Discover Financial Services

Good morning. My name is Chelsea, and I will be your conference operator today. At this time, I would like to welcome everyone to the first quarter 2023 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. Sir, please go ahead.

Thank you, Chelsea, 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 our first 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 to the queue. Now it's my pleasure to turn the call over to Roger.

Thanks, Eric, and thanks to our listeners for joining today's call. I'll begin by commenting on some of the recent events in the banking industry, review our highlights for the quarter, and then John will take you through the details of our first quarter results and our updated perspectives on 2023. This past quarter included the failure of two large banks, an event that catalyzed more widespread stress in some segments of the banking system and raised questions about the funding models and embedded portfolio losses of multiple banks. In contrast, our strong results underscore how our model, with its diversified funding, trusted brand, focus on prime consumer lending, and conservative risk management, positions us to succeed through a range of operating conditions. I want to call out a few results in particular that highlight our performance in this challenging environment. We reported first quarter net income of $1 billion, or $3.58 per share. We had an all-time record quarter in terms of consumer deposit inflows, leveraging our award-winning digital experience and our leading customer service. And we're improving key elements of our guidance. As we look to the remainder of 2023, we may adjust our outlook as conditions evolve. We believe there is the potential for more stringent regulation. We believe we're well-positioned for more rigorous regulatory capital and liquidity requirements, given our strong internal standards. And we also continue to focus on enhancing our compliance management systems. This past quarter also included an important milestone with respect to our investment in human capital. We're honored to have been recognized as one of Fortune's 100 best companies to work for in 2023. This is the first time we've earned this distinction. It builds upon recognition we received last year, ranking us among the best workplaces for parents and Fortune's best workplaces for women. In conclusion, we believe our earnings power, balance sheet strength, investments in people, and advancements in capabilities support our strategy of becoming the leading consumer digital bank. I'll now turn the call over to John to review our results in more detail.

Thank you, Roger, and good morning, everyone. I'll start with our financial summary results on slide four. Our performance this quarter was characterized by strong revenue growth, continued credit normalization, a slight change to our outlook on the macroeconomic environment resulting in a reserve increase, and a year-over-year increase in expenses. Let's review the details starting on slide five. Net interest income was up $653 million year-over-year, or 26%. Our net interest margin continued to expand benefiting from higher prime rates partially offset by higher funding costs and increased promotional balances. NIM ended the quarter at 11.34%, up 49 basis points from the prior year and seven basis points sequentially. Receivable growth was driven by CAR, which increased 22% year over year, reflecting stable sales growth, modest new account growth, and payment rate moderation. Sales increased 9% in the period, slightly higher than the 8% growth we experienced in the prior quarter, and down from the 16% growth we experienced in 2022. Sales growth so far in April is a modest 2.5%, but this is coming off a very high comp of 22% in April of last year. New card account growth decelerated, reflecting the tightening of underwriting standards over the past several months, but grew by 3% from the prior year. The impact of slowing sales growth on receivable expansion was offset by decreases in payment rates. The card payment rate decreased 80 basis points in the quarter and is currently slightly over 200 basis points above the pre-pandemic level. Turning to our non-card products, personal loans were up 21% driven by higher originations over the past year and lower payment rates. we continue to experience strong consumer demand while staying disciplined in our underwriting of this product. Organic student loan receivables grew by 3%, largely driven by a reduction in the payment rate. In terms of funding mix, consumer deposit balances were up 17% year over year and 7% sequentially. As Roger highlighted, we achieved record quarterly deposit growth, deposits now make up 66% of our total funding mix with over 90% insured. And we continue to target 70% to 80% deposit funding over the medium term. Outside of deposits, our funding channels remain open and at attractive costs. As an example, in early April, we issued $1.25 billion of card ABS fixed rate notes. This offering was upsized, and our spread was nine basis points tighter than our November securitization. Additionally, we recently received a ratings upgrade by Moody's for our bank subsidiary and our banking holding company. Moody's cited a number of reasons to support this upgrade, including our prudent underwriting, conservative risk management, and resiliency in an economic downturn. Looking at other revenue on slide six, Non-interest income increased $198 million, or 47%. This was partially due to a $162 million loss on our equity investments in the prior year quarter compared to an $18 million loss this quarter. Adjusting for these, our non-interest income was up 9%, primarily driven by loan fee income and higher net discount and interchange revenue. Moving to expenses on slide seven. Total operating expenses were up $253 million, or 22% year-over-year, and down 7% from the prior quarter. Compensation costs were up primarily due to increased headcount and wage inflation. Marketing expenses increased $49 million at 26% as we continued to prudently invest for growth in our card and consumer banking products. Professional fees increased $55 million, or 31%, driven by investments in technology and increases in consulting activities that support our consumer compliance initiatives. Even with these increases, our efficiency ratio was 37%, and we generated about 700 basis points of operating leverage in the period. Moving to credit performance on slide 8. Total net charge-offs were 2.72%, 111 basis points higher than the prior year and up 59 basis points from the prior quarter. In the card portfolio, the net charge-off rate of 3.1% was 126 basis points higher than the prior year and 73 basis points higher sequentially. Consistent with our commentary back in January, We expect the seasoning of new account vintages from the past two years and normalization of older vintages to a more typical loss rate. These trends remain consistent with our expectations. Turning to the discussion of our allowance on slide nine. This quarter, we increased our allowance by $385 million and our reserve rate increased by 25 basis points to 6.8%. This increase in reserve rate was driven by two factors. About 10 basis points reflects the runoff of seasonal transactor balances that we typically experience in the fourth quarter. The remaining portion was largely driven by deterioration in our expectations of the macroeconomic environment. We increased our expectations for the 2023 year-end employment rate to the midpoint of our 4.5 to 5% range. This change reflects the potential for a reduction in lending impacting economic growth. We will continue to monitor the macroeconomic conditions and make adjustments to our expectations. Looking at slide 10, our common equity Tier 1 for the period was 12.3%, and we repurchased $1.2 billion of common stock during the quarter. The net unrealized loss on our AFS securities portfolio at the end of the quarter was $45 million. The impact on our regulatory capital if our OCI opt-out were not allowed would have been about 20 basis points. Our capital position remains robust and well ahead of regulatory requirements. We continue to prioritize investment in strong organic growth and returning excess capitals to shareholders. Included in our press release was the announcement that our Board of Directors approved a new $2.7 billion share repurchase program for the five quarters ending June 2024, and increased our common stock dividend by 17% to 70 cents per share. Concluding on slide 11 with our outlook, following the strong first quarter performance, we are raising our expectations for loan growth this year to be low to mid-teens. There is no change to our NIM forecast. We are maintaining our guidance for operating expenses to be less than 10%. However, we do see risk of upward pressure on this from collection and customer service expense related to growth in our lending and deposit accounts and professional service support and continued investment in technology. We are targeting our expected range of net charge-offs to 3.5% to 3.8% based on our current delinquencies and roll rates. This represents a reduction to the top end of the range by 10 basis points. Finally, as mentioned, our board of directors approved a new share repurchase authorization. We have returned substantial excess capital over the past two years, and we anticipate moving towards a more standard cadence of share buybacks over the second half of this year. To conclude, our first quarter results have given us significant momentum into this year and we're well positioned to deliver on our financial objectives. With that, I'll turn the call back to our operator to open the line for Q&A.

Thank you. At this time, if you would like to ask a question, please press star 1 on your telephone keypad. If you wish to remove yourself from the queue, you may do so by pressing star 2. We remind you to please pick up your handset for optimal sound quality. And we'll take our first question from Sanjay Sakrini with KBW. Your line is open.

Thank you. Good morning. John, quick question on the reserve commentary you had. Just to be clear, I know you guys had a weighting of scenarios, and it sounds like the low end went from 4.5 to 4.75. When we average that out between all the scenarios, does that take you above the 5% unemployment rate assumption, or how should we think about that? And also, just in terms of the narrowing of the range of the charge-offs this quarter, is that more because the unemployment rate hasn't necessarily panned out the way you expected it to, meaning it's coming in better?

Yeah. Thanks, Sanjay. Yeah, I'll start with the reserve portion of the question and then swing over to the charge-off aspect. So, you know, as we mentioned, we run a number of different scenarios. So, we looked at unemployment ranges from 3.5% to north of 6%. We centered around a range between 4.5 and 5% for 2023, and then a slight improvement in 2024. And that was essentially the driver of the increase in the reserve rate outside of the 10 basis points I talked about in my preparatory remarks related to kind of transactors, running off as they typically do in the first quarter. So hopefully that clarifies your question or clarifies any questions you have on reserves. Related to charge-offs, so there's a couple factors there. The first and what I would say is the most important is that the portfolio is performing almost exactly as we expected it to in terms of charge off roll rates and delinquencies. So we're generally pleased with that. As each month and quarter goes by, we have better line of sight to what we expect the total year to be. Our internal kind of roll rate models basically can take a very, very good look at six months forward And then we moved to more advanced models for anything beyond that. So as the first quarter passed, a great line of sight through September. And then beyond September, we've relied on our analytical models. So that's essentially the reason why we were able to tighten the charge-off guidance from the upper end. And each quarter, we'll give an update on that, certainly.

Okay. Thank you.

Thank you. Our next question will come from Moshe Orenbuck with Credit Suisse. Your line is open.

Great. Thanks. I guess, first, you talked about a kind of slowing of new account growth. Could you kind of, Roger, perhaps drill down a little more into the drivers, I guess, in terms of what you're seeing either in the competitive environment or in the consumer kind of credit environment?

Yeah, so I'll start with the credit. The competitive environment remains robust, right? Most of our key competitors in the card business are the larger money center banks, well-capitalized, a lot of deposits. So, you know, cards tends to always be competitive. I think what you're seeing are the results of some of the changes we've made in credit policy. We've talked about tightening at the margin. And then also some very tough comps over the growth we saw last year. So we feel really good about the new accounts we're booking, but also believe our credit policy is appropriate for the current environment.

Got it. And maybe, you know, can you talk, John, maybe talk a little bit more about the expense comment that you made, you know, how much of that would be tied to revenue growth and you know, if expenses were higher. Yeah.

So, you know, as I said in their prepared remarks, we maintain the less than 10% guidance, although we're seeing a little bit of pressure on those lines I mentioned. So in terms of marketing, what we said in January was that we expected marketing to be up double digits. We still expect that to be the case. despite the reduction in the rate of growth of new accounts, we are still seeing good opportunities to generate positive account growth with an appropriate risk tolerance. The other portion of that marketing spend will be to roll out the the cashback debit program, which we anticipate to be rolled out late in the second quarter, maybe early in the third quarter. So we're going to put some substantial dollars behind that to generate some activity, both new account generation as well as awareness of the product and the product features that we think will help help build, continue to build our strong deposit franchise.

All right, thank you. Our next question will come from Bob Napoli with William Blair. Your line is open.

Thank you, and good morning. The slowdown in spend growth that you called out in the month of April, I was wondering if you could give, I know it's tough comps, versus a year ago, but just any color on what you're seeing on that front and then any change in your view of the health of the consumer.

Yeah, so I would say that the slowdown is pretty broad-based and is really a continuation of the trend. If you look at the quarter itself, overall sales growth was a little over 9%. But March, it had dropped to 4%. So broad-based across all categories. I think some of it is just a reduction in the pressures from inflation. But also, you've got some tough comps in terms of last April, sales were up 22% year over year. For us, the most important thing for the consumer is the strength of the job market. and that remains pretty robust. So while we are tightening credit and continuing along that, you know, overall the consumer is still holding up pretty well.

Great. Thank you. Then just any more cover on the cashback debit product and what you believe that will, I guess, do for you strategically? Just any thoughts on, I know you guys have been doing a lot of work on it, over the years, and it seems like you're ready to really roll with it.

Yeah, it's a product we're really excited about. Offering 1% cash back on debit transactions is virtually unique. It's something that no big bank can match. We take advantage of having a proprietary payments network. And one of the outcomes from the pandemic is consumers, even for their primary checking or debit account, are a lot more comfortable dealing with a direct bank. So this is gonna be a critical initiative, not just for this year, but for many years to come. And part of our transition to being way more than credit cards, personal loans, student loans, home equity, but being the true leading digital bank.

Thank you.

Thank you. Our next question will come from Rick Shane with JP Morgan. Your line is open.

Thanks, everybody, for taking my question this morning. Roger, when you look at the credit outlook and, you know, you updated the NCO guidance, I'm curious about some of the puts and takes you see in terms of sort of the internals of numbers, whether it's roll rates, utilization, payment rates. What do you see out there that is the most constructive and what's the factor that gives you the most pause?

Yeah, you know, it varies for new accounts versus what we look for in our portfolio. For the portfolio side, you know, it's hard to pick an individual factor given the complexity of the models we use, but certainly overall levels of indebtedness, their behavior in terms of payments, the amount of payment, we even look at, you know, when a payment comes in during the month. So, you know, Given that we're still focused on growth, I would say in general, the consumers are doing well, but we have continued to tighten and it's something we look at every account, every day across all of our different products.

Got it. And is there one metric you might point to that kind of your, when you get your daily reports, you scan to right away to because it's a concern for you?

Yeah, so you may find this hard to believe, but there are very few numbers I look at on a daily basis. I'm lucky to have an amazing team, and so I can look at it a little less frequently. But you can't point to a single number. We have kind of a composite behavioral score that I see on a lot of our internal risk reporting. But again, there are literally countless variables in some of our most complex machine learning models that are evaluating portfolio credit.

Okay, thank you very much.

Thank you. Our next question will come from Betsy Gracek with Morgan Stanley. Your line is open.

Yeah, hi, this is Jeff Adelson on for Betsy. Good morning. John, just wanted to follow up on the comment about the potential for a reduction in lending impacting economic growth. I know that was more of a macro overlay comment, but Just wanted to understand maybe where you think Discover is going to fit into that potential tightening regime. I know you're already doing some tightening, slowing account growth on your side, but just wondering, do you see yourself at some point this year taking a more meaningful cut? Maybe what would cause you to revisit the loan growth that you're seeing today?

Yeah, thanks for the question, Jeff. You know, as we look at loan growth for 2023, we feel very, very positive. And, you know, that's why we moved the loan growth range up a bit. So in terms of the overall lending environment and what would trigger additional cuts, it would be meaningful changes to the unemployment outlook, meaningful changes in the number of job openings, and then further signs of stress within the consumer. So that would, within the portfolio itself, it would be payment rates, timing of payments. We take a look at flow rates from one bucket to another. So those would all be certainly signs as well as kind of the broader, broader indications of delinquency and and the rate of charge off on a vintage basis. But, you know, as we look at things right now, you know, employment, I believe, will continue to be strong, right? So we have strong growth in the healthcare sector, manufacturing sector, defense, oil and gas, and onshoring of supply chain continues. So my sense is that, you know, we're not going to have any seismic changes to unemployment despite the Fed tightening action. So that means that we'll continue to look at things around the margins and make good calls to ensure that the accounts we're putting on are profitable and the accounts that are in the portfolio that we have early warning triggers so that our customer service and collection folks can reach out to ensure that collections and cash flows remain strong.

Thank you. And one follow-up I just want to have on expenses and technology investment. There's been a lot of focus out there on AI and some advances in that technology. I know Discover has been pretty nimble in investing on its own in that space, but just wondering, is there anything

Oops.

Hello, Jeff or operator? Is the line open?

Yes, his line is still open. Okay.

Hey, Jeff, I think we missed the last little bit of your question, but I think it was essentially about the use of AI.

Yeah, so why don't I take that briefly, and Jeff or Betsy, we can follow up separately in the afternoon if you'd like. So in terms of investing in technology, so there's three, I'll call it three or four different strands. The first is to ensure we have leading edge capabilities, which would include machine learning, AI. Second is ensure that our core systems are robust and resilient. And third, around the network, making sure that our network continues to have you know, leading edge or at a minimum market equivalent capabilities. So those are the tiers and we continue to invest in those aspects as well as technology to support our overall compliance management system as we talked about in the prepared remarks. So overall, you know, it's an area of investment. You know, we're a digital institution. We need to continue to invest in technology to ensure we keep capabilities advancing. Okay, thank you.

Thank you. Our next question will come from Dominic Gabrielli with Oppenheimer. Your line is open.

Hey, thanks so much and good morning. I would imagine that Discover, given the prudence of the way you run your franchise, has really strong kyc and i think some of the fintech players are actually having some difficulty there and so i'd love to hear you talk about your checklist for opening an account and is there a difference for kyc when you issue a debit card versus extending credit with a credit card and i just have a follow-up thanks so much guys

yeah great question so you know aml bsa kyc is one element of of compliance there are many others that that we focus on you know first thing i'd say is our task might be a little easier just given that we don't handle much cash not having branches we don't have huge you know private net worth operations much outside the us but it is a key area of focus there's a pretty big overlap between what we're required to do from a KYC standpoint and actually what we do ourselves to tackle fraud. A huge amount of the new fraud attacks do come via identity theft. And while there are sort of nuanced differences by product, very, very similar in terms of what we do when someone's opening a new credit card account versus opening a checking or a debit account.

Okay, thanks. Thank you very much. And, you know, I guess kind of a double question here, but is, you know, how closely aligned is your CECL unemployment rate and thus reserve outlook correlated with your net charge off guidance? Is there a possibility that, I mean, you had mentioned before that you don't expect, you know, unemployment rate to rise very much. Is there a chance that there could be actually a disconnect between the CECL Reserve and company NCO Outlooks? Thank you so much.

Yeah, thanks, Dominic. So, yeah, we have a process that we take great pains to make sure there's no disconnects between our Outlook on kind of charge us over it. call it a three-quarter or four-quarter period. And the CECL reserves, which is life of loan losses, which would include charge-offs through the life of the relationship. And the modeling systems that we use are essentially the same. Same tools, same people kind of managing those, and a bunch of work to ensure that the organization, so each of the functions, credit and risk management systems and finance and accounting are on the same page in terms of what we're trying to accomplish here. So there's no chance to disconnect here at Discover. I will say that the difference in terms of the tightening of our charge off outlook in terms of updated guidance and what happened in the reserve has a couple factors that that are at play there the first is you know we're talking about a three three-quarter period of forecasting on the charge-offs and we gave a fairly wide range which we intend to tighten as each quarter passes on on the reserves You know, we take a number of different factors, including the macro environment, portfolio, and then there's certainly a level of management judgment that we use to ensure that we have an appropriate reserve under financial accounting standards. So that's essentially a quick sketch of the process that we use.

Excellent. Thanks so much for taking my questions. Have a good day. Thank you.

Thank you. Our next question will come from Mihir Bhatia with Bank of America. Your line is open.

Hi, this is Nate Richemont for Mihir Bhatia. Quick question for me. Are you seeing any changes to the credit quality for new applicants? I understand that you're tightening credit and underwriting, but just curious to see how the consumers are asking for loans now versus a year or two ago.

Yeah, I mean, it's a tricky question to answer because it varies by channel. You know, obviously, we do quite a lot of pre-approved marketing, so we kind of set the criteria who applies. And even within our non-pre-approved channels, we tend to be targeted. So, you know, I haven't seen, I would guess, a huge difference in terms of applicant profile, but our new account profile has tended to improve as we've tightened credits.

I can hear it. And then as a quick follow-up, can you just talk about the vintage performance? Like how are card loan vintages from like 2020 through 2022 performing versus the loans or pre-pandemic?

Yeah, I think, you know, in general, you know, John mentioned all of the vintages are performing as expected. And so, you know, total losses are still normalizing in line with, you know, what we forecast. So, you know, I would say continued performance strong performance across the board. And we haven't seen huge differences in behavior by vintage.

Great. Thank you.

Thank you. Our next question will come from Mark DeVries with Barclays. Your line is open.

Hey, Mark. I think your line is open.

Chelsea, we'll come back to Mark offline.

Okay. Yes, sir. And as of this moment, there are no further questions in the queue, so I would like to turn it back over to management for any additional or closing remarks.

Great. Well, if there are any additional questions, please reach out to us here at the IR team, and thanks very much. Have a great day.

Thank you, ladies and gentlemen. This does conclude today's conference, and we appreciate your participation. You may disconnect at any time.