Discover Financial Services

NYSE:DFS

Earnings Call Analysis

Discover Financial Reports Strong Q3 Results and Updates Guidance

In the third quarter, Discover Financial reported a net income of $965 million, a substantial 41% increase year-over-year, fueled by a rise in loan balances and improved net interest margins, now at 11.38%. However, card sales decreased by 3% due to cautious consumer behavior. The company anticipates loan growth to slow to low to mid-single digits, adjusting its net interest margin guidance to 11.2%-11.4%. Operating expenses rose 16%, attributed mainly to compensation and technology investments. Additionally, net charge-offs are expected between 4.9% and 5%, reflecting a stable credit performance amid changing consumer spending patterns.

Strong Financial Performance

Discover reported impressive financial results for the third quarter, achieving a net income of $965 million. This marks a significant 41% increase from the previous year, driven by growth in revenue stemming from modestly higher loan balances and net interest margin expansion. The company also recognized a $70 million gain from its first closing of the private student loan portfolio sale, indicating effective asset management amidst a changing economic climate.

Interest Margin and Loan Trends

The net interest margin for Discover reached 11.38%, a rise of 43 basis points compared to the past year and 21 basis points over the previous quarter. This improvement in margins was primarily influenced by a reduction in card promotional balances. However, card sales declined by 3% year-over-year, impacted by cautious consumer behavior and tightening credit conditions. Conversely, personal loans experienced a 9% increase due to sustained demand for debt consolidation, maintaining an average FICO score over 750.

Ongoing Asset Disposition Strategy

As Discover approaches the conclusion of its strategy to sell its private student loan portfolio, around 55% of these assets have now been disposed. The management aims to finalize the sale of the remaining portions by mid-November. This move is part of a broader strategy to refocus the business model, ensuring it aligns with future growth ambitions.

Operating Expenses and Credit Performance

Operating expenses surged by 16% year-over-year, totaling an increase of $238 million. This uptick includes a 22% hike in compensation costs, reflecting the company's investment in employee retention and competitive wages. Despite the rise in expenses, the risk management framework remains healthy, with net charge-offs for the card segment improving, while personal loan charge-offs are stable within historical norms. Notably, the total net charge-off rate stands at 4.86%, which is 134 basis points higher than the previous year.

Guidance Adjustments and Economic Outlook

Looking ahead, Discover updated its 2024 guidance, projecting loan growth to be in the low to mid-single digits, a slight decrease from earlier projections due to a higher-than-anticipated payment rate and reduced card sales. The company tightened its net interest margin range to between 11.2% and 11.4%, and adjusted net charge-off expectations to a range of 4.9% to 5%. The economic outlook assumes an unemployment rate of 4.4% at year-end 2024, with a GDP range between 1% and 3%.

Merger with Capital One

The ongoing merger with Capital One is a pivotal focus for Discover, with regulatory review processes currently in motion. Integration planning is progressing as anticipated, which could yield significant operational efficiencies and enhanced market positioning once finalized.

Earnings Call Transcript 2024-Q3

[Erin Stieber, executive]

Thank you, and welcome to this morning's call. By way of introduction, I'm Erin Stieber, Senior Vice President of Financial Planning and Analysis and Investor Relations. Eric Wasserstrom has decided to pursue an opportunity outside the company. We appreciate his contributions to the Investor Relations and Corporate Strategy programs over the past 4 years and wish him well. I'm excited for this new opportunity and look forward to getting to know all of you over the coming months.

I'll begin by referencing Slides 2 and 3 of our earnings presentation, which you can find in the Financials 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 our third 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, Erin. Good morning, and welcome to today's call. Discover's financial performance remained strong in the third quarter, and we continue to advance our critical strategic priorities of driving business results, strengthening risk management and compliance and planning for the merger with Capital One.

We've made significant progress on the execution of the sale of the private student loan portfolio, successfully completing the first of 4 closings. Additionally, earlier this month, we completed the sale of the second tranche. As we near the end of our student loan disposition journey, we look forward to realizing the benefits of a more focused business model. John will review the details of the sale a bit later in the call.

Our risk management and compliance capabilities continue to advance. We are seeing improved results from new programs, which focus on reducing risk and preventing customer harm. Our organization is driven by our commitment to customers, communities and employees. And as part of our culture, we reinforce ethical decision-making and customer service through strengthened governance and controls.

Discover ranked #2 in customer satisfaction among U.S. credit card issuers by J.D. Power for the fifth consecutive year. We are glad to report that this marks an 18-year run of being ranked either first or second.

We recently reached 2 important milestones in our community-based facility strategy. First, we celebrated the grand opening of our Whitehall, Ohio customer care and community center, marking a significant investment in the region. Second, we achieved 1,000 active jobs in the Chatham neighborhood of Chicago, fulfilling our 3-year commitment. We are proud to create valuable jobs and offer free access to state-of-the-art facilities in the communities where we operate.

Our employees are a key reason for our success and our award-winning customer service. We are very pleased that employee engagement remains high. Attrition is relatively low, and we continue to be recognized as a great place to work. Discover was ranked #16 by Fortune for Best Large Workplaces in Financial Services and Insurance, and was also recognized as a 2024 Best Place to Work for people with disabilities.

Shifting attention to our pending merger. Capital One continues to lead merger-related activities with applications currently under regulatory review. Integration planning is advancing well.

With that, I'll now ask John Greene to review our third 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 $965 million, which was up 41% from the prior year. Financial performance was strong, driven by revenue growth from modestly higher loan balances, net interest margin expansion. We recognized a gain from the first closing of the private student loan portfolio sale. And credit is performing in line with expectations with net charge-offs plateauing.

Let's review the details beginning on Slide 6. Our net interest margin ended the quarter at 11.38%, up 43 basis points from the prior year and up 21 basis points sequentially. On a quarter-over-quarter basis, margin expansion was primarily driven by a lower card promotional balance mix.

Card receivables increased 3% year-over-year due to a lower payment rate, partially offset by a decrease in sales volume. The payment rate declined around 100 basis points from last year, but stable versus the prior quarter and is approximately 70 basis points above pre-pandemic levels.

Discover card sales were down 3% compared to the prior year. Sales were impacted by cautious consumer behavior and credit tightening actions, which began in 2022. We expect these dynamics to persist for the remainder of the year.

Personal loans were up 9% from the prior year. We continue to see strong demand from consumers seeking debt consolidation. The average FICO for new personal loan accounts is above 750.

Student loans were down 19% year-over-year as a result of the first student loan asset sale. We recognized a gain of $70 million in the quarter. As Michael mentioned, shortly after the quarter ended, we completed the sale of the second tranche. Approximately 55% of the portfolio has been sold to date. We expect to sell the remaining portions of the portfolio by mid-November.

Average consumer deposits were up 11% year-over-year and 1% sequentially. We are managing deposit balances to meet our liquidity needs and we have benefited from the student loan sale. We anticipate a through-the-cycle beta of around 70%.

Looking at other revenue on Slide 7. Noninterest income increased $76 million or 11%. Other income increased due to the gain from the loan sale. Loan fee revenue was up $20 million driven by higher instances.

Our rewards rate was 144 basis points in the period, an increase of 2 basis points versus the prior year quarter and up 12 basis points sequentially. The increases were driven by changes in the promotional categories. During the third quarter of 2024, consumers enjoy higher rewards with grocery and Walmart spend earning 5%.

Moving to expenses on Slide 8. Total operating expenses were up $238 million or 16% year-over-year. Looking at our major expense categories, compensation costs increased $128 million or 22%, primarily due to higher wage rates and employee retention awards.

Information processing increased as a result of technology investment and accelerated student loan software depreciation. And professional fees were up $42 million or 15%, driven by higher recovery fees and merger and integration costs.

We recognized $43 million of merger and integration planning costs in the quarter, $65 million year-to-date and anticipate about $125 million for the full year 2024 spread across multiple expense categories. We expect total risk management and compliance expense of approximately $550 million in 2024, excluding card misclassification cost.

Moving to credit performance on Slide 9. Total net charge-offs were 4.86%, 134 basis points higher than the prior year and up 3 basis points from the prior quarter. Adjusting for the impact of reclassifying private student loans to held for sale, the total net charge-off rate would have declined 20 basis points.

In card, net charge-offs declined 27 basis points from the prior quarter, outperforming seasonality. 30-plus day delinquency formation increased in line with seasonal trends.

The 2023 card vintage continues to perform in line with the 2022 vintage and remains highly profitable. An early look at the 2024 vintage suggest improvements compared to 2022 and 2023. Personal loan net charge-offs and delinquencies ticked up modestly but are well within historical norms, and vintages are meeting profitability targets.

We continue to see a stable yet cautious consumer. The labor markets remain strong and wages are growing. However, households are contending with inflation and the impacts on everyday living expenses. Spend per card member is returning to a more normal level. Slower, stable spending indicates that households have adjusted spending patterns to manage their budgets, which is beneficial from a credit standpoint.

Turning to the allowance for credit losses on Slide 10. Our credit reserve balance increased $31 million from the prior quarter as a result of loan growth. The reserve rate was 7.18%, down 4 basis points from the prior quarter, driven by our credit performance and modest improvements in the forecast for household net worth and debt service burden.

Our economic outlook assumes year-end 2024 unemployment of 4.4%, with peak unemployment at 4.6% and GDP in the 1% to 3% range.

Looking at Slide 11. Our common equity Tier 1 ratio for the period was 12.7%, up 80 basis points, supported by core earnings and the student loan sale. We declared a quarterly cash dividend of $0.70 per share of common stock.

Before we discuss our revised view of 2024, I would like to provide a brief regulatory update. As part of its review of the joint proxy statement and prospectus, the staff of the SEC has indicated that they disagree with certain aspects of Discover's accounting approach for the card misclassification matter. We are working diligently to resolve their comments, which largely focused on the allocation of previously incurred card misclassification charges between revenue and expense. We do not anticipate resolution of this matter to have an impact to cumulative historical earnings, capital or our counterparty restitution plan liability.

Concluding on Slide 12. We have revised our 2024 outlook to reflect our latest view. We are updating our loan growth expectations to down low to mid-single digits. This change is driven by a higher than anticipated payment rate and slightly lower card sales. Excluding the student loan sale, loans are estimated to grow low single digits.

We are tightening our net interest margin range to 11.2% to 11.4%. Our operating expense guidance is unchanged. We are tightening our range of net charge-offs to 4.9% to 5%, reflecting our improved credit performance. Our capital management expectations have not changed.

In summary, we continue to deliver strong financial results, prudently manage our business and prepare for our merger with Capital One.

This concludes our remarks. I'll turn the call back over to the operator.

[Operator]

Thank you. Today's call has ended. The Discover Investor Relations team will be available for your questions. Thank you for joining. You may now disconnect.