發現金融 (DFS) 2019 Q2 法說會逐字稿

Good afternoon.

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

At this time, I would like to welcome everyone to the Second Quarter 2019 Discover Financial Services Earnings Conference Call.

(Operator Instructions) I will now turn the call over to Mr. Craig Streem, Head of Investor Relations.

Thank you, Erica.

Welcome everybody to our call this afternoon.

I will begin briefly on Slide 2 of our earnings presentation, which you can find in the financial section of our Investor Relations website, investorrelations.discovery.com.

Our discussion today contains certain forward-looking statements that are subject to risks and uncertainties that may cause actual results to differ materially.

Please refer to our notices regarding forward-looking statements that appear on today's earnings press release and presentation.

Our call today will include remarks from our CEO, Roger Hochschild, covering second quarter highlights; and then Mark Graf, our Chief Financial Officer, will take you through the rest of the earnings presentation.

And after Mark completes his comments, there will be plenty of time for a question-and-answer session.

(Operator Instructions)

And now beginning on Slide 3, it's my pleasure to turn the call over to Roger.

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

Very simply, this was another very good quarter for us with solid loan growth, strong net interest margin, and ongoing improvements in underlying credit performance.

We earned $753 million after tax or $2.32 per share and generated a robust return on equity of 26%.

Our ability to balance loan growth with disciplined credit management continues to generate very strong returns, while our investments in the Discover brand and advanced technology enhance our ability to drive a differentiated customer experience and competitive advantage.

To that point, we were recently awarded the highest ranking by J.D. Power for customer satisfaction among credit card, mobile apps and websites.

This recognition highlights how our investments in technology and analytics have enabled us to deliver industry-leading customer value while maintaining operating efficiency.

Looking at some of the specifics of our second quarter performance.

Total loans were up 6%, with strong credit performance across all of our products, reflecting our discipline in underwriting new accounts and line management, along with continued investments in collection capabilities.

Looking at our lending products, the 7% growth in card receivables was sourced from a healthy mix of new versus existing customers.

In terms of card portfolio mix, growth was primarily from higher-yielding merchandise balances versus promotional balances.

We have previously shared with you our intent to decrease the level of growth from promotional activity, and that trend continued in the second quarter.

This provided a meaningful contribution to our net interest margin performance this quarter.

Turning to our student loan business, growth remains strong.

And as we enter the peak season, early origination activity looks good and is consistent with our expectations.

We believe we are well positioned to continue to gain market share.

In personal loans, our recent credit tightening has achieved its desired effect with both charge-off and delinquencies declining from the prior quarter and loan growth consistent with our target.

We remain focused on originating loans that will generate satisfactory long-term returns rather than pursuing faster growth in what remains a very competitive environment.

Overall, underlying credit trends continue to be favorable across our lending products as the normalization impact on the back book continues to lessen and credit performance is increasingly driven by growth in receivables.

Our Payment Services segment generated a robust 15% increase in pretax income, driven by strong growth in volume, the majority of which came from our PULSE business.

The team at PULSE continues to win new relationships to build business with existing issuers by developing creative debit solutions that deliver meaningful value for partners.

We continue to execute our strategy in payments to enhance global acceptance by investing in partnerships, primarily with local acquirers in Western Europe as well as adding to our network-to-network alliance partnerships as we make progress against our objective of universal merchant acceptance.

In summary, our results this quarter reflect the discipline and commitment to excellence that we bring to serving our customers and delivering long-term value to our shareholders.

Clearly, the favorable economic environment has contributed to our performance and we don't see any signs that this is changing in the near term.

Nevertheless, we recognize that this may moderate at some point and are continuing to adapt our growth and credit strategies as appropriate.

Before I turn the call over to Mark, I want to highlight 2 important additions to the Discover team.

First, I want to welcome Wanji Walcott, our new Chief Legal Officer and General Counsel.

Wanji joins us from PayPal with significant prior experience at American Express.

So she brings a wealth of highly relevant knowledge to Discover.

I also want to welcome Jennifer Wong, Chief Operating Officer at Reddit, who has joined our Board of Directors.

Jen will be an invaluable addition to our board, bringing deep experience in media and digital advertising.

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

Thanks, Roger, and good afternoon, everyone.

I'll begin by addressing our summary financial results on Slide 4.

Looking at the key elements of the income statement, revenue growth of 10% this quarter was driven by solid loan growth and a higher net interest margin.

Looking at the provision for loan losses, roughly 3/4 of the 6% increase was driven by the seasoning of loan growth, with the remaining 25% reflecting continued supply-driven normalization in the consumer credit industry.

Operating expenses were up 10% year-over-year due to higher compensation expense and investments in support of growth and new capabilities.

The effective tax rate for the quarter was in line with our expectations at 24%.

Turning to Slide 5. Total loans increased 6% over the prior year, led by 7% growth in credit card receivables.

As Roger noted, higher-yielding standard merchandise balances were the primary driver of the increase, while the contribution from promotional balances was less of a factor this quarter as it continued to decelerate.

Compared to the prior year, promotional balances were down 80 basis points and dropped 70 basis points sequentially, reflecting our decision to decrease the level of growth from promotional activity over the last several quarters.

Turning to our other primary lending products.

Our organic student loan portfolio increased 9% year-over-year, while total private student loan balances were up 3%.

Personal loans increased 2%, which was in line with expectations given the slowdown in originations, which we have mentioned previously.

Moving to the results from our payment segment on the right-hand side of Slide 5. You can see that proprietary volume was up 4% year-over-year.

In Payment Services, PULSE volume increased to 7% over the prior year, driven by incremental volume from existing issuers, new issuers on the network as well as growth in our PINless products such as PULSE PAY Express and PULSE E-commerce.

Network Partners volume was up 29% primarily driven by AribaPay.

Diners Club volume was up 1% over the prior year having been impacted by unfavorable foreign exchange movements.

Moving to revenue on Slide 6. Net interest income increased $203 million or 10% from a year ago, driven by higher loan balances and increased market rates.

Total noninterest income increased $46 million, primarily driven by a 14% increase in net discount and interchange revenue.

The 5% increase in gross discount and interchange revenue was primarily driven by the year-over-year increase in sales volume, which was also up 5%.

Rewards costs were flat to the prior year and up a bit sequentially, reflecting increases in sales volume, offset by lower utilization in the rotating 5% category.

Just to remind you, groceries, which we featured in the first quarter, is a rotating category that attracts the highest level of spending, and quarterly shifts in the 5% category can have a significant impact on both the rewards rate and sales volume.

As shown on Slide 7, our net interest margin was 10.47% for the quarter, up 26 basis points year-over-year and 1 basis point sequentially.

Relative to the second quarter of last year, the net benefit of prime rate increases in March, June and December of 2018 as well as the favorable shift in the promotional balance mix and revolve rate, were partially offset by higher deposit costs in both brokered and direct-to-consumer and higher charge-offs of accrued interest.

Compared to the first quarter, the benefits from 2 additional cycle days, a shift in promo balance mix and a favorable funding mix were mostly offset by the higher costs in brokered and direct-to-consumer deposits.

Looking forward, our outlook for net interest margin reflects continued strong credit performance and favorability in portfolio mix, balanced against a degree of uncertainty around the timing and level of Fed action.

That said, it's fair to say that it's looking more likely that full year net interest margin will evidence a bit of the upside bias we spoke about when we provided 2019 guidance.

Total loan yield increased 54 basis points from a year ago to 12.82% primarily driven by an increase of 56 basis points in card yield and a 54 basis point increase in private student loans yield.

Prime rate increases, favorability in the revolve rate and a lower level of promotional balances led card yields higher, partially offset by an increase in interest charge-offs.

As we noted earlier, the mix of lower-yielding promotional balances decreased 80 basis points from a year ago, reflecting the slowdown in growth from promo activity, which had a positive impact on both card yield and overall NIM.

The year-over-year increase in student loan yield was primarily driven by higher short-term interest rates as slightly over 60% of the portfolio is at a variable rate.

On the liability side of the balance sheet, average consumer deposits grew 16% and now make up over half of total funding.

The strong growth in consumer deposits reflects our continued focus on attracting more stable and cost-effective funding.

Consumer deposit rates rose during the quarter, increasing 5 basis points sequentially and 49 basis points year-over-year.

We continue to see cumulative deposit betas below historic norms.

As we consider potential cuts in the Fed funds rate, we expect that the resulting decline in loan yields would be mostly but not completely offset by lower funding costs.

We've been trimming our asset sensitivity and expect to be down to roughly 0.75% asset sensitive by the end of the third quarter.

Turning to Slide 8. Total operating expenses rose $94 million from the prior year.

Employee compensation increased $27 million driven by higher average salaries and benefits, which included the impact of the higher minimum hourly wage we implemented in May of 2018.

Information processing costs were up, reflecting our continued investments in infrastructure and analytic capabilities.

Professional fees increased $22 million primarily due to increased collection costs related to higher recoveries in the quarter as well as investments in new capabilities.

Now I'll discuss our credit results on Slide 9. Total net charge-offs rose 11 basis points from the prior year.

The increase in charge-offs continues to be primarily driven by the seasoning of loan growth in the past few years and, to a lesser extent, supply-driven credit normalization.

Credit card net charge-offs were 15 basis points higher year-over-year.

From a sequential perspective, this was the seventh consecutive quarter of slowing year-over-year increases in card charge-offs, and this trend reflects the fact that normalization continues to moderate.

The credit card 30-plus delinquency rate was up 18 basis points year-over-year and down 11 basis points sequentially.

Credit performance in the card business continues to be very solid, reflecting our disciplined approach to credit management in both new and existing accounts.

Private student loan credit performance also remains strong with net charge-offs down 31 basis points year-over-year and 5 basis points sequentially, aided by efficiency gains in collections.

Personal loan net charge-offs were up 36 basis points from the prior year and down 20 basis points sequentially.

The 30-plus delinquency rate was up 7 basis points year-over-year and decreased 2 basis points sequentially.

Credit performance in the personal loan portfolio continues to stabilize, which you can see reflected in the sequential improvements in both charge-off and delinquency.

Looking at capital on Slide 10.

Our common equity Tier 1 ratio decreased 10 basis points sequentially as loan balances grew.

Our payout ratio for the last 12 months was 82%.

We recently announced that our Board of Directors has approved our capital plan for the 4 quarters ending June 30, 2020, which includes a $0.04 per share increase in our quarterly common stock dividend as well as planned share repurchases up to $1.63 billion over the next 4 quarters.

I'll remind you that we were not subject to CCAR for 2019 but we're required per our capital plan that was approved by our Board of Directors and submitted to regulators.

As always, we remain committed to efficiently deploying our shareholders' capital by focusing on profitable and disciplined asset growth and returning excess capital via dividends and share repurchases.

To sum up the quarter on Slide 11, we generated 6% total loan growth and a 26% return on equity.

Our consumer deposit businesses saw strong growth of 16% while deposit rates increased 49 basis points year-over-year.

With respect to credit, while our charge-off rates have increased as loan growth seasons and credit conditions normalize, performance reflects positive trends across our lending products and remains consistent with both our expectations and our return targets.

And last but not least, we're continuing to execute on our capital plan with loan growth and capital returns helping to bring our capital ratio closer to target levels.

In conclusion, this was a terrific quarter for us, characterized by continued receivables growth, solid credit performance and very strong returns.

That concludes our formal remarks.

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

(Operator Instructions) We'll take our first question from Bob Napoli with William Blair.

Solid quarter and, Mark, sorry to see you leaving next year, but it's been great working with you.

A question on CECL, I guess, and hopefully you're not leaving for the CECL, Mark.

I know that's frustrated you there a little bit but the -- can the reserve build, do you have an idea what you expect the reserve build to be?

And then maybe more importantly, after the reserve build, just any thoughts you would have on what effect CECL would have on earnings growth over the long term on average over time.

Sure.

First of all, Bob, I would say thanks for the kind words.

I appreciate it and I have enjoyed working with you and all the folks in the market tremendously over the last 9 years.

So I'm not going yet, so you've got to suffer through with me for a little while.

In terms of the CECL, I would say, Bob, there's no change to our 55% to 65% guesstimate for the increase in reserves at adoption of CECL.

Now I'd be remiss if I didn't remind you that, that is a guesstimate.

It's heavily dependent on both the composition and trends in the portfolio and the forward-looking view of the economy actually at the time we adopt.

But again, if we had adopted this quarter, it looks like roughly a 55% to 65% range would be the right way to think about it.

In terms of where that impact comes in, it's longer duration, higher lifetime loss content assets, and actuarially managed asset classes are obviously pretty heavily dependent on a macro forecast in a CECL environment.

So the volatility going forward, I think, is really going to be the speed and level of change, and macroeconomic forecasts will really be the driver in volatility as you sit and look at those things in addition to loan growth itself, right?

There's a penalty for growth under CECL.

So those would be the moving parts and pieces.

I think our #1 concern remains comparability across issuers is going to be challenging.

So it's going to be incumbent upon us to provide really good disclosure and for all the users of the financial statements to really dig in there.

The capital return is a little bit below what we were looking for.

Is that because of CECL?

We're just trying to figure out how -- is that at all related?

So CECL and the implementation of CECL definitely impacted our thoughts in terms of the forward 4-quarter ask in terms of a capital return basis, yes.

Our next question comes from Rick Shane with JPMorgan.

Mark, congratulations and we will definitely miss you.

I wanted to ask a little bit about the sort of transition on promotional rates.

I'm curious what the results have been with the promotional balances.

Have you been able to convert them to full pay in the way that you anticipated?

And is the NPV on that program what you expected?

Yes.

Promotional balances remain very profitable for us and it's a mix of using promo rates around BT and retail for new accounts as well as targeted offers to our existing portfolio.

So profitability has been very strong.

It's just some of the growth we're seeing around merchandise balances and some other forms of stimulation, including rewards, are working well.

And so that's driving down the overall mix that's at promotional rate.

And in terms of the NPV part of the question, I would say yes, the NPVs continue to perform in line with expectations.

And candidly, some of the level of focus on promotional balances obviously is, do we believe in the current environment based on competitor actions and otherwise?

Do we have the ability to keep hitting those NPVs?

And if we can't, we pull back because we don't want to put asset growth on the books that doesn't meet our desired return thresholds.

Great.

And then you'd alluded to the fact that you've been able to implement some strategies to dampen asset sensitivity.

Can you talk a little bit about that?

Yes.

Principally, what we've been doing is over the course of the last several months, we've been adding to our investment portfolio specifically buying short-dated treasuries 2 years in.

It's been the primary vehicle we've used to accomplish that dampening on the asset sensitivity side.

I think realistically, there's a little bit more room there to add a little bit more on the treasury book but then there will also be some synthetic activities we'll engage in to do.

Principally, plain vanilla asset swaps will be the way to think about it.

We are in market today with an ABS floater, a 2-year ABS floater.

Specifically, we won't swap that effect the way we have done over the years with a number of our ABS floaters as well.

That will also help in that capacity.

That's about an $800 million deal roughly, give or take.

Our next question comes from Mark DeVries with Barclays.

I was hoping you could help us better understand the pace of reserve builds.

While the year-over-year increases in delinquencies and charge-offs have been improving at a fairly steady pace, changes in the reserve ratios have been a lot more erratic with some quarters like this one where there's almost no change sequentially and quarters like the last one where it was up 17 basis points.

In this quarter, it's kind of flat, was actually in a period where, for the first time in a while, you actually saw your year-over-year delinquencies increase.

So I was hoping, Mark, you could just give us kind a sense of how to think about on a quarterly basis what causes you to move your reserve rate up or down.

Sure.

So today, pre-CECL, we set our reserve based on expected losses on loans that are on the balance sheet now and it will be the losses we expect to see over the coming 12 months.

And the key really influencers of that level are going to be delinquency trends we see in the portfolio, macroeconomic trends and forecast, obviously bankruptcy forecast.

What we see going on in incidence rates and what we see happening with consumer leverage and ability to pay, right, would really be the key influencers, I guess, that would be out there today, Mark.

And I think the other thing is we try not to react with a knee-jerk reaction 1 quarter versus the next.

So when we see some goodness, we've got a relatively flat reserve rate this quarter vis-à-vis last quarter.

We saw a little bit of goodness in a couple of areas.

We're not just going to assume that, that represents a trend.

We're going to wait and see that develop and we're going to make sure we're being prudent in how we think about trends in the portfolio as opposed to just knee-jerk reacting up and down.

As we go into a CECL environment, I think that level of judgment will increase candidly, but we will become far more sensitive to changes in macroeconomic forecast as well as the level of growth in the portfolio in a CECL environment as well.

So that would be how to think about it now and really how to think about it going forward.

Okay.

That's helpful.

But then when we think specifically about this quarter versus last quarter, what did you see maybe differently in all those different things you evaluate that caused you to keep reserves mostly unchanged, at least the reserve ratio versus last quarter where there was a more substantial increase?

Yes.

I mean I think the reserve rates stayed relatively flat.

I think we saw constructive activity on a quarter-over-quarter basis in delinquency trends.

We saw constructive developments and quarter-over-quarter trends in charge-off trends.

Macro trends, a little less clear candidly than we would have seen historically, relatively flat but uncertainty around what the hell is going on with the Fed, quite honestly, would be entering into that process.

Incidence rates, up a tad but nothing significant.

I mean there's no question severity remains the primary driver.

Consumer leverage, pretty consistent.

So you kind of put all that into the blender and hit go.

I suppose you could have gotten yourself comfortable with a modest reserve rate reduction, but we don't target a reserve rate.

Again, we set reserves based on the loans we see on the books and all those factors we talked about earlier and we want to see those factors develop over more than just a month or 2. We actually want to see them develop into trends before we respond to those trends because most importantly, those reserves are meant to reflect the risk that we as a management team feel exist in the loan book today and not just a knee-jerk quarter-over-quarter based on things we see moving.

Our next question comes from Jason Kupferberg with Bank of America.

This is [Mihir] for Jason.

Just a quick question on the purchase volume.

Is there anything you would call out in terms of the Discover card purchase volume other than just the different category and rewards?

Because we saw a little bit of a slowdown this quarter.

I think it was up 4 -- 4.5% versus 6.5% last quarter and I was just wondering if there's anything particular with that.

Yes, a couple of things at how I -- one, when you look at us compared to competitors, ours is explicitly more of a lens-focused model versus spend focus because sometimes, there's a bit of a disconnect.

Part of it was just a challenging comp year-over-year.

The switch in 5% category probably cost us roughly almost a point of growth.

The other thing is gas prices can have an impact, and so that also dampened our year-over-year sales growth.

Got it.

And then can you give us an update on the checking product, the one with the rewards?

What kind of engagement are you seeing from customers?

Is the population different that are attracted to this product, whether it's millennials versus your core card product, if you will?

And is there an opportunity to drive that growth a little further in the interest rate as -- if the interest rate environment goes as we're expecting with the lower Fed funds rate maybe and you might see a little bit less yield chasing?

Yes.

The benefits of checking compared to other products actually gets tougher in a lower rate environment just because in checking, you're not paying interest but you're paying OpEx.

And so as rates become lower, the advantage of checking versus, say, savings starts to get compressed.

We continue to be excited about how checking is performing.

The average age of new customers is about 35.

Our card actually does well with students and millennials, too, but we're excited about the product.

About 1/4 of the new customers are also opening a savings account.

So we're excited about that.

We've seen good growth year-over-year in new accounts.

So it continues to be a good product for us, but I would caution you, we view it as a long-term build before checking deposits become a meaningful piece of our funding.

Overall though, the debt -- direct-to consumer deposit portfolio is doing very well.

And as we mentioned on the call, it's now over half of our funding.

Our next question comes from Sanjay Sakhrani with KBW.

I guess I had a question on loan growth.

Obviously, the card growth continues to be strong and the mix is actually improving to less promo.

Could you just talk about what's driving this window to be open for you for this long, Roger?

And maybe you could also just talk about how you're incorporating the shifting views on the macro into the underwriting process.

Yes.

We have not -- I'll start with the back of that, Sanjay.

We haven't changed our views on macro.

We continue to be at the margin-tightening credit and nothing has changed there in terms of how we think about our card underwriting.

I think the window is there as long as we can execute on having a compelling value proposition for consumers in a very competitive environment.

And so we always target a healthy mix of loan growth coming from both new accounts as well as stimulating our existing card accounts.

We're happy with how it's performing but continue to see good opportunities as well.

And it continues to skew towards prime-oriented solid growth, Sanjay, if you -- something you'll see in our Q as it comes out at the end of the quarter.

I'll go ahead and front run a little bit.

The percentage of accounts below -- at or below 660 actually decreased to about 19% in the quarter.

So you're seeing the percentage of the book that's actually classified as subprime begin to shrink as well.

Okay.

And then just a follow-up for you, Mark.

I appreciate the commentary on the NIM and lower rates so far, but maybe you can just -- backing up a little bit more high level, talk about deposit betas and how they may vary early in the process of rates going down versus later in the process because we were seeing that difference as we were going late into the rate pricing cycles.

So maybe you could just talk about those dynamics.

Yes.

Sure.

We typically -- it's not unusual for deposit pricing to continue increasing after market rates stop.

So we did see a little bit of that across the industry.

More recently though, we've seen decreases, including some of our product book as well.

We have implemented rate decreases also.

So last quarter when we talked, Sanjay, the cumulative beta through the cycle was 51.

The cumulative beta through the cycle as we sit here today is 49.

So at the end of the day, obviously competitor actions will have a bearing on how we act and respond because we are trying to be relevant in the market.

We continue to target that 5th -- that 6th to 10th kind of place in bank rate to offer real significant value but not to have rate be the leading proposition.

So that's generally how I would think about it.

On the NIM question more broadly, I guess what I'd say is -- I mentioned we did see a little bit of upside -- bias to the upside when we gave our guidance, and we're really seeing that being more likely right now.

I'm guessing NIM could come in anywhere from, call it, 5 to 9 basis points, roughly higher than that 10.3% that was part of our initial guide.

I think -- I want to make sure folks don't overreact in -- to the growth we've seen in NIM and really make -- extrapolate that as well because we are asset-sensitive still.

Roughly 25 basis point increase by the Fed on a 12-month forward basis takes about a basis point or 2 off a margin, give or take.

It's the kind of the way to think about it.

And those treasuries we've been buying to dampen our asset sensitivity also are at lower yields and some other things as well.

So we were doing the right things to prudently position the balance sheet.

NIM is going to be clearly on the plus side of that guide with a bias to the upside, but I don't want folks to run away and assume it's going to the moon either.

Our next question comes from Ryan Nash with Goldman Sachs.

Mark, so when I look at credit broadly, so net charge-offs year-to-date are running kind of towards the bottom of the range.

3Q historically is seasonally strong for losses.

Could you maybe just talk by product how you're feeling about the trajectory of losses?

And given positive seasonality, could we end up coming in at or below the low end of your 3.2% to 3.4% targeted range?

Yes.

I'm not going to get into the trap of revising guidance on you on the credit one here, but I will be happy to walk you through the parts and pieces.

I would say card, Ryan, continues to feel very stable and very good.

I would say from that perspective, this is the seventh consecutive quarter we saw the rate of increase in charge-offs moderate year-over-year -- the rate of growth moderate year-over-year.

We still are seeing the impact of normalization but it's down to roughly, call it, a quarter of the impact.

The other 3 quarters is really coming from growth.

And as our loan growth has moderated a little bit, our guidance for the year of 6% to 8%, as we're coming in closer to that 6-ish percent kind of range so far, I would say that has bearing on that equation a little bit as well.

So it feels to me at the end of the day like we're in good shape with respect to trends in card charge-offs.

If we talk student loans, that product has consistently just been a very solid credit performer for us, don't see any signs of change on that and the horizon at all.

It just continues to feel decidedly solid, I would say.

Personal loans, too early to declare victory, but it is looking like that 5% general soft guide we gave around personal loan charge-off rates because of working through some of those segments that we talked about going back about a year or so ago.

It looks like that was probably a little conservative.

So I do think our personal loan charge-offs will come in inside of that 5% number.

You saw really positive quarter-over-quarter trends this time.

Again, I'm not going to declare a victory on the basis of a quarter, but it does feel like things are trending well there as well.

So not prepared to revise credit guidance at this point in time but I would say we continue to feel really good about the trajectory of credit, the performance of credit and the health of the book.

Got it.

And sorry to ask another question on the net interest margin, but if I look year-to-date, you're running -- at close to 10.47%, the guidance would imply about a 20 basis point falloff in the back half, which is historically seasonally strong.

So I guess I just want to make sure I understand all of the moving pieces given that you're slightly asset sensitive, you have better seasonality, but then you also have lower promo activity, which is helping support the margin.

So can you just walk us through the puts and takes of how we end up with the margin in the back half of the year that's lower relative to the first half?

Yes.

I'll do my best and I would not interpret this as being -- to be all-inclusive, but I'll give you some things to think about.

So as we head into the latter part of the year, transactor engagements typically tends to pick up as we go into the holiday shopping season.

So you'll have a bigger percentage of the mix that essentially is effectively a 0% earning asset.

So that has an effect that -- there that you should be thinking about at the end of the day.

The asset sensitivity, depending upon the pace of the Fed, the guidance we have implies -- right now, our guidance would imply 25 coming up here shortly and 25 in the fourth quarter.

If the pacing is greater than that, it would have a bigger impact.

And I already said 12 months forward, a basis point or 2 for every 25 the way to think about that.

Those portfolio purchases have a dampening effect on the treasury.

On the promo piece, we don't expect that to continue to decline from its current levels.

We're thinking the level we're sitting at right now as a percentage of the mix feels about right.

So you won't have further tailwind from promo at this point in time.

So those will be some of the things I would generally be thinking about, Ryan.

It's not all-inclusive but I'm trying to send a balanced message on NIM.

It's clearly a good story.

It's going to end up higher than that 10.3% that we had talked about, but I don't want folks to think we're sandbagging and setting something up or going to the moon either.

I'm trying to send a very balanced, very clear message there.

Our next question comes from Bill Carcache with Nomura.

My first question is on rewards and promotional activity.

I know it's early in the quarter, but can you discuss whether including PayPal in this quarter's 5% cash back, kind of cash back rewards category, whether you'd expect that to drive a pickup in volumes?

And how should we think about the sustainable rewards rate level as we look ahead from here in light of the decrease that we saw this quarter?

Yes.

I wouldn't read too much into the decrease this quarter.

We talked about how the categories can have a significant impact Q-over-Q, but that doesn't change our long-term perspective.

We're very excited about the program with PayPal.

They're a great partner.

So -- but just given their overall scale, I would say modest impacts on rewards rate in the coming quarter.

Yes.

And on a full year basis, I would say we aren't moving that guide we gave for the year, that 132 to 134.

So it definitely does tend to move around based on how lucrative that category is, right?

So like in the first quarter, groceries, it's really easy to max out on the $1,500 in spend.

I think you have to spend $125 a week or something inside of that even to max out.

It's really easy to do.

Certainly the other categories, it's not as easy to max out on that, if you will, unless you're a high-spend transactor.

So we do see variability based on that as well but I -- the guide for the year, the 132 to 134, is still, I think, how I would be thinking about it.

Got it.

That's helpful.

Roger and Mark, my last question is regarding your digital investments and specifically on cloud.

You guys have talked about pursuing a hybrid cloud strategy versus the public cloud strategy that some of your competitors are pursuing.

Can you discuss whether you have any concern that, first of all, you may be falling behind your competitors?

And secondly, maybe if you could discuss what you're seeking to optimize with your strategy.

Yes.

So in terms of hybrid cloud versus sort of moving purely to the public cloud, I think our focus around technology is always technology to drive business value, not technology for technology's sake.

And we try and take a really practical view.

So moving 100% of your applications to the public cloud, moving your general ledger there, I'm not sure I see the benefit.

On some of the consumer-facing applications, we have migrated to the cloud and rewritten architecture.

You're seeing 30% plus increases in feature delivery rate.

So clear benefits from public cloud but we feel like our hybrid strategy is the right way to go.

In terms of falling behind our competitors on technology, I maybe think more about what's the opportunity in front of us versus comparing because everyone's business is a bit different.

Certainly, we're doing a great job in business value.

If you look at what we've done, the mobile space being #1 ranked there, but I'm also excited about how quickly technology is changing and what we can do in the coming years.

Our next question comes from John Hecht with Jefferies.

Actually, most of my questions have been asked, so I just have one.

And you -- Roger, you referred to a good mix of sources of growth from new customers and increasing advances.

I wonder -- can you parse that out, give us a little bit more information of the growth, how much of it's coming from utilization versus advances versus new customers?

Yes.

I guess a bit more from new customers versus the portfolio.

So probably for the last roughly 18 months, we've been closer to that 60-40 range between the 2, maybe a little higher this quarter, but again, a healthy mix that's consistent really with what we've done for a while now.

Okay.

And I guess as a related follow-up is how would you discuss the competitive environment?

You guys have used the word competitive quite a bit, but has it leveled off?

Is there changing dynamics on competition for new customers and rewards?

Or how do we think about that?

We've said for a while that rewards competition has leveled off.

Going back a couple of years, it was just every quarter someone was out there with a hot new program.

So it's stable.

Look, the card business is always very competitive if you look at the returns, and so it's really the same competitors pursuing it aggressively and that's just a constant state for the business.

And your next question is from Vincent Caintic with Stephens.

Most of my questions have been answered as well.

So just maybe switching gears to the expense side.

So on Slide 8, very helpful color on some of the expense growth.

If you could talk about maybe in some more detail about the information processing and the professional fees and other expenses.

So they're up on a double-digit range.

Is that something that we should expect continuing going forward?

Or is there onetime things?

And specifically for the investments in infrastructure and capabilities, if you could discuss that further in detail.

Sure.

So if you think about the information technology spend, I think that is -- that really is the battlefield on which the bank of the future is being built, quite honestly.

So I would not expect to see technology spend be something you'd look to see us ratchet back on anytime soon.

Obviously, we have leverage there if we were hit a downturn, a major bump in the road, something like that, but it feels like those investments are driving great returns.

You're seeing it already in some of the performance in our personal loan book as we're able to better weed out some of the challenges we were faced with there, if you will.

You're seeing it kind of across the board in the portfolio.

So we feel good about that.

If you're talking about the professional fees, I think on that piece to the puzzle, yes, I believe there is some lumpiness to that one.

So I think you'll see that one continue to be -- exhibit a degree of lumpiness, and I would not take that as an elevated run rate or something that I would expect to see on a normalized basis.

On the other other, the other category that was up $28 million, I would say the variance there, it's about $11 million year-over-year due to global acceptance, about $13 million.

And at this year, I think there was about $2 million in it last year, same quarter, something like that.

And about $9 million of that is driven by fraud reserve.

We had a -- second quarter of '18 last year, we had a reserve release in the fraud reserve.

This year, second quarter, we had a normal build driven consistent with loan and deposit growth.

So at the end of the day, those would be the big drivers in the other other.

So continue to feel good about the expense guide broadly for the full year and continue to feel that there is significant untapped leverage in the expense base that we can avail ourselves of if and when we see a shift in the environment.

And maybe to build off Mark's comment, you can see great stability in operating efficiency even as we made those increases in investment and technology.

And I think that reflects really our discipline around expenses that to the extent we need to make investments, we're going to look hard at everything and see how we can fund this.

Yes.

And actually, we're at not, for peak season, DSL expenses that you incur.

Your efficiency ratio actually this quarter would have come in at 37.1%.

So I think -- again, I feel real good about the expense guide and I feel very good about the leverage that exists there.

Our next question comes from Meng Jiao with Deutsche Bank.

A quick question just on M&A.

I think earlier this year, you guys spoke to loving to -- would be loving to do acquisitions in the payment space but you noted that valuations are high.

I just wanted to get any sort of updated thoughts that you guys had in terms of M&A space whether it relates to payment space or direct U.S. banking.

Yes.

I think the same comment still holds true.

We'd love to do acquisitions in payments and valuations are still high.

So if you look back over the years, both PULSE and Diners were transformational acquisitions in the payment side, but Mark and his team run a very disciplined process and we're focused on value and making sure that transactions work out well for our shareholders.

On the banking side, there's probably a bit less to get excited about.

Just buying a portfolio is like buying a bond.

And we're very happy with the presence we've built in the products we're in on the consumer side.

So I wouldn't necessarily encourage you to think about any acquisitions on the Direct Banking side.

We look at anything opportunistically but we feel good and I think this quarter shows there's a lot we can do around organic growth.

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

I wanted to ask about the competitive environment for deposits because Mark, I thought I heard you say that you have put some decreases in the product book, and we've seen Ally and the Marcus product from Goldman Sachs, we've seen some incremental reductions.

Just -- I'm trying to get a sense of how confident you feel that you can trim deposit rates without having any adverse impact.

So I would say that is always the $64,000 question.

I think the real question out there is, where do you see it on a relative basis, right?

You have to be in the relevant range in the marketplace.

I think -- do we have the ability to lead the market down in terms of deposit pricing?

No, I don't think we have the ability to lead the market down in deposit pricing.

We didn't lead it up going up either.

Do I feel like the betas that we have built into our asset liability models and the guidance we provided around NIM and other things for the year continue to feel really good?

And do I feel like that is a business that continues over time to look more and more like a traditional bank's deposit business where there's real relationship?

Yes, I do.

I mean I think when I look most recently, I think we're just a hair shy of 70% of our depositors now have a relationship with us on the asset side of the balance sheet, right?

So I feel very good that these are not hot money, quasi-capital market accounts.

And I feel very good about our ability in a declining rate environment to harvest some benefit there.

Okay.

That makes sense to me.

Then just kind of curiosity-wise, on the upper end of the competitive spectrum, we've seen robo-advisors like Betterment and Wealthfront get a little more aggressive on deposit products using not a traditional bank product but using bank relationships to get FDIC protection.

Anyway, have you seen any meaningful competition from them?

Or is that really hitting kind of a different part of the marketplace than you're targeting for deposits?

Yes, we haven't seen any impact from them.

Our next question comes from Moshe Orenbuch with Crédit Suisse.

Most of my questions have been asked and answered but I was hoping to kind of talk a little bit a couple of questions before about competition.

Marketing spend was kind of flattish and as you mentioned, the rewards category in Q2 didn't at a lower level.

I mean as you look in the second half, I mean is there an opportunity to take more share to generate a little better growth in either lending or spending or both?

We tend to think about it in terms of the ROI for the marketing dollars we put out there.

If you think product by product, certainly seasonally, you're going to start seeing a ramp-up in Q3 given the peak for student loans.

For personal loans, we were very explicit about trimming back some channels based on credit performance but also that we're starting to see the benefits from that in terms of losses and the new generation of models going in.

Fourth quarter tends to be heavy for card.

So again, I think you can expect to see us continue to invest and look to gain share particularly around student loans and card.

Personal loans, I think you want to not pursue share and growth there too aggressively.

That's really driven by return and we've been very vocal over years now.

There are times to market that product and there are times to cut back and we'll continue to be disciplined.

Got it.

And maybe just a follow-up for Mark.

You've always used capital markets funding in conjunction with deposits.

And as we're getting into this declining rate environment and to the extent that the industry doesn't cut as fast, I mean would you kind of switch over to a greater degree of capital markets funding?

I'd say I think about it a little bit like a constrained optimization, Moshe.

At the end of the day, I think over the long haul, the value of a true relationship-oriented deposit base can't be replicated.

So I would still have a bias to that general direction.

That being said, we are economically motivated.

And to the extent the cost of funding in the capital markets really started to gap out, sure, we'd be willing to do that at the end of the day, subject to maintaining good discipline around asset liability management and make sure we're not doing anything that is near-term beneficial but planned landmines in the forward P&L when those things mature or repriced.

But sure, I'd be willing to consider it, yes.

Our next question comes from Betsy Graseck with Morgan Stanley.

A couple of questions.

First, for Mark, I just want to make sure your commentary around for every 25 bps, 1 to 2 basis points that I think last quarter was 4 to 6. So I just want to make sure I heard that right as well as just understand the reading for that differential, all the actions that you discussed earlier.

Is that a 1 to 2 for the second half of the year?

Or is that 3Q and so we should expect an even lower level of impact as we hit 4Q?

So the 4 to 6, Betsy, would've been predicated -- that goes back maybe a quarter -- 2 quarters ago and is predicated on what the benefit would be from a rate increase.

We're now looking at what the likely cost of a rate decrease would be and it wasn't symmetrical the way we built it.

So you're looking at 1 to 2 basis point of cost to margin on a 12-month forward basis associated with a 25 basis point reduction.

And we are continuing to shift the asset sensitivity.

So I would expect, over time, that will moderate from that current 1 to 2 basis point level as we continue to shift the positioning of the balance sheet.

Got it.

And that's against spot or that's against the forward curve?

That's against the forward curve.

That's against the forward curve.

Got it.

Okay.

And then, Roger, a question for you.

In the prepared remarks, you were talking a bit about the European opportunity and how you saw some of that come through this quarter.

Could you give us a sense as to which kind of markets you're seeing the uptake the most rapidly and where you feel you are in terms of the opportunity set here?

Is what we saw this quarter something that you think you can continue for a while?

Or is there anything in particular that would say, "Hey, this is more of a 1 quarter event?"

Yes.

I think for us, probably a lot of focus is around Spain but also the U.K. and Ireland.

Some of the smaller markets, we're seeing great success and exciting partnership.

So Bulgaria is another one I'll highlight.

But this really is a multiyear strategy.

Different countries will link in and out but it's a broad focus across Western Europe.

Okay.

So early innings because this is -- these are not necessarily new markets for you, but they're new given the relationships that you extended recently, it's an accelerating growth path.

Is that fair?

Yes.

And some of them -- while clearly we are in hundreds of countries around the world, some of these reflect, I would say, step function changes in terms of merchant acceptance within those markets.

Okay.

So we could see the pace continue as your relationships build out in these new -- in these markets?

Yes.

There are no further questions at this time.

Mr. Streem, your closing comments, please?

Thanks, Erica.

Thank you all for your interest.

We appreciate your queuing up with us in light of who else may be out there this afternoon.

And anything else you need, of course, feel free to come back to us.

Thank you.

Thank you.

This does conclude today's conference call.

You may now disconnect.