Discover Financial Services

Good afternoon. My name is Erica, and I will be your conference operator today. At this time, I would like to welcome everyone to the third quarter 2019 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 at that time, please press star 1 on your touch-tone phone. If you should need operator assistance, please press star 0. Thank you. I will now turn the call over to Mr. Craig Stream, Head of Investor Relations. Please go ahead.

Thank you very much, Erica, and welcome, everyone, to this afternoon's call. I'll begin on slide 2 of our earnings presentation, which you can find in the financials section of our investor relations website, investorrelations.discover.com. Our discussion today contains certain forward-looking statements that are subject to risks and uncertainties that may cause actual results to differ materially. Please refer to our notices regarding forward-looking statements that appear in today's earnings press release and presentation. Our call today will include formal remarks from our CEO, Roger Hochschild, covering third quarter highlights, And then it's my pleasure to welcome John Green, our new chief financial officer, who will take you through the rest of the earnings presentation. After John completes his comments, there will be time for a question and answer session. During the Q&A session, please limit yourself to one question and one follow-up so we can accommodate as many participants as possible. Now it's my pleasure to turn the call over to Roger.

Thanks, Greg, and thanks to our listeners for joining today's call. As you can readily see from our results, we continued to deliver very sound fundamental performance this quarter, leading to net income of $770 million after tax, or $2.36 per share, with a robust return on equity of 26%. We achieved our key objectives for loan growth, net interest margin, and credit performance, setting us up to finish the year on a very solid footing. At the same time, the strength and profitability of our business allow us to make ongoing investments that should further enhance our competitive position in each of our products and enable us to achieve continued strong results. Looking at the key drivers, total loans were up 6% and credit performance remained strong across all of our products, reflecting our discipline in underwriting new accounts and line management, as well as the clear benefits of our continued investments in servicing and collection capabilities. Card receivables grew 7% this quarter, reflecting a healthy mix of volume for both new and existing customers, and origination activity skewed more to higher yielding merchandise balances versus promotional balances. This demonstrates a positive degree of customer engagement while providing a favorable contribution to the overall net interest margin. Turning to our student loan business, growth remained strong this quarter and originations were in line with our expectations through the peak season. We're seeing an improvement in conversions driven by increasing awareness of the Discover brand in the student loan market and better customer experience at the front end. We're excited about our competitive position in private student lending and we remain confident in our ability to grow loans and gain market share despite competitive pressure. In personal loans, growth was in line with our expectations as we remain disciplined on originating loans that meet our return objectives. Credit performance continues to stabilize, reflecting the positive outcome from recent credit tightening and implementation of enhanced risk mitigation strategies. Overall, underlying credit trends continue to be favorable across our lending products with credit performance driven more by growth in receivables as compared to normalization of the back book. The U.S. consumer and the overall economy continue to look good with unemployment at a 50-year low and consumer sentiment at a high level as we enter the holiday season. This was also another quarter of strong growth in consumer deposits which passed the $50 billion mark and are now over half of our total funding. We've been able to maintain deposit pricing in the middle of the pack and have been pleased with our ability to continue to attract cost-effective funding in a falling rate environment. We recently introduced our no-fee commitment across our deposit products, and while still early, we believe this has resonated with customers and is contributing to our deposit growth. Pre-tax income for our payment services segment increased 16%, primarily driven by strong volume growth from our Pulse business. The Pulse team continues to expand business with existing issuers and win new relationships through creative debit solutions that deliver meaningful value for partners. Additionally, we continue to make progress against our strategy to enhance global acceptance by investing in partnerships with local acquirers and adding network-to-network partners. This quarter, we added two acquirer partners in France, Banque Postale and Arkea, as we continue to focus on acceptance in Western Europe. In addition, we're expanding acceptance in Africa with our partnership with Verve, a Nigeria-based payments network that will provide acceptance in a number of African countries for Discover and our net-to-net partners, such as RuPay and BC Card. To summarize the quarter, our performance once again demonstrates the strength of the Discover business model. Our commitment to providing an industry-leading experience to our customers and our disciplined approach to profitable growth and credit management continue to provide strong returns and long-term value to our shareholders. The economic environment remains favorable, and we do not see that changing in the near term. That said, it is likely that we are in the later stages of the economic cycle, and we are continuing to manage origination, servicing, and operational effectiveness with that very much in mind. Before I wrap up my section of our formal remarks, I want to acknowledge Mark Graff's retirement from Discover. Mark has been a valued colleague and leader since he joined the company in 2011 and will remain at Discover as an executive advisor until his retirement in early 2020. We wish Mark and his family the very best for the future. And now I want to take a moment to formally introduce our new CFO, John Green. John brings significant experience in financial services, including over eight years at HSBC, where he held the role of CFO of their largest business unit, Retail Banking and Wealth Management, And he also brings over 12 years of experience at GE. John held public company CFO roles at Willis Group Holdings, where he was instrumental in a turnaround of the company and subsequent merger with Towers Watson. And most recently, John was CFO at the Biogen spinoff, BioVeritiv. John is joining Discover at an important time and brings very relevant capabilities and experience. I'm very excited about the impact I expect John to have here at Discover, and I'm sure you'll enjoy working with him. I'll now ask John to discuss our financial results in more detail.

Thank you, Roger. Before I begin, I wanted to say that I'm very excited to be part of the Discover team. My first month confirmed my initial view that I was joining a great organization. I'm looking forward to an exciting future with Discover. as well as the opportunity to work with all of you. Now onto the business at hand. I'll begin by addressing our summary financial results on slide four. Looking at the key elements of the income statement, revenue growth of 6% this quarter was driven by loan growth of 6%, consistent with our expectation, and a very solid 8% growth in net interest income. The 8% increase in provision for loan losses was mainly driven by the seasoning of newer vintages and to a lesser extent by the continued supply-driven normalization in the consumer credit industry. Operating expenses were up 9% year-over-year due to higher compensation expense and investments in support of growth and new capabilities. The effective tax rate for the quarter was 22.5%, reflecting a $12 million benefit from the favorable resolution of a certain tax matters. Net income and EPS were up 7 and 15% respectively. Turning to slide five, loans increased 6% over the prior year, led by 7% growth in credit card receivables. Standard merchandise balances continued to be the primary driver of card receivable growth, while the contribution from promotional balances was minimal, reflecting our decision to reduce the level of growth from promotional activities over the past several quarters. Roughly 60% of the increase in loan balance was from new accounts and about 40 from existing. Turning to student loans, total loan balances were up 4% from the prior year. The organic piece of our student loan portfolio increased 9% year over year, reflecting our strong competitive position. Personal loan growth was in line with our expectations, increasing 1% from the prior year. reflecting the previously mentioned slowdown in originations as we work through the development and testing of new underwriting models. Moving to payments volume. To the right on slide 5, you can see that proprietary volume was up 6% year over year. In payment services, Pulse volume increased 5% over the prior year, driven by incremental volume from existing issuers, new issuers on the Pulse network, and growth in our pin list products such as Pulse Pay Express and Pulse eCommerce. Arriva Pay drove the 30% increase in network partners volume, while Diners Club volume was flat to the prior year. Moving to revenue on slide six. Net interest income of $2.4 billion was up 8% from the prior year, driven by three factors. First, higher loan balances. Second, a higher revolve rate this quarter. And third, somewhat lower promotional balances in this year's quarter. Total non-interest income was $498 million in the quarter, down $3 million or 1% from last year's quarter. The principal drivers of the decline were lower net discounts and interchange revenue, partially offset by higher loan fee income. Drilling down a bit, Net discounts and interchange revenue was $255 million in the quarter, down 9%, as revenue from higher sales volume was more than offset by higher rewards costs. This was primarily due to adding PayPal to the 5% rewards category. Sales volume was up 4% from the prior year, or 5% when normalizing for processing days. Offsetting the decrease in net discounts and interchange revenue was an increase of 17 million or 17% in loan fee income. The increase was principally due to an increase in late fee occurrences, as well as an adjustment in late fee pricing tiers. As shown on slide seven, our net interest margin was 10.43%, up 15 basis points year over year and down four basis points sequentially. Relative to the third quarter of last year, The increase in NIM was due to a favorable promotional balance mix and higher revolve rate. These were partially offset by higher brokered and direct-to-consumer deposit costs and by higher interest charge-offs. Compared to the second quarter, NIM decreased principally due to the roll-off of lower coupon brokered and direct-to-consumer deposits, along with the impact of prime rate decreases in July and September, partially offsetting this was a favorable funding mix, a higher revolve rate, and lower interest charge-offs. Total loan yield increased 31 basis points from a year ago to 12.76%, driven by increases in yields for all of our principal loan products. 29 basis points in card, 35 basis points in private student loans, and 51 basis points in personal loans. Card yield benefited from the impact of the 2018 prime rate increases, favorability in the revolve rate, and a lower level of promotional balances, which were partially offset by higher interest charge-offs and the impact of recent prime rate decreases. The year-over-year increase in student loan yield was primarily driven by higher short-term interest rates, as about 60% of the portfolio is floating rate. The increase in personal loan yield was also driven by the impact of prime rate increases in the prior year, as well as positive pricing actions. We expect to see a degree of yield compression from recent cuts in the Fed funds rate, which won't entirely be offset by lower funding costs. We have taken action by steadily reducing our asset sensitivity and consider our interest rate risk position to be essentially neutral at this point. Looking ahead, we expect to maintain this interest rate risk position for the foreseeable future. Our outlook anticipates one more 25 basis points rate reduction in 2019. On the liability side of the balance sheet, average consumer deposits grew 19% from last year and now make up 53% of total funding. Consumer deposit rates decreased four basis points from the prior quarter, and are 28 basis points above the prior year. Importantly, we've been able to achieve strong deposit growth while maintaining a disciplined pricing strategy. Since the Fed began raising rates in 2015, we realized a 51% cumulative deposit price beta for online savings. Of course, the Fed has recently cut its target rate by 50 basis points, and we've responded by lowering our deposit rates with a realized beta of 50% on our savings accounts over the last few months. We will continue to manage deposit costs prudently, taking into account competitors' behavior. Turning to slide 8, total operating expenses rose $92 million from the prior year. Employee compensation increased $31 million, driven by staff additions in technology and other areas to support business growth. as well as higher average salaries and benefits. Increased investments in new account acquisitions across our deposits, student lending, and card products drove marketing costs up 6% from the prior year. The 8% increase in information processing reflects our continued investment in infrastructure and analytic capabilities. Professional fees were $23 million higher with a little over half of that due to increased collection costs related to higher recoveries in the quarter. Now, I'll discuss our credit results on slide nine. Total net charge-offs were up eight basis points from the prior year. The increase continues to be primarily driven by the seasoning of loan growth and supply-driven credit normalization. Credit card net charge-offs were 18 basis points higher year over year, and down 17 basis points from the prior quarter. The credit card 30 plus delinquency rate was up 18 basis points year over year and up 16 basis points sequentially. Credit performance in the card business continues to be very solid, reflecting our disciplined approach to credit management in both new and existing accounts. Private student loan credit performance also remains strong. with net charge-offs down 37 basis points year over year and two basis points sequentially, aided by efficiency gains in collection, including enhanced communication and outreach to co-signers. Personal loan net charge-offs decreased 10 basis points from the prior year and 34 basis points sequentially. The significant improvement from the prior quarter reflects a degree of seasonality and originations in charge-offs, a 30-plus delinquency rate, was down eight basis points year over year and flat to the prior quarter as credit performance continues to stabilize. Looking at capital on slide 10, just a brief comment here. Common equity tier one ratio remains sequentially flat at 11.4%. Our capital payout ratio for the last 12 months, including buyback, was 79%. Now summarizing our results for the quarter on slide 11. We generated 6% total loan growth and a 26% return on equity. Our consumer deposit business saw a strong growth of 19% and now composes over half our total funding. With respect to credit, while our charge off rates have increased as loan growth seasons and credit conditions normalized, performance reflects positive trends across our lending products and remains consistent with our expectations and return targets. We continue to execute on our capital plan with loan growth and capital returns, helping to bring our capital ratios closer to targeted levels. Finally, we remain on track for a strong finish to 2019, achieving all aspects of our financial and operational guidance. In conclusion, this was a great quarter with solid execution by the team. Now, before I go to Q&A, I wanted to say again how excited I am to be part of the Discover team. I look forward to helping the business continue its history of strong execution as we grow this great franchise. With that, I'll turn the call back to the operator, Erica, to open the lines for Q&A.

At this time, if you would like to ask a question, please press star 1 on your touch-tone 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'll take our first question from Mark DeVries with Barclays.

Yeah, thank you. Roger, I was hoping you could comment on significance of today's announcement around click-to-pay and what you think it could mean for the business.

So in terms of the announcement on SRC, we are very excited as a member of EMV Co. to be part of that. I think it's really fundamentally going to be great for consumers. It reflects the industry moving forward to significantly enhance the online checkout experience. I think it will be a great step forward, so we're very excited to be part of it.

Okay. In terms of just what it can mean, though, in terms of volumes or defending market share, anything else you could share on that?

You know, I think it's probably too early to talk about share shifts. But, you know, to the extent that we're working with other networks on a seamless, integrated customer experience, we think that will help our cardholders and be good for our business.

Okay. Fair enough. Thank you.

We'll take our next question from Bessie Grasick with Morgan Stanley. Hi. Good afternoon.

Hey, Bessie. Hey.

Two questions related. Roger, just wanted to understand, you had a really strong quarter on the revenue side, and the expense ratio came in nicely as well, but it looks like there was a little bit of investment spend going on the quarter. How should we think about that? Is there a kind of expense ratio that you're looking to run between, or was this just a quarter where you had an opportunity to invest a little bit more and so you upped the the investment spend this quarter, or should we expect this level of investment spend to continue from here?

You know, we don't necessarily target an efficiency ratio. To the point you're making, our investment spend is we see opportunities to drive loan growth consistent with our, you know, conservative approach to credit. We will do so, and we think more in terms of overall returns. You know, our efficiency ratio is one of the best within financial services. But in terms of overall expense levels, those can vary based on the marketing investment.

And then as we think about the NII and the NIM, I think, John, you were mentioning that you are largely neutral and you've got one more recut baked into your outlook. But we should expect NIM comes down a little bit. So I'm just trying to square that and maybe get a little bit more understanding as to what you're expecting over the next couple of quarters from a NIM perspective?

Certainly, happy to take that. So we ended the third quarter year-to-day results with a NIM rate at 10.45%. And then as we look at the fourth quarter, there's really three things that are going to impact it. So certainly the rate cuts that occurred throughout 2019 will be fully baked in. And then we'll have our funding rate, which actually ticked up mildly. And then, of course, in the fourth quarter, there's transactor and revolver mix shifts that ultimately will impact the rate. So, I know the company gave some guidance at 10.3, and then it was subsequently revised upward by five to nine basis points. You know, I would expect, based on what we're seeing here, looking at the fourth quarter, to come in probably at the higher end of that and probably one or two basis points higher than 10.39, so probably 10.4-ish. Got it.

Okay, thank you.

We'll take our next question from Don Vendetti with Wells Fargo.

Yes, Roger. So, you know, it looks like the card business is hitting on a lot of cylinders. You know, credit's pretty stable, competition's stable, demand is decent from the consumer. I guess I wanted to just get your thoughts on whether or not, you know, you see any risk to that in the near term. Obviously, we're all focusing on the macro. But, you know, for example, is your sense that the delinquency rate year-over-year is going to continue to be in this sort of zip code? and if you're seeing any type of movement within segments of higher end to mid-prime.

Yeah, so we spend a lot of time looking for turns in the economy, looking at our portfolio, kind of every way we can cut it, whether it's geographically. We look at the different vintage buckets, et cetera. And as I said on the call, the U.S. consumer is holding up well. I think part of it is reflected in terms of the 50-year low in unemployment. But we remain disciplined and conservative in credit because it feels late cycle and certainly is by any historic measure. But in terms of what you see in consumer behavior and the numbers we've reported, the consumer is holding up very well.

And then I guess if you look around at the other networks, there's a lot of talk about B2B. We're seeing a lot of bolt-on acquisitions for the payment companies. Where are you in terms of your thought process on B2B? I know you have a small business card that's pretty modest. And then do you think you need to make any type of bolt-on acquisitions at this point, or are you in good shape?

So in terms of B2B, we're always looking at opportunities, but I think we tend to think about it in terms of a mix of acquisitions, but also partnerships. So we see a lot of B2B volume coming through our partnership with SAP and Ariba. We announced a new B2B space partnership this quarter. So it's an area we're focused on. Margins tend to be a little thinner on the B2B side compared to B2C payments, but it's an area that we focused on for quite a while in the payments part of our business. Thank you.

We'll take our next question from Sanjay Sekharani with KBW.

Thanks. I guess I got a question on the private student loan credit quality and, you know, the nice improvement in the reserve rate there. Obviously, we've seen some pretty significant improvement in the charge-off rate, and the associated coverage with the reserve came down quite a bit. Is it just a reflection of the delinquency rate trajectory, and you expect that to continue? And sort of what's driving that improvement? Yeah.

Sanjay, this is John. I'll take that. So, you know, we're really pleased with the performance there. And, you know, first of all, the book is really solid. About 90% of the portfolio has co-signers. And in the first quarter of this year, the collection team began an outreach to to co-signers when there was an early stage delinquency. And that's actually made a pretty substantial difference in collection effectiveness and overall delinquency levels.

Okay. I guess question for Roger, sort of similar to what Don was asking. I guess, you know, the ROEs have been really, really strong. I'm wondering if you're surprised at how strong they are, given where we are in the cycle. It seems like with such high returns, you'd have more competition, but there hasn't been a whole lot. So I'm just curious how to reconcile. Is it something you guys are doing differently that's generating these returns, or is it just that the competitive intensity is weaker because we're this late into a cycle?

Yeah, I probably would challenge the view that there isn't much competition in the card space. If you look at the players who are in it and the investments they make, I think part of it is it is a very challenging business. So you tend not to see too many new entrants, but it is very competitive. And I think there's a difference between the marginal return that competitors look to as they think about how to grow their book and the total return. But I think You know, the credit card business has been one of the highest returning consumer asset classes for my, you know, 25 years in the business. And I think it reflects just sort of some of the challenges in operating it well. And we have a very disciplined model here at Discover.

Okay. I wanted to welcome and congratulate John on his new position. And just one quick clarification, the NIM guidance that you provided, was that a fourth quarter guide or was that for the full year?

That was fourth quarter. So when we come out with year-end results in January, we'll provide updated guidance for 2020. All right.

Thank you.

We'll take our next question from Eric Wasserstrom with EBS. Great.

Thanks very much. Just to circle back on the credit discussion for a moment, certainly the The NCO trends seem very contained, and the delinquency trends also seem to be very contained in terms of the rate of change. On the other hand, the late fees are creeping up. That's often a harbinger of future credit deterioration. You guys have talked a little bit about what you're doing on mods. So I'm just trying to put the whole picture together. Is the characterization that it's stable but with a slow slope towards deterioration, or how should I think about it?

Yeah, I think I would probably highlight more of the stable side. You know, part of what's driving up late fees is just overall growth in the portfolio, and certainly that's going to drive more delinquent accounts. But as you look at the overall delinquency rate and the trajectory those have been on, I think those reflect, you know, strong performance in a continued stable economic environment.

Thank you for that. And if I may just follow up just quickly on NIM as well, without pushing you to provide point guidance, which is not my intent. But I think in the past, what you've indicated is every incremental 25 basis point reduction is one to two points of annualized NIM reduction. And so as we just think through whether it's our own economist or the blue chip consensus in terms of the 2020 expectation, is that still a good framework to to consider on the basis of the fourth quarter endpoint?

Eric, it is. One to two basis points for every 25 basis points downward.

All right. Thanks very much.

You're welcome. We'll take our next question from Ryan Nash with Goldman Sachs.

Hey, good afternoon, guys. And John, congrats on joining Discover.

Oh, thank you.

Roger, maybe I'll start with a similar question that some of the others have asked. So you've been tightening credit for two years yet. You're still growing above the market. So, one, do you think this can continue? And, two, what do you think that you're doing different from the market now that's allowing you to continue to take share?

A, I feel good about the credit decisions we've made. And they're a mix of what we do for new accounts, but also for the portfolio. A lot of it has to do with differentiation. And so we focus a lot on innovation. So if you think about going back to the FICO score on statements, the ability to freeze your card, cash back match continues to perform well for us. And then also focusing on a superior customer experience. We've won the J.D. Power Award for five of the last six years. We have the best mobile app in the business. So really that relentless focus on every part of the customer experience and then wrapping that with the Discover brand, which obviously having our own proprietary network helps us in terms of building that brand. and providing differentiation. So I think the whole business model is focused on driving high-quality loan growth.

Got it. Maybe one for John. Last quarter and the quarter before, the company had outlined the upfront impact regarding CECL. I was just wondering if you could maybe talk a little bit about the day-two impact, how to think about the impact for a company that's experiencing nice growth yet still seeing supply-driven normalization and a very uncertain macro backdrop. Thanks.

Yeah, thank you. Good question. So, let me start by saying that, you know, we're looking at CECL and the impact pretty extensively. We have now three-quarters of simulations. We expect the overall reserve rate to be somewhere between 55 and 65, and the two most recent quarters, it's trending to the north end of that. We'll continue to monitor that, and it will be impacted by the composition of the portfolio, and certainly macro factors. So none of that is probably new to the folks on the call. In terms of the volatility, it does drive a level of volatility, and we are, you know, frankly, I'm holding off on giving a quantification on the volatility until we bat down the estimates and clearly have a a view of what the portfolio will look like, and also the macroeconomics. So it will be more volatile, and we'll provide disclosures that provide a clear view on an apples-to-apples basis, so non-GAAP disclosures that will align to 2019 GAAP so that there's comparability.

Got it. Thank you for taking my questions. You're welcome.

We'll take our next question from David Sharf with JMP Securities.

Thanks for taking my questions and welcome aboard, John. Maybe a couple more questions on the credit side, maybe more hypothetical. Listen, we're obviously closing in on four years of everybody wondering whether we're in the eighth or ninth inning of this cycle, and the data has suggested otherwise. But, you know, I'm wondering, two things, you know, just hypothetically, whether this occurred in one quarter or six quarters from now, if you had any indicators, whether internally based on delinquency trends or even macro indicators, you know, suggesting we're heading towards, let's say, a five and a half to six percent unemployment environment, which You know, it's consistent with two recessions ago. I'm kind of going to ignore the Great Recession. Trying to get a sense, and I realize there are so many variables and inputs, but generally speaking, from a strategic standpoint, should we be thinking about Discover as a business that is still targeting some level of loan growth in the midst of that kind of environment, sort of flat or year-over-year decline? I realize it's very hypothetical. Just trying to get a sense for how to think about, you know, at this stage of maturity, how the business operates in that type of macro backdrop.

Yeah, I can't really sort of comment on exactly how much we'd grow at what unemployment level. I would say, though, that as we look at the new accounts we book and the models that John and the finance team do, We use the through-the-cycle loss rate as opposed to where we are at any given point in time. And we've spent a lot of time analyzing accounts that we've booked through the last downturn. The vast majority of our new accounts we would have booked in, you know, December of 2007. So even going into that time, even if we had known what was coming, the vast majority of accounts we would have booked. There are certain segments that are sort of more on the near prime side that are more volatile, and so those tend to be where you cut back. You cut back on the number of line increases you do, and there are other actions on the portfolio. But again, most – again, the vast majority of those new accounts, we use the through-the-cycle loss rate and book in a much more challenging credit environment than what we have now.

Got it. Now, that's helpful, and maybe just a follow-up along those lines. Once again, this is hypothetical, but maybe it's something you can quantify for us. If the loan book in aggregate starting today, I mean the back book today, were to be flat over the next 12 months, is there any sense you could give us in basis points of how much upward activity pressure on loss rates just the pure seasoning would exert if we no longer had any contributing denominator effect?

That's something we really couldn't put together. I mean, we don't run any scenarios of our loan book flat because we're going to keep trying to grow it, but, you know, I really can't answer that. Got it. Fair enough. Thanks very much.

We'll take our next question from Rick Shane with J.P. Morgan.

Hey, guys, thanks for taking my question. Look, the uptake on the rewards program with PayPal was very strong during the quarter. I'm curious if you could help us understand tactically what the intent of that program is. Is it a demographic drive for millennials or is there something else we should be thinking about?

Sure. So, you know, a lot of our programs do, in fact, target millennials. PayPal is a great business partner, both on our issuing side, but as well as on the payment side. And with some merchants like PayPal, you do get a bit of a lock-in because once people change their default card, there tends to be a tail of sales. So we're always looking for how to use our rewards dollars to cost effectively drive growth. and provide value for our customers. I think it's one of the advantages we have from the structure of our rewards program. And so that was an investment we made, and we're excited about what we're seeing in terms of cardholder pickup of that.

Got it. That makes a lot of sense. Thank you for answering the question.

We'll take our next question from Bill Karkacci with Numera Instanet.

Thank you. Good afternoon. I had a couple of follow-up questions. First, a follow-up on Rick's PayPal 5% category question. Can you give any kind of early indication of the stickiness of those customers post-promo, just trying to get a sense for the willingness of those customers to keep Discover as their primary card after the promotion ends versus how much gaming behavior you're seeing?

You know, I won't comment specifically. I would say we've had a lot of experience running our 5% promo and know kind of by each different category what type of tail we spend, and that goes into the targeting. So I'll go back to saying we're very excited about how it's performed, and we think we're getting good value for our investment.

Okay. Thanks, Roger. And then as another follow-up on Ryan's question about the day two impact of CECL, at a high level, Is it reasonable to expect that the building of reserves on future growth under CECL would also increase by the 55 to 65% that you guys have guided to versus what it would have been under the incurred loss model?

Yeah, so great question. So, no, to be specific on that. So, The portfolio, when we're putting up the 55 to 65 increase for day one, reflects a maturity of the portfolio that already has some incurred losses reflected in it. So when you put up new loan accounts, what happens is you have to book the lifetime losses, and therefore the impact is actually greater than the day one impact of 55 to 65 that we've talked about.

Okay, so it's like as a starting point, 55% to 65% day one impact, the day two impact on the incremental building would actually be larger than that?

It would for new loan account, and then obviously the macro factors would come into play there. The type of assets we're putting on the book, so are they credit card or personal loans, will impact. There's a lot of factors, and as I said, I'm going to hold off on giving a specific number until we get it sorted out. We've got more work to do as an organization, but we're progressing well on it, and in the first quarter, we'll share that.

Got it. Thanks, John. Welcome to the team, and I look forward to working with you.

Thank you much.

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

Thank you. And I'll also welcome you, John. Look forward to working with you as well. The first question is just on the direct deposits. The growth of direct deposits has been so strong, and it is by far your lowest cost of funds. And if you could have any thoughts around what percentage of your funding over the long term could be be through direct deposits because it's a nice tailwind, obviously, to your business, to your margins.

Yeah, so it is. So, you know, what we do is we concentrate on the overall funding stack. And obviously, it's really important to make sure we have the right level of liquidity and other funding sources in place. But with that said, as we mentioned on the prepared comments, you know, 53% of the funding stack was from deposits. You know, we'd like to grow that. I think the previous guidance the business has given was in the medium term, somewhere around 60. And, you know, we'll look at that as a path forward, and we may adjust upward if conditions warrant.

Thank you. And follow-up call on Roger, on the competitive front, I mean, you do have, one, you have an Apple card and just your thoughts around that. And then we've had some mega mergers in the payment space, and they're looking for revenue synergies. And one area that one company feels like is low-hanging fruit would be related to the Pulse business. And so I just wondered if you could comment on the Apple and then, you know, the mega mergers and the ability to be able to continue to grow your payments business.

Yeah. In terms of the Apple card, we've yet to see that have a noticeable impact on our volume. So we're watching it carefully. But, again, no noticeable impact. In terms of the mega mergers on the payment side, you know, A, we compete against Visa and MasterCard, so we're used to competing against very large companies in payments. You know, a lot of it is it's sort of a broader ecosystem where there are, in fact, partnership opportunities with some of those companies as well. So I'd probably say it's too early to understand the full impact on Pulse, but, you know, our goal is to be able to compete globally against anyone in the payments industry.

Great. Thank you. Appreciate it.

We'll take our next question from Chris Donat with Sandler.

Good afternoon. Thanks for taking my questions. I had one on the professional fees and the increase in them. Does that represent some sort of change in how you're doing collections? Like, are you using, rather than first-party or in-house collections, are you using more third-party collections, or is it just something else going on there?

Chris, thanks for the question. No, what actually you see there is a pretty substantial increase in overall recovery. So, recovery is third quarter 19 versus third quarter 18 are up about 32%. So that drives obviously a bit of the I'll call it commission for the third party collectors.

Okay, got it. And then just one more on on Cecil as you talk about the the volatility as you get more experience with the sort of the parallel run of Cecil. Does that affect how you might be thinking about capital in 2020 and beyond of maybe needing to have a little more pressure in recognizing that there's a phase-in from a regulatory perspective for CECL, or is that too soon to tell?

Yeah, so, you know, there will be a capital impact, right? The phase-in is 25% over a four-year period. You know, it doesn't change the underlying cash flows of the business. So we're going to continue to try to optimize the capital base. And, you know, we're progressing, excluding CECL, towards a target level of 10.5%. So we'll present a capital plan to the board and to the regulators and see what that looks like in 2020. Okay. Thanks very much.

We'll take our next question from John Hetch with Jefferies.

Thanks very much. Welcome, John. Most of my questions were asked. I was maybe going to dive a little bit into the consumer behavior. So for new customers that you're attracting at this point, are they reacting more to zero balance transfers, or what other promotional factors are having heavy reactions at this point?

You know, we always try and bring in cardholders that are not just balanced transfer active, but use their card as well. And so the cashback match continues to perform very well for us. But, you know, that probably is the other thing that's impacting new customers. But, again, we focus on customer experience. We focus on line assignment. You know, every component is important. But I'd probably highlight that cashback match is sort of the biggest thing we have for new car holders.

Okay. And you mentioned the lines. Any changes to utilization rates, or have those behaviors been pretty consistent as well?

You know, we haven't – I'll go back. We have not picked up signs of distress in our portfolio as we look.

So utilization rates just stable as expected? Yeah. Okay. Thanks very much.

We'll take our next question from Ming Zhao with Deutsche Bank.

Hi. Good afternoon, guys. A quick question on, I guess, long growth. Just from simple back-of-the-envelope math, I mean, long growth and need to, I guess, accelerate a bit in 4Q to reach that low end of that 6 to 8 prior guidance range. I'm wondering if if you guys could provide any color on it and do you still expect that to be true or and where are you seeing, you know, the most strength there? Thanks.

You know, I won't comment on the guidance. I would say if you look at the quarter, we feel very good about our card loan growth. We feel good about how student loans perform in the peak season. And we had talked about really a lower growth rate for personal loans in terms of expectations for this year. As we tested our new credit models for some segments that had not performed as well as we wanted, we're excited about how those are doing as well. So, again, we feel good about our ability to achieve loan growth. It will, of course, depend on the holiday season. But so far, consumers seem to be in a pretty good space.

Gotcha, great. And my second question is just on overall international acceptance. I think, you know, mid-quarter you mentioned that international acceptance was somewhere in the seventh inning, and I know in your prepared remarks you mentioned focusing more on Africa as well as Western Europe. I'd like to get any sort of updated thoughts you had there in terms of innings and how you see Discover progressing internationally going forward.

You know, the seventh inning is quite long. We may go to extra innings. So maybe that's not the best way to phrase it. It will be a continued investment. And I think Africa just gives you an example of the breadth of our investments. We're also working with network partners everywhere from Eastern Europe to Asia to South America. A particular focus has been on Western Europe and working with acquirers there. So you've HIRT has announced a number of partnerships. So we will continue to build out our global acceptance footprint.

Great. Thanks for taking my questions.

We'll take our next question from Brian Foran with Autonomous.

Hi. Good evening. Hello, Brian. Good evening, Brian. Maybe just on the deposit betas, the 50% so far was interesting, and I think most of the traditional banks are struggling to get 15%, 20% betas so far. Is your feeling that that's a timing issue, i.e., it's easier for you and peers to lower the online deposit rates and reprice most of the existing book quickly, or are you more encouraged that maybe the betas could just be higher on online deposits throughout a Fed easing cycle?

Yeah, I mean, I think if you compare to a lot of the more traditional branch-based banks, they tend to have a lower data. A lot of it has to do with their product mix, and so having more in checking or in savings accounts and are paying sometimes in the single-digit basis points. They pay through operating expenses as opposed to the rate. So I think there's a natural symmetry between the betas you experience on the way up and what you have on the way down. And so a lot of those banks captured the rate increases on the way up and didn't move their rates much at all. But that unfortunately doesn't give you much room to adjust when rates are coming back down. Got it.

And then two small things on the one on the loan fees when you referenced the changes that drove it to 120 versus kind of around 105 before. Does it all else equals stay around 120, or does it go back to 105 as we, you know, think about putting something in the model going forward?

So that's a function of the late payments and also the pricing tiers that we put in place. So I would expect a little – certainly a tick-up based on, you know, history – But, you know, some of it will be tied, obviously, to late payments, and that's, you know, you'll be able to see the trends there.

And then I hate to ask for a clarification of the clarification of the NIM guidance, but I managed to get myself tripped up. When you were kind of saying a basis point or two above the old 1039 high end, that was for the full year, we should think about 1040?

Yes. Yeah, thanks for that clarification question. Yes, it would be for the full year.

Okay, so 4Q, 10.3% plus or minus is kind of the implied output of that.

Yeah, you'll solve the math.

I wouldn't put a lot of trust in that, so I figured I'd ask. I appreciate it. Thank you. You're welcome.

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

Hi, this is Mihir on for Jason. Thanks for taking my questions. And firstly, congratulations, John, on joining the team. The first question, I think if I could go back where we started, I guess, back to the quick to pay or the unified payment button. And I was just curious, will you be putting any promotional efforts around getting your cardholders to enroll their Discover cards or make them default on that button?

Yeah. You know, I think we're in the early stages of implementation. You know, clearly we try and make sure that our cardholders are using Discover, and I think this is where there may be an advantage for us in terms of our integrated network and card issuer model. We can enable it probably more seamlessly than, you know, someone who uses a third-party issuer. You know, as an example, we were the first ones to be able to provision Apple Pay from within our app. So we'll look for opportunities where we can make the experience more seamless for Discover cardholders.

Got it. Thanks, Vlad. And then just around – I just had a question around credit and just your net charge-off guidance. I think you've mentioned 3.2% to 3.4% for the year, and I was just, you know, just doing – the rough math here, looking at how you performed year to date, is there a potential for it to come in a little better than that? Or are you sticking with, or at least, you know, the very low end of that just because, I mean, it sounds like you're pretty favorable on credit and, you know, looking at year to day performance and Q3 performance, that need to be pretty meaningful quarter over quarter degradation to get to the higher end of that. Certainly.

Yes, so thanks for that. So, yeah, the guidance was 3.2 to 3.4, and we're certainly performing at the lower end of that. At this point, I'll probably just pause there and say that lower end of the guidance, and if you choose to put something else in your model, be comfortable with it.

Thank you.

We'll take our final question from John Arpstrom with RBC Capital Markets.

Thanks. Good afternoon. Good afternoon. Hey, just a quick one on deposit growth. Curious if you had to put your finger on what's driving it. Would you say that new deposit account growth is tracking with overall deposit account growth, or are you seeing something like higher average balances on existing accounts, or is it both, if that makes sense?

Yeah, no, it's both. So we're attracting new customers, but we're also seeing some of our existing customers build their balances, whether it's adding another CD or just putting more money into the savings accounts. So it's a mix of both from new as well as existing customers.

Okay. All right. Thank you.

And there are no further questions at this time. Mr. Stream, your closing comments, please.

Thanks, Erica. And thank you all for your attention, for your questions. And you know where to find us for any follow-up. Thanks. Have a good evening.

Thank you for your participation. This does conclude today's conference call. You may now disconnect.