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Edited Transcript of DFS earnings conference call or presentation 22-Oct-19 9:00pm GMT

Q3 2019 Discover Financial Services Earnings Call

RIVERWOODS Nov 4, 2019 (Thomson StreetEvents) -- Edited Transcript of Discover Financial Services earnings conference call or presentation Tuesday, October 22, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Craig A. Streem

Discover Financial Services - VP of IR

* John Thomas Greene

Discover Financial Services - Executive VP & CFO

* Roger Crosby Hochschild

Discover Financial Services - CEO, President & Director

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Conference Call Participants

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* Betsy Lynn Graseck

Morgan Stanley, Research Division - MD

* Bill Carcache

Nomura Securities Co. Ltd., Research Division - Research Analyst

* Brian D. Foran

Autonomous Research LLP - Partner & US Regional Banks

* Christopher Roy Donat

Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research

* David Michael Scharf

JMP Securities LLC, Research Division - MD and Senior Research Analyst

* Donald James Fandetti

Wells Fargo Securities, LLC, Research Division - Senior Analyst

* Eric Edmund Wasserstrom

UBS Investment Bank, Research Division - MD & Consumer Finance Analyst

* John Hecht

Jefferies LLC, Research Division - Equity Analyst

* Jon Glenn Arfstrom

RBC Capital Markets, LLC, Research Division - MD

* Mark C. DeVries

Barclays Bank PLC, Research Division - Director & Senior Research Analyst

* Melissa Marie Wedel

JP Morgan Chase & Co, Research Division - Analyst

* Mengxian Jiao

Deutsche Bank AG, Research Division - Research Analyst

* Mihir Bhatia

BofA Merrill Lynch, Research Division - Research Analyst

* Richard Barry Shane

JP Morgan Chase & Co, Research Division - Senior Equity Analyst

* Robert Paul Napoli

William Blair & Company L.L.C., Research Division - Partner and Co-Group Head of Financial Services & Technology

* Ryan Matthew Nash

Goldman Sachs Group Inc., Research Division - MD

* Sanjay Harkishin Sakhrani

Keefe, Bruyette, & Woods, Inc., Research Division - MD

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Presentation

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Operator [1]

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Good afternoon. My name is Erica, and I will be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter 2019 Discover Financial Services Earnings Conference Call. (Operator Instructions)

I will now turn the call over to Mr. Craig Streem, Head of Investor Relations. Please go ahead.

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Craig A. Streem, Discover Financial Services - VP of IR [2]

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Thank you very much, Erica, and welcome, everyone, to this afternoon's call. I'll begin on Slide 2 of our earnings presentation, which you can find in the financial section of our Investor Relations website, investorrelations.discover.com.

Our discussion today contains certain forward-looking statements that are subject to risks and uncertainties that may cause actual results to differ materially. Please refer to our notices regarding forward-looking statements that appear on today's earnings press release and presentation.

Our call today will include formal remarks from our CEO, Roger Hochschild, covering third quarter highlights. And then it's my pleasure to welcome John Greene, our new Chief Financial Officer, who will take you through the rest of the earnings presentation. After John completes his comments, there will be time for a question-and-answer session. (Operator Instructions)

Now it's my pleasure to turn the call over to Roger.

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [3]

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Thanks, Craig, and thanks to our listeners for joining today's call. As you can readily see from our results, we can see it's delivered very sound fundamental performance this quarter, leading to net income of $770 million after tax or $2.36 per share with a robust return on equity of 26%. We achieved our key objectives for loan growth, net interest margin and credit performance, setting us up to finish the year on a very solid footing. At the same time, the strength and profitability of our business allow us to make ongoing investments that should further enhance our competitive position in each of our products and enable us to achieve continued strong results.

Looking at the key drivers. Total loans were up 6% and credit performance remained strong across all of our products, reflecting our discipline in underwriting new accounts and line management as well as the clear benefits of our continued investments in servicing and collection capabilities.

Card receivables grew 7% this quarter, reflecting a healthy mix of volume from both new and existing customers and origination activity skewed more to higher-yielding merchandise balances versus promotional balances. This demonstrates the positive degree of customer engagement, while providing a favorable contribution to the overall net interest margin.

Turning to our student loan business. Growth remained strong this quarter and originations were in line with our expectations through the peak season. We're seeing an improvement in conversions, driven by increasing awareness to the Discover brand in the student loan market and better customer experience at the front end. We're excited about our competitive position in private student lending, and we remain confident in our ability to grow loans and gain market share despite competitive pressure.

In personal loans, growth was in line with our expectations as we remained disciplined on originating loans that meet our return objectives. Credit performance continues to stabilize, reflecting the positive outcome from recent credit tightening and implementation of enhanced risk mitigation strategies.

Overall, underlying credit trends continue to be favorable across our lending products, with credit performance driven more by growth in receivables as compared to normalization of the back book. The U.S. consumer and the overall economy continue to look good, with unemployment at a 50-year low and consumer sentiment at a high level as we enter the holiday season.

This was also another quarter of strong growth in consumer deposits, which passed the $50 billion mark and are now over half of our total funding. We've been able to maintain deposit pricing in the middle of the pack and have been pleased with our ability to continue to attract cost-effective funding in a falling rate environment.

We recently introduced our no fee commitment across our deposit products, and while still early, we believe this has resonated with customers and is contributing to our deposit growth. Pretax income for our Payment Services segment increased 16%, primarily driven by strong volume growth from our PULSE business. The PULSE team continues to expand business with existing issuers and win new relationships through creative debit solutions that deliver meaningful value for partners.

Additionally, we continue to make progress against our strategy to enhance global acceptance by investing in partnerships with local acquirers and adding network-to-network partners. This quarter, we added 2 acquirer partners in France, Banque Postale and Arkéa, as we continue to focus on acceptance in Western Europe. In addition, we're expanding acceptance in Africa with our partnership with Verve, a Nigeria-based payments network that will provide acceptance in a number of African countries for Discover and our net-to-net partners such as RuPay and BC Card.

To summarize the quarter, our performance once again demonstrates the strength of the Discover business model. Our commitment to providing an industry-leading experience to our customers and our disciplined approach to profitable growth and credit management continue to provide strong returns and long-term value to our shareholders. The economic environment remains favorable, and we do not see that changing in the near term. That said, it is likely that we're in the later stages of the economic cycle, and we are continuing to manage origination, servicing and operational effectiveness with that very much in mind.

Before I wrap up my section of our formal remarks, I want to acknowledge Mark Graf's retirement from Discover. Mark has been a valued colleague and leader since he joined the company in 2011 and will remain at Discover as an executive adviser until his retirement in the early 2020. We wish Mark and his family the very best for the future.

And now, I want to take a moment to formally introduce our new CFO, John Greene. John brings significant experience in financial services, including over 8 years at HSBC, where he held the role of CFO of their largest business unit, Retail Banking and Wealth Management. And he also brings over 12 years of experience at GE. John held public company CFO roles at Willis Group Holdings, where he was instrumental in a turnaround of the company and subsequent merger with Towers Watson. And most recently, John was CFO at the Biogen spin-off, Bioverativ. John is joining Discover at an important time and brings very relevant capabilities and experience. I'm very excited about the impact I expect John to have here at Discover, and I'm sure you'll enjoy working with him.

I'll now ask John to discuss our financial results in more detail.

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [4]

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Thank you, Roger. Before I begin, I wanted to say that I'm very excited to be part of the Discover team. My first month confirmed my initial view that I was joining a great organization. I'm looking forward to an exciting future with Discover as well as the opportunity to work with all of you.

Now onto the business at hand. I'll begin by addressing our summary financial results on Slide 4. Looking at the key elements of the income statement. Revenue growth of 6% this quarter was driven by loan growth of 6%, consistent with our expectation, and a very solid 8% growth in net interest income. The 8% increase in provision for loan losses was mainly driven by the seasoning of newer vintages and to a lesser extent by the continued supply-driven normalization in the consumer credit industry.

Operating expenses were up 9% year-over-year due to higher compensation expense and investments in support of growth and new capabilities. The effective tax rate for the quarter was 22.5%, reflecting a $12 million benefit from the favorable resolution of the certain tax matters. Net income and EPS were up 7% and 15%, respectively.

Turning to Slide 5. Loans increased 6% over the prior year, led by 7% growth in credit card receivables. Standard merchandise balances continued to be the primary driver of card receivable growth, while the contribution from promotional balances was minimal, reflecting our decision to reduce the level of growth from promotional activities over the past several quarters. Roughly 60% of the increase in loan balance was from new accounts and about 40% from existing.

Turning to student loans. Total loan balances were up 4% from the prior year. The organic piece of our student loan portfolio increased 9% year-over-year, reflecting our strong competitive position. Personal loan growth was in line with our expectations, increasing 1% from the prior year, reflecting the previously mentioned slowdown in originations as we worked through the development and testing of new underwriting models.

Moving to payments volume. To the right on Slide 5, you can see the proprietary volume was up 6% year-over-year. In Payment Services, PULSE volume increased 5% over the prior year, driven by incremental volume from existing issuers, new issuers on the PULSE network and growth in our PIN-less products such as PULSE PAY Express and PULSE E-commerce. AribaPay drove the 30% increase in Network Partners volume, while Diners Club volume was flat to the prior year.

Moving to revenue on Slide 6. Net interest income of $2.4 billion was up 8% from the prior year, driven by 3 factors: first, higher loan balances; second, a higher revolve rate this quarter; and third, somewhat lower promotional balances in this year's quarter.

Total noninterest income was $498 million in the quarter, down $3 million or 1% from last year's quarter. The principal drivers of the decline were lower net discounts and interchange revenue, partially offset by higher loan fee income.

Drilling down a bit. Net discounts and interchange revenue was $255 million in the quarter, down 9%, as revenue from higher sales volume was more than offset by higher rewards cost. This was primarily due to adding PayPal to the 5% rewards category. Sales volume was up 4% from the prior year or 5% when normalizing for processing days. Offsetting the decrease in net discounts and interchange revenue was an increase of $17 million or 17% in loan fee income. The increase was principally due to an increase in late fee occurrences as well as an adjustment in late fee pricing tiers.

As shown on Slide 7, our net interest margin was 10.43%, up 15 basis points year-over-year and down 4 basis points sequentially. Relative to the third quarter of last year, the increase in NIM was due to a favorable promotional balance mix and higher revolve rate. These were partially offset by higher brokered and direct-to-consumer deposit costs and by higher interest charge-offs. Compared to the second quarter, NIM decreased principally due to the roll-off of lower coupon brokered and direct-to-consumer deposits along with the impact of primary decreases in July and September. Partially offsetting this was a favorable funding mix, a higher revolve rate and lower interest charge-offs.

Total loan yield increased 31 basis points from a year ago to 12.76%, driven by increases in yields for all of our principal loan products: 29 basis points in card, 35 basis points in private student loans and 51 basis points in personal loans.

Card yield benefited from the impact of the 2018 prime rate increases, favorability in the revolve rate and a lower level of promotional balances, which were partially offset by higher interest charge-offs and the impact of recent prime rate decreases. The year-over-year increase in student loan yield was primarily driven by higher short-term interest rates as about 60% of the portfolio is floating rate.

The increase in personal loan yield was also driven by the impact of prime rate increases in the prior year as well as positive pricing actions. We expect to see a degree of yield compression from recent cuts in the Fed funds rate, which won't entirely be offset by lower funding cost. We have taken action by steadily reducing our asset sensitivity and consider our interest rate risk position to be essentially neutral at this point. Looking ahead, we expect to maintain this interest rate risk position for the foreseeable future. Our outlook anticipates one more 25 basis points rate reduction in 2019.

On the liability side of the balance sheet, average consumer deposits grew 19% from last year and now make up 53% of total funding. Consumer deposit rates decreased 4 basis points from the prior quarter and are 28 basis points above the prior year. Importantly, we've been able to achieve strong deposit growth while maintaining a disciplined pricing strategy.

Since the Fed began raising rates in 2015, we realized a 51% cumulative deposit price beta for online savings. Of course, the Fed has recently cut its target rate by 50 basis points, and we've responded by lowering our deposit rates with a realized beta of 50% on our savings accounts over the last few months. We will continue to manage deposit cost prudently, taking into account competitors' behavior.

Turning to Slide 8. Total operating expenses rose $92 million from the prior year. Employee compensation increased $31 million, driven by staff additions in technology and other areas to support business growth as well as higher average salaries and benefits. Increased investments in new account acquisitions across our deposits, student lending and card products drove marketing cost up 6% from the prior year. The 8% increase in information processing reflects our continued investment in infrastructure and analytic capabilities. Professional fees were $23 million higher, with a little over half of that due to increased collection costs related to higher recoveries in the quarter.

Now I'll discuss our credit results on Slide 9. Total net charge-offs were up 8 basis points from the prior year. The increase continues to be primarily driven by the seasoning of loan growth and supply-driven credit normalization.

Credit card net charge-offs were 18 basis points higher year-over-year and down 17 basis points from the prior quarter. The credit card 30-plus delinquency rate was up 18 basis points year-over-year and up 16 basis points sequentially. Credit performance in the card business continues to be very solid, reflecting our disciplined approach to credit management in both new and existing accounts.

Private student loan credit performance also remained strong, with net charge-offs down 37 basis points year-over-year and 2 basis points sequentially, aided by efficiency gains in collection, including enhanced communication and outreach to cosigners.

Personal loan net charge-offs decreased 10 basis points from the prior year and 34 basis points sequentially. This significant improvement from the prior quarter reflects a degree of seasonality in originations and charge-offs. The 30-plus delinquency rate was down 8 basis points year-over-year and flat to the prior quarter as credit performance continues to stabilize.

Looking at capital on Slide 10. Just a brief comment here. Common equity Tier 1 ratio remains sequentially flat at 11.4%. Our capital payout ratio for the last 12 months, including buyback, was 79%.

Now summarizing our results for the quarter on Slide 11. We generated 6% total loan growth and a 26% return on equity. Our consumer deposit business saw a strong growth of 19% and now composes over half our total funding. With respect to credit, while our charge-off rates have increased as loan growth seasons and credit conditions normalize, performance reflects positive trends across our lending products and remains consistent with our expectations and return targets. We continue to execute on our capital plan with loan growth and capital return helping to bring our capital ratios closer to targeted levels.

Finally, we remain on track for a strong finish to 2019, achieving all aspects of our financial and operational guidance.

In conclusion, this was a great quarter with solid execution by the team.

Now before I go to Q&A, I wanted to say again how excited I am to be part of the Discover team. I look forward to helping the business continue its history of strong execution as we grow this great franchise.

With that, I'll turn the call back to the operator, Erica, to open the lines for Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll take our first question from Mark DeVries with Barclays.

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Mark C. DeVries, Barclays Bank PLC, Research Division - Director & Senior Research Analyst [2]

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Roger, I was hoping you could comment on significance of today's announcement around click-to-pay and what do you think it could mean for the business.

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [3]

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So in terms of the announcement on SRC, we are very excited as a member of EMVCo to be part of that. I think it's really fundamentally going to be great for consumers. It reflects the industry moving forward to significantly enhance the online checkout experience. I think it will be a great step forward. So we're very excited to be part of it.

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Mark C. DeVries, Barclays Bank PLC, Research Division - Director & Senior Research Analyst [4]

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Okay. In terms of just what it can mean, though, in terms of volumes or defending market share, anything else you could share on that?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [5]

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I think it's quite too early to talk about share shift. But to the extent that we're working with other networks on a seamless integrated customer experience, we think that will help our cardholders and be good for our business.

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Operator [6]

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We'll take our next question from Betsy Graseck with Morgan Stanley.

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Betsy Lynn Graseck, Morgan Stanley, Research Division - MD [7]

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Two questions related. Roger, just wanted to understand, you had a really strong quarter on the revenue side, and the expense ratio came in nicely as well, but it looks like there was a little bit of investment spend going on in the quarter. How should we think about that? Is there kind of expense ratio you're looking to run between? Or was this just a quarter where you had an opportunity to invest a little bit more, and so you upped the investment spend this quarter? Or should we expect this level of investment spend to continue from here?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [8]

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It's -- we don't necessarily target an efficiency ratio. To the point you're making, our investment spend, as we see opportunities to drive loan growth consistent with our conservative approach to credit, we will do so and we think more in terms of overall returns. Our efficiency ratio is one of the best within financial services, but in terms of overall expense levels, those can vary based on the marketing investment.

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Betsy Lynn Graseck, Morgan Stanley, Research Division - MD [9]

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And then as we think about the NII and the NIM, I think, John, you were mentioning that you are largely neutral and you've got one more rate cut baked into your outlook, but we should expect NIM comes down a little bit. So I'm just trying to square that and maybe get a little bit more understanding as to what you're expecting over the next couple of quarters from a NIM perspective?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [10]

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Certainly, happy to take that. So we ended the third quarter year-to-date results with a NIM rate at 10.45%. And then as we look at the fourth quarter, there's really 3 things that are going to impact it. So certainly, the rate cuts that occurred throughout 2019 will be fully baked in. And then we'll have our funding rate, which actually ticked up mildly. And then, of course, in the fourth quarter, there is transactor and revolver mix shifts that ultimately will impact the rate.

So I know the company gave some guidance at 10.3%, and then it was subsequently revised upward by 5 to 9 basis points. I would expect, based on what we're seeing here, looking at the fourth quarter to come in probably at the higher end of that and probably 1 or 2 basis points higher than 10.39%, so probably 10.4%-ish.

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Operator [11]

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We'll take our next question from Don Fandetti with Wells Fargo.

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Donald James Fandetti, Wells Fargo Securities, LLC, Research Division - Senior Analyst [12]

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So it looks like the card business is hitting on a lot of cylinders, credit is pretty stable, competition stable, demand is decent from the consumer. I guess I wanted to just get your thoughts on whether or not you see any risk to that in the near term? Obviously, we're all focusing on the macro, but for example, is your sense that the delinquency rate year-over-year is going to continue to be in this sort of ZIP Code and if you're seeing any type of movement within segments of higher-end to mid prime?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [13]

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Yes. So we spend a lot of time looking for turns in the economy, looking at our portfolio, kind of every way we can cut it, whether it's geographically. We look at the different vintage buckets, et cetera. And as I said on the call, the U.S. consumer is holding up well. I think part of it is reflected in terms of the 50-year low in unemployment. But we remain disciplined and conservative in credit, because it feels late cycle and certainly is by any historic measure. But in terms of what you see in consumer behavior and the numbers we reported, the consumer is holding up very well.

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Donald James Fandetti, Wells Fargo Securities, LLC, Research Division - Senior Analyst [14]

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And then, I guess, if you look around at the other networks, there's a lot of talk about B2B. We're seeing a lot of bolt-on acquisitions for the payment companies. Where are you in terms of your thought process on B2B? I know you have a small business card that's pretty modest. And then do you think you need to make any bolt-on acquisitions at this point? Or are you in good shape?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [15]

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So in terms of B2B, we're always looking at opportunities. I think we tend to think about it in terms of a mix of acquisitions, but also partnerships. So we see a lot of B2B volume coming through our partnership with SAP and Ariba. We announced a new B2B-based partnership this quarter. So it's an area we're focused on. Margins tend to be a little thinner on the B2B side compared to B2C payments, but it's an area that we focused on for quite a while in the payments part of our business.

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Operator [16]

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We'll take our next question from Sanjay Sakhrani with KBW.

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Sanjay Harkishin Sakhrani, Keefe, Bruyette, & Woods, Inc., Research Division - MD [17]

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I guess I've got a question on the private student loan credit quality and the nice improvement in the reserve rate there. Obviously, we've seen some pretty significant improvement in the charge-off rate, and the associated coverage with the reserve came down quite a bit. Is it just a reflection of the delinquency rate trajectory and you expect that to continue? And sort of what's driving that improvement?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [18]

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Sanjay, this is John. I'll take that. So we're really pleased with the performance there. And first of all, the book is really solid. About 90% of the portfolio has cosigners. And in the first quarter this year, the collection team began an outreach to cosigners when there was an early-stage delinquency, and that's actually made a pretty substantial difference in collection effectiveness and overall delinquency levels.

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Sanjay Harkishin Sakhrani, Keefe, Bruyette, & Woods, Inc., Research Division - MD [19]

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Okay. I guess a question for Roger, sort of similar to what Don was asking. I guess the ROEs have been really, really strong, and I am wondering if you're surprised at how strong they are, given where we are in the cycle. It seems like with such high returns, you'd have more competition, but there hasn't been a whole lot. So I'm just curious how to reconcile. Is it something you guys are doing differently that's generating these returns? Or is it just that the competitive intensity is weaker, because we're this late into a cycle?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [20]

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I probably would challenge the view that there isn't much competition in the card space. If you look at the players who are in it and the investments they make, I think part of it is, it is a very challenging business. You tend not to see too many new entrants, but it's very competitive. And I think there is a difference between the marginal return that competitors look to as they think about how to grow their book and the total return. But I think the credit card business has been one of the highest returning consumer asset classes for my 25 years in the business, and I think it reflects just sort of some of the challenges in operating it well, and we have a very disciplined model here at Discover.

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Sanjay Harkishin Sakhrani, Keefe, Bruyette, & Woods, Inc., Research Division - MD [21]

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Okay. I wanted to welcome and congratulate John on his new position and just one quick clarification. The NIM guidance that you provided, was that a fourth quarter guide? Or was that for the full year?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [22]

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That was fourth quarter. So when we come out with year-end results in January, we'll provide updated guidance for 2020.

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Operator [23]

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We'll take our next question from Eric Wasserstrom with UBS.

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Eric Edmund Wasserstrom, UBS Investment Bank, Research Division - MD & Consumer Finance Analyst [24]

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So if you could just circle back on the credit discussion for a moment, certainly the NCO trends seem very contained and the delinquency trends also seem to be very contained in terms of the rate of change. On the other hand, the late fees are creeping up. That's often a harbinger of future credit deterioration. You guys have talked a little bit about what you're doing on mod. So I'm just trying to put the whole picture together. Is the characterization that it's stable, but with a slow slope towards deterioration? Or how should I think about it?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [25]

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Yes. I think I would probably highlight more of the stable side. Part of what's driving up late fees is just overall growth in the portfolio, and certainly, that's going to drive more delinquent accounts. But as you look at the overall delinquency rates and the trajectory those have been on, I think those reflect strong performance and a continued stable economic environment.

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Eric Edmund Wasserstrom, UBS Investment Bank, Research Division - MD & Consumer Finance Analyst [26]

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And if I may just follow up just quickly on NIM as well without pushing you to provide point guidance, which is not my intent. But I think in the past, what you've indicated is every incremental 25 basis point reduction is 1 to 2 points of annualized NIM reduction. And so as we just think through whether it's our own economist or the blue-chip consensus in terms of the 2020 expectation, is that still a good framework to consider on the basis of the fourth quarter endpoint?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [27]

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Eric, it is, 1 to 2 basis points for every 25 basis points downward.

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Operator [28]

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We'll take our next question from Ryan Nash with Goldman Sachs.

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Ryan Matthew Nash, Goldman Sachs Group Inc., Research Division - MD [29]

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Roger, maybe I'll start with a similar question that some of the others have asked. So you've been tightening credit for 2 years, yet you're still growing above the market. So one, do you think this could continue? And two, what do you think that you're doing different from the market now that's allowing you to continue to take share?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [30]

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A, I feel good about the credit decisions we've made, and there are mix of what we do for new accounts, but also for the portfolio. A lot of it has to do with differentiation. And so we focus a lot on innovation. So if you think about going back to the FICO score on statements, the ability to freeze your card, Cashback Match continues to perform well for us. And then also focusing on a superior customer experience. We've won the J.D. Power Award for the 5 of the last 6 years. We have the best mobile app in the business.

So really that relentless focus on every part of the customer experience and then wrapping that with the Discover brand, which obviously having our own proprietary network helps us in terms of building that brand and providing differentiation. So I think the whole business model is focused on driving high-quality loan growth.

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Ryan Matthew Nash, Goldman Sachs Group Inc., Research Division - MD [31]

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Got it. Maybe one for John. Last quarter or -- and the quarter before, the company had outlined upfront impact regarding CECL. I was just wondering if you can maybe talk a little bit about the Day 2 impact. How to think about the impact for a company that's experiencing nice growth, yet still seeing supply-driven normalization and a very uncertain macro backdrop?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [32]

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Yes. Good question. So let me start by saying that we're looking at CECL and the impact pretty extensively. We have now 3 quarters of simulations. We expect the overall reserve rate to be somewhere between 55% and 65%. In 2 most recent quarters, it's trending toward the north end of that. We'll continue to monitor that, and it will be impacted by the composition of the portfolio and certainly macro factors. So none of that is probably new to the folks on the call.

In terms of the volatility, it is -- it does drive a level of volatility, and we are -- frankly, I'm holding off giving quantification on the volatility until we bat down the estimates and clearly have a view of what the portfolio will look like and also the macroeconomics. So it will be more volatile, and we'll provide disclosures that provide a clear view on an apples-to-apples basis, so non-GAAP disclosures that will align to 2019 GAAP so that there's comparability.

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Operator [33]

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We'll take our next question from David Scharf with JMP Securities.

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David Michael Scharf, JMP Securities LLC, Research Division - MD and Senior Research Analyst [34]

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Welcome aboard, John. Maybe a couple of more questions on the credit side, maybe more hypothetical. We're -- listen, we're obviously closing in on 4 years of everybody wondering whether we're in the eighth or ninth inning of this cycle, and the data has suggested otherwise.

But I'm wondering, 2 things, just hypothetically, whether this occurred in 1 quarter or 6 quarters from now, if you had any indicators, whether internally based on delinquency trends or even macro indicators, suggesting we're heading towards, let's say, a 5.5% to 6% unemployment environment, which is consistent with 2 recessions ago. I'm kind of going to ignore The Great Recession.

Trying to get a sense -- and I realize there's so many variables and inputs. But generally speaking, from a strategic standpoint, should we be thinking about Discover as a business that is still targeting some level of loan growth in the midst of that kind of environment, sort of flat or year-over-year decline? I realize it's very hypothetical. Just trying to get a sense for how to think about, at this stage of maturity, how the business operates in that type of macro backdrop?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [35]

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Yes. I can't really sort of comment on exactly how much we grow at what unemployment level. I would say, though, that as we look at the new accounts we book and the models that John and the finance team do, we use the through-the-cycle loss rate as opposed to where we are at any given point in time. And we spend a lot of time analyzing accounts that we booked through the last downturn. The vast majority of our new accounts, we would have booked in December of 2007. So even going into that -- even if we had known what was coming, the vast majority of our accounts we would have booked.

There are certain segments that are sort of more in the near prime side that are more volatile, and so those tend to be where you cut back. You cut back on the number of line increases you do and there are other actions on the portfolio. But again, most -- again, the vast majority of those new accounts, we use the through-the-cycle loss rate and book in a much more challenging credit environment than what we have now.

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David Michael Scharf, JMP Securities LLC, Research Division - MD and Senior Research Analyst [36]

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Got it. That's helpful. And maybe just a follow-up along those lines. Once again, this is hypothetical, but maybe it's something you can quantify for us. If the loan book in aggregate, starting today, I mean, the back book today were to be flat over the next 12 months, is there any sense you could give us in basis points of how much upward pressure on loss rates, just the pure seasoning would exert if we no longer had any contributing denominator effect?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [37]

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That's something we really couldn't put together. I mean we don't run any scenarios of our loan book flat, because we're going to keep trying to grow it, but I really can't answer that.

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Operator [38]

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We'll take our next question from Rick Shane with JPMorgan.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [39]

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Look, the uptake on the rewards program with PayPal was very strong during the quarter. I'm curious if you could help us understand tactically what the intent of that program is? Is it a demographic drive for millennials? Or is there something else we should be thinking about?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [40]

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Sure. So a lot of our programs do in fact target millennials. PayPal is a great business partner, both on our issuing side, but as well as on the payment side. And with some merchants like PayPal, you do get a bit of lock in, because once people change their default card, there tends to be a tail of sales. So we're always looking for how to use our rewards dollars to cost effectively drive growth and provide value for our customers. I think it's one of the advantages we have from the structure of our rewards program. And so that was an investment we made, and we're excited about what we're seeing in terms of cardholder pickup of that.

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Operator [41]

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We'll take our next question from Bill Carcache with Nomura Instinet.

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Bill Carcache, Nomura Securities Co. Ltd., Research Division - Research Analyst [42]

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I had a couple of follow-up questions. First, a follow-up on Rick's PayPal 5% category question. Can you give any kind of early indication of the stickiness of those customers, post-promo? Just trying to get a sense for the willingness of those customers to keep Discover as their primary card after the promotion ends versus how much gaming behavior you're seeing?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [43]

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I won't comment specifically. I would say, we had a lot of experience running our 5% promo and know kind of by each different category, what type of tail we spend, and that goes into the targeting. So I'll go back to saying, we're very excited about how it's performed and we think we're getting good value for our investment.

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Bill Carcache, Nomura Securities Co. Ltd., Research Division - Research Analyst [44]

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Okay. And then as another follow-up on Ryan's question about the Day 2 impact of CECL. At a high level, is it reasonable to expect that the building of reserves on future growth under CECL would also increase by the 55% to 65% that you guys have guided to versus what it would have been under the incurred loss model?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [45]

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Yes. So great question. So no, to be specific on that. So the portfolio, when we're putting up the 55% to 65% increase for Day 1, reflects a maturity of the portfolio that already has some incurred losses reflected in it. So when you put up new loan accounts, what happens is you have to book the lifetime losses, and therefore, the impact is actually greater than the Day 1 impact of 55% to 65% that we've talked about.

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Bill Carcache, Nomura Securities Co. Ltd., Research Division - Research Analyst [46]

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Okay. So it's -- like as a starting point, 55% to 65% Day 1 impact. The Day 2 impact on the incremental building would actually be larger than that?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [47]

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It would for new loan account, and then obviously, the macro factors would come into play there. The type of assets we're putting on the book, so the credit card or personal loans will impact. So -- and there's a lot of factors. And as I said, I'm going to hold off on giving a specific number until we get it sorted out. We've got more work to do as an organization, but we're progressing well on it. And in the first quarter, we'll share that.

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Operator [48]

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We'll take our next question from Bob Napoli with William Blair.

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Robert Paul Napoli, William Blair & Company L.L.C., Research Division - Partner and Co-Group Head of Financial Services & Technology [49]

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I'd also welcome you, John, and look forward to working with you as well. The first question is just on the direct deposits. The growth of direct deposits has been so strong and it is by far your lowest cost of funds. And I guess, if you could have any thoughts around what percentage of your funding over the long term could be through direct deposits, because it's a nice tailwind, obviously, to your business, to your margins?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [50]

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Yes. So -- it is. So what we do is we concentrate on the overall funding stack, and obviously, it's really important to make sure we have the right level of liquidity and other funding sources in place. But with that said, as we mentioned on the prepared comments, 53% of the funding stack was from deposits. We'd like to grow that. I think the previous guidance the business has given was, in the medium term, somewhere around 60%. And we'll look at that as a path forward, and we may adjust upward if conditions warrant.

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Robert Paul Napoli, William Blair & Company L.L.C., Research Division - Partner and Co-Group Head of Financial Services & Technology [51]

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A follow-up call on -- Roger, on the competitive front. I mean you do have -- one, you have an Apple card and just your thoughts around that? And then we've had some mega mergers in the payment space, and they're looking for revenue synergies. And one area that one company feels like it's low-hanging fruit is -- would be related to the PULSE business. And so I just wondered if you could comment on the Apple and then mega mergers and the ability to be able to continue to grow your payments business.

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [52]

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Yes. In terms of the Apple card, we've yet to see that have a noticeable impact on our volumes. So we're watching it carefully, but again, no noticeable impact.

In terms of the mega mergers on the payment side, A, we compete against Visa and Mastercard. So we're used to competing against very large companies in payments. A lot of it is -- it's sort of a broader ecosystem, where there are in fact partnership opportunities with some of those companies as well. So I'd probably say it's too early to understand it, the full impact on PULSE. But our goal is to be able to compete globally against anyone in the payments industry.

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Operator [53]

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We'll take our next question from Chris Donat with Sandler O'Neill.

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Christopher Roy Donat, Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research [54]

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I have one on the professional fees and the increase in them. Does that represent some sort of change in how you're doing collections? Like are you using rather than first-party or in-house collections, are you using more third-party collections? Or is it just something else going on there?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [55]

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Chris, thanks for the question. No, what actually you see there is a pretty substantial increase in overall recoveries. So recoveries third quarter '19 versus third quarter '18 are up about 32%. So that drives obviously a bit of the, I'll call it, commission for the third-party collectors.

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Christopher Roy Donat, Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research [56]

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Okay. Got it. And then just one more on CECL as you talk about the volatilities, you get more experience with sort of the parallel run of CECL. Does that affect how you might be thinking about capital in 2020 and beyond of maybe needing to have a little more pressure in recognizing that there's a phase in from a regulatory perspective for CECL? Or is that too soon to tell?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [57]

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Yes. So there will be a capital impact, right? The phase in is 25% over a 4-year period. It doesn't change the underlying cash flows of the business. So we're going to continue to try to optimize the capital base. And we're progressing, excluding CECL, towards the targeted level of 10.5%. So we'll present a capital plan to the Board and to the regulators and see what that looks like in 2020.

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Operator [58]

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We'll take our next question from John Hecht with Jefferies.

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John Hecht, Jefferies LLC, Research Division - Equity Analyst [59]

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Welcome, John. Most of my questions were asked, so maybe going to dive a little bit into the consumer behavior. So for new customers that you're attracting at this point, are they more -- are they reacting more to 0 balance transfers? Or what are the promotional factors are having heavy reactions at this point?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [60]

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We always try and bring in cardholders that are not just balance transfer active, but use their card as well. And so the Cashback Match continues to perform very well for us, but that probably is the other thing that's impacting new customers. But again, we focus on customer experience, we focus on line assignment. Every component is important, but I'd probably highlight that Cashback Match as sort of the biggest thing we have for new cardholders.

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John Hecht, Jefferies LLC, Research Division - Equity Analyst [61]

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Okay. And you mentioned the lines. The -- what are -- any changes to utilization rates? Or have those behaviors been pretty consistent as well?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [62]

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We haven't -- I'll go back. We have not picked up signs of distress in our portfolio as we look.

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Melissa Marie Wedel, JP Morgan Chase & Co, Research Division - Analyst [63]

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So utilization rate is stable as expected?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [64]

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Yes.

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Operator [65]

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We'll take our next question from Meng Jiao with Deutsche Bank.

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Mengxian Jiao, Deutsche Bank AG, Research Division - Research Analyst [66]

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A question on, I guess, loan growth. Just from simple back-of-the-envelope math, I mean, loan growth need to, I guess, accelerate a bit in 4Q to reach that low end of that 6% to 8% prior guidance range. I'm wondering if you guys could provide any color, and do you still expect that to be true? Or -- and where are you seeing the most strength there?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [67]

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I won't comment on the guidance. I would say, if you look at the quarter, we feel very good about our card loan growth. We feel good about how student loans performed in the peak season. And we have talked about really a lower growth rate for personal loans in terms of expectations for this year. As we tested our new credit models for some segments that had not performed as well as we wanted, we're excited about how those are doing as well. So again, we feel good about our ability to achieve loan growth. It will, of course, depend on the holiday season. But so far, consumers seem to be in a pretty good space.

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Mengxian Jiao, Deutsche Bank AG, Research Division - Research Analyst [68]

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Got you. Great. And my second question is just on overall international acceptance. I think mid-quarter, you mentioned that international acceptance was somewhere in the seventh inning. And I know in your prepared remarks, you mentioned focusing more in Africa as well as Western Europe. I'd like to get any sort of updated thoughts you had there in terms of innings and how you see Discover progressing internationally going forward?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [69]

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The seventh inning is quite long, and we may go to extra innings. So maybe that's not the best way to phrase it. It will be a continued investment. And I think Africa just gives you an example of the breadth of our investments. We're also working with network partners everywhere from Eastern Europe, to Asia, to South America. A particular focus has been on Western Europe and working with acquirers there. So you've heard us announce a number of partnerships. So we will continue to build out our global acceptance footprint.

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Operator [70]

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We'll take our next question from Brian Foran with Autonomous.

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Brian D. Foran, Autonomous Research LLP - Partner & US Regional Banks [71]

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Maybe just on the deposit betas, the 50% so far was interesting. And I think most of the traditional banks are struggling to get 15%, 20% beta so far. Is your feeling that that's a timing issue, i.e., it's easier for you and peers to lower the online deposit rates and reprice most of the existing book quickly? Or are you more encouraged that maybe the betas could just be higher on online deposits throughout a Fed easing cycle?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [72]

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Yes. I mean I think if you compare to a lot of the more traditional brand space banks, they tend to have a lower beta. A lot of it has to do with their product mix. And so having more in checking or in savings accounts and are paying in the -- yes, sometimes in the single-digit basis points. They pay through operating expenses as opposed to rate. So I think there is a natural symmetry between the betas you experience on the way up and what you have on the way down. And so a lot of those banks captured the rate increases on the way up and didn't move their rates much at all. But that unfortunately doesn't give you much room to adjust when rates are coming back down.

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Brian D. Foran, Autonomous Research LLP - Partner & US Regional Banks [73]

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Got it. And then 2 small things, one on the loan fees when you referenced the changes that drove it to $120 million versus kind of around $105 million before. Does it, all else equal, stay around $120 million, or does it go back to $105 million, as we think about putting something in the model going forward?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [74]

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So that's a function of the late payments and also the pricing tiers that we put in place. So I would expect a little -- certainly a tick up based on history. But some of it will be tied, obviously, to late payments and that's -- you'll be able to see the trends there.

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Brian D. Foran, Autonomous Research LLP - Partner & US Regional Banks [75]

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And then I hate to ask for a clarification of the clarification of the NIM guidance, but I managed to get myself tripped up. When you were kind of saying 1 basis point or 2 above the old 10.39% high end, that was for the full year we should think about 10.40%?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [76]

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Yes. Thanks for that clarification question. Yes, it would be for the full year.

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Brian D. Foran, Autonomous Research LLP - Partner & US Regional Banks [77]

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Okay. So 4Q 10.3% plus or minus is kind of the implied output of that?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [78]

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Yes. You solved the math.

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Brian D. Foran, Autonomous Research LLP - Partner & US Regional Banks [79]

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I wouldn't put a lot of trust in that. So I figured I'd ask. I appreciate it.

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Operator [80]

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We'll take our next question from Jason Kupferberg with Bank of America.

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Mihir Bhatia, BofA Merrill Lynch, Research Division - Research Analyst [81]

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This is Mihir on for Jason. And firstly, congratulations, John, on joining the team. The first question, I think, if I could go back where we started, I guess, back to the click-to-pay or the unified payment button. And I was just curious, will you be putting any promotional efforts around getting your cardholders to enroll their Discover cards or make them default on that button?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [82]

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I think we're in the early stages of implementation. Clearly, we try and make sure that our cardholders are using Discover, and I think this is where there may be an advantage for us in terms of our integrated network and card issuer model. We can enable it probably more seamlessly than someone who uses a third-party issuer. As an example, we were the first ones to be able to provision Apple Pay from within our app. So we'll look for opportunities where we can make the experience more seamless for Discover cardholders.

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Mihir Bhatia, BofA Merrill Lynch, Research Division - Research Analyst [83]

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Got it. And then just around -- I just had a question around credit and your net charge-off guidance. I think you've mentioned 3.2% to 3.4% for the year. And I was just doing the rough math here, looking at how you performed year-to-date.

Is there a potential for it to come in a little better than that? Or are you sticking with -- or at least at the very low end of that, just because -- I mean it sounds like you're pretty favorable on credit. And looking at year-to-date performance and Q3 performance, that need to be pretty meaningful quarter-over-quarter degradation to get to the higher end of that certainly?

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John Thomas Greene, Discover Financial Services - Executive VP & CFO [84]

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Yes. So thanks for that. So yes, the guidance was 3.2% to 3.4%, and we're certainly performing at the lower end of that. At this point, I'll probably just pause there and say that lower end of the guidance, and if you choose to put something else in your model, be comfortable with it.

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Operator [85]

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We'll take our final question from Jon Arfstrom with RBC Capital Markets.

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Jon Glenn Arfstrom, RBC Capital Markets, LLC, Research Division - MD [86]

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Just a quick one on deposit growth. Curious if you had to put your finger on what's driving it, would you say that new deposit account growth is tracking with overall deposit account growth? Are you seeing something like higher average balances on existing accounts? Or is it both, if that makes sense?

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Roger Crosby Hochschild, Discover Financial Services - CEO, President & Director [87]

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Yes. No, it's both. So we're attracting new customers, but we're also seeing some of our existing customers build their balances, whether it's adding another CD or just putting more money into the savings account. So it's a mix of both from new as well as existing customers.

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Operator [88]

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And there are no further questions at this time. Mr. Streem, your closing comments please.

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Craig A. Streem, Discover Financial Services - VP of IR [89]

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Thanks, Erica, and thank you all for your attention, for your questions. And you know where to find us for any follow-up. Thanks. Have a good evening.

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Operator [90]

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Thank you for your participation. This does conclude today's conference call, you may now disconnect.