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Discover Financial Services
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Good afternoon, my name is Salacia and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter 2018 Discover Financial Services Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session.
Thank you, I will now turn the call over to Mr. Craig Streem, head of Investor Relations. Please go ahead.
Thank you, Salacia. Welcome, everyone, to our call this afternoon. As always, I'll begin on slide 2 of our earnings presentation, which you can find in the financial section of our Investor Relations website, investorrelations.discover.com.
Our discussion today contains certain forward-looking statements about the company's future financial performance and business prospects, which are subject to risks and uncertainties, and speak only as of today. Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today's earnings press release, which was provided to the SEC in an 8-K report, and in our 10-K and first quarter and 10-Q, which are on our website and on file with the SEC.
In the second quarter 2018 earnings materials, we've provided information that compares and reconciles the company's non-GAAP financial measures with GAAP financial information. And we also explain why these measures are useful to management and investors. We urge you to review that information in conjunction with today's call.
Our call will include remarks from David Nelms, our Chairman and Chief Executive Officer, covering second quarter highlights and developments; and then Mark Graf, our Chief Financial Officer, will take you through the rest of the earnings presentation. And then, as Salacia said, we will have time for Q&As following the formal comments. Appreciate it if you'd limit yourself to one question and one follow-up, so we can accommodate everyone during the time that we have.
Now it's my pleasure to turn the call over to David.
Thanks, Craig, and thanks to our listeners for joining today's call. In our second quarter, we earned $669 million after tax or $1.91 per share, generating a return on equity of 25%. This performance reflects a simple strategy, focus on the customer, maintain a disciplined approach to credit, and invest for long-term profitable growth.
And as you can see from our results, effective execution of this strategy continues to generate outstanding returns. These returns primarily reflect strong revenue growth, which itself is a function of outstanding receivables growth, particularly in the card business.
Over time, we've invested in brand advertising, in marketing analytics, in superior service and in enhancements to our rewards offerings. And together, these investments continue to drive profitable loan and revenue growth from a balanced mix of new accounts and existing cardholders.
Turning to our other lending products. In student loans, we are just entering the peak season and early origination activity looks good, and it's consistent with our internal projections. In personal loans, competition continues to intensify.
Just to illustrate, the industry sent more direct mail for personal loans in the first half of this year than it sent for credit cards. And industry pricing and credit standards seem to be focused more on near-term growth than long-term returns.
As a result, we are continuing to cut back on origination activity, as we see less opportunity for profitable growth in this portfolio in the near-term. In fact, we expect personal loans receivables to be flat to potentially down over the second half of this year.
Turning to credit, performance remained strong with charge-offs flat and delinquencies down 15 basis points on a sequential basis. This reflects a number of factors. First, we've maintained our disciplined approach to underwriting.
Second, we've seen meaningful benefit from our investments in advanced analytics, modeling and machine learning. And finally, the strength of the U.S. economy has certainly helped. In addition to our Direct Banking business, in Payment Services, good business momentum drove a 14% increase in volume and an 11% increase in income before tax on a year-over-year basis. During the quarter, we returned $656 million of capital through dividends and share repurchases, and have raised our quarterly common stock dividend by another $0.05, or 14%.
In summary, this was another very solid quarter, led by the terrific performance of our card business. Looking at the economic environment for prime consumers, all indications suggest that economic conditions remain favorable. Overall, we feel very good about our ability to continue to generate strong risk-adjusted returns with a continued tailwind from the economy enhancing our ability to deliver profitable growth.
I'll now ask Mark to discuss our financial results in more detail. Mark?
Thanks, David, and good afternoon to everyone. I'll begin by addressing our summary financial results on slide 4. Looking at key elements of the income statement, revenue growth of 8% this quarter was driven primarily by strong loan growth.
The increase in provision was largely consistent with ongoing supply-driven normalization in the consumer credit industry, as well as the seasoning of loan growth. Operating expenses rose 8% year-over-year as a result of the investments David alluded to in support of growth and new capabilities.
Turning to slide 5, total loans increased 9% over the prior year, led by 10% growth in credit card receivables. Growth in standard merchandise balances drove much of this increase, spurred by accelerating sales growth.
Promotional balances were a modest contributor to our strong performance, although balance transfer volume came in above our expectations for the quarter. Looking forward, we expect balance transfer activity to slow and for the mix of promotional balances in the portfolio to gradually decline.
Looking at our other primary lending products, year-over-year growth in personal loans was 5%. And as David said, originations are expected to continue to slow. Private student loan balances rose 2% in aggregate, but our organic portfolio increased 10% year-over-year.
Moving to the results from our Payment segment. On the right-hand side of slide 5, you can see that proprietary volume rose 9% year-over-year, up from 8% last quarter. This increase was driven by two primary factors.
First; a high level of customer engagement with our 5% category, which was supermarkets this quarter. And second, higher gas prices. In our Payment Services segment, PULSE volume growth was once again strong this quarter, with 14% higher volume compared to the prior year, driven by both new issuers, as well as incremental volume from existing issuers. Diners Club volume rose 8% from the prior year, on strength from newer franchises. And Network Partners volume increased 33%, driven by AribaPay volume.
Moving to Revenue on slide 6, net interest income increased $191 million, or 10% from a year ago, driven by a combination of higher loan balances and higher market rates. Total non-interest income was down $7 million, due to a decline in net discount and interchange revenue.
Gross discount and interchange revenue grew in line with sales. But higher rewards costs more than offset that impact due to higher customer engagement in the 5% promotional rewards category. As I mentioned earlier, this was driven by our decision to feature groceries this quarter.
We remain comfortable with our expectation for the rewards rate for the year. As shown on slide 7, our net interest margin rose 10 basis points from the prior year, and was down 2 basis points sequentially, ending the quarter at 10.21%.
Relative to the second quarter of last year, the net benefit of a higher prime rate and a favorable shift in funding mix were partially offset by an increase in promotional balances and higher interest charge-offs. Relative to this year's first quarter, the net benefit of a higher prime rate was more than offset by strong engagement on the part of transactors, and higher promotional balances, which as I noted earlier, are expected to decline as a percentage of the portfolio over the remainder of the year. On balance, we remain comfortable with our outlook for net interest margin for the full year.
Total loan yield increased 30 basis points from a year ago to 12.28% as a result of a 22-basis-point increase in card yield, and a 60-basis-point increase in private student loan yield. Prime rate increases and a modest increase in the revolve rate lead card yields higher, partially offset by the impact of somewhat larger promotional balances and higher charge-offs.
Higher short-term interest rates drove the increase in student loan yields, where about 60% of the organic portfolio is variable rate in nature. On the liability side of the balance sheet, consumer deposits grew faster than loans, at 12%, up 2 points sequentially. Consumer deposit rates rose during the quarter, increasing 12 basis points sequentially, and 42 basis points year-over-year. Deposit betas have continued to rise, but at this point remain below our cycle-to date-expectations.
Turning to slide 8, operating expenses rose $72 million from the prior year. Employee compensation and benefits was higher, the result of increased technology and volume-related head count to support business growth as well as higher average salaries.
Marketing expenses were up as a result of greater investment in account acquisition and increased brand advertising. Information processing cost increased due to investments in infrastructure as well as analytic capabilities. We remain comfortable with our operating expense guidance for the full year.
I'll now discuss credit results on slide 9. Total net charge-off rates rose 40 basis points from the prior year, and 2 basis points sequentially. As we've talked about over the last year or so, supply driven credit normalization, along with the seasoning of loan growth in the past few years, have been the primary drivers of the year-over-year increase in charge-offs.
Credit card net charge-offs rose 40 basis points year-over-year. However, from a sequential perspective, this quarter represented the third consecutive quarter of slowing year-over-year increases in card charge-offs. In addition, delinquency formation slowed. The credit card 30 plus delinquency rate was up 16 basis points year-over-year, but down 17 basis points sequentially.
Private student loan net charge-offs rose 7 basis points year-over-year, and were flat sequentially. Personal loan net charge-offs increased 79 basis points from the prior year, but fell 6 basis points sequentially. The 30-plus delinquency rate was up 28 basis points year-over-year and 5 basis points sequentially. Taking into account the delinquency trends as well as the competitive conditions, we have chosen to slow personal loan originations as David noted earlier.
Looking at capital on slide 10, our common equity Tier 1 ratio decreased 30 basis points sequentially as loan balances grew. Our payout ratio for the last 12 months was 118%. On June 28, in conjunction with the receipt of our CCAR non-objection, we announced our capital plan for the four quarters ending June 30, 2019.
Specifically, we disclosed planned share repurchases of $1.85 billion over the next four quarters, as well as a $0.05 per share increase in our quarterly common stock dividend. We remain focused on efficiently deploying our shareholders' capital by driving profitable and disciplined asset growth and returning excess capital via dividends and share repurchases.
To sum up the quarter on slide 11, we generated 9% total loan growth and a 25% return on equity. Our consumer deposit business also posted robust growth of 12%, while deposit rates increased 42 basis points year-over-year.
With respect to credit, while our charge-off rates have risen, as credit conditions normalize and loan growth seasons, performance remains consistent with both our expectations and our return targets. And we're continuing to execute on our capital plan with strong loan growth and a leading payout ratio helping to bring our capital ratio closer to target levels. In conclusion, we're pleased with our performance this quarter, and are confident in our outlook for the balance of the year.
That concludes our formal remarks, so now I'll turn the call back to our operator, Salacia to open the line for Q&A.
And we ask that you please limit yourself to one question and one follow-up. We will take our first question from Sanjay Sakhrani with Keefe, Bruyette & Woods.
Thank you. David or Mark, maybe you could talk about the personal loan product and your decision to slow it down. What's the nature of the competition entering the market? Is it, kind of, fintech players or is it more traditional players? And how do you envision it playing out in terms of getting back in if you wanted to?
Well, first, we're not in any way exiting that business. It's a great business, and we basically need to pull back the growth to maintain our returns, but we're still putting on new accounts, just, probably it will be fewer than needed to replace attrition by the end of this year.
And I would say that a lot of it is fintechs. I don't know – I guess you'd call Goldman, I don't know if you really called him a fintech, but you've got some people like them that haven't traditionally been in the business that are also entering.
It is by far the easiest product to enter, a lot easier than credit cards or student loans. And we have seen this in past cycles, where people enter, and a lot of times a crisis sorts things – a credit cycle sorts things out. But I would just say that mainly these new entrants have produced, as I mentioned, more direct mail in the first half of this year than credit cards.
And that market is about 15% the size of credit cards. So, there's a lot going out there. And that impacts cost per account, but also the availability of credit will impact credit, and so to maintain our discipline, we need to selectively tighten and be more selective on how we're marketing.
And I think, Sanjay, I'd just add to that. I mean, we've been pretty consistent all along, in saying global domination in this business has never made sense, right? It's a business where discipline and humility matter a great deal. And risk-adjusted returns rule the way we think about things at Discover. So it's just time to feather the accelerator a little bit.
I appreciate that. I guess my follow-up question is, obviously, I'm sure you've seen today's announcement of Walmart, sort of, switching issuers. I'm curious if you have any updated views on the private label space, or even the co-brand space if an opportunity presented itself? Maybe you could talk about your appetite to get into that market. And then also, how the backdrop is with the BSA/AML issue, in terms of making a deal of any sort? Thanks.
Yeah. While the private-label business, I think, could fit strategically, I think the entry paths are limited. And I think it's probably unlikely for us, at least in the near-term. What was your second question?
Co-brands.
Co-brands. One of the things we have is the Discover brand. We're not issuing Visa/Mastercards. We have differentiation. We have leading service, and frankly, optimizing and extending Discover-branded products, I think has shown to produce the highest returns. And we're also outgrowing, at the moment, all those people who actually have co-brand programs.
Thanks.
Your next question comes from the line of Don Fandetti with Wells Fargo.
Hi, good evening. Mark, just want to talk a little bit more about the NIM. I know it looks like you came in a little bit lower than expected around some promo activity, but you're keeping the full year guidance. I mean, it implies a nice uptick. I guess I want to just, kind of, get a sense of your confidence there, just given that it can be so variable based on the mix of the portfolio.
Yeah, absolutely, I would say, Don, maybe the right place to start is a quick walk to Q1. So if you think about the benefit of the Fed rate increase we saw go through there, just on a pure rate per rate basis point, that was a 10 basis point good guy in the quarter to NIM.
We had 12 basis points of bad guys that were essentially half and half. BT and promo mix in the portfolio coming in higher than we thought it would be, and then a real uptick in transactor volume, which obviously is a good guy on the gross interchange side of the equation and the sales growth side of the equation, so maybe dilutive to margin in that regard, but obviously a good guy elsewhere on the income statement.
Got really good visibility into the BT and the promo mix, already see that coming down, so very comfortable there. Promos right now are about 21% of the book roughly, and we see that declining over the remainder of the year, pretty significantly.
So, again, feel good about that. Transactor volume is obviously the wild card. If we continue to see a stronger level of transactor engagement, that could mute it somewhat, but it would still make its way into the range that we've set out for the full year.
Thank you.
Yep.
Your next question comes from the line of Ryan Nash with Goldman Sachs.
Hey, good evening, guys.
Hey, Ryan.
Mark, maybe just picking up on the back of that last question, just given your expectations for promos to come down from the 21% level, do you have any thoughts on what that could mean for loan growth?
And David as a follow-up to that, can you just maybe talk about what you're seeing in the competitive environment for loan growth? Are you seeing any changes to competitor behavior, and what do you think it means for loan growth at this point in the cycle?
So from my perspective, Ryan, I'd say we continue to feel good about that 7% to 9% range we've talked about for total loan growth for the year. Card obviously came in above that range. It came in at 10% this quarter, although down somewhat – still rounded to 10%, but down somewhat from where it was last quarter.
Obviously, with a little less BT and promo volume, we would expect to see some slowing in card loan growth there as we go on through the course of the year, and that's reflected not only in our NIM thoughts for the year, but also our overall financial outlook for the year at this point as well.
And I would say the competitive environment is pretty stable compared to the last two quarters. It's still well off it's – I guess frothier stage from a year, year and a half ago, and I think generally, I've seen most of the prime competitors just maybe slowing loan growth to the low single digits, if you take out any acquisitions that they might have had, and sales growth, pretty close to where we are. Maybe a touch higher, but this quarter, our sales growth really moved up quite a bit, and we're right there with the other guys on sales.
And I think generally, people – my take is people started seeing higher rewards cost a year ago, and most recently and started making some adjustments, so we have seen some tapering off of some of the most aggressive rewards programs.
We've seen some taping off of marketing spend and volumes, and that has really helped us with some costs per accounts that look really attractive and our ability to maintain a pretty stable rewards rate, and good – stable pricing, but still growing faster.
Got it. And then maybe if I could squeeze in one follow-up on credits. Mark, you highlighted second derivative improvement in card. It looks like most products in terms of year-over-year you're seeing better loss rates.
So I could just – I was just hoping you could maybe talk about what you're seeing from the customer base from a credit perspective. David, you alluded to this in your opening remarks. We've heard from a handful of companies, other consumer lenders that severity of loss is improving given that customers are in a little bit better shape. I was just wondering if you are seeing the same thing. And given the improvement that you're seeing, can you talk about what it means for your outlook for charge-offs, could we end up being on the low end of that 3% to 3.25%? Thanks.
A lot in there, Ryan. I'll try to touch on all of it. I guess I would say, first and foremost, we continue to see quarter-over-quarter a – what I guess I would call a lessening of the slope of the normalization curve for three consecutive quarters now, in the card space, which feels very good.
This quarter about 50% of the reserve build was driven by the front book about 50% was driven by the back book. That's a lesser percentage off the back book, which I'd tell you, we, again, saw the pace of that normalization in the quarter continuing to mute.
Not ready to declare a seminal change at this point in time based upon one quarter's trajectory, but at the end of the day, clearly in the quarter we saw improvement in the consumer's ability to service their debt.
Overall macro, factors continue to feel good. Leverage is manageable on the part of the consumer. Unemployment's strong. You've got strong consumer confidence, so the environment feels pretty good, and we're very confident in that 3% to 3.25% range we put out there for charge offs on a full year basis.
Got it. Thanks for taking my questions.
Your next question comes from the line of Mark DeVries with Barclays.
Yeah, thanks. I had a follow-up question on credit. And I think Mark, the last call you alluded potential benefits you were seeing from tax cuts. I'm wondering if you still see signs of that, and if so, also whether you expect maybe you have a bigger impact towards the beginning of next year when refunds come in, as opposed to what comes through, just as a result of improved withholdings?
Yeah, so we did – Mark, you're right, we did see a coincident improvement in credit along with the – at the same when payroll processors changed their withholding levels.
Can't prove causality there, but there was clearly a coincident change. Since that point in time, though, we think that produced about $100 in the pocket of our average customer give or take. Since that point in time, though, we've seen gas prices creep back up that would theoretically have eaten into that, so it's a little unclear exactly what the net impact, the tax reform is at this point.
I'm clearly not a bad guy in and of itself in isolation. But it's a little unclear how much of a good guy it is. The overall improvement we're seeing, in terms of, again, that muting of the pace of growth in that normalization curve on the back book would lead me to conclude it's something more than a $100 in the pockets of every individual consumer that's driving that.
But I would say tax definitely belongs as one of the good guys on the list. In terms of what the refund scenario could look like at the beginning of next year, candidly, I don't think we spent a lot of time noodling over that one right now. But it's something good for us to think about as we move forward.
Okay. Great, thanks. And just a question on the optics of delinquencies and charge-offs in the personal loan portfolio, as you actually potentially shrink that in the coming quarters, and obviously aren't adding as many receivables that are at the very early stage of their seasoning and don't have delinquencies, should we expect that to, kind of, tick up in the coming quarters?
Absolutely. You will see a denominator effect, Mark, as that (00:26:04), that lapping or the slowing of the growth. So I would expect charge-offs in that book to continue to rise from where they are right now.
You'll have seasoning of the vintages we have booked. You'll have the normalization that still continues that we just got done talking about in the card space, but clearly applies here as well.
You'll have the effect of slowing growth from the sub-segments we exited, that we talked about over the course of the last couple quarters. And then you'll have the incremental effect of the pull-back we're doing here. So, the ultimate dollars of losses we take won't be any higher. But because you won't be bringing on as many new accounts, the denominator effect will kick in, and you'll see the loss rate pick up.
Okay, great, thank you.
You bet.
Your next question comes from the line of Eric Wasserstrom with UBS.
Thanks very much. Just wanted to circle back on that issue of debt service. Mark, you just pointed out that there has been certainly some benefits to consumer tax reform and wage growth. But when we look at the aggregate data, we also see that leverage seems to be growing faster than disposable income.
So how do you think about that, particularly with respect to the fact that I think half your growth comes from your existing customer base. So presumably, you're contributing to that growth in leverage. Do you feel that there is an embedded credit risk there that's being fully acknowledged?
Yeah. I think that right now as we look, Eric, we see the consumers' level of leverage, in our book, as measured by debt-to-income really coming back toward the levels it was at prior to the crisis, so let's call it normalization.
But the nature of that leverage has changed pretty dramatically. Prior to the crisis, the vast majority was variable rate in nature and was housed in an ARM. So, as rates were rising, that consumer had a real double whammy and came under a significant degree of stress.
Today, less than 10% of the consumer debt out there is variable rate. So you've got fixed rate and most of the growth that we have seen of recent years too has been really in fixed-rate product. It's been in Federal student loans, it's been in auto loan, it's been in personal loan. So, it feels like the levels of leverage are really returning to more normal levels, but that the composition of that leverage feels a little bit healthier than we saw before.
But clearly, that has been what's been driving the normalization that we've been experiencing along with all the other issuers in the back book. We're not seeing big movements in incidence rate. It's up a little, but we're not seeing big movements in incidence rates. It's really severities that are up. And that's just because when people go bad, they're carrying more debt, and the losses that all the lenders take are bigger.
Sure. And if I can just follow-up one question on deposit pricing. I think you indicated 31 basis points in the quarter, which looks to be about what effective Fed funds rate moved in the quarter. So, I know you're well below the through-the-cycle average. But how do we think about the marginal cost of deposit pricing from here, and as it relates to your net interest margin?
Yeah, so the marginal beta was 10 basis points that we saw on the last Fed move. The cumulative beta thus far, since the rates have started rising, has been 46.
So continue to feel good about that. There has been a high degree of variability, in terms of – I think with the excess liquidity the Fed pumped into the system with their QE and the tapering hasn't gone on long enough now. You still have an excess of deposits kicking around in the system a little bit. And that's made the path of normalization of beta a little bit lumpier than it would have otherwise been because we've seen betas on some rate moves as high as 80. Again, the beta on the most recent move was 10 bps and cumulatively, we're sitting at a 46 since rates started to rise. So we feel really good about that, and we think a big chunk of that performance is tied to the fact that 60% of those depositors have got a relationship with us on the asset side of the balance sheet.
Great. Thanks very much.
Your next question comes from the line of Rick Shane with JPMorgan.
Thanks, guys, for taking my questions. Mark, we definitely see what you're pointing out, in terms of the trends on delinquencies and charge-offs starting to flatten out. And I think one of the other trends that's emerging is normal seasonality is re-emerging into the numbers. As this occurs, I'm curious, will we see the year-over-year provision expense start to converge back towards asset growth?
Yeah, it's probably a step further than I'm prepared to go at this point in time, would be the honest answer, Rick. Not ready to declare victory on that point yet. We've had a couple of quarters watching that normalization flatten. We've had a couple of quarters where normal seasonality seems to be occurring. So I agree with all your data points. Just not quite ready to make that call at this point in time. But we do feel very good and constructive about the credit environment. And we're hopeful that we actually do get comfortable making that call at some point here.
Okay. So perhaps asking the question in a slightly different way, unlikely at this point that the reserve rate will continue to rise in the way that it has over the last year, it started to flatten – it started to stabilize the last couple quarters?
Yeah I would say that – we set the reserves on a quarterly basis, and we set them based on what we see emerge in the course of that quarter, in terms of 12-month-forward-looking losses.
So we're too early in the quarter this year for me to be able to sit back and prognosticate on exactly what that's going to look like. I would be so bold as to say we continue to see that flattening that we talked about earlier continue thus far in the quarter. So, that's obviously a positive indicator. But reserves will set once we have the benefit of a lot more information as the quarter moves on.
Got it. Appreciate that. Thanks, Mark.
You bet.
Your next question comes from the line of Bob Napoli, with William Blair.
Thank you. Good afternoon, and solid quarter. And you guys have been delivering solid numbers now for years. It's been somewhat hidden, as I think Rick was getting into the growth, the buildup in provisions. And it looks like credit losses are stabilizing.
And I know Mark, you're not ready to make that call on credit. But just as we look out, essentially, this company's had pre-tax income of $3.6 billion for five years in a row. And it looks like you're ready to accelerate, and you've reduced the share count dramatically.
So the combination of growing earnings and reducing share count, I guess, is what the market's looking for to improve your multiple. But as we look out over the next few years, David, what is the model for this company? Is it – loan growth and operating efficiency is great, but can it improve? How much should it improve? I think technology's allowing improvement. Do you expect loan growth 6% to 8%? Should pre-tax earnings grow at 10% over the medium to long-term? What is the business model for Discover? And what's going to drive that growth?
Well, I would say that we will continue to focus on trying to grow revenues faster than expenses. And for a number of years, we've been having very nice revenue growth. But normalization pushes back against the PBT growth. And yet, we're earning very high returns. So, a lot of the EPS growth has come from buybacks.
And if at some point, the normalization slows, that would be what should allow us to then start growing PBT again. But we're not providing guidance at this point. So, I don't want to get into specific targets. But I guess one thing I would say, is that our total asset base is much larger today than it was five years ago. And so essentially we've maintained a PBT while the ROA has gradually come down.
I think that's very healthy, because I think a few years ago we were probably overearning. We had, maybe an unsustainably high ROA, if you look at the long-term potential in a card business, and so I think we're now starting off with a more reasonable ROA, and if we can then, kind of, get to a point where we maintain that ROA, but continue to grow our loans, that then translates into PBT growth.
And I guess that makes sense. Will you revisit? I mean, at one point you had given targets, and I think your last Investor Day and before that you had given longer term targets. Any thoughts of putting out longer term targets or raising your ROE target?
Bob, I would say on that front, that's something we evaluate every year and think about every year, but those are really meant to be through the cycle guides as opposed to annual guides. I'd just kind of – I'd echo David's comments that the EPS drivers really are going to be in this business, it's loan growth, it's NIM, it's expense management, it's capital management and it's underwriting credit card performance, right?
Those are going to be the key levers, and I appreciate in your question, given the way you asked it, because you're right, we focus on long-term value creation and those drivers that we control. And we're not – at Discover, we're really not going to get caught up in what folks are looking for this quarter or next quarter. We're going to run the compound shareholder value over the long haul.
Thank you.
And Bob, one thing that I would just add – we were just looking at some returns back from when we spun off, and our EPS over the year up until last year, was 18% compounded EPS growth.
But essentially, it all came the first four year – or there was a huge jump in the first couple of years. That's when we had a huge jump in PBT, but after the crisis, we had some big reserve releases which gradually diminished.
That turn gradually builds. And so it's – you almost have to look at it across the full cycle, it looks great, but you – depending on what part of the cycle is, it's lumpy. You get huge surges and then you, kind of, give back the ROA for a period of time. And so we feel really good that we've been able to maintain profitability even with a lot higher charge off rate, and much more normal charge off rate of about 3%, than when we were charging off at 2% and had reserve releases from a number of years ago.
Understood. Thank you very much.
Your next question comes from the line of Chris Donat with Sandler O'Neill.
Hi, thanks for taking my question. Mark, I know you said you were comfortable with the expense guidance you've given, but looking back over the last few years, at least in two of the last three years, you had about 50% of the annual expenses spent in the first half of the year, and I know there were some unique things going on in some of those years, like with higher regulatory expenses or things tied to some other things. But just wondering if you expect the cadence of expenses this year to be a little bit more back-end weighted, given that you've already had like $1.9 billion in the first half of 2018?
Yeah, I would say the expense growth is really a function, Chris, of the business growth, right? So, we talked about it at the beginning of the year when we gave that annual guidance that we were going to be investing a chunk of the benefits of tax reform not only into advanced data and analytics capabilities, but also into some growth-related activities.
Those continue throughout the course of the year, and the pacing of those is not exactly linear, I would say, would be the right way to think about it. At the end of the day, we do believe we have the ability to drive the efficiency ratio lower over time.
We definitely had a lot more expense leverage in the model than you're seeing out of this, thus far this year, right? But as a kid who grew up on a farm, I'll use my farm analogy and that is you make hay while the sun shines. And we've got a great investment to invest for that growth. We've got a great opportunity to continue to enhance our digital and analytic capability.
And back to that thought about running the business for the long haul, this is the year we're choosing to make those investments. You saw 4% positive operating leverage out of us each of the last two years. This is a business model that naturally produces that positive operating leverage. It's just a choice we've made consciously to build for growth this year, to invest for the future this year.
Okay. And then for my follow-up coming on a very different topic, so we recently got the Supreme Court's ruling in favor of American Express on anti-steering rules. Just wondering, not so much on the American Express side, but Visa and Mastercard had their settlements they made, I think in 2011 with the Department of Justice on some steering issues. But I'm not sure much has changed in the market since that time, I think, waiting for what the outcome of what the Amex litigation would be. Anyway, any changes you're expecting to make, now that we're through all this litigation? Or is it pretty much the same as it ever was, for issues around steering and your opportunities?
For us, it maintains the status quo, and so I don't expect a business impact.
Okay. Thanks very much.
Your next question comes from the line of Betsy Graseck, with Morgan Stanley.
Hi, good evening.
Hey, Betsy.
Hey, just a couple of questions. Mark, I think you mentioned earlier around promo balances, that you expected they were going to be falling throughout the year. I wasn't sure, as a percentage of total, I think that's what you meant. But maybe you could give us a little more color as to why you used the word rapidly, and just your outlook there?
Yeah, we invested pretty heavily as part of those growth expenses we talked about early in the year, Betsy. And part of that investment, in that case, went toward balance transfer activities.
Those mailings and those digital placements have not continued at anywhere near the same pace. Normally when you stop those mailings and digital placements, you start to see fall-off in the volume that's coming on from those offers sooner than we did this time.
So, we are now seeing the fall-off from those offers. We're clearly seeing the pieces of the puzzle align that's very comfortable that with a much lower level of balance transfer offering going forward than having changed the program a little bit as well, that that trajectory is going to continue and feel good that we will see 1% or more reduction over the course of the year in the level of promo balances in the portfolio today.
Got it, okay. So it's around 1%, okay. And second question was just on transactors. And I know you're looking more for revolvers than transactors, but maybe you can help us understand how you're balancing between wanting to grow sales and having offers that do attract transactors with the balance growth that you're really looking for?
I'd say, Betsy, our strategy has been very consistent, in that, we target people that are credit worthy, but at least have some propensity to maybe revolve at some point.
I think everyone knows that, if you think rewards pretty much offset interchange, if someone's a lifetime transactor, there is no revenue from that customer. And so we've continued to, therefore, focus on profitable resolvers. And some of our boost in transactor volume is more of a return to normal. Because there's fewer competitive offers that were pulling away some of the transactors from us a year ago and two years ago, particularly in some of the Sam's and Costco wars, and some of the people really targeting very high-end transactors. So to some degree, the grocery category also had an impact this quarter, because that seems to be more transacted. But generally, it's just bounced back to probably more normal levels, where loan and sales growth are about the same for us this quarter.
And do you feel like gas had a material impact, or even noticeable impact on the spend levels this quarter?
It did. Our gas purchases are up 25% year-over-year. And that was a negative for several years, and it's flipped around to be a positive.
Okay. Thank you.
Your next question comes from the line of Bill Carcache, with Nomura Instinet.
Thank you. Good evening. Mark, can you give us an update on what's happening specifically with negative credit migration in the portfolio? Just wondering whether along with the generally favorable credit trends that you've described, you're perhaps also seeing a notable lessening in the pace of customers that you've underwritten as prime credits, but are falling to sub-prime, and if so, why you think that is?
We have seen in the most recent quarters a slowdown in the rate of a drop-off from the above 660, into the below 660 book. So yes, we have seen that. I really don't want to hazard a guess for you here on the call in terms of exactly what the moving parts and pieces of that are, other than to point back to what we've already talked about, and that being specifically the level of normalization, that curve is beginning to become muted.
I think the people who were overleveraged are, kind of, working their way through the system at this point in time a little bit. And at this point, looking at the roles in the buckets, looking at the current delinquency situation, credit is encouraging, right? That's not saying we expect credit to turn around and start having reserve releases, I don't want you to misunderstand. But clearly we see a very clear path where the health of the book is clearly still very good, and any signs of stress are moderating.
Understood, thank you. If I may as a follow-up, what's the level of deposit beta where you think we'll no longer see NIM flow through benefit from additional rate hikes?
Considerably high right now. That 46 cumulative beta we're sitting at right now, is well below what our through the cycle expectations are, and the 10 basis point marginal beta on the most recent move is obviously – the 40 beta, rather, with the 10 basis point move is obviously well below. So, I would say we still have rate good guys from the positioning of the balance sheet and the deposit book.
Great. Thank you very much for taking my questions.
Yep.
Your next question comes from the line of Chris Brendler with Buckingham.
Hi, thanks for taking my questions. Mark, sort of, circle back on the NIM for a second, you did a nice job of, sort of, walking through the quarterly progression. But can you maybe discuss the annual progression. Like I just noticed 22 basis points on the card yield year-over-year after 100 basis points plus of Fed moves.
I know there's lots of different factors that go into that, but you haven't really moved the sub-prime percentage that much. The one thing we can see hasn't moved that much. Obviously transactors have an effect, promotional balances, but 22 basis points seems real low, and is there a lag and maybe that can continue to catch up with some of the Fed moves?
So the book re-prices, if you think about it, on the next cycle date after a Fed move. So, there's not a particularly large lag on the revolving balances we have.
I think you rightly called out the moving parts and pieces. It's the level of promotional activity, which is coming in higher than we expected it to in the first half of the year, which has had a muting effect on that card yield number for sure. And the level of transactors we saw emerge in the book, obviously has a muting effect as well, because ultimately at the end of the day, that's a zero percent interest earning balance you're carrying.
So, our NIM guidance in terms of sticking to our full year thoughts obviously implies we expect to see improvement in the combination of those categories. So, I would expect you'd see more flow through to card yield as we look forward here.
Great, thanks. And then a quick follow-up on, maybe for David. Just an update on the checking accounts, the debit rewards products. It seems like a really exciting opportunity and was just hoping for additional update there in terms of traction and when are you going to go full scale and launch that product?
Well, we're very pleased with the results in the first half of the year. We've had virtually no marketing, but with the redesign of the reward component early this year, we've seen a much higher per month take-up rate, doubled our new accounts per month.
We do expect to do some marketing in the second half of the year. We'll be introducing a new plastic design, and some additional feature functionality here shortly, but it will probably be next year before we're really ready to put more serious marketing heft behind it as we continue to get experience on the marketing and the fraud patterns and adding more feature functionality. We want to do this right. It'll be a gradual build. And over the very long term, we think it's very important, but we don't want to go too fast too early.
All right, great. Looking forward to that, so. Thanks so much.
Your next question comes from the line of Moshe Orenbuch with Credit Suisse.
Great thanks. Most of my questions have been asked and answered, but I wanted to, kind of, just concur with your point on the mail volume in the personal loan business. Your mail volume, though, is probably – (00:50:22) probably 2.5 times your personal loan business, but you're still doing a couple of hundred million pieces a year. Could you talk a little bit about whether there's anything we should think about on your costs from reducing that, or are you going to be able to reallocate that to other activities?
I wouldn't – we're going to be pulling back, but I don't – I'm not sure what percentage it is, but don't think that that volume is going to go away for us. I mean we're keeping disciplined. We're mailing segments that work. Our cost per account actually has held up remarkably well considering the volumes.
In fact, one of the things that seems to be as a lot of that marketing that we're seeing out there, is not going to the same people that we're sending to. We're seeing people send many more pieces of mail than we think are good credit risks, and we see some people going maybe into sub-prime marketing, which obviously we're not in.
So I would think about maybe some expense pullback, but it's not going to be material to the company, and it doesn't get us out of the range that, Mark, kind of, reaffirmed that we expect for the year for the full company.
Yeah, I would say Moshe, most of it gets reallocated, right? To the extent there's pullback, we'll reallocate it because we continue to see great opportunities elsewhere to drive great risk-adjusted returns. So, this is not a reflection of some giant concern we have in our personal loan book. It's really more reflective of what we said earlier, there's times when in this business, you want to be on the accelerator, and there's times in this business where you want a slightly lighter foot. And so I think it's really more that and those expenses will get reallocated largely.
And essentially we'll continue to mark it down to the marginal return being strong, and there's still a lot of good personal loan business out there that has strong marginal returns as long as one keeps the pricing and credit discipline, which we're doing.
Well said.
Great. Just as a follow-up, Mark, in the past you've talked about a lot of different factors, kind of, in addition to the underlying performance of your consumers, but macro factors, we talked a little bit about leverage. Other macro factors when you think about the level of the reserve, how are they performing? And how does that fit into your, kind of, reserve determination?
So the big macros they go into their reserve, Moshe, it would be, unemployment is a biggy. That one is obviously continuing to perform at a benign fashion as you think about the forward 12 months.
I think Moody's has been the outlier there in terms of forecasting, and they continue to kick the can down the road on when they see that tick up. I would say nonfarm payrolls would be a big input in terms of what we see, and that continues to go well.
Initial bankruptcy claims are a big one. We don't see a significant movement there at this point in time. Consumer confidence is a big input, that remains strong. It's deteriorated a little bit, but remains very strong. That's been just choppy with all of the geopolitical and political noise out there.
HPI continues to be a big input. That has continued to be strong across the spectrum, so that's why when we talk about a good environment, Moshe, in which to continue generating quality loans, the backdrop right now continues to feel very healthy on the part of the consumer. It doesn't mean you don't look for those pockets where, okay, there is signs of things getting a little long in the tooth emerging some of these segments in personal loans and the like, and you feather the accelerator there, and you reallocate toward areas where you see additional opportunities.
Thanks so much.
Yep.
Our final question comes from the line of Brian Foran with Autonomous.
Oh, hi, how are you?
Good, Brian, how are you?
My last question has six parts. First, just to make sure I'm not doing anything stupid, I mean, you went through each of the guidance lines individually, so if I'm looking at the fourth quarter presentation and the six line items you gave ranges on, you're basically saying you're still comfortable with each of those six ranges – loans, expenses, rewards, NIM, net charge offs, and tax rate. It's all still the same in your mind?
Yeah, we didn't say anything about tax rate, but I'll go ahead and say, we're comfortable with the tax rate.
And then just on the NIM trajectory, listening to you, it sounds like it would build through 3Q and then build again into 4Q if it's promos going down and Fed funds going up as two key drivers. Are you thinking like the exit run rate for NIM for the year is closer to 10.50? It seems optically like a big jump. I know you went through it one time. But is that like the implication? It's a 10.50 exit run rate for the year?
I wouldn't validate the 10.50 number, but I would validate that it's definitely a big jump. There's no question. Through the first two quarters, we're sitting at a 10.22. That's not lost on us in any way, shape, means, or form.
And obviously we see a significant movement in the balance transfer and promo portion of the portfolio, as you might imagine, preparing for this call. And we spent a lot of time looking at that and making sure and pressure testing.
And we feel confident that we're going to see meaningful uptick in the NIM in the remainder of the year, and that for the full-year basis, that guidance still feels good.
The other thing I would say is, just to be clear, maybe give you a little bit of a peek under tent in this regard too, it was never our expectation that NIM was going to be flat, higher across the full course of the year anyway. We knew some of the growth investments we were making earlier in the year would have some muting effect there as well. Again, some of them just had more of a halo effect for longer than we thought they would.
And then if I could sneak two small ones in, on just these dynamics you're talking about, on the balance transfers, is it just a dynamic around how many offers went out and what the take-up was?
Or has there been any change relative to what you thought on the maturing balance transfer sticking around at the standard rate? So any thoughts you can give on retention and balance transfers?
And then on the transactor and seasonality in two key point – and it's something you've brought up and CapOne brought up, and USB brought up – and it wasn't even on my radar screen, is it that transactors were higher than expected or is it just that the transactor drag, now that rates are higher, is a little bit more noticeable and we all, kind of, forgot about the seasonality when rates were at zero for so long. So, maybe if you could just remind us, is that transactor thing something that was unusual this year or something we should think about seasonally every year going forward?
So BT retention at the expiration of the BT continues to be economically positive, continues to perform well. That being said, in a rising rate environment, there's only so much of your balance sheet, you want to allocate to that BT environment. And again, kudos to our marketing team, they designed stuff that really worked and stuck around longer. It worked better than we expected it to.
So, we ended up with a little bit more of the balance sheet there. And again, that feathers off as we move forward throughout the remainder of the year pretty meaningfully. But I would say, BTs remain economic.
At this point in time, the retention is good there. And the NPV of those offers continue to be positive and good. In terms of the transactor side of the equation, I would say the answer to your question is it it's a both/and. It is both transactors engaged at a higher level, higher degree of velocity. They were a greater portion of our spend increase to this quarter than they have been in a meaningful period of time.
And the cost of carrying that transactor float is obviously a little bit higher too, as rates have risen. So, our quarter-over-quarter comment really is reflective more of their percentage competition of the growth. But as time goes on, obviously the cost of that float goes up. And that will be a piece too.
Great. I think I got four in there. So I'll stop there.
You can call us back with the other two.
Okay. Thanks, Craig.
Salacia, I think we're done. What do you think?
Yes, sir. I will now turn the floor back over to Craig Streem for any additional or closing remarks.
Sure. Thanks for your interest everyone. And of course, we are available for any follow-up questions you might have. Thank you, bye.
This concludes today's call. You may now disconnect.