Q2 2024 Discover Financial Services Earnings Call

Music

Todd: 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 second quarter 2024 Discover Financial Services earnings conference call. All lines have been placed on mute to prevent any background noise.

Todd: Good morning. My name is Todd and I will be your conference operator today.

Speaker Change: At this time, I would like to welcome everyone to the second quarter 2024 Discover Financial Services earnings conference call. All lines have been placed on mute to prevent any background noise.

Todd: Please note there will be no question and answer period after this morning's prepared remarks. After the call ends, questions should be directed to the Discover Investor Relations team. Lastly, if you need operator assistance, please press star zero. Thank you. I will now turn the call over to Mr. Eric Wasserstrom, Senior Vice President of Corporate Strategy and Investor Relations.

Speaker Change: Please note there will be no question and answer period after this morning's prepared remarks.

Speaker Change: After the call ends, questions should be directed to the Discover Investor Relations team.

Eric Edmund Wasserstrom: Lastly, if you need operator assistance, please press star zero. Thank you. I will now turn the call over to Mr. Eric Wasserstrom, Senior Vice President of Corporate Strategy and Investor Relations. Please go ahead.

Eric Edmund Wasserstrom: Thank you, and welcome to this morning's call. I'll begin by referencing slides two and three 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 in the second quarter 2020 earnings press release and presentation, as well as the risk factors detailed in our annual report and other filings with the SEC.

Eric Edmund Wasserstrom: Thank you and welcome to this morning's call. I'll begin by referencing slides 2 and 3 of our earnings presentation which you can find in the financial section of our Investor Relations website, www.investorrelations.discover.com

Speaker Change: Our discussion today contains certain forward-looking statements that are subject to risks and uncertainties that may cause actual results to differ materially.

Speaker Change: Please refer to our notices regarding forward-looking statements that appear in the second quarter 2020 for earnings press release and presentation, as well as the risk factors detailed in our annual report and other filings with the SEC.

Eric Edmund Wasserstrom: Our call today will include remarks from our Interim CEO, Michael Shepard, and John Greene, our Chief Financial Officer. There will be no question-and-answer session following today's remarks. However, the Investor Relations team will be available for any inquiries. It is now my pleasure to turn the call over to Mike.

Speaker Change: Our call today will include remarks from our Interim CEO , Michael Shepard, and John Greene, our Chief Financial Officer. There will be no question and answer session following today's remarks. However, the Investor Relations team will be available for any inquiries. It is now my pleasure to turn the call over to Michael.

Mike: Thank you, Eric. Good morning, and welcome to our guests who have joined today's call.

Michael Shepard: Thank you, Eric. Good morning and welcome to our guests who have joined today's call. Discover's second quarter operating performance was very good, and we advanced several strategic priorities. Let me highlight a few of these accomplishments.

Mike: Discover's second quarter operating performance was very good, and we advanced several strategic priorities. Let me highlight a few of these accomplishments. On July 17th, we entered into an agreement to sell our private student loan portfolio to affiliates and limited partners of Carlyle and KKR. Firstmark, a division of Nelnut, will assume responsibility for servicing the portfolio upon sale. This agreement represents an important milestone in our journey to simplify our operations and business.

Speaker Change: On July 17th, we entered into an agreement to sell our private student loan portfolio to affiliates and limited partners of Carlyle and KKR. Firstmark, a division of Nelnet, will assume responsibility for servicing the portfolio upon sale.

Speaker Change: This agreement represents an important milestone in our journey to simplify our operations and business mix.

Mike: The completion of the sale also has financial implications, which John Greene will detail in a few moments. Additionally, as we continue to resolve past issues and strengthen our risk management and compliance posture. We have entered into a settlement agreement to resolve the merchant class actions associated with the card misclassification litigation, subject to court approval. The decision to settle was based upon internal reviews, extensive dialogue with key constituencies, including merchants and regulators, and our pending merger with Capital One. The settlement agreement would resolve claims by parties affected by the card misclassification, including merchants, acquirers, and intermediaries. Our current remediation reserve is sufficient to cover the expenses under the terms of the settlement agreement.

Speaker Change: The completion of the sale also has financial implications, which John Greene will detail in a few moments.

Speaker Change: As we continue to resolve past issues and strengthen our risk management and compliance posture, we have entered into a settlement agreement to resolve the merchant class actions associated with the card misclassification litigation subject to court approval.

Speaker Change: The decision to settle was based upon our internal reviews, extensive dialogue with key constituencies, including merchants and regulators, and our pending merger with Capital One.

Speaker Change: The settlement agreement would resolve claims by parties affected by the card misclassification, including merchants, acquirers, and intermediaries.

Speaker Change: Our current remediation reserve is sufficient to cover the expenses under the terms of the settlement agreement.

Mike: Our results also benefited from a litigation settlement in our payment services segment, where Discover was the plaintiff. We are happy to have this matter resolved and are satisfied with the favorable financial outcome. Finally, turning to our pending merger with Capital One, Capital One continues to lead the integration planning process, and the teams are working well together on integration planning and regulatory applications. Upcoming merger-related milestones include a virtual public hearing hosted by the Federal Reserve and the OCC.

Speaker Change: Our results also benefited from a litigation settlement in our payment services segment where Discover was the plaintiff. We are happy to have this matter resolved and are satisfied with a favorable financial outcome.

Speaker Change: Finally, turning to our pending merger with Capital One. Capital One continues to lead the integration planning process, and the teams are working well together on integration planning and regulatory applications.

Speaker Change: Upcoming merger-related milestones include a virtual public hearing hosted by the Federal Reserve and the OCC, the completion of the written comment period, an in-person public hearing with the Delaware State Bank Commissioner, and the filing of the definitive merger proxy.

Mike: The completion of the written comment period, an in-person public hearing with the Delaware State Bank Commissioner, and the filing of the definitive merger proxy. We expect shareholder votes to occur this fall. We are encouraged by how the merger planning and application processes are progressing and continue to believe that the strategic rationale, operating scale, and economics of the combined company are compelling. With that, I'll now ask John Greene to review our second quarter 2024 financial results.

Speaker Change: We expect shareholder votes to occur this fall.

Speaker Change: We are encouraged by how the merger planning and application processes are progressing, and continue to believe that the strategic rationale, operating scale, and economics of the combined company are compelling.

Speaker Change: With that, I'll now ask John Greene to review our second quarter 2024 financial results.

John Thomas Greene: Thank you, Michael, and good morning, everyone. I'll start with our summary financial results on slide 5. In the quarter, we reported net income of $1.5 billion, which was up 70% from the prior year quarter. Our fundamental performance in the period was driven by revenue expansion from loan growth, higher net interest margin, and non-interest revenue growth. Credit continues to perform in line with expectations, supporting our view that losses are near their peak and will plateau during the second half of 2024.

John Thomas Greene: Thank you, Michael, and good morning, everyone. I'll start with our summary financial results on slide 5.

John Thomas Greene: In the quarter, we reported net income of $1.5 billion, which was up 70% from the prior year quarter.

John Thomas Greene: Our fundamental performance in the period was driven by revenue expansion from loan growth, higher net interest margin, and non-interest revenue growth.

John Thomas Greene: Credit continues to perform in line with expectations, supporting our view that losses are near peak and will plateau during the second half of 2024.

John Thomas Greene: There are several unusual items which impacted the quarter. These included an $869 million student loan reserve release, a gain of $26 million from the sale of our Lake Park facility, and largely offsetting one another were the favorable litigation settlement and a charge for expected regulatory penalties related to the card misclassification matter. Excluding unusual items, we would have reported net income of approximately $915 million and EPS of about $3.63 per share. Let's review the details, beginning on slide six.

John Thomas Greene: There are several unusual items which impacted the quarter. These included a $869 million student loan reserve release, a gain of $26 million from the sale of our Lake Park facility.

John Thomas Greene: and largely offsetting one another were the favorable litigation settlement and a charge for expected regulatory penalties related to the card misclassification matter.

John Thomas Greene: Excluding unusual items, we would have reported net income of approximately $915 million, and EPS of about $3.63 per share.

John Thomas Greene: Our net interest margin ended the quarter at 11.17%, up 11 basis points from the prior year and up 14 basis points sequentially. On a quarter-over-quarter basis, margin expansion was primarily driven by a lower card promotional balance mix. As anticipated, receivable growth continues to normalize from its early 2023 peak.

John Thomas Greene: Let's review the details beginning on slide 6.

John Thomas Greene: Our net interest margin ended the quarter at 11.17%, up 11 basis points from the prior year, and up 14 basis points sequentially.

John Thomas Greene: On a quarter-over-quarter basis, margin expansion was primarily driven by a lower-card promotional balance mix. As anticipated, receivable growth continues to normalize from its early 2023 peak.

John Thomas Greene: Card receivables increased 7% year-over-year due to a lower payment rate and a smaller contribution from new accounts. The payment rate declined about 130 basis points compared to last year and is now about 90 basis points above 2019 levels. Discover card sales were down 3% compared to the prior year. Spending at restaurants, which is a large category for sales volume, declined sequentially as a result of being included in the 5% promotion during the first quarter. Accounting for the influence of promotional categories, sales trends are relatively stable.

John Thomas Greene: Card receivables increased 7% year-over-year due to a lower payment rate and a smaller contribution from new accounts.

John Thomas Greene: The payment rate declined about 130 basis points compared to last year and is now about 90 basis points above 2019 levels.

John Thomas Greene: Discover card sales were down 3% compared to the prior year. Spending at restaurants, which is a large category for sales volume, declined sequentially as a result of being included in the 5% promotion during the first quarter.

Speaker Change: Accounting for the influence of promotional categories, sales trends are relatively stable. We continue to see a cautious consumer, evidenced by less card members spend, with lower income households being most affected.

John Thomas Greene: We continue to see a cautious consumer, evidenced by less card members spending, with lower income households being most affected. However, personal loans were up 13% from the prior year period. In response to market conditions, we prudently tightened underwriting over the past year, which has served to modestly reduce originations. For example, student loans were down 1% year over year. As Michael mentioned, we have entered into an agreement to sell our student loan portfolio. We expect the transaction to be completed in four tranches by the end of 2024.

Unknown Executive: Posted. Personal loans were up 13% from the prior year period.

Speaker Change: Personal loans were up 13% from the prior year period.

Unknown Executive: In response to market conditions, we've prudently tightened underwriting over the past year, which has served to modestly reduce originations. Student loans were down 1% year over year.

Speaker Change: In response to market conditions, we prudently tightened underwriting over the past year, which has served to modestly reduce originations.

Michael: As Michael mentioned, we have entered into an agreement to sell our student loan portfolio. We expect the transaction to be completed in four trenches by the end of 2024. The purchase prices added a premium to the principal balance and is based on the formula that varies depending on the closing timing, interest rates, and other factors. In association with this development, student loans are now accounted for as held for sale. The two most notable impacts to the financial statements are that we will no longer maintain a credit reserve for student loans, and future student loan net charge loss will be recognized through operating expense rather than credit losses.

Speaker Change: Student loans were down 1% year-over-year. As Michael mentioned, we have entered into an agreement to sell our student loan portfolio.

Michael Shepard: We expect the transaction to be completed in four tranches by the end of 2024. The purchase price is at a premium to the principal balance and is based on a formula that varies depending on the closing timing, interest rates, and other factors.

John Thomas Greene: The purchase price is at a premium to the principal balance and is based on a formula that varies depending on the closing timing, interest rates, and other factors. In association with this development, student loans are now accounted for as held-for-sale. The two most notable impacts on the financial statements are that we will no longer maintain a credit reserve for student loans, and future student loan net charge-offs will be recognized through operating expense rather than credit loss.

Michael Shepard: In association with this development, student loans are now accounted for as held for sale.

Michael Shepard: The two most notable impacts to the financial statements are that we will no longer maintain a credit reserve for student loans, and future student loan net charge-offs will be recognized through operating expense rather than credit losses.

John Thomas Greene: Average consumer deposits were up 15% year over year and 1% sequentially; deposit balances are being managed in relation to our liquidity needs, which will benefit from the student loan sale. Our disciplined approach to deposit pricing has led to a modest reduction in average deposit rates in the second quarter, consistent with our practice of leading the industry on pricing in downed parts of the site.

Unknown Executive: Average consumer deposits were up 15% year over year and 1% sequentially. The positive balances are being managed in relation to our liquidity needs, which will benefit from the student loan sale. Our disciplined approach to deposit pricing has led to a modest reduction in average deposit rates in the second quarter, consistent with our practice of leading the industry on pricing in down parts of the cycles.

Michael Shepard: Average consumer deposits were up 15% year-over-year and 1% sequentially.

Michael Shepard: Deposit balances are being managed in relation to our liquidity needs, which will benefit from the student loan sale.

Michael Shepard: Our disciplined approach to deposit pricing has led to a modest reduction in average deposit rates in the second quarter, consistent with our practice of leading the industry on pricing in downed parts of the cycle.

John Thomas Greene: Looking at other revenue on slide 7, managers' income increased $313 million, or 45%. Discount and interchange revenue was up $67 million as a result of lower rewards costs. Our rewards rate was 132 basis points in the period, a decrease of 10 basis points versus the prior year quarter. The decline reflects lower cash back match. Other income increased due to unusual items, including the litigation settlement and the facility sale. On an adjusted basis, non-interest revenue grew 14%. Moving to expenses on slide eight, total operating expenses were up $325 million, or 23% year-over-year.

Unknown Executive: Looking at other revenue on slide seven, nine interesting come increase $313 million or $45 per cent. Discount and interchange revenue was up $67 million as a result of lower rewards cost. Our rewards rate was 132 basis points in the period, a decrease of 10 basis points versus the prior year quarter. That decline reflects lower cashback match.

Michael Shepard: Looking at other revenue on slide seven, non-interest income increased $313 million or 45%.

Michael Shepard: Discount and interchange revenue was up 67 million dollars as a result of lower rewards cost.

Michael Shepard: Our rewards rate was 132 basis points in the period, a decrease of 10 basis points versus the prior year quarter. The decline reflects lower cash back match.

Unknown Executive: Other income increased due to unusual items, including the litigation settlement and the facility sale. On an adjusted basis, nine interest revenue grew 14%.

Michael Shepard: Other income increased due to unusual items including the litigation settlement and the facility sale. On an adjusted basis, non-interest revenue grew 14%.

Unknown Executive: Moving to expenses on slide eight, total operating expenses were up $325 million, or 23% year over year. The most significant driver of this increase was a charge for expected regulatory penalties related to the card misclassification issue.

Michael Shepard: Moving to expenses on slide 8.

Michael Shepard: Total operating expenses were up $325 million or 23% year-over-year. The most significant driver of this increase was a charge for expected regulatory penalties related to the card misclassification issue.

John Thomas Greene: The most significant driver of this increase was a charge for expected regulatory penalties related to the card misclassification issue. However, it is important to note that actual penalties imposed are subject to further discussions and may be more or less than this amount. Adjusting for this charge, our expenses would have increased by 9% year over year, looking at our major expense categories. Compensation costs increased $70 million or 12%, primarily due to an increase in business technology resources. Professional fees were up $80 million, or 37%, driven by higher recovery fees and investments in compliance and risk management.

Unknown Executive: It is important to note that actual penalties and posts are subject to further discussions and may be more or less than this amount. Adjusting for this charge, our expenses would have increased by 9% year over year. Looking at our major expense categories, compensation costs increased $70 million or 12% primarily due to an increase in business technology resources. Professional fees were up $80 million or 37%, driven by higher recovery fees and investment and compliance and risk management.

Michael Shepard: It is important to note that actual penalties imposed are subject to further discussions and may be more or less than this amount.

Michael Shepard: Adjusting for this charge, our expenses would have increased by 9% year over year.

Michael Shepard: Looking at our major expense categories, compensation costs increased 70 million dollars or 12 percent primarily due to an increase in business technology resources.

Michael Shepard: Professional fees were up 80 million dollars or 37 percent driven by higher recovery fees and investments in compliance and risk management.

John Thomas Greene: Our expectation for compliance and risk management expenses for the full year remains in the $500 million range with an upside bias. This figure excludes card misclassification related costs. Moving to credit performance on slide nine, total net charge-offs were 4.83%, 161 basis points higher than the prior year, and down 9 basis points from the prior quarter. In CARD, delinquency formation improvement continued. The 30-plus day delinquency rate was down 14 basis points versus the prior quarter. From a vintage perspective, our 2023 card vintage continues to perform in line with our 2022 vintage.

Unknown Executive: Our expectation for compliance and risk management expenses for the full year remains in the $500 million range, within upside bias. This figure excludes hard misclassification-related costs.

Michael Shepard: Our expectation for compliance and risk management expenses for the full year remains in the 500 million dollar range with an upside bias.

Michael Shepard: This figure excludes card misclassification related costs. Moving to credit performance on slide 9.

Unknown Executive: Moving to credit performance on slide 9. Total net charge costs were 4.83%, 161 basis points higher than the prior year and down 9 basis points from the prior quarter. In card, the Lincwency formation improvement continued. The 30 plus stayed the Lincwency rate was down 14 basis points versus the prior quarter. From a vintage perspective, our 2023 card vintage continues to perform in line with our 2022 vintage.

Michael Shepard: Total net charge-offs were 4.83%, 161 basis points higher than the prior year, and down 9 basis points from the prior quarter.

Michael Shepard: In CARD, delinquency formation improvement continued. The 30-plus day delinquency rate was down 14 basis points versus the prior quarter.

Michael Shepard: From a vintage perspective, our 2023 card vintage continues to perform in line with our 2022 vintage.

Unknown Executive: As we look into the second half of the year, we'd expect there could be some variability in monthly card losses from both seasonality and various credit management actions we've taken. This does not change our broader outlook for losses to generally peak in plateau this year.

John Thomas Greene: As we look into the second half of the year, we expect there could be some variability in monthly card losses from both seasonality and various credit management actions we've taken. However, this does not change our broader outlook for losses to generally peak and plateau this year. Turning to the allowance for credit losses on slide 10, our credit reserve balance has declined $777 million from the prior quarter, reflecting the student loan reserve release partially offset by a $92 million reserve bill primarily to support loan growth.

Michael Shepard: As we look into the second half of the year, we expect there could be some variability in monthly card losses from both seasonality and various credit management actions we've taken. This does not change our broader outlook for losses to generally peak and plateau this year.

Unknown Executive: Turning to the allowance for credit losses on slide 10. Our credit reserve balances declined 777 million dollars from the prior quarter, reflecting the student loan reserve release, partially offset by a 92 million dollar reserve build, primarily a support loan growth. Our reserve rate was just over 7.2%, largely unchanged after adjusting for student loans.

Michael Shepard: Turning to the Allowance for Credit Loss is on slide 10.

Michael Shepard: Our credit reserve balance has declined $777 million from the prior quarter, reflecting the student loan reserve release partially offset by a $92 million reserve bill primarily to support loan growth.

John Thomas Greene: Our reserve rate was just over 7.2%, largely unchanged after adjusting for student loans. Looking at slide 11, our common equity tier one for the period was 11.9%, up 100 basis points bolstered by core earnings generation and the reserve release. We declared a quarterly cash dividend of 70 cents per share of common stock, concluding on slide 12.

Michael Shepard: Our reserve rate was just over 7.2%, largely unchanged after adjusting for student loans.

Unknown Executive: Looking at slide 11.

Unknown Executive: Our common equity tier one for the period was 11.9%, up 100 basis points, bolstered by core earnings generation and the reserve release.

Michael Shepard: Looking at slide 11, our common equity tier 1 for the period was 11.9%, up 100 basis points bolstered by core earnings generation and the reserve release. We declared a quarterly cash dividend of 70 cents per share of common stock.

Unknown Executive: We declared a quarterly cash dividend of 70 cents per share of common stock, concluding on slide 12.

Unknown Executive: We have revised our 2024 outlook and having included the impacts of the pending student loan sale. We are updating our loan growth expectations to be down low single digits, reflecting the roughly $10 billion asset sale. Absent this year, over your loan growth would be consistent with our prior review.

John Thomas Greene: We have revised our 2024 outlook and have included the impacts of the pending student loan sale. We are updating our loan growth expectations to be down low single digits, reflecting the roughly $10 billion assets. Absent this, year-over-year loan growth would be consistent with our prior review. We are increasing our net interest margin range to 11.1 to 11.4 percent. This change was driven by two factors.

Michael Shepard: Concluding on slide 12, we have revised our 2024 outlook and have included the impacts of the pending student loan sale.

Michael Shepard: We are updating our loan growth expectations to be down low single digits reflecting the roughly 10 billion dollar asset sale. Absent this, year-over-year loan growth would be consistent with our prior view.

Unknown Executive: We are increasing our net interest margin range to 11.1 to 11.4%. This change was driven by two factors. We now anticipate higher car yields reflecting a lower promotional balance mix and the student loan sale, which increases NIM by about 10 basis points. Our operating expense guidance is unchanged, notwithstanding the inclusion of the student loan net charge loss in this line item. Our base case for net charge loss remains at the low end of the 4.9% to 5.2% range. This includes the 10 basis points impact from student loans.

Michael Shepard: We are increasing our net interest margin range to 11.1 to 11.4 percent.

John Thomas Greene: We now anticipate higher card yields reflecting a lower promotional balance mix and the student loan sale, which increases NIM by about 10 basis points. Our operating expense guidance is unchanged, notwithstanding the inclusion of the student loan net charge-offs in this line item. Our base case for net charge-offs remains at the low end of the 4.9 to 5.2 percent range, which includes the 10 basis points impact from student loans.

Michael Shepard: This change was driven by two factors. We now anticipate higher card yields reflecting a lower promotional balance mix and the student loan sale, which increases NIM by about 10 basis points.

Michael Shepard: Our operating expense guidance is unchanged, notwithstanding the inclusion of the student loan net charge-offs in this line item.

Michael Shepard: Our base case for net charge us remains at the low end of the 4.9 to 5.2 percent range. This includes the 10 basis points impact from student loans. And finally, our capital management expectations have not changed.

John Thomas Greene: And finally, our capital management expectations have not changed. To summarize, we continue to generate solid financial results, remain steadfast in our efforts to resolve compliance matters, and look forward to consummating our plan merger. This concludes our remarks. I'll turn the call back over to the operator.

Unknown Executive: And finally, our capital management expectations have not changed. To summarize, we continue to generate solid financial results.

Michael Shepard: To summarize, we continue to generate solid financial results, remain steadfast in our efforts to resolve compliance matters, and look forward to consummating our planned merger. This concludes our remarks. I'll turn the call back over to the operator.

Unknown Executive: We need steadfast in our efforts to resolve compliance matters and look forward to consummating our plan merger.

Unknown Executive: This concludes our remarks. I'll turn the call back over to the operator.

Unknown Executive: This concludes the call. The Discover Investor Relations team will be available for questions. Thank you for joining.

Todd: This concludes today's call. The Discover Investor Relations team will be available for questions. Thank you for joining us. You may now disconnect.

Speaker Change: This concludes today's call.

Speaker Change: The Discover Investor Relations team will be available for questions. Thank you for joining. You may now disconnect.

Unknown Executive: You may now disconnect.