Discover Financial Services - Q1 2023

Transcript

Operator (participant)

Good morning. My name is Chelsea. 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 one 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.

Eric Wasserstrom (Head of Investor Relations)

Thank you, Chelsea. Good morning, everyone. Welcome to this morning's call. I'll begin on slide 2 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 Greene, 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'll 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.

Roger Hochschild (CEO)

Thanks, Eric, 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 includes 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 report 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. 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, and it builds upon recognition we received last year, ranking us among the best workplaces for parents and Fortune 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.

John Greene (CFO)

Thank you, Roger. Good morning, everyone. I'll start with our financial summary results on slide 4. 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 5. 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 card, 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 rates. 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 cost. 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 6. 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 7.

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 2 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 9. This quarter, we increased our allowance by $385 million, 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%. 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 5 quarters ending June 2024 and increased our common stock dividend by 17% to $0.70 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%. 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.

Operator (participant)

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

Sanjay Sakhrani (Managing Director)

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? Also just in terms of the narrowing of the range of the charge-offs this quarter, was that more because the unemployment rate hasn't necessarily panned out the way you expected it to, meaning it's coming in better?

John Greene (CFO)

Thanks, Sanjay. Yeah, I'll start with the reserve portion of the question and then swing over to the charge-off aspect. You know, as we mentioned, we run a number of different scenarios. We looked at unemployment ranges from 3.5 to north of 6%. We centered around a range between 4.5% to 5% for 2023, and then a slight improvement in 2024. That was essentially the driver of the increase in the reserve rate outside of the 10 basis points I talked about in my prepared remarks related to kind of transactors running off as they typically do in the first quarter. Hopefully that clarifies your question or clarifies any questions you have on reserves.

Related to charge-offs, 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 delinquency. 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 good look at six months forward, and then we move to more advanced models for anything beyond that.

As the first quarter passed, a great line of sight through September, and then, beyond September, you know, we've relied on our analytical models. That's essentially the reason why we're able to tighten the charge-off guidance from the upper end. You know, each quarter, we'll give an update on that certainly.

Sanjay Sakhrani (Managing Director)

Okay. Thank you.

Operator (participant)

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

Moshe Orenbuch (Managing Director)

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

Roger Hochschild (CEO)

I'll start. 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. 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. We feel really good about the new accounts we're booking, but also believe our credit policy is appropriate for the current environment.

Moshe Orenbuch (Managing Director)

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

John Greene (CFO)

Yeah. You know, as I, as I said in the prepared remarks, we've maintained the less than 10% guidance, although we're seeing a little bit of pressure on those lines I mentioned. 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, you know, positive account growth with an appropriate risk, tolerance

The other portion of that marketing spend will be to roll out the Cashback Debit program, which we anticipate to be rolled out late in the second quarter, maybe early in the third quarter. We're gonna put, you know, 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 build, continue to build our strong deposit franchise.

Operator (participant)

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

Bob Napoli (Partner and Senior Research Analyst)

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?

Roger Hochschild (CEO)

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%. March, it had dropped to 4%. Broad-based across all categories. You know, I think some of it is just a reduction in the pressures from inflation. Also you've got some tough comps in terms of last April, sales were up 22% year-over-year. You know, for us, the most important thing for the consumer is the strength of the job market, and that remains pretty robust. While we are tightening credit and continuing along that, you know, overall, the consumer is still holding up pretty well.

Bob Napoli (Partner and Senior Research Analyst)

Great. Thank you. Just, any more color on the Cashback Debit product and what you believe that will, I guess, do for you strategically? I mean, just any thoughts? I mean, 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.

Roger Hochschild (CEO)

No, that is, it's a product we're really excited about. You know, offering 1% cashback on debit transactions is virtually unique. It's something that no big bank can match. We take advantage of having a proprietary payments network. You know, 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. This is gonna be a critical initiative, not just for this year, but for many years to come. You know, part of our transition to being, you know, way more than credit cards, personal loans, student loans, home equity, but being the true leading digital bank.

Bob Napoli (Partner and Senior Research Analyst)

Thank you.

Operator (participant)

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

Rick Shane (Managing Director and Senior Equity Research Analyst)

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?

Roger Hochschild (CEO)

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. 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. You know, given that we're still focused on growth, I would say in general, the consumers are doing well. We have continued to tighten, and it's something we look at every account, every day across all of our different products.

Rick Shane (Managing Director and Senior Equity Research Analyst)

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

Roger Hochschild (CEO)

Yeah. 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, I can look at it a little less frequently. 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. Again, there are literally countless variables in some of our most complex machine learning models that are evaluating portfolio credit.

Rick Shane (Managing Director and Senior Equity Research Analyst)

Got it. Okay. Thank you very much.

Operator (participant)

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

Jeffrey Adelson (Executive Director)

Yeah. Hi, this is Jeffrey Adelson on for Betsy. 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, just wanted to understand maybe where you think Discover is gonna fit into that potential tightening regime. I know you're already doing some tightening, slowing account growth on your side. 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?

John Greene (CFO)

Yeah, thanks for the question, Jeff. You know, as we look at loan growth for 2023, we feel very positive and, you know, that's why we moved the loan growth range up a bit. 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 consumers. Within the portfolio itself, it would be payment rates, timing of payments. We'd 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 indications of delinquency and the rate of charge-off on a vintage basis. You know, as we look at things right now, you know, employment, I believe will continue to be strong, right? We have strong growth in the healthcare sector, manufacturing sector, defense, oil and gas, and onshoring of supply chain continues. My sense is that, you know, we're not gonna have any seismic changes to unemployment despite the Fed tightening action.

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, you know, collections and cash flows remain strong.

Jeffrey Adelson (Executive Director)

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

John Greene (CFO)

Oops. Hello, Jeff or operator? Is the line open?

Operator (participant)

Yes, his line is still open.

John Greene (CFO)

Okay.

Eric Wasserstrom (Head of Investor Relations)

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

John Greene (CFO)

Yeah. Why don't I'll take that briefly, and Jeff or Betsy Graseck, we can follow up separately in the afternoon if you'd like. In terms of investing in technology, 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. Third, around the network, making sure that our network continues to have, you know, leading edge or at a minimum market equivalent capabilities. 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.

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 that we keep capabilities advancing. Okay, thank you.

Operator (participant)

Thank you. Our next question will come from Dominick Gabriele with Oppenheimer. Your line is open.

Dominick Gabriele (Senior Analyst)

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. I think some of the fintech players are actually having some difficulty there. So I'd love to hear you talk about your checklist for opening an account. Is there a difference for KYC when you issue a debit card versus extending credit with a credit card? I just have a follow-up. Thanks so much, guys.

Roger Hochschild (CEO)

Yeah, great question. You know, AML, BSA, KYC is one element of compliance. There are many others that we focus on. 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 U.S., 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.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.

Dominick Gabriele (Senior Analyst)

Okay, thanks. Thank you very much. You know, I guess, kind of a double question here, 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?

John Greene (CFO)

Yeah.

Dominick Gabriele (Senior Analyst)

Thanks so much.

John Greene (CFO)

Yeah. Thanks, Dominic. Yeah, we have a process that we take great pains to make sure there's no disconnects between our outlook on kind of charge-offs over, call it a three-quarter or four-quarter period. The CECL reserves, which is life of loan losses, which would include charge-offs through the life of the relationship. 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. There's no chance of 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 are at play there. The first is, you know, we're talking about a three-quarter period of forecasting on the charge-offs. We gave a fairly wide range, which we intend to tighten as each quarter passes. 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. That's essentially a quick sketch of the process that we use.

Dominick Gabriele (Senior Analyst)

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

John Greene (CFO)

Thank you.

Operator (participant)

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

Nate Richmond (Research Analyst)

Hi, this is Nate Richmond 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 in underwriting, but just curious to see how the consumers are asking for loans now versus a year or two ago.

Roger Hochschild (CEO)

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. Even within our non-pre-approved channels, we tend to be targeted. You know, 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 credit.

Nate Richmond (Research Analyst)

I can hear it. 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 we were seeing pre-pandemic?

Roger Hochschild (CEO)

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

Nate Richmond (Research Analyst)

Great. Thank you.

Operator (participant)

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

Eric Wasserstrom (Head of Investor Relations)

Hey, Mark, I think your line's open. Hey, Chelsea, we'll come back to Mark he's offline.

Operator (participant)

Okay. Yes, sir. 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.

Eric Wasserstrom (Head of Investor Relations)

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.

Operator (participant)

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