Discover Financial Services

Good morning. My name is Maria, and I will be your conference operator today. At this time, I would like to welcome everyone to the first quarter 2021 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 zero. Thank you. I'll now turn the call over to Mr. Eric Wasserstrom, head of investor relations. Please go ahead.

Thank you, Maria, and good morning, everyone. Welcome to this morning's call. I'll begin on slide two of our 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 presentation. Our call will include remarks from our CEO, Roger Hochschild, and John Green, our Chief Financial Officer. After we conclude our formal comments, it will be time for a question and answer session. During the Q&A session, please limit yourself to one question, and if you have a follow-up question, please get back into queue so we can accommodate as many participants as possible. Now it's my pleasure to turn the call over to Roger.

Thanks, Eric, and thanks to our listeners for joining today's call. Last April, if you told me that a year into the pandemic we'd be reporting excellent credit performance, positive sales trends, and solid earnings growth, I wouldn't have believed it. While the pandemic is far from over and there may be twists and turns ahead, as a nation, we have made tremendous progress toward addressing the health crisis and reopening the economy. This quarter, we earned $1.6 billion after tax, or $5.04 per share. I'm very pleased with these results, which reflect our robust business model, strong execution, including a disciplined approach to managing credit, improving economic trends, and the impact of federal support for U.S. consumers. Since the end of 2020, our view on economic conditions has improved. The rapid pace of the recovery has lessened our concern of job losses spreading to the white-collar workforce, and there has also been substantial support for the U.S. consumer through stimulus in January and in March. Our current expectation is that credit losses in 2021 will be flat to down year over year. This improved economic view, combined with lower loan balances and continued strong credit performance, were the primary drivers of an $879 million reserve release in the quarter. As discussed in previous quarters, the strong credit performance was accompanied by elevated payment rates that continued to put pressure on loan balances, which were down 7% year over year. Payment rates were over 350 basis points higher than last year and at their highest level since the year 2000. While the impact from stimulus payments should abate over the next few months, we expect payment rates will remain elevated for the rest of the year as households use savings to meet debt obligations and continue to benefit from payment relief programs, such as federal student loan and mortgage payment forbearance. Despite this pressure, we still expect modest loan growth this year, supported by several factors. First, there has been a significant increase in sales volume, up 11% from a year ago and up 15% from the first quarter of 2019. Improving trends in categories like retail and restaurants are positive signs for future growth. Additionally, based on our credit performance and our current outlook for macro conditions, we have begun to migrate our credit standards back to pre-pandemic levels. This is particularly true in CARD, where our value proposition centered on best-in-class customer service, valuable rewards, and no fees continues to resonate strongly among consumers. We're also expanding credit standards and personal loans, but not quite back to 2019 norms. To offset the higher payment rate as well as leverage these credit actions, we intend to increase our marketing spending through the rest of this year. Outside of marketing, we expect that expenses will be relatively flat year over year as we remain committed to expense management. We're reinvesting some of the benefits from our strong credit performance and efficiency gains into technology and analytics to further improve our account acquisition targeting, fraud detection, and collections capabilities. The rapid pace of the economic recovery and strong credit performance may provide additional opportunities to lean further into growth. We intend to take advantage of these opportunities and may make additional marketing and non-marketing investments that will create long-term value. On the payment side, we continued strong performance in our pulse business with volumes up 23% driven by stimulus payments in the first quarter and higher average spend per transaction. We also continue to expand our global acceptance through network partnerships, and this quarter we signed new partners in Jordan and Malaysia. Our digital banking model generates high returns, and we remain committed to returning capital to our shareholders. This quarter, we restarted our share repurchase program with $119 million in buybacks, in line with the regulatory restrictions still in place. Looking at our strong credit performance and robust earnings, we see an opportunity to revisit our capital return to shareholders in the second half of the year. As I look towards the future, I'm excited about Discover's prospects. Our products continue to bring value to our customers. We remain flexible as we support our employees and their families through the pandemic, and we are well-positioned to continue driving long-term value for our shareholders. Before I turn it over to John, one last thing. You may not know it, but our CLO, Wanji Wolcott, sits in on these calls and is a great part of the team. Today is her birthday, so I want to wish Wanji a very happy birthday. With that, I'll now ask John to discuss key aspects of our financial results in more detail. Thank you, Roger. Happy birthday, Wanji. And good morning, everyone. I'll begin by addressing our summary financial results on slide four. As Roger indicated, the results this period reflect many of the same dynamics we've seen over the past few quarters. The influence of stimulus resulted in elevated payment rates, which pressured loan growth. It also contributed to strong asset quality and our significant reserve release in the quarter. Revenue, net of interest expense, decreased 3% from the prior year, mainly from lower net interest income. This was driven by a 7% decline in average receivables and lower market rates, partially offset by a reduction in funding costs as we continued to manage deposit pricing and optimize our funding mix. Non-interest income was 5% lower primarily due to a $35 million net gain from the sale of an equity investment in the prior year. Consistent with our excellent credit quality, lower loan fee income reflects a decline in late fees, while net discount and interchange revenue was up 12% from the prior year, reflecting the increased sales volume. The provision for credit losses was $2 billion lower than the prior year, mainly due to an $879 million reserve release in the current quarter compared to a $1.1 billion reserve bill in the prior year. Our improved economic outlook, lower loan balances, and strong credit drove the release. Additionally, Net charge-offs decreased 30% or $232 million from the prior year. Operating expenses decreased 7% year-over-year as we remained disciplined on expense management. Other than compensation, all other expenses were down from the prior year, led by marketing, which decreased 33% year-over-year. Looking ahead, we intend to accelerate marketing investments over the remainder of the year. We'll go into details on our spending outlook in a few moments. Moving to loan growth on slide five. Total loans were down 7% from the prior year, driven by a 9% decrease in card receivables. The reduction in card receivables was driven by two primary factors. First, the payment rate remains elevated, driven by the latest round of stimulus and improved household cash flows. Promotional balances have continued to decline, reflecting the actions we took at the onset of the pandemic to tighten credit. As a result, these balances were approximately 300 basis points lower than the prior year, although we expect new account growth will cause promotional balances to begin to stabilize. As the economy reopens further, we believe consumer spending and prudent expansion of our credit box should drive profitable loan growth going forward. Looking at our other lending products, organic student loans increased 5% from the prior year and originations returned to pre-pandemic levels. We continued to gain market share through the mini peak season. Personal loans were down 9%, primarily due to actions we took early in the pandemic to minimize credit losses. As we've previously mentioned, we see opportunity to expand credit a bit given the strong performance of this portfolio. Moving to slide six, the net interest margin was 10.75% up 54 basis points from the prior year and 12 basis points sequentially. Compared to the prior quarter, the improvement in net interest margin was driven by lower deposit pricing as we cut our online savings rates from 50 to 40 basis points during the quarter. We also continue to benefit from the maturity of higher rate CDs and a favorable shift in funding mix. our funding from consumer deposits is now at 65%. Future deposit pricing actions will be dependent upon our funding needs and competitor pricing. Average consumer deposits were up 14% year over year and flat to the prior quarter. Consumer CDs were down 7% from the prior quarter, while savings and money markets increased 4%. Loan yield was flat to the prior year, Seasonal revolve rate favorability and a lower mix of promotional rate balances were offset by the impact of reduced pricing on personal loans. Looking at slide 7, total non-interest income was $465 million, down 25 million, or 5% year-over-year, driven by the one-time gain in the prior year that I previously mentioned. Excluding this, non-interest income was up 2%. Net discount and interchange revenue increased 12% as revenue from higher sales volume was partially offset by higher rewards costs. The decrease in loan fee income was driven by lower late fees, which move in line with delinquency trends. Looking at slide eight, total operating expenses are down 78 million or 7% from the prior year. Marketing and business development decreased $77 million, or 33%, year over year. The reduction reflects actions we implemented in March of last year to align marketing spend with tightened credit criteria. However, we accelerated our marketing spend late in the first quarter and plan to continue this through the year. These investments will drive new account acquisition and loan growth. The year-over-year decrease in other expenses was mainly driven by lower fraud volume to an due to enhanced analytics around disputed transactions and decreased fraud in deposits. This improvement demonstrates a small part of the benefit we expect from the investments we've made in analytics over the past few years. Partially offsetting the favorability was a $39 million increase in employment compensation that was driven by two factors, $22 million from a higher bonus accrual in the current year, The remaining increase was driven by higher average salaries reflecting the talent build in our technology and analytics team. Moving to slide nine. We had another strong quarter of very, very strong credit performance. The total charge-offs were 2.5% down 79 basis points year over year and up 10 basis points sequentially. The card net charge-off rate was 2.8%, 85 basis points lower than the prior year, with the net charge-off dollars down $209 million, or 31%. Sequentially, the card net charge-off rate increased 17 basis points, and net charge-off dollars were up $11 million. The increase in card net charge-offs from the prior quarter was driven by accounts that had been in skip pay and did not cure. The program ended six months ago, and at this time, most of the accounts that were in skip-a-pay have returned to making payments. Looking forward, we expect minimal impacts to charge-offs from this population. The card 30-plus delinquency rate was 1.85%, down 77 basis points from the prior year, and 22 basis points lower sequentially. With the influence of the skip-a-pay group now largely complete, we think that delinquencies are the most clear indicator of our loss trajectory over the short term. Credit remains strong in private student loans. Net charge-offs were down 15 basis points year-over-year and 18 basis points compared to the prior quarter. The 30-plus delinquency rate improved 55 basis points from the prior year and 19 basis points sequentially. In personal loans, Net charge-offs were down 79 basis points year-over-year, with a 30-plus delinquency rate down 47 basis points from the prior year and 24 basis points from the prior quarter. The positive impact of additional stimulus combined with an improved economic outlook have shifted our expectation on the timing of losses. We had previously expected losses would increase in the second half of this year and remain elevated into 2022. That is no longer the case. Based on our current delinquency trends, we believe losses are likely to be flat to down this year with the possibility of some increase in 2022. That said, a material shift in the economic environment could alter the timing and magnitude of losses. Moving to the allowance for credit losses on slide 10. This quarter, we released $879 million from the allowance. This reflected several factors, including favorable changes to our macro assumptions, a moderate decrease in our loan balance, the continued decline in delinquencies, and lower losses. Relative to our view in January, the economic outlook has continued to improve. As we've done in prior quarters, we've modeled several different scenarios and took a conservative but more optimistic view. Our assumptions on unemployment were a year-end 2021 rate of 6%. With a return to full employment in late 2023, we assume GDP growth of about 4.6%. Our reserve assumptions did not contemplate any additional stimulus directed to consumers, but did anticipate broader economic benefits from infrastructure spending beginning in the second half of this year. The modest increase to reserves in our student loan portfolio was driven by loan growth coming out of the mini peak season. Looking at slide 11. Our common equity tier one ratio increased 180 basis points sequentially to 14.9%, well above our internal target of 10.5%. We have continued to fund our quarterly dividend at 44 cents per share and repurchased $119 million of common stock during the quarter. Our board of directors previously authorized up to $1.1 billion of repurchases. We will likely accelerate our share repurchases in the second quarter, and we see the potential for capital returns to increase in the second half of the year. As I mentioned earlier, we continue to optimize our funding mix, and consumer deposits now make up 65% of total funding. Our goal remains to have 70% to 80% of our funding from deposits, which we feel is achievable, though we expect some quarter-to-quarter variability in this figure. Moving to slide 12, our perspectives on 2021 have evolved from last quarter. We continue to anticipate modest positive loan growth for the year. We are investing in new account acquisition and have already seen strong sales growth through the first quarter. High payment rates will continue to pressure loan growth near term, but should become less of a headwind over the course of the year. Versus the first quarter level, we expect our NIM to remain in a relatively narrow range over the rest of the year. While we'll continue to benefit from improved funding costs and mix, we may experience modest yield pressure over the next few quarters from variability in the revolve rates. Our commitment to expense management has not changed, but as Roger mentioned, we believe there is an opportunity to drive long-term growth through increased marketing and further investments in data and analytics. Excluding marketing, expenses should be near flat from the prior year. Credit performance has remained stronger than originally anticipated, and we now expect credit losses to be flat to down compared to 2020. we remain committed to returning capital to shareholders through dividend and buybacks. Given the level of reserve release and the strength of our fundamental performance, we plan to revisit our capital return levels for the second half of this year. In summary, we're pleased with our first quarter results. Our sales trend, credit expansion, and marketing investments position us well for growth going forward. We released $879 million of reserves, NIM continue to improve driven by lower funding costs, and expenses were down, but we'll invest in marketing analytics that will drive revenue as well as operating and credit cost improvements over the longer term. As the economy reopens, I'm positive regarding the opportunities for growth. We have a strong value proposition that resonates with consumers, and our digital banking model positions us well for strong returns going forward. With that, I'll turn the call back to our operator, Maria, to open the line for Q&A.