Discover Financial Services

NYSE:DFS

Earnings Call Analysis

Discover Financial's Q2 2024: Strong Growth and Strategic Moves

Discover Financial Services reported a significant 70% increase in net income to $1.5 billion for Q2 2024. Key drivers were loan growth, higher net interest margins, and robust non-interest revenue. The company entered into an agreement to sell its private student loan portfolio, expected to conclude by year-end. Strategic settlement agreements and a pending merger with Capital One were also highlighted. Guidance for net interest margin was raised to 11.1%-11.4%, with loan growth adjusted to low single digits due to the student loan sale. Despite regulatory issues, Discover remains optimistic about the future, focusing on compliance and risk management.

Impressive Financial Performance

Discover Financial Services saw a remarkable financial performance in the second quarter of 2024. The company reported a net income of $1.5 billion, representing a substantial 70% increase from the last year's corresponding quarter. This impressive growth was driven by a combination of loan growth, higher net interest margins, and increased noninterest revenue. Notably, the net interest margin expanded to 11.17%, up 11 basis points from the previous year. This expansion was primarily influenced by a lower mix of promotional card balances.

Revenue and Receivables Developments

Card receivables grew by 7% year-over-year, largely due to a lower payment rate and reduced contributions from new accounts. Discover experienced a decline in Discover card sales by 3% compared to the previous year, with restaurant spending down sequentially after the first quarter's 5% promotion. Nonetheless, personal loans surged by 13% within the same period, while student loans dropped by 1%. The company recently inked a deal to sell its student loan portfolio, with the transaction expected to complete in four stages by the end of 2024. This sale is anticipated to affect financial statements as student loans are now marked as held for sale.

Growing Deposits

Average consumer deposits soared by 15% year-over-year and 1% sequentially. These deposits are being managed concerning the company's liquidity needs, which will be bolstered by the student loan sale. Furthermore, Discover's disciplined approach to deposit pricing has resulted in a slight reduction in average deposit rates for the second quarter.

Noninterest Income and Expenses

Discover's noninterest income climbed by $313 million or 45%, driven by lower rewards cost and a 10 basis points decrease in the rewards rate. However, total operating expenses increased by $325 million or 23% year-over-year. This hike was primarily due to expected regulatory penalties related to a card misclassification issue. Excluding this charge, operating expenses would have risen by 9% year-over-year. Key categories seeing cost increases include compensation, which rose by 12%, and professional fees, which jumped by 37%.

Credit Performance

The total net charge-off rate was 4.83%, up by 161 basis points from the previous year but down 9 basis points sequentially. Card delinquency rates showed improvement, with a 14 basis points reduction from the previous quarter. Discover projects that losses will peak and plateau during the second half of the year, reflecting stable credit performance. The credit reserve balance saw a decline of $777 million due to the student loan reserve release, but this was partially offset by a $92 million reserve build to support loan growth.

Capital and Dividend

Discover's common equity Tier 1 ratio rose by 100 basis points to 11.9%, driven by core earnings generation and the reserve release. The company declared a quarterly cash dividend of $0.70 per share of common stock, signaling robust capital management.

Guidance Update

For the remainder of 2024, Discover revised its outlook due to the impending student loan sale. The company anticipates loan growth to be down in the low single digits, considering a $10 billion asset sale. Conversely, they have raised the net interest margin expectation to a range of 11.1% to 11.4%, attributing this to lower promotional balances in card yields and the student loan sale. The operating expense forecast remains steady, with expected net charge-offs positioned at the low end of a 4.9% to 5.2% range.

Strategic Movements and Future Outlook

Discover is undergoing significant strategic changes aimed at simplifying its operations and enhancing risk management. The sale of the student loan portfolio marks a major milestone. Simultaneously, Discover reached a settlement agreement regarding the card misclassification litigation, solving historical issues and avoiding prolonged legal battles. The pending merger with Capital One is also progressing well, with expected shareholder votes set for the fall. The company remains optimistic that the merger will provide significant strategic advantages and operating efficiencies.

Earnings Call Transcript 2024-Q2

[Operator]

Good morning. My name is Todd, and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter 2024 Discover Financial Services Earnings Conference Call. [Operator Instructions] Please note, there will be no question-and-answer period after this morning's prepared remarks. After the call ends, questions should be directed to the Discover Investor Relations team. [Operator Instructions] Thank you. I will now turn the call over to Mr. Eric Wasserstrom, Senior Vice President of Corporate Strategy and Investor Relations. Please go ahead.

[Eric Wasserstrom, executive]

Thank you, and welcome to this morning's call. I'll begin by referencing Slides 2 and 3 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 the second quarter 2024 earnings press release and presentation as well as the risk factors detailed in our annual report and other filings with the SEC. Our call today will include remarks from our Interim CEO, Michael Shepherd; and John Greene, our Chief Financial Officer. There will be no question-and-answer session following today's remarks. However, the Investor Relations team will be available for any inquiries. It is now my pleasure to turn the call over to Michael.

[J. Shepherd, executive]

Thank you, Eric. Good morning, and welcome to our guests who have joined today's call. Discover's second quarter operating performance was very good, and we advanced several strategic priorities. Let me highlight a few of these accomplishments. On July 17, we entered into an agreement to sell our private student loan portfolio to affiliates and limited partners of Carlyle and KKR. Firstmark, a division of Nelnet will assume responsibility for servicing the portfolio upon sale. This agreement represents an important milestone in our journey to simplify our operations and business mix. The completion of the sale also has financial implications, which John Greene will detail in a few moments.

As we continue to resolve past issues and strengthen our risk management and compliance posture, we have entered into a settlement agreement to resolve the merchant class actions associated with the card misclassification litigation, subject to court approval. The decision to settle was based upon our internal reviews, extensive dialogue with key constituencies, including merchants and regulators and our pending merger with Capital One. The settlement agreement would resolve claims by parties affected by the card misclassification, including merchants, acquirers and intermediaries. Our current remediation reserve is sufficient to cover the expenses under the terms of the settlement agreement. Our results also benefited from a litigation settlement in our Payment Services segment, where Discover was the plaintiff. We are happy to have this matter resolved and are satisfied with the favorable financial outcome.

Finally, turning to our pending merger with Capital One. Capital One continues to lead the integration planning process, and the teams are working well together on integration planning and regulatory applications. Upcoming merger-related milestones include a virtual public hearing hosted by the Federal Reserve and the OCC, the completion of the written comment period, an in-person public hearing with the Delaware State Bank Commissioner and the filing of the definitive merger proxy. We expect shareholder votes to occur this fall. We are encouraged by how the merger planning and application processes are progressing and continue to believe that the strategic rationale, operating scale and economics of the combined company are compelling. With that, I'll now ask John Greene to review our second quarter 2024 financial results.

[John Greene, executive]

Thank you, Michael, and good morning, everyone. I'll start with our summary financial results on Slide 5. In the quarter, we reported net income of $1.5 billion, which was up 70% from the prior year quarter. Our fundamental performance in the period was driven by revenue expansion from loan growth, higher net interest margin and noninterest revenue growth. Credit continues to perform in line with expectations, supporting our view that losses are near peak and will plateau during the second half of 2024. There are several unusual items which impacted the quarter. These included a $869 million student loan reserve release, a gain of $26 million from the sale of our Lake Park facility. And largely offsetting one another were the favorable litigation settlement and a charge for expected regulatory penalties related to the card misclassification matter. Excluding unusual items, we would have reported net income of approximately $915 million and EPS of about $3.63 per share.

Let's review the details beginning on Slide 6. Our net interest margin ended the quarter at 11.17%, up 11 basis points from the prior year and up 14 basis points sequentially. On a quarter-over-quarter basis, margin expansion was primarily driven by a lower card promotional balance mix. As anticipated, receivable growth continues to normalize from its early 2023 peak. Card receivables increased 7% year-over-year due to a lower payment rate and a smaller contribution from new accounts. The payment rate declined about 130 basis points compared to last year and is now about 90 basis points above 2019 levels. Discover card sales were down 3% compared to the prior year, spending at restaurants, which is a large category for sales volume declined sequentially as a result of being included in the 5% promotion during the first quarter.

Accounting for the influence of promotional categories, sales trends are relatively stable. We continue to see a cautious consumer, evidenced by less card member spend with lower income households being most affected. Personal loans were up 13% from the prior year period. In response to market conditions, we prudently tightened underwriting over the past year, which has served to modestly reduced originations. Student loans were down 1% year-over-year. As Michael mentioned, we have entered into an agreement to sell our student loan portfolio. We expect the transaction to be completed in 4 tranches by the end of 2024. The purchase price has added a premium to the principal balance and is based on a formula that varies depending on the closing timing, interest rates and other factors.

In association with this development, student loans are now accounted for as held for sale. The 2 most notable impacts to the financial statements are that we will no longer maintain a credit reserve for student loans and future student loan net charge-offs will be recognized through operating expense rather than credit losses. Average consumer deposits were up 15% year-over-year and 1% sequentially. Deposit balances are being managed in relation to our liquidity needs, which will benefit from the student loan sale. Our disciplined approach to deposit pricing has led to a modest reduction in average deposit rates in the second quarter, consistent with our practice of leading the industry on pricing in down parts of the cycle.

Looking at other revenue on Slide 7. Noninterest income increased $313 million or 45%. Discount and interchange revenue was up $67 million as a result of lower rewards cost. Our rewards rate was 132 basis points in the period, a decrease of 10 basis points versus the prior year quarter. The decline reflects lower cash back match. Other income increased due to unusual items, including the litigation settlement and the facility sale. On an adjusted basis, noninterest revenue grew 14%. Moving to expenses on Slide 8. Total operating expenses were up $325 million or 23% year-over-year. The most significant driver of this increase was a charge for expected regulatory penalties related to the card misclassification issue.

It is important to note that actual penalties imposed are subject to further discussions and may be more or less than this amount. Adjusting for this charge, our expenses would have increased by 9% year-over-year. Looking at our major expense categories. Compensation costs increased $70 million or 12%, primarily due to an increase in business technology resources. Professional fees were up $80 million or 37%, driven by higher recovery fees and investments in compliance and risk management. Our expectation for compliance and risk management expenses for the full year remains in the $500 million range with an upside bias. This figure excludes cards misclassification related costs.

Moving to credit performance on Slide 9. Total net charge-offs were 4.83%, 161 basis points higher than the prior year and down 9 basis points from the prior quarter. In card, delinquency formation improvement continued. The 30-plus day delinquency rate was down 14 basis points versus the prior quarter. From a vintage perspective, our 2023 card vintage continues to perform in line with our 2022 vintage. As we look into the second half of the year, we expect there could be some variability in monthly card losses from both seasonality and various credit management actions we've taken. This has not changed our broader outlook for losses to generally peak and plateau this year. Turning to the allowance for credit losses on Slide 10. Our credit reserve balances declined $777 million from the prior quarter, reflecting the student loan reserve release, partially offset by a $92 million reserve build primarily to support loan growth. Our reserve rate was just over 7.2%, largely unchanged after adjusting for student loans.

Looking at Slide 11. Our common equity Tier 1 for the period was 11.9%, up 100 basis points, bolstered by core earnings generation and the reserve release. We declared a quarterly cash dividend of $0.70 per share of common stock. Concluding on Slide 12. We have revised our 2024 outlook and having included the impacts of the pending student loan sale. We are updating our loan growth expectations to be down low single digits, reflecting the roughly $10 billion asset sale. Absent this, year-over-year loan growth would be consistent with our prior view. We are increasing our net interest margin range to 11.1% to 11.4%. This change was driven by 2 factors. We now anticipate higher card yields reflecting a lower promotional balance mix and the student loan sale, which increases NIM by about 10 basis points.

Our operating expense guidance is unchanged, notwithstanding the inclusion of the student loan net charge-offs in this line item. Our base case for net charge-offs remains at the low end of the 4.9% to 5.2% range. This includes the 10 basis points impact from student loans. And finally, our capital management expectations have not changed. To summarize, we continue to generate solid financial results, remain steadfast in our efforts to resolve compliance matters and look forward to consummating our planned merger. This concludes our remarks. I'll turn the call back over to the operator.

[Operator]

This concludes today's call. The Discover Investor Relations team will be available for questions. Thank you for joining. You may now disconnect.