發現金融 (DFS) 2017 Q4 法說會逐字稿

Good afternoon.

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

At this time, I would like to welcome everyone to the Q4 2017 Discover Financial Services Earnings Conference Call.

(Operator Instructions) Thank you.

I will now turn the call over to Craig Streem, you may begin your conference.

Mike, thank you very much.

Welcome, everybody, to this afternoon's call.

I will begin on Slide 2 of our earnings presentation, which you can find in the financial information 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 also on file with the SEC.

In the fourth quarter 2017 earnings materials, we've provided information that compares and reconciles the company's non-GAAP financial measures with GAAP financial information and, of course, 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 remarks from David Nelms, our Chairman and Chief Executive Officer, covering fourth 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, we will, of course, have time for a Q&A session.

(Operator Instructions)

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

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

Before I get into my review of our full year 2017 results and accomplishments, I'd like to comment on the recently enacted tax legislation.

While the new law did have a negative impact on our fourth quarter results, which Mark will discuss later on, I am truly excited about the clear benefit to Discover's future earnings and the ability to make incremental investments in our business, our people and the community in which we do business.

I also believe that the legislation will stimulate economic growth in 2018, which will tend to benefit consumers and Discover.

Now let's turn to Slide 3 and get into our review of full year 2017 results and key accomplishments.

In 2017, we delivered earnings per share of $5.42 and a return on equity of 19%, which included a number of onetime items primarily related to the passage of new tax legislation.

Adjusting for these charges, EPS was $5.98, which was in line with our expectations.

Benefiting from the ongoing strength in the economy and, more specifically, on our own ability to deliver attractive products to our customers, we accelerated revenue growth in 2017, resulting from faster loan growth and a disciplined approach to credit.

Our card portfolio loss rates have risen but remain well within our risk-adjusted return parameters, and the economic outlook for consumers remains favorable.

I'll talk more about loan growth and credit trends a bit later.

In Payment Services, our PULSE, Diners Club and Network Partners businesses all drove increases in volume and revenue while reducing operating expenses.

I'm pleased that volume for the segment was up 12% year-over-year, which contributed to a healthy increase in profit before tax.

In PULSE, growth continued to come primarily from our core point-of-sale business and was driven by merchant and acquire routing decisions as well as the addition of new issuers and incremental volume from existing issuers.

In Diners, some of our newer franchises made meaningful contributions to growth in 2017.

Shifting to expenses.

In 2017, we continued to make important and impactful investments in our people, marketing and technology to drive growth and new capabilities, resulting in a 5% increase in operating expenses.

Our Direct Banking strategy produces an efficient operating model, resulting in a best-in-class efficiency ratio.

In 2017, we grew revenue 4% faster than expenses, and our efficiency ratio was 38%.

Finally, we returned $2.5 billion to shareholders in the form of dividends and share repurchases, resulting in a payout ratio of 123% and bringing us closer to our capital targets.

Moving to Slide 4. Total loans increased 9% in 2017 to $84 billion with the card business generating more than 80% of this growth.

We achieved these results by continuing to focus on prime revolvers and maintaining discipline in pricing, rewards and credit.

Card loan growth continues to come from a balanced mix of new accounts and existing customers.

The student loan business originated $1.6 billion in new loans in 2017, another record year, up 12% from the prior year.

With faster growth in the other large student lenders, we believe we are now the second-largest originator of private student loans in the country.

We continue to expand our presence in the student loan market, focusing on early awareness with the website, collegecovered.com, designed to help students and their families prepare for making decisions about college and how to pay for it.

Personal loans remains an important part of our product offering, generating strong returns while providing a helpful tool for customers looking to consolidate debt and manage their finances.

As we have discussed the last several quarters, we've taken actions to curtail growth in some segments, and we expect that the growth rate in personal loans will continue to slow.

Our strategy will remain focused on originating profitable, quality loans.

We will not pursue growth simply for the sake of growth.

After several years of historically low net charge-off rates, charge-off rates rose in 2017, reaching 2.7% for the full year.

One factor contributing to the higher levels was higher loss severities.

The increasing supply of credit from lenders and greater demand for credit from consumers have contributed to rising debt levels and larger losses when a customer defaults.

Consumer debt service burdens, while rising, are still near historic lows.

But while consumers are releveraging, both creditors and borrowers are still generally behaving responsibly.

The other factor playing a role in rising net charge-offs is the seasoning of growth.

In fact, each vintage since the crisis has been larger than the preceding vintage for us, which, while driving revenue growth, also puts upward pressure on net charge-offs as each new vintage reaches peak losses.

Of course, our commitment to disciplined, profitable growth in the prime revolver segment remains unchanged, and we're quite comfortable with how those vintages are performing.

As we think about tax reform, it not only enhances our current profitability but also affords us the opportunity to build incremental shareholder value by investing further in growth, our people and the community.

The first investment we made was in our people.

All nonexecutive full-time employees, over 15,000 people, received a onetime $1,000 bonus to recognize the critical role they play in delivering exceptional service to customers.

Further, later this year, we will be increasing our starting hourly wage to $15.25 for all full-time U.S.-based employees.

We expect our shareholders will benefit in the long term from these incremental portfolio growth initiatives and investments in our people.

In summary, our consistent focus on the customer, strong momentum across our businesses and favorable economic conditions continue to drive strong revenue and loan growth and profitability.

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

Thanks, David, and good evening, everyone.

I'll begin by addressing our summary financial results on Slide 5.

Earlier today, we reported earnings per share of $0.99 for the quarter, including a number of onetime items primarily related to the passage of new tax legislation.

Adjusted for these charges, EPS was $1.55 for the quarter and $5.98 for the full year.

Our adjusted fourth quarter EPS was nearly 11% higher than last year's comparable period.

Looking at key elements of the income statement.

Our 11% revenue growth in the fourth 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.

Operating expenses rose 15% year-over-year, driven by investments to support new growth and capabilities as well as an unusually low level of expenses in the fourth quarter of last year.

Turning to Slide 6. 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 in card receivables, spurred by strong sales growth, particularly among revolvers.

Promotional balances also contributed to growth.

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

Personal loans increased 14% from the prior year, down from the peak of 22% in the second quarter of 2017 as a result of the tightening of underwriting standards in certain segments that we've talked about for the last several quarters.

We expect that personal loan growth will continue to slow in coming quarters as a result of these changes.

Private student loan balances rose 2% in aggregate, but our organic portfolio increased 11% year-over-year with strong performance during 2017's peak season.

Moving to the results from our Payments network.

On the right-hand side of Slide 6, you can see the proprietary volume rose 7% year-over-year, driven primarily by an increase in active Discover Card accounts.

In our Payment Services segment, PULSE volume growth continued to increase with 19% higher volume compared to the prior year.

Diners Club volume rose 14% from the prior year on the strength from newer franchises.

Moving to revenue on Slide 7. Net interest income increased $228 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 up $28 million as a result of increased card sales volume and a slightly lower rewards rate this year resulting from changes to the rotating 5% category we opted to feature in the fourth quarter.

Discover Card sales volume showed 9% growth this quarter in part due to a greater number of processing days in 2017 when compared to 2016.

If we adjust for the number of processing days, sales growth would have been closer to 6%.

We expect to see the reverse impact in the first quarter of 2018.

As shown on Slide 8, our net interest margin rose 21 basis points from the prior year and was flat sequentially, ending the quarter at 10.28%.

Relative to the fourth quarter of last year, a higher prime rate and tighter credit spreads on refinanced long-term debt drove margin higher, offset in part by an increase in promotional balances and higher interest charge-offs.

Relative to the third quarter, the impact of higher loan yields and tighter credit spreads on new long-term debt were offset by higher charge-offs and deposit rates.

Total loan yield increased 26 basis points from a year ago to 12.14%, driven by a 17 basis point increase in card yield and a 63 basis point increase in private student loan yield.

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

Higher short-term interest rates drove 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 7 basis points sequentially and 18 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 9. Operating expenses rose $139 million from the prior year's unusually low level.

Employee compensation and benefits was higher, driven primarily by higher headcount to support business growth, the $16 million pretax cost of the onetime bonus granted to eligible employees David mentioned a moment ago, higher average salaries and adjustments to reflect changes in certain compensation policies.

Marketing expenses were higher as a result of higher acquisition costs and increased brand advertising.

Professional fees were also higher as we continued to invest in digital and mobile capabilities as well as advanced analytics and machine learning technologies.

I'll now discuss credit results on Slide 10.

Total net charge-offs rose 54 basis points from the prior year and 22 basis points sequentially.

For the full year, the total net charge-off rate was 2.7%, which is at the low end of guidance we provided in the second quarter call.

As we've talked 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 56 basis points year-over-year and 23 basis points from the prior quarter.

Private student loan net charge-offs rose 3 basis points year-over-year and fell 11 basis points sequentially.

Personal loan net charge-offs increased 92 basis points from the prior year and 43 basis points sequentially.

As we indicated last quarter, we identified several segments in the broad market personal loan book that were not performing in line with expectations and took actions to curtail those originations.

Last quarter, we told you that we expected up to $30 million in incremental exposure over the remaining lives of these loans, and $10 million of this amount is reflected in the fourth quarter reserve build.

In addition, you can see the impact begin to flow through the net charge-off rate in the fourth quarter.

The personal loan net charge-off rate is also impacted by the denominator effect associated with pulling back on originations in the affected segments.

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 15 basis points sequentially and 23 basis points year-over-year.

Looking at capital on Slide 11.

Our Tier 1 common equity ratio declined 90 basis points sequentially as loan balances grew, and we returned $657 million of capital to shareholders through common stock dividends and share repurchases.

To sum up the quarter on Slide 12, we generated 9% total loan growth with a significant contribution from all 3 of our primary lending products.

Our consumer deposit business posted equally strong growth of 10%, while deposit rates increased 18 basis points.

With respect to credit, while our charge-off rates have risen as credit conditions normalized in loan season, they remain below historical norms and well within our return targets.

And we are 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 11% revenue growth and a 2% increase in profit before tax despite ongoing credit normalization.

In addition, expenses remain well managed, though they were elevated this quarter due to the timing of investments in growth and technology.

I'll now move to 2018 guidance on Slide 13.

We've established a loan growth target range of 7% to 9% based on opportunities that we see to continue driving disciplined, profitable loan growth.

As we've discussed, the actions we've taken will result in continued deceleration of growth in the personal loan business, so achieving our overall target will require relatively greater contributions from both card and student loans.

In order to support that level of loan growth, we expect operating expenses to be in a range of $4 billion to $4.1 billion next year.

This reflects higher base levels of expenses to support growth in the business as well as continuing investments in digital and mobile capabilities, advanced analytics and machine-learning technologies.

Planned operating expenses for the year include the reinvestment of 20% to 30% of the year 1 savings from tax reform.

Roughly 3/4 of this amount will be reinvested in marketing and other initiatives to spur incremental growth with the remainder allocated to investments in our people and our communities.

We expect the rewards rate to come in between 128 and 130 basis points for 2018.

We've enhanced some of the 5% rotating categories this year, and we're also making further improvements to the customer experience.

In addition, as we originate all of our new accounts from the Discover it platform, the portfolio mix will continue to shift towards the Discover it product, which has a slightly higher average rewards rate.

Competition in the rewards base did seem to plateau last year.

However, it remains to be seen how peers may choose to invest the benefits of tax reform.

Moving to our outlook for net interest margin.

We expect it to increase and be between 10.3% and 10.4% for the full year 2018.

The prime rate increase from December of last year is not fully reflected in fourth quarter results due to timing, and that alone should result in NIM expansion in 2018.

Further rate increases would also result in NIM expansion due to the asset-sensitive position that we've built into the balance sheet, and we're currently expecting a couple more based on the market-implied forecast.

Somewhat offsetting the benefit provided by the rate environment will be higher deposit betas and modestly higher interest charge-offs.

We expect the total net charge-off rate this year to be in a range of 3% to 3.25% as a result of continued supply-driven credit normalization as well as the seasoning of a growing portfolio.

Let me reiterate that the overall consumer credit environment remains constructive.

Finally, we expect a significant drop in our effective tax rate as a result of the Tax Cuts and Jobs Act.

In 2018, we expect that our effective tax rate will be approximately 24%.

In conclusion, we're pleased with our performance in 2017 and are looking forward to continued momentum in 2018.

That concludes our formal remarks.

So now I'll turn the call back to our operator, Mike, to open the line for Q&A.

(Operator Instructions) Your first question is from David Scharf from JMP Securities.

First one is I want to -- with the benefit of 3 more months having passed since last quarter's commentary and pulling back on the personal loan growth, obviously, the outlook for card and student loan growth remains very robust in your guidance.

And I'm just wondering, is there anything in the personal loan borrower profile you see that often serves as any kind of leading indicator of credit and other payment patterns for your other products?

Yes.

We think a fair amount of the -- what we're seeing in personal loans has to do with a lot more growth in supply.

Most -- many of the fintechs that are out there in the lending business are focused on this product in part because it's the easiest product to offer compared to a credit card or a student loan, much more operational -- easier operationally.

And so we think that, in some cases, there's been an oversupply of credit, and we're reflecting that not only in our personal loan business but also in our credit card business where we see the incidence of personal loans and maybe higher debt levels that may impact their people's performance across-the-board.

So it is on average a more indebted consumer because sometimes people get a consolidation loan from a competitor and then maybe not reduce their original balance, so they end up with a higher balance and the same income.

And we're not sure that FICO fully picks up this effect because it's a fairly new phenomenon, and FICO scores take a number of years to really even out with -- when there's been a big change in supply or demand of a type of loan product.

So I might just tag on to that, David, by noting that we do expect we will continue to grow the personal loan portfolio, albeit at a slower rate, I think is what we were telegraphing in our commentary.

We've said pretty consistently over a number of years that this is a product where attempting global domination can be challenging and you have to be disciplined.

And I think at the end of the day, the actions we've taken reflect that discipline.

They were isolated in a few segments, right.

It wasn't the personal loan book more broadly.

It really is a few segments where we're seeing this disconnect.

And I think it highlights we're managing it prudently.

And just -- sorry, one more on it.

I would just point out that it's very profitable for us, which is in contrast to some of the other players who are not making money even in a very attractive part of the cycle.

So we're pleased overall.

It's really just one segment, as we mentioned, of about 5% of the portfolio that we saw unacceptable performance and we took action on.

Okay, that's helpful.

And maybe just a quick follow-up on the rewards side.

You highlighted that it still remains to be seen whether or not -- the plateauing we saw over the course of the last year, whether that might reverse itself if some competitors decide to deploy some of the Tax Act savings towards the rewards wars again.

I'm just curious, do you feel like you may have built in a little bit of a cushion in the rewards rate guidance for this year?

Or is that potentiality still something that's just an unknown, and we'll have to wait and see?

No, we -- there's no kind of a cushion built in there, David.

We try and give our best guidance at the time we give it, and that reflects what we expect to be going on in the business this year as represented.

The next question is from Sanjay Sakhrani with KBW.

Mark, question on provision expense for 2018.

I appreciate the charge-off rate guidance.

But obviously, a lot of the provision expense this year is likely for next year's charge-offs, and some of the growth map impacts sort of kick in at that time.

Could you just talk about how we should think about the adequacy of reserves as we move through the year as it relates to sort of your expectations?

And then also just the range on the charge-off rate.

Could you just talk about what gets you to lower end versus the higher end?

Is the expectation -- is there a buffer built into this range?

There's a lot in there, Sanjay.

I'll try and touch on it all.

If I miss anything, come back [indeed.] The first thing I would touch on is just is there a buffer in that range.

I would say, similar to the comment I just made to David on the rewards right now, I mean, when we give guidance, we try and give the best range of guidance we possibly can.

So there's no buffer built in there.

It reflects our best expectations of where we think the business will end as we move forward.

I would point out that, if you think about that, we saw 54, 55 basis points of increase in our charge-off rate this year.

If you take a look at the guidance we're giving right now, you'd have to hit the very high end of that range to see a similar increase in charge-offs in 2018.

So I think there's an element of that, that should probably reflect on how we think the business is likely to perform over the course of the year.

In terms of thinking about provisions, we don't provide guidance on provisions.

So I have to be really more circumspect around the answer to that one, unfortunately.

I guess, what I would say, Sanjay, is I think about a couple different things.

First of all, I would say, we manage credit very much with a through-the-cycle, risk-adjusted return focus.

So it really governs who we targets, the acquisition costs will extend, how much credit will extend, how we're going to price for the rest.

We could manage to an arbitrary charge-off level, but that would probably leave a pretty significant amount of money on the table.

So if we think about transitioning to that in the provisioning, the way to think about it is the losses that are on the balance sheet today that we expect to recognize over the coming 12-month period of time.

So one piece we did give a little bit of guidance in my comments I can speak to, maybe help you think through it, as we said specifically on that personal loan, the subsegments in the personal loan book, last quarter, we said we expected $30 million of incremental exposure associated with that, right.

We took -- $10 million of that was reflected, we said in our comments, in the reserve rate this quarter, right.

So that should imply to the listener that a further $10 million of that $30 million of incremental exposure we expect to recognize over the course of the coming 12 months, right, from where we sit today.

So that additional $20 million piece is still out there.

So we're looking at loss content on the balance sheet.

We're reserving for what we see coming at us in the coming 12 months.

And we feel, in all respects, our reserves are adequate in conformity with GAAP, and we're very comfortable with their current levels.

Okay.

On the NIM, you guys are sitting here in the fourth quarter at the low end of your guidance range, and you mentioned that you're expecting a couple of rate hikes and you're asset-sensitive.

Could you just reconcile that with the NIM range you've given?

Sure.

So as we sit here right now, I would say the fourth quarter, Sanjay, doesn't really reflect the impact of the move in December because you don't get the card accounts repricing until their next cycle date after that prime rate move.

So you'll really see the benefit of the December rate increase in the first quarter of this year.

The other thing I would say is we continue to be positioned to be asset-sensitive, continue to expect that further rate increases will benefit us.

The one thing that's a little bit different than at the time we gave guidance last year is, this time last year, deposit betas were exactly 0, I believe, or close to it.

As we sit here today, I think on the savings product, the cumulative beta now is at 36 -- 35, 36 something like that.

So deposit betas will chew into that a little bit.

So I would expect you'd probably see as a rubric, think of about 7 or 8 basis points of margin expansion associated with every 25 basis point movement that we get from the Fed.

Other [impactor] to that, obviously, is, as we see slightly higher charge-offs, we'll see slightly higher charge-offs of accrued interest as well, so that will also contribute to that muting effect, getting us down to that 7 or 8 bps.

Your next question is from Bill Carcache from Nomura.

Mark, I recall you using the term bumping along near the bottom during those years where the year-over-year change in delinquency rates was hovering near 0 and would periodically bounce around.

And I wonder if -- when we look at the year-over-year change in delinquency rates today, they're certainly not continuing to inflect up and to the right.

They're actually -- they seem to be on a downward trajectory.

Some months, they kind of may go up a little bit but then kind of move sideways.

Could you comment on the overall trajectory of how should we be thinking?

Is there kind of a downward bias to that year-over-year change as we look forward from here, given, a, the healthy macro environment that we're in; b, the fact that you serve prime customers; and I guess, all else equal?

Yes.

I guess, Bill, there's, again, a lot embedded in there.

Grab me if I missed any of it.

I guess, what I would say is, I pointed out a second ago in response to Sanjay that our guidance for charge-offs.

We'd have to hit the very upper end of that range in order for us to match the increase we saw this year and, obviously, delinquencies are a precursor to charge-offs, right.

So I think a reasonable person could come to the conclusion that we do see a little bit of flattening in the trajectory there.

I think you saw that reflected in our reserve build this fourth quarter versus last fourth quarter, right.

The reserve build was lower despite the seasonally high level of balances in the fourth quarter as delinquency -- growth in delinquencies moderated, right.

So I think that is something that is reasonable now.

What I would say is that can change from time to time.

So at the end of the day, there's lots of factors.

I always encourage people, really, if you're looking for returning credit, watch delinquency trends over a period of time.

Don't just react to point estimates in delinquency trends.

Watch macroeconomic trends through time, again not just reacting to point estimates, and then always ask about incidence rates in the portfolio, right.

And if we think about our card product, our student loan product, our incidence rates are darn near flat, personal loans also very flat if you pull out those segments.

So that implies a degree of stability there.

So given your comments, Mark, and the fact that we're growing off a larger base of reserve building in 2017, is it reasonable to expect that the reserve build in 2018 will be lower than '17 and, all else equal, that, that trajectory should continue as we look forward from here?

We don't guide on provision, Bill, so I got to disappoint you on that one with apologies.

So I can't comment on the trajectory.

I think put the pieces together and you can come up with your assessment, but I have to stay silent on that one.

Okay, understood.

Maybe lastly, if I could with my follow-up.

How should we think about operating leverage and scale benefits?

And in the rising rate environment, there's just -- there are a lot of questions on whether we can expect revenues to grow faster than expenses and, perhaps, see there are some downward pressure exerted on your efficiency ratio perhaps to the point where we can see it fall below 38%.

Can you just clarify like the rate hikes that you do have?

You have the forward curve implicit in your NIM guidance -- the rate hike look that is implicit in your NIM guidance.

That's it.

Yes.

The rate hike outlook, there's 3 hikes, April, August, December, in the forward curve that we're working off of.

And obviously, the December increase wouldn't really impact '18, if indeed it were to materialize.

So that's why I mentioned earlier we kind of have a couple more hikes in our cadence.

As far as the operating leverage question is concerned, we've seen a pretty meaningful improvement, pushing on toward 100-and-some-odd -- over 100-some-odd basis points on our efficiency ratio year-over-year.

And we delivered 9% -- or rather 4% positive operating leverage this last year with 9% revenue growth and 5% expense growth.

So we feel very good about the leverage embedded in the model and are happy to continue with a focus on managing expenses diligently and driving revenue growth in the current environment to the extent we see great credit opportunities to do so.

That's great, Mark.

If I could just...

Bill, let's make sure everybody gets a chance.

We can follow up later on.

The next question is from Ryan Nash from Goldman Sachs.

I'll make it quick.

David, I was wondering on tax reform.

We had a competitor last night who is talking about how he thought it would be competed away very quickly.

So I'm interested in your view on what you think will happen competitively.

Obviously, you talked about taking steps, reinvesting 20% to 30% in the business.

And then related to that, unless you guys are going to go tighten underwriting, I guess, this, in theory, should open up the credit box, so could this lead to better growth across the industry?

And then I have a follow-up.

Well, I think that having some faster growth in the industry would make sense because, at least the way we look at it, all of our marginal returns have just increased as we drop a lower tax rate into our models.

And that means that, that marketing, those accounts that we just missed marketing to now are profitable, meet our hurdle rates to market to.

And I would think that other issuers would find the same, and so I would expect that there'd be some further growth above whatever it would have been.

Certainly, that's the case for us.

In terms of whether things would be competed away, I think that it's likely that some will be competed away.

I personally think it would not be reasonable for it all to be competed away or for anything to happen very quickly.

I mean, this was a big change.

It's not what I view as a temporary change.

I mean, if you look at our returns, we've been averaging 20%-plus return on equities for a bunch of years, and I think that's the top of the industry.

But even the industry tends to have a better return than other parts of financial services.

And so if you just -- if you were a theorist and said, well, all excess profits get competed away, that would not be sustainable.

And it has been because we're differentiated.

We're a brand.

There's a lot of reasons.

So I think we're going just to stay disciplined post-CARD.

There's a lot more discipline post-CARD Act.

The -- some of these competitors need to drive higher returns to cover other parts of their business that aren't doing so well.

So I think we feel like, at least in the near term, it's going to be -- it's just a big opportunity for us.

Got it.

And if I could have one follow-up.

So Mark, you guys have done a great job growing loans, which has led to significant preprovisioned growth.

But obviously, substantially, all of that has been eroded by higher provisions, or you need -- had your own version of Growth Math.

So from the outside looking in, it's hard for us to see the profitability of these newer vintages.

So do you expect that on the other side of this, we will see any earnings acceleration once provisions begin to level off?

And what do we need to see for that to happen?

Yes.

I mean, I think at the end of the day, Ryan, I'd point to a couple different things there.

Number one, I would say, and we've talked about this pretty consistently, that we have a very defined rubric for how we will go after growth, right.

And our acceleration isn't so much that -- well, it really isn't in any way that we have changed our model and what we're willing to do.

It's really more reaction to how intensely competitive the market has been and what others have been willing to do, right.

So you go back a few years ago, our growth rate was below the industry for prime card receivables at a period of time when folks were willing to pay acquisition costs through a number of channels that just wouldn't work on our model.

So we had slower growth not because -- we decided to slow growth just because we weren't willing to chase what we didn't see as growth that was meeting our return hurdles.

Today, you see a lot of folks who've pulled back in that regard.

So things that met our return hurdles -- now meet those same return hurdles we had in place previously are back to meeting them.

So I think there's a discipline that underlies the way we approach these things.

And I think we've proven when we see things don't meet our profitability models, we'll pull back.

I would point to the student loan segments we talked about earlier where credit's not meeting and, as a result, the return's not meeting, and I would point to that card space where we didn't chase acquisition costs where they didn't meet our return hurdle.

So I think we've demonstrated in a couple of instances here the discipline we're applying in the way we grow.

I think you've got a sense for our acquisition strategy or decisioning strategy.

We want the returns on those investments to exceed the return on the buyback program plus the risk premium, and we're looking for them to break even inside of 5 years.

So I think we've got pretty strong criteria that governs that, that I think is pretty meaningful and should give you a high degree of comfort.

The one thing I would just add is that while you're right to point out that provision has been a headwind over the last 12 months, the very strong revenue growth and positive operating leverage has meant that the results we just reported in the fourth quarter on an invested basis have an 11% growth in EPS even during this normalization, so I think that's strong.

Your next question is from Moshe Orenbuch with Credit Suisse.

Maybe a quick follow-up on the reserving.

I mean, not trying to kind of pigeonhole you into a forecast, but if you were to just think about the improvement in the economy that you expect to come about as a result of these tax law changes and no other effects, how would you describe that effect on the reserve?

So I would say, right now, we have not factored in any expectations of improvement on the part of the consumer in our modeling and in the guidance we've provided.

I would say we're hard-pressed to see that it could produce a major negative on the borrower, but we don't know quite how to figure out yet as we're still processing through things whether there's real upside there.

Okay.

And maybe -- you started to discuss this question about other lenders kind of spending too much to acquire in your traditional or favored space and then pulling back some.

And I guess -- I mean, what -- as you put together that 7% to 9% growth forecast, what is it that you see about other lenders that gives you that confidence?

Because it's a healthy forecast, and it's wonderful, especially given that you've now been able to see the volume ramp to kind of be consistent with the growth in receivables.

So what -- from the competitive standpoint, why haven't they made better inroads?

And how do you get comfortable that that's going to continue?

Well, look, I think we've now had a full 12 months where we've seen some of the craziest stuff subside.

And the things that affected us in 2016 and caused us to grow a little slower as we maintain our discipline as some people backed off.

2017, we've had consistently strong growth, and we don't see anything in the recent trends, in even the announcements on people's first quarter calls.

I'm not hearing any restoration of huge upfront points or cash back or opening new accounts or what have you.

So I think we're going to have to keep watching through the year to see if anything restores.

But my sense is that most of these players are a little focused on getting their profits up to more reasonable levels because some of them are really low ROAs in their card business compared to us now, and I think rewards is part of it.

The other thing I'd say is everyone is having somewhat higher charge-offs, and I don't see interchange rising from here.

So I think there is sort of an upward bound where people need to both improve profitability and cover some rising credit costs.

And Moshe, I'd just tack -- and I'd just tack on to that, Moshe.

At the end of the day, if we're wrong, and if competition does reemerge and start doing things that we don't think make sense, I'd harken back to my comments of a minute ago, we'd go ahead and revise the guidance, miss the guidance, and we're going to book quality loans that make sense for our shareholders.

Our next question is from Bob Napoli with William Blair.

Just to be -- I want to be clear on the reinvestment of the tax reduction.

I mean, that reinvestment of 20% to 30% is embedded within the guidance on Page 13?

That is correct, Bob.

Okay.

And so -- and where -- and that is in the -- primarily, that's in a combination of rewards and operating expense?

So that would be specifically operating expense that we're referencing in that piece of the guidance.

And I would say from that perspective, it's about 75%, 3/4 of that benefit roughly, is going into specific investments in growth.

The remaining 25% of that windfall is really going into what I would describe as investing in our employees.

David alluded to the first piece, which was really -- the first pieces which were the $1,000 bonus, that was actually last year, the move to the $15.25 an hour minimum wage that will be happening this year and then some other things we are thinking about for our employees as well that we haven't really aired at this point in time yet as well as some investments in some of our communities.

So that's really to think through the way we're parsing it.

And we really do view those as investments in our employees, right.

When you really have a customer service, customer-centric business model that is so heavily focused on surprising and delighting the customer, part of the way you do that is by having who we think are the very best customer service contact personnel.

And paying to attract and retain those folks makes all the sense in the world to us.

It's also in the growth line where we're obviously expecting some more loan and revenue growth than we otherwise would have had even though it's a little bit lower than the very strong growth that we recently had that was far in excess of our original targets in '17.

And just my follow-up, your spend growth did pick up in your Payments business and in your proprietary businesses.

Do you sense that, that is competition pulling back?

Or do you sense that, that is somewhat a strengthening in the economy or just the marketing efforts of Discover?

I think it's a combination of things.

I would caution you that I think about us having the same day sales increase of around 6% this year -- this quarter versus the 9% that we posted just because of the number of days, and that's going to flip around the other way in the first quarter this year.

So that's -- we do want to call that out.

But we've taken some specific efforts to get sales growth up to -- closer to loan growth.

We also think that when we talk about competitors backing off of some irrational rewards programs, they were maybe depressing some of our sales growth before, and that's less of a depressor now as they're stealing fewer customers and we're getting more new customers coming into our program with more spend.

On the network side, the big growth, obviously, was PULSE.

And we had -- there was one large player that did help with the growth, but over half the growth came from a whole lot of our other customers.

And we're pleased that after several really tough years that the PULSE is back to some really nice growth.

Your next question is from John Hecht with Jefferies.

Mark, I guess, we've been talking about normalization for quite some time now.

And we're still below long-term charge-off averages, but we're starting to get in the zone.

I guess, from your perspective, is '18 the year that we're fully normalized?

Or do we hit normalization in the cycle below long-term averages?

Or how do you just think about the trajectory of credit?

Yes, I think just being intellectually honest, I don't think anybody knows where new normal is until we go through a cycle because none of us have been here post-CARD Act to understand how the much more disciplined behavior across the industry is going to impact some of that.

I think what we've said in the past is that we clearly see losses this cycle being lower than what you would have seen in normal cycles because they were so low for so long and the industry has been very disciplined.

Clearly, at this point in time, I'm not going to call -- we're not going to call when we think the cycle will actually reach a normalized peak or a normalized point.

What we do know is we are not underwriting to anything like the current loss rates we're seeing.

We're underwriting to what we believe through-the-cycle loss rates embedded in that book -- embedded in those accounts to be.

So our originations, our underwriting, our credit decisioning has never been tied to where we are at a point in the cycle.

So we're taking a long view and originating stuff that, in our acquisition modeling, drives very profitable long-term returns in very different environments than we're in today.

Okay, that's helpful.

And then second question is related to the growth guidance, the loan growth guidance.

And forgive me if you've provided details.

Is there any change in the composition of whether it's line advances or new customers or maybe utilization rates?

Or is that fairly consistent in terms of the composition of that this year versus last year?

So the composition in the card side, it's about close to 50-50 on growth coming from new accounts as well as from the portfolio, which is, in our minds, very healthy because you want growth to come from your legacy customers.

You don't want them to think they've disengaged.

You also want to attract new accounts that exhibit the right behavior.

So that feels real healthy to get a balanced mix.

The other thing I would say is, with respect to the businesses overall, the one thing I did call out, in case you missed it, is I did say the growth rate in personal loans will decelerate.

So a greater portion of the growth going forward would be picked up by card and student loans.

Your next question is from Rick Shane from JPMorgan.

Most of my questions have been asked, but just want to revisit that growth composition a little bit.

Mark, you said private -- or excuse me, that the personal loan growth is going slow.

The organic growth for the industry on personal -- or private student lending is about 5%.

So I'm curious, do you think that you're going to go above that?

Or is the conclusion that really the bulk of the growth is going to come from the U.S. card business?

I would say that the bulk of our growth is going to come from the card business just because of size.

And I think -- I would expect that in the last year, as I mentioned, we think we grew faster than the other large student loan businesses -- competitors and moved into second place.

I would expect that we would try to continue to grow somewhat faster than the industry in student -- in private student loans this coming year, not triple the rate kind of thing but faster as we did this year.

And card, the same way.

And as we mentioned, personal loans, we think we're probably still going to grow, but it'll just be at a much lower rate than we have in the last 2 years where we had much higher growth in that business than any of our other businesses.

Got it, Okay.

And what I'm really trying to draw out is, of those 3 businesses, it strikes me that the only one that's actually going to be above that 7% to 9% growth rate could be U.S. card.

Student loans could be as well.

I mean, if you take out the acquired loans, it was above that level as well.

Our organic portfolio grew 11% this past year.

Your next question is from Betsy Graseck with Morgan Stanley.

Two questions.

One on digitization.

I think you mentioned that some of the investment spend that you'd be doing is around digitization.

I think your app's pretty well highly rated.

So wondering what plans you have there, what's your looking to do with that.

We're very pleased to have been recognized as the top app and tops in -- by consumers and by independent groups, J.D. Power, who looked at digital capabilities of us versus competitors.

And we need to keep investing in enhancements, make things simpler, add functionality to consumers.

Just as an example, I think Apple yesterday announced a new business messaging, and we were 1 of only 2 financial institutions in that initial launch.

And so having additional digital ways for our customers to communicate with us and manage their accounts and manage their security with the alerts that we've put in this past year, as an example, we're going to be heavily investing in all of those.

The other thing I think about is that Mark mentioned some investments in areas like machine learning and artificial intelligence and so on, and we're using those increasingly in our call centers to help with compliance, efficiency, effectiveness to aid our customers.

And so even the sort of traditional phone service is being impacted by digital, recognizing what people are saying and then queuing up suggested [scripts] information and so on.

So it's a fantastic trend for us, and it was a big part this year of that positive operating leverage with revenues growing faster than expenses.

Okay, all right.

That's helpful.

And then secondly, on the dividend.

Could you give us a sense as you're thinking -- I know it's CCAR period, and we don't know what the rules and tests are going to be, but maybe you could help us understand how you're thinking about the payout ratios, dividend, especially going into next year.

Do you think that you keep the dividend going in line with earnings growth, and so payout ratio is similar to what it is now?

Or do you feel like, given where the stocks have gone, there's more of an [inship] on the divi payout versus buybacks?

So without being too specific because I don't want to guide on that topic, what I would say is we've established a track record of increasing the dividend.

And I think we've also said publicly, our goal is to be an S&P dividend achiever, and I think that takes 10 years of consistent movement of the dividend.

So I think it's -- a reasonable person should be assuming we're thinking about adjusting that dividend as we look forward.

One of the really perverse things, Betsy, that's -- no gift comes without a dark side, I guess.

If you think about tax reform, it actually has an unintended consequence in its interaction with CCAR.

Specifically, it's going to increase losses in stress scenarios because you're going to have a larger after-tax loss due to the lower tax rate and you're going to have a larger disallowed DTA as NOLs can only be carried forward now that tax law limited carrybacks.

So I think it's likely that stress capital consumption for the industry goes up unless the Fed changes their instructions, particularly around the Fed's severely adverse, what some people refer to as the brain-dead scenario.

In a -- in the 2018 instructions, if they don't revise those, I think there could be some impact.

We were encouraged by commentary coming out of the Fed publicly that they're looking at this.

So we're hopeful that there won't be a real negative impact coming from that but remains to be seen exactly what that will be.

The good news is repurchases for the first 2 quarters of this year are governed by the existing CCAR filing that we did last year and don't see any reason we would need to make any change there.

So again, none of this would mean we wouldn't be in a position to move the dividend.

None of this would mean we wouldn't be in a position to return capital.

It's just a perverse interaction that I thought you all needed to be aware of.

Your next question is from Ashish Sabadra with Deutsche Bank.

My question was about the card reserve build, you talked about that moderating.

The reserve rate also declined, specifically for the card business, from 3.29% to 3.19%.

So just want to better understand what drove that decline in the reserve rate?

Is that delinquency data that you were talking about, the monthly delinquency data coming in better than expected?

And just what drove that improvement, in your view, from third quarter to fourth quarter?

Yes.

So I'd just remind everybody, just so everybody keeps in mind that we don't manage to a reserve rate.

It's a mathematical outcome of how we establish reserves, right.

So we're basically reserving for the loss content we see embedded on the balance sheet in the 12-month forward period, and then the reserve rate kind of falls out.

I think that said, you're on the right track.

One of the big impactors was what we saw happen with the rate of delinquency -- the increase in the rate of delinquency formation and the trends therein.

We also, the loss forecasting models, look at 100-some-odd variables, I don't remember the specific number here.

But there were a couple others in addition to delinquencies that caused us to set the reserve where we set the reserve.

But again, as I said earlier, feel very good about the level of the reserves, think it adequately reflects the loss content embedded in the portfolio today, and we're encouraged by the trends and the rate of delinquency formation.

That's helpful.

And then my question was going to be about growth, just a follow-up to earlier questions asked about the growth in the card business.

Is there a way to think about how much of it comes from existing versus new customers?

And when you think about capturing new customers, are you thinking about expanding your credit box just because of the stimulus that we're going to get from the tax reform?

So any thoughts there?

So I would say the breakdown in the growth in the portfolio, it's right now roughly 50-50, new accounts and legacy portfolio, which feels really healthy to us.

So we're very pleased with that.

In terms of any expansion to the credit box in relation to tax reform, I think our perspective is, you live with bad credit decisions for an awful long time.

It's a lot easier if your return hurdles move to, say, maybe I'll spend a couple shekels more for every account I bring in or something like that, than it is to convince yourself that you can start opening up the credit box dramatically.

So I would think incremental investing we would make would be really more toward the advertising and acquisition cost side of the equation.

The next question is from Chris Donat with Sandler O'Neill.

Just wanted to ask one on expenses and see if I could parse out some of the movement on the income statement for 2018 with your guidance because it seems like you will be having some higher compensation expenses related to the activities like the -- and I don't imagine some big number but for the minimum wage employees, and then you've got the investment in there.

What are the sort of offsets there?

Is there anything you're expecting to reduce going forward?

Or is it just the numbers aren't that big on the investments off the $3.8 billion base you had for 2017?

Yes.

I would say I think our goal is to remain very disciplined in what I would call the core service delivery areas, and I'm thinking that really more the support functions within the company.

And so that the incremental lift you're seeing is really outwardly focused on those folks who actually support the revenue growth in the call centers and the like with that minimum wage increase as well as that increased marketing and advertising expense we talked about earlier.

So clearly, the comp piece to our employees is something that, let's just say, wouldn't have a real big toggle lever associated with it.

Some increased marketing spend and what we're willing to put toward brand advertising and acquisition cost, if you saw the environment turn on you, those are things you could pull back on pretty quickly.

And I would just add, I think you were kind of implying why aren't expenses up more if you've got reinvestment in there as well.

And I would say you could conclude that our base plan involves some fairly aggressive expense management while still growing the revenues.

And so -- and one of the reasons, things like the reinvestment with employees to a higher minimum starting pay, is it bigger, is because we expect some real benefits from that as well.

Turnover is very expensive.

We spend a lot of money on training and so on.

The quality of the calls matters a lot to us, and so we actually expect some paybacks in terms of attracting and retaining talent that can help support these revenues.

And that's why, to some degree, tax reform passing on to employees is partly because we need more -- we need people to really help grow those revenues to achieve the higher returns over time from the additional investments we're making.

So we think it's -- we do think of it as an investment, not just kind of slicing out a piece of the pie.

Your next question is from John Pancari with Evercore.

On the tax reform reinvestment, the 20% to 30%, what is the time frame of that?

Do you think it will be 100% in the run rate by the end of this year?

Do you think there'll be some carryover into next year?

No.

I would expect that is actual dollars of spend we expect to see over the course of the year this year.

Okay.

And then is any of that capitalized?

There might be a small portion of it that's capitalized depending on some of the choices we make, some decisions we make.

But I would think, for modeling purposes, I'd just assume it's not and flow it through.

And I'd remind you again in the thought process, because you brought up the notion of a run rate, a lot of these things are increased brand advertising, increased marketing spend.

They aren't necessarily things that go into a run rate, per se.

They're things you look at and think about every year.

So I wouldn't think about this as a reset of the overall cost base other than maybe some of that employee spend.

Got it.

And then lastly, on the loan growth outlook, the midpoint of the guidance implies a little bit of moderation off of the 2017 level.

Is that entire moderation to personal loan growth slowing?

Or is there some other factors that you're taking into consideration?

I'd say a second component is just the year-over-year period is a tougher comparison given our strong growth last year.

And so I'd say it's mostly those 2 things together.

Your next question comes from Don Fandetti with Wells Fargo.

Mark or David, curious what your thoughts are on external growth, whether it's portfolios or acquisition?

I know you had the consent order.

I think it was lifted a while ago, so maybe a little more flexibility.

And then as you sort of look at the Payments business, obviously, it's changing very rapidly with digital.

Do you feel like you need any assets out there?

Or would it just be more of an opportunistic sort of move if you were -- I know in the past you've expressed valuations have been pretty high.

Well, I think -- to take Payments first, I think we see great opportunity in partnerships.

And I'd say whether it's with suppliers, with other networks around the world, with some fintech players, I'd say we see a lot more opportunity to partner or have been to relationships.

Maybe some small investments over time and some of them could make sense but probably less likely that we would -- that it would make economic sense for us to start buying a bunch of stuff in that space.

On the banking side, we will continue to -- we've not been restricted from buying portfolios and even under the consent order and, obviously, we bought some student loan portfolios over time.

We would continue to be opportunistic.

As consent orders come off, we -- it would open up presumably more optionality.

But I would just say that there's not a lot of direct banking stuff that's attractive out there.

And so I think the few direct banking things out there probably don't make money, which is usually a negative for us.

And most of what's out there are traditional banks that are also in the direct banking space.

So I would say that we are -- we'll keep looking at things, but we are primarily focused on organic growth, and we'll be opportunistic on anything else in that -- but it has to fit financially and strategically.

Our last question at this time is from Henry Coffey with Wedbush.

It's a very interesting call.

I just want to narrow in on one area, really just personal interest.

Student loans, when you say you moved to the #2 spot, you mean in terms of loan origination or loan balances?

And then as you think of...

Of loan -- go ahead.

I'm sorry.

And then as you think of growth opportunities, you're very good in the direct in-school business.

Have you started looking -- it's not as profitable from a yield point of view, but have you started looking at the refinance side of the equation?

Well, on -- to answer the second question first, the -- we've done a little bit of consolidation loans.

But as you point out, the pricing seems really hard to make money at.

And so we'll -- I think what you should expect from us is primarily to continue to focus on the in-school channel.

And the in-school channel is very specialized.

There's only a few players because you have to do special underwriting.

There's cosigners involved.

There's disbursements only through schools.

So it's operationally pretty unique, and so there's only a few of us that can do that, and we do that very well.

And so we think that's where we can really help students actually pay for their education and get degrees and do it at the lowest APRs of any kind of unsecured loan out there.

Your first question was student loans...

It was origination.

Yes.

So originations, and I would say Sallie Mae is #1, and we have now moved into the #2 spot of originations.

And even versus Sallie, our originations grew faster by a good margin than their originations did in the last year.

So we're pleased with how that business is performing.

I will now turn the call back over to the presenters.

Thanks, Mike.

Thank you all very much.

Have a great evening.

And of course, for follow-up, you know how to reach us, and we'll be available for you.

This concludes today's conference call.

You may now disconnect.