Discover Financial Services

NYSE:DFS

Earnings Call Transcript 2019-Q2

[Operator]

Good afternoon. My name is Erica [ph] 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. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you.

I will now turn the call over to Mr. Craig Streem, Head of Investor Relations. Please go ahead.

[Craig Streem, Head, Investor Relations]

Thank you, Erica [ph] welcome everybody to our call this afternoon. I’ll begin briefly 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 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 in 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 question-and-answer session. But we’d limit yourself to one question please and one follow-up so we can make sure that everyone gets one and now beginning on Slide 3.

It’s my pleasure to turn the call over to Roger.

[Roger Hochschild, Chief Executive Officer]

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 disciplined and underwriting new accounts and line management along with continued investments in collection capabilities. Looking to our lending products, the 7% growth in card receivables was forced 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’ve 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 entered the peak season early origination activity looks good and is consistent with our expectations. We believe, we’re well positioned to continue to gain market share.

In personal loans, our recent credit tightening has achieved its desired effect with both charger 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 that 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 performances increasingly driven by growth in receivables.

Our payment services segment generated a robust 15% increase in pretax income driven by strong growth in volume, that majority of which came from our PULSE business. The team at PULSE continues to win new relationships and 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 reflects a disciplined and commitment to excellence that will bring to serving our customers and delivering long-term value to our shareholders. Clearly, the favorable economic environment is contributed to our performance and we don’t see any signs this is changing in the near-term. Nevertheless, we recognized that this may moderate at some point and are continuing to adapt our growth in credit strategies as appropriate.

Before I turn the call over to Mark, I want to highlight two 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 shows 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 will now ask Mark to discuss our financial results in more detail.

[Mark Graf, Chief Financial Officer]

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 at 10% this quarter was driven by solid loan growth and a higher net interest margin. Looking at the provision for loan losses roughly three quarters of the 6% increase was driven by the seasoning of the 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 merchandized 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 to 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 our 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 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 Revit BIM. 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 non-interest income increased $46 million primarily driven by 14% increase in net discount and interchange revenue. The 5% increase in gross discount in interchange revenue was primarily driven by the year-over-year increase in sales volume which was also up 5%. Rewards cost 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 attract 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 one basis point sequentially. Relative to the second quarter of last year, the net benefit of prime rate increases in March, June and December 2018 as well as favorable shift in the promotional balance mix and revolve rate were partially offset by higher deposit costs in both brokered and direct consumer, a higher charge offs of accrued interest. Compared to the first quarter, the benefits from two additional cycle days a shift in promo balance mix and a favorable funding mix were mostly offset by the higher cost in brokered and direct 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 set actions. That said, it’s fair to say that it’s looking more likely that full year net interest margin will evidence a bit of upside biased 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 loan yield. Prime rate increases favorability in the revolve rate in 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 [indiscernible] activity which had a positive impact on card yields 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 five basis points sequentially and 49 basis points year-over-year. We continue to see cumulative deposits betas below historic norms. As we consider potential cuts in the feds funds rate. We expect that the results in 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 three quarters of 1% 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, 2018. Information processing costs were up reflecting our continued investment 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 as 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 five 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 seven basis points year-over-year and decreased two 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-offs 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 four quarters ending June 30, 2020 which includes $0.04 per share increase in our quarterly common stock dividend as well as planned share repurchases up to $1.63 billion over the new four quarters. I’ll remind you we were not subject to CCAR for 2019 but will require [indiscernible] capital plan that was approved by our Board of Directors and submitted to regulators.

As always, we remain committed to efficiency 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 26% return on equity. Our consumer deposit business saw a 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 normalized 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 in 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 [ph] to open the line for Q&A.

[Operator]

[Operator Instructions] We’ll take our first question from Bob Napoli with William Blair.

[Bob Napoli, William Blair]

Solid quarter and Mark, sorry to see you leaving next year but it’s been great working with you. Question on CECL I guess and hopefully you’re not leaving because of CECL mark. I know that’s frustrated you there a little bit. Can you – the reserve build, do you have an idea what do 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 overtime?

[Mark Graf, Chief Financial Officer]

Sure. First of all, Bob, I would say thanks for the kind words. I appreciate it. I have enjoyed working with you and all the folks in the market tremendously over the last nine years so I’m not gone yet so you got to suffer through with me for a little while. In terms of 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 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%, 65% range would be the right way to think about it.

In terms of where that impact comes in, its longer duration, higher lifetime loss content assets and [indiscernible] managed asset classes are obviously pretty heavily depended on a macro factor in a CECL environment. So, the volatility going forward I think is really going to be the speed and level of change in macroeconomic forecast 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 number one 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.

[Bob Napoli, William Blair]

The capital return is a little bit below what we were looking for is that because of CECL, was just trying to figure out, is that all related?

[Mark Graf, Chief Financial Officer]

So CECL and the implementation of CECL definitely impacted our thoughts in terms of the forward four quarter ask in terms of the [indiscernible] or churn basis, yes.

[Bob Napoli, William Blair]

Great, so I thought. Thank you appreciated.

[Operator]

Our next question comes from Rick Shane with JP Morgan.

[Rick Shane, JP Morgan]

I wanted to ask a little bit about transition on promotional rates. I’m curious what the results have been with promotional balances that you’ve been able to convert to full pay in the way that you anticipated. Is the NPV MF [ph] program what you expected?

[Roger Hochschild, Chief Executive Officer]

Promotional balances remain very profitable for us and it’s a mix of using promo rates around ET 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 merchandized 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 rates.

[Mark Graf, Chief Financial Officer]

And in terms of NPV part of the question I would say, yes, the NPV’s continue to perform in line with expectations and candidly some of the level of focus on promotional balances obviously as you know, do we believe in the current environment based on competitor actions and otherwise. Do we have the ability to keep hitting those NPV’s 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?

[Rick Shane, JP Morgan]

Great, thank you. And then, you’ve 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?

[Mark Graf, Chief Financial Officer]

Yes, principally what we’ve been doing is over the course of the last several months we’ve been adding to our invest portfolios specifically buying short dated treasuries [indiscernible] two 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 and there also be some synthetic activities will engage in to do principally and then asset swaps will be the way to think about it. We’re in market today, with an ABS floater, a two-year ABS floater. Specifically, we won’t swap that fix, the way we’ve done over the years with a number of our ABS floaters as well, that will also help in that capacity that’s about $800 million deal roughly give or take.

[Rick Shane, JP Morgan]

Thank you, guys, very much.

[Operator]

Our next question comes from Mark DeVries with Barclays.

[Mark DeVries, Barclays]

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 and the reserve ratios have been 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. And this quarter is 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 of sense of how to think about on a quarterly basis, what causes you to move your reserve up or down?

[Mark Graf, Chief Financial Officer]

Sure. So today pre-CECL, we set our reserve base 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 forecasts. Obviously, bankruptcy forecast what we see going on incident rates and what we see happening with consumer leverage and abilities to pay.

Where – would be the key influencers I guess that will be out there today Mark and I think the other thing is we try and not to react with a knee-jerk reaction one 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 areas. We’re not just going to assume that represents a trend we’re going to wait and see that developed and we’re going to make sure we’re being prudent in how we think about trends in the portfolio as oppose to just knee-jerk reacting up and down.

As we go into 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.

[Mark DeVries, Barclays]

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 because you keep reserves mostly unchanged, is the reserve ratio versus last quarter where there’s a more substantial increase.

[Mark Graf, Chief Financial Officer]

I mean 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 in quarter-over-quarter trends in charge off trends. Macro trends a little less clear candidly then we would have seen historically not relatively flat, but uncertainty around what the [indiscernible] is going on the with the fed quite honestly, would be entering into that process. Incident 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 talk about earlier and we want to see those factors develop over more than just a month or two. We actually want to see them develop into trends before we responded as trend 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 to knee-jerk quarter-over-quarter based on things we see moving.

[Mark DeVries, Barclays]

Okay, that’s very helpful. Thank you.

[Operator]

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

[Unidentified Analyst]

This is Mihir for Jason. Just 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 in reward because well you saw a little bit of slowdown this quarter? I think it was up 4.5% plus there’s even 6.5% last quarter and so I was just wondering, is there anything particular there?

[Mark Graf, Chief Financial Officer]

Couple of things, one when you look at us compared to competitors ours is explicitly more of a lend focus model versus spend focus because sometimes there’s a bit of disconnect, part of it was just a challenging comp year-over-year. The switch in 5% category probably caused 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.

[Unidentified Analyst]

Got it. Thank you and then just, can you give us an update on the checking products, the one with the rewards. What kind of engagement are you seeing from the customers, is the population different that are attractive to this product, whether it’s millennial versus your card product if you will and is there an opportunity to drive that growth a little further in the interest rate as you know, if the interest rate environment is we’re expecting with the lower outside funds rate maybe and might see a little bit less yield chasing.

[Mark Graf, Chief Financial Officer]

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 come lower the advantage of checking versus say saving starts to get compressed. We continue to be excited about how checking is performing, the average age of new customer is about 35, our card actually does well with students and millennial too, but we’re excited about the product about a quarter of the new customers are also opening a savings account, so exciting about that, we’re seeing good growth year-over-year in new account. 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. The role – the direct to consumer deposit portfolio is doing very well and as we mentioned on the call, it’s not over half of our funding.

[Unidentified Analyst]

Thank you.

[Operator]

Our next question comes from Sanjay Sakhrani with KBW.

[Sanjay Sakhrani, KBW]

I guess I have 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 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 shift views on the macro and to the underwriting process?

[Roger Hochschild, Chief Executive Officer]

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 is changed there in terms of how we think about our card underwriting. I think the window is there, as long as we can execute around having a compelling value proposition 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 we continue to see good opportunities as well.

[Mark Graf, Chief Financial Officer]

And it continues to skew toward prime oriented solid growth Sanjay if you something you’ll see in our Q as it comes out at the end of the quarter [indiscernible] front run a little bit, the percentage of accounts 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.

[Sanjay Sakhrani, KBW]

Okay and then just a follow-up for you Mark. I appreciate the commentary on the NIM in 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 rising cycle, so maybe you could just talk about those dynamics.

[Mark Graf, Chief Financial Officer]

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 we’ve seen decreases including some of our product book as well. We’ve implemented rate decreases also. So last quarter when we talked Sanjay the cumulative beta through the cycle was 51, the cumulative 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 to the market, we continue to target that sixth to tenth kind of place in bank rate to offer real significant value but not to have rate due to 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 biased to the upside when we gave our guidance in, we’re really seeing that be more likely right now I’m guessing NIM could come in anywhere from call it five to 9 basis points roughly higher than 10.3 that was part of our initial guide. I think want to make sure folks don’t overreact 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 two off a margin give or take. It’s kind of the way to think about it and those treasuries we’ve been buying to dampen our asset sensitivity also are – that lower yields than some other things as well.

So, I mean we’re doing the right things to prudently position the balance sheet. NIM is going to be clearly on the plus side of that guide with the biased to the upside but I don’t want folks to runway and assume it’s going to the moon either.

[Sanjay Sakhrani, KBW]

Thank you very much.

[Operator]

Our next question comes from Ryan Nash with Goldman Sachs

[Ryan Nash, Goldman Sachs]

When I look at credit broadly, so net charge offs year-to-date running kind of towards the bottom of the range 3Q historically it’s seasonally strong for losses. Can you maybe just talk by-product, how you’re feeling about the trajectory of losses and giving positive seasonality, could we end up coming in at or below the low end of your 3Q to 3.4 targeted range? Thanks.

[Mark Graf, Chief Financial Officer]

Yes, I’m not going to get into the trap of revising guidance on you on the credit one here, but I’ll be happy to walk you through the parts of pieces. I would say, card Ryan continues to feel very stable and very good. I would say that 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 impacts of normalization but it’s down to roughly call it a quarter of the impact. The other three quarters is really coming from growth and as our loan growth has moderated a little bit, our guidance for the year is six to eight, as we’re coming in closer to that six-ish percent kind of range so far, I would say that has bearing on that equation a little bit as well, so it feel to me at the end of the day like we’re in a 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 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 declare a victory on the basis of quarter. But I do 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.

[Ryan Nash, Goldman Sachs]

Got it and sorry to ask you 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 impact about a 20-basis point fall off in the back half which is historically seasonally strong. So, I guess I just want make sure I understand all of the moving pieces given that, you’re slightly asset sensitive, your better seasonality. But then you also have lower promo activity which is helping support the margin. So, if you just walk us through the puts and takes of how we end up with the margin, the back half of the year that’s lower relative to the first half. Thanks Mark.

[Mark Graf, Chief Financial Officer]

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 transact or engagement 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 – is 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-month forward a basis 0.1 or 0.2 for every 25 the way to think about that. Those portfolio purchases have a dampening effect of 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 sending that right now is a percentage of 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 would be thinking about Ryan it’s not all inclusive but I’m trying to send a balance 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 we it’s going to moon either. I’m trying to send a very balanced, very clear message there.

[Ryan Nash, Goldman Sachs]

Got it. Thanks for all the color.

[Operator]

Our next question comes from Bill Carcache with Nomura.

[Bill Carcache, Nomura]

My first question is on rewards and promotional activity. I know it’s early in the quarter, but can you discuss whether include PayPal and this quarter’s 5% cash back rewards category whether you had 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.

[Roger Hochschild, Chief Executive Officer]

Yes, I wouldn’t read too much into the decrease this quarter. We talked about how the categories can have a significant impact to 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 impact on rewards in the coming quarter.

[Mark Graf, Chief Financial Officer]

On a full year basis, I would say we aren’t moving that guide we gave for the year that 1.32 to 1.34 so it definitely does tend to move around based on how lucrative that category is. 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. Certain of the other categories it’s not as easy to max out on that if you unless you’re a high spend transactor. So, we do see variability based on that as well, but the guide for the year the 1.32 to 1.34 is still I think, how would be thinking about it.

[Bill Carcache, Nomura]

Got it. Thanks, helpful. Thanks 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.

[Roger Hochschild, Chief Executive Officer]

So, in terms of hybrid cloud versus sort of moving purely to the public cloud. I think our focus around technology, it was always technology to drive business value not technology for technology sake. I mean so we try and take a really practical view, so moving 100% of your applications to the public cloud, moving your general ledger. I might actually see the benefit. On some of the consumer facing applications we have migrated to the cloud and we’ve written 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 a bit different. Certainly, we’re doing a great job in business value, if you look at what we’ve done to mobile space being number one rank there. But I’m also excited about how quickly technology is changing and what we can do in the coming years.

[Bill Carcache, Nomura]

It’s very helpful. Thanks for taking my questions.

[Operator]

Our next question comes from John Hecht with Jefferies.

[John Hecht, Jefferies]

Actually, most of my questions have been asked, so I just have one. Roger you referred to a good mix of sources of growth from new customers and increasing advances. Can you parse out that gives a little bit more information of the growth? How much of its coming from utilization versus advances versus new customers?

[Roger Hochschild, Chief Executive Officer]

I’d guess a bit more from new customers versus the portfolio so probably for the last roughly 18 months, we’ve been close to that 60-40 range between the two, maybe a little higher this quarter. But again, a healthy mix, so it’s consistent really with what we’ve done for a while now.

[John Hecht, Jefferies]

Okay and I guess it’s related – 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?

[Roger Hochschild, Chief Executive Officer]

We 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. 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.

[John Hecht, Jefferies]

Great, thanks very much for the color.

[Operator]

And your next question is from Vincent Caintic with Stephens.

[Vincent Caintic, Stephens]

Most of my questions have been answered or raised. So maybe just 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 information processing and the professional fees and other expenses those are up on the double-digit range. Is that something we should expect to continue going forward or is there one-time things and specifically for the investments infrastructure and capabilities maybe you could discuss that further into the deal. Thank you.

[Mark Graf, Chief Financial Officer]

Sure, if you think about the information technology spend, I think that really is the battle field 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 [indiscernible] back on anytime soon. Obviously, we have a leverage there, if we were hit 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 their if you will, you’re seeing it 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’s some lumpiness to that ones 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 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 this year I think that it 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 2018 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.

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.

[Roger Hochschild, Chief Executive Officer]

And maybe to build off Mark’s comment. You can see great stability in operating efficiency even as we made those increases in investments in 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.

[Mark Graf, Chief Financial Officer]

And actually, we’re at not to peak season DSL [ph] expenses that you incur, your efficiency ratio actually this quarter would have come in at 37.1. So, I think yes and I feel really good about the expense guide and I feel very good about the leverage that exist there.

[Vincent Caintic, Stephens]

Okay, got it. Thanks very much.

[Operator]

Our next question comes from Meng Jiao with Deutsche Bank.

[Meng Jiao, Deutsche Bank]

A quick question just on M&A. I think earlier this year you guys spoke to – would be loving to do acquisitions at 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 US banking. Thanks.

[Roger Hochschild, Chief Executive Officer]

I think the same comments still holds through, we 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 are on 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 buyer portfolios is it’s 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’ll look at anything opportunistically but we feel good and I think quarter shows there’s a lot we can do around organic growth.

[Craig Streem, Head, Investor Relations]

Erica [ph].

[Operator]

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

[Chris Donat, 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 [ph] and the Marcus product from Goldman Sachs we’ve seen some incremental reductions just trying to get a sense of how confident you feel that you can trim deposit rates without having any adverse impact.

[Mark Graf, Chief Financial Officer]

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 market place. I think do we have the ability to lead the market down in the 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 going up either. Do I feel like the betas that we’ve 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 overtime to look more and more like a traditional banks 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 the relationship with us on the asset side of the balance sheet. Right, so I feel very good these are not hot money quasi-capital markets accounts and I feel very good about our ability in a declining rate environment to harvest some benefit there.

[Chris Donat, Sandler O'Neill]

Okay, that makes sense. Then just kind of curiosity wise on the upper end of the competitive spectrum we’ve seen. Robo-advisors like better manual front get a little more aggressive on deposit products using [indiscernible] traditional bank product, but using bank relationships to get FDIC – anyway you’ve seen meaningful competition from there or is that really hitting kind of different part of the marketplace and you’re targeting for deposits.

[Roger Hochschild, Chief Executive Officer]

Yes, we haven’t seen any impact from that.

[Chris Donat, Sandler O'Neill]

Okay, thanks very much.

[Operator]

Our next question comes from Moshe Orenbuch with Credit Suisse.

[Moshe Orenbuch, Credit Suisse]

Most of my questions have been asked and answered. But I was hoping to kind of talk a little bit to couple of questions before that competitions. Your marketing spend was flattish as you mentioned that rewards category in Q2 didn’t had 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.

[Mark Graf, Chief Financial Officer]

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 ramp up in Q3 given the peak for student loans. For personal loans, we were very explicit about trimming back from channels based on credit performance but also that we’re starting to see the benefits from that in terms of the losses and the new generation of models going in. fourth quarter tends to be heavy for card, so yes 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.

[Moshe Orenbuch, Credit Suisse]

Got it, thanks and maybe just a follow-up for Mark. You’ve always used capital markets funding in conjunctions with deposits and as we’re getting into this declining rate environment and to the extent that the industry doesn’t cut as fact. I mean would you kind of switch over to a greater degree of that capital markets funding.

[Mark Graf, Chief Financial Officer]

I’d say, I think about 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 that general direction. That being said, we’re economically motivated and to the extend the cost of funding and the capital markets really started to gap out, sure. 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 plans land mines in the forward P&L when those things mature or reprice [ph], but sure be willing to consider.

[Moshe Orenbuch, Credit Suisse]

Yes, thanks so much.

[Operator]

Our next question comes from Betsy Graseck with Morgan Stanley.

[Betsy Graseck, Morgan Stanley]

Couple of questions, first for Mark. Just want to make sure, your commentary around for every 25 bps, 1.2 basis points that I think last quarter was four to six so just want to make sure I heard that right as well as just understand the [indiscernible] differential all the actions that you discussed earlier, is that 1.2 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?

[Mark Graf, Chief Financial Officer]

So, the four to six Betsy would have been predicated that goes back maybe two quarters ago and it’s 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 one to two basis points of cost to margin on a 12-month forward basis associated with a 25 basis point reduction and we’re continuing to shift the asset sensitivity. So, I would expect overtime that will moderate from that current one to two basis points level as we continue to shift the positioning of the balance sheet.

[Betsy Graseck, Morgan Stanley]

Got it and that’s against spot or that’s against the forward curve.

[Mark Graf, Chief Financial Officer]

That’s against the forward curve.

[Betsy Graseck, Morgan Stanley]

Got it, okay. And then Roger 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 opportunity set here is, what we saw this quarter something that you can continue for a while or do you think anything in particular, hey this is more of a one quarter event.

[Roger Hochschild, Chief Executive Officer]

I think for us probably a lot of focus is around Spain, but also the UK and Ireland. Some of the smaller markets we’re seeing great success and exciting partnership. So, Bulgaria is another one highlight this really is a multi-year strategy different countries will link in and out, but it’s a broad focus across Western Europe.

[Betsy Graseck, Morgan Stanley]

Okay so early innings because these are not necessarily new markets for you but they are new given the relationships that you extended recently it’s an accelerating growth path, is that fair?

[Roger Hochschild, Chief Executive Officer]

Yes, and some of them while, clearly, we’re 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.

[Betsy Graseck, Morgan Stanley]

Okay, so we could see these paces continue as your relationships build out in these markets.

[Roger Hochschild, Chief Executive Officer]

Yes.

[Betsy Graseck, Morgan Stanley]

Okay, thank you.

[Operator]

There are no further questions at this time. Mr. Streem, your closing comments please.

[Craig Streem, Head, Investor Relations]

Thanks Erica [ph]. Thank you all for your interest. We appreciate your queuing up with us in light of who else maybe out there this afternoon and anything else you need of course, feel free to come back to us. Thank you.

[Operator]

Thank you. This does conclude today’s conference call. You may now disconnect.