Discover Financial Services

good afternoon my name is stephanie and i will be your conference operator today at this time i would like to welcome everyone to the second 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 telephone keypad If you should need operator assistance, please press star zero. Thank you. I will now turn the call over to Mr. Eric Wasserstrom, Head of Investor Relations. Please go ahead, sir.

Thank you, Stephanie, and good morning, everyone. Welcome to today'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 our second quarter earnings press release and presentation. Our call today will include remarks from our CEO, Roger Hochschild, and John Green, our Chief Financial Officer. After we conclude our formal comments, there will be time for a question and answer session. During the Q&A session, you will be permitted to ask one question followed by one follow-up question.

After your follow-up question, please return

strength of our digital business model strategic priorities against the backdrop of continued economic improvement this quarter was events first our card receivables grew sequentially in may and june causing our period and receivables to be up quarter over quarter this

consumer spending and our account acquisition increased our conference growth this year and stronger growth in 2022.

Second, we benefited from a gain in our payment services segment. This gain is an outgrowth of a long underscores our payments. Ability to forge innovative and lasting partnerships. Lastly, we achieved a historic low in delinquencies, which resulted from consumers' strong liquidity position, our conservative stance on underwriting, and the proactive measures we took into the downturn to protect our credit quality. This out of order. Turning to the quarter's results, we earned $1.7 billion after tax, or $5.55. These results include a $720 million $729 million one-time gain, but even excluding this gain, our results were very strong at $3.73 per share. The drivers of the quarter's strong results reflect the combination of our solid execution and supportive macro conditions. Total sales were up 48% from a year ago and 24% from 2019. Retail sales remained very strong, and there was significant improvement in T&E categories by the pandemic. Even travel returned to growth in June compared to 2020 levels.

And sales volumes are accelerating. The 24% growth I cited is in 2019. We also see an attractive environment for account acquisition, even though

We have removed nearly all of our pandemic credit tightening and have increased our marketing investment to align with these actions. These decisions supported new accounts over 2019 levels with strong growth among prime consumers as our differentiated brand and integrated network support our strong value proposition, which centers on transparent and useful rewards, outstanding customer service, and no annual fees. While the current operating environment is broadly constructive, there are also some challenges. As we have highlighted before, the counterpoint of sustained strong credit performance is high payment rates, which in the second quarter were over 500 basis points above 2019 levels. We may be seeing evidence that payment rates are plateauing, and while we expect some, we believe payment rates will remain above time. Even so, we expect to strengthen our sales figures and the contribution through the back half of this year and accelerate in 2022. As we have seen, when we see attractive opportunities and the actions we took this quarter with increased marketing expenses and investments in technology and analytics, we're an example of that approach. These investments are consistent with our commitment to long-term positive operating leverage and an improving efficiency ratio as they drive loan growth and enable a more efficient operating platform. In our payments business, we benefited from a gain on our equity investment in Marketo. This gain was the result of a relationship that began a decade ago, and we continue to see opportunity and innovative partnerships. I'm very excited about our investment in Sezzle that was in place last week as we look to expand our partnership with a leading buy-now, pay-later provider. We also continue to grow our global acceptance presence and announce new partnerships in Bahrain and Portugal, adding to the two network alliances that we announced earlier this year. Our debit business continued to build on its recent strength. Pulse volume increased 19% year-over-year and was up 33% from 2019 levels. In addition to the influence of economic recovery, this performance reflects the greater relevance of debit to many consumers through the pandemic period. Volume at diners has also recovered to some extent and was up 41% from the prior year's lows. However, volume is still below pre-pandemic levels and may remain so for a period of time. The strong fundamental performance of our digital banking model drove significant capital generation, which this quarter was also aided by our equity gain. We accelerate our share repurchases to $553 million of common stock, a level near the maximum permitted under the Federal Reserve's four-quarter rolling net income test. We remain committed to returning capital to our shareholders, and going forward, our approach will be governed by the stress capital buffer framework. On our call last quarter, we indicated that we hope to revisit our capital return for the second half of this year. and I'm very pleased that our board of directors authorized the new $2.4 billion share repurchase program that expires next March. We also increased our quarterly dividend from 44 cents to 50 cents per share. With the current strength of the U.S. economy, I'm increasingly optimistic about our growth opportunities this year and beyond. Our value proposition continues to resonate with consumers, Our payment segment is expanding its partnerships and acceptance, and our capital generative model positions us for strong returns over the long term. I'll now ask John to discuss key aspects of our financial results in more detail.

Thank you, Roger, and good morning, everyone. I'll begin with our summary financial results on slide four. As Roger noted, our results this quarter highlighted the strength of our digital model, solid execution on our priorities, and continued improvement in the macroeconomic environment. Revenue, net of interest expense, increased 34% from the prior year. Excluding one-time items, revenue was up 9%. Net interest income was up 5% as we continued to benefit from lower funding costs and reduced interest charge-offs, reflecting strong credit performance. This was partially offset by a 4% decline in average receivables from the prior year levels. Excluding one-time items, non-interest income increased 29% driven by higher net debt count and interchange revenue due to strong sales volume. The provision for credit losses decreased $2 billion from the prior year, mainly due to a $321 million reserve release in the current quarter compared to a $1.3 billion reserve bill in the prior year. An improvement in the economic outlook and ongoing credit strength were the primary drivers of the release. Net charge-offs decreased 41% or $311 million from the prior year. Operating expenses were up 13%, primarily reflecting additional investments in marketing, which was up 36%, and employee compensation, which was up 10%. A software write-off and a non-recurring impairment at Diners Club also contributed to the increase. I'll provide more details on expense drivers and outlook later in the presentation. Moving to loan growth on slide five. Ending loans increased 2% sequentially and were down just 1% from the prior year. This was driven by card loans, which increased 2% from the prior quarter and were down 2% year over year. Lower year over year card receivables reflect two primary factors. First, the payment rate remains high as households continue to have a strong cash flow position due to several rounds of government stimulus. Promotional balances were approximately 250 basis points lower than the prior year quarter. While card receivables declined year over year, we consider this sequential increase to be an important data point reflecting continued momentum in account acquisition and very strong sales volume. The high payment rate remains a headwind to receivable growth, although we expect to see modest decreases in late 2021. Looking at our other lending products, Organic student loans increased 4% from the prior year. We are well positioned as we enter the peak origination season. Personal loans were down 6%, driven by credit tightening last year and high payment rates. We are encouraged by continued strong credit performance in the portfolio and have expanded credit for new originations. Moving to slide six. Net interest margin was 10.68%, up 87 basis points from the prior year and down 7 basis points sequentially. Compared to the prior quarter, the net interest margin decrease was mainly driven by a nearly 200 basis points reduction in the card revolve rate. Loan yield decreased 17 basis points from the prior quarter, mainly due to the lower revolve rate. This decline reflects the impact of increased payments as well as seasonal trends. Yield on personal loans declined seven basis points sequentially due to lower pricing. Student loan yield was up four basis points. Margin benefited from lower funding costs primarily driven by maturities of higher rate CDs. We cut our online savings rate to 40 basis points in the first quarter and did not make any pricing adjustments during the second quarter. Average consumer deposits were up 6% year-over-year and declined 1% from the prior quarter. The entire sequential decline was from consumer CDs, which were down 9%, while savings and money market deposits increased 2% from the prior quarter. Consumer deposits are now 66% of total funding, up from 65% in the prior period. Looking at slide seven, Excluding the equity investment gains, total non-interest income was up $123 million or 29% year over year. Net discount and interchange revenue increased $102 million or 43% as revenue from strong sales volume was partially offset by higher rewards costs. Loan fee income increased $20 million or 24%, mainly driven by higher cash advance fees with demand increasing as the economy reopens. Looking at slide 8, total operating expenses were up $145 million, or 13% from the prior year. Employee compensation increased $46 million, primarily due to a higher bonus accrual in the current versus 2020 when we reduced the accrual. Excluding this item, employee compensation was down from the prior year as we've managed headcount across the organization. Marketing expense increased $46 million from the prior year as we accelerated our growth investments. We still see significant opportunities for growth, and we plan to accelerate our marketing spend through the year to drive account acquisition and brand awareness. Information processing was up due to a $32 million software write-off. The increase in other expense reflects a $92 million charge on the remainder of the diner's intangible asset. Partially offsetting this was lower fraud expense, reflecting some of the benefits from our investments in data analytics. Moving to slide nine, we had another quarter of improved credit performance. Total net charge-offs were 2.1% down a 132 basis points year over year, and 36 basis points sequentially. The net charge-off rate was 2.45%, 145 basis points lower than the prior year quarter, and down 35 basis points sequentially. Net charge-off dollars were down $276 million versus last year's second quarter and $62 million sequentially. The card 30-plus delinquency rate was 1.43%, down 74 basis points from the prior year and 42 basis points lower sequentially. Credit in our private student loans and personal loans also remained very strong through the quarter. Moving to the allowance for credit losses on slide 10. This quarter, we released $321 million from the reserves due to three key factors. continued improvement in the macroeconomic environment, sustained strong credit performance with improving delinquency trends and lower losses. These were partially offset by a 2% sequential increase in loans. Our current economic assumptions include an unemployment rate of approximately 5.5% by year end and GDP growth of 7%. Embedded Within these assumptions are the expanded child care tax credits and the benefits from the infrastructure fiscal package beginning in late 2021. Looking at slide 11, our common equity tier one ratio increased 80 basis points sequentially to 15.7%, a level well above our internal target of 10.5%. As Roger noted, we are committed to returning capital. The recent Board approval increasing our buybacks and dividend payouts reflect that.

On funding, we continue to make progress towards our goal of having deposits be 70% to 80% of our mix.

Moving to slide 12, our perspectives on 2021 continue to evolve as we see additional opportunities to drive profitable growth. We have increasing confidence in our outlook for modest loan growth in 2021 as strong sales and our new account growth should offset the higher payment rates. We expect NIM will remain in a relatively narrow range compared to their first quarter levels of 75% with some quarterly variability similar to what we experienced this quarter. We anticipate a slight benefit from higher coupon deposit maturities and an optimized funding mix with yields affected by variability in the revolved rate. Our commitment to disciplined expense management has not changed, and we remain focused on generating positive operating leverage and an improving efficiency ratio. For this year, we now expect non-marketing expenses to be up slightly over the prior year, reflecting the higher compensation accruals and recovery fees. The increase in these expense categories is closely tied to the economic recovery. For example, the high level of consumer liquidity is supporting elevated recoveries. These recoveries have some costs associated with them, but are more than offset by lower credit losses. Regarding marketing expenses, We expect this will step up more significantly in the second half of 2021 as we further deploy resources into account acquisition and brand marketing. With the continued improvement in credit performance, our current expectation is that credit losses will be down this year compared to 2020. Naturally, a material change in the economic environment could shift the timing and magnitude of losses. Lastly, as evidenced by our dividend increase and new share repurchase authorization, we remain committed to returning capital to shareholders. In summary, we had another very strong quarter. We are well positioned for a positive top-line trajectory given our sales trends and new account growth. Credit remains extraordinarily strong and the economic outlook continues to improve. We maintained our discipline on operating expenses while investing in returning organic growth opportunities. And finally, we continue to deliver high returns, allowing for enhanced buybacks and dividends. With that, I'll turn the call back to our operator to open the line for Q&A.

At this time, if you would like to ask a question, please press star one on your touchtone phone. If you wish to remove yourself from the queue, you may do so by pressing the pound key. We remind you to please pick up your handset to provide optimal sound quality. We'll take our first question from John Pancari with Evacor ISI.

Morning. Morning. Just wanted to see if you could – morning. Just wanted to even give a little more color on the payment rate expectation. I guess just what do you see and what gives you confidence in the – um, the moderate decline expected for the back half of this year. And if you could talk about the, you know, how you weigh the risks that the payment rate may not moderate from here. And then secondly, on that, are you seeing any differences in your, your FICO bands in terms of the payment rate behavior? Thanks.

Okay, great. Yeah, I'll, I'll take the call or I'll take the question, John. Thanks. Thanks for that. So, uh, You know, payment rates are, frankly, at a record high. So if you looked at our trust data, you can see that in June they came in at about 29 percent, and that's, frankly, that's an all-time high, at least as far back as 2005. So what we're seeing when we look at the portfolio, now the portfolio, the trends are similar, but the overall payment rate's a bit lower. What we're seeing is a couple factors. So one is a deceleration of the growth in payment rate. And second, you know, we formed our expectation on the second half of the year based on all of the government programs that are out there. And the most significant ones are expiring or have expired by the end of the third quarter. So we expect that, coupled with the strong economic activity and lower savings rate that we're observing, to result in a moderate decrease in the payment rate, certainly in the fourth quarter. In the third quarter, it could be flat to maybe even up a mild bit. But overall, you know, our sense is that we've approached the peak of this, and it's going to begin to tail off.

And in terms of the mixed by FICO band, you know, it's pretty broad. Certainly the higher FICO skew transactor, so you'll have a higher payment rate. In some of the mid-FICOs, you've seen revolvers turn transactor. But, again, to John's point, we do expect it gradually to normalize.

great now that's helpful and then separately um i appreciate the the commentary around the loan growth expectation and um and you also expect some variability in your margin so how what does that imply for your net interest income expectations if you could elaborate a little bit on that in terms of the second half trajectory there and possibly going into 2022

Yeah, so I'll touch upon it. So, you know, the net interest income, you know, will follow loan growth. But as you know, in the fourth quarter, the build of loan balance is skewed towards the last two months of the quarter. So, you know, net interest margin is, what I'll say, the trajectory is changing in a positive direction given the sequential loan growth we saw from first quarter to second quarter. But again, you know, it's going to be in the single digits, lower single digits is the general expectation.

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

Thanks. Good morning. My first question is I know everyone's sort of waiting for the consumer to relever and there's positive signs, but maybe, Roger, you could just speak to the competitive environment. I mean, obviously everyone's chasing growth or wanting to grow. Maybe you could just speak to how it's out there.

Yeah. Thanks, Sanjay. You know, as we've discussed in the past, the card business is always competitive. You know, there was a nice little lull last year that we were able to take advantage of and pick up, you know, even more market share. But I think this is returning to more normal, you know, maybe a little heightened, but more normal level of competition. You're seeing new products out there, increased marketing spend. But as I look at our value proposition, look cost per accounts we're achieving and the returns. I feel very, very good about the marketing spend we're putting out there and what we're generating for it.

Okay, great. My follow-up is on the Sezzle investment. Obviously, they're an up-and-coming buy-now-pay-later company. I'm just curious sort of if you could speak to that specific investment and how you see that unfolding for yourselves, both in terms of the investment itself, but also strategically inside of buy-now-pay-later. Thanks.

Sure. So in terms of our buy now, pay later strategy, they're really two parts. The Sezzle investment is really being driven by the payment side. And that's similar to the investment we made in Barketta a while back. You know, our set of network assets are very useful for many fintechs. in terms of just an easier way to process payments and connect to merchants in a wide variety of forms. So I'd say that's the core of what we're doing with Sezzle. We also believe that potentially over time there may be opportunities on the banking side. So in terms of our providing lending, not necessarily with Sezzle, but in the buy now, pay later space more broadly. And again, leveraging what we can do with unsecured lending and our direct merchant relationships. But I would say we haven't announced anything on the lending side of buy now, pay later at this time.

Your next question comes from Ryan Nash with Goldman Sachs.

Hey, good morning, guys. Morning, Ryan. Morning. John or Roger, can you maybe just talk about the expectations for monetizing the market again? How much do you expect to reinvest versus use for repurchases? Is it already factored into the buyback? Second, can you maybe just remind us what the lockup is and your intention for the stake and Maybe just lastly, you know, these increasing expenses that we have right now, marketing and non-marketing investments, how much of these are being driven by the market again, and should we expect these to be one time in nature, or should we expect them to stay in the run rate? Thanks.

Okay. All right, Ryan. Thanks. So, you know, the market again was something that when we – When we looked at the plan for the year, we didn't frankly envision that that opportunity would turn out quite the way it did, so certainly a nice outcome. The spend that we're seeing isn't dictated based on that size of the marketa gain, but more about the broad economic opportunity that we're seeing right now to be able to drive positive growth. Frankly, we'd be spending at this level with or without the market of gain. The lockup, those points are disclosed in the S-1, so you can reference that and get real specificity on it. And then finally, in terms of the expenses, are they one time in nature? Within the presentation itself, we highlighted kind of three items that were significant. So one was the bonus accrual, unrelated to Marquetta again, and more broadly a reflection of what's happening in the business and the outcomes we're seeing here in terms of generating positive returns. the um the other the other item there was the diners intangible which um we took we took the opportunity based on what we see as as a change in the in the cash flows in diners to to fully impair that um and took a 92 million dollar write-off and then the third the third item was was the 30 million dollar software write-off so um all those are part of our normal i'll say hygiene factors so the last the last two items were you know what i would consider relatively one-off and i wouldn't i wouldn't include those in in the kind of operating cash flows going forward but as you're trying to get a sense for overall spend in um in 2021 we talked about accelerating marketing expense so So the way I would think about marketing specifically is that we anticipate it to return to 2019 levels, which would indicate a material acceleration in the second half of the year, which, again, is tied to the fact that we're seeing good origination opportunities to drive growth and long-term profitability.

Got it. Thanks for the call on that. And maybe as my follow-up, so, you know, you announced the new $2.4 billion buyback, but just given how high the levels of profitability are, you know, you're still going to be well above the 10.5 level. So, can you maybe just help us understand the strategy of getting the capital down over what timeframe? Are you managing all into CECL Day 1? And then maybe, you know, attach that, Roger, you know, you talked about potential lending opportunities and buy now, pay later. We've seen others take some go at it organically, some go via acquisition. You know, what would you expect to be the strategy for Discover on a go-forward basis? Thanks.

All right. So I'll hit the capital point real quick, and then we'll flip it over to Roger to handle it back. The second part of that question, the second part of that question, Second question, I should say. So one, we want to be prudent in our distributions of capital and make sure that we allocate our capital to organic growth opportunities and then buybacks and dividends and then acquisitions as they appear. So that hasn't changed whatsoever. The planning in terms of capital overall is that we are committed to that 10.5%. As we look at the impacts of the CISO capital relief transition, that's about 200 basis points. And then in the first quarter of next year towards the end of this year, as we review the outlook for 2022 with our board, we'll make recommendations with a couple points in mind. The SCV and where we are with that, and there's plenty of room there. And then finally, approaching the... And in terms of buy now, pay later...

There are many, you know, sort of different things we could do. You know, clearly going direct with the merchant relationships we have is one option. We could work with partners. You know, I think the market is still very immature in different combinations, and it will evolve over time. But we don't have anything specific to share at this time.

Your next question is from Don Fendetti with Wells Fargo.

Hi, good morning. Roger, kind of a bigger picture question around technology spend. I just want to get your thoughts on where your head is right now, whether you're kind of making enough investments in AI and machine learning and staffing in different financial institutions or at different points of the cycle.

Yeah, it is a major source of investment for us. and i would say that the scarcest asset there is talent uh as opposed to technology dollars and then part of it is just making sure you're investing to monetize the the you know granularity you can pick up with enhanced data analytics so looking at the entire martech stack your personalization abilities what you can deliver through different channels so it's a big focus I think we're probably the only major bank where the head of data and analytics is a direct report to the CEO. And so I think that reflects the importance we see on that. And I feel very good about our level of investment.

Okay. Thank you.

Your next question is from Bob Napoli with William Blair.

Thank you. Appreciate it. Good morning. Question, just to follow up, I guess, on Roger, your in investments in, uh, like Marquetta and Cecil and just, uh, the thought, I mean, how are you working with Marquetta? How are these investments, uh, you know, improving, uh, the, uh, the product set, if you would, uh, for discover and are there, you know, more of these types of, uh, investments or could they become acquisitions, uh, in the future?

Sure. So, you know, all of these investments start with a commercial relationship. We are not venture capitalists. We have no desire to get into that business. But where we have a commercial relationship with a company where we think there's a lot of potential and there is a way to invest and perhaps extract additional terms, maybe an exclusive arrangement or other commitments, Those are the types of opportunities we pursue, and they're largely on the payment side. And we may even, given some of the opportunities we're seeing, accelerate that, although, again, it's going to be relatively modest. In terms of acquisitions, given the valuations, I'm not sure I necessarily see doing acquisitions and this approach around partnership and investment seems to work well, but we will look at it. John and our payments team have a very strong business development effort and will consider acquisitions where it's a capability that will help us monetize our payments assets.

Great. Thank you. Follow-up on your chart on page 16. the acceleration through the quarter relative to 2019. I mean, are you surprised by the level of spend that we're seeing? And how do you think about that relative to the long-term trend? I guess if you take this quarter, you maybe had a 10% compound growth from 2019. But were you surprised by this and the acceleration through the quarter and your thoughts on spend growth 2019? you know, as you laugh, as you look at 2022 and onward?

Yeah, I mean, I think compound growth is a very challenging measure because it smooths an unbelievable cycle that I don't think any of us would have expected in 2019. So, you know, the year-over-year spend growth numbers are unsustainably high for the economy as a whole. The economy is growing above, I think, what economists would say its real level should be. And so you're seeing that pent up demand from consumers. You know, we expect it to normalize at a strong level, and we look to continue gaining market share given how we're positioned. But I don't think anyone is expecting, you know, retail sales to stay up 30% forever.

Your next question comes from Mark DeVries with Barclays.

Yeah, thanks. I had a question about the reserve levels. Can you give us some sense of what you're kind of contemplating, both from a delinquency and a charge-off perspective in those reserves? I mean, I think trends have obviously been very benign, and yet you're still almost 200 basis points above kind of your CECL day one. What do you need to see to see those reserves come down more meaningfully?

Mark, thanks for the question. So when we approach this quarter, certainly the economic data is was improving, the portfolio is performing extremely well, and, you know, the charge-off trajectory, you know, we revised our guidance and now believe it'll be below the prior year. So all those are very, very positive from a reserving standpoint. We did put a bit of caution in the kind of reserve numbers as a result of the various government programs that are out there. So if you think about the eviction moratoriums, foreclosure moratoriums, various payment deferral programs, and then the massive amount of government transfer payments that hit the economy, we felt like those contributed to driving delinquencies and charge-offs below historical norms for our customer base. So under CECL, we reserve for life of loans, and accordingly, we were waiting for those programs to run their course and the cash flows to kind of feed through the economy and impact our customers, and then be able to make, you know, call it a deeper change to the reserve levels. So as I said earlier, most of those programs ran their course in the third quarter. We obviously have the child care tax or the child tax credit. We don't expect that to be a impact. So in the fourth quarter, we should begin to see more data that would allow us to take a different look at reserves and then into 2022 certainly. You know, our expectation is that the credit environment is very positive from a growth standpoint and accordingly will make reserves that kind of align with that.

Okay, got it. And then just one more question. Do you have any other private investments that look like they could be in a large gain position just based on any kind of subsequent funding rounds and evaluations those are done at?

So, we, you know, we have some investments, yes. We try to get in early and, you know, build out the commercial relationship, as Roger alluded to. And, you know, we're hopeful that the combination of working with quality companies and developing deeper commercial relationships will help those folks be profitable and help us drive business in our payments area while giving us an option value for that investment. So, you know, one would hope that there's more, but at this point it would be way premature to speculate.

Your next question comes from Manute Srivirirat. from UBS.

Good morning, guys. Good morning. Good morning. Thanks for taking my question. I guess you've talked a lot about the benefits of having a differentiated product with flexible cash rewards. Now, as things get back to normal and travel rewards become more relevant for consumers, are you seeing any impact to your utilization levels? Is there any indication that consumers might have a shifting preference for travel and lifestyle rewards over cash rewards?

You know, we've been successfully marketing cash rewards against travel rewards and every other type of card out there for decades. So I wouldn't get too caught up in sort of the shift away from frequent flyer miles and travel. 2020 i think it points to sort of the stability and and structure of our program that we didn't have to make a series of changes we focus on you know continuously enhancing it a lot of people don't focus as much as we do on redemption so the ability to redeem that point of sale at amazon through our partner paypal So we are confident that we can compete with the travel rewards programs. A lot of the miles cards really target the super prime transactors, which isn't, you know, ours is much more a lend-focused model. You know, we've got a very good miles card ourselves that we market. But, again, I feel really good that our rewards can compete against anyone out there.

Okay. Thank you for that. And just as a follow-up, how should we think about the rewards rate as you think about growing loan balances, for example? Is there anything to that?

Yes, I'll cover this one. So, you know, the rewards rate over time has been, you know, relatively stable. It's increased, you know, somewhere between one and three pips annually. You know, we expect that... you know, the 5% programs and the reward structure will continue that trend while helping us to sustain, you know, a strong level of customer loyalty. So we look at that increase as a natural evolution of a good investment in our customer relationships.

Okay. Thank you very much. Thanks for the call. Have a good day, guys. Thank you.

Your next question comes from Rick Shane with JP Morgan.

Hey, guys. Thanks for taking my questions. Mark really covered what I wanted to talk about in terms of reserves, but I'd just like to follow up on that slightly. The observation was made that your reserve rate is about two points higher than it would have been on day one. Day one was essentially an ideal economic environment, low unemployment, steady growth, et cetera. Should we look at day one as a destination for where the reserve rate will go or more as a channel marker in terms of sort of an ideal operating environment?

Yeah, good question. So, you know, the short answer is that it depends on the economic outlook. and the portfolio performance. I would say to give a kind of view on the marker, you know, when we look at the reserve rate back in, call it January 1, we're at just over 6%. We're at just over 8% now. That difference is about $1.7 billion of reserves on the current loan book. So if If we have a level of confidence in the economic environment, portfolio continues to be positive. And the work we've done on analytics drive, I'll say, positive credit performance. You know, there is an expectation in a benign environment that we should march back that way. Now, I think it's premature to say we'll get there. There's a lot of factors that could change, but I look at that day one as a marker for a solid credit environment and, you know, a relatively strong performing credit book.

Great. Okay. That's very helpful. Thank you, guys.

Your next question comes from Bill Carcacci with Wolf Research.

Thanks. Good morning, Roger and John.

Good morning.

Thank you, Bill.

Can you guys help square the continued strength in customer acquisition that you expect on one hand with payment rates remaining low for an extended period on the other? You mentioned, I think, John, the end of the pandemic-related federal forbearance programs this summer as a catalyst for payment rate normalization. But why do you think payment rates will remain elevated after that support has ended?

Yeah, I'll start it, and then maybe Roger will add a couple points on the back end. So, you know, certainly if you look at, frankly, the projected GDP, that's above normal levels for a strong U.S. economy, and that's as a result of, frankly, all of the activity and the transfer payments I talked about earlier. I think there's a natural – I'll say transition from where we are today to something that approaches historical norms. The savings rate is still high, but it's falling. And so that's positive. And in terms of overall sales activity versus payment rates, we do expect the sales levels at some point to moderate. you know, partly because of year-over-year comps and partly because of what's happening on economic activity. But with that said, I would expect that payment rate, there's a bit of an inverse relationship. And what we're seeing from a growth standpoint is the sales activity, the new account acquisition, the payment rate is a bit of a headwind. and then that revolve transactor rate aligning to payment rate. But despite all that, we've been able to grow from first quarter to second quarter. So as that payment rate moderates a bit, sales activity, I think, will be a lag to that and we'll be well-positioned to grow in the fourth quarter of the year.

Okay, that's helpful. Thank you. If I may follow up on that. As we look out to next year, would you expect that process of, you know, that you've described as sort of this payment rate and revolve rate normalization, should that provide an incremental tailwind to loan growth such that we could actually see your loan growth start to outpace your spending growth?

You know, 2022 is still – about six months away, five to six months away. So, you know, we're working on it right now. I'll tell you this, I'm positive in terms of how the business is positioned and what we can expect from a top-line standpoint as well as, you know, credit and expense. So those factors I feel very good about, but to get into level specificity at this point is probably a bit early.

Your next question is from Ming Zhao with Deutsche Bank.

Hi, guys. Good morning. Thanks for taking my questions. I wanted to ask about student loans. You know, as we head into the third quarter, it's probably the first time in over a year that probably many college students are on campus. I guess, are you doing anything differently in terms of how you're approaching the start of this particular school year? And, you know, sort of, is it fair to say that, you know, marketing to students is going to be a large piece of that accelerating marketing spend that you guys have commented on?

You know, the third quarter is peak season for student loans, but, you know, all the marketing is done before they get to campus. Volume was suppressed last year because for many of our customers, we encouraged them to take federal student loans and then use our private student loans to top off. And if their expenses were lower because they're paying tuition but not paying housing and food, et cetera, that had an impact on our volume. On the other hand, we did benefit last year from a major competitor pulling out of the marketplace. So I would say we're optimistic with kids going back on campus that this will be a strong year for Originations and that we will continue to gain market share in the student loan product.

Gotcha. Great. And then secondly, I think you mentioned growing confidence in the consumer. Quarter date, have you seen, I guess, a continued acceleration in that spending? I know we're roughly 22 days into the third quarter. And then secondly, Roger, I think you said spend trends are unsustainably high. I'm just curious if you had any further call as to when you expect that to sort of normalize.

I'll start with that one. You know, I think it'll take a while to normalize. There is a good amount of pent-up demand, but also pent-up liquidity in the form of the savings that have built up, as well as just the open-to-buy that people have on their cards from sort of month after month of a pretty high rate. payment rate so i think that'll provide some support on the other hand you know huge amount of uncertainty in terms of what will happen with the delta variant and and other factors that can drive the economy so you know we feel like we're well positioned but you know unclear what the back half of the year will bring. In terms of what we're seeing so far this month, I would say, you know, travel continues to be constructive, but overall, you know, not necessarily accelerating, but spend levels staying very strong.

Your next question is from Moshe Orenbuck with Credit Suisse.

Great, thanks. I guess getting back to the BNPL, is your primary kind of revenue or growth, you know, kind of opportunity in the sizzle on the lending side, is that the way we should think about it?

No. You should think about it on the payment segment. So transaction processing revenue and with payment processing and sort of connectivity to the merchant side. And so that's sort of our first entry into buy now, pay later has been more on the payment services segment as opposed to our direct banking side.

Gotcha. One of the things that you've talked about in the past about buy now, pay later is the question of whether it kind of encourages or discourages younger consumers from taking out a credit card. And I think you had said either on the last call or one of the presentations that because of the student lending brand of Discover that you haven't kind of seen that impact. Could you just talk a little bit about how you think about the value, I guess, of the student lending in terms of that marketing of the Discover brand?

Sure. You know, we are very successful in the student card business. I think the student loans help, but it also has to do with the product, the value proposition, and, you know, some very good marketing. And we see actually great credit performance from students because, you know, contrary to popular belief, a lot of them are very responsible in how they handle their cards. You know, with student loans, I'd start by saying we think it's a great business. It's profitable. I would say it is operationally complex. But it also, you know, gets our brand out there with parents as well as students when making a series of financial decisions. So, you know, there are not that many banks that are in it at scale, not that many, too, that have sort of the product set that we have to be able to leverage those relationships. So it's a key part of our banking strategy.

Got it. Just a quick follow-up on the reserving point. I guess I was sort of wondering if, you know, if your reserves on day one included an expectation of a potential of a recession somewhere in the life of those receivables, just as you think about it as we kind of enter 2022, would that be a lower probability, just given the experience that we've had, or is that how you think about it?

Yeah, so when... when we did day one we looked at um uh through the cycle view so so what essentially that means is we didn't look at the troth of delinquencies in charge us nor did we look at tricks so um to extremely oversimplify it a bit of averaging um with the help of a bunch of data scientists so you know that day one is a call it a normalized view of of a credit environment your next question comes from maher batia with bank of america hi uh thank you for taking my questions and good morning good morning i wanted to i

competitive intensity, and it certainly does feel like cash back cards has increased. I think you alluded to intensity being a little higher than maybe the average. So maybe just talk a little bit more about the dimensions of this competition. Is it spilling over beyond just higher direct rewards like the 1.5% or 2% rewards? Are you seeing any irrational signing bonuses, introductory offers, spend $5,000 in three months, get $100? Anything irrational? Are you seeing anything on the balance transfer side? How is Discover responding to this increased competition? of this elevated competition?

Yeah, so I'll start with the backup. The increase in marketing spend is driven really by the opportunity we see. So it is not by the competition. You know, I do expect the cost per account to be modestly higher than, say, 2019 levels. 2020 was extraordinarily good. But part of that has to do with just booking more new accounts, and the marginal ones tend to be more expensive. You know, I do think some of the rewards products out there will not be sustainable long term. You know, you've seen 2% cashback offers come and go for a very long time, especially when we eventually get to a higher rate environment. You know, so far, balance transfer demand is still a bit suppressed. So we're not seeing the overly long 24-month 0% offers. You are starting to see some of those high, you know, spend $4,000, get $400 type offers from some of the issuers that I think are most aggressive around growth. But, again, nothing that I would say we haven't seen before. You know, it tends to be different people at different times. But, you know, this is part of the card business and what we're used to competing against.

Great. Thank you. And then just wanted to ask about your debit product. Any update on that? Has that, you know, where are we? Has that been rolled out? Is there thoughts to expand the marketing or push behind it? Just any update on the debit product. Thank you.

Yeah. So, you know, given the excess deposits we had, we really pulled back on the vast majority of our deposit marketing, including that product. But we're very excited about the differentiation, you know, having cash back. So, you know, we think we're well positioned against the challenger banks as well as traditional banks. And so we'll continue to ramp it up, probably more so towards the back half of the year and as we get into 2022. Thank you. Stephanie, I think we have time for one last question.

Your last question comes from Betsy Grasick with Morgan Stanley.

Hi, thanks. So I just had two. One is on the marketing. I just wanted to make sure I understood what you meant by marketing expense anticipated return to 2019 levels. Are you saying that the back half of 21 will be at a run rate similar to full year 2019, or the back half of 21 is going to be similar to the quarterly run rate of 2019?

So think total year 21 to be similar to total year of 19. Yeah, OK. That would require in the back half.

Got it. Okay. And then just separately on credit, I know a huge debate in the group here is around payment rates and how we're anticipating them to traject over the course of the next year or so. One of the questions specifically for you is that, if I recall correctly, you've got a homeowner skew to your book, and home prices have clearly – accelerated significantly, 15%, 20%, depending on the location. I know you look at your customers routinely and check how they're doing financially. Are you seeing any signs of your customer base having refined and materially dropped their monthly mortgage payment requirements, which would potentially keep your payment rates elevated for longer, or how you think about this refi cycle and what it means for your customers and their financial health and how that translates to payment rate for you. Thanks.

Yeah, we have, and this cuts across past cycles, we haven't seen a link between sort of a refi boom and card payment rates. And so don't have any expectation that would happen this time.

Okay. Thank you.

I would now like to turn it back over to Eric Wasserstrom for closing remarks.

Well, thank you very much for joining us. If you have any additional questions, the IR team is available all day and, of course, whenever. So thanks again, and have a great day.

Thank you. This concludes today's conference call. You may now disconnect.