Discover Financial Services

NYSE:DFS

Earnings Call Transcript 2019-Q4

[Operator]

Good afternoon. My name is Erica, and I will be your conference operator today. At this time, I would like to welcome everyone to the Fourth 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 of Investor Relations]

Thank you, Erika. Welcome everyone to this afternoon. We will begin as usual on Slide 2 of the earnings presentation, which you can find in the Financials section of our Investor Relations Web site, 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 on today's earnings press release and the presentation. Our call today will include formal remarks from our CEO, Roger Hochschild, covering 2019 full year and fourth quarter highlights. And then John Greene, our Chief Financial Officer, will take you through the rest of the earnings presentation. And when John completes his comments, there will be plenty of time for a Q&A session. And please limit yourself, if you don't mind, to one question and one follow up so we can accommodate as many participants as possible.

Now 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. I'll begin by reviewing the highlights and key performance metrics for the full year. Then turn the call over to John to review fourth quarter results as well as our guidance elements for 2020.

2019 was another very good year for Discover with net income of $3 billion after tax or $9.8 per share, and a healthy return on equity of 26%. These results reflect our business model that brings together the positive attributes of high return consumer lending and direct banking with the benefits and long-term potential of owning our own global network. Our robust returns allowed us flexibility to return excess capital to our shareholders, while continuing to make important investments in the Discover brands' advanced technology and expanding our acceptance globally. These investments have further strengthened our competitive position in 2019, and set us up for continued strong returns in 2020 and beyond.

Looking at some of the specifics. Total loans grew 6%, in line with our expectations. And credit performance was also on target, as we benefited from the continued strength of the U.S. consumer and ongoing advances in our risk management and servicing capability. We achieved a robust net interest margin of 10.41%, and operating expenses remained in our targeted range. The economists are forecasting continued growth in the economic environment in 2020. However, given the unprecedented duration of the economic expansion, we will manage credit with that in mind.

We continue to invest in our global payments business in 2019, focusing on expanding acceptance by adding network partners and relationships with acquirers in key markets like the UK, New Zealand, France and Spain. Our payment services segment generated 24% increase in pretax income, primarily driven by strong volume gains from our PULSE business. The team at PULSE had a great year, adding volume from acquirers and both existing and new issuers.

Turning Slide 4, we had solid loan growth in all our products, with total loans and card loans both up 6%. In our card business, the majority of this growth was in higher yielding merchandise balances as opposed to promotional activity, reflecting strong card member engagement. We continue to introduce features and service enhancements that are relevant to customers and prospects, including for example, leveraging merchant partnerships to provide even greater value to our partners.

We also had a good year in our student lending business, with organic receivables up 9%. Loan growth is benefiting from increased awareness of the Discover brand, enhancements through acquisition models and improvements in the conversion process. We continue to benefit from our strong position as the second largest provider for private student loans.

Our personal loan portfolio grew 3% in 2019, a touch above our expectations. Our investments in analytics and modeling have had a significant impact on our personal loan credit performance, enabling us to increase originations, while maintaining an acceptable level of credit risk.

Turning to Slide 5, credit performed very well in 2019 and was in line with our expectations. The seasoning of loans from recent vintages was the primary driver as the impact of normalization in the consumer credit industry continues to abate. As I said earlier, we feel good about the underlying economic and credit trends as we enter 2020, and we'll have more to say about overall credit environment when we discuss fourth quarter performance and 2020 guidance later in the call.

Before I turn the call over to John, I want to wrap up by saying how excited I am about our prospects for continuing to create value for Discover's customers, team members and shareholders. We finished 2019 on very solid footing, generating outstanding returns by combining solid loan growth and effective credit risk management. I'll now ask John to discuss our financial results in more detail.

[John Greene, Chief Financial Officer]

Thank you, Roger and good afternoon, everyone. I'll begin by addressing our summary financial results on Slide 6, looking at key elements of the income statement. Revenue, net of interest expense, increased 5% this quarter, driven primarily by 6% increase in average loans. Provisions for loan losses increased 5%, mainly driven by loan growth and to a lesser extent by ongoing supply-driven normalization in the consumer credit industry. Operating expenses were up 7% due to higher compensation expense and continued investments to support growth in collections, digital platforms and advanced analytics.

Moving to Slide 7. Roger already covered the key loan metrics. But I wanted to emphasize that the majority of the growth in card receivables came from standardized merchandise balances, with a smaller contribution from promotional balances. We expect merchandise balances will continue to be a primary driver of card growth in 2020. Just under 70% of the increase in receivables was from new accounts with the remainder from existing cardholders. Looking at student loans, total receivables were up 3% from the prior year with the organic student loan portfolio increasing 9% year-over-year.

Turning to Slide 8. Volume on the Discover network rose 5% from the prior year, in line with growth in the Discover card spending. Within our payment services segment, PULSE volume increased 6% over the prior year, driven by strong performance in key product.

Moving to Slide 9. Net interest income of $2.4 billion increased $122 million or 5% from the prior year. The increase was driven by higher loan balances, a higher revolve rate, lower promotional balances and a favorable funding mix as we continue to grow lower cost direct-to-consumer deposits. This was partially offset by the impact of a lower average prime rate in the quarter, an unfavorable funding rate reflecting maturities of lower coupon brokered and direct-to-consumer deposits and higher interest charge-offs.

Total noninterest income was $520 million for the quarter, up $15 million or 3% year-over-year. The primary drivers of the increase were higher loan fees and an increase in transaction processing revenue. Net discounts and interchange revenue was up $281 million or 1%.

Turning to Slide 10. Our net interest margin was 10.29% for the fourth quarter, consistent with our expectations. This was down 6 basis points year-over-year and 14 basis points sequentially. Relative to the prior year quarter, the decrease in NIM was due principally to three factors; first the unfavorable funding rate I just mentioned; second, the impact of a lower prime rate; and third, higher interest charge-offs. These were partially offset by a higher revolve rate, BT fees and a favorable promotional balance mix. Relative to the third quarter NIM decreased 14 basis points due to the impact of lower prime rate and an unfavorable funding rate, partially offset by a higher revolve rate and BT fees.

Total loan yield decreased 7 basis points from a year ago to 12.52%, primarily driven by 12 basis point decrease in card yield reflecting prime rate decreases and higher interest charge-offs. This was partially offset by a higher revolve rate, BT fees and lower promotional balances.

On the liability side of the balance sheet, average consumer deposits grew $3 billion in the quarter and now make up 55% of total funding. Consumer deposit rates decreased 13 basis points from the third quarter as we actively managed our funding costs lower. Although market observers expect a stable Fed funds rate this year, we'll remain vigilant for opportunities to prudently manage our deposit and other funding costs.

Turning to Slide 11. Operating expenses increased $74 million or 7% from the prior year. Employee compensation was $33 million higher, reflecting staff increases in technology, as well as higher average salaries and benefit costs. Professional fees were $24 million higher, mainly driven by third party recovery fees. Cost to support investments in analytics also contributed to higher professional fees. The $20 million increase in information processing was driven by our continued investment in advanced analytics and infrastructure cost.

Turning to credit on Slide 12. The takeaway here is that overall credit performance remains stable and well within our risk and return expectations. Total net charge offs increased 11 basis points from the prior year with the primary driver continuing to be the seasoning of loan growth and to a lesser extent, the supply driven normalization in consumer credit.

Credit Card net charge offs increased 18 basis points from the prior year and 9 basis points from the prior quarter. The credit card 30-plus delinquency rate was 19 basis points higher year-over-year and 12 basis points sequentially. This was another solid credit performance in our card business, reflecting our disciplined underwriting and line management.

We saw a modest uptick in student loan charge offs as portfolio seasoned. Student loan credit performance continues to be aided by efficiency gains in collections, including expanded outreach to co-signers. In personal loans, charge offs rose in the quarter consistent with typical seasonal pattern. The 30 plus delinquency rate was down 23 basis points from the prior year and 12 basis points compared to the third quarter. We continue to see credit improve as a result of our prior credit tightening and improved fraud detection.

Before leaving the subject of credit, I wanted to preview an additional disclosure and trouble debt restructuring you'll see in our 10-K. To provide greater clarity on the growth in our TDR receivables, we will now report that balance of receivables to have successfully completed programs. At December 31st, we had total credit card TDRs of $3.4 billion, up $1.1 billion from the prior year. But in fact, over half of the $1.1 billion increase was from customers who had successfully completed a program. In account number terms, this equates to above an 80% success rate. This demonstrates that our modification programs are an important aspect of helping customers through temporary hardship and also benefit Discover by reducing overall credit costs and enhancing revenue.

Let's turn now to Slide 13. Our common equity tier one ratio decreased 20 basis points sequentially, reflecting loan growth and capital returns, partially offset by strong earnings. Our payout ratio, which includes buybacks, was 77% over the last 12 months. And as we noted earlier, average consumer deposits now make up 55% of total funding.

Slide 14 provides a summary of 2019 business performance compared to our guidance for the year, and against 2018 performance. You'll see green check-marks against each of the metrics, and I want to congratulate the team for its solid execution against all of our key financial objectives for 2019.

The following slide provides a summary of our outlook and guidance for 2020. First, we share the consensus view that the macroeconomic environment will remain stable. We do not see any indicators that point to a recession next in 12 months. We expect the U.S. consumer to remain healthy and unemployment remaining near the current levels. We also note that household debt service levels are at a 40 year low, an indication that consumers remained financially resilient. Based on these factors, we've assumed no Fed rate changes in our 2020 business plan. This backdrop sets us up for another year of profitable growth and strong returns.

Now turning to the specific guidance elements. First, we expect loan growth to be in the range of 5% to 7%. Next, we expect operating expenses to be in the range of $4.7 billion to $4.9 billion, as we continue to invest for future growth with incremental spending on our brand to increase awareness and considerations. We expect net charge-offs to be in the range of 3.3% to 3.5% percent this year, reflecting a stable credit environment and the seasoning of our growing portfolio.

Our target CET1 ratio continues to be 10.5%, which remains an achievable target under CECL due to the phase-in for regulatory capital purposes and our capital generative business model. I'm sure you've noted our list of guidance for 2020 is a bit shorter. In fact, we've taken a fresh look and decided to no longer provide specific guidance on rewards rate for NIM.

The rewards rate can vary quarter-to-quarter depending on the 5% category. The annual rate has been increasing by around 2 to 3 basis points due to the ongoing shift from the more card to the card, and we expect this trend to continue. In terms of NIM, the single largest driver of changes in net interest margin has been Fed actions. Given this, we've elected not to provide specific guidance but we'll comment on the other drivers, such as deposit beta and spending patterns as part of our quarterly earnings calls.

So with that, I'll move onto the topic of CECL. On the last earnings call, I indicated that day-one adjustment would be towards the north end of the 55% to 65% range we'd guided to. We now expect our adjustment to be approximately $2.5 billion or 75% above the year end incurred basis.

In terms of the day-two impact, the reserve change will depend upon the mix of the business, economic outlook, overall credit performance at the point in time in which quarterly estimates are determined. Additionally, the seasonality of our business will impact quarterly reserve changes and could introduce some volatility from one quarter to the next. As you've seen, our business model is capable of generating high returns, which should enable us to largely offset the capital implications of CECL overtime.

Wrapping up on Slide 16. In 2019, we generated 6% total loan growth and delivered a robust 26% return on equity. We had a very strong year in our consumer deposits business with growth of 22%. Credit remained in line with our expectation and return targets, and we executed on our capital plan by allocating capital to loan growth and share buybacks. In conclusion, 2019 was a strong year and we're very pleased with our performance and positioning for 2020.

That concludes our formal remarks. So I will turn the call back to her operator Erika to open up the line for Q&A.

[Operator]

[Operator Instructions] We will take our first question from Ryan Nash with Goldman Sachs.

[Ryan Nash, Goldman Sachs]

So John, thanks for the updated day-one outlook on CECL where you said 75% increase. I guess first, what is driving that higher from the initial guidance? And then second on last quarter's call, you mentioned the day-two impact on the reserve builds to be higher than day-one since you’re adding new accounts that don't have any incurred loss. The message is slightly different from what we've heard from others. So I just wanted to get sense, one, how should we think about -- does the fact that you're growing faster and adding more accounts factoring to that faster day-two impact, or is there something else that's impacting it? Thanks, and I have a follow up.

[John Greene, Chief Financial Officer]

So let me start with day one impact. I think as I said one the last call, my take was team did a fantastic job in terms of modeling and preparing for CECL implementation, and that view still hold very, very strongly. The initial guidance, 55% to 65%, included a number of factors. And as we came through the fourth quarter, we took a look at the modeling, the performance of the portfolio and specifically recovery assumptions. And we ended up revising a recovery assumption that had to do with overall recoveries taking a look at most recent history, which was certainly stellar performance and we moved it back to the middle point of the observable history on recovery. So that was the primary driver of change in day-one.

In terms of day-two, I said on my first call third quarter that day-two would be higher. And certainly in the third quarter was higher as we modeled, and that increase had to do with the amount of volume, we put on the books related to our student loan products, which in terms of day-two impact has a significantly higher impact than day-one would under incurred basis.

Now, that actually points to some of the volatility that we're seeing in CECL. So as we take a look at all our product and the relative mix throughout the year, I would say a good proxy for day-two would be that range around 75%. So it's slight nuance on the initial message that I provided. But I would also caution that that's a preliminary number and we're working through it. And there's a bunch of dynamics that impact CECL, including the macroeconomic outlook, portfolio performance, mix of products that we're putting on the book in any one quarter and obviously, the delinquency and the rates that we're observing, so a lot to consider there. But I hope I've provided enough specificity to be helpful as you think about how to model this business.

[Ryan Nash, Goldman Sachs]

And then I guess a follow up for the both of you. So if I look at the expense guide and that was about 7.5% to 12% expense growth, which is ahead of I guess expectations and where you are running. So first, John, can you be size what are some of the incremental investments? And Roger, are there any one off investments in here that you feel you need to make for this year? Or are we entering into a new phase of elevated investing? And then second, how should we think about seeing the paybacks from these investments?

[John Greene, Chief Financial Officer]

Ryan, I'll start and then Roger I'm sure will have a follow up. So I'm going to start with by editorializing a little bit here. So if you look at the efficiency ratio that this company has generated overtime, it's among the lowest in the industry. And then if you also look at the returns in terms of return on equity, we are among the highest in the industry. And one could use those two data points to make a simple argument that perhaps we've under invested over time, given how much -- given the returns that we're generating.

So as we put the plan together for 2020, we looked at where it was appropriate to invest, where we thought we'd generate the best long term returns for our shareholders. And there was there was two items specifically. So investments in brand around awareness and consideration and that's a meaningful number to be around $100 million, believe or not. And then also continued investment in our infrastructure to add functionality and ensure it's appropriate from a scale and resiliency standpoint going forward.

[Roger Hochschild, Chief Executive Officer]

And maybe just to build on what John said in terms of the payback. Some will be more immediate, so drive our car continued strong loan growth but others, we expect multiyear returns. And as you think more broadly about our expenses, I'd say it's sort of a dual story of efficiency but then also investments. And so the vast majority of the expense lines are close to flat year-over-year, as John and I look across the P&L. We're looking for our efficiencies in terms of our marketing expenses, so our CPAs that we're targeting across the different products. But we are investing significantly around building the brand and also building brand awareness of some of our non-card products, as well as some investments in technology that we think will be very helpful in driving growth in the future.

[John Greene, Chief Financial Officer]

And then just one follow up comment. So this company has a rich tradition of effectively managing costs and certainly my background, I've had my share of cost management and analytics to ensure we are going to get a payback on these investments. So as Rodger said, some of these are longer-term, some of these are shorter-term. We will continue to monitor and ensure that for every dollar we're spending, we're getting appropriate paybacks for our shareholders.

[Operator]

We will take our next question from Sanjay Sakhrani with KBW.

[Sanjay Sakhrani, KBW]

I guess I wanted to dig in again on day-two impact related to CECL. So I was wondering, John, if you could give us a little bit more to help us sort of triangulate on how we should think about the provision for 2020?

[John Greene, Chief Financial Officer]

So I've guided around that 75% figure as a sort of poster and anchor as you think about day-two. It's early, as I mentioned in my last comment, Sunjay. So I would say for the year, that's a decent way to think about it, it might be a little higher, might be a little lower. And in terms of quarter-over-quarter, you know the third quarter we originate a lot of student loans and that day-two will certainly exceed the 75% number that I just mentioned. So mix will be an important factor of it. But beyond that, you know I don't know if I'd be doing any one of service by being more specific.

[Sanjay Sakhrani, KBW]

And then on the other guidance data point around loan growth and not getting a whole lot on NIM and rewards rate. I was wondering if we think about loan growth and what revenue growth might do in relation to loan growth. Is it fair to assume that it should be fairly commensurate, i.e. there's not significant factor that would lead to a different direction than what loan growth would suggest, or am I thinking about it incorrectly?

[John Greene, Chief Financial Officer]

No, I think you're definitely in the right direction. So there's a couple of things that I just want to point out. So as I said in my prepared remarks, we assume no Fed rate changes in our planning assumptions. So if that changes, that certainly as it has historically and been a problem from a forecasting standpoint, that would impact NIM. We're also -- I alluded to this in the prepared remarks, in terms of our focus around deposits and increasing the level of overall funding from direct-to-consumer deposits, which are cheaper funding service.

I also mentioned that I think there is some over time we will continue to work to see what we can do in terms of the cost of deposits, making sure that we're originated the deposits at an appropriate level that fund the balance sheet towards our longer-term target, but also being very mindful of the cost of funding. So if things went well, there could be a basis point or two on the deposit side. That's your call whether you want to put that into your model. And then in terms of pricing action, the company has been pretty stable, but we will continue to look for opportunities on the pricing side.

[Operator]

We will take our next question from John Pancari from Evercore.

[John Pancari, Evercore]

I just have a question on the TDRs, and know you will be giving us more disclosure in the K. But I wondered if you could give us of the $85 million loan loss reserves build that you recorded for the quarter. How much of that was related to TDRs? And then separately, do you have what the delinquency ratio was for the TDRs for the quarter?

[John Greene, Chief Financial Officer]

So for the quarter, we previously said this and it remains consistent that from a TDR standpoint only 5% are more than 90 days delinquent so that's remain consistent, so performance there, no major change. In terms of reserve provisioning, we’re probably not going to break that down on this call. I don't know that it would be super helpful and if I did, it would take the balance of the call, that's kind of walk through the nuances of it. So we will pass on that one if you don’t mind. Sorry, I can't be more specific, John.

[John Pancari, Evercore]

No, I get it, that’s fine. I guess one more on the TDR topic. Just given the increase that you cited, up $1.1 billion year-over-year that's about just under 50% increase and then TDRs were up 9% linked quarter it looks like. What are you seeing differently in your -- the makeup of your card base that you, that Discover is seeing a much larger increase in the usage of TDRs versus a lot of your peer institutions. I know you can't really talk too much about what the peers are seeing. But the increase in TDRs has certainly outpaced that of other lenders in the space.

[John Greene, Chief Financial Officer]

So let me start off by saying that we have some really solid analytics around our TDRs. And we test populations and once those tests come back and show that indeed cash flows are improving, we'll open it up to certain population. And then we will observe that and then we will adjust accordingly based on any differences we see between test populations and when the TDR specific program is in process. So I'm not really going to talk about what other folks are doing.

There also is an approach that we take where we think that, and we've seen real differences in terms of outcomes for our customer base, in terms of helping them work through some difficulty and they end up, some 80% of them end up sticking with us, have their credit lines open backup and continue to be very, very satisfied customers.

So what around the edges, we're going to take a look at smaller account and see if the effort to make a TDR is worthwhile based on our beliefs in terms of what's going to happen in those particular populations. But these are good programs. The financial impact is taken as soon as we TDR, they remain in the delinquency buckets that they are in unless they have made three successful payments.

So what you're seeing flow through the financials is exactly what you would hope in terms of overall good credit performance and a solid book and TDRs is an approach to work with customers and help cash flow.

[Roger Hochschild, Chief Executive Officer]

And maybe just to build on that. There has been a lot of noise around this, and so that's part of why we decided to add the disclosures to help provide you more information and kind of give us more insight into the way we see it. You know a better way to classify it might be, not just TDRs but customers who have ever been in a TDR. And so the growth, really some of them, will have returned to prime will be getting line increases et cetera and are well into the book. It just happens to be the way we account for these is once a TDR always a TDR. So that's why we think these new disclosures that you see in the K will be very helpful.

[Operator]

We'll take our next question from Mark DeVries with Barclays.

[Mark DeVries, Barclays]

My question is what are the implications of the 10.5% CET1 target for the end of 2020, which I believe is kind of what you guys have indicated, you think you should operate longer term on the payout ratio as we look beyond 2020 and sort of to factor in the continued phase in of the CECL impacts along with continued loan growth?

[John Greene, Chief Financial Officer]

So I'll take this and maybe Roger will have a comment if that's appropriate. So when the team set up the original target for CET1, they did that with the idea that indeed CECL would be implemented and would impact the overall capital plan for the year 2019 through the first half of 2020. So we are going through our beginning our CCAR work and we're going to make the submission, and we'll get some feedback likely in June. And we'll use that coupled with our overall plan around capital allocation that we'll review with the board to make a determination of what the future dividend payout ratio and buyback programs will look like. I would say this.

So as we look at CECL for 2020 and our capital generative business models, we can likely absorb over the short term based in the phase in and long term the impact CECL. Now there's questions regarding our regulators and how CECL will impact the consumer finance industry especially given its pro-cyclical nature and the fact that products with longer lives, such as student loans and certain home equity products and even to a lesser extent personal loans. In a tough economic environment, certain lenders might not look like the profile of that that will impact the availability of credit. I will say this, we like our products under Cecil and under the current FAS5 methodology. So it's based on the cash flow, CECL is not impacting the cash flows. And we like the return profiles that we've generated historically and will in the future.

[Roger Hochschild, Chief Executive Officer]

And to build on that from our discussions with regulators, I wouldn't interpret the phase-in as just delaying the pain. The Fed has indicated to us that it's designed to give them time to see how CECL is impacting different financial institutions, and that actually they feel like the amounts of loss of absorption in the system currently, i. e. pre-CECL, which is capital plus provision, is appropriate. So we'll see how that comes out. But again, I wouldn't just necessarily view it as something that's going to phase-in and that's that.

[Mark DeVries, Barclays]

So Roger, does that imply that there is some room for the Fed to potentially say now that you've got greater loss absorption capacity kind of post-CECL that maybe the 10.5% isn't the right level that maybe you could go a bit lower?

[Roger Hochschild, Chief Executive Officer]

I would not predict what the Fed is going to do. I can just say what I've heard directly from them, which is they feel like pre-CECL the lost absorption is right for the system as a whole and that the phase-in is not just spread it out overtime, that actually gives them time to figure out what they want to do. So I'd say, all we have to stay tuned.

[John Greene, Chief Financial Officer]

And the other kind of party that will help form this will be the rating agencies. And you know we spend some time with the rating agencies in December, and the view there is at least my take, my personal takeaway is that they're going take a look at equity and reserves as in the aggregate. So I don't see any major implications at least in the short-term there.

[Operator]

We will take our next question from Eric Wasserstorm from UBS.

[Eric Wasserstorm, UBS]

I have a question just about credit. You know I heard your commentary about broad-based stability, but also we're seeing a few other trends too, such as you know higher interest charge-offs and investment in collections, higher late fees. There is a TDR experience that you cited, the interest rate seems high but there is plenty to add just to growth in TDRs is also very large. So I'm just trying to put all of those pieces together to understand kind of how to really think about the credit experience over the near-term horizon.

[John Greene, Chief Financial Officer]

Yes, I wouldn't worry about straining a bunch of things together. I think we've talked about the TDRs and are adding more disclosures so that hopefully that will help you see them the way we do. In terms of investing in collections, I think that's something that makes a ton of sense just about any time but certainly late cycle. But that's something we've talked about, I think pretty consistently for multiple years there. So if you are trying to spring those data points into a bigger story, I'm not sure that's something I would agree with.

[Eric Wasserstorm, UBS]

And maybe just transitioning topics for a moment in terms of the investment expense that you've highlighted. Is this an expense that you are thinking about over a specific horizon, or should we just think about the overall efficiency ratio of Discover as just being a little bit different going forward than maybe what the recent historical experience has been?

[John Greene, Chief Financial Officer]

I think we've provided guidance for what to expect for 2020. My guess is going beyond that, we'll continue to invest in growth. But I'm also optimistic about our ability to find efficiencies as well, especially leveraging some of those investments on the technology side around robotic process automation, around advanced analytics. So we're not prepared to really give guidance beyond 2020. But you can rest assured we'll be looking to see what we can find on the efficiencies side to help fund investment in growth.

[Operator]

We will take our next question from Moshe Orenbuch with Credit Suisse.

[Moshe Orenbuch, Credit Suisse]

Sort of following and I appreciate Roger that you're not interested in giving guidance beyond that. But if you put together the comments that you do expect to pay back from those investments and obviously the efficiency ratio, given you're likely to see revenue growth in between 5% and 6% at most there is going to deteriorate in 2020. I mean should we take from that the inference that at some point it should be improving, or can you discuss that a little bit?

[Roger Hochschild, Chief Executive Officer]

Actually, it sound like you're asking for long-term guidance. No, again, as I said earlier, we're not giving guidance beyond next year. But I did want to make it clear that you shouldn't necessarily take that as a run rate number. And we do believe, to the point John made, as efficient as our model is compared to the rest of the financial services industry, we believe there's further efficiencies to be gained by deploying some of these advances in technology. So we're not also saying that you can just continue to print the number for 2020.

[Moshe Orenbuch, Credit Suisse]

And maybe just to take that idea, because I’m not a huge fan of the ideas that well, because it's lower than others, we should want it necessarily to be higher for some period of timing. You talked about the high level of returns, but it's not like we're seeing degradation in that, it's not like that it was running down. So maybe talk a little bit about what are the things you saw that you know made this the right time to take that stand on expenses?

[Roger Hochschild, Chief Executive Officer]

I think it’s a very good point, Moshe. We don't manage the business to an efficiency ratio. We manage our expenses to be as efficient as possible. But then also look to invest and drive growth, but some of those too really is the entire expense base and drive the calculation of efficiency ratio. But to the extent we see opportunities to make investments to drive accelerated growth and we feel good about the payback, as John talked about, we will do that and communicate that as appropriate. But I think your points are good one, you don’t honestly just manage the business to an efficiency ratio.

[Moshe Orenbuch, Credit Suisse]

No, I don’t think so and I guess I look forward to having a future discussion about seeing some of those gains coming in on the revenue side.

[Operator]

We will take our next question from Jason Kupferberg with Bank of America.

[Unidentified Analyst]

This is Mihir for Jason. I just had a -- maybe we could start with just CECL, just want to make sure we understand you. And given I think you mentioned CECL has a differential impact on some of your products, particularly on day-two and then as we go into the quarters. Does that change the way you think about those products and also just relatedly in terms of just the disclosures you will be providing. Are you going to provide disclosure for the next several quarters so we can compare results on a more apples-to-apples basis?

[John Greene, Chief Financial Officer]

So in terms of how we think about our products, we think about them from a cash flow standpoint and risk and return -- on a risk and return basis. And we continue to like all our products, whether we are on an incurred basis or under this new regime CECL, so no change in the thinking there. Now in terms of disclosure, what we've said previously, we continue to be in the same spot that we will provide disclosures that will create transparency between CECL incurred for the next four quarters.

[Unidentified Analyst]

And then just real quick, if I can go back to just the OpEx. I guess, clearly it's the topic on this call, but maybe we could get -- if you could give us a little bit of more color on just kinds of investments you're making and just maybe, just help us understand. Your loan growth next year is 5.5 to 7 is a little, I guess, in the range similar to this year, and it sounds like that some of these investments have a little bit longer payback period, but if it also supporting that 5 to 7 loan growth this year. And do you need to make those investments to achieve that growth, I guess on that…

[John Greene, Chief Financial Officer]

So here's how we think about it. So there is the investment in brands to drive awareness and considerations. We haven't actually baked it in but we think that over time will lower our acquisition cost, our per unit acquisition cost as people find greater awareness of Discover, the product offerings, the customer experience and frankly, a fair value exchange, so that is one aspect but that is overtime and to be determined.

The other piece around technology investments, we're going to be very judicious about those and with those to make sure that we are deploying functionality that help make a difference to either our growth trajectory or expense profile. So overtime, I would expect that indeed we'll see efficiency gains, either top line or through the expense base. And some of them, as Roger said, longer term some are shorter term, but there's a thorough process to make sure we're getting the banks the buck.

[Operator]

We'll take our next question from Rick Shane with JPMorgan.

[Rick Shane, JPMorgan]

When we think about the sort of normal factors that cause hardship, loss of job, death, unemployment or illness and divorce. Is there anything that idiosyncratic that you're seeing that's changing in the portfolio, or is there a policy shift that's driving this?

[John Greene, Chief Financial Officer]

No, there's no change in terms of, I'll say customer behaviour. What you're seeing here is frankly, the benefit of frankly some from solid analytics by our collections team in terms of when a customer is experiencing difficulty and helping that customer managed through it. The only process change we've made is it used to be someone has to call in and talk to a rep. For large balances, that continues to be the case. For certain customers who meet certain criterias, they can do it online on their mobile app. And we've tested those populations versus the call in populations and actually the mobile app populations are performing as well or better than when someone talks to a rep.

So what you're really seeing here in the growth is a couple of factors; one is that I think there's a difference in reporting versus some competitors; two is, we have done an analytical exercise to make sure we understand paybacks and where to make a difference to cash flows positively and we've will opened those up. So it's a combination of those factors. And we're going to keep doing it as long as they're cash flow positive.

[Rick Shane, JPMorgan]

And to the extent if you construct it from an NPV perspective, does the transition to CECL and for lifetime reserve make it easier, because there is less accounting sort of penalty to doing this?

[John Greene, Chief Financial Officer]

In terms of the P&L impact right when you take a TDR, you basically take the net present value of the cash flows and compare it to your balance, and that's the P&L impact. CECL, you basically do the same thing on life of loan losses. So yes, the relative kind of detriment to the P&L if you are growing TDRs is smaller under CECL. But you know that's not how we make decisions here.

[Operator]

We will take our next question from Don Fandetti with Wells Fargo.

[Don Fandetti, Wells Fargo]

John, couple of follow ups on the day-two or conceptual accounting, can you clarify what you mean by the 75% not on day-one but on day-two. Are you talking about incremental division on just the loan growth? And then also can you talk once your allowance rate sort of is set, will it remain relatively stable through the year if there's no change in sort of mix or economic outlook?

[John Greene, Chief Financial Officer]

So in terms of 75% on day-two, it would be relative to what they would on incurred basis. So an incremental 75% versus incurred. Now loan growth will create incrementality versus an incurred basis, just the nature of taking a lifetime loss upfront in a provisioning standpoint.

And the team did a really good job in terms of modeling. And you know we feel like we're appropriately reserved. And from a day-one standpoint and going forward, if we're seeing better recoveries through a cycle or are better performance from a overall portfolio standpoint, then we'll adjust. And correspondingly, if we're challenged somewhere we will adjust the other way.

[Don Fandetti, Wells Fargo]

But conceptually, what do you think about sort of the reasons all else equal that the allowance rate remain relatively stable throughout year despite mix or economic change and we talking about sort of CECL being an incremental couple percent GAAP EPS impact, all else equal?

[John Greene, Chief Financial Officer]

So I'm not sure I’m totally clear on the question. But I will try to answer and if I miss, we can come back. So in terms of -- if we're seeing a change in the economy or outlook of the economy, or a change in the performance of our portfolio, or a change in mix, all those will have an impact on the CECL reserves.

[Don Fandetti, Wells Fargo]

No I get that, but I’m saying if those were not to change with the allowance rate, all else equal, kind of stay the same throughout the year.

[John Greene, Chief Financial Officer]

So it would build for loan growth at that rate. But in terms of relative difference to incurred, it'd be fairly consistent.

[Operator]

We will take our next question from Betsy Graseck with Morgan Stanley.

[Betsy Graseck, Morgan Stanley]

So Roger, just wanted to swing back to the investment spend. I think during some of the comments, you were mentioning that with the investment spend, you are expecting to be able to enhance the brand awareness, if you use of words in particular or especially in non-card product. I'm wondering if your messaging does that you think that you're under-representing either the personal loans or in the student loans, or if there is products that you're looking to get into? Maybe you could touch base on what implications for that is. And if the payback for the investment should come in the form more in loan growth and NII, or should there be any fees associated with it as well? I just like to understand how to think about that.

[Roger Hochschild, Chief Executive Officer]

So the investment in brand there two parts, right. Part of it is just increasing considering on the card side. You've some more ground building awareness that we offer products other than just cash back, so we put add money behind miles as well. But we do, as we look at consumers out there, there is a gap in terms of both top of tunnel, people who consider Discover and have us top of mind. So that’s why as we think about our marketing mix, we're going to heavy up a bit on top of funnel brand type advertising.

There also is an opportunity for our non-core products, in particular some of the deposit products. We've made great strides in terms of the product themselves, went out with no fees across any of our deposit products. But there still are huge amounts of consumers that don't understand, for example, we've even in the student loan business, let alone we are the second largest originator of private students loans and the same holds true with understand that Discover offers the savings account and checking account. So it’s a mix of both of those. Building and enhancing consideration on the card side and building awareness for our non-card products.

[Betsy Graseck, Morgan Stanley]

And then this investment spend should kick off in 1Q, like if I take this $100 million and just divide by four and throw that through the model linearly, or is this going to be back end loaded in a 4Q environment. How should I think about the pace of that spend throughout the year?

[Roger Hochschild, Chief Executive Officer]

We tend not to comment on the seasonality of the spend.

[Operator]

We'll take our next question from Bill Carcache with Nomura.

[Bill Carcache, Nomura]

Roger and John, I had a high level of question on the guidance for you. I think everyone would agree with your earlier point that you guys have a rich history of generating high returns and industry leading operating efficiency. But within that, there's also been a commitment to positive operating leverage that we're not seeing in this year's guidance with your revenue growth and expense guidance suggesting that you're explicitly guiding to negative operating leverage. And so when we think about what's changed, it seems like in the past what we've seen from Discover is a commitment to managing expenses for the revenue environment and achieving positive operating leverage by finding cost improvement opportunities in one area, to the extent that you need to make investments in another, as opposed to the approach that you guys seem to be taking now, which is more along the lines of making the investments upfront with the expectation that you'll get the efficiency improvements later. So is that an accurate way of thinking about? I was just hoping you could comment on that and to share any high level thoughts, and that's my only question. Thanks.

[Roger Hochschild, Chief Executive Officer]

So first I'd say it's -- John is new, but you've got the same team that's been here for decades, making the investment. And I think you've seen a lot of discipline from us over the years, whether it's on the credit side or the expense side. It isn't necessarily a trade off where we sort of manage to an expense budget and then sort of if we can generate more efficiencies and that frees up more money for growth, we try and be disciplined and consistent.

So our investments in growth are really more driven by the opportunities we see to put our shareholders' money to work to drive good organic growth, with strong return profiles for that. And I mentioned that we expect our unit costs on the investments and the acquisition to be coming down next year. But we do feel like there's an opportunity to put some money to work with a bit of a longer payback on the brand side, in particular sort of top of funnel brand advertising dropping that awareness and consideration and on technology, that reflect some specific decisions we're making for 2020, I would not read into it any change in discipline, or philosophy from the team here at Discover.

[Operator]

We'll take our next question from Bob Napoli with William Blair.

[Bob Napoli, William Blair]

I guess kind of follow up on, just on the revenue growth, the loan growth and revenue growth. Is there the potential through some of the deposit products, are they consumer banking products, the growth of AREVA pay B2B that you could get revenue growth higher than loan growth over time. Is that a goal and is there a potential to do that? And it seems you've made a lot of investments in the network and in B2B payments over the last several years?

[Roger Hochschild, Chief Executive Officer]

Yes, B2B payments have benefited probably so far more in terms of volume than profitability. The margins can be very thin, but we've been clear that we would love to see more of our earnings come from the payments segments, and are very focused on driving that. That can be a multiyear initiative. So I wouldn't necessarily expect something transformational in 2020, but we have a unique collection of payments assets. If you look at PULSE, Diners Club and sort of the fact that we built the third largest global network in terms of acceptance, so the team is very focused on monetizing that. But again, you're talking about a B2B sales cycle and so that will take some time.

[Bob Napoli, William Blair]

Maybe a follow-up on the competitive environment, and with the entrance of the Apple Card, which mean maybe is going, there have to be your demographic, the growth of [neobanks] probably going after the deposit space. In your target segments, several of them -- some of those companies getting super high valuations as private companies. What are your thoughts on the Apple Card, on the [neobanks], and some of your investment in brand in response to the competitive environment?

[Roger Hochschild, Chief Executive Officer]

So our investments in brand are much more driven by our traditional competitors. And as we're seen those super-high private company valuations appear to come and go. As I think about competition, competition in the card space is always intense. It tends to be rational but you have some large sophisticated players, it's a high-return business. It's challenging but always intensively competitive. So I would view that Apple Card as you can't underestimate anything that Apple does. It's is a new competitor and one I told before formidable, but I don't think it's transforming the overall competitive environment in the cards space.

On the deposit side, it's a different decision in terms of who you take a loan from, from who you give your money. And so brand and trust remain key elements of that. I think as you saw from the very strong direct-to-consumer deposit growth we posted, we feel like we have the product set and ability to compete, we really just need to build awareness. And a lot of the focus is on moving deposits from some of the traditional branch based players as opposed to us really going head-to-head with some of these emerging online players.

[Operator]

We will take our next question from John Hecht from Jefferies.

[John Hecht, Jefferies]

Actually most my questions have been asked but a couple of follow ups there. Number one is that you mentioned some unfavorable funding triggers in the quarter and I'm wondering are you able to unwind or are those kind of permanent aspects of the funding going forward?

[John Greene, Chief Financial Officer]

So actually what that was is if you go back about a year-and-a-half ago, we had some really cheap CDs on the books, and then there was Fed rate actions and more expensive deposits came on the books. And over time if there is no Fed action, you will see favorability come through into the P&L on that. And if you look at...

[John Hecht, Jefferies]

And what duration should we expect that and where you'll get that favorable outcome on the deposit costs?

[John Greene, Chief Financial Officer]

So, it's throughout this year and into next year.

[John Hecht, Jefferies]

And then follow up question would be, you've taken deposit as a percentage of funding up a couple of hundred basis points in 2019 period. How should we think about funding mix over the course of 2020?

[John Hecht, Jefferies]

So we enjoyed great growth there, I think it's testament to both the team and the products and Discover, in general. We have a longer-term target of 70% direct to consumer deposits thereabouts, and I would say next three to five years on that. So one way to do it would be to draw a line and plot it accordingly.

[Operator]

We will take our next question from David Scharf with JMP.

[David Scharf, JMP]

Once again pretty much all my questions have been answered except that I do want to just follow up when I hope is not a repetitive topic. On the investment spend, it seemed like collections was highlighted a couple of times, and I think backward looking in the fourth quarter, I have written down that you had more third-party professional fees. And then going forward, it was more of a broader investment late cycle. Just curious, I mean should we be thinking about sort of under capacity with in-house collectors. Is that why you defaulted to more third parties, or are you finding any challenges with recovery rates internally? Can you give us a little color besides just the cyclical factors?

[Roger Hochschild, Chief Executive Officer]

Ss just to be clear, in terms of collections which we define as prior charge off, 100% of that in house. And so that’s with our own US-based employee, it is very scalable. A lot of our investments have been in the area of analytics, as well as if you think about collections is marketing. We have seen great impact from building out digital collections. There are a lot of people who may not want to talk about the situation therein, but like seeing an office they have online.

And so I think collections is an area where you can achieve competitive advantage. So it's been something that -- there hasn't been a change in our investment strategy there, it's been a multiyear journey and we expect to continue. On the recovery side, we do work with third parties. And so to the extent recoveries are more successful, because of the commission structures we will pay more in recovery fees but that usually means there is a net benefit.

[John Greene, Chief Financial Officer]

And just adding onto that. So the recoveries are up year-over-year about 28%. So what you're seeing is that that's I think a factor of portfolio but probably more reflective of where we are in the economic cycle and the fact that the consumer strength is probably quite frankly increasing and as wealth distribution is also improving mildly. So not a bad story there on the professional fees whatsoever.

[Roger Hochschild, Chief Executive Officer]

And just one thing I will point out, on the recovery side, we do not sell any of our charge-off paper, and haven't for well over 10 years. So you know you do enjoy a stream from those recoveries as opposed to people who would just sell and take the NPV.

[David Scharf, JMP]

And as far as -- just a quick follow-up, I assume embedded in your net charge-off range you provided for 2020 is a consistent recovery rate as a percentage of gross charge off rate is there any modification or conservatism built out?

[John Greene, Chief Financial Officer]

So overall charge-offs, I mean we gave the range that's a net , and I think we're pretty comfortable with that as guidance.

[Operator]

We'll take our next question from Meng Jiao with Deutsche Bank.

[Meng Jiao, Deutsche Bank]

I just have one quick question, I guess on the deposits. It looks like I guess the brokered deposits were pretty down here. Is that the -- I guess the runway going forward is that we should see more, I guess, run off in the broker deposits range, as well as continued expansion in the direct to consumer?

[Roger Hochschild, Chief Executive Officer]

In general, that's the plan. We're going to keep that open as the channel. But in terms of our funding stack, that should continue to decrease as an overall percentage of the funding stack as the DTC increases.

[Meng Jiao, Deutsche Bank]

And then I guess the second question is in terms of M&A, I know you guys are focused on B2B partnerships and noting that less interest in a bank deal. Has that changed materially from -- in prior quarters, or is that still the same message going forward?

[Roger Hochschild, Chief Executive Officer]

I think we feel good about the businesses we're in and our ability to grow that organically. And I think if you look on the banking side, I don't see any gaps in our model that we would need to fill.

[Operator]

We'll take our next question is from Bill Ryan with Compass Point.

[Bill Ryan, Compass Point]

Question on student lending, if you could maybe give us some idea of what your origination volume was in 2019 versus 2018 dollars and/or percent and maybe what your outlook is for 2020? And maybe a little bit of color what you're seeing in terms of pricing your market share and borrower profile.

[John Greene, Chief Financial Officer]

So in terms of growth, we said organically we had 9% organic growth in student loans, not on originations but loan balance and we provided overall guidance on loan growth, which is inclusive of student loans. So we're not going to get into kind of origination levels, we just don't think that's probably the most helpful information.

[Bill Ryan, Compass Point]

And any color on pricing or where do you think your market share is and things like that?

[Roger Hochschild, Chief Executive Officer]

I think we feel good about the season of originations we've had. So again, they're a little harder to get market share data, but we certainly thought we held our position as the second largest originator, even in an environment where there were some new entrants. And in terms of kind of who we target and credit, we remain very disciplined.

[Operator]

We'll take our next question from Dominick Gabriele with Oppenheimer.

[Dominick Gabriele, Oppenheimer]

When you talk about the investment spend, how much of the investment spend, or are other plans to use this period of time to significantly invest in the global network in particular? And how much is the focus there given what you've talked about on investment spend? Thanks.

[Roger Hochschild, Chief Executive Officer]

Yes, I think we highlighted the two areas where we want to call out a significant increase. One was around the brand and advertising, the one the other one was on technology. We did not highlight a significant change in spending. And again, as we look at building our global acceptance, some of it is working with acquirers, some of those are very cost-effective. We built through the network-to-network agreements and that will remain a core part of the strategy.

[Operator]

And there are no further questions. At this time, Mr. Streem, your closing remarks please.

[Craig Streem, Head of Investor Relations]

Thanks, Erika. Thank you everybody for your attention and for staying with us through this long call. But we wanted to make sure that we took care of everybody's questions and didn't cut anybody off. But if you have any follow-ups, please come back to me and we will take care of it. Thank you.

[Operator]

Ladies and gentlemen, this does conclude today's conference call. Thank you for participating. You many now disconnect.