發現金融 (DFS) 2017 Q3 法說會逐字稿

Good afternoon.

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

At this time, I would like to welcome everyone to the Discover Financial Services Third Quarter Earnings Conference Call.

(Operator Instructions) Craig Streem, you may begin your conference.

Thank you, Ruth, and welcome, everybody, to today's call.

Moving on to Slide 2 of our earnings presentation, which you can find in the Financials 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 in an 8-K report and in our 10-K and 10-Qs, which are on our website and of course on file with the SEC.

In the third quarter 2017 earnings materials, we've 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.

And of course we urge you to review that information in conjunction with today's discussion.

Our call today will include remarks from David Nelms, our Chairman and Chief Executive Officer, covering third quarter highlights and developments; and then Mark Graf, our Chief Financial Officer, will take you through the rest of the earnings presentation.

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'll begin on Page 3 of the presentation.

Thanks, Craig, and thanks to our listeners for joining today's call.

For the third quarter, we delivered net income of $602 million on revenue growth of 10%, earnings per share of $1.59 and a return on equity of 22%.

I'm particularly pleased with the strong growth we achieved across all product lines.

We drove total loan growth of 9% as we continue to focus on delivering profitable prime loan growth.

In Payment Services, total volume grew 16%, our fastest growth in more than 6 years.

Looking specifically at card, loan growth was split about evenly between new accounts and growth from existing customers.

While the third quarter of last year was highly competitive, characterized by unusually aggressive offers on new products from a number of competitors, this year some of the issuers appear to have pulled back a bit.

However, our strategy and discipline remain unchanged.

We continue to innovate and enhance our flagship product, the Discover it Card, and to offer unique features like Cashback Match, which allows new card members to earn double the Cashback bonus in their first year and creates meaningful benefit for us through sustained customer engagement.

Our consistent approach in a slightly less intense competitive environment have created more opportunity to drive both sales and receivables growth without a significant increase in marketing expenses.

Over time, strong customer engagement drives lower voluntary attrition and enhanced growth.

For Discover, attrition has remained consistently low among prime revolvers, reflecting the loyalty of our customer base.

The foundation for our strong performance is our commitment to outstanding customer service and a unique and expanding feature set in our Discover it Card.

In our advertising, we remind customers that "We treat you like you'd treat you." Customers are loyal to us in part because we serve them well, which includes providing a helping hand in response to unexpected events.

The Equifax data breach and the increased potential for personal identity theft it has created had been on the forefront of consumers' minds.

The breach resulted in an increase in call volume from customers but highlighted that we have been on the right path in focusing on features and innovations that help consumers monitor their credit.

In July, even before we became aware of the Equifax breach, we introduced a free alert service available to all Discover cardmembers.

Enrolled cardmembers will receive an alert if we find their Social Security numbers on any of thousands of risky websites.

We will also monitor their credit reports and notify them of any new account openings.

This feature is the latest example of our ongoing investment to provide our cardmembers with the simplicity and innovative features they expect from us.

The number of enrollments in this feature has already surpassed our goal for the full year.

Our new alert feature is just one element of our continued investment in technology.

As a direct bank, differentiation in technology is critically important for us.

Our innovative features like Freeze It and our new alert service further differentiate Discover in a competitive marketplace.

The appeal of these features was recognized by J.D. Power last quarter when our mobile app was ranked highest in customer satisfaction among all U.S. credit card companies.

We continue to invest in new digital and mobile capabilities that enhance customer experience as well as advanced analytics and machine learning technologies that will provide sustainable credit and operating efficiency benefits.

Turning to credit for a moment.

While credit costs have risen, our performance remains largely in line with our expectations, and our card portfolio loss remains -- rates remain below the industry average.

The prime consumer remains healthy, buoyed by a robust labor market, rising home prices and manageable debt service levels.

The Federal Reserve recently released the Survey of Consumer Finances, which showed median debt-to-income and payment-to-income ratios at their lowest levels since the early 2000s.

Moreover, the share of heavily embedded consumers, those with payment-to-income ratios above 40%, fell to its lowest level since 2001.

I would add that in October, consumer sentiment reached its highest level in well over a decade.

The U.S. consumer continues to feel positive about future prospects for their personal finances and employment.

Given our commitment to growing prime receivables, it makes great sense for us to continue to drive quality loan growth because the economic and competitive environment remains conducive to creating long-term shareholder value.

Of course, we remain attentive to emerging credit data, and in fact, over the last year, have reduced exposure by cutting back open lines in some segments of the card portfolio.

Mark will talk more about it later, but one area where we're taking some more significant action is in personal loans, where we're scaling back the volume of origination sourced through broad market channels.

While the environment remains favorable for most, a number of our customers were unfortunately affected by Hurricanes Harvey, Irma and Maria.

For our 1.8 million customers in areas most impacted by the hurricane, we offered a range of proactive benefits such as suspensions of late fees and collection activities.

Additionally, we and our customers provided support to these communities by donating $3 million to the American Red Cross.

In summary, our differentiated approach and relentless focus on serving customers well continue to drive strong revenue and loan growth along with a robust return on equity.

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

Mark?

Thanks, David, and good evening, everyone.

I'll begin by addressing our summary financial results on Slide 4. Our 10% revenue growth in the third quarter was driven primarily by a combination of strong loan growth and margin expansion.

The increase in provision is largely consistent with ongoing supply-driven normalization in the consumer credit industry as well as the seasoning of our last several years of loan growth.

The only exception to this is contained in a limited portion of the personal loan book that we alluded to last quarter.

Operating expenses rose 6% year-over-year as we continued to invest for growth.

EPS was up $0.03 to $1.59, including, coincidentally, $28 million of income tax benefits in both the current and the prior year.

And in terms of returns, it was once again a very strong quarter, as evidenced by our return on equity of 22%.

Turning to Slide 5. Total loans increased 9% over the prior year, driven by 9% growth in credit card receivables.

Growth in standard merchandise revolving balances drove much of this increase, spurred by strong sales growth, particularly among revolvers.

Promotional balances contributed to growth as well.

We also achieved strong loan growth in our other primary lending products.

Personal loans increased 18% from the prior year, thanks to active consumer engagement with our simplified application experience and expanded digital presence.

This growth rate is down 4 percentage points from last quarter as a result of our tightening of certain underwriting standards in our unsolicited channel.

And we expect that these changes will lead to a further deceleration in personal loan growth in the coming quarters.

Private student loan balances rose 2% in aggregate but our organic portfolio increased 11% year-over-year.

As a result of expanded marketing efforts with a focus on digital content, we're on track for another year of record originations in our student loan business in 2017.

Moving to the results from our payments network.

On the right-hand side of Slide 5, you can see that proprietary volume rose 6% year-over-year, driven primarily by an increase in active Discover card accounts.

In our Payment Services segment, PULSE volume grew at a faster rate during the third quarter with an increase of 17%.

Diners Club volume rose 9% from the prior year on strength from newer franchises.

And finally, Network Partners volume rose 15%, driven largely by AribaPay volume.

Moving to revenue on Slide 6. Net interest income increased $225 million or 12% from a year ago, driven by a combination of higher loan balances, market rates and our balance sheet positioning.

Total noninterest income was down $1 million as higher discount and interchange revenue was more than offset by increased rewards expense resulting from greater customer engagement in the rotating 5% category we opted to feature this quarter.

I'd remind you that we have previously said that you should expect an uptick in our rewards rate in the second half of this year, and this result is completely consistent with our full year guidance of 126 to 128 basis points.

As shown on Slide 7, our net interest margin rose 29 basis points from the prior year and 17 basis points sequentially, ending the quarter at 10.28%.

Relative to the third quarter of 2016, a higher prime rate and a lower proportion of student loans bolstered the margin, offset in part by higher charge-offs and an increase in promotional balances.

Total loan yield increased 33 basis points from a year ago to 12.15%, driven by a 30 basis point increase in card yield and a 43 basis point increase in private student loan yield.

Prime rate increases, partially offset by higher charge-offs and a shift in portfolio mix towards promotional balances, drove card yields higher.

Higher short-term interest rates were the driver of the increase in student loan yields.

On the liability side of the balance sheet, we once again generated robust growth in our consumer deposits.

Average balances increased $3.4 billion or 10% year-over-year.

Consumer deposit rates moved slightly higher during the third quarter, rising 8 basis points sequentially and 11 basis points year-over-year.

We expect deposit betas will continue to rise gradually toward more normalized levels with any future rate hikes.

Turning to Slide 8. Operating expenses rose $53 million or 6% year-over-year.

Employee compensation and benefits was higher, driven primarily by higher headcount to support business growth and compliance activities as well as higher average salaries.

Professional fees were also higher as we invested in the technology initiatives that David spoke of earlier.

I would point out that even as we made these investments in growth, our expense discipline and strong revenue growth produced positive operating leverage of 4% in the current period.

I'll now discuss credit results on Slide 9. David highlighted for you the assistance we provided to customers in areas affected by the hurricanes.

While we provided relief to these customers by not aging their accounts, we did, from an accounting point of view, accelerate the recognition of $17 million of likely charge-offs in hurricane-affected areas.

That said, the ultimate impact from the hurricanes may be somewhat greater than this amount, primarily driven by the more recent and severe impact of Hurricane Maria on Puerto Rico.

Total net charge-offs rose 61 basis points from the prior year and fell 8 basis points sequentially.

As we've spoken about for the last several quarters, supply-driven credit normalization, along with the seasoning of loan growth from the past few years, have been the primary drivers of the year-over-year increase in charge-offs.

Credit card net charge-offs rose 63 basis points year-over-year and fell 14 basis points from the prior quarter.

Private student loan net charge-offs rose 44 basis points year-over-year and 29 basis points sequentially.

The increase in the student loan net charge-off rate is principally due to seasoning of a large vintage.

Personal loan net charge-offs increased 56 basis points from the prior year and 1 basis point sequentially.

As we indicated last quarter, we've identified a subsegment of the broad market personal loan book that's not performing in line with expectations and have taken actions to curtail those originations.

This quarter, you can see the impact in our reserve build.

In future quarters, the personal loan net charge-off rate will rise as these loans flow through the charge-offs.

We expect that future exposure for this subsegment will not exceed $30 million over the remaining lives of the assets.

Of course, for the total personal loan portfolio, the net charge-off rate will also be impacted by the denominator effect associated with pulling back on originations in the affected segment.

30-day delinquency rates were up sequentially across all of our primary lending products.

Looking at total loan receivables, our 30-day delinquency rate increased 12 basis points sequentially and 26 basis points year-over-year.

Looking at capital on Slide 10, our common equity Tier 1 ratio declined 50 basis points sequentially as loan balances grew and we returned $667 million of capital to shareholders through common stock dividends and share repurchases.

Looking ahead to the fourth quarter, we may have an opportunity to refinance our existing preferred shares.

It currently appears as though this would be a beneficial trade.

However, if executed, it would be dilutive in the fourth quarter to the tune of $0.05 to $0.06 per share.

This dilution would result from 2 factors: first, we would have a period of overlapping dividend payments; and second, we would need to take a charge to retained earnings for the capitalized fees incurred when we issued the existing preferred shares.

To sum up the quarter on Slide 11, we generated 9% total loan growth with significant contributions from all 3 of our primary lending products.

Our consumer deposit business posted equally strong growth of 10% while deposit betas remained low.

With respect to credit, while our charge-off rates have risen as credit conditions normalize and loans season, they remain below both historical norms and the industry average.

And we're continuing to execute on our capital plan with strong loan growth and a leading payout ratio helping to bring our capital ratio closer to target levels.

Our commitment to disciplined profitable growth fueled strong operating performance with 10% revenue growth, NIM expansion and a healthy 22% return on equity.

In addition, expenses remain well managed, as evidenced by one of the best efficiency ratios in the industry.

That concludes our formal remarks.

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

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

I was hoping, Mark, you could give us a framework for future allowance builds and provisions and the charge-off rate as we're going into 2018, because I know there's a lot going on with the growth inflections that you've seen over the last 1.5 years.

Yes, I would say I'm going to stay away from 2018 guidance at this point, Sanjay.

I'm going to make you wait until the January call until we talk about the year ahead.

I guess what I would say is the provision build that we are experiencing at this point in time, if we take that small subsegment of the personal loan book and set it aside, the provision build we're seeing is completely consistent with the normalization of credit we're seeing from the standpoint of that supply side phenomenon we've spoken about any number of times, as well as the seasoning of the growth that we're seeing, right?

And as we have continued to find ways to drive very strong profitable growth in that prime segment, the 9% loan growth this quarter, it will drive increases in the provision, right?

I mean, there's just a mathematical equation that takes place there.

What I would tell you is any place we have seen the returns on that growth not meet our expectations, we've demonstrated a willingness to peel back on that, right?

We did it in the aggregator channel in the card space a few years ago when the cost of acquisition got too high.

And you've heard us talk about it in this broad market segment of the personal loan business where credit costs are running a little bit high, quite honestly.

So I think the discipline is there such that we feel comfortable, while the provision expense has been growing, it's been growing for the right reasons as we're investing and building shareholder value for the long term.

Okay.

My follow-up is on the NIM.

I guess, what drove the sequential move higher on a year-over-year basis, if you get what I mean?

And I was wondering if there was any hurricane impacts in the revenue yields?

Yes, there hasn't been a significant amount of hurricane impact that we can identify in the revenue line at this point in time, Sanjay.

In terms of a walk of the margin from Q2 to Q3, get your pencil ready because it's a bunch of things this time around.

The biggest piece is market rates contributed about 7 basis points, give or take.

Credit contributed about 2 basis points.

The receivables rate contributed about 2. The funding rate contributed about 2. And then the mix of receivables was about another 2, and the funding mix was about another 2. So if you add those all up, you get that 17 basis point quarter-over-quarter increase in the margin.

So it feels, again, very strong.

We're benefiting from that positioning of the balance sheet to be asset-sensitive.

And then I think we're also seeing just good prudent management of the funding of the assets and the nature of the assets that are coming on as well.

Your next question comes from Ryan Nash with Goldman Sachs.

Mark, I guess just a different question on the reserve build this quarter.

Can you maybe talk about how much of the reserve build was due to growth versus how much was from credit normalization?

And I guess related to charge-offs, if you look at the breakdown of the 60 that you're up year-over-year, can you maybe contextualize how much of that is from the supply side seasoning versus maybe losses that you're seeing in the back book?

A lot in there, Ryan.

I'll try and touch on it all.

And I'll give you credit for one quick follow-up, just in case I missed any of it.

I would say a couple different things.

First of all, the primary driver of the provisioning is growth.

That has been and continues to be the primary driver of the provisioning.

But the normalization factor is material.

I don't want to downplay that too much, just to be clear.

I would say, if you think about the nature of the build, if you take a glance at the supplement, what you can see is about $111 million of that build was specifically related to the card business.

There was an outsized build in personal loans to the tune of $34 million, $35 million this time around, reflecting that small book that we talked about a second ago and getting ahead and getting a good chunk of provisioning for that out of the way.

And then I would say the student loans piece of the equation, you saw an uptick in the charge-off rate this quarter.

That's really related to that seasoning we talked about earlier, that higher vintage, as well as we had a conversion that we went through on the student loan system onto our new platform during the course of the quarter and probably weren't as diligent about working delinquencies for a couple days in there, too; probably drove a little bit of that delta, is my guess.

But if you look at the reserve rate there, you can see it's up only 3 basis points.

So at the end of the day, I would say it really continues to be where we are seeing the strongest growth, with the exception of the DPL portfolio, is where we are seeing the greatest provisioning.

Got it.

And maybe if I could just ask a quick question on personal.

You saw loan growth on a year-over-year basis come in about 400 basis points, yet it does look like the quarter-over-quarter growth did increase.

Maybe there was some seasonality in there.

So could you maybe just expand on your comments about pulling back and how do you expect growth rates to progress in that business?

Yes, I would expect you would see growth rates continue to slow further in that business as a result of the actions we've taken and continue to take in that affected segment.

The good news, it's a very defined, identifiable piece of the book and it's not gigantic.

So I think from that standpoint, I'm not overly concerned about it in any way.

I would expect, though, you would see growth rates continue to decelerate in that regard.

I don't think we are permanently abandoning the subsegments in question.

I think we just need to figure out a way to go back to looking at them in a constructive fashion.

And that'll take us a little bit of time to look at models and do some further work.

Your next question comes from Bill Carcache with Nomura Instinet.

Mark, we saw the year-over-year change in your delinquency rates decelerate last month.

Was there a hurricane benefit underlying that improvement?

Or would we have seen an improvement anyway?

You would have seen a bit of a seasonal improvement anyway.

I would say, Bill...

I'm sorry.

I mean year-over-year.

Sorry, Mark.

I mean year-over-year so not...

Okay, okay, got it.

No, on a year-over-year...

Year-over-year change, right.

The year-over-year change, yes, you would have seen benefit there, is the honest answer, absent the hurricanes.

I do think the rate of delinquency formation has slowed, again, with the exception of that small subsegment of personal loans, just to be clear.

We're carving that one out here.

But delinquency rate formation has definitely slowed.

And absent the hurricane impact, which was relatively modest for us, you would have seen improvement.

Okay.

And as a follow-up, your reserve rate in card increased to 3.29% this quarter.

That now exceeds your net charge-off rate of 2.87% -- or sorry, 2.8% by the greatest amount that we've seen in a while.

So should we start to see the rate of increase in that reserve rate start to slow here, particularly given that deceleration in DQ formations that we just talked about?

What I would say, Bill, is that the way I think about it when I parsed it up is charge-offs are kind of looking at what's already happened; reserves are really looking at what we expect to happen.

And while the rate of delinquency formation has slowed, the rate of growth has increased, right, the rate of growth in the absolute underlying level of assets.

So if we're going to have a higher level of assets going through that seasoning process, with seasoning being the greatest piece of the driver, part of that is what you're seeing there.

So you're seeing that increase to reflect that increased growth that we're seeing roll on quarter over quarter over quarter.

So it's not the 9% this quarter that's the driver.

It's the stronger growth from a couple quarters ago as that comes up into the seasoning curve that's really driving that.

Your next question comes from Rick Shane with JPMorgan.

Mark, look, I understand not wanting to provide guidance on provision into 2018, but I'd love to think about it a little bit more conceptually, which is can you help us think about the lag between when loans are added and the loss curve and when you would be reserving for that?

Given the steady loan growth throughout the year, that might help us think about how to model provision into 2018.

Yes, from a pure seasoning impact as opposed to that normalization element of it, Rick, I absolutely can.

So the way I think about it is you think about a normal seasoning curve for a normal vintage of card loans, you typically tend to take peak losses about 24 months after you originate that vintage, give or take.

So think about a bell curve that starts at 0 losses.

It increases to peak about 24 months out, and then it drops off on the back end of that to stabilize at the portfolio loss rate somewhere 3 years or shortly thereafter, is kind of really the way to think about the way the card loan -- the seasoning impact of the card loan would work.

Student loans, interestingly enough, follow a very similar pattern.

It's just that vintage curve doesn't kick in until the loan comes out of deferral, right?

So the student graduates or drops out, you have a 6-month deferment period, deferral period.

That deferral period ends, that's when that -- basically that same curve would kick in with peak losses occurring 24 months thereafter.

And if you think about it, it's logical because if you -- the biggest losses are taken when a student comes out and is unemployed or underemployed, right?

So it's a pretty logical process.

Personal loans follow a similar curve.

They tend to peak just a tad bit earlier.

Maybe kind of like 18 to 20 months out is really the way to think about them.

But again, a very similar process.

So as you think about loan growth, it's really that area under that peak of the curve you're providing for.

And every year since the crisis, our vintage of new credit has been larger than the one from the year that preceded it.

So while it's not mathematically correct, for digit heads in the crowd like me, what I would say is the way to visualize it is the area under the peak of that curve is growing, right?

You have a larger and larger and larger vintage coming in to replace it at 12 months to replace the one that's falling off at 36.

No, you've done a nice job painting that picture.

And just to refine this a little bit, because you're reserving 12 months in front of that, the reserve build actually starts around month 12?

That is -- it actually begins before month 12 but it kicks in, in earnest somewhere around month 8, 9, 10, somewhere in that range as you climb the peak of that curve, that's correct.

So if you really think about it just mathematically, the absolute peak is going to be somewhere between month, call it, 18 and month 30, right, is when you're going to have the bulk of the losses under the peak of that curve be recognized.

Your next question comes from Don Fandetti with Wells Fargo.

David, you talked a little bit about this early in the remarks, but investors continue to just ask why is Discover growing so much in their card portfolio at this point in the cycle?

And clearly you have a lot of excess capital and you see good returns as competitors are pulled back.

Can you just drill down a little bit more, because sometimes I have a hard time answering that question.

Well, I would say, for one thing, the market is growing faster now than it was certainly 2 years ago, 3 years ago.

And 1 year ago was probably when we saw the really absolute peak of competitive intensity, particularly around cash reward programs.

And so that impacted some of our response rates a year ago.

And it also impacted where we invested because some things were getting just too expensive.

And that's -- actually, our cost per account has dropped even with, at the margin, tighter credit this year than last year.

So our relative -- our growth rates basically were -- it's almost a same-store sales kind of thing a little bit, because last year was when we were -- had really slowed growth, and so we're looking back at that period.

Competitors have pulled back.

We've been consistent, maybe a little bit more aggressive with some of our new features and so on, but it's appealing to consumers.

So there's no dramatic new product launch, but we've had a lot of new feature launches, and the combination.

And it's not just new accounts.

We had a little bit more attrition a year ago, given some of those over-the-top and often promotional offers, specifically targeting Cashback Bonus.

That makes sense.

And then one of the large banks actually this quarter were saying how they were shifting acquisitions a little bit away from transactors more to revolver.

It's hard to -- you see some plus and minus data points on competition.

Do you still feel like competition has kind of peaked in your business or...

Well, it's still the best thing going in banking, so I don't -- I wouldn't characterize it as anything but robust competition.

But it was over the top a year ago.

So I think some of the craziness probably has passed.

And we, frankly, couldn't really understand why everyone else seemed to be going after transactors and paying out higher rewards than interchange.

And if you have no interest income, you can't make that up on volume.

I mean, it's, by definition, a money-losing proposition.

And I think a few competitors probably have noticed that.

It's -- focusing on prime revolvers has been our strategy for over a decade, so we're continuing to pursue that consistent strategy.

Your next question comes from Chris Brendler with Buckingham Research.

The NIM walk-through was very helpful.

I had my pencil ready, but I was hoping if you could, Mark, just comment briefly on how those will trend going forward either directionally -- I can't imagine that they're all positive as we continue on.

Obviously market rates are going higher.

But can you talk about the funding rate and the loan mix and the funding mix?

How does that look going forward?

If you could give us direction and help that would be great.

Sure.

I think at the beginning of the year we gave NIM guidance on the full year to be -- I think we said slightly higher, and I think I defined that as probably 15 or so basis points.

Full year last year was 9.99%.

I would tell you I would expect our fourth quarter this year to have an increase in NIM but not by very much.

So you'd have some further expansion but really more modest in nature.

So maybe you close out the year 20, 21, 22 basis points higher than that 9.99% on a full year basis you printed last year, so would be the real way to think about it.

We continue to be positioned in an asset-sensitive fashion, and plus or minus 2% is kind of what we target in this environment, asset sensitivity, and feel really good about the work that the treasury group has done to get the balance sheet positioned that way but also that the deposits business has done, continuing to put up pretty strong growth in that channel, which is our least market-rate-sensitive channel.

So feel good about the trajectory on NIM.

Okay.

And then a follow-up on personal loans.

I may have missed it.

Did you size the portion of the portfolio that you've decided that you don't like at this point?

And also related, do you expect personal loans to continue to grow or dip negative potentially?

So I would say we would expect personal loans to continue to grow.

I would guess, as a result of the pullback, you might see a slightly smaller vintage overall next year than you'll see this year.

But on balance, the affected portfolio is really small.

We didn't size it, but if I did, it would be low single-digit percentage points.

It's a very small portion of the book.

It is principally behind us at this point in time in terms of the provisioning impact.

I think what we said earlier in the prepared remarks is there's probably $30 million of economic risk over the remaining lives of those assets associated with them.

Your next question comes from John Hecht with Jefferies.

Yes, I guess following a little bit on some of Rick Shane's questions about the nuances of credit.

I guess you guys are about the fourth quarter, you're entering the fourth quarter where you started seeing accelerated growth.

I'm wondering, at this point in time, can you tell us how you look at the loss content of the latest vintage, this year's vintage versus last year's vintage, say, and how you look at that both on a gross and net basis?

Because it looks like recoveries have come down a little bit as well.

A lot in there.

I'll try and answer it simply and just kind of say, if you think about that vintage curve we spoke about earlier, in the card book, that curve is still peaking lower than we have seen it in a precrisis environment.

But what I would say is it is every year successively getting closer and closer and closer to that normalized vintage seasoning process.

So that's the way I would think about it.

The vintages are performing better than precrisis historic norms, but the gap to that precrisis historic norm continues to shrink every year.

Kind of consistent, if you think about it, as what we said.

We say that loss rates have been unsustainably low.

We continue to see opportunities to put things on the books that season below normalized expectations.

And as David alluded to earlier in his response to an earlier question, I think that's the key to compounding value in a lend-centric model.

We don't really charge fees.

It's kind of inconsistent with our business model.

That would be leg 1 of the stool.

Margin's already pushing 10.30%.

So I mean, I don't think there's a lot more juice in margin, probably.

Expenses, we've got the lowest efficiency ratio of any of the general purpose issuers, so I think the third leg of the stool, expenses, is in pretty good shape.

So that fourth leg of the stool of how you compound value is quality loan growth.

And I think our pullback in DPL this year, our pullback in card growth a few years ago demonstrates that, when we don't see the quality we need to have, we will pull back on that loan growth.

But to the extent we can put quality on the books that makes sense, that's good for shareholders, we believe it's the right thing to do in this environment.

That's very helpful, Mark.

Appreciate that.

And second question, you guys talked about and we've heard this quarter commentary through others that everybody's expecting deposit betas to move up.

I'm wondering, can you just talk about the tenure, the duration?

Where have you been focused on issuing deposits and how might that impact the overall betas as we stretch through next year?

Yes, so I think we are particularly focused on the indeterminate maturities.

We find those to be the stickiest of all of our deposit base.

So I think that's an area that we tend to pay an awful lot of attention to.

As we think about the retail CD product, I would say we tend to move around a bit there and we tend to emphasize those products that are the greatest need in the funding profile given upcoming maturities and other things we look at as we look to stagger out and stack the funding profile.

And then if you think about the brokered CD product, some of the suite products that we access as well, those really get us duration.

Most of those things we tend to focus well out the curve because they're one of our most cost-effective solutions as a split-rated issuer to getting duration in the funding profile.

So taking all that, is the duration now consistent with where it was, say, 6 months ago?

It's a little longer actually.

Your next question comes from Chris Donat with Sandler O'Neill.

Mark, you'd mentioned in your prepared remarks that balance transfers were one source of growth.

I was wondering if you could -- I know in the past you've done this, you've quantified the amount of your portfolio that is balance transfers.

Looks to me like that you might of -- like the amount of balance transfers might have been up about 20% year-on-year.

But I'm just trying to get a sense of how big they are in your loan mix.

No, I mean, I think, when you look at the card book in general, that's a pretty good guesstimate.

It's somewhere right in that range, actually a hair below.

It would have a 19 handle on it, would be the way to think about it.

And they continue to be, as we look at them, a very good way not only to attract new customers but also to re-engage legacy customers who've chosen to deprioritize this in their wallet, right, get them back active again with a product.

So we've got pretty disciplined process around the returns on that, and they have continued to produce great returns for us.

So your guesstimate is pretty darn good.

I hope I qualify, then, as a digit head like you some day, Mark.

And then wanted to ask something maybe a little forward-looking.

And David, I don't know how much you'll opine on it, but with the Supreme Court deciding that they're going to rehear -- or hear the Amex case against -- that's been brought by the Ohio Attorney General, just how you think about your discount rate if -- in an environment where merchants would be allowed to steer.

I'm imagining that you would not -- I think the phrase you used before is actually steering pilots, that you might do something like that, but you're not going to jump in whole hog and you'd only do something if the cut in discount fee would be more than offset, obviously, by a pickup in volume, right?

Like just sort of how should we think about what steering might mean for you strategically from your discount pricing perspective?

I think it's really premature to comment on this.

It would be speculative.

We'll see what happens.

And if there is an actual change, then I'm sure we'll have more comments after that.

(Operator Instructions) Your next question comes from the line of Betsy Graseck with Morgan Stanley.

A couple of follow-ups here.

One is, just as we're thinking about reward costs, I know you mentioned second half of the year is a little bit higher.

I think that's a seasonal pattern.

But we've also seen a little bit of pullback in some of the competitive dynamics around rewards.

Could you give us a sense as to how you're thinking about your rewards offering, where you feel you are in your life cycle of the current rewards that you have out there and give us a sense as to what you're thinking going forward?

I'll let David speak to the life cycle comment, but I'll speak directly to the kind of what we're thinking, what we're seeing.

So the third quarter was a particularly attractive quarter in terms of the 5% rotating category, Betsy.

We chose to run restaurants in that quarter.

Whenever throughout the year we choose to feature restaurants, we tend to see a very high level of engagement with that because it's pretty easy to max out in that category, spending $1,500 over the course of 3 months.

So that would be the driver of what you saw in that quarter.

This quarter what you've got is principally Amazon is the big driver.

We typically tend to do that as a fourth quarter promotion around the holiday season.

It tends to also be more costly than what you would have seen really in the first half of the year.

So I would say, based on the level of engagement we're seeing right now, we've been running these programs for a while, we're generally pretty good about getting our arms around where we think we're going to come in, I'm not losing any sleep whatsoever about coming in certainly in line with that 126 to 128 guidance.

And Betsy, I would say that while there still will be some upward bias going forward as we continue to have a higher mix of Discover it customers versus Discover More customers in the portfolio, we really kept our discipline a year ago.

And so what you're seeing is, if the competitive intensity slowed just a bit in this category, we stayed the course and we're seeing the benefit with the better marketing results and less attrition as some of the crazy stuff comes away.

Our absolute -- my guess is we're probably 50 basis points or more below a number of cash back competitors in terms of cost.

And so I feel it's a very sustainable place to be, and we're just happy that we're able to drive revenue and stay the course.

Okay.

And then just separately, Mark, you mentioned about the potential to refi the pref in 4Q.

Could you just give us a sense as to what's going to drive your go/no-go decision and then what the benefit is to EPS?

I know you outlined the hit to EPS in the fourth quarter, but the forward ongoing benefit, can you speak to that as well?

Yes.

So what would drive the go/no-go decision would obviously be market conditions, Betsy, and just having an open window where we didn't have something that would cause us to not be able to issue.

Some type of a corporate event or corporate news or something can also end up closing windows.

I would say at this point in time, I don't have in front of me the full run rate EPS impacts.

What I would say is, just on a pure coupon basis, the last numbers I saw would show we benefit by at least 100 basis points in the coupon.

So it's a pretty significant pickup in benefit.

The first call date that we have available to us is December 1 on the existing pref.

So we're studying it intensely.

And obviously, keep your eyes on a Bloomberg terminal, and if we end up doing something you'll see it there first.

Your next question comes from Moshe Orenbuch with Credit Suisse.

Can you talk a little bit about kind of the texture of the loan growth in the card business?

I mean, has it primarily been existing customers?

You mentioned a couple of questions ago about the promotional rate piece.

I mean, how much of it is coming from new customers?

And kind of any other kind of details you'd be willing to provide.

I can give you some pretty concrete data on that one, Moshe.

I would say, from my perspective, a couple different things.

This quarter, it's about 50-50 from new customers and from the legacy back book.

We view that -- we like to keep that bouncing somewhere between, call it, 30-70, 70-30.

50-50 sounds just about perfect if you could always end up there, because it tells me that the customer is -- the new customers are coming on board and seeing value in the offering.

It also tells us that the legacy back book customer is choosing to continue engaging with the Discover product in a top of the wallet fashion, right?

So both of those are critically important, because in the long run all our existing customers will die.

Not to sound morose, but they will.

So you have to attract the new customers.

By the same token, if you just have a revolving door trying to get new customers because your legacy customers disengage, you have a problem.

So feel really good about the health there.

I would say by far and away the biggest driver of the volume growth this time around for both categories was standard merchandise spend, Moshe.

So yes, promos are a piece of it.

We've actually used promos a little bit more aggressively to stimulate the back book, but even there, standard merch spend is the big piece.

Got it.

And the follow-up, I guess, particularly since Discover is responsible for a couple of the large personal loan portfolios that are out there in the industry, maybe just a little more detail about the -- what distinguished these customers that you kind of decide -- I know it's a small -- a single-digit percentage, but what -- were they at one end or the other of the credit spectrum?

Were they acquired in a particular channel?

What brought them to your attention other than...

Yes, I'm going to be a little bit coy on that one, Moshe, for competitive reasons.

We really don't want to say specifically "It was exactly this." I think what we have said is it was the broad market channel where we see these folks.

It wasn't a cross-marketed, cross-sold channel.

So I would re-highlight that.

The other thing I think we have said, not on the call today, but we mentioned it earlier in the quarter, so I would highlight that again, is I think we said one specific factor we'd seen that was a tag of underperformance is where somebody already had taken out another personal loan, right?

So that was one characteristic of -- call it a recidivist, would be one piece.

Beyond that, I would give you comfort in saying the size of the book here that's affected is pretty darn small.

Again, I think I said earlier we didn't size it, but if we did, it would be low single-digit percentages of the overall book.

And we think we have the issues largely behind us.

And certainly we have it ring-fenced.

But for competitive reasons, I don't think we want to say exactly it was this and this and this.

Your next question comes from the line of Ken Bruce with Bank of America Merrill Lynch.

My question, first question relates to growth.

I guess there's been a lot of discussion around folks pulling back and the market becoming a little less competitively intense.

You look around and at least most of the large issuers are still growing well above what the industry is.

So I'm always a little perplexed as to exactly kind of where this growth is coming from, if it's the cutback has been on maybe the lower end of the prime and this is just really kind of the re-engagement of revolving credit by prime borrowers, or if there's any kind of change in the composition of what the market looks like today.

No, it's a fairly -- I mean, the top 6 issuers represent a high percentage of the total business.

So I would say you average them together, you're going to get pretty close to the industry average.

So I'd say a few people have slowed down their growth, but where we've seen the bigger change is probably how much marketing and what the marketing was.

And frankly, I think there were some crazy offers out there that was leading to, a year ago, a lot more shifting of people from one issuer to another.

So it was maybe a little bit of a zero-sum game where people were just paying more rewards and moving balances between them.

And so I think that if we look at the level of what the bidding for terms on the Internet marketing are, it's come down this year versus a year ago.

Direct mail volumes, particularly in the cash back segment and the sub-prime segment, which we're not in, have had probably the 2 greatest reductions in new account offers.

And then you've also seen some well-publicized headlines of some people that have pulled back from some offers that I think they actually admitted were too rich.

One of the things that happened a year ago is there was a lot of -- a lot going on in the warehouse club space.

And you had both Costco -- the people that were losing that relationship were fighting hard and the people who were gaining that relationship were fighting hard.

Visa was accepted at Sam's Club for the first time, and that particularly impacted us because at one point it was an exclusive.

So some of those headwinds have abated for us.

And that probably helps -- it's not that the market has slowed.

Actually, the market has kind of kept up, and that makes it easier for us to grow, but there's less shifting, and our marketing is more effective relative to the others.

Yes, we actually tightened our credit criteria for cards at the end of last year.

So we're actually upgrading into a tighter box now than we were last year.

Right.

That's -- we hear that basic tenet from others as well, and that's why I'm a little curious as to why everybody's growing faster today than it would appear the average is.

But I understand David's point that there's a couple of high profile slow growers out there.

My follow-up question just relates a little bit to -- as a follow-up to the comment around the personal loan risk layering that you saw.

You referenced something similar a couple of quarters ago on the credit card.

With late-stage delinquencies you'd seen higher levels of indebtedness.

Can you maybe kind of step back and give us any sense as to whether you think there's parts of the consumer business, whether your own or just more broadly, that you see this increase in leverage that's occurring?

I think the increase in leverage is really across the consumer spectrum broadly.

I think it's most prominent in the sub-prime space where we don't really play.

But if you think about it in the prime revolver space, there was a Fed study out there, I don't know exactly where to point you because I don't remember exactly when it was, but it basically took a look at coming out of the crisis indexing levels of consumer indebtedness to 1 and then kind of showing by product what those levels are at today.

And I think card was like at a 1.06.

I think autos, personal loans and federal student loans were the principal drivers of that increase in leverage.

So I think it's a driver.

When we look at our portfolio across the board, our incidence rates, that is, the number of accounts -- expressed as a number of accounts as opposed to a number of balances, our incidence rates of delinquencies are darn near flat across the book.

We really don't see meaningful movements there.

What we're seeing is increases in severities, because when a customer does go bad, they are more indebted, and therefore higher losses.

So maybe the arithmetic way to think about it would be the probabilities of default really haven't changed much.

The loss given a default has changed, just as consumers are carrying more leverage.

But it's still below the levels that you would have seen precrisis.

And meaningfully, the debt-to-income ratios of the consumers are in far better shape now.

They don't have exploding ARMs that are going to be ticking time bombs.

The leverage they have built up is more largely in fixed-rate product.

So it feels -- the leverage there feels much healthier.

The thing I would add from an industry perspective is a year ago we were seeing very high growth rates in auto loans, and that's really flattened out from last year to this year.

We had been seeing several years of rapid growth in federal student loans, and that has flattened out.

Credit cards hadn't grown that much on loans, single-digit levels, but the credit card lines outstanding had been growing quite rapidly for a couple years as people were chasing some of those transactors in particular.

But this year, we've seen very flat total cumulative credit card loans for the industry.

And so I think all of those things show that there was kind of a recovery after -- some releveraging, some recovery in both supply and demand for a couple years, and then this year it's really flattened out.

There are no further questions at this time.

Okay.

Thanks, everybody, for your interest, your questions, and of course we're available for any follow-up that you have.

Thanks.

Good night.

This concludes today's conference call.

You may now disconnect.