them continue to rise a bit at least into 2018.

I don't see anything dramatic as long as, as you point out, the economic environment is actually quite good.

So with 4.5% unemployment and rising house prices, I don't think -- I think the normalization you're talking about is the driver as opposed to the beginning of a new cycle.

But at some point, unemployment will start to rise and then that will start to impact as well.

So we're really going to have to see another cycle before we know what the new normal is.

And I would say at -- for us, below 3% charge-off rates continues to be well under our long-term business model.

But I would also say that we think the long-term new normal is way below what it is historically was before all the structural changes that happened with CARD Act and deconsolidation and so on in the industry.

So maybe a little bit of a long answer, but we're not providing guidance yet but I would expect '18 to be somewhat higher than 2017 as I sit here today.

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

A couple of follow-ups.

Just one on the -- what keeps you up at night kind of question.

And it sounds like things are going really well, and you are still investing in growth.

I just want to understand, is there anything out there that kind of keeps you up at night and slows down the growth at all?

No, I sleep very well, thank you.

But I would say, over my career, I mean, credit is probably the single most important thing that I think we have to be diligent on.

And that has served us well and will continue to be the thing that we probably focus on the most.

And I'd say secondly, being diligent on pricing, rewards -- sustainable reward structures.

One thing about credit cards is that I mean, our average credit card has customer's been with us for 12 years.

And so you really lock in a long-term relationship when you approve someone.

And so it's important to take the long term and not to get carried away by short-term fluctuations in the market.

And we took a little criticism a year ago when we slowed down and others were starting to speed up, and I think it's paying off with us as we continue to grow our EPS and others are struggling to do so and as we continue to have a 20% ROE.

So I would say -- focusing on the basics, I mean, some people might point to technology changing or to competitive set changing.

But I think people -- when I observe what's gotten people into trouble over time, it's when they lose track of the basics of credit extension and pricing.

Okay.

And then just a follow-up on balance transfers.

Did I hear you correctly in saying that, that impacted NIM in part this quarter?

Promotional activity broadly did impact NIM a little bit this quarter, Betsy.

So it's about 5 basis points was due to mix was a detractor from NIM, and that was really 3 main components.

It was partially -- we saw transactors reemerge in the book to a larger degree than we expected.

We did see some higher promotional activity, with our Double Cashback match as well as some BTs.

And then student loans ticked up a little bit as a percentage of the overall book.

And there's simply lower yielding.

You make up for it on the loss rate but it does have a modest negative effect on NIM.

And the improvement that you saw on spend year-on-year, that's a function -- I mean, that's also an output, is that correct?

Yes, the spend is really a function.

I mean, it was standard merch balances that drove the increase in spend.

So it was regular way utilization of the card that we feel really good about.

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

The efficiency ratio continues to be very good.

As we look out over the next few years, is there still operating leverage left in this business?

Can you drive that efficiency ratio lower over time?

And if so, what's a reasonable way to think about that over the next few years?

Bob, I think our business model is kind of established at that 38% efficiency ratio target that we came in just below this quarter.

And when you combine that with that other thought process that I shared earlier about the key to compounding shareholder value in a lend-centric business model is continuing to drive the right kind of quality loan growth over time, I'd be concerned about peeling back on muscle.

It's one thing to cut fat, start thinking about cutting muscle, you have other effects on the business.

So we will always look for opportunities to be more efficient.

We will always look for opportunities to find ways to protect the customer experience while doing more with less.

But ultimately, I wouldn't propose to revise that 38% longer-term guidance that's there.

That being said, that's kind of a separate question in one respect from the expense leverage because, obviously, if credit does turn meaningfully against you, you have some giant geopolitical event, whatever the case might be, you clearly do have expense leverage in the model that you could act and react accordingly and appropriately.

That's helpful.

Just -- and then on the Payments businesses, you did have some acceleration this quarter.

And I think you lapped, got easier comps as well.

Any thoughts on the ability to try to accelerate that business further?

I still think it's well below where you'd like to see it on a longer-term basis.

I mean, Diners Club, that's a pretty impressive acceleration.

Well, we do think there's opportunity to accelerate at past this.

I'm really pleased that we returned to growth after a couple of difficult years mainly from the loss of one business from one very large customer.

We don't have that kind of concentration anymore.

And PULSE had a long term, for many years after we bought PULSE, it outgrew the industry and the last couple of years has been very difficult as we lost some share.

And so we're taking all the steps we can to try to regain share.

It's very tough when we got to deal with some of the things that a few competitors are doing, which are really hard to compete against without that level playing field.

But I'm pleased that we're at least -- that we're growing and looking to accelerate from here.

Okay.

The tax rate for this year, is it -- the 35% tax rate in the first quarter, is that what you would expect for the full year or...

No.

We had a couple of settlements, some open tax matters in a few states in the quarter, Bob.

I'd think sort of that 36% to 37% range is the right way to think about the full year.

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

Mark, I want to revisit -- it's been asked a few different ways, but as you recounted the litany of puts and takes in NIM this quarter, you, among other things, mentioned transactors were reemerging in the book and a bigger part of them asset mix.

Trying to get a sense for whether or not that's -- in your mind, as you plan your rewards rates, I mean, is that a leading indicator, any kind of red flag that perhaps the rewards spend may be getting a little too high?

I mean, is the transactor mix, was it very modest on the margin?

Or is it a sign that tells us from an ROE basis, there's actually room to potentially trim back rewards at the end of the year?

It's David.

I'll take that one.

If you look at the -- our sales grew 6% and our loans grew 7% this time.

And so I think if you had that concern, you'd see sales growing a whole lot faster than loans because you're getting transactors that aren't turning into loans, which some of our competitors have been chasing.

So I feel very pleased that our sales have gotten up very close to loans, and that's been our target for a couple of years, and we're hoping to maintain it.

And it doesn't -- it more gives me a signal that our programs are working, and we're moving to a nice balance as opposed to needing to change something from here.

Okay, that's helpful.

And switching to the credit side.

Notwithstanding the commentary on normalization, I'm wondering within the personal loan category, was that sequential rise in losses from Q4 to Q1, was that in line with your expectations?

I mean, it was steeper obviously than all the other categories and steeper than anything that took place seasonally a year ago.

Is there anything behind that?

No, it actually was in line with our expectations.

I think there's 2 pieces of the puzzle there.

Piece number one is just simply the level of overall loan growth we generated over the period of time preceding and leading up to that, that really kind of goes through the peak seasoning and drives that, that's a piece of it, number one.

The second piece of it is we did run a small test of some potential to set up a marketplace business, for lack of better way of putting it, so we did originate some stuff that was a little bit lower than we normally would have played.

It was a very small portfolio test and control, and that had an impact of adding a few basis points to what that reported rate was as well.

It wasn't directionally the driver by any stretch of the imagination but it was a small piece of it also.

So all consistent with our expectations and in line with our guidance for the full year as well.

Got it.

And just real quickly as a cleanup, on the reserve rate, is the level we saw at the end of the Q1 a good way to think about for most of the balance of the year?

Yes, we always set reserves on a forward-looking basis, so we're going -- I'm going to have to -- I bluntly couldn't even tell you my reserve rate was.

I can tell you roughly where it was, but I couldn't tell you exactly because we can't manage to it.

So we're setting on a forward-looking basis.

What I would say is I -- there's going to be the element of normalization that's taking place out there which remains modest and -- but really it's going to be growth that are going to be the primary drivers of the growth in reserve and the provision expense as I look forward.

And we're not losing any sleep that we can't manage the credit situation we're confronted with right now.

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

Mark, I know you've been pretty clear on the big drivers for the upswing in charge-offs around both growth and normalization.

Is there an element to which it's also being driven by a bit of a loosening in the credit box and maybe moving down FICO a little bit in your new growth relative to what you've done?

Or have you really held the line on FICO scores and loss content?

I think we've pretty well held the line.

I mean, if anything, the last quarter or 2, we've tightened credit in terms of directionally where we've gone as opposed to liberalizing it.

So feel pretty good about that.

If you go back a few years, we've talked to Mark in the past about we will look to expand the credit box a little bit from time to time.

And if you go back a few years, we did a little bit of it.

I think that's all performing in line with our expectations, and we're getting paid for it in the NIM as well.

So feel very good about that.

And if you think about it as a sundae, it wasn't the ice cream or the hot fudge.

Maybe it was the whipped cream or the cherry is the way to think about it on the growth levels.

So it was just marginal.

Okay, got it.

And then -- sorry, one of your competitors in the student lending space reported slower growth, loan growth for the quarter than they expect for the year.

And they attributed that to kind of the disproportionate share of for-profit schools in the disbursement season for the spring.

Are you seeing any kind of uptick in your share of for-profit schools, and if so, any kind of thoughts on implications for losses going forward?

Well, it wouldn't be us because we're not -- we don't underwrite or sell or not-for-profit schools.

For-profit.

For-profit schools, I'm sorry.

And the first quarter is not a big quarter for disbursements so it's hard to get a read.

But we're seeing -- we had expected somewhat higher growth this year in that business, more originations this year than last year and so far, we're seeing that.

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

They've been asked and answered, but wanted to come back quickly just to the rewards side of things.

And maybe if you could just, David or Mark, talk a little bit about how you might use that, whether it's the rotating category or some other aspect to kind of drive -- David, you said you're generally happy with the characteristics but are there any other ways that you can think about kind of optimizing your performance in the coming year?

Well, we are -- because we have quarterly categories, we're able to be somewhat strategic and see what else is going on in the industry, what performance we've had in the past.

And so as it's been talked about several times, this time, we purposely went out with somewhat richer categories, 5% programs in this first quarter of the year based on some of the things that we saw going on in the market.

And you see the sales results, in particular, show that those have been well received.

And so I think the 5% program is the one that we can change the most.

I think then the second thing is the Double is continuing to work very well.

We had originally put that in as a test.

It worked.

We continued and right now, we have no plans to back off on that.

And it's allowing us to get strong cost per account, strong engagement and not be as wedded to some of the aggregator sites as some of our competitors are.

And then the third piece is we continue to work very hard on the redemption side and growing the competitor -- growing the number of partners who help fund and provide additional value to cardholders, leveraging our network in a way that's hard for our competitors to follow.

Now it's not quite Cashback Bonus but I'll just mention that we're really pleased that we're doing a program right now with Walmart that you've seen launch last week, I think.

And we think programs like that is still rewards essentially, and it's cost marketing.

And we don't have results yet but we're optimistic that, that kind of engagement with our customers, with our retailer partners, it will pay dividends.

So please use your card at Walmart and provide a free meal.

Just a quick follow-up.

You mentioned, David, the 12-year kind of average tenure.

But part of the Discover it was to attract a somewhat younger demographic.

And can you talk a little bit about how that's going and what your success there has been because that's been a kind of a hot (inaudible).

Yes, I'd say it's working well.

And we -- all of our marketing results and brand tests show that we do particularly well with millennials compared to almost any other card brand.

And so I would say we have a double-edged strategy.

One is to grow, especially with the millennials, but growth in new accounts, but the second is to retain our existing customers through better service, through lower charge-offs and through a strong rewards program.

And it's that combination of not having a leaky bucket and then filling the bucket with new customers with a differentiated product with Discover it specifically, that is working for us.

Your next question comes from the line of Henry Coffey with Wedbush.

When we -- this is probably overly simplistic, but when we look at quarterly trends and quarterly charge-offs, is it -- was -- do you think that there was a sort of "a jump" in the second half of last year, which will make the quarter-over-quarter comparisons easier as we go into the second half of the year?

And I know you talked about it in the past, but is it fair to think of the March quarter as a bigger reserve build relative to the rest of the year?

I'll let Mark answer the reserve question.

But on the seasonality, I guess the way I would look at it is first quarter of last year was a pretty low quarter on charge-offs.

It's the low point for delinquencies, early-stage delinquency.

And so that essentially is what you're describing and is what you would expect in order to reach the roughly 35 basis points increase for the full year.

We obviously would not reach that if we have kept up the same year-over-year, so we would expect the year-over-year to moderate from here.

Mark, on the reserve?

Yes.

On the reserve, I'll -- we don't give provision guidance so I'll steer clear of that one, Henry.

But what I would say is we didn't give the charge-off guidance, and I think I can use that to answer your question.

And really we did see a bigger bump in first quarter charge-off growth than we're guiding for in basis point terms for the full year.

So clearly, that low point of delinquencies in the first quarter of last year is entering into our thought process.

And then just kind of an unrelated question.

But right now, you have 3 core products that are driving the equation plus the direct bank.

Have you thought about adding a fifth or sixth product to the quiver?

Or is it really you're going to focus right where you are?

Well, I -- first, I would certainly include the deposit products.

I mean, it's $37 billion of deposits from our customers.

So I would look at it more like 4 and even within deposit products, CD is very different than money markets, checking, et cetera.

But I would say home equity is the product that we are in.

It's very small, it's a very big market relative to many other markets.

I think we're coming into a particularly good part of the cycle in which home equity will be in higher demand as people look to use home equity as opposed to refinancing their very low-rate first mortgage.

We're in the early days of that.

We're still fine-tuning our infrastructure, our modeling and so on.

So it's not particularly significant today, but it is an area that we would like to grow further to create what I would call a fifth product.

Inside into where the student loan market is likely to go relative to the federal programs or...

We're not counting on any change today.

I would hope that any changes that come in future years might be positive.

To me, it is an unusual market in that 95% is provided by the federal government and only about 5% or 6% by private.

And so if the government backs off any piece of that market such as graduate loans, as an example, it's a market that we would hope could accelerate, and we would take the -- positioned to take advantage of it.

And we are in the final stages of converting our system.

We talked about that in previous calls.

And I think having a state-of-the-art proprietary system that's very scalable, I think, could position us well for possible acceleration in future years.

I don't know if that would be 2018 or 2019.

But it's a great market.

It's, by far, the lowest charge-off market for any kind of installment loan that I'm familiar with.

And you saw that was the one product that actually improved this quarter, and was the lowest charge-offs of any quarter that we've had in the last 2 years.

Your next question comes from the line of Jason Harbes with Wells Fargo.

Maybe just a quick one on the longer-term credit outlook.

I think at the last Investor Day, you provided a longer-term charge-off ratio target of 3.5% to 4.5%.

Is that still a reasonable range to think about as we look ahead over the next couple of years?

Yes, I think the most recent guidance we gave was back in January of last year, and we said 3% to 4% is what we kind of expected the normalized to be.

So a little bit inside of that.

I'd pick up on David's earlier comment.

There's a bit of Kentucky windage in that estimate.

None of us have been here in a post-CARD Act world before, with our books kind of having gone through the crisis and all the cleansing that took place from that, coupled with the discipline that's kind of brought in by CARD Act.

So we think that's a pretty good guesstimate of what new normal looks like through the cycle.

But as David noted earlier, we're kind of going to need to ride through a cycle to validate that definitively.

And then just a quick follow-up on the direct bank.

Looks like you guys had some good success with your deposit gathering efforts while the deposit betas remained surprisingly low, at least thus far into the tightening cycle.

Can you maybe share your expectations for what you're expecting for the remainder of the year?

Yes, I think we'll probably start to step into normalized betas over the next several rate increases.

I think it's kind of really a stairstep function.

The money supply that's in the market has just got a tremendous amount of deposits in the system more broadly.

But I think as the Fed begins to shrink its balance sheet, that will have a bearing and an impact on that.

I think to the extent loan growth continues across the industry, I think there'll be demand for those deposits.

So I think you'll start to see some betas kick in.

But I do think it plays out over time so as opposed to going from a beta of essentially 0 to normalized assume betas, I think over the next 2, 3, 4, I'm not smart enough to tell you exactly how many moves, you kind of stair step your way there.

Our last question comes from the line of Bill Carcache with Nomura-Instinet.

My questions have been asked and answered.

I believe that concludes the question-and-answer session on the call.

I'd like to thank everyone for joining us today, and if you have any follow-up questions, please call the Investor Relations Department.

Have a good night.

This concludes today's conference call.

You may now disconnect.