Discover Financial Services

Good afternoon. My name is Celicia, and I will be your conference operator today. At this time, I would like to welcome everyone to the fourth quarter 2018 Discover Financial Services earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your touchtone phone. If you need an operator assistance, please press star zero. Thank you. I will now turn the call over to Mr. Craig Stream, Head of Investor Relations. Please go ahead.

Thank you, Cilicia. Welcome, everyone, to our call this afternoon. I'll begin on slide two of the presentation, which you can find in the financial section of our Investor Relations website. The discussion today contains certain forward-looking statements about the company's future financial performance and business prospects, which are subject to risks and uncertainties and speak only as of today. Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today's earnings press release, which was provided to the SEC in an 8K report, and in our 2017 10K and third quarter 2018 Q, which are on our website and on file with the SEC. In the fourth quarter 2018 earnings materials, we provided information that compares and reconciles our non-GAAP financial measures with GAAP financial information, and we explain why these measures are useful to management and investors. We urge you to review that information in conjunction with today's discussion. Our call today will include remarks from our Chief Executive Officer, Roger Hochschild, covering fourth quarter and full year highlights and developments. And then Mark Graff, our Chief Financial Officer, will take you through the rest of the presentation. And after Mark completes his comments, as Cilicia said, we will have time for Q&A session. And we would ask, of course, that you hold your Q&As to one with one follow-up so that we have time for everyone to submit their questions. So thank you. Now it's my pleasure to turn the call over to Roger.

Thanks, Craig, and thanks to our listeners for joining today's call. With this being our year-end call, I want to begin by reviewing full year highlights and key performance indicators on slide three, then turn the call over to Mark to review fourth quarter results. Later in the call, we'll cover our guidance elements for 2019. We earned $2.7 billion after tax, or $7.79 per share in 2018, generating a return on equity of 25% as we put our capital to work to grow the business and repurchase our shares. Once again, we generated a very strong return on equity, reflecting our unique combination of businesses across consumer lending and payments, as well as strong operating performance. Our performance in 2018 reflected robust receivables and revenue growth, particularly in the card business. We've continued to invest in brand advertising, in marketing analytics, and in superior service. And together, these investments continue to drive profitable growth. And of course, we remain focused on providing an exceptional customer experience and are proud to have won the J.D. Power Award for credit card customer satisfaction in 2018. On the subject of how we treat our customers, I want to take a minute to acknowledge the difficult financial situation now faced by furloughed government employees. To support customers in that situation, we are providing payment holidays to those that ask for flexibility at this time. Overall credit performance continues to stabilize. The impact of normalization is diminishing, and we are experiencing tangible benefits from enhancements to our underwriting and collections strategies. Our payment services segment generated strong volume gains of 15% in 2018, largely due to the performance of Pulse. The Pulse team has been successful at winning new relationships and building business with existing issuers by developing creative debit solutions that deliver meaningful value for partners. Finally, I want to emphasize the importance of investing in our global acceptance footprint and technology. These are two distinct areas, but both are critical to our ongoing success. In terms of global acceptance, we continue to see a great opportunity to partner with local acquirers to enhance merchant acceptance. We made significant progress on this in the fourth quarter. signing a number of agreements in a variety of markets, including the UK and continental Europe. Universal merchant acceptance remains an important objective as we pursue our longer-term vision of being a leading global payments partner. And in terms of technology spend, we are continuing to invest in initiatives to drive even better customer experience and competitive advantage. For example, We're making ongoing investments in machine learning to enable faster and better decisions about how to target our collection strategies and marketing campaigns. We've begun to see the benefits of these investments in 2018 with positive impacts on loan growth and credit performance. Now turning to slide four, we were pleased to generate strong total loan growth for the year of 7%, with card receivables up 8%. I alluded to this a moment ago in talking about machine learning, but I am particularly pleased with our growth in new card accounts, even as we continue to tighten credit and brought down the average acquisition cost per account. Student lending turned in another great year with organic receivables up 9% and record originations of $1.8 billion. Our personal loan portfolio grew 1% in 2018 as we cut back on origination activity by tightening underwriting standards. Competitive intensity remains high with new entrants continuing to ramp up originations. We will maintain our traditional underwriting discipline as we focus on driving growth that meets our return objectives. Turning to slide five, credit continues to perform in line with our expectations with seasoning of recent growth and normalization being the key drivers. We will have more to say about the overall credit environment when we discuss fourth quarter performance in 2019 later in the call. But as we enter 2019, we feel very good about underlying trends. I'll now ask Mark to discuss our financial results in more detail.

Thanks, Roger, and good afternoon, everyone. I'll begin by addressing our summary financial results in slide six. Looking at key elements of the income statement, revenue growth of 7% this quarter was driven by strong loan growth and a slightly higher net interest margin. Provision for loan loss has increased due to the combination of the seasoning of loan growth and ongoing supply driven normalization in the consumer credit industry. Operating expenses rose 7% year over year as a result of investments in support of growth and new capabilities. This includes the higher level of incentive payments made in support of the global merchant acceptance initiatives that Roger talked about earlier. Turning to slide seven, total loans increased 7% over the prior year, led by 8% growth in credit card receivables. Growth in standard merchandise balances drove much of this increase with a lesser contribution from promotional balances. We currently expect the promotional balance mix to decline modestly in 2019, and for standard merchandise balances to continue to be the primary engine for growth in CARD. Moving to the results from our payment segment, on the right-hand side of slide seven, you can see that proprietary volume rose 6% year over year. In payment services, Pulse continues to drive the lion's share of both volume and growth, with volume up 11% compared to the prior year. Growth was driven by both new issuers as well as incremental volume from existing issuers. Moving to revenue on slide eight, net interest income increased $182 million, or 9% from a year ago, driven by higher loan balances and modest NIM expansion. Total non-interest income grew $11 million, primarily from a 13% increase in loan fee income. Sales volume grew by 5%, driven principally by growth in active card members. Adjusted for the number of processing days, sales growth would have been 6%, which is down from 9% on a day-adjusted basis last quarter. Our rewards rate for the fourth quarter was 128 basis points, up five basis points year over year. This increase is due to both portfolio mix, which continues to shift toward the Discover It product with its slightly higher average rewards rate, as well as our decision to feature warehouse clubs in the 5% category in the fourth quarter. As shown on slide nine, our net interest margin was 10.35% for the quarter, up seven basis points on both a year-over-year and a sequential basis. Relative to the fourth quarter of the prior year, the benefit of a higher prime rate and the expiration of the FDIC surcharge were offset by the impact of an increase in promotional balances, higher deposit costs, and higher interest charge-offs. Relative to the third quarter, The increase in net interest margin reflected a higher prime rate, the expiration of the FDIC surcharge, and a mixed shift in our liquidity portfolio from cash to investment securities. Total loan yield increased 45 basis points from a year ago to 12.59%, primarily driven by a 41 basis point increase in card yield. Prime rate increases and a modest increase in the revolve rate led card yield higher, partially offset by a higher mix of promotional balances and higher charge-offs. On the liability side of the balance sheet, consumer deposits grew 12% as we continued to focus on more stable and cost-effective sources of funding. Consumer deposit rates rose during the quarter, increasing 12 basis points sequentially and 56 basis points year over year. Deposit betas have increased, though cumulative betas continue to be better than historic norms. Turning to slide 10, operating expenses rose $74 million from the prior year. Other expenses were up $40 million, with almost $35 million of the increase due to the investments in global merchant acceptance, which Roger spoke about earlier and had previewed at the Goldman Conference in December. These were driven by agreements that we signed with new partners as well as existing partners in new territories. In some cases, acceptance milestones were achieved more quickly than anticipated and that contributed to the higher level of incentive payments in the fourth quarter. In marketing, expenses were up as a result of greater brand and digital advertising activity. Finally, our ongoing investments in infrastructure and analytic capabilities accounted for the increase in information processing costs. I'll now discuss credit results on slide 11. Total net charge-offs rose 23 basis points from the prior year. The seasoning of loan growth from the past few years and supply-driven credit normalization continue to be the primary drivers of the year-over-year increase in charge-offs. Credit card net charge-offs rose 20 basis points year-over-year. From a sequential perspective, this quarter represented the fifth consecutive quarter of slowing year-over-year increases in card charge-offs. The credit card 30-plus delinquency rate was up 15 basis points year over year and 11 basis points sequentially. Our disciplined approach to managing credit with both new and existing accounts has led to continued solid credit performance in the card business. Private student loan credit performance has also been very strong, with net charge-offs down 17 basis points year over year and 10 basis points sequentially. Personal loan net charge-offs were up 87 basis points from the prior year and 40 basis points sequentially, slightly better than the 50 to 60 basis points we'd expected. The 30-plus delinquency rate was up 20 basis points year over year and three basis points sequentially. Looking at capital on slide 12, our common equity Tier 1 ratio decreased 30 basis points sequentially as loan balances grew. Our payout ratio for the last 12 months was 93%. To sum up the quarter on slide 13, we generated 7% total loan growth and a 25% return on equity. Our consumer deposit business also posted robust growth of 12%, while deposit rates increased 56 basis points year over year. With respect to credit, our total company charge-off rate, just over 3%, reflects positive underlying trends in card and student loans, And finally, we're continuing to execute on our capital plan with strong loan growth and capital returns, helping to bring our capital ratio closer to target levels. Turning to slide 14, I want to shift gears and review the key factors that we believe will contribute to another year of strong returns, even as we continue to invest for longer-term growth. First, our base case for 2019 adopts the consensus view that macroeconomic conditions remain stable. although our growth plan does contemplate a degree of tightening at the margin. The economy is growing. Of particular importance to us as a consumer lender, employment and wages are growing, and consumer leverage remains manageable. Very simply, we don't see any indication in the data of a turn in the credit cycle. Second, Discover has a very strong and widely recognized brand which consumers associate with value, trust, and exceptional customer service. particularly in card. These attributes remain core to driving profitable growth, and we will continue to invest in brand awareness for our other consumer banking products as well. Third, we will continue to invest in technology, supporting the deployment of advanced analytics and automation. This will allow us to make better, faster decisions, drive operational efficiencies in account acquisition, servicing, fraud, and collections. And, of course, the thread that weaves all this together is our relentless focus on customer experience. We recognize that we live in a highly competitive environment, but we've been able to distinguish ourselves by introducing features and benefits that customers value. Our customer-centric approach has been fundamental to our consistently strong growth and returns. With that, let's move on to 2019 guidance on slide 15. As I said a moment ago, our base assumption for 2019 is a continuation of the current economic environment. If this proves to be wrong and we see meaningful deterioration in macroeconomic conditions, we would in all likelihood pull back on growth and experience an increase in net charge-offs. Of course, we would also have flexibility in managing rewards costs and operating expenses, which would provide a degree of mitigation. Looking at the specific guidance elements, first, we've established a loan growth target range of 6% to 8%. based on opportunities that we believe will allow us to continue driving disciplined, profitable loan growth. Moving to expenses, we expect operating expenses to be in a range of $4.3 to $4.4 billion. This reflects higher base levels of expenses to support growth in the business, as well as continuing investments in the initiatives that Roger and I have mentioned. With respect to rewards, we expect the rate to come in between 132 and 134 basis points for 2019, a modest increase largely resulting from the ongoing shift in product mix as we originate all of our new card accounts on the Discover It platform, which has a slightly higher average rewards rate than the predecessor product. Moving to our outlook for net interest margin, we expect the full year NIM to come in around 10.3% with a bias to the upside. The prime rate increases from last year will contribute positively to NIM in 2019. We also anticipate a modest NIM benefit from a lower mix of promotional balances. Potentially offsetting these benefits would be deposit pricing pressure, wider wholesale funding spreads, and modestly higher interest charge-offs. In terms of credit costs, we expect the total net charge-off rate this year to be in a range of 3.2% to 3.4%. as a result of the seasoning of a growing portfolio, as well as continued, though moderating, supply-driven credit normalization. So to sum things up, we're pleased with our performance in 2018 and look forward to continued momentum in the year ahead. One final comment. Earlier today, we announced internally that Noel Whitehead will be assuming a leadership role in our student lending business. I want to take this opportunity to thank her publicly for her outstanding service as a member of the investor relations team over the last several years. That concludes our formal remarks. I'll turn the call back to our operator, Cilicia, to open the line for Q&A.

At this time, if you would like to ask a question, please press star 1 on your touchtone phone. If you wish to remove yourself from the queue, you may do so by pressing the pound key. We remind you to please pick up your handset for optimal sound quality. We will take our first question from the line of Mark DeVries with Barclays.

Yeah, thanks. I think you guys indicated last quarter that you saw better than expected growth in promotional balances in part due to some more effective marketing on your end. Could you just talk about, you know, whether that trend kind of held this past quarter and what your outlook is for that into 2019 and what, if any, impact it may have on your NIM guidance?

Sure, Mark. Happy to tackle it. We did continue to see promotional growth play a role in the growth in our card book over the course of the quarter. But it was a secondary level of growth, and it was a distant secondary level of growth to standard merchandise purchases. So I would say we saw moderation in the component of the growth that was represented by promotional balances. As we think about looking into 2019, we would continue to see the proportion of growth represented by promotional balances continue to decline modestly. So, in terms of NIM guidance, that's what's kind of baked in there, thought through there. I think in terms of the 10.3% with a bias to the upside on the NIM thought just generally, That guidance doesn't include any increases in rates by the Fed, any short-term rate increases. It's following the forward curve instead of the dot plots. So that would also be a little bit of upside to margin if we were to get some of that, probably to the tune of about four to six basis points for every 25 from the Fed.

Okay. And anything you can share around what you're assuming around deposit betas in that guidance?

Yeah, we've never talked about our deposit beta specifically, but I would tell you, cumulatively, the beta is looking – so CDs are 33% of the books. CDs always have a beta close to one, right? So we'll put that aside. But for the indeterminate maturity deposits, the cumulative beta is sitting at 51 as we sit here right now. So it continues to be well below where you'd expect it to be cycle to date. I would not expect there to be a lot of upward pressure on that from market rates. If there's any upward pressure, it's likely to come from competitors as opposed to a lot of movements in the market.

Okay, great. Thank you.

You bet.

Your next question comes from the line of Sanjay Sakmarini with KBW.

Thanks. Good evening. I guess on loan growth, I think it's clear your baseline on the economy that it's okay and you're seeing opportunities for growth. But I was wondering if there's any specific attributes that in the loan growth that make you comfortable with their resilience through a cycle? Because, I mean, it's pretty robust growth.

Yeah, sure, Sanjay. I would say, you know, if I sit and I look at the nature of the growth, you know, the line-weighted FICOs at acquisition in the card side continue to be right at about 730. So they continue to be very consistent in terms of, you know, what we have booked over time. And as we continue to book these new vintages, we see the card members come on more engaged with the brand, more engaged with the card, and driving the types of behaviors that tend to drive long-term profitability. So we feel real good about that. In terms of line utilization, it's not like all these folks are coming on board and maxing out their lines, so it's good, responsible behavior that we're seeing out of those folks. The student lending business just continues to be – A fabulous product for us, risk-adjusted basis. It drives great returns. We think it's a great introduction of new young people into the fold that can become a part of the broader Discover family as they grow. The personal loans business, you know, I think we've talked there, and I would say we don't expect personal loans to be a giant grower as we look into 2019. We do expect it's probably going to be balances there will be flattish to maybe a little up, but not a major contributor. And, of course, in student, you're fighting a little bit of attrition from the acquired book, too. So we would expect CARD to drive the lion's share of the growth in loans over the course of 2019. Okay.

My follow-ups for Roger, I guess you guys talked about the importance of building out a global merchant acceptance via those initiatives. Is there any way to sort of assess the payoff economically as we look at those investments?

You know, it's hard to look at that on a merchant-by-merchant basis. You know, the payoff comes when you reach critical mass of coverage in any given market, and that benefits not just our own card-issuing business, but also our network partners around the world who will see the benefits from that. So we have a very disciplined investment process that looks at target cost per merchant and When we can do a partnership with a network in a market, that, of course, lets us build acceptance at a very affordable cost. But, you know, that ongoing level of investment is embedded in the expense guides we've provided for 2019.

Yeah, and I think, Sandeep, just to pile onto that for a second, I think, you know, the $35 million or so that came in in the fourth quarter is You know, I would say largely we'd encourage you guys to think about that as one time. That's why, you know, Roger kind of called it out specifically at Goldman. Anything else that we see currently is obviously baked into our guidance for 2019. Okay. Great.

Thank you.

You bet.

Your next question comes from the line of Ken Bruce with Bank of America. Mayor Lynch.

Thank you. Good evening. Let me pick up where you just left off on the comment about the building out of the global network. Understanding you've got some, I guess, factored into your guidance for next year, do you feel like you're in the early stages of an investment cycle in terms of building out that acceptance? Is this something that we're going to be looking at in terms of a longer-term payback? Maybe just give us a sense as to where we are in that in that cycle and kind of what the payback horizon may look like?

Yeah, I would say it's been a long process of investment. So it's been continuous. It's been something we've been at for many years. I think the reason it's maybe attracting some attention now is really the lumpiness Mark talked about in the fourth quarter. But we view building out acceptance both in the U.S. but also in these international markets as critical components to our network strategy. which again is both monetizing it through our third-party payment segment, but also driving our proprietary card growth.

Okay, and maybe a two-part follow-up just so I can finish on that. So you would expect the payback to be over a longer horizon, if I can just make that assumption. You can correct it if not. And then my follow-up is just in the area of competition, we've seen – quite a bit of increase in cost related to whether it be acquisitions or rewards across the board and I'd like for you to maybe discuss where you think the competitiveness is within the specific segments that Discover is active in and how we should be thinking whether that is in a sense getting more competitive or if in fact there maybe is some easing which was suggested by the press recently.

Yeah, I mean, we, you know, with our lend-focused model are always in the prime lending space. We're not a subprime issuer. That business is always competitive. It can go up and down a bit. But in my, you know, 25-plus years in card issuing, there's never an easy time. You can see from our performance around new accounts that, you know, we're booking more new accounts, Our cost per account is coming down, and all of that is occurring as we've been tightening credit over the last couple years. So we feel very good about our value proposition and how it can compete. In terms of overall activity, you know, we believe a lot of the rewards competition has plateaued. You're not seeing the same pace of introduction of new programs. So, you know, it's going to remain competitive, but, you know, we feel good about our product, how it's positioned. And if you're buying business with big upfront incentives or the highest reward weight in the market, you'll attract a disproportionate share of gamers and transactors, neither fit with our long-term focus on the business.

Great. Thank you.

Your next question comes from the line of Rick Shane with JP Morgan.

Hey, guys. Thanks for taking my question. Roger, I appreciate your comments related to the shutdown and just wanted to ask two questions related to that. One is how do you think your customer base indexes sort of more broadly against government employees? Are you slightly higher concentrated in line or lower? And then second, given that we're now almost 34 days in, which is a pretty significant chunk of time, have you seen any slowdown or change in spending behaviors?

So I'll start with the second one. We have not seen a change in overall spending behaviors across our portfolio. I don't think we over-index for government employees. We don't have necessarily employer current for our entire base, but it's not a meaningful percent. I think it's very important that all of us do everything we can to support the employees in this situation, and so that's why I called it out. But compared to programs we've done around major natural disasters, for example, in the past those have had a much more significant scale.

Okay, that's helpful context. Thank you.

Your next question comes from the line of Eric Wasserstrom with UBS.

Thanks very much. Just two questions related to the guidance. Mark, on the rewards rate, I think historically the transition from Discover to the Discover It product had about a two basis point inflation in the rewards rate. Is that still true?

Yeah, I would say it's run somewhere over time between two and three basis points. I think last year it was three basis points. So, you know, if you think about the sort of the guidance range, if you will, what we're kind of calling out is we really don't expect any pressure and rewards other than that continued migration as a greater percentage of the portfolio is made up of IP card members.

Okay, great. And then just on the NCO guidance, I think last quarter you indicated that on the personal loans component, you expected a change third quarter to fourth, and you came in a bit better. But I think the fourth quarter to first quarter of this year, I think that was something like an incremental 40 basis points. Is that still your outlook?

Yeah, I would say that feels somewhere in the right general zip code. I'm not going to call it out as a specific number at this point in time. But really, we saw a little bit of goodness in the fourth quarter relative to what we expected. we installed a number of new technologies in the personal lending business that are helping us really do a better job snipping out synthetic fraud and really segregating our underwriting a little bit better. So, you know, we are hopeful we can do better than that five-ish percent kind of guidance we gave last quarter. But for right now, we're early in the year. So I think I'll stick to something pretty close to that 40 basis points for the first quarter. Thanks very much. You bet.

Your next question comes from the line of Chris Brindler with Buckingham.

Hi, thanks. Good evening. Thanks for taking my question. I just wanted to ask on domestic spending, sort of the 6% normalized rate down from 9% normalized last quarter, despite what appeared to be a pretty successful rewards quarter. Is that just sort of tougher comps or a little bit of macro slowdown? It seems like we had a good Christmas, so it's a little bit of a surprise to see that magnitude of deceleration. Thanks.

Yeah, there are a mix of factors in there. Part of it is a bit tougher comps. We booked a lot of new accounts in the fourth quarter last year, and those, of course, come on and activate and start spending quickly. There was a slowdown in holiday spending towards the back half of the holiday season. I think that's not just us. You've seen a number of major retailers pull that out. So those are probably the biggest drivers on the sales front.

Okay. And a follow-up on your NIM guidance, Mark, does it matter that much, you know, what the Fed does? If the Fed, you know, sort of stays on a more aggressive path, it would sort of help out your yields. If not, you know, it could potentially deposit costs to start to catch up with yields. Is that a big swing factor or is that doesn't play in fast enough to really matter to the 19 outlook?

No, it's not a giant swing factor. I mean, you know, if a A little bit inside baseball, if I go back to the fall when we were putting together our operating plan for the year, you know, you looked at the forward curve, it assumed two rate increases, one in June and one in December. So you'd have gotten the benefit of half a year of one of those increases and essentially none of a year of the other of those increases. So if you go to zero, it's not a giant impactor, if you will. So I'd take you back to that other thought, really sitting back and saying, you know, roughly if we do get them, all in, including the deposit beta assumptions and everything else, you're probably looking at somewhere between four to six basis points of nimicretion flowing through as a result of a 25 basis point move where we get one.

Awesome. Thanks so much, guys.

You bet.

Your next question comes from the line of Betsy Grasick with Morgan Stanley.

Hi, good evening. A follow-up to that question, so four to six BIPs up if you get another 25 BIP hike, but if we don't get another hike, then I know your guidance is saying 10.3 plus minus with a bias to the upside. Is that bias also a four to six BIP range?

No, it really, Betsy, would depend on too much of what happens. I mean, I've got And pulling together thoughts around guidance, we've obviously got, you know, 50 scenarios we've run about what if this and what if this and what if this. I think how you should interpret it is a lot more of those scenarios come out better than 10-3 than come out tougher than 10-3. And that's why we're kind of talking about a bias to the upside. You know, I think at the end of the day, If we see continued mitigation in the rate of increase in delinquency formation, which is kind of pretty flat right now, or if we see, you know, charge-off formation continue to moderate, there could be some goodness there. But, you know, in terms of overall, it's going to be a function of market rates, portfolio mix, promo activity, interest charge-offs, you know, deposit betas, funding mix, and a whole host of other things. So it's hard to call. But I emphasize the bias to the upside for a reason.

Okay, and then maybe I could just have a follow-up on how you're thinking about reinvesting the deposits that you've got. I mean, in this past quarter, deposit growth was very strong, and I believe the mid-teens or so. Maybe you could give us some color on how you're thinking about driving that growth rate in a flat rate environment. Should we expect that that tails off, slows down, or do you think you hold that level of deposit growth and then how do you think about the reinvestment of that given that the loan growth is more in the mid singles?

Yeah, you know, clearly we have multiple channels to use in our funding mix. So it's not as if we'll have to go out and buy assets or accelerate asset growth. Mark will, you know, do his magic on the treasury side. I think we and others benefited from a big investor move towards cash in the fourth quarter. And so that drove flows up across the industry. But we do feel good about our ability to continue to grow deposits without, you know, posting at the top of the rate tables and having a value proposition very similar to card in terms of differentiated products, service, customer experience, leveraging our brand, and then also cross-selling into the card base. So, you know, deposits... will continue to be the most significant part of our funding mix. We expect it to grow faster than assets, but that will just, you know, therefore result in us shifting the overall mix.

Okay. Thanks. Your next question comes from the line of Bill Carcacci with Nomura.

Good evening. The high end of your expense guidance is a bit higher than the low end of your loan growth, and I know it's difficult to be precise with all of the moving parts, but At a high level, you know, Mark, you mentioned all of the different scenarios. Maybe could you just speak to, at a high level, your commitment to controlling expenses for the revenue environment and generating positive operating leverage in 2019? You guys have historically done a good job with positive operating leverage, but curious, you know, if you could speak to that in 19.

Sure, happy to. I would say the bulk of that investment activity, I mean, obviously there is spend ongoing to support the generation of assets in a, let's call it a BAU-type environment, but the bulk of that incremental spend is really investment into a lot of these new technology platforms that Roger and I spoke about. Most of these new technologies are domiciled in the cloud as opposed to resident in our four walls. One of the big differences between traditional systems development within your own four walls in the cloud is you capitalize the traditional version, so it doesn't have a big annual impact on expenses. Cloud-based development gets expensed. So a chunk of the increase, really a big driver of the increase you're seeing year over year, is the result of our continued migration to and deployment of a lot of these new technologies that the results we're seeing from them are just really strong, and we feel very good about that. In terms of just overall the commitment to expense discipline, no question. I mean, I appreciate your commentary on the positive operating leverage. I think it's been a number of years since there was a negative number in front of that, despite some really big investment activity on our part. So I think it underscores the strength of the revenue engine as well. But we definitively are committed to managing our operating expense base We're committed to positive operating leverage, and we unequivocally have leverage in the model, as I called out in my prepared remarks, that if we see something in the environment start to change, we've got leverage in marketing dollars, we've got leverage in rewards costs, we've got leverage in a lot of different line items in the P&L that we won't hesitate to pull those levers if it's the right thing to do.

That's very helpful. Thanks, Mark. If I can follow up quickly on credit. On an annual basis, we saw your provision growth exceed your loan growth by incrementally larger amounts in 2015, 2016, and 2017, but the excess of provision growth over loan growth actually shrank in 2018, and this trajectory is consistent with some of the favorable credit trends that you highlighted in your prepared remarks. As we look ahead to 2019, is it reasonable to expect that that excess of provision growth over loan growth should continue to compress modestly?

Yeah, I'm going to kind of stay away from answering that one specifically because I don't want to give provision guidance. What I would say is, you know, we have called out that we continue to see the rate of increase in charge ops in the card business moderate for five consecutive quarters. You know, we obviously set our reserves and provide on a quarterly basis based on a whole number of factors that we see at that point in time. But the fundamental underlying underpinning piece that is the biggest component of it, obviously, is what are the trends we're seeing in credit. And those trends with normalization slowing continue to feel pretty good. But in terms of actually calling on a forward basis what provision is going to be, I'm going to stay away from that one.

Understood. Thanks very much for taking my questions. You bet.

Your next question comes from the line of Bob Napoli with William Blair.

Thank you, and good afternoon. New card growth in the cost 11% and cost per account down 6%. A pretty impressive combination is the new card growth and acceleration, and what is going on with net card growth? Is the runoff picking up? What is driving those really good metrics in card growth and cost per account, and then are those, I guess, the same quality of accounts Are you seeing any faster runoff of accounts?

Yeah. So, you know, in terms of I would separate the two. First, we have not seen any change in attrition. And given, you know, how we deliver on customer experience, our attrition tends to be the lowest in the industry. In terms of what's driving our card acquisition performance, it really is a lot of those investments around technology and in particular next-generation analytics and modeling, as well as just how well the value proposition competes with millennials and younger consumers especially. So we're very pleased to see that. And, again, I'll repeat, all of that is in the context of continuing to tighten credit around our new account underwriting.

Great. Thank you. Follow-up question. Just in line with the 2019 growth, Mark, one area you didn't give any color around and not that you have in the past is the non-interest income revenue growth. And that's kind of been a low single-digit revenue growth item. Is that the continued expectation is kind of low single-digit growth of non-interest revenues?

Yeah, I don't think we've historically guided on non-interest revenue, Bob, and so I'm going to kind of stay away from that one. It's not really a giant driver of our components of our P&L.

Okay, great. Thank you very much. Appreciate it.

You bet.

Our next question comes from the line of Chris Donat with Sandler O'Neill.

Good afternoon. Thanks for taking my question. Mark, I had sort of a clarification question. as you use the expression, supply-driven credit normalization a few times on the call. Just want to see if you could expand on that one. And then if you want to get philosophical, maybe also give us your view on what, if at some point we ever have an end to the credit cycle, what might cause that?

Well, in the first part, that's easy to do. I would say the supply-driven credit normalization, if you think about the components that would drive an increase in delinquencies and charge-offs, you really have an incidence component, in other words, what percentage of the portfolio comes under stress, and then you have a severity component, which is once an account does come under stress, what's happened to the balances? Are they bigger now than they were a couple years ago? And I would say the driver cycle to date in this has really been, in our case, has really been we have seen severities increase much more so than we've seen incidence rates increase. So if you think about it, going through the crisis, consumers delevered either by choice or otherwise. And so for a number of years coming out of the crisis, they carried really low levels of leverage. A few years back, consumer credit availability started creeping back in. Consumers started levering up. So while we're not seeing a much greater percentage of the book come under stress, when somebody does come under stress, they're carrying more debt. Therefore, the severity of the charge-off is bigger. We're referring to that as supply-driven normalization because it's the supply of consumer credit that's really been the primary driver of that. Speculating as far as what's going to be the driver of the next recession, there's a lot smarter people than me that you could ask who could give you a better sense on that one. I guess what I would say is looking at the data, seeing everything we see, we don't see it as a consumer-led issue. It feels more geopolitical, global macro, something like that, as opposed to an over-leveraged consumer or a consumer asset bubble.

Got it. I appreciate that one. Then just as a follow-up, I'll ask a very pedestrian one of the other expense line on the income statement. It's just a little higher than normal. Is that where we saw some of the merchant acquisition or your cloud-based investments show up in that line or are those elsewhere?

It's the global network stuff that we spoke about earlier on the merchant side that is showing up there. Got it. Okay. Thanks very much, Mark.

Your next question comes from the line of John Hecht with Jefferies.

Well, all my questions have been asked. I'm going to throw out a painful topic, Mark, and it's related to CECL. Sure. I think a specific question is, you know, I believe you're all supposed to start running parallel models now, and I guess the specific question is, do you have enough I guess, insight to all the elements of CECL to begin running that? If not, where are the uncertainties around, you know, what the modeling would entail? And if so, do you have any comments on that at this point?

I knew the question was going to come up, so no worries about the painful ask. Not a problem. I guess I would say one of the places a lot of that technology that Roger and I have alluded to a few times ago has been put to work in is in the CECL modeling, trying to break away and come up with some machine learning approaches, really starting to think about every way we can to start slicing and dicing our portfolios. So we are in the process of going through what I would describe as a giant Monte Carlo simulation. You know, the standard itself is very broad in terms of how you can think about and how you can define certain things. So we're doing a Monte Carlo simulation to really kind of figure out what the right answer for Discover is, right? What's going to produce, you know, essentially the best, least volatile answer that most accurately reflects the lost content in the portfolio? So I would say the technology is largely in place. Now we're in the process of running these Monte Carlo simulations to figure out how exactly we want to think about this going forward. So parallel, yes, some point in time this year we will go to a full parallel. There's no question about that. And as we said, at that point in time, once we have a sense of what that CECL reserve is going to look like, we feel like we have a disclosure obligation we'd put in front of you. I would say Right now, I would just underscore what we've said before, and that is in a CECL environment, reserves will be higher and more volatile for consumer loans. That's just the nature of the beast in terms of the way the standard is set and it would work. On the positive note, we continue to interact heavily with the FASB, along with a number of our peer institutions who are also actively engaged. There is a proposal out there to run a lot of the volatility created Cecil through AOCI as opposed to through the income statement. And we're hopeful that the powers that be will see the wisdom in that instead of creating a truckload of EPS volatility that doesn't reflect the underlying trends in the business.

Really appreciate that, Kyler. Thanks very much.

You bet.

Your next question comes from the line of Moshe Orenbach with Credit Suisse.

Great. Thanks. Most of my questions actually also have been asked and answered, and I think that it is kind of interesting, you know, that you've been talking for a couple of quarters about improvement in account acquisition costs, and, you know, and I think it's particularly notable that you're able to do that with you know, without increased reliance on promotional balances. And so, you know, maybe it's not a fair question, but, you know, it seems like the entire industry is trying to do that. What, you know, is there anything you can tell us that you're able to, you know, any reason that you're able to do that and others aren't?

Yeah. One thing we've always highlighted is the differentiation we get from our proprietary network. And so I do think you've seen two issuers that have proprietary networks really stand out in terms of growth, and both of us tend to be conservative on the credit side. The other thing I would say is it's just that relentless focus on the customer. We've won the J.D. Power Customer Experience Award for the last five years. It's not just the great 100% U.S.-based customer service. It's the mobile app. It's the rewards. It's the new features, and benefits. So we look carefully at our target customers and are always thinking of new ways to add value.

Got it. And maybe just from a credit standpoint, since you've kind of given some expectation that losses will be higher, the rate of increase on the personal loan side, while it's a smaller piece of the portfolio, is going to be higher than your overall expected rate of increase, I guess, I mean, the arithmetic conclusion is that you're expecting the increase in losses on credit cards to be less than that. I mean, you know, so, I mean, you know, I think that is any kind of, you know, thoughts or additional insight you can give us there?

No, I would say mathematically, I agree with your conclusion, Moshe. You know, it really – we've seen some, you know, pretty big increases in the personal loan book, and I think we've, you know, kind of called that out and talked about that one, as you know, pretty extensively in the past. We're hopeful that we can actually produce a better result than what we called out over the course of the last couple quarters in terms of looking into 19 there, but we're early in the year, so I'm not going to declare a victory. But, yeah, the rate of increase in the charge-offs in the card book continues to moderate. We feel very good about that. Student loan book, you know, you can see in the supplement the statistics there is performing exceptionally well. So, you know, unless something else pops up that changes the trend, it really does feel that both the card and the student businesses are performing really well from a credit perspective right now. Great. Thanks so much. You bet.

Our next question comes from the line of Don Fandetti with Wells Fargo.

Hi, good evening. So, Roger, are there any competitive implications from the FISER for state acquisition in terms of Pulse on TIN debit? And then secondarily, how do you think about that business? Is that a strategic asset? I know it sort of leverages into rewards on debit cards and plays into checking, but have you ever thought seriously about trying to monetize that?

Yeah. So, first, we don't discuss M&A, so acquisitions and divestiture is But, you know, in terms of the merger, I'd say it's probably too early to tell. Both companies are good partners of ours. We compete in some parts. We partner in others. And so, you know, I think we'll watch that very carefully. In terms of the Pulse business, you know, coming off a very strong year of performance. And clearly, as we look at our payment segment today, being able to offer both credit and debit capabilities out there is very important as a network. So we feel very good about the payments assets we've assembled, both through the Pulse acquisition as well as Diners, and are working hard to continue to increase the share of profits that come from payments. Got it. That's all I had. Thank you.

Your next question comes from the line of Vincent Cantick with Stevens.

Thanks. Good evening, guys. Just a few quick follow-ups. So just first a follow-up on the global merchant acceptance. So it's great to see the partnerships that you've put together. Just kind of wondering when we think about the medium term, what are your thoughts about increasing the merchant acceptance in terms of what activities do you plan to do? Should we expect more partnerships, different products, other investments?

Yeah, I would say it's a continuation of a multi-year journey. So again, getting a lot of attention because of lumpiness in a single quarter, but we've been working, and if you go back and look at the stream of announcements, we've been working with merchant acquirers and markets outside the U.S. for many years. The one part I would say we're particularly focused on are partnerships with networks around the world and which brings us both broad acceptance in different markets, but also volume as they leverage our account number ranges, our chip specs, and so it helps strengthen the overall network. And so that's a strategic thrust that you can expect to continue.

Okay, great. Thank you. And then just one more, shifting to the private student loan market. So notice that – The credit trends have gotten better year over year in 2018, and they got progressively better over the course of each quarter in 2018. I'm just wondering if there's anything in particular that's driving that, and what should we expect for 2019? Thank you.

I would say you've had a growing portfolio at a pretty rapid rate over the course of a couple of years, and as that portfolio season was getting to a maturation level, you were seeing a bit of uptick in the credit statistics and the charge-off rates and the like. As that portfolio begins to – as the growth there begins to moderate a little bit, I think you're seeing some of the impact of that. I think the other key piece of the puzzle is really just the disciplined nature of the underwriting. that's continued to go on there. You've got an average FICO in that book on the order of 750 right now. So it's a full 20 points higher coming on the books than the average card account is. And just to remind all of you who don't live in the FICO world normally, every 20 FICO points doubles default risk. So a 750 defaults at half the risk of a 730 as a starting point on addition to that. So I would say that's a key piece of the puzzle as well. And obviously, you know, not to try taking credit for brilliance, you also have a really strong economy out there. These kids are coming out of school and they're able to find jobs, right? So that's a piece of the puzzle as well. So I'd say all those are contributing factors. Great. Thanks very much. You bet.

Our next question comes from the line of Dominique Gabrielli with Oppenheimer.

Hi, thanks for taking my question. The new loan growth guidance is a bit lower than what we saw in 2019. Can you talk about how much this is related to gas prices and non-gas price impacts? Could the impact be about maybe 2%? And then are there any other categories that are standing out within spend that you see potentially slowing down, or is this just really related to you tightening those new card acquisitions? Thank you.

You bet. So I think there's a couple pieces embedded in there. We do over-index as a card to gas. It tends to be on the order these days of about 5% of our sales. That's down from about 10% of our overall sales when gas prices were higher. So there definitely is a muting impact associated with the decline in gas prices. There's no question about that. Um, certainly an element of it reflects the, just the tightening around the margin that Roger referenced earlier in terms of our, um, our credit standards in terms of, uh, booking new accounts. And then the third piece of it obviously is look, you know, personal loans, as we've talked about, we expect, you know, to be a pretty much a flat to a very modestly growing book. So, uh, and that's a book that over the last couple years has been, you know, a significantly higher grower. So I think, you know, taking that growth component out of the mix as well also has an impact. So put all those together, and that's kind of how we're triangulating on that range.

Great. Thank you. And just really quick, can you talk about if you expect any impacts, you know, in the next few years in your student loan originations and loan growth, given that Navient is kind of coming up to that here with a new in-school student lending product and then maybe – pushing a little harder on the refinance loans. Could you talk about the industry dynamics there? Thanks so much.

Yeah, I mean, I think we tend not to focus on any specific one competitor. So I would say, in general, the refi volume, not them, but just the whole growth of student loan refi, has had an impact on our payment rates. And so that's something we're watching closely. We've still been able to grow through that, but it's had a noticeable impact. And so I think we'll see how sustainable that is, both, A, as those companies at some point need to focus on profitability, and then, B, also as rates have risen. So, you know, ReFi does have an impact, but we are continuing to grow through it. Thanks so much. I really appreciate it.

Your final question comes from the line of Jill Saywood, Citi.

Bill?

Jill, are you there? Alicia, it looks like Jill may have dropped.

Sorry about that. Can you hear me?

Yep, we got you.

Okay, thanks so much. So maybe just quickly on credit quality. In the past, you've mentioned the portion of the loan loss reserve bill that's related to the seasoning of accounts versus the normalization of the back books. I was just wondering if you could give us an update there and what you're seeing in terms of trends.

Sure, I'd be happy to. In the fourth quarter, this isn't a sniper rifle kind of estimate. It's more of a ballpark estimate, but I would say about two-thirds of the provisioning was related to new accounts. about one-third of the provisioning ballpark was related to the seasoning of the back book, again, reflecting that moderating pace of normalization taking place across the industry that we referenced earlier.

Okay, great. Thank you.

You bet.

And at this time, there are no further questions. I'd like to turn the call back over to CorrectStream for any additional or closing remarks.

Sure. Thanks, Lisa, and thanks, everybody, for your questions, and we're available for any follow-ups. that you might have. Thanks. Have a good evening.

This concludes today's call. You may now disconnect.