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 fourth 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 would now like to turn the call over to Mr. Craig Stream, head of investor relations. Please go ahead.

Thank you, Erica. Welcome, everybody, to our call this afternoon. We will begin, as usual, on slide two of the earnings presentation, which you can find in the financial 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 the presentation. Our call today will include formal remarks from our CEO, Roger Hochschild, covering 2019 full year and fourth quarter highlights. And then John Green, our chief financial officer, will take you through the rest of the earnings presentation. And when John completes his comments, there will be plenty of time for a Q&A session. And please limit yourself, if you don't mind, to one question and one follow-up so we can make sure that we 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. I'll begin by reviewing the highlights and key performance metrics for the full year, then turn the call over to John to review fourth quarter results as well as our guidance elements for 2020. 2019 was another very good year for Discover, with net income of $3 billion after tax, or $9.08 per share, and a healthy return on equity of 26%. These results reflect our business model that brings together the positive attributes of high-return consumer lending and direct banking with the benefits and long-term potential of owning our own global network. Our robust returns allowed us flexibility to return excess capital to our shareholders and while continuing to make important investments in the Discover brand, advanced technology, and expanding our acceptance globally. These investments have further strengthened our competitive position in 2019 and set us up for continued strong returns in 2020 and beyond. Looking at some of the specifics, total loans grew 6% in line with our expectations, and credit performance was also on target. as we've benefited from the continued strength of the U.S. consumer and ongoing advances in our risk management and servicing capabilities. We achieved a robust net interest margin of 10.41%, and operating expenses remain in our targeted range. Economists are forecasting continued growth in the economic environment in 2020. However, given the unprecedented duration of the economic expansion, we will manage credit with that in mind. We continue to invest in our global payments business in 2019, focusing on expanding acceptance by adding network partners and relationships with acquirers in key markets like the UK, New Zealand, France, and Spain. Our payment services segment generated a 24% increase in pre-tax income, primarily driven by strong volume gains from our Pulse business, The team at Pulse had a great year, adding volume from acquirers and both existing and new issuers. Turning to slide four, we had solid loan growth in all our products, with total loans and card loans both up 6%. In our card business, the majority of this growth was in higher-yielding merchandise balances as opposed to promotional activity, reflecting strong card member engagement. We continue to introduce features and service enhancements that are relevant to customers and prospects, including, for example, leveraging merchant partnerships to provide even greater value to our card members. We also had a good year in our student lending business, with organic receivables up 9%. Loan growth is benefiting from increased awareness of the Discover brand, enhancements to acquisition models, and improvements in the conversion process. we continue to benefit from our strong position as the second largest provider of private student loans. Our personal loan portfolio grew 3% in 2019, a touch above our expectation. Our investments in analytics and modeling have had a significant impact on our personal loan credit performance, enabling us to increase originations while maintaining an acceptable level of credit risk. Turning to slide five, Credit performed very well in 2019 and was in line with our expectations. The seasoning of loans from recent vintages was the primary driver as the impact of normalization in the consumer credit industry continues to abate. As I said earlier, we feel good about the underlying economic and credit trends as we enter 2020, and we'll have more to say about the overall credit environment when we discuss fourth quarter performance and 2020 guidance later in the call. Before I turn the call over to John, I want to wrap up by saying how excited I am about our prospects for continuing to create value for Discover's customers, team members, and shareholders. We finished 2019 on very solid footing, generating outstanding returns by combining solid loan growth and effective credit risk management. I'll now ask John to discuss our financial results in more detail.

Thank you, Roger, and good afternoon, everyone. I'll begin by addressing our summary financial results on slide six. Looking at key elements of the income statement, revenue, net of interest expense increased 5% this quarter, driven primarily by a 6% increase in average loans. Provisions for loan losses increased 5%, mainly driven by loan growth and to a lesser extent by ongoing supply-driven normalization in the consumer credit industry. Operating expenses were up 7% due to higher compensation expense and continued investments to support growth in collections, digital platforms, and advanced analytics. Moving to slide 7. Roger already covered the key loan metrics, but I wanted to emphasize that the majority of the growth in card receivables came from standardized merchandise balances with a smaller contribution from promotional balances. we expect merchandise balances will continue to be a primary driver of card growth in 2020. Just under 70% of the increase in receivables was from new accounts, with the remainder from existing cardholders. Looking at student loans, total receivables were up 3% from the prior year, with the organic student loan portfolio increasing 9% year over year. Turning to slide eight, Volume on the Discover network rose 5% from the prior year, in line with growth in the Discover card spending. Within our payment services segment, Pulse volume increased 6% over the prior year, driven by strong performance in key products. Moving to slide 9. Net interest income of $2.4 billion increased $122 million, or 5% from the prior year. The increase was driven by higher loan balances, a higher revolve rate, lower promotional balances, and a favorable funding mix as we continued to grow lower cost direct-to-consumer deposits. This was partially offset by the impact of a lower average prime rate in the quarter, an unfavorable funding rate reflecting maturities of lower coupon-brokered and direct-to-consumer deposits, and higher interest charge-offs. Total non-interest income was $520 million for the quarter, up 15 million or 3% year-over-year. The primary drivers of the increase were higher loan fees and an increase in transaction processing revenue. Net discounts and interchange revenue was up 281 million or 1%. Turning to slide 10, our net interest margin was 10.29% for the fourth quarter, consistent with our expectations. This was down six basis points year-over-year, and 14 basis points sequentially. Relative to the prior year order, the decrease in NIM was due principally to three factors. First, the unfavorable funding rate I just mentioned. Second, the impact of a lower prime rate. And third, higher interest charge-offs. These were partially offset by a higher revolve rate, BTC, and a favorable promotional balance mix. Relative to the third quarter, NIMS decreased 14 basis points due to the impact of lower prime rate and an unfavorable funding rate, partially offset by a higher revolve rate and VT fees. Total loan yield decreased seven basis points from a year ago to 12.52%, primarily driven by a 12 basis point decrease in card yield reflecting prime rate decreases and higher interest charge-offs. This was partially offset by a higher revolve rate BT fees, and lower promotional balances. On the liability side of the balance sheet, average consumer deposits grew $3 billion in the quarter and now make up 55% of total funding. Consumer deposit rates decreased 13 basis points from the third quarter as we actively managed our funding costs lower. Although market observers expect a stable Fed funds rate this year, we'll remain vigilant for opportunities to prudently manage our deposit and other funding costs. Turning to slide 11, operating expenses increased $74 million, or 7%, from the prior year. Employee compensation was $33 million higher, reflecting staff increases in technology, as well as higher average salaries and benefit costs. Professional fees were $24 million higher, mainly driven by third-party recovery fees. Cost to support investments in analytics also contributed to higher professional fees. The $20 million increase in information processing was driven by our continued investment in advanced analytics and infrastructure costs. Turning to credit on slide 12. The takeaway here is that overall credit performance remains stable and well within our risk and return expectations. Total net charge-offs increased 11 basis points from the prior year with the primary driver continuing to be the seasoning of loan growth and, to a lesser extent, the supply-driven normalization in consumer credit. Credit card net charge-offs increased 18 basis points from the prior year and 9 basis points from the prior quarter. The credit card 30-plus delinquency rate was 19 basis points higher year over year and 12 basis points sequentially. This was another solid credit performance in our card business, reflecting our disciplined underwriting and line management. We saw a modest uptick in student loan charge-offs as the portfolio seasons. Student loan credit performance continues to be aided by efficiency gains in collections, including expanded outreach to co-signers. In personal loans, charge-offs rose in the quarter consistent with typical seasonal patterns. The 30-plus delinquency rate was down 23 basis points from the prior year and 12 basis points compared to the third quarter. We continue to see credit improve as a result of our prior credit tightening and improved fraud detection. Before leaving the subject of credit, I wanted to preview an additional disclosure on trouble debt restructuring you'll see in our 10-K. To provide greater clarity on the growth in our TDR receivables, we will now report the balance of receivables that have successfully completed programs. At December 31st, we had total credit card TDRs of $3.4 billion, up $1.1 billion from the prior year. But in fact, over half of the $1.1 billion increase was from customers who had successfully completed a program. In account number terms, this equates to about an 80% success rate. This demonstrates that our modification programs are an important aspect of helping customers through temporary hardship and also benefit Discover by reducing overall credit costs and enhancing revenue. Let's turn now to slide 13. Our common equity Tier 1 ratio decreased 20 basis points sequentially, reflecting loan growth and capital returns, partially offset by strong earnings. Our payout ratio, which includes buybacks, was 77% over the last 12 months. And as we noted earlier, average consumer deposits now make up 55% of total funding. Slide 14 provides a summary of 2019 business performance compared to our guidance for the year and against 2018 performance. You will see green check marks against each of the metrics, And I want to congratulate the team for its solid execution against all of our key financial objectives for 2019. The following slide provides a summary of our outlook and guidance for 2020. First, we share the consensus view that the macroeconomic environment will remain stable. We do not see any indicators that point to a recession in the next 12 months. We expect the U.S. consumer to remain healthy. and unemployment remaining near the current levels. We also note that household debt service levels are at a 40-year low, an indication that consumers remain financially resilient. Based on these factors, we've assumed no Fed rate changes in our 2020 business plan. This backdrop sets us up for another year of profitable growth and strong returns. Now turning to the specific guidance elements. First, we expect loan growth to be in the range of 5 to 7%. Next, we expect operating expenses to be in the range of 4.7 to 4.9 billion as we continue to invest for future growth with incremental spending on our brand to increase awareness and consideration. We expect net charge-offs to be in the range of 3.3 to 3.5% this year, reflecting a stable credit environment and the seasoning of our growing portfolio. Our target CET1 ratio continues to be 10.5%, which remains an achievable target under CECL due to the phase-in for regulatory capital purposes and our capital generative business model. I'm sure you've noted our list of guidance elements for 2020 is a bit shorter. In fact, we've taken a fresh look and decided to no longer provide specific guidance on rewards rate or NIM. The rewards rate can vary quarter to quarter depending on the 5% category. The annual rate has been increasing by around two to three basis points due to the ongoing shift from the more card to the it card, and we expect this trend to continue. In terms of NIMS, The single largest driver of changes in net interest margin has been Fed Actions. Given this, we've elected not to provide specific guidance, but we'll comment on the other drivers, such as deposit data and spending patterns, as part of our quarterly earnings calls. So with that, I'll move on to the topic of CECL. On the last earnings call, I indicated the day one adjustment would be towards the north end of the 55 to 65% range we had guided to. We now expect our adjustment to be approximately 2.5 billion or 75% above the year end incurred basis. In terms of the day two impact, the reserve change will depend upon the mix of the business, economic outlook, overall credit performance at the point in time in which quarterly estimates are determined. Additionally, the seasonality of our business will impact quarterly reserve changes and could introduce some volatility from one quarter to the next. As you've seen, our business model is capable of generating high returns, which should enable us to largely offset the capital implications of CECL over time. Wrapping up on slide 16. In 2019, we generated 6% total loan growth and delivered a robust 26% return on equity. We had a very strong year in our consumer deposits business with growth of 22%. Credit remained in line with our expectation and return targets, and we executed on our capital plan by allocating capital to loan growth and share buybacks. In conclusion, 2019 was a strong year. and we're very pleased with our performance and positioning for 2020. That concludes our formal remarks, so I'll turn the call back to our operator, Erica, to open up the line for Q&A.

At this time, I would like to remind everyone, press star 1 on your touchtone phone if you wish to ask a question at this time. If you wish to remove yourself from the queue, you may do so by pressing the pound key. We remind you... Please pick up your handset for optimal sound quality. We'll take our first question from Ryan Nash with Goldman Sachs.

Hey, good evening, guys.

Hey, Ryan. Good evening.

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

Okay. Thank you, Ryan. Thanks for the question. So let me start with day one impact. So I think, as I said on the last call, that my take was that Dean did a fantastic job in terms of modeling and preparing for CECL implementation, and that view still holds very, very strongly. The initial guidance, 55% to 65%, included a number of factors. And as we came through the fourth quarter, we took a look at – the modeling, the performance of the portfolio, and specifically recovery assumptions. And we ended up revising a recovery assumption that had to do with overall recoveries, taking a look at most recent history, which was certainly stellar performance, and we moved it back to the middle point of the observable history on recovery. So, So that was the primary driver of the change in day one. In terms of day two, I said on my first call, third quarter, that day two would be higher. And certainly in the third quarter, it was higher as we modeled. And that increase had to do with the – with the amount of volume we put on the books related to our student loan products, which in terms of day two impact has a significantly higher impact than day one would under an incurred basis. Now, that actually points to some of the volatility that we're seeing in CECL. So as we take a look at all our product and the relative mix throughout the year, I would say a good proxy for day two would be that range around 75%. So it's a slight nuance on the initial message that I provided. But I would also caution that that's a preliminary number. And we're working through it. And there's a bunch of dynamics that impact CECL, including the macroeconomic outlook, portfolio performance, mix of products that we're putting on the book in any one quarter, and obviously the delinquency and rural rates that we're observing. So a lot to consider there, but I hope I've provided enough specificity to be helpful as you think about how to model this business.

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

Okay. Hey, Ryan, I'll start, and then Roger, I'm sure, will have a follow-up. So I'm going to start with my editorializing a little bit here. So if you look at the efficiency ratio that this company has generated over time, it's among the lowest in the industry. And then if you also look at the returns in terms of return on equity, we are among the highest in the industry. And, you know, one could use those two data points and make a simple argument that perhaps we've underinvested over time, given the returns that we're generating. So as we put the plan together for 2020, we looked at where it was appropriate to invest, where we thought we'd generate the best long-term returns for our shareholders. And there was two items specifically. So investments in brand around awareness and consideration. And, you know, that's a meaningful number, you know, around $100 million, believe it or not. And and then also continued investment in our infrastructure to add functionality and ensure it's appropriate from a scale and resiliency standpoint going forward.

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

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

Thanks. Appreciate the call.

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

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

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

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

No, I think you're definitely in the right direction. So there's a couple things that I just want to point out. So as I said in my prepared remarks, we assume no Fed rate changes in our planning assumptions. So if that changes, that certainly, as it has done historically and been a problem from a forecasting standpoint, that would impact NIM. We're also, I alluded to this in the prepared remarks, in terms of our focus around deposits and increasing the level of overall funding from direct-to-consumer deposits, which are a cheaper funding source. I also mentioned that I think there's over time, we will continue to work to see what we can do in terms of the cost of deposits, making sure that we're originating the deposits at an appropriate level to fund the balance sheet towards our longer term target, but also being very mindful of the cost of funding. So, you know, if things went well, you know, there could be a basis point or two on the deposit side. You know, that's your call whether you want to put that into your models. And then in terms of pricing action, you know, the company's been pretty stable, but we'll continue to look for opportunities on the pricing side.

Thank you.

We'll take our next question from John Pancari with Evercore.

Good afternoon. Hey, John.

I just have a question on the TDRs. I know you'll be giving us more disclosure in the K, but I wanted you to give us of the $85 million loan loss reserve build that you recorded for the quarter, how much of that was related to TDRs? And then separately, do you have what the – delinquency ratio was for the TDRs for the quarter?

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

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

Yeah. So, let me start off by saying that, you know, we have some really solid analytics around our TDRs. And, you know, we test populations and then once those tests come back and show that, indeed, cash flows are improving, we'll open it up to a certain population. And then we'll observe that, and then we'll adjust accordingly based on any differences we see between the test population and when the TDR-specific program is in process. So, you know, I'm not really going to talk about what other folks are doing. There also is a an approach that we take where we think that and we've seen real differences in terms of outcomes for our customer base in terms of helping them work through some difficulty and they end up some 80% of them end up sticking with us, have their credit lines open back up and continue to be very, very satisfied customers. Around the edges, we're going to take a look at smaller accounts and see if the effort to make a TDR is worthwhile based on our beliefs in terms of what's going to happen in those particular populations. But these are good programs. The financial impact is taken as soon as we TDR them. They remain in the delinquency buckets that they're in unless they've made three successive payments. what you're seeing flow through the financials is exactly what you would hope in terms of overall good credit performance and a solid book and TDRs as an approach to work with customers and help cash flows.

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

Got it.

Okay, thank you.

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

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

Yeah. Okay. So I'll take this, and maybe Roger will have a comment if appropriate. So when the team set up the original target for CET1, They did that with the idea that, indeed, CECL would be implemented and would impact the overall capital plan for the year 2019 through the first half of 2020. So we are going through our beginning, our CCAR work, and we're going to make the submissions. And we'll get some feedback likely in June. And we'll use that coupled with our overall plan around capital allocation that we'll review with the board to make a determination of what the future dividend payout ratio and buyback programs will look like. I would say this. So as we look at CECL for 2020 and our capital generative business models. We can likely absorb over the short term based in the phase and long term the impact of CECL. Now, there's questions regarding our regulators and how CECL will impact the consumer finance industry, especially given its pro-cyclical nature and the fact that products with longer lives, such as student loans and certain home equity products, and even to a lesser extent personal loans, you know, in a tough economic environment, you know, certain lenders might not look like the profile of that. That'll impact the availability of credit. I will say this. We like our products under CECL and under the current FAS 5 methodology. So, you know, it's based on the cash flows. CECL is not impacting the cash flows. And, you know, we like the return profiles that we've generated historically and will in the future.

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

Okay. So – sorry, Roger. Does that imply that, you know, there's some room for the Fed to potentially say now that you've got greater loss absorption capacity kind of post-seasonal that maybe the 10.5% isn't the right level that maybe you could go a little bit lower?

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

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

Okay. Thank you.

I'll take our next question.

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

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

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

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

Thanks very much.

We'll take our next question from Mousha Orenbuck with Credit Suisse.

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

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

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

Yeah, no, I think it's a very good point, Marcia. We don't manage the business to an efficiency ratio. We manage our expenses to be as efficient as possible. but then also look to invest and drive growth. And the sum of those two really is the entire expense base and drives the calculation of the efficiency ratio. But to the extent we see opportunities to make investments to drive accelerated growth, and we feel good about the payback as John talked about, we will do that and communicate that as appropriate. But I think your point's a good one. You don't want to necessarily just manage the business to an efficiency ratio.

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

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

Hi, this is Mihir for Jason. Maybe we should start with CISO. I just want to make sure we understand. I think you mentioned CISO has a differential impact on some of your products, particularly CISO. on day two and, you know, as we go into the quarters. Does that change the way you think about those products and also just relatedly in terms of just the disclosures you'll be providing? Are you going to provide disclosures for the next several quarters so we can compare results on a more apples-to-apples basis?

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

Got it. That makes sense. Thank you. And then just real quick, if I can go back to just, you know, the OPEX guide. Maybe, I guess, you know, clearly it's the topic on this call, but maybe we could get, if you could give us a little bit more of color on just the kinds of investments you're making and, you know, just maybe just help us understand what Yeah, your loan growth next year is, you know, 5.5 to 7 is a little, I guess, in the range similar to this year. And it sounds like some of these investments have a little bit longer payback period, but is it also supporting that 5 to 7 loan growth this year? And would, you know, do you need to make those investments to achieve that growth, I guess?

Thank you. So here's how we think about it. So there is the investment in brand to drive awareness and considerations. We haven't actually baked it in, but we think that over time will lower our acquisition cost, our per-unit acquisition cost, as people find greater awareness of Discover, the product offerings, the customer experience, and, frankly, a fair value exchange. So that is one aspect, but that is over time and to be determined. The other piece around technology investments, you know, we're going to be very judicious about those and with those to make sure that we are deploying functionality that helps make a difference to either our growth trajectory or expense profile. So over time, You know, I would expect that, indeed, we'll see, you know, efficiency gains either top line or through the expense base. And, you know, some of them, as Roger said, longer term, some are shorter term. But there's a thorough process to make sure we're getting the bang for the buck.

Thank you.

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

Hey, guys. Thanks for taking my question. You know, when we think about the sort of normal factors that cause hardship, loss of job, death, unemployment, or illness and divorce, is there anything idiosyncratic that you're seeing that's changing in the portfolio, or is there a policy shift that's driving this?

Yeah, no, there is no change in terms of, I'll say, customer behavior. What you're seeing here is, frankly, the benefit of, frankly, some solid analytics by our collections team in terms of when a customer is experiencing difficulty in helping that customer manage through it. The only process change we've made is it used to be someone had to call in and talk to a rep. For large balances, that continues to be the case. For certain customers who meet certain criteria, they can do it online on their mobile app. And we've tested those populations versus the call-in populations and actually the mobile app populations. are performing as well or better than when someone talks to a rep. So what you're really seeing here in the growth is a couple of factors. One is that I think there's a difference in reporting versus some competitors. Two is we've done an analytical exercise to make sure we understand paybacks and where to make a difference to cash flows positively, and we've opened those up. It's a combination of those factors and we're going to keep doing them as long as they're cash flow positive.

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

Yeah, you know what, in terms of the P&L impact, right, when you take a TDR, you basically take the net present value of the cash flows and compare it to your balance, and that's the P&L impact. CECL, you basically do the same thing on life of loan losses. So, yeah, the relative kind of decrement to the P&L if you were growing TDRs is smaller under CECL, but, you know, That's not how we make decisions here. Thank you so much.

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

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

Yes. So in terms of the 75% on day two, it would be relative to what they would be on an incurred basis. So an incremental 75% versus incurred. Now, loan growth will create incrementality versus an incurred basis. It's just the nature of taking a lifetime loss up front in a provisioning standpoint. And, you know, the team did a really good job in terms of modeling. And, you know, we feel like we're appropriately reserved. And, you know, from a day one standpoint and going forward, if we're seeing, better recovery through a cycle or, you know, better performance from an overall portfolio standpoint, then we'll adjust. And if correspondingly, if we're challenged somewhere, we'll adjust the other way.

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

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

No, I understand that, but I'm saying if those were not to change, would the allowance rate all else equal kind of stay the same throughout the year?

Yeah, so it would build for loan growth, right? at that rate, but in terms of kind of relative difference to incurred, it'd be fairly consistent.

Okay.

Thank you. We'll take our next question from Betsy Gracek with Morgan Stanley.

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

Okay. So the investment in brand, there are two parts, right? Part of it is just increasing consideration on the card side. You've seen some work around building awareness that we offer products other than just cash back, so we put ad money behind miles as well. But we do, as we look at consumers out there, there's a gap in terms of what I'll call top of funnel, right, people who consider Discover and have us top of mind. So that's why, as we think about our marketing next, we're going to heavy up a bit on top of funnel brand-type advertising. There also is an opportunity for our non-card products, in particular some of the deposit products. We've made great strides in terms of the products themselves, went out with no fees across any of our deposit products, but there still are huge amounts of consumers that don't understand, for example, we're even in the student loan business, let alone we are the second largest originator of private suit loans. And the same holds true with understanding the Discover offer as a savings account, a checking account. So it's a mix of both of those, building and enhancing consideration on the card side and building awareness for our non-card products.

And then this investment spend should kick off in one cue, like should I take this $100 million and just divide it? by foreign and throw that through the model linearly, or is this going to be back-end loaded, you know, kind of in a 4Q environment? How should I think about the pace of that spend throughout the year?

You know, we tend not to comment on the seasonality of the spend.

Sorry. Okay.

We'll take our next question from Bill Karkathy with...

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

Yeah. So first I'd say it's, you know, by and large, John is new, but you've got the same team that's been here for decades making the investment decisions. And I think you've seen a lot of discipline from us over the years, whether it's on the credit side or the expense side. It isn't necessarily a tradeoff where we sort of manage to an expense budget and then sort of if we can generate more efficiencies, then that frees up more money for growth. We try and be disciplined and consistent. So our investments in growth are really more driven by the opportunities we see to put our shareholders' money to work to drive good organic growth. with strong return profiles for that. And I mentioned that we expect our unit costs on the investments in account acquisition to be coming down next year. But we do feel like there's an opportunity to put some money to work with a bit of a longer payback on the brand side, in particular sort of top of funnel brand advertising, grabbing that awareness and consideration. and on technology. That reflects some specific decisions we are making for 2020. I would not read into it any change in discipline or philosophy from the team here at Discover.

Understood. Thanks for taking my question.

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

Thank you, and good evening. I guess... Try to follow up on just on the revenue growth, the loan growth and revenue growth. Is there the potential through some of the deposit products or the consumer banking products, the growth of Ariba Pay, B2B, that you could get revenue growth higher than loan growth? Yes. Is that a goal, and is there potential to do that? It seems you've made a lot of investments in the network and in B2B payments over the last several years.

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

Okay. Maybe a follow-up on a competitive environment and with the – maybe with the entrance of of the Apple card, which maybe is going after your demographic, the growth of neobanks, probably going after the deposit space in your target segment, several of them, some of those companies getting super high valuations as private companies. What are your thoughts on the Apple card, on the neobanks, and is some of your investment in brand in response to the competitive environment?

So our investments in brand are much more driven by our traditional competitors. And as we've seen, those super high private company valuations appear to come and go. As I think about competition, competition in the card space is always intense. It tends to be rational, but you have some large, sophisticated players. It's a high-return business. It's challenging, but always intensely competitive. So I would view the Apple card as, you know, you can't underestimate anything that Apple does. It's a new competitor and one that I'm sure will be formidable, but I don't think it's transforming the overall competitive environment in the card space. On the deposit side, you know, It's a different decision in terms of who you take a loan from, from who you give your money. And so brand and trust remain key elements of that. I think, as you saw from the very strong direct-to-consumer deposit growth we posted, you know, we feel like we have the product set and the ability to compete. We really just need to build awareness. And a lot of the focus is on, you know, moving deposits from some of the traditional branch-based players. as opposed to necessarily going head-to-head with some of these emerging online players. Okay. Thank you.

We'll take our next question from John Hecht with Jeffrey.

Yeah, hi. Thanks very much for taking my questions. Actually, most of my questions have been asked, but a couple that I'll throw out there. Number one is you mentioned some unfavorable funding issues. you know, triggers in the quarter. And I'm wondering, are, are those, are you able to unwind those or those kinds of permanent, you know, aspects of the funding going forward?

Yeah. So, so actually what that was is if you go back, uh, about a year and a half ago, we had, um, we had some really cheap, uh, CDs on the books and then, um, there was fed rate actions and more expensive, um, Deposits came on the books, and over time, if there's no Fed action, you'll see favorability come through into the P&L on that.

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

Yeah, so it's throughout this year and into next year. Okay.

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

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

Great. That's very helpful. Thank you guys very much.

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

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

Sure. So just to be clear, in terms of collections, which we define as sort of prior to charge-off, we do 100% of that in-house. And so that's with our own U.S.-based employees. It is very scalable. A lot of our investments have been in the area of analytics as well as, you know, if you think about collections as marketing, we've seen great impact from sort of building out digital collections. There are a lot of people who may not want to talk about the situation they're in, but like seeing the operations they have online, And so I think collections is an area where you can achieve competitive advantage. So it's been something that, you know, there hasn't been a change in our investment strategy there. It's been a multi-year journey, and we expect it to continue. On the recovery side, we do work with third parties. And so to the extent recoveries are more successful there, Because of the commission structures, we will pay more in recovery fees. But that, you know, usually means there's a net benefit.

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

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

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

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

Great. Thank you.

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

Good. Good afternoon, guys. Most of my questions have been answered already. I just have one quick question. I guess in the deposits, it looks like I guess the broker deposits were pretty down this year. Is Is that the, I guess, the runway going forward is we should see more, I guess, runoff in the broker deposits range as well as, you know, continued expansion of the direct-to-consumer?

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

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

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

Great. Thank you.

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

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

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

Okay. Any color on pricing or where you think your market share is and things like that?

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

Thank you.

We'll take our next question from Dominic Gabriel with Oppenheimer.

Hi. Thanks so much for taking my question. You know, when you talk about the investment spend, how much of the investment spend or are there plans to use this period of time to significantly invest in the global network in particular? And how much is the focus there given what you've talked about on investment spend? Thanks.

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

Okay, great. Thanks so much.

And there are no further questions at this time. Mr. Sheen, your closing remarks, please.

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

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