Discover Financial Services Q3 2022 Earnings Call Transcript

Quartr
Provided by Quartr
October 25, 2022

There are 18 speakers on the call.

Operator

Good morning. My name is Katie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter 2022 Discover Financial Services Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session.

Operator

Thank you. I will now turn the call over to Mr. Eric Wasserstrom, Head of Investor Relations. Please go ahead.

Speaker 1

Thank you, Katie, and good morning, everyone. Welcome to today'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.

Speaker 1

Please refer to our notices regarding forward looking statements that

Speaker 2

appear in our 3rd quarter's earnings release,

Speaker 1

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. Now it's my pleasure to turn the call over to Roger. Thanks, Eric, and thanks

Speaker 2

to our listeners for joining today's call. I'm very pleased with our results this quarter. Against a fluid macroeconomic backdrop, we generate strong financial performance while continuing to advance our strategic priorities. Let's start with a summary on Slide 3. For the Q3, we reported net income of $1,000,000,000 after tax or $3.54 per share.

Speaker 2

Over the past 3 months, as Fed policy has become more restrictive, that has made fears of a recession more acute. Against this backdrop, the key narratives of the 3rd quarter results are the strength of our balance sheet and the quality of our earnings. Our increase in revenues this year has been largely driven by our strong receivables growth with loans up 17% year over year. This growth was driven largely by elevated sales volume and the increased number of new accounts we've added since mid-twenty 21. We continue to use a through the cycle approach to underwriting, which considers all stages of the credit cycle including downturns.

Speaker 2

As part of our conservative credit management, we marginally tightened our new account underwriting criteria this quarter. Given these factors, we consider our growth to be consistent with current macroeconomic conditions. Naturally, discussion of our session elicits concerns about credit quality, but the credit performance of our loan portfolio at this stage does not suggest anything other than gradual normalization. Nonetheless, a late cycle environment requires a particular awareness of changing conditions and underscores the importance of our strong financial condition. We also continue to advance our strategic priorities.

Speaker 2

As a few examples, in August, we expanded our global presence with the signing of MoriCard, one of the largest issuers in South Korea. The extension of this relationship as well as the number of new network partnerships we've announced this year highlight our focus on expanding our international presence. And we continue to demonstrate the value of our network and our growing relationships with FinTech Partners. As an example, we announced in October that we will facilitate payments for Tidi's new healthcare vendor management system, which will digitize and streamline payments in an industry where legacy purchasing is still primarily manual. Finally, this summer, we announced the opening of our new Advanced Analytics Resource Center at our downtown Chicago location.

Speaker 2

The first cohort of 75 individuals, which we selected from over 1,000 applicants has already started and we intend to grow the program with cohort in 2023. This follows the grand opening of our customer care center in the Southside neighborhood of Chatham earlier this year and underscores our commitment to bring additional jobs to Chicago while supporting great customer experiences. I'll now turn the call over to John to review our results in more detail.

Speaker 3

Thank you, Roger, and good morning, everyone. I'll start with our financial summary results on Slide 4. There were 3 important trends in the quarter, strong asset growth, net interest margin expansion and modest credit normalization. The strength in asset growth combined with a NIM rate improvement increased revenue 8% sequentially and 25% year over year. Asset growth resulted in an increase in our reserves under CECL of $304,000,000 but our reserve coverage ratio declined slightly.

Speaker 3

So while our reported net income was down 8% year over year, Adjusting for the reserve change, our net income would have been 28% higher on a year over year basis. Let's review the details starting on Slide 5. Net interest income was up $438,000,000 year over year or 18%, driven by higher average receivables and improved net interest margin. We achieved a record high NIM rate of 11.05%, up 25 basis points from the prior year and 11 basis points sequentially. On both a year over year and sequential basis, the increase in net interest margin primarily reflects The higher prime rate, partially offset by higher funding costs and increased promotional and balance transfers.

Speaker 3

Receivable growth was driven by card, which increased 19% year over year reflecting continued strong sales and the contribution from new accounts growth last year and into this year. Sales growth was 15% in the period, a deceleration from the 20% growth we experienced in the first half of the year. As anticipated, the sales decline was partially mitigated by a decrease in the payment rate, which fell 70 basis points in the quarter. Nonetheless, it remains more than 400 basis points over 2019 levels. We expect payment rate to continue to decline through the back half of twenty twenty three, which should help support receivable growth.

Speaker 3

Turning to our non card products. Organic student loans increased 4% as a result of peak season originations. Personal loans were up 11%. The growth reflects our disciplined approach to marketing, underwriting and pricing of this product, which we believe has created an attractive competitive position for us in the market, particularly relative to some non bank originators. In terms of funding mix, our customer deposit balances were up 4% year over year and 2% sequentially.

Speaker 3

So far, deposit pricing has been in line with what we expected in a rising rate environment. As we mentioned last quarter, our strong asset growth has caused deposits to vary as a portion of our funding mix, but we continue to target 70% to 80% deposit funding over the medium term. We also issued $2,000,000,000 of card ABS fixed notes in the quarter and booked $5,000,000,000 of broker deposits. We maintain broad access to a variety of funding sources enabling us to confidently fund our asset growth. Looking at other revenue on Slide 6.

Speaker 3

Non interest income increased $264,000,000 or 71%. This was partially due to a $167,000,000 loss on our equity investments in the prior year quarter compared to a $4,000,000 loss this quarter. Adjusting for these, our non interest income was up 19%. This was driven by higher net discount and interchange revenue, which was up $47,000,000 or 16%, reflecting strong sales and favorable sales mix, partially offset by higher rewards costs. Similar to last quarter, We estimate that inflation contributed between 202.50 basis points of sales growth in the period.

Speaker 3

The strong sales also drove higher reward expense. Consistent with the prior quarter, our rewards rate increased 3 basis points year over year, driven by substantial growth in new accounts increasing the cost of our cash back program. Year to date, our rewards rate is up 2 basis points, consistent with our expectation of 2 to 4 basis points of annual reward rate inflation. Moving to expenses on Slide 7. Total operating expenses were up $198,000,000 17% year over year and up 13% from the prior quarter.

Speaker 3

Compensation costs were up primarily due increased headcount. Our servicing organization is a key component of our value proposition. We expect to grow this as our accounts and assets expand. This will contribute to an increase in salary and wages through the end of this year and into next year. Marketing expenses increased 66 $1,000,000 or 31 percent as we continue to invest for growth in our card and consumer banking products.

Speaker 3

We grew new card accounts by 22% from last year's Q3. Professional fees increased $43,000,000 or 22% as a result of investments in technology and increased consulting costs. We also had additional fraud costs in the consumer bank, driven by increased volumes as well as some legal expense elevating our other expense category in the quarter. Moving to credit performance on Slide 8. Total net charge offs were 1 0.71 percent or 25 basis points higher than the prior year, but down 9 basis points from the prior quarter.

Speaker 3

Total net charge off dollars were up $114,000,000 from the prior year and only up $10,000,000 sequentially. In the card portfolio, the net charge off rate of 1.92% was 27 basis points higher than the prior year and 9 basis points lower sequentially. Similar to our commentary from last quarter, we are not seeing evidence of emerging credit stress beyond normal expected normalization. Delinquencies among our lower prime segment have been normal normalized, but in the upper prime delinquencies and charge offs remain below pre pandemic level. This is consistent with our baseline expectation that credit will continue to normalize over the next several quarters absence a change in macro conditions.

Speaker 3

Turning to the discussion of our allowance on Slide 9. This past quarter, we increased our allowance by $304,000,000 due to higher receivable balances. Our reserve rate modestly declined to 6.7%. For us, changes to employment conditions pose the most significant risk to loss levels. As part of our reserving process, we have considered the prospects of higher unemployment among a range of macroeconomic scenarios and is reflected in our reserve balance.

Speaker 3

Looking at Slide 10. Our common equity Tier 1 for the period was 13.9%. The strong asset growth was a primary driver of the approximate 30 basis point decline from the prior period. Our long term target remains 10.5%. In terms of capital return, We declared a quarterly common dividend of $0.60 per share and repurchased $212,000,000 of common stock in the period before we decided to temporarily suspend our buyback activity.

Speaker 3

Including on Slide 11. As we look at the last quarter of the year, our prospects for 2022 remain favorable and we are once again improving elements of our expectations. We are revising our view on loan growth to high teens, continued strong sales, new account acquisitions through the Q3 and some recent improvements in the payment rates support our confidence in the outlook. In terms of NIM, we expect the full year to be mildly above the high end of our expected range with sequential margin improvement in the 4th quarter based on rate hikes that happened in late September. We are revising our expense outlook to be up high single digits versus the prior year, driven by increased marketing and compensation costs.

Speaker 3

In line with previous communications, we still expect marketing costs to come in above 2019 levels as we've discussed. We expect to add headcount, which will elevate salary and wages as well as benefit expense. Excluding these two categories, Expenses are expected to increase by low single digits. We now expect net charge offs to be between 1.8% and 1.9 for the full year driven by lower than expected credit losses through this point in the year. Our temporary pause on share repurchases remains in place, but we hope to resume share repurchases before year end.

Speaker 3

In summary, receivable growth accelerated as we continue to benefit from elevated sales, strong new account acquisitions and improvements in the payment rate. NIM continues to benefit from prime rate increases, Funding costs are consistent with expectation and credit performance is slowly normalizing, reflecting our disciplined approach to underwriting and credit management. These results demonstrate the resiliency of our integrated digital banking and payments model. Our earnings power coupled with our strong balance sheet and capital position keeps us well positioned for continued profitable growth through a range of economic conditions. With that, I'll turn the call back to our operator, Katie, to open the line for Q and A.

Operator

Thank you, sir. We'll take our first question from Ryan Nash with Goldman Sachs. Your line is now open.

Speaker 4

Hey, good morning, guys. Good morning. Good morning. So maybe to start on the net interest margin. John, you commented that it implies another Given the rate hikes that we saw at the end of the quarter, can you maybe just talk about where we go from here on the margin?

Speaker 4

I think last quarter you talked about it potentially peaking out. I'm just curious, do you think you could continue to hold the line around these levels and maybe what is incorporated within that in terms of deposit betas and the like?

Speaker 3

Great. Okay. Thanks for the question, Ryan. There's a lot there. So let me start with Just the fundamentals that we're seeing.

Speaker 3

So the liability side of the balance sheet is certainly subjected to increases in deposit funding costs as a result of competitive actions and in general needs across the market to attract some deposits. With that said, the 11% -plus we delivered in the 3rd quarter. We do expect some upside from that as a result of the Fed hikes in September. So certainly sequentially into the Q4, we'll see further improvement. Now Beyond the 3rd beyond excuse me, into the 4th quarter, we'll see improvement.

Speaker 3

Beyond the 4th quarter, At this point, we're going to reserve any commentary. But what I would say is, we don't expect any specific, seismic changes to net interest margins in 2023 based on the stability of our funding base and current access to multiple sources of funds.

Speaker 4

Got it. Thanks for the color. Roger, maybe one for you. You mentioned you guys are marginally tightening on account acquisition. Can you maybe just give additional color regarding some of the changes you're making to underwriting?

Speaker 4

And What do you think this might mean for growth over the intermediate term? Thanks.

Speaker 2

Sure. So I would start by saying in general, it remains a very good environment. We're seeing cost per account on the prime side below what we had last year. The value proposition is resonating well. For the new account space at the margin, we tightened some of those segments that will be most volatile in a downturn.

Speaker 2

So think the lower end of Prime and are ready to take further action on new accounts or the portfolio side. But again, I'd say overall a very good environment And that's part of why you're seeing such strong growth.

Speaker 5

Got it. Appreciate the color.

Operator

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

Speaker 6

Great. Thanks. I was hoping maybe you could talk a little bit of a different tack, maybe talk a little bit about competitive environment and what you're seeing from a credit standpoint and from a competitive marketing standpoint, kind of in your 2 installment loan businesses, both in The personal loan business and the student loan business and maybe talk about that and the outlook there for a moment.

Speaker 2

Yes. So it is hard, Marcia, to know what individual competitors are doing. I would say, in general, most of them are much broader spectrum lenders than we are. And so my guess is we'd be seeing some stress at the lower ends of their books. For us, a rising rate environment creates a lot of focus on debt consolidation, which is the primary use of our personal loans.

Speaker 2

So we're maintaining very disciplined credit criteria, but seeing strong originations in that segment.

Speaker 6

Got it. Thanks. It is interesting. I mean, I think we've seen that for others that are at the higher end of the credit spectrum where the stress you're talking about, we do see at the lower end. Follow-up question that I had is, you talked about the hoping to restart the buyback by year end or so, and a little bit growth kind of causing a 30 basis point downtick in your capital, but you're still well above.

Speaker 6

Just talk about, I guess, the appetite for that given and does the kind of macro environment figure into that, just talk about the appetite for the buyback once that restarts?

Speaker 3

Yes, sure. Moshe, I'll take that. So from an overall capital level. We are very well capitalized, right? So we're 13% approaching 14% on CET1.

Speaker 3

Our target is 10.5%. The credit book has been very, very stable. It's normalizing, but overall very, very stable. So the capital allocation priorities for the firm remain in place. So first is to invest in organic strong organic growth.

Speaker 3

2nd would be a return of capital. And then 3rd, perhaps a bolt on acquisition and if we're going to do that, it'll likely be in the payments segment. So Overall, those priorities didn't change. So the suspension remains in place, but we're hopeful that it'll resume buybacks So resume here in the 4th quarter.

Speaker 7

Okay. Thank you.

Operator

Thank you. Our next question will come from Sanjay Sakhrani with KBW. Your line is now open.

Speaker 8

Thanks. Good morning. John, I wanted to just walk through the expense guide increase. You mentioned this blend of marketing and comp, could you just parse apart what part is how much of each sort of contributed to the increase? And I'm just trying to put the marketing comments to slightly pulling back the credit box.

Speaker 8

And then as far as like the headcount increases. Was that related to the growth? I'm just trying to figure out what changed in terms of the comp costs.

Speaker 3

Yes. Happy to help with that Sanjay. So let me provide some context upfront here. So Year to date total expenses are up 7%. Comp expense is up 5% And excluding marketing, our expense base year to date is up 2%.

Speaker 3

So Actually, really, really what I'll say first half of the year and end of this quarter, some strong fundamentals. Now we did have a significant growth in the asset base, which of course means that there are accounts that we're going to have to service. And you might have seen a press release that came out that indicated we were hiring about 2,000 servicing agents through the balance of this year and into next year depending on the balance sheet and

Speaker 1

our

Speaker 3

customer value proposition and metrics. So overall, the strong growth and The strong acquisition has necessitated investments in our people. We'll continue to do that. We've also Made specific investments in information technology, specifically around resources, advanced analytics in order to further position us to be able to grow profitably and then also enhanced underwriting and customer targeting. So we believe all those investments make perfect sense for the long term.

Speaker 3

And what you're seeing here in the Q3 is a culmination of what I'll say is a tough comp as a result of some turnover last year. And then us coming on with backfilling resources, what I'll say is salary resources as well as the investments I talked about in terms of customer service. So hopefully that provides some context and color to your question.

Speaker 8

Okay. That's very helpful. And then I know we're trying to read between the lines in terms of the student loan servicing inquiry or investigation that's going on. But just to be clear, there's no change to how you guys are thinking about it relative Last quarter and as far as expenses are concerned, it seems like things are progressing as you expected it to and it's just a matter of timing. Is that a correct statement?

Speaker 3

Yes, that is a correct statement. So no change. Obviously, when we have some news to share, we're going to share it. The expense guidance we provided in the update reflect those items I discussed on your previous question and no specific changes related to expenses related to the buyback suspension.

Speaker 9

Okay, great. Thank you.

Operator

Our next question will come from John Hecht with Jefferies. Your line is now open.

Speaker 7

Good morning, guys. Actually, most of my questions have been asked, and I was going to ask one about marketing. But maybe since you addressed the spend patterns, maybe Can you talk about just because it's a topic that we haven't really talked about in detail recently, your perspective on rewards And the competitive environment around rewards and what that means for the intermediate term?

Speaker 2

Yes, sure. So a lot of the most Intense competition on rewards is in the super prime segment. And we've talked over the last year or 2 how we think some of

Speaker 5

those propositions issuers are putting out aren't necessarily

Speaker 2

sustainable in the long Issuers are putting out aren't necessarily sustainable in the long run. As John mentioned, our rewards Costs are moving up exactly as we forecast. We haven't felt the need to make any structural changes to our program. So as you can see from the growth in the new Our value proposition competes very well in that prime revolver segment. And so while the market is always competitive, We bring a differentiated value proposition that resonates well with consumers.

Speaker 7

Okay. And then second question is maybe thinking about like the 21 cohort and I know it's probably early for the 22 cohort, but What can you tell us in terms of how they're seasoning, utilization rates and kind of delinquency seasoning? Is there is it back to what it looked like in 2019 or is there something different that's worth pointing out with respect to more recent vintages?

Speaker 2

Yes. I would say more recent vintages are performing exactly in line with our expectations, right? I mean, every vintage got distorted during the pandemic. So you saw cut across the curves. But again, we feel very good about the performance.

Speaker 7

Okay. Thank you, guys.

Operator

Thank you. Our next Question will come from John Pancari with Evercore. Your line is now open.

Speaker 3

Good morning. Good morning. Good morning. On

Speaker 5

the efficiency ratio came in around 40% for the 3rd quarter. And just given the commentary that you gave around the investments that you're making and your expense expectations, Can you maybe help us think about how that could shape up for the Q4 and more importantly into 2023? How we could think about the trajectory

Speaker 2

there? Thanks.

Speaker 3

Yes. John, thanks for the question. So, what we said in the past and what We've told our board and what we're targeting is an efficiency ratio in the high-30s. And through this year, we've done a pretty good job in terms of Being able to deliver that. Certainly, the really strong growth and The great performance through the first half on expense on the expense base and then the 3rd quarter reflect some investments.

Speaker 3

And despite those investments, still below 40. We're going to continue to make investments where we see an opportunity to drive Great returns for our shareholders. And as we approach 2023, We are aware that the economic environment is a little tougher. We do feel like we have remaining tailwinds in terms of asset growth. And we do have investments we're going to continue to make.

Speaker 3

So I would say for 2023 specifically, we'll come out in January to give More specific details, but the overall commitments remain in place. Commitment to positive operating leverage and efficiency ratio south of 40 and expense discipline while investing for growth.

Speaker 5

Okay. Thank you. That's helpful. And then on the reserve front, just wanted to get your take on how you see that Projecting here, I know you allowed the reserve to bleed a bit in terms of the ratio this quarter. But now as You're seeing some of the normalization that you indicated and some of the pressure on delinquencies.

Speaker 5

How should we think about The reserve as you look here, particularly as you factor in the economic conditions and how you're looking at the how the economy, the impact on the economy plays out? Thanks.

Speaker 3

Yes. Great. Yes. Thanks for that question. So a little bit of context there.

Speaker 3

So we put on About $5,500,000,000 to $5,600,000,000 worth of assets in the quarter, Our reserves increased by $304,000,000 So, as we look at The portfolio and the macro environment, we're seeing the portfolio Continuing to be very, very stable, but normalizing. The macro environment indications of a recession are certainly increasing. Roger mentioned his comments about some mild in his comments about some mild tightening. So, in terms of expectation around reserves, we'll continue to take a look at The macros will run multiple scenarios and then make sure The balance sheet, the portfolio specifically continues to perform as anticipated and we'll make appropriate calls for reserves under GAAP. It's really tough to give any specific guidance on that, other than we're going to be mindful of the macros, Continue to watch the portfolio and that prime revolver targeting we do tends to add a high level stability.

Speaker 3

A matter of fact, one other point that may be useful, not specific to reserves, but rather charge offs. You have to go all the way back to the Q2 of 2011 to see charge offs that charge off rate It is north of 4%. So we're seeing great stability this year and we expect it to be stable next year

Speaker 10

as well.

Speaker 5

Got it. Okay. Thanks for taking my question.

Operator

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

Speaker 11

Hi, good morning.

Speaker 3

Good morning. Good morning.

Speaker 11

I just wanted to see if I could get you to unpack Your statement on no seismic changes in 2023, maybe we could speak a little bit about how you're thinking And I know you just detailed a little bit, but how you're thinking about how the loan yield should traject. I know in the slide deck you called out that The loan yield was driven by Prime obviously, but with partial offset from higher promotional mix and the timing of pricing changes. Could you help us understand how that works? How much the promo mix and the timing impacted loan yields? And how you're thinking about that trajecting as we continue to go through Fed rate hike period here.

Speaker 3

Okay. Yes. So there's a lot there. And as you know, It's fairly complex, Betsy, but I'll do my best to create some transparency here. So And let me start with the loan yield.

Speaker 3

So 80% of our book This floating rate of the asset side. So, as the Fed increases that Create the opportunity to move the contract rate up with the Fed changes. And correspondingly, if the Fed were to come down, The contract rate would come down. So what we're seeing there is in a rising rate environment, we still expect 3 to 5 basis points of yield improvement, so net interest margin yield improvement over a 12 month period. So we saw significant increases in September It looks like based on the forward curve, there's another maybe as much as 125 basis points of further Fed action this year and then next year depending on the economy, there could be a couple more or there'll be a pause.

Speaker 3

I don't think there will be much in the way of Fed rate reductions until maybe as late as 2024. So what that means is we're going to get the benefit from the Fed rate increases into the portfolio. We're seeing deposit pricing continue to go up. We haven't been a price leader on that. Certainly, we've been a follower to make sure we have a positive value proposition for our customer base.

Speaker 3

And then, the next question would be around betas and what do you think about betas? So I'm going to try to address that right now. So as there's greater disparity between our rates from a deposit standpoint and the brick and mortar banks. It creates plenty of opportunity for us to market into those customers and they'll find an attractive value proposition, which should help dampen the impact of further rate increases. So we do think the combination of the Fed increases, Us being able to manage the deposit book, but in a rising rate environment.

Speaker 3

Stability from a credit standpoint, but normalization, which will create a bit of incremental interest reversals impacting net interest margin.

Speaker 11

And then ultimately,

Speaker 3

the pricing decisions we're going to make, where we have that flexibility to make sure we're making good decisions for our customers and for our shareholders. So ultimately, it nets out that we expect relative stability over net interest margin through 2023.

Speaker 11

Okay, got it. No, I appreciate that. Thanks. My follow-up has to do with buyback discussion that we had earlier, and I know you mentioned that you're hopeful it can resume in 4Q. Would you expect to put out an 8 ks that indicates that you can now resume buybacks or would we hear about buybacks only after you'd started there's no obligation to put a notification into the market that you can resume.

Speaker 11

Thanks.

Speaker 3

Correct. There isn't an obligation, but we would likely put an 8 ks out.

Speaker 11

Okay. No obligation, but you would likely do it.

Speaker 7

Okay. Thanks.

Speaker 9

Yes.

Operator

Thank you. Our next question will come from Robert Napoli with William Blair. Your line is now open.

Speaker 12

Thank you and good morning. So just following up on, it's good to hear resuming the buybacks. I guess that would suggest that the review is behind you. But would you expect then to get your to go towards your 10.5% target capital ratio? And over what timeframe would you like to do that?

Speaker 12

Or what kind of a buffer do you want above that 10.5%?

Speaker 3

Yes. Hey, Bob, thanks for the question. I just want to be very specific about something you said. And our comments have consistently been here on this call that we hope to resume the buyback in the 4th quarter. We say that because we're hopeful, but there's ultimately, it'll be a decision that the board helps with.

Speaker 3

So in terms of The 10.5% target is, so we've been well north of that for quite some time. There's We have said that we want to step towards that. We intend to step towards that. So certainly the earnings power that the firms generated and the buybacks as well as dividends have impacted our ability to get there. So we're going to step towards that throughout 2023 2024.

Speaker 3

What we said previously is we hope to be around the 10.5% target sometime in 2024, 2025.

Speaker 12

Thank you. And the follow-up just on normalization of credit losses. As we think about normalized credit losses, looking back over history, Credit cards, high 3s, I guess, or mid-three percent to high 3 percent personal loans in the 4% range. Is that the way We should think is there anything that's changed? Should we continue to think about normalized credit losses in that kind of an area.

Speaker 3

Yes. So I would put 2 points out there. First, I would take a look at the historical trends and use that and make certain judgments. The other item here I'm going to say is a matter of judgment. But certainly, I have a belief Credit cards have increased in the payment priority Because folks can access the digital economy without a credit card, some folks with a debit card, but most specifically around the credit card.

Speaker 3

So that I believe helps prioritize the primary credit card among many other debt obligations that a consumer has. So could that impact the relative charge off rates versus the historical trend. My belief is yes, but your judgment is what I'd say You should apply when you're working through your forward looking outlooks.

Speaker 5

Thank you.

Operator

Our next question will come from Don Vendetti with Wells Fargo. Your line is now open.

Speaker 3

John, personal loan growth is pretty strong this quarter. Just wanted to get your thoughts on the outlook there and growth and also any updates on your home equity lending initiative. Yes. Thanks for the Question, Don. So certainly nice growth there.

Speaker 3

On the personal loan front, You go back in a few quarters and it was flat and we said it was flat to down actually if you go back 3, 4 quarters as a result of some underwriting decisions we took. We then we sent strength in the underwriting for that product And it's given us greater confidence to be able to market that product. And there's been a high level of appeal to it. So we'll continue to be mindful of the product in the face of a tougher economic condition. But certainly, we feel like it's a good product and it's meeting customer needs and that's helped drive the growth.

Speaker 3

In terms of kind of forward looking guidance, I'm not going to start to do that at a product level. All I would do is ensure that I was wrong more often. But if I go to the kind of The home equity loan, that portfolio is relatively small. So it's actually Not moving the dial at this point from an earnings standpoint, but what we've seen is a Great level of interest in the 2nd lien product and we're also originating that first lien product as well. So Both products performing well and nice appeal.

Speaker 7

Thanks.

Operator

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

Speaker 10

Good morning. Thank you for taking my question. Maybe I just wanted to start with, if you just take your guidance for NIM and loan growth And I think that works out about 4 point effectively works out of 4th quarter NIM of at least 11.2% and 3,000,000,000 plus NII. Is that the right way to think about it and frame the exit rate for NIM? And then should NIM NII just increase from there given loan growth and your comments about NIM stability.

Speaker 10

Am I thinking of that correctly?

Speaker 3

Yes. So, Maher, thanks for the question and I certainly appreciate The specificity, what I've said about NIM is probably as far as I'm going to go here on this call. We do expect sequential improvement as I said. Beyond that, it will be tough to give specific details.

Speaker 10

Okay. And then just wanted to ask about losses normalizing. I think previously you had talked about it being in 2H 2020 3 is when we get to a more normalized loss rate, but I think there was talk of that it could maybe push into even 2024 later. Any update on that? Thank you.

Speaker 3

Yes. So normalization through 2023 and then the macro environment will Make a term will help us determine whether it pushes 'twenty three into 'twenty four. But Where we're sitting today, we're very pleased with the portfolio performance. And the only surprises, Frankly, the pace of normalization on the upper end is a little slower than we expected, which to help drive the improved guidance that we gave on the charge off rate.

Speaker 7

Thank you.

Operator

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

Speaker 13

Thanks everyone for taking my question. Look, your customer base really represents a great sample of the domestic population. I'm curious when you look at spending on a category level basis, If there's anything that you're seeing that is a cause for concern, not asking are people spending more of the pump, that's obvious, with the inflationary pressures. But are there categories where you're seeing people use their cards that are signals for something we should be thinking about?

Speaker 2

Yes, great question. So our base probably does skew a little upward, so more in the prime. But we're seeing continued strength in sales in October. So I'd say year over year in the low teens, Some of the trends you've heard about were picking up. So consumer durables softening in terms of year over year.

Speaker 2

But again, our households, by and large, they have the liquidity to absorb inflation. It causes some pain and they will switch categories. We'll downgrade within a category. But I would say travel is coming off some of the very, very strong growth we saw over the summer. A little less strength in travel and consumer durables are probably the key trend.

Speaker 13

Got it. Thank you very much.

Operator

Thank you. Our next question will come from Bill Carcache with Wolfe Research. Your line is now open.

Speaker 14

Thank you. Good morning, Roger and John.

Speaker 7

Good morning. You mentioned

Speaker 14

That operating conditions are consistent with late cycle expansion. Historically, Fed hiking cycles have typically ended in slowing loan growth, but You're already exceptionally strong. Loan growth seems to be accelerating and certainly the whole industry is enjoying strong growth. Can you share any thoughts around how you'd The late cycle expansion to end and I'll just layer in my follow-up now. And if you can give any commentary around what level of Unemployment is implicit in your reserve rate and what a change in unemployment would mean for the reserve rate that would be very helpful.

Speaker 2

Yes. So, great question. So, I mean, in terms of late cycle, I think back pre pandemic, we talked about it being late cycle for a couple of years and then it ended in a way that I think no one expected. And so that's part of why we tend to use a through the cycle loss rate and look to be disciplined in our credit management. So while I would agree, it's not a time for it to be widening credit.

Speaker 2

We're seeing a lot of benefits from the investments in Advanced Analytics, in particular around the personal loan product And on the card side, where the growth we're achieving the growth while swapping in and swapping out different populations and again with a policy that I think is appropriate for late cycle. And it builds on some of the really strong new account production we had in 2021 as those accounts mature. So, again, we'll continue to look at it both in terms of our portfolio actions as well as new account originations across all of our products. But we feel good about the credit approach And just the traction our products are getting in the marketplace. And I'll pass it to John for part 2.

Speaker 3

Yes. Hey, Bill. And in terms of kind of fundamental assumptions for kind of reserve setting, So as I said earlier, we used a number of different scenarios, which included kind of non recession scenario as well as recessionary scenario. The recessionary scenario that we modeled, we certainly didn't wait as As much as the non recession and also the view in terms of the unemployment rate. There's pretty wide range right now, right?

Speaker 3

So some forecasted going north of 6 percent in a very, what I'll say, a dark scenario. The more optimistic scenario is 4%. And so we looked at complete range of scenarios and weighted it more towards stability with increasing unemployment. GDP, not as big a driver, but certainly an indication for The economy today, we're at about 1% and in 2023 In a recessionary scenario, there would be mild contraction, not deep contraction. So, we think overall, There will be general stability despite a tougher macro.

Speaker 10

Thank you.

Operator

Thank you. Our next question comes from Kevin Barker with Piper Sandler. Your line is now open.

Speaker 9

Thank you. Thank you. Concerning the comments Regarding unemployment rate, maybe some slight tightening on underwriting. That being said, are you seeing Any minor shifts in consumer spending or payment patterns that may indicate certain pockets of stress, Whether it's the lower end of prime or other parts, or maybe even certain vintages, of customers that are on your books?

Speaker 2

Yes. I mean, all the vintages are performing well. As John said, I think we're seeing the normalization to occur faster and pretty close to fully normalized for the lower end of Prime. While the payment rate has softened a bit and come down by about 70 basis points. It remains 400 basis points higher than 2019 levels.

Speaker 2

And so I think that speaks to the fact that there's still very strong employment market out there. People can find jobs, can find extra hours. And so good amount of liquidity that is supporting the debt burden for our segment.

Speaker 9

Okay. And then I know it's a fluid situation, but the student debt repayment is supposed to restart here Maybe early next year, who knows, given what's happening with the fighting in the courts. But do you expect any incremental impact to credit with a lot of student debt payments. Obviously, there's the forgiveness is obviously a credit positive, But is there something that you could see as a potential headwind as student debt repayments restart here potentially in January?

Speaker 2

Not necessarily. We've watched it closely. I mean, I think we have experienced an elevated payment rate, which has a dampening impact on loan growth as students have put more of their payments towards their private student loans. But we don't see anything that would have a significant impact on credit.

Speaker 9

Okay. Thank you for taking my questions.

Operator

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

Speaker 15

Yes, thanks. How should we think about how you manage expense discipline if we start to see Some revenue and credit weakness if the economy softens here.

Speaker 3

Yes. I would just simply say that we will take a look at the opportunities we have in front of us and we'll make what I hope will be great long term decisions for our shareholders. And we're going to Be very, very mindful around discretionary spending and around employment decision. So overall, we hope we're good stewards of the company.

Speaker 15

Okay. Got it. And then just given where the rewards cost has trended so far this year in the guidance, I think you said it was 2 basis points, but guidance is 2 to 4. Is it right to assume that 4Q is a relatively big quarter for expenses. Maybe you've got more of the 5% categories this quarter.

Speaker 3

Yes. I wouldn't necessarily assume that. What the point of the guidance between 24 is that's what we had said previously still within the range and we wanted to keep it within the range. So that 2% to 4% is something that We've seen historically and to an extent managed to and we'll continue to do that. I wouldn't lean on any particular information to assume the 4th quarter is going to be extraordinarily high or low.

Speaker 15

Okay. Got it. Thank you.

Operator

Thank you. Our next question will come from Bill Ryan with Seaport Research Partners. Your line is now open.

Speaker 16

Thanks. Good morning. And a couple of quick questions. Just following up on the personal loans business. Historically, it's been heavily focused on your credit card base.

Speaker 16

And I was just wondering if that's still the case. And you also had I'd say very, very strong credit checks in that business, paying off creditors directly. Has anything changed there as well?

Speaker 2

No. So I would say it's pretty balanced in terms of cross sold to the card base versus broad market. Probably the biggest change has been just the continued advancement in analytics and the underwriting approach there, But very, very conservative. So a lot of employment verification, etcetera, heavily manual processes just to make sure we get it right because as opposed to the card business where you can manage credit as you go, you get one shot in personal loans. But again, I would say that The performance remains very, very strong there and it's a lot of it thanks to that disciplined approach.

Speaker 16

Okay. And just one follow-up on the promotional balances that's kind of been brought up on the card book for the last several quarters. Is it still increasing as a percentage of the overall card portfolio? Or is it kind of stabilized? And maybe give us some historical perspective of where it stands to recent history.

Speaker 16

Thanks.

Speaker 3

Yes. Thanks. It's stabilized In the Q3, basically, approach stabilization into the second quarter And it's very close to where it has been historically.

Speaker 16

Okay. Thanks for taking my questions.

Speaker 10

You're welcome.

Operator

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

Speaker 17

Hey, thanks so much for taking my questions. Throughout the call and throughout other calls, you've kind of laid out your playbook and pieces, in particular, on the credit side for a slowing economy. But maybe, Roger, you can just provide us with a more holistic idea of what Discover would change across various pieces of the businesses to protect profitability in a tougher economic environment. And then I just have

Speaker 10

a follow-up. Thank you.

Speaker 2

Yes. I'd start by saying we don't necessarily optimize on protecting profitability on a quarter by quarter basis. We focus on sort of delivering long term value to the shareholders. And I think as I've been in this business a while, people who just totally got marketing in a downturn, miss out on what usually turn out to be some of the most profitable vintages. And so Yes, you cut marketing mainly because as you tighten the credit box, there are fewer and fewer people to market to.

Speaker 2

But We try and operate our company almost like we're always in a recession, always be conservative on credit, always be tight on expenses. There's more you can do, especially around discretionary items. But that ability to Keep momentum through a downturn has really distinguished us in previous cycles and we would try and do that again.

Speaker 17

Okay, great. Thank you. And I think it'd be really helpful to understand what both of your views are On the normalization of the personal loan portfolio net charge offs versus the credit card portfolio, Consensus has just such a huge ramp on the personal loan side versus credit cards for 2023 and Not looking for specific guidance, but is there any reason why there would be such a difference in faster normalization on the personal loan side versus credit card as far as basis point movements as a percentage of loans. Thanks so much guys.

Speaker 2

Yes. I mean we haven't put out product by product guidance, But I would say that given how we underwrite the personal loans, I'm not sure why Our portfolio would jump much faster than the card book. In general, we have a higher FICO for the personal loans business. They do tend to be a little more volatile than card in recession, but I wouldn't that isn't necessarily behavior I would expect.

Speaker 17

Great. Thanks so much.

Speaker 1

All right. Well, thank you everyone for joining us and thank you, Katie. And if there's any additional follow ups, Please reach out to the IR team. We'll be here and looking forward to speaking with you. Thanks and have a great day.

Speaker 1

Thank you.

Operator

Thank you. Ladies and gentlemen, this concludes today's event. You may now disconnect.

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Earnings Conference Call
Discover Financial Services Q3 2022
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