Discover Financial Services (NYSE:DFS) Q3 2023 Earnings Call Transcript

Discover Financial Services (NYSE:DFS) Q3 2023 Earnings Call Transcript October 19, 2023

Operator: Good morning. My name is Chelsea, and I will be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter 2023 Discover Financial Services Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there’ll be a question-and-answer session. [Operator Instructions] Thank you. I will now turn the call over to Mr. Eric Wasserstrom, Head of Investor Relations. Please go ahead.

Eric Wasserstrom: Thank you, Chelsea, and welcome to this morning’s call. I’ll begin on Slide 2 of our earnings presentation, which you can find in the Financials 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 third quarter earnings press release and presentation. Our call today will include remarks from our Interim CEO, John Owen, 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 will be permitted to ask one question, followed by one follow-up question. After your follow-up question, please return to the queue. Now, it’s my pleasure to turn the call over to John.

John Owen: Thank you, Eric, and thanks to our listeners for joining today’s call. As I shared a few months ago, I have three priorities in my role as Interim CEO. First is, continue delivering a great customer experience at every touch point, which we do by providing our customers award-winning service and products. At the heart of this is, a team of more than 20,000 employees connected by common values and a shared mission to help people achieve a brighter financial future. Our second priority is to advance our culture of compliance. We have made significant strides in this area. By now, you’ve all had the opportunity to review the consent order issued by the FDIC in September. Consistent with the terms of this consent order, we have made meaningful investments in improving our corporate governance and enterprise risk management capabilities, and expect to drive further enhancements across the organization in the coming quarters.

We have also started the process of engaging with our merchant partners on the card misclassification issue, remain in active dialog with our regulators on this topic. The resolution of this issue is likely to be complex and we anticipate it will take several quarters fully resolve. Our third priority is to sustain our strong financial performance. In the third quarter, revenue was up 17% year-over-year, driven by strong asset growth. Our credit losses continued to perform in-line with expected ranges. In addition, we were off to a strong start with the launch of our Cashback Debit product. We continue to believe that this product will be an important channel to welcome many new customers into our company. To highlight the Discover experience and support our brand and banking products, we’re proud to have just introduced a new national advertising campaign featuring celebrity spokesperson, Jennifer Coolidge.

As we continue to advance our priorities, we are focused on preserving and enhancing the elements to make Discover a great place to work. Last month, we’re ranked among the 2023 Fortune Best Workplaces in Financial Services & Insurance. This accolade builds upon our recognition as one of Fortune 100’s Best Companies to Work For. Before handing the call off to John Greene, I’ll briefly comment on the CEO search. The Board is considering several excellent candidates both internal and external, remain confident that we will identify the next outstanding leader for this organization in the coming months. In summary, we continue to target excellence in all parts of our business, driving sustainable, long-term financial performance. I will now hand the call off to John to review our results in more detail.

John Greene: Thank you, John, and good morning, everyone. I’ll start with our financial summary results on Slide 4. In this quarter, we reported net income of $683 million, down from just over $1 billion in the prior-year quarter. Provision expense grew by $929 million, reflecting an increase in reserves and charge-offs. Strong loan growth, along with changing macroeconomic and household liquidity conditions drove the increase to our reserve balance. Charge-offs increased due to portfolio seasoning and remain in line with expectations. Revenue grew 17%, deposits grew 23%, and expenses increased 6% year-over-year. Further details are reflected on Slide 5. Net interest income was up $479 million year-over-year, or 17%. Our net interest margin ended the quarter at 10.95%, down 10 basis points from the prior year and down 11 basis points sequentially.

This decrease was driven by higher funding costs, which were partially offset by the benefits from higher prime rates. Receivable growth was robust. Card increased 16% year-over-year, reflecting new account growth and a lower payment rate versus the prior year. The payment rate declined about 30 basis points quarter-over-quarter, but remains just under 200 basis points above 2019 levels. Sales volume was relatively flat for the quarter. Personal loans were up 25%, driven by strength in originations over the past year and lower payment rates. We continue to experience strong consumer demand while staying disciplined in our underwriting. Student loans were up 1%. Deposit growth in the quarter was solid with average consumer deposits up 23% year-over-year and 4% sequentially.

Our direct-to-consumer balances grew $4 billion. Looking at other revenue on Slide 6. Non-interest income increased $97 million or 16%. This was primarily driven by higher transaction processing revenue from our PULSE business, an increase in loan fee income and strong net discount and interchange revenue. Moving to expenses on Slide 7. Total operating expenses were up $86 million or 6% year-over-year and up 4% from the prior quarter. This increase is driven primarily by investments in our compliance and risk management programs, and is reflected across several of our expense line items. Looking at our major expense categories, compensation costs were up $24 million, or 4%, primarily from increased headcount. The increase in information processing expense was driven by software licensing renewals, professional fees reflect an increase in third-party support as we focus on accelerating our compliance and risk management efforts.

Moving to credit performance on Slide 8. Total net charge-offs were 3.52%, 181 basis points higher than the prior year and up 30 basis points from the prior quarter. In card, we continue to see the effects of seasoning of newer accounts, which have higher delinquency rates than older vintages. Losses remained consistent with targeted ranges. These newer vintages support strong long-term profitability. Turning to the allowance for credit losses on Slide 9. This quarter, we increased our reserves by $601 million and our reserve rate increased by 22 basis points to just over 7%. The reserve increase reflects a modest deteriorating macroeconomic outlook, increasing delinquencies and higher loan balances. Our macro assumptions reflect a relatively strong labor market, but also consumer headwinds from declining savings rates and increasing debt burdens.

Looking at Slide 10. Our common equity Tier 1 for the period was 11.6%. The sequential decline of 10 basis points was driven largely by our strong organic asset growth. We declared a quarterly cash dividend of $0.70 per share of common stock. Concluding on Slide 11 with our outlook. We now expect our loan growth to be in the mid-teens, as declining payment rates are offsetting the impact of slowing sales. There is no change to our NIM expectations to be approximately 11% for the full year. We’re maintaining our expectations for operating expenses to be up low double digits. And there is no change to our expected range for net charge-offs to be between 3.4% and 3.6% for the year. In conclusion, our business fundamentals remain strong. We continue to generate solid financial results, while building out our compliance and risk management capabilities and prudently investing in actions that drive sustainable long-term performance.

With that, I’ll turn the call back to our operator to open the line for Q&A.

Operator: [Operator Instructions] And we’ll take our first question from Sanjay Sakhrani with KBW. Your line is open.

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Q&A Session

Sanjay Sakhrani: Thanks. Good morning. I just wanted to get a little bit more on the reserve build. As we look ahead, John Greene, can you just talk about like how we should think about that reserve rate increasing from here? Because, obviously, you made some adjustments, but you’ve said the credit numbers are performing pretty consistent with your expectations. So, is it a reflection on how you see things unfolding next year? Maybe you can just talk about the relation and how we should think about that reserve coverage on a go-forward basis, assuming the unemployment assumptions don’t change much.

John Greene: Yeah. Thanks, Sanjay. Appreciate the question. So, let me back up and just give a little bit of an overview in terms of what happened in the quarter and why we increased the reserve rate. So, as we took a look at the portfolio performance and the loan growth, obviously, we had to make a reserve build for loan growth and that represented about 50% of the $600 million. The other 50% or approximately $300 million reflected our view on the macros. Now, while the unemployment numbers remain relatively in line and strong by historical standards, we are seeing some indications of stress. And if we go back to the pandemic and the learnings there, we found that certainly unemployment remains an important factor in terms of reserves, but there’s other factors.

And what we’ve done over the past year is try to build into those other factors into our loss models and reserve models, and we’ve done that. So, as we took a look at household net worth and savings rate, both have deteriorated. And we’re seeing deterioration more specifically in lower FICO bands. So, we use those macro factors in order to capture loss content that we felt was appropriate from a reserving standpoint. So, as we look at reserve levels today and into the future, there’s a couple of things that I’ll say are just kind of general process items. First, it will be dependent on the macro views and whether they remain stable or deteriorating. Second, certainly, the portfolio performance will be a very, very important factor. And then, third will be the timing and trajectory of loss content.

So, as losses become closer in terms of our projection period, their probability adjusted and, therefore, could increase reserve rate. Now, there’s a lot of detail that I just provided. So, let me give a view of our expectations. So, first, the portfolio is performing generally well, although we are seeing mildly increased stress at the lower FICO bands to mid-FICO bands. We’re also seeing that 2022 vintage performed slightly worse than ’21, ’23 although highly profitable. So, as we look forward to ’24, we’ll run our process and adjust the reserve as we deem most appropriate. An important piece will also be the charge-off trajectory. So, what we’ve said previously is we expect charge-offs to peak sometime around the midpoint of the year to the second half of the year, if — second half of 2024.

So, if we don’t see a slowing in delinquency rates between now and first quarter, certainly that could be an indication that we’ll have to take incremental provisions. So, a lot there. Hopefully enough for you to be able to digest and move forward with.

Sanjay Sakhrani: Yeah. Thank you. That’s clear. And just under the banner of sort of regulatory stuff, question number one, it doesn’t seem like there is a whole lot to update in terms of other actions. We obviously got the consent order. And then, I saw in the perspective for 2023, you still have a pause for the capital management fees not any change to that. So, could you just give us a sense of sort of how to think about that unpausing of the share repurchase? I know John Owen mentioned it might take several quarters to resolve the merchant issue. So, just trying to reconcile these — those comments. Thanks.