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Discover Financial Services (DFS) David Nelms on Q1 2016 Results - Earnings Call Transcript

Discover Financial Services (NYSE:DFS)

Q1 2016 Results Earnings Conference Call


Bill Franklin - VP IR

David Nelms - Chairman and CEO

Mark Graf - CFO and EVP


Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

John Hecht - Jefferies LLC

Ryan Nash - Goldman Sachs

Henry Coffey - Sterne, Agee & Leach

Christopher Donat - Sandler O'Neill & Partners LP

Donald Fandetti - Citigroup Global Markets, Inc.

David Ho - Deutsche Bank Securities, Inc.

John Pancari - Evercore ISI

Bill Carcache - Nomura

Matthew Howlett - UBS

Moshe Orenbuch - Credit Suisse Securities

Richard Shane - JPMorgan Securities LLC

Bob Napoli - William Blair & Co. LLC

David Scharf - JMP Securities

Mark DeVries - Barclays Capital, Inc.


Good day, ladies and gentlemen, and welcome to the Discover Financial Services First Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to introduce your host for today's conference, Bill Franklin, Head of Investor Relations. You may begin your conference.

Bill Franklin

Thank you, Connor. Good afternoon, everyone. We appreciate all of you for joining us. Let me begin, as always, with slide two of our earnings presentation, which is in the Investor Relations section of Our discussion today contains certain forward-looking statements about the company's future financial performance and business prospects which are subject to risks and uncertainties and speak only as of today.

Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today's earnings press release, which was provided to the SEC today in an 8-K report and in our 10-K and 10-Qs, which are on our website and on file with the SEC.

In the first quarter 2016 earnings materials, we have provided information that compares and reconciles the company's non-GAAP financial measures with the GAAP financial information and we explain why these presentations are useful to management and investors. We urge you to review that information in conjunction with today's discussion.

Our call today will include formal remarks from David Nelms, our Chairman and Chief Executive Officer and Mark Graf, our Chief Financial Officer. After Mark completes his comments, there will be time for a question-and-answer session. During the Q&A period, it would be very helpful if you limit yourself to one question, so we can make sure that everyone is accommodated.

So, now it is my pleasure to turn the call over to David.

David Nelms

Thanks Bill, and welcome, all of you, to our call. For the first quarter, we delivered net income of $575 million, earnings per share of $1.35, and a return on equity of 21%. Our direct banking business continues to deliver solid results. Discover achieved total loan growth of 4% over the prior year, which now brings us into the lower end of our targeted range for 2016.

Specifically, we grew card receivables by 4%, accelerating year-over-year growth versus the fourth quarter. This receivables growth was the result of more new accounts and slightly higher customer spending and borrowing on cards, as our overall revolver mix for the portfolio increased.

Our brand, rewards and overall value proposition remained focused on the prime revolver segment, which we believe is the most profitable part of the card market.

Card sales grew by 4% over the prior year. Excluding the impact of gas prices, sales were up approximately 6%, which shows that the lower gas prices at the pump remain a drag on card sales. Also, I'll point out that leap year in the first quarter added roughly 1% to sales growth.

Last quarter, we were recognized as highest in customer loyalty in the annual Brand Keys' survey. This marks the 20th consecutive year that we've earned the top spot. I believe our focus on the customer has allowed us to have some of the lowest attrition rates in the industry and will continue to allow us to grow loans profitably.

Our other lending products are performing well. The organic student loan portfolio increased 15% and personal loans grew 9% over the prior year. The strong organic student loan growth was driven by disbursements related to students going back to school for the second semester and our continued focus on increasing awareness of Discover student loans.

On the funding side, I'm very pleased with the 6% sequential increase in direct-to-consumer deposits. Our consumer deposits grew approximately $2 billion and made up 45% of funding at the quarter end. We captured the growth as investments in marketing over the last several months delivered positive results, specifically in savings accounts and balances.

Moving to our payments business, total volume for the segment declined, as increases in network partners and Diner's Club volume were offset by year-over-year declines in debit volume at PULSE. We believe PULSE volumes will stabilize at approximately currently levels for the remainder of the year.

Lastly, in payments, we continue to leverage our proprietary network to deliver great returns in our card issuing business and are pleased with the increasing domestic and global acceptance. Overall, it was a good quarter and we're making progress against our key focus areas for the year.

Now, I'll turn the call over to Mark and he'll walk you through the details of our first quarter financial results.

Mark Graf

Thanks David, and good afternoon, everyone. I'll start by going through the revenue detail on slide five of our earnings presentation. Net interest income increased $121 million or 7% over the prior year, driven by continued loan growth and a higher net interest margin.

Total non-interest income decreased $68 million to $474 million. The prior year's results included $42 million in mortgage origination revenue, a category that is absent this year as we subsequently exited the business.

Net discount and interchange revenue was up 2%, driven by increased sales, partially offset by a higher rewards rate year-over-year. Our rewards rate for the quarter was 106 basis points, up four basis points over the prior year due to higher promotional and standard rewards. Sequentially, the rewards rate was down 12 basis points. The fourth quarter typically represents a seasonal high and also included the Apple Pay rewards bonus.

Protection products revenue declined $10 million, as new product sales remain suspended. Sequentially, protection products revenue was relatively flat; however, we continue to expect some runoff this year.

Moving to payment services, revenue decreased $6 million from the prior year, mainly due to the previously announced loss of volume from a third-party issuer. Overall, we grew total company net revenues by 2% for the quarter.

Turning to slide six, total loan yield of 11.69% was 32 basis points higher than the prior year, primarily driven by a 37 basis point increase in card yield. The year-over-year increase in yield was primarily due to a higher percentage of revolving card receivables in the portfolio, as well as the impact of the prime rate increase in December.

On the funding side, we grew average direct-to-consumer deposits 9% and we've completed two ABS deals year-to-date. Funding costs increased only eight basis points, partly as a result of fixed rate debt issuances in the last year muting the impact of rising rates.

Overall, net interest margin expanded 25 basis points from the prior year to 9.94%. We achieved good acceleration in card loan growth through stronger sales and an increased revolve rate, so we did not feel a need to increase our promotional mix during the quarter. However, looking forward, we may yet choose to invest some of this NIM benefit to drive continued loan growth.

Turning to slide seven, operating expenses were up $13 million over the prior year. Last year's results included $37 million in expense associated with the direct mortgage origination business, more than half of which was reflected in employee compensation.

The $14 million year-over-year increase in total employee compensation you see in the table was driven primarily by higher headcount to support compliance activities, as well as annual merit increases.

Marketing expenses decreased $20 million, due in part to the timing of card marketing, as well as the elimination of mortgage marketing activities. Professional fees increased $33 million to $160 million, as expenses associated with the AML/BSA look back project totaled approximately $30 million for the quarters.

We expect the look back project costs to be largely complete in the first half of this year. And finally, other expense was lower, as the prior year included a $20 million addition to the legal reserve.

This quarter, our total company efficiency ratio was about 40%. However, if you exclude the $30 million look back project expense I mentioned a moment ago, total company efficiency ratio was roughly 38.5%.

Turning to provision for loan losses and credit on slide eight, provision for loan losses was higher by $34 million compared to the prior year, due to higher reserves and charge-offs, primarily driven by loan growth.

This quarter we increased reserves $52 million, while last year we had a $30 million reserve build. The credit card net charge-off rate of 2.34% decreased by six basis points year-over-year and increased 16 basis points sequentially. The 30 plus day delinquency rate of 1.68% increased four basis points year-over-year and was down four basis points sequentially.

On balance, the credit backdrop continues to remain benign and reserving continues to be driven primarily by the compounding effect of several years of consistent loan growth, a meaningful portion of which has come from new accounts.

Moving to private student loans, the net charge-off rate, excluding acquired loans, decreased 18 basis points from the prior year, benefiting from the benign credit environment, as well as a couple of items that we've discussed in the past, specifically, more effective collection strategies, as well as the introduction of several new payment plans over the last year.

Student loan delinquencies, once again excluding acquired loans, increased 26 basis points to 1.92%, as a larger portion of the portfolio continues to come into repayment. Overall, the student loan portfolio continues to season generally in line with our expectations.

Switching to personal loans, the net charge-off rate was up 23 basis points from the prior year and the over 30 day delinquency rate was up 21 basis points to 97 basis points. The year-over-year increases in the personal loan charge-off and delinquency rates were primarily driven by the expected seasoning of recent loan growth.

Next, I'll touch on our capital position on slide nine. Our common equity Tier 1 capital ratio increased sequentially by 30 basis points to 14.2%, due to the seasonal decline in loan balances from the fourth quarter. This ratio declined 50 basis points from the prior year, due to capital deployment in the form of loan growth, buybacks, and dividends.

In the quarter, we again repurchased nearly 2% of our common stock. Lastly, while we did not recognize any material tax benefits this period, there will be a favorable resolution to an outstanding tax matter which will have the one-time effect of lowering the effective tax rate for the second quarter.

In summary, it feels like a good start to the year, with a strong margin and good loan growth and a continued benign credit environment. We expect to see provisioning driven by loan growth and will continue to work diligently to manage the core expense base as we absorb increasing regulatory and compliance costs.

That concludes our formal remarks. So, now I'll turn the call back to our operator, Connor, to open the line up for Q&A. Connor?

Question-and-Answer Session


[Operator Instructions]

Our first comes from the line of Sanjay Sakhrani from KBW.

Sanjay Sakhrani

Thank you. Good afternoon. Just had a question on the revolve rate. Was wondering if you could just talk about what drove that higher. Was it something that you guys were doing, or was it just a broader consumer trend? Obviously, kind of, in this market, people are jittery about the macro. Any comments on the macro would be helpful as well. Thank you.

Mark Graf

Sanjay, it's Mark, I'll let David pile on, as well, here, but I think the revolve rate was really driven by a continued focus on the revolver in our book. And I think, as we telegraphed on the last -- on the call last quarter, over the course of last year, we pulled back a number of activities that weren't driving the kinds of behavior that we wanted to see in the book and had refocused our efforts really along some of the more traditional areas where we had emphasized growth in the portfolio and that's paid very significant dividends over the course of the last quarter.

I would say it's paid dividends not only in the form of growth from balances from new accounts, but also growth in formerly dormant accounts that have reactivated also showed good contribution to growth in that regard.

David Nelms

And the only thing I would add is we have been talking about the continued impact of gas prices on sales and that has much less of an impact on loans and has the effect of helping the revolve rate a bit.

Sanjay Sakhrani

Okay. And any comments, David, on just the state of the consumer or on the macro?

David Nelms

I think it continues to be steady, but slow growth. And we're seeing sales continue to kind of bump along, increasing from last year. But the consumers are continuing to be cautious and that is -- that makes it tough on the sales line, but is certainly benefiting the credit line where the caution is showing up in continuing great credit results.

Sanjay Sakhrani

Okay, great. Thank you.


Our next question comes from the line of John Hecht with Jefferies. Your line is open.

John Hecht

Thanks very much, guys. Real quick, Mark, can you quantify the tax benefit in Q2 just so we have it for a model perspective?

Mark Graf

Yeah, I would say with respect to tax benefit, it relates to a matter that's disclosed in our SEC filings. It's the OID treatment of cashback bonus. It's for an extended period from 1999 to 2007, and it's a pretty complex matter over a number of years, so we are still in the process of putting a fine point on it.

I guess what I would say is on the tax line itself, it looks to be kind of a mid-8 figure kind of number in the quarter that we would indeed recognize. So I think that probably gives you a good triangulation for how to think about it.

John Hecht

Okay. Thanks very much. And then second question, you got a little bit better margin expansion than we expected from rising prime rate. Is all that priced in the portfolio, or is there some kind of residual upside as we stretch into the second quarter?

Mark Graf

No, I think it really relates to, we talked on the last call about a natural upward bias in the NIM in the book and that we thought it might lean more heavily into promotional activity. We didn't end up doing that, as it turned out, because we saw growth reaccelerating along the lines of what we hoping for from a cadence perspective.

So I think I would say, as you look forward over this year, I would kind of discourage you from flattening NIM out and just saying, this is where it will be for the rest of the year. I think there would be relative stability in NIM, but it could be affected by promotional activity, that revolving behavior Sanjay asked about a second ago, and obviously, any further moves the Fed makes, because of that positive bias in positioning.

John Hecht

Okay. Appreciate the details. Thanks very much.

Mark Graf

You bet.


Our next question comes from the line of Ryan Nash with Goldman Sachs. Your line is open.

Ryan Nash

Good afternoon, everyone. David, just following up on one of the questions that Sanjay asked about, could you maybe just talk about how the efforts to accelerate loan growth are going?

Last quarter, you laid out a handful of initiatives. I was wondering if you could share how they are going, maybe any other metrics you have, account openings, activations, to help us understand what the pipeline could look like for loan growth for the rest of the year.

David Nelms

Sure. Well, I think that the best indicator that our efforts are working in total is just to look at actual loan growth. And so we accelerated from just over 3% to about 4% year-over-year. And as you know, we had just established a new higher 4% to 6% full-year target, also for total loan growth, also for long-term, to be in that target.

So I'm pleased at all of our various actions have moved us into that lower end of the range, and we're certainly taking efforts to continue to move higher in that range, if we're able to, later this year.

And I'd say those efforts include, I mentioned more new accounts. We are continuing to look for places where we can appropriately increase credit lines or extend credit where we expect good and are achieving good results.

Also, some of our new features have been well received, whether it's some of our cash back, Freeze It, continued great take-up of free FICO scores. So I'd say that we have -- I don't think there's a single home run kind of initiative for loan growth, but a whole lot of singles that we are working on across the franchise.

Mark Graf

And Ryan, I' add on to that, just quickly, the loan growth continues to be close to 50/50 new accounts, as well as existing accounts, which is a really healthy way to see that loan growth coming in.

And if you look at the $2.2 billion in card receivables growth over the course of the last year, over 80% of that is coming in what I'll call the standard merchandise bucket, customers just simply using their cards, exhibiting the behaviors that drive the kind of long-term profitability we want to see out of the book.

Ryan Nash

Got it.

Mark Graf

So it feels very...