Bread Financial Holdings, Inc.

Good morning and welcome to Bread Financial's fourth quarter earnings conference call. My name is Charlie and I'll be coordinating your call today. At this time, all parties have been placed on listen-only mode. Following today's presentation, the floor will be open for your questions. To register a question, please press star followed by one on your telephone keypad. It's now my pleasure to introduce Mr. Brian Verab, Head of Investor Relations at Bread Financial. The floor is yours.

Thank you. Copy of the slides we will be reviewing and the earnings release can be found on the investor relations section of our website. On the call today, we have Ralph Andretta, President and Chief Executive Officer of Bread Financial and Perry Beiberman, Executive Vice President and Chief Financial Officer of Bread Financial. Before we begin, I would like to remind you that some of the comments made on today's call and some of the responses to your questions may contain forward-looking statements. These statements are based on management's current expectations and assumptions and are subject to the risks and uncertainties described in the company's earnings release and other filings with the SEC. Also on today's call, our speakers will reference certain non-GAAP financial measures, which we believe will provide useful information for investors. Reconciliation of those measures to GAAP are included in our quarterly earnings materials posted on our investor relations website at BredFinancial.com. With that, I would like to turn the call over to Ralph Andretta.

Thank you, Brian, and good morning to everyone joining the call. We set ambitious goals in 2022, and I am extremely proud of our associates for moving our company forward by executing on our initiatives to achieve these goals. I'll begin on slide three. which highlights several major accomplishments achieved in 2022 as part of our ongoing business transformation. To begin, we rebranded from Alliance Data Systems to Bread Financial, a tech forward financial services company providing simple, personalized payment, lending, and saving solutions to consumers. Following our multi-year corporate transformation, Bread Financial has emerged as a more modern, nimble, and streamlined company backed by leading technology and custom platform solutions that empower today's consumer. Coinciding with our rebrand, we launched our direct-to-consumer Bread Cashback American Express credit card and rebranded our Buy Now Pay Later platform to Bread Pay, which offers installment lending and split-pay solutions through an omnichannel approach. We also rebranded our retail deposit platform to Bread Savings. These enhanced products Enhanced products provide industry-leading benefits and complement our existing suite of financial offerings, ensuring our customers across generational segments have access to payment and savings solutions. We continue to sign new iconic brand partners, including AAA and the NFL, while renewing valued long-term relationships like Victoria's Secrets. We have secured renewals with brand partners representing approximately 85% of our year-end 2022 credit card balances through 2025, after adjusting for the anticipated sale of the BJA's portfolio. We also saw success with de novo program launches in 2022, such as B&H Photo, which exceeded our initial performance and growth projections for the year. We look forward to working with our new and existing brand partners to drive incremental sales growth and customer loyalty through our sophisticated data and analytics capabilities, enhanced value propositions, and comprehensive product suite. In 2022, we invested more than $125 million in technology modernization, digital advancement, marketing, and product innovation. Major achievements included transitioning our credit card processing services to Fiserv, converting to the cloud, and integrating Alveria, a state-of-the-art solution that enhances the productivity of our customer care and collections efforts. Our digital advancement continued to progress as well as we expanded mobile and web-based customer servicing capabilities and launched a virtual card with web-to-wallet provisioning to provide our customers a more simplified user experience. These upgrades supported our transformation enhance our strategic differentiation, and are essential to driving operating efficiencies and innovation. We remain committed to ongoing technology investment with a focus on further digital advancement. As part of our investments, we increased our marketing investment in 2022 to bolster spend through joint marketing campaigns with our brand partners. Developing strong collaborative relationships with our partners has underpinned our decades of successful growth as these investments build loyalty with both our partners and their customers, as well as expand sales opportunities. Additionally, by leveraging our sophisticated data and analytics capabilities and efficient targeting channels, we were successful in driving new acquisition and engagement with our Bread Cashback American Express credit card, Bread Pay, and Bread Savings offerings. We will continue to invest for the future to deliver value for our brand partners, customers, and shareholders. Finally, I'm proud to announce that Bread Financial was recognized for a prioritization of environmental, social, and governance across our entire business, earning a spot on Newsweek's 2023 list of America's most responsible companies. Our commitment to advancing our ESG strategy, objectives, and accountability is evident through the organization and remains core to our sustainable business practices. Turning to slide four. We are pleased to have achieved our 2022 financial targets, driven by organic growth from our existing brand partners, as well as addition of our new brand partners and product offerings. Average loans grew 13% compared to 2021. Revenue growth exceeded average loan growth at 17% year over year. Pre-tax, pre-provision earnings increased 19% versus 2021, highlighting the quality of the growth we are generating and the underlying value we are creating. We remain disciplined, generating more than 200 basis points of positive operating leverage for the year as we manage our expenses in alignment with our revenue and growth outlook while continuing to invest in our future. Our net loss rate of 5.4% remain within our full year guidance range and below our historic average of approximately 6%. Along with accomplishing our 2022 targets, we significantly strengthen our balance sheet and bolstered our financial resilience through greater product and funding diversification. We increased loss absorption capacity and growth in capital and tangible book value. Retail deposits on our bread savings platform increased to $5.5 billion or 72% year over year. We plan to build on these achievements in 2023 through continued execution of our long-term strategy. Moving to slide five, I'll highlight some of our most recent business development success. I am pleased to announce that we have signed a new long-term credit card relationship with Hard Rock International, a well-recognized hotel, casino, and restaurant operator. Hard Rock attracts a broad demographic given its diverse offerings, further expanding our reach across generations. We will offer Hard Rock customers a new way to pay while incenting loyalty and brand affinity through our co-brand credit card. During the quarter, we announced a new agreement with the New York Yankees. This exciting relationship rewards Yankees fans for their purchase and provides enhanced benefits through our New York Yankees co-brand credit card, while further diversifying our brand partner base. Also during the fourth quarter, we signed a multi-year renewal with long-term partner Helzberg Diamonds, underscoring our strong market share position in the jewelry space. Helzberg Diamonds has more than 100 years of diamonds expertise and operates online at over 200 stores nationwide. We will continue to leverage our advanced data and analytics to enhance the shopping experience to Helzberg's customers. Turning to BreadPay, we continue to add new brand partners to our platform, and importantly, we have now extended nearly 50% of our current loan origination volume with new long-term renewals. Because these contracts historically have been short-term in nature, having long-term extensions will reduce volatility and promote long-term sustainable growth. Additionally, our strategic relationship with Sezzle continued to outpace our expectations with now more than 200 live merchants and installment loan origination volume exceeding our initial goal. We are pleased with our many accomplishments in 2022 and plan to build on this momentum in 2023. Our business development pipeline remains strong, and we are confident in our ability to grow responsibly in 2023, despite a more challenging macroeconomic landscape. As always, we remain vigilant in responsibly driving sustainable, profitable growth. Perry will outline our specific 2023 financial targets, which include continued strategic investments aligned with quality loan and revenue growth. Our 2023 outlook assumes continued inflationary pressures and gradually rising unemployment levels. Headwinds that we expect will result in a full year net loss rate above our long-term historic average of approximately 6%. This corresponds with our expectations that net loss rates will hover above our historic average during more challenging economic periods and drop below our historic average during more favorable economic periods. With three decades of experience, our differentiated and tested underwriting and credit risk modeling is purposely structured to navigate the full range of economic scenarios, focused on producing positive annual earnings and a strong risk-reward margin, even during periods of economic stress. With the changes we have made over the past three years to strengthen our credit profile, we remain confident in our long-term guidance of the through-the-cycle average net loss rate below our historic average of 6%. Our seasoned leadership team is experienced in managing through credit cycles, and every cycle is different. Some factors, like inflation, are impacting all consumers and cannot be fully controlled or mitigated. We will manage what we can control. In these instances, we run our business with a long-term focus, as we have done effectively in previous downturns. We have and will continue to proactively adjust our underwriting and credit line management to account for the anticipated challenges faced by consumers. We manage our business with strong governance and controls intact and remain aligned and confident on our objective to deliver long-term value for our stakeholders. With that, I will turn it over to Perry Beaverman, our CFO, to review the financials.

Thanks, Ralph. Slide 6 provides our fourth quarter financial highlights. Brett financials credit sales were up 16% year over year, $10.2 billion. Average and end of period loans were each up 23% driven by our new program additions, as well as new products and organic growth from existing brand partners. Revenue for the quarter was 1 billion, increasing 21% versus the fourth quarter of 2021 resulted from higher average loan balances and improved loan yields. while total non-interest expenses increased 28% as anticipated. As we signaled previously, EPS was materially impacted this quarter by the higher provision for credit losses reflecting seasonal loan growth in the quarter, coupled with the required upfront CECL reserve build from the acquisition of the approximately $1.5 billion AAA loan portfolio. Turning to slide seven, I'll review our full year 2022 financial highlights. Brad financial credit sales were up 11% year over year to $32.9 billion and average loans increased 13%. Revenue for the year was $3.8 billion. It increases 17% compared to 2021 while total non-interest expenses increased 15% driven by portfolio growth, inflation, and ongoing investments in technology, modernization, digital advancement, marketing, and product innovation as Ralph had discussed earlier. Income from continuing operations was $224 million, and diluted EPS from continuing operations was $4.47 for the year, both of which were materially impacted by the higher provision for credit losses in the year as a result of our strong loan growth, portfolio acquisitions, and a higher reserve rate. Looking at the financials in more detail on slide eight, Total interest income was up 30% from the fourth quarter of 2021, resulting from 23% higher average loan balances, coupled with improved loan yields. Non-interest income, which primarily includes merchant discount fees and interchange revenue, net of the impact from our retailer share agreements and customer awards was negative $97 million. Total non-interest expenses increased 28% from fourth quarter of 2021, driven by three primary factors. First, card and processing expenses related to incremental card issuance volume. Second, information processing and communication expenses as a result of the transition of our credit card processing services and other software licensing expenses. And third, higher employee compensation and benefit costs. Additional details on expense drivers can be found in the appendix of the slide deck. Overall, income from continuing operations was down $195 million for the quarter versus the fourth quarter of 2021 as the improvement in pre-tax pre-provision earnings, or PPNR, was offset by a higher provision for credit losses in the quarter, including the previously discussed upfront CECL reserve impact from the AAA portfolio acquisition in the quarter. Taking out the tax and provision impacts, we are pleased that our PPNR improved 13% year over year marking the seventh consecutive quarter that we have generated year-over-year double-digit growth in PPNR. As we have said, we remain focused on making responsible decisions to produce quality earnings. Turn to slide nine. The left side of the slide highlights our earning asset yields and balances. The fourth quarter loan yield increased 80 basis points year-over-year driven by the increases in the prime rate but decreased 120 points sequentially due to seasonally higher balances in the quarter, the addition of the lowering yield, higher quality AAA portfolio, and an increase in reversals of interest and fees revenues from higher gross losses. Net interest margin increased 30 basis points to 19.1% year over year as the benefit from loan yields more than offset the increase in funding costs. On the liability side, We saw funding costs increase in the fourth quarter in line with our expectations, given the Fed interest rate increases through December of 2022. As you can see from the stacked bars on the bottom right, our direct to consumer deposits continue to grow and now represent $5.5 billion or 26% of our total interest bearing liabilities. We expect that our retail deposit balances will continue to increase providing a stable funding base as retail consumer deposits become an even more meaningful portion of our funding over time. Moving to slide 10, and starting in the upper left with delinquency rate. The fourth quarter rate of 5.5% was slightly below the third quarter rate following typical seasonality. On the upper right, the net loss rate was 6.3% for the quarter, slightly better than our earlier projection due to lower than expected losses in November. The loss rate in December of 6.7% was more in line with our expectations, given continued payment rate pressure. If we think about where the consumer is today, we have to look at how we got here. Earlier in 2022, we still saw some of the benefits from the late 2021 stimulus aid coming through in terms of both spend and very strong payment rates. If you look at a trend line from our low point in 3Q21 to today, you can see the upward movement or normalization of loss rates from both the wind down of stimulus, which has largely run its course, and the influence of elevated inflation. We saw lower scoring and lower income cohorts normalized first. However, given the broad impact of inflation, we're seeing impacts across the full credit spectrum and all income groups. As you would expect, We continue to proactively manage risk-reward decisions at the margins for both new account underwriting and existing account line management. This is an ongoing and evolving as the macroeconomic environment unfolds. Moving to the bottom left, the reserve rate increased 10 basis points sequentially from the third quarter to 11.5% as a result of continued elevated inflation increasing consumer debt levels and weakening macroeconomic indicators, pulling down the base case scenario outlook. This was modestly offset by the addition of the higher quality AAA portfolio and seasonal transactor balance growth in the fourth quarter. Our intention is to maintain a conservative weighting of economic scenarios in our credit reserve model in anticipation of the increase in macroeconomic challenges and the expected potential impact on our credit performance metrics. We estimate that our reserve rate could increase up to approximately 100 basis points due to the continued macroeconomic trends, seasonality, and the impact from the anticipated sale of the better credit quality BJ's portfolio. In nominal dollar terms, we would expect a meaningful decrease in our allowance balance and therefore a provision for credit losses release in early 2023, again, due to the anticipated sale of the BJ's portfolio as well as projected seasonal decline in loan balances from year-end. Our credit distribution improved from the third quarter with economic consumer headwinds offset by the benefit from the AAA portfolio acquisition. We would expect our overall proportion of 660-plus VantageScore customers to move down when we exit the BJ's portfolio. A fundamental element built into our business model includes having controls in place to manage our risk tolerance. with the objective of ensuring that we are properly compensated for the risk we take to underwrite and manage our portfolio. We closely monitor our projected returns with the expectation that we generate strong risk-adjusted margin above pure levels. As Ralph alluded to previously, we remain confident as a management team in our ability to manage for credit risk and drive sustainable profitable growth through the full economic cycle. Rob Leibowitz, slide 11 provides our financial outlook for the full year 2023 Rob Leibowitz, For the full year average loans are expected to grow in the mid single digit range relative to 2022 Rob Leibowitz, Our expectation includes projected new and renewed business announcements visibility into our pipeline anticipated sell that BJ's portfolio and our current economic outlook. Rob Leibowitz, The range is contingent on credit strategy actions that will lever on macro economic conditions. We expect revenue growth to be consistent with average loan growth in 2023, excluding the anticipated gain on sale with a full year net interest margin similar to 2022 full year rate of 19.2%. The first quarter NIM is expected to be below our full year guidance given the inclusion of the lower loan yield BJ's portfolio and a larger headwind from the reversal of billed interest and fees related to expected elevated first quarter credit losses. Our outlook assumes additional interest rate increase by the Federal Reserve will result in a nominal benefit to total net interest income. We expect to deliver nominal positive operating leverage in 2023, excluding anticipated gain on sale. As Ralph highlighted, we will continue to strategically invest in our business to fuel growth opportunities and create operating efficiencies. while balancing these investments with responsible revenue growth in order to achieve sustainable profitable growth. First quarter 2023 total expenses are projected to be sequentially down from the fourth quarter of 2022, benefiting from seasonally lower transaction volume and lower marketing expenses. At this time, from a dollar perspective, we expect the second half 2023 total expenses to be flat to down from the first half of the year. driven by lower intangible amortization expenses and improved operating efficiencies related to our technology modernization efforts. We anticipate the full year 2023 net loss rate will be approximately 7%. As you can imagine, there's a broad range of outcomes for net charge-offs for the year based on potential economic scenarios. Given persistent inflation and rising interest rates, borrowers are making decisions to pull back on discretionary spend and drawing down on savings pressuring their ability to pay despite low unemployment moderate income households are increasingly noting payment difficulties during the collections process our outlook assumes inflation remains elevated and that these pressures will persist throughout 2023 at the same time our outlook contemplates a gradual increase in the unemployment rate in 2023 We will continue to closely monitor macroeconomic indicators as we gain clarity on the Fed's efforts to tamp down inflation. We'll update our expectations accordingly. We expect the first half 2023 loss rates to trend upward given the current inflationary pressures as well as the impact of the sale of the BJ's portfolio. Our first half net loss rate is projected to be above 7% inclusive of the impacts from the previously discussed customer accommodations we made in the second half of 2022 in connection with the transition of our credit card processing services. Finally, we expect our full year normalized effective tax rate to remain in the range of 25 to 26% with quarter over quarter variability to timing of certain discrete items. Looking forward, we intend to host an analyst event Later this year, we will further highlight what we believe are the strategic differentiators and competitive advantages of our business model, including the capital generation potential it creates. At that time, we plan to provide new long-term financial targets as well as more detail around our capital priorities and capital allocation going forward. Regarding current parent capital levels, our TCE to TA ratio temporarily dropped in the fourth quarter of 2022 due to the timing of the acquisition of the AAA portfolio. Given the anticipated sale of the BJ's portfolio, our TCE to TA ratio is projected to increase to a level above the 3Q22 figure of 8% after the sale. In keeping with our business transformation over the past three years, we made strategic decisions to enhance our financial resilience as indicated on slide 12. We improved our credit quality, product and funding diversification, loss absorption capacity through our loan loss reserve and capital positioning, and increased our tangible book value. Our tangible equity plus credit reserve ratio as a percent of loans is up nearly 200 basis points since 2020. Our parent level debt is down more than 33% over the same time period. These enhancements and improvements to our underlying credit portfolio mix strengthen our confidence in our ability to sustain more challenging economic outcomes and outperform our historical results through an entire economic cycle. Our experienced team will continue to manage our portfolio proactively. We're utilizing our recession readiness playbook for both new and existing accounts with a heightened focus on open-to-buy authorizations and helping consumers manage their credit lines and balances in a healthy manner. We believe that our improved risk profile coupled with our more diverse portfolio and brand partner base make us better positioned than ever to manage the recessionary period. We look forward to building upon our successes from 2022 and will continue to make strategic decisions to create long-term, sustainable value for all our stakeholders. Operator, We're now ready to open the lines for questions.

Of course. Ladies and gentlemen, if you'd like to ask a question, please press star followed by one on your telephone keypad now. If you change your mind, please press star followed by two. When preparing to ask a question, please ensure your phone is unmuted locally. As a reminder, that's star followed by one on your telephone keypad now. Our first question comes from Sanjay Sakrani of KBW. Sanjay, your line is open. Please go ahead.

Thanks. Good morning. I guess I have some questions on the loss assumptions and reserve rate. Perry, you talked about the reserve rate possibly going up another 100 basis points in 2023. So I'm just making sure I got this right. So you think by the end of this year, we're probably closer to 12 and a half. And then the 7% charge off rate for the year. Can you maybe just separate what the processing rate conversion impacts are versus, uh, sort of the deterioration you're seeing as a result of normalization. Thanks.

Sure. Thanks, honey. So let me start with the reserve rate first. Um, you know, we're always trying to give our best thinking, you know, based on our current visibility into our portfolio and the economic landscape. You know, as I mentioned, um, earlier, you know, we expect the rate to increase in 2023, given the sale of the BJ's portfolio and potentially, uh, continue economic with, um, weakness. So when BJ's exit, that's going to cause a step up in our reserve rate because today that's on the portfolio at a lower than the current average that we have. And then you look at the, you know, I would say that a lot is going to happen in the first quarter. Plus then you've got seasonal impacts that can also affect the first quarter. Specifically regarding the risk overlays, you know, I think you guys could see that we are proactive in getting ahead of what we deem to be future potential weakness, which is what the CECL economic risk overlays help us to achieve. And one thing we recognized early on was that all industry loss models have been calibrated historically on changes in unemployment and those unemployment-led recessions. This elevated inflation environment that's currently creating strain on consumers is not what these models are calibrated on. So it requires a different degree of judgmental overlays, which is When you hear us talking about, hey, we're leaning into more of those more severe scenarios, you know, which for our severe scenarios, the severe has a, you know, reaches an unemployment rate of 7.8% over the next 24 months at peaks. And then the severe adverse peaks at 8.9%. Look, I don't think those are realistic outcomes of what's going to happen, but we lean into those for weightings to care for that inflation component. So you can decouple that to, hey, there's a judgmental piece, but then there's also the unemployment. So this is kind of a new environment for these models to care for. So when we get to the end of this year, we're thinking that we're going to exit the year with a mid to high 4% range for unemployment. So that's kind of the, sorry, I gave you probably a lot more on that with the reserve rate. And then I'll answer the second, the first part or second part of the 7% loss outlook You know, that's an increase of 150 to 175 basis points year over year. And there's three components that are in that, right? There's the macroeconomic pressure that we're seeing in the consumers, and we expect throughout the year there'll be the continued impact of inflation that may be in the back half of the year. That starts to abate, but then you start to pick up some elevated unemployment. Then you also have the second piece in there that's contributing to the increase of 150 to 175 basis points is inflation. BJ's, which has a lower NCL rate than the rest of the portfolio. That's going to cause a little bit of lift. And then the third piece for us is we do have some trail and conversion related items from customer accommodations that was simply the timing of credit losses that would have been in 2022 that are pushing into the first half of 23.

Are those equally weighted or unequal? You know, like is there a more prominent impact from one over the other or?

I'd say macro is definitely more than half.

Okay. And just maybe one follow-up question for Ralph, just on the processing conversion. I'm just curious, are all the residual impacts over at this point, all the kinks ironed out? I'm just wondering if we should think about anything else. Thanks.

Hey, Sanjay, how are you? You know, I think a lot of the growing pains are in the rearview mirror. And, you know, now we're going to reap the benefits of why we moved. Quicker to market, better capabilities, you know, less expensive to operate. So, you know, unfortunately, you know, we have these kinks, but I think a lot of that is in our rearview mirror, and we're focused on, you know, continuing to stabilize the system and then take use of all of the capabilities that we signed up for.

Okay. Thank you very much.

Thank you. Our next question comes from Robert Napoli of William Blair. Robert, your line is open. Please proceed. Thank you.

Question on your target capital ratio. Do you have a formal target, and when do you target reaching that target?

Yeah, so what we've been communicating is that, you know, we're striving to get to a 9% TCE to TA ratio is a good low end mark. You know, the first priorities of our capital has remained to provide and support profitable growth. And then the second priority is to pay down debt. And, you know, we will provide more information about our capital priorities and plans at the investor event later this year.

No, thank you. And I would expect that we wouldn't see buybacks until you hit that or share capital return until you hit that target. Is that fair?

I don't want to give specifics, but again, our priorities are to support our growth, get our capital levels up, and then start to pay down our debt.

Thank you. And then can you give any cover on the competitive environment? There's been a lot of portfolios, obviously, that have changed hands. You guys have re-signed a lot. You've added a lot. What's going on with the competitive environment and the returns that you and your competitors are requiring for deals?

I think no matter what the economy is, the competitive environment is always, always hot. That never changes. When we look at things, we look at things and say, you know, can we grow the portfolio for the partner? Can we do it profitably? And does it contribute to growth for us in the right way? That's how we look at portfolios. So, you know, portfolios change hands. The portfolios we, you know, we signed and acquired, you know, we have a lot of confidence that we'll grow those portfolios, we'll grow them responsibly, and we'll have, you know, good, consistent growth.

Great. Thank you. Thank you.

Our next question comes from Mosh Orenbock of Credit Suisse. Mosh, your line is open. Please go ahead.

Great. Thanks. One of the things you talked about a little bit in the prepared remarks was the idea of consumer spending. Could you talk a little bit about how you kind of formed your expectations for receivables growth in terms of what you're seeing in consumer spending and payment rates and how those two interact over the course of 23? And I've got a follow-up.

Yeah, when I start, I'll ask Perry to chime in. So, you know, we saw good consumer spending in the, you know, we're seeing good consumer spending in January. But, you know, given the environment, you know, there is pressure on sales. That will offset some of the payment rate improvements. It's just the reality of the macro environment we're going into.

Yeah, and I'll add on to what Ralph just said. With that context of decelerating spend, consumers making choices within category to deal with the inflation, and then there's a rising cost of debt overall for them, they're pulling back on spend, too. So we do contemplate that. Coupled with, you know, you think about elevated losses, credit losses through the year, that also dampens your growth. So if you're up 1.5% for what you were the prior year, that impedes growth by 1.5%. And then on top of that, you know, we're being more thoughtful about credit strategies and we can pull back online and underwriting. So that affects that. And then as well, it may throttle what we do with marketing because, you know, the marketing returns look a little different for certain cohorts now. So, you know, there's a combination of things that go into our receivables outlook and all those things are contemplated.

And the last thing I'll say is, you know, our book is changing and, with this spend shift to non-discretionary to essential. Years ago, we wouldn't have been able to catch that because we didn't have the products. We now have the products and co-brands and buy now, pay later and other things that are direct to consumer. We're catching just general spend, but we wouldn't have caught that before. Brand launches and new products are going to also help us drive sales growth over the course of the next year.

Great. And as a follow up, you mentioned kind of an unemployment outlook of, you know, you know, four and a half to upper fours. How do you think about the variability around that if unemployment is either better or worse than that? And, you know, and, you know, as we sort of think about, you know, the economic performance over just beyond 23 as well?

Yeah, you know, you know, economic unemployment is always a leading indicator of creditworthiness. So, You know, if the rate is better, we would expect, you know, credit to perform a little bit better. Obviously, if the rate is worse, we would expect it to perform worse. But we don't expect a spike in 2023. I think we're feeling what we've forecasted. We feel that is where we'll be. You know, if that's an exit rate for 23, that'll impact 24. Okay.

Thank you.

Thank you. Our next question comes from Vincent Saintik of Stevens. Vincent, your line is open. Please go ahead.

Thank you for taking my question. I wanted to ask about late fees. So two-part question, the main one being just your overall thoughts about that, given potential regulation that might challenge late fees. So just your thoughts on what the potential impact is and how you can kind of maybe move around that. And then a follow-up question is, so saw that this quarter, part of the yield decline quarter-by-quarter was from the reversals of interest and fees. So just wondering if you might be able to quantify that and what are your thoughts on that for 2023? Thank you.

Yeah, it wouldn't be an analyst call without the question about lease fees. So, but I'm happy to address it. You know, I look at this as no different than Card Act. You know, the industry was able to adjust. We adjusted accordingly. And, you know, we'll lean into any regulation that is out there and, you know, adjust accordingly around this. I will say that, you know, as we think about late fees and any other regulatory changes, we have the ability to, you know, work with our grant partners to negotiate, renegotiate terms if that's appropriate. So, you know, and there's other levers to pull. So, you know, we'll adjust accordingly just as we did with CART Act. Terry, you want to take that?

Yeah, so as it relates to net interest margin, which is where late fees reside for us, when we see some delinquency increasing, you see the late fees materialize in that interest margin early. And then when the delinquency manifests itself into elevated charge-off, the reversal of some of those interest and fees occur in that period. So if you have a period where you're going to be above, which is what we've indicated for the first half, you should expect that you're going to have some more reversal of interest and fees impact in that quarter relative to the prior quarter where losses were lower and you had less interest and fee reversal, so you actually had a little bit higher net interest margin. So that's going to be the dynamic throughout the year, and that's normal when you're going through periods of rising and falling delinquency and then the charge will follow.

Okay, that's great. Very helpful.

Thank you. As a reminder, if you wish to submit a question, please press star followed by one on your telephone keypad now. Our next question comes from Jeff Adelson of Morgan Stanley. Jeff, your line is open. Please go ahead.

Hi, thanks for taking my question. Perry, just wanted to dig into the new loss guide. You know, I think a lot of your competitors are still at or below their cycle averages, and you're now getting to something that's above that. I know we've got the noise coming through the portfolio, but you talked about some of the changes you've made over the past three years, how you've kind of enhanced the credit profile of that book. Just wondering what gives you confidence that that's going to drop back down to a below 6% level by the end of this year or after this year?

I'm going to make sure I heard the question correctly. I think there's two parts. One is why are we guiding higher? I think the increase in basis points is probably in line with what we're hearing across the board. What we're seeing with our portfolio is we did normalize faster. And it's simply every company has a different composition of its portfolio. We're more of a full-spectrum lender. And as we communicated well over a year ago, We expected normalization to occur faster in our portfolio as consumers use their stimulus early and then that would start and they would normalize faster and that has happened. And then as you mentioned, we do have some noise in our numbers because of the BJs departing and then some trailing impacts of timing of losses from customer accommodations that we did. But when you talk about the confidence to get at or below i think i heard you say at or below six i think the the thing is to have a six handle back on the back half of the year it's because we do have front end of the year noise that you know with the economic assumptions you know i think it again there's a range of outcomes for the second half of the year depending i mean if it's a mild year if inflation starts to abate and then you have a slow increase in unemployment I think that could be where things fall. The 6% average that we talk about is through the cycle. So you're going to have periods where you're below 6%, years where you're below 6%, and you're going to have years when you're above 6%. And when you're in a recessionary environment, you've got to be above 6% if you're going to have a through-the-cycle average of 6%. And that's where we are. And I think the question then is for all of us is, okay, How long is this recession, recessionary environment, will it get officially labeled with that R word or not? How deep does it go and how long does it stay, right? Is it mild and short? Then you get back towards that, the reversion to the mean faster.

Yeah, I would say a thing to remember is we have improved our portfolio over the last three years, but our portfolio is still a bit riskier than our competitors because we underwrite deeper. That said, we get paid for that risk and managing that risk as we move forward. So although we've improved our portfolio, we are still casting a wider net than others, and we get paid for that net that we cast.

Got it. Thank you. And then just in terms of the credit sales this quarter, I'm just wondering how much of the boost that you saw out of the credit sales was driven by AAA?

Yeah, that was a significant amount of the increase. I mean, there was a slight increase in credit sales if you were to exclude III. Thank you.

Our next question comes from Bill Karash of Wolf Research. Bill, your line is open. Please go ahead.

Thank you. Good morning, Ralph and Perry. Perry, I wanted to follow up on your comments around legacy credit models having been built around the concept of rising unemployment and not necessarily some of the inflationary pressures that consumers are facing. There's a view that delinquencies are going to continue to rise, but because labor markets remain exceptionally strong, we'll see them flatten out once we get to sort of the quote unquote normalized pre-pandemic levels. Are you expecting You know, given that point that you made that delinquencies could continue to trend higher, you know, sort of above, you know, normalized levels because of these inflationary dynamics, even though labor market conditions could still remain pretty strong. Just wanted to make sure I understood the point you were making correctly.

Yeah, the point I was making on the models was more on off-forecasting models, not credit underwriting models credit underwriting models take into account things at the consumer level and take in a whole host of attributes of the consumer that do care for things like you know you mentioned income you know gainful employment uh you know their their debt they have on other issuers uh so that's all goes into that but yeah i mean you you raise exactly the one of the key points and why inflation is that that the thing the Fed's trying to tackle is a regressionary type tax, right? And so moderate income to middle income families are feeling the pressure of that. So yes, while they're gainfully employed and yes, while there is wage growth, that wage growth is not keeping up with things that are putting pressure on their families. And you see that with some increasing leverage and all of this impacts, you know, eventually ability to pay and that's where customers can fall behind. And if you even think about inflation as what we're seeing today, while it's moderating a little bit, some of it is there's good news in there, but it's really driven because there's lower fuel prices and lower used in new car prices, which certainly helps people own cars, but not everybody does. But on the flip side, shelter costs, food prices, and utility costs are up significantly month over month and year over year. So while You know, inflation is abating. This is still concerning for most Americans, even while they're, you know, as you said, it's a job-full environment. And, you know, they're doing their best, but they're making choices on spend, which is why I think you're starting to start to see some deceleration in overall spend. And we see some shifts from discretionary to nondiscretionary. But all these things put pressure on folks.

Understood. That's super helpful, Perry. Thank you. And separately, Ralph, I wanted to follow up on your late fee commentary. I appreciate all the color, but I wanted to ask if I could follow up on the comment you made last quarter that the safe harbor you thought surrounding late fees was more likely to be reduced rather than eliminated. Is there any way you could give us an update there and maybe frame the potential magnitude of any reduction or impact that you think we could see?

I know what you know from the CFPB. That was just what I would suspect would happen in the third quarter. I don't want to guess on what will happen. Whatever will happen, we're ready for it. We will lean into it, and we will manage accordingly.

Understood. Thanks again for taking my questions.

Thank you. Our next question comes from Mihir Bashir of Bank of America Merrill Lynch. Mihir, your line is open. Please proceed. Excuse me.

Good morning, and thank you for taking my question. I wanted to go back to the credit guidance. Following up a little bit on Jeff's questions earlier, I just wanted to better understand the reason you have a high degree of confidence that the back half of 23 would be below 7% at least. right, just given your implied guide of 1H above the 7%. So, like, given higher unemployment, you have BJs coming out. I understand you have some noise in the first half, but if I recall, that's about a 30-35 impact there. Why would the back half come in below the first half, just given the macroeconomic pressures you are pointing to, right, with unemployment increasing throughout the year? And then, relatedly, just you know, in terms of your delinquencies and losses, like when do you expect delinquencies to peak? And in terms of losses, given you've normalized faster than peers, do your losses peak before your peers, who've all talked about that happening maybe in 2024? Any additional color you can help us with some of that? Thank you.

Yeah, so I want to be more clear, right? When we say losses could be approximately or around 7%, that does not necessarily imply that the back half of the year will be significantly below the first half of the year. So it could still have a seven handle on it. It could be slightly below, it could be still slightly above, or it could be flat. So I want to moderate the expectation that the second half will be, you know, materially lower. And I think you said it, there's a lot of economic uncertainty in the back half of the year and what continues to happen with inflation and unemployment. So I think there's a lot of speculation, and we'll continue to update those expectations as we march forward. In terms of normalization, will we peak sooner? I hope so. So normalization of the higher end consumer is lagging. And when you think about the way when you underwrite with where we do the full spectrum we could we manage losses very carefully and at a uh and lines carefully where they um you manage a low line with a lot less uh open to buy compared to if you were if we were in that super prime space you'd have a large line lots of open to buy so when unemployment hits you're taking for a large line for us you don't have as much open to buy so as unemployment comes through we have less severity risk is the way to think about that. So we may be less volatile.

Thank you. Thanks for taking my question.

Thank you. Our next question comes from David Scharf of JMP. David, your line is open. Please go ahead.

Good morning. Thanks for taking my questions. Most have been answered. Perry, I guess I just wanted to follow up a little on the NIM outlook, which is effectively, you know, flattish from fourth quarter throughout the year. You know, I mean, I believe historically, you know, the company's always had sort of a net asset-sensitive model. And, you know, notwithstanding the abrupt rise in rates, you know, I'm wondering, you know, given the fact that deposit rates funding has continued to increase as a part of the mix. And we've successively had, you know, a number of months past now where, you know, we can flatten out that, you know, the impact of the abrupt changes, the abrupt Fed rate rises and passing it along to consumers. Why wouldn't throughout this year, especially if we're not looking at any surprise increases from the Fed beyond the current outlook, why wouldn't there be a net positive impact to NIM? Is it primarily related to expectations that late fees first get reversed out with higher losses and maybe tempering kind of the late fee modeling as well based on what the CFPB might propose?

What I would say is that our outlook doesn't contemplate anything with the CFPB changes, because as Ralph said, we can't speculate on what that means. But as it relates to net interest margin, you kind of touched on it, is we have been slightly asset sensitive. Our objective is to be close to neutral. And then as you think about NIM, there's many components from the asset mix, meaning the product mix, risk mix that goes in there, And then when you enter a period of rising losses, you kind of said it, is that the increase in late fees that you get or rollover is partially dampened when the losses come through because the reversal of billed interest and fees. So it's all those things together. And then on top of that, we will have a changing funding mix throughout the year as we work through our debt stack. And then you continue to shift to more deposits and other things. So we're just giving guidance for what we think is a good way to model a base case for it.

Understood. Appreciate the detail. And then just a quick follow-up. I know I'm sure on the upcoming investor event we'll get an updated background on kind of the vertical mix. and other ways to sort of slice and dice the portfolio profile. But I noticed in the slides on new signings, there was another jewelry vertical retailer involved. Can you update us on kind of what percentage of, you know, balances are associated with that vertical, which has always been so prominent for you?

Jewelry is jewelry specific?

Yes.

Probably for us the low double-digit in terms of receivables.

Got it. Perfect. Thanks so much. That's all I got.

Thank you. Our next question comes from Dominic Gabriel of Oppenheimer. Dominic, your line is open. Please proceed.

Great. Thank you so much for taking my questions. You know, I want to talk about the spending trajectory throughout 2023. And do you think it would make sense that the consumer would continue to slow their spending, you know, given what we're seeing in inflation coming down? Because, you know, that's going to hurt nominal dollars, right? The grow over effect of nominal dollars being dampened. And really the fact that would you expect spending to slow down through the period up until we hit peak unemployment, and then I just have a follow-up thing.

Yeah, I think that is our speculation a little bit. We're starting to see some decelerating spend. So I think when you think about that, that's impacting the individual consumers, as we talked about earlier. If you think that they're Utilities costs and food costs have gone up $100 in a month. Well, they've got to slow down spend elsewhere. So I do think that's a factor for us as a company, you know, we will we've continued to add partners in 2022 and increase our marketing. So, you know, for us, we continue to see some overall spend growth originations growth, even with the departure of BJ's. But, you know, that and that is a was a high-transactor portfolio. So for us, that will slow our growth a little bit more than what it might have otherwise. But overall, the consumer, again, is still, I think we said earlier, still gainfully employed, jobs to be had, small business or hiring. Even though you're reading about big companies, there's lots of jobs out there. So that's what gives me encouragement that we're going to move through what would be more of a mild economic scenario.

Yeah, and I kind of mentioned it before, you know, the shifts in our portfolio help us maintain spend, right? So, you know, if they move from discretionary, you know, discretionary, non-discretionary, we have products and services that the spend will be sticky to us.

Great, great. I really appreciate that. And, you know, if we, I just want to walk through this this formula with you guys. You know, if you think about growth math and the fact that a lot of, you know, you and your peers have seen some really significant growth over the last few years, you know, that puts that kind of growth math seasoning pig through the Python dynamic, right, on the front book. But if we have unemployment rising, that would affect the front and back book. And so I feel like that would have almost like a doubling of, not a pure double, but an increase, you know, additive effect on the net charge off rate if you have the pig through the python and the back book is getting worse because of unemployment. Does that make sense to you or am I getting something wrong?

No, I think in general terms, sure. But I'll speak specific to us. When you think about the growth that we've taken on for over the past year, A good chunk of that was due to two portfolio acquisitions of the NFL and AAA in 2022. Those are already seasoned portfolios. So when you hear others talk about all this growth and they've got vintages that are going to get peak losses in the next 24 months, that's not the case for us because they already came in season. We were taking losses in the first month they were on the books. So start with that for us. And then if you think about the product mix, that also influences this that growth math seasoning concept because of the degree that we have private label cards they start to season and peak in say month 12 to 18 months whereas many of those co-brands and other things peak 24 to 36 months so hours within the first 12 to 18 months we've peaked in season. So we season a lot faster.

Yeah, I think the other thing I would say too is, you know, we haven't been sitting still. We've been proactively managing the back book and the front book, you know, with the right line assignments, right treatments for card members, the right underwriting for the right vantage score. So, you know, we've been managing our recession handbook for the last two and a half years. And so as I think about it, it puts us in you know, in good shape to know what's in the book and know where to focus.

Great. That's really, really helpful. Ralph, maybe just really quickly, one more for you. Just, you know, you have really great co-brand and private label portfolios. You know, how do you see the dynamics playing out between the two as far as that charge-off rates and where you may decide to pull back in your underwriting, one versus the other in the downturn? Thanks so much for everything.

Yeah, so it's so stupid that the private label portfolios have terrific margins, but they also have a little bit more risk in them. While the co-brand portfolios have good margins, but the risk is less. So if you think as you go into the economy, we certainly want to be fair with all our partners. It's important that we work through and make sure that we are doing the right things by all our partners. But to me, it's really a balanced approach. and making sure that we're taking the right risk for the right reward.

Thanks again.

Thank you. Our next question comes from John Hecht of Jefferies. John, your line is open. Please go ahead. Morning, guys.

Thanks very much for taking my questions. Just your newer partners, the NFL, the Yankees, the AAA, It's a different, I guess, characteristic relative to some of your older traditional retail counterparts. So I'm wondering, given that they represent slightly different kind of associations, is there a difference in characteristics with the usage of the credit cards or the credit relationship with the customers from those different channels?

Yeah, so, you know, some of those cards are top-of-wallet cards. So you think about it, right? So think about AAA. It's real... top of all the cards. So you've got to make sure you have the right line for the right people. It's higher use. It's discretionary spend. It's non-discretionary spend. That's their product. So make sure that we have the right treatments for those co-brand cards, which may differ a little bit from the treatments you have for the private label card. But diversification for us is key. And we don't treat every card equally. We treat it based on the habits of those people and those products.

Is the general line extension and utilization rate consistent with some of the other platforms, or is there anything to point out there?

It depends on the creditworthiness of the individual, right? So that's how we look at it. We don't look at it on a portfolio basis. We look at it within the portfolio and the performance of the individual and their creditworthiness.

Okay, that's helpful. Thank you. And then a follow-up. We've heard from some of the other card issuers that maybe there's a decline and ongoing pressures on deposit prices. Are you guys seeing that, or is there any commentary just over the past few weeks on what you're seeing in the deposit market?

Yeah, so for us, direct-to-consumer deposit remains a key funding component. uh the pressures are out there in terms of pricing yeah it's competitive and we've been helping to lead the way on that competition because you know for us it's a great source of funds we are variable priced and we have terrific loan yields that can absorb the increases in prime and that as prime goes up if we want to pass that through our deposit pricing we get it on the top side revenue so we're good yeah it's a real opportunity for growth for us we have low overhead and really helps our funding capabilities

I guess the question is, as we go into this year, is it similar competition to the last few months? Or given that the new rate outlook might be changing, are you seeing mitigated – not mitigated competition, but maybe less aggressive pressure on incremental rates?

It's the same.

Okay. Wonderful. Thanks very much, guys.

Thank you. Our final question of the day comes from Reggie Smith of JPMorgan Chase. Reggie, your line is open. Please go ahead.

Thanks a lot. I know the call is going kind of late. I appreciate you taking the question. A little bit, I guess, on a different subject. A lot of focus has been on credit quality. I was curious. I was hoping you guys could probably answer this. What proportion of your business today, and whether it's spend or revenues, would you say is related to bread? And that could be the buy now, pay later. It could be the Amex card. Let me actually expand beyond that. So not just bread, but anything like modern. So a digital first card. What I'm trying to get at or understand is it feels like there's probably a story within the story that may be getting missed. And so I was curious if you could share you know, how large that business is and maybe how fast it's growing. Uh, cause I would imagine that over time that that's going to be, um, a bigger piece and an interesting piece of the story.

Yeah. Well, you know, you know, the cart's business, right? Things take time to grow, right? So we've all, we've been with the, with both those products, you know, a year or less or just about a year. So I can tell you that 40% of our new accounts are digital channels, right? So, and I expect that 40% to grow. uh given our new capabilities given the capability given the capabilities we're going to put in place so we expect those digital channels to grow and and we do expect direct to consumer to grow uh i think that american express product two percent cash back is a really good quality product out there uh the virtual card was just introduced that'll have some uh traction in 2023 2024 so while it's not the biggest part of our portfolio today it is a growing part of our portfolio

got it uh and if i could sneak one more in have you guys ever provided a um i guess a longer term target for efficiency ratio i know you talk about uh margin expansion um you know that's been a theme every year you kind of mentioned that uh but is there is there a long-term target um that you're driving towards thank you you know we we we we talk about in terms of positive operating leverage for now you know as we think about the future

potentially, but right now we talk about positive operating leverage, which also helps our efficiency ratio. We have some internal targets, but primarily we're looking at making sure that our revenue outpaces our expense growth.

Understood. Thank you.

Thanks, Roger. Thank you all. I know we ran a bit over, but I think it's time well spent. I really appreciate the interest in Red Financial. I look forward to talking to you all soon. Everybody have a good day.

Ladies and gentlemen, this concludes today's call. You may now disconnect your lines.