Discover Financial Services (NYSE:DFS) Q4 2022 Earnings Call Transcript

Discover Financial Services (NYSE:DFS) Q4 2022 Earnings Call Transcript January 19, 2023

Operator: Good morning. My name is Todd, and I will be your conference operator today. At this time, I would like to welcome everyone to the Fourth Quarter and Full Year 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. Thank you. I will now turn the call over to Mr. Eric Wasserstrom, Head of Investor Relations. Please go ahead.

Eric Wasserstrom: Thanks, Todd, and good morning, everyone, and welcome to today’s call. I’ll begin on Slide 2 of the 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 the fourth quarter earnings press release and presentation. On 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 questions, please return to the queue. And with that, it’s my pleasure to turn the call over to Roger.

Roger Hochschild: Thanks, Eric, and thanks to our listeners for joining today’s call. I want to begin by reviewing the highlights and key metrics for the year, and then John will take you through the details of our fourth quarter results and our perspectives on 2023. I’m very pleased to say that 2022 was the second strongest year for earnings in our company’s history. We reported net income of $1 billion or $3.77 per share for the fourth quarter and $4.4 billion or $15.50 per share for the full year. This was accomplished against a fluid and unusual macroeconomic and monetary policy backdrop and I want to thank the entire Discover team for their solid execution. This performance gives us significant momentum going into 2023 and beyond.

I want to give a few highlights that underscore these strong results. First, we grew new accounts by 23% and loan receivables by 20%. This demonstrates the appeal of our consumer value proposition and advancements in our consumer targeting and acquisition capabilities while maintaining our conservative approach to underwriting and credit management. We’re also prudently investing for growth, including an acquisition and brand marketing, the continuing build-out of our data and analytic capabilities and increasing field personnel for both servicing and collections, all while achieving a 39% efficiency ratio. The combination of revenue expansion and disciplined cost management contributed to our 31% return on equity this past year and underscores the highly capital-generative nature of our business model.

Over the course of 2022, we repurchased $2.4 billion in common stock and increased our dividend by over 20%, and we expect to sustain attractive levels of capital return to our shareholders into the future. As we look into 2023, we expect a less favorable macroeconomic backdrop. Nevertheless, we intend to maintain an appropriate level of investment in our organization. For example, we have several initiatives that will improve our digital marketing capabilities, and we anticipate the broad market launch for mass market cash-back debit product. And of course, we’ll continue to invest in our brand and in account acquisition in a manner consistent with the environment. We’re very aware of the climate in which we are operating. And should there be changes in economic conditions, we will adjust.

Our model with its focus on prime lending and through-the-cycle underwriting has historically supported resilient returns through the economic cycle. These factors, combined with our earnings power, reserves and capital, underpin our strategy of being the leading consumer digital bank. I’ll now turn the call over to John to review our results in more detail.

John Greene: Thank you, Roger, and good morning, everyone. I’ll start with our financial summary results on Slide 4. The takeaway of the quarter is largely about strong asset growth and net interest margin expansion, partially offset by growth-based provisioning. Asset growth combined with a NIM rate improvement, increased revenue 7% sequentially and 27% year-over-year. Similar to last quarter, asset growth also drove an increase in our reserves of $313 million. This increase has our reserve coverage ratio relatively flat at 6.6%. In the prior year, we released $39 million of reserves. So while our reported net income was down 3% year-over-year, adjusting for the reserve change, our net income would have been 23% higher on a year-over-year basis.

Let’s review the details starting on Slide 5. Net interest income was up $584 million year-over-year or 24%. Our net interest margin expanded, benefiting from the higher prime rate partially offset by higher funding costs and increased promotional balances. NIM ended the quarter at 11.27%, up 46 basis points from the prior year and 22 basis points sequentially. For the full year, NIM was 11.04%, up 28 basis points from the prior year. Receivable growth was driven by card which increased 21% year-over-year, reflecting continued strong sales, new account growth and payment rate moderation. Sales increased 8% in the period, a deceleration from the 15% growth we experienced in the prior quarter and the 20% in the first half of the year. New card accounts grew by 17% from last year’s fourth quarter.

Similar to the prior quarter, the sales growth decline was mitigated by a decrease in the payment rate, which fell 150 basis points in the quarter. We expect payment rates to continue to decline through 2023, but at a more moderate pace. Turning to our non-card products. Organic student loans increased 4% as a result of peak season originations. Personal loans were up 15%. We continue to stay disciplined in our approach to marketing, underwriting and pricing of this product. Our attractive value proposition has positioned us well in the market that is experiencing strong consumer demand and some improvement in competitive conditions. In terms of funding mix, our customer deposit balances were up 10% year-over-year and 5% sequentially. Deposit pricing continues to be in line with what we expected in a rising rate environment.

Recently, we have seen some moderation in the pace of pricing changes. Looking at other revenue on Slide 6. Non-interest income increased $212 million or 47%. This was partially due to a $138 million loss on our equity investments in the prior year quarter, compared to a $6 million loss this quarter. Adjusting for these, our non-interest income was up 14%. This increase was primarily driven by two items. First, loan fee income was up $51 million or 39%, driven by volume. And second, we had higher net discount and interchange revenue, which was up $23 million or 7% reflecting strong sales and a favorable sales mix, partially offset by higher rewards costs. Moving to expenses on Slide 7. Total operating expenses were up $183 million or 14% year-over-year and up 8% from the prior quarter.

Compensation costs were up primarily due to increased headcount and wage inflation. Marketing expenses increased $42 million or 15% as we continue to prudently invest for growth in our card in consumer banking products. Premise and equipment expense was elevated this quarter due to a onetime write-off related to the exit of our Phoenix servicing location. Adjusting for this, premise and equipment would have been flat to the prior year quarter. With this recent action, we have resized or exited three of our four major call center locations, and we’ll continue to evaluate our footprint going forward. Moving to credit performance on Slide 8. Total net charge-offs were 2.13%, 76 basis points higher than the prior year and up 42 basis points from the prior quarter.

In the card portfolio, the net charge-off rate of 2.37% was 87 basis points higher than the prior year and 45 basis points higher sequentially. As expected, portfolio loss rates are normalizing, reflecting seasoning of new account vintages from the past two years, normalization of older vintages and mild deterioration and low credit bands, largely inflation-driven. These trends are within our expected risk tolerances and are consistent with our historical approach to underwriting and credit management. Among our core prime revolver segment, we don’t see evidence of broader stress given the robust labor market. I’ll cover our 2023 view in a moment. Turning to the discussions of our allowance on Slide 9. This quarter, we increased our allowance by $313 million driven by the increase in receivable balances.

Our reserve rate declined slightly to 6.6%. Adjusting for the elevated level of transactor balances in the fourth quarter, our reserve rate would have been near sequentially flat. Under the CECL accounting standard, we are required to contemplate life of loan losses and adjust our reserve levels accordingly. For us, the changes to employment conditions pose the most significant risk to our forecast. For the year-end 2022 reserve, our baseline assumption was unemployment in 2023 between 4.5% and 6.5% and with alternative scenarios above 6%. Looking at Slide 10. Our common equity Tier 1 for the period was 13.3%. Our longer-term target remains at 10.5%. We expect to make progress against this target over the next four to six quarters. Yesterday, we announced a quarterly common dividend of $0.60 per share.

And in the fourth quarter of 2022, we repurchased $602 million of common stock. Concluding on Slide 11 with our outlook. Momentum is strong, which should help to generate double-digit revenue growth and positive operating leverage. We expect end-of-period loan growth to be in the low double digits with average loan growth somewhat higher. This is driven by three factors: our prior year growth in new accounts moderation in the payment rate and sales volume trends. Through mid-January, sales are up 13%, but we expect deceleration to the high single digits over the course of the year. We expect net interest margin to be modestly higher than the full year 2022 levels. More specifically, we expect NIM to be above the fourth quarter levels in the first half of the year driven by continued loan re-pricing benefits and decline in the second half.

We are looking for total operating expenses to increase less than 10%. Salary and benefit expense will increase due to hiring in the second half of 2022. Additionally, we expect marketing to be above our full year 2022 level. We expect net charge-offs will average between 3.5% and 3.9% for the full year. The low end of the range is more in line with our base case, while the high end is more consistent with a weaker employment scenario. Lastly, we have $2.8 billion of remaining capacity under the $4.2 billion share repurchase program that expires in June of this year. We expect to repurchase around $2.2 billion of shares in the first half of 2023. We’ll provide an update on future share repurchase authorizations after we complete our stress testing process and review recommendations with our Board.

In summary, receivable growth continued to benefit from new account acquisition, payment rate moderation and positive sales. NIM continues to benefit from prime rate increases with funding costs consistent with expectations and credit is performing in line with our approach through-the-cycle underwriting process and conservative credit management. Our perspective for 2023 reflect our focus on advancing our strategic priorities generating high returns and capital while remaining disciplined in our credit and expense management. With that, I’ll turn the call back over to our operator to open the line for Q&A.

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Q&A Session

Operator: We’ll take our first question from Moshe Orenbuch with Credit Suisse.

Moshe Orenbuch: Great. And John, thanks for kind of outlining the parameters of the range of expected credit loss. But could you talk a little bit about the past kind of from here to getting to the 3.5%? Like what either has to happen that’s bad or not happen, that’s good. And at what points along that way, would you know whether that 3.5% base case is too high or too low?

John Greene: Yes. Great. Yes. Thanks for the question, Moshe. So the range is some unlocked, right? 3.5% to 3.9% for ’23. And — we certainly have a great deal of visibility through the first six months of the year through a roll rate methodology. Post six months, so in the second half of the year, we use our analytical models which anticipate a number of different possible outcomes but used as historical data that’s been tested significantly to make a projection of what we expect to happen. So as we get through the first quarter, we’ll be able to see what’s happening with our roll rates in terms of is it a roll to one bucket and the roll to two bucket, consistent with our expectations on the base case on the reserve. Beyond that, we’ll certainly look at the macro environment and what’s happening with unemployment levels and the overall job market.

That will give us some perspective. And then an important component of this, and I know there was some questions in terms of the step-up from where we ended ’22 to where we’re projecting ’23. We have fairly significant vintages that are going through the normal seasoning process right now. So for example, our end-of-period card portfolio, so last year 12/31 to this year 12/31 increased by $15.7 billion. And if you think about kind of a maturity cycle of a credit card, typically within the first year to two years, you hit peak losses. So that is some of what we’re expecting here, and therefore, the guidance that we’ve provided. We do expect that in a stable macroeconomic environment, in the second half of the year, we should see this slope of the curve begin to bend down a little bit with perhaps top losses coming through in ’24 and then returning down.

So overall, what we’re seeing here is just a strong portfolio, very significant vintages that came through in ’21 and ’22 that are seasoning at levels that were — that are completely within our expectation of total return thresholds. And then, we’ll see the overall portfolio normalized. So hopefully, that provides some clarity on both the trajectory as well as what we’re seeing in the portfolio.

Moshe Orenbuch: Perfect. And just as a follow-up, the reserve rate was down. You mentioned that was largely a result of transactor balances. But I guess even with that, it wasn’t up. And so when you think about that, kind of how do you — I mean, how should we think — it doesn’t feel like you’re anticipating a deteriorating environment if you’re keeping your reserve certainly no worse than flat. And how do we think about that going through ’23 as well?

John Greene: Yes, great question. And they’re connected, so happy to cover them in the same set. So CECL reflects life of loan losses as we all know, right? And so, what drives that is the portfolio performance and the — our view of the macroeconomic environment today and going forward. And we haven’t had any substantial changes to the macroeconomic environment. And essentially, the portfolio is performing within our expected ranges of outcomes. So, as we look at the fourth quarter receivable balances in the aggregate, and the portfolio performance, a stable macro, we felt most appropriate reserve levels would be fairly consistent with what we did in the third quarter. And essentially, without taking you through a ton of detail that the teams spend weeks and weeks working through, that’s essentially how we arrive at the answer.

Operator: Thank you. Our next question will come from Sanjay Sakhrani with KBW.

Sanjay Sakhrani: Maybe just a follow-up question to the credit question is Moshe asked. John, you talked about the seasoning. Is there any way to parse apart the impact of seasoning in your range versus the actual degradation as a result of just the deteriorating delinquencies on a base case? And then you mentioned sort of the slope of the curve decelerates, I think you said in the second half, but I just want to make sure to understand sort of how the seasoning will impact us for the next two years. Does it still weigh in on you in the first half of 2024?

John Greene: Yes. So in terms of the impact of the vintages, I explicitly called out the card vintage in 2022, so the $15.7 billion to give the folks that are listening here, a place to anchor on in terms of thinking about the vintage and then you can run out peak losses for our portfolio in terms of what typically happens after a significant vintage and in a stable macro. So that should help you at least in terms of the thinking in terms of the vintage. As we think about this year, we gave that range of 3.5% to 3.9% on the loan base — on the average loan base. So you should think about the ultimate kind of range here. It will depend first on the macro. Second, we’ll continue to give updates in each of the quarters in terms of what we’re seeing. But ultimately, we expect this vintage will mature in 2024. And then, we should see in a stable macro, the curve not only slope pending, but actually inverting slightly.

Sanjay Sakhrani: Okay. Follow-up question on loan growth. Obviously, you mentioned the strong growth driving the seasoning, but you guys are still expecting double-digit growth in the face of maybe a tougher economic backdrop. What gives you the comfort here? Maybe Roger, speaking to the growth in the past, and I know every cycle takes on a different complexion. What are you guys looking at that makes you comfortable to grow here? Because that’s a question I get quite a bit from investors.

Roger Hochschild: Yes. Good question, Sanjay. I think you’ve seen us operate this business through multiple cycles and the disciplined approach we take both in good times as well as in bad. And frequently, the accounts that you put on during a challenging economic time, perform extraordinarily well, and you can see very good cost per account as competitors pull back. So, we have been pretty clear that starting in the back half of last year, we started tightening credit standards, and you can expect us to continue to look at that and adjust according to economic conditions, both for new accounts as well as the portfolio. Nevertheless, we’re seeing great returns on the marketing investments we’re putting out there. And so, that’s what gives us the confidence to keep investing in growth.

Operator: Thank you. Our next question comes from John Hecht with Jefferies.

John Hecht: Not to beat the dead horse, but maybe just one more question on the kind of the provisioning and the credit. John, I think you kind of detailed the unemployment assumptions. I think they were kind of in the 4.5% to 6% range with maybe somewhere making the 5% range, kind of the middle of the fairway. Just maybe can you tell us what’s the sensitivity for the — either the charge-offs or the ALL at say unemployment moves to level like 100 basis points higher than that.

John Greene: Yes. So in our kind of primary case here, we assumed a 100 basis points increase in unemployment. Now that that was specific to our charge-off forecast. In terms of kind of reserve levels, we actually used a composite of multiple scenarios. The more heavily weighted scenario reflected a loss rate of 4.5% and then going up all the way to 6%. So, I’m feeling actually like we’re down the middle here in terms of appropriateness in terms of overall reserve levels and more specificity in terms of sensitivity. I don’t think that would be a service given if we’re seeing unemployment kind of creep up in that sort of matter or that sort of quantum that would indicate that the macro environment has changed, and we have to change our view on that, which could change our perspectives on life of loan losses.

John Hecht: Okay. That’s helpful. And then you gave annual guidance with NIM, and it sounds like maybe an elevated NIM in the first part of the year coming down second, what are the drivers of that with respect to the yield and the cost of capital?