The Second Quarter 2023 Discover Financial Services Earnings Conference Call was opened by Todd, the conference operator, and Eric Wasserstrom, the Head of Investor Relations. Roger Hochschild, the CEO, and John Green, the Chief Financial Officer, shared highlights from the quarter, including strong asset and deposit growth and credit performance in line with expectations. The quarter resulted in a net income of $901 million or $3.54 per share.

This quarter, Discover has advanced several operational priorities, including relaunching their cash back debit product, expanding their Discover Global Network, and investing in their human capital. They were recently recognized as one of the Best Places to Work for People with Disabilities. Unfortunately, Discover misclassified certain card accounts into their highest merchant and merchant acquirer pricing tier, which is not material but has caused deficiencies in their corporate governance and risk management. They are taking actions to correct the misclassification and are in discussions with their regulators regarding these matters.

Roger reviewed the financial implications of the card misclassification, which resulted in a liability of $365 million and an adjustment to retained earnings of $255 million. John Greene then discussed the financial summary results, which showed strong revenue growth and a low efficiency ratio, but a decrease in net income of 18%. Net interest income was up 22%, and the net interest margin was 11.06%. Card receivable growth was 19%, and sales volume grew 3%.

Growth in mid-July was up 1%. Personal loans were up 27% due to strong consumer demand while deposits increased 20% year-over-year and 4% sequentially. Non-interest income increased 16% due to a gain on equity investments. Operating expenses increased 15% due to investments in compliance management systems and compensation costs increased 14%. Net charge-offs were 3.22%, 142 basis points higher than the prior year and up 50 basis points from the prior quarter.

This quarter, the company increased its reserve by $373 million due to double-digit loan growth and its common equity Tier 1 ratio was 11.7%. They also repurchased 6.8 million shares of common stock and declared a quarterly common dividend of $0.70 per share, however they have paused share repurchases while they review compliance, risk management and corporate governance. They are expecting loan growth to be in the low to mid-teens, an NIM of 11%, operating expenses to be up low double digits and net charge-offs to be 3.4% to 3.6%. Their business model continues to generate solid financial results and their capital, funding and liquidity positions remain strong.

Roger Hochschild addressed a question from Rick Shane of JPMorgan regarding the link between the misclassification and the inquiry into governance and consumer tracking. Hochschild clarified that the FDIC matter is not linked to the misclassification, but that the misclassification may result in further regulatory action. He also noted that regulatory action can take many forms and that the company is working with its regulators on a draft consent order, which will be made public once it is completed.

Jeff Adelson and Roger Hochschild discuss the similarities between the current compliance and risk management issues and the student loan servicing issue from last year. John Greene explains that the priority is to invest in the business and growth and return excess capital to shareholders, with the buyback providing clarity on the timing of resumption.

Roger Hochschild and John discussed the consumer spend trajectory in July, which is around 1%. They noted that this is not as bad as it sounds due to challenging comps from last year and high levels of new accounts. They also discussed the strength of the job market being constructive for their prime consumer base. In terms of investments, they have been investing in compliance over the last couple of years, and John can provide more color on the timeline for these investments.

John Greene discusses the investments Discover is making in its compliance management system, including technology, outside consultants, and headcount. He also mentions that the company is increasing their compliance spend from 2019 to 2023, with an expected increase of $250 million to $300 million from 2019 to 2022 and a $200 million increase from 2022 to 2023, and expects that expense burn to reduce once they reach that level. He then talks about their confidence in the credit loss curve continuing to normalize, and bending as they approach the midpoint of next year.

John Greene talks about the tightening in the range of forecasting and how it is reflective of a couple of things such as comfort with forecasting and the use of a traditional roll rate model. He also mentions that the jobs data and forecast of employment has given them additional comfort. He states that the newer vintages are seasoning to expectations and older vintages are normalizing to 2019 levels. He expects charge-offs to peak in the second half of 2024 and stabilize for two to three quarters after. In response to John Hecht's question about when to expect normalization of loan growth, John Greene states that it depends on the comps and stabilization of inflation.

The speaker is discussing loan growth and competitive spending in the financial sector. They expect loan growth to slow in the third and fourth quarter of the year, and typically this business has loan growth between 2-4 times GDP growth. They are cutting back on lower credit quality which will impact new account growth, and sales growth is expected to slow and stabilize in the single digits. They are investing in compliance and technology, and have seen good results from their marketing front in terms of cost per account with the relaunch of cash back debit. They will also put money against the mass market campaign in the fall.

John Greene discussed the merchant miscalculation, which was found internally. He then discussed the trajectory of NIM, which was initially expected to move up modestly, but then peak and normalize to a higher level than historically. He attributed the change in guidance to promotional balances, which had a minor impact on NIM in the short term, as well as increased deposit competition, which caused the competitive set to be more aggressive in terms of price increases.

The decision to pause share repurchases was made out of prudence, and the company has done multiple tests to ensure that capital and liquidity remain above regulatory requirements. Sanjay Sakhrani asked if there are other ways to moderate the overall implications of the consent order, to which John Greene responded that they are looking into it.

John Greene and Roger Hochschild discuss the investments they are making in their expense base and how they are leveraging their procurement organization to ensure a fair value exchange. They are continuing to tighten credit, but still bringing in very strong new accounts. They are monitoring the performance closely and making adjustments when necessary.

John Greene states that the company is targeting a low double digit expense growth for the year and is confident that the goal can be achieved. He also mentions that the company is investing in compliance and growth, and that they will dial each of the expense levers in order to meet the expectations of shareholders, the Board and the management team. He also notes that there are opportunities to create efficiencies in areas such as marketing and headcount.

The company has invested in advanced analytics to drive rewards cost efficiencies and reduce third-party spending. This year, they have increased their personnel by 3,000 people, leading to additional costs. To manage the situation, they have prioritized getting the right resources and plan to focus on driving efficiencies in the future. In response to a question about the application quality of new applicants, they have tightened their underwriting and are actively monitoring the health of the consumer and the portfolio to ensure caution.

Roger Hochschild explains that Discover's goal is to become the leading digital bank, and the relaunched debit product is a step towards that goal. By having a proprietary network, they can offer rewards in debit that no other large bank can, and it builds on their heritage of cashback and credit card rewards. This product is not just to cross-sell to their card customers, but can quickly become a significant entry point into the franchise for new customers.

Roger Hochschild states that the compliance issue is the top priority of the team and is aligned with the views of the regulators. He outlines the steps taken to address the issue, such as simplifying the architecture, automating manual processes, streamlining and standardizing business processes, and bringing on new talent. He also provides a timeline for when the review should be complete, expecting it to take a quarter or two.

Roger Hochschild and John Greene discussed the opportunity to simplify operations in order to improve compliance and efficiency. They also discussed how they consider their businesses and products in line with their capital allocation priorities and customer base.

Roger Hochschild is confident that Discover can deliver the returns investors have come to expect over the last 10-20 years, despite the higher compliance bar and competitive environment. He believes the company's scale and resources, investments in data and analytics, and award-winning customer experience will help them to compete with anyone. They are also re-launching their cash back debit product.

Roger Hochschild acknowledges that Discover has not been investing enough in compliance in the past, but is now focused on it. This includes bringing in highly talented people, building out monitoring and controls, and investing in technology to automate manual processes. Hochschild believes that this investment will help Discover manage risks, as the complexity of their business increases.

John Greene and Arren Cyganovich discuss the net charge-off peak that will occur in the second half of 2024 and possibly into 2025. Greene explains that their underwriting is focused on prime revolver and the return expectations remain high. He also states that their credit box has been relatively consistent and their analytics have improved over the years. Finally, Greene clarifies that they have not made a decision to pull back on marketing and explains the trajectory of the compliance management cost.

The company is expecting loan growth to be in the low to mid-teens range for the year, which would mean 7% growth in the second half and low single digit growth in the fourth quarter. This would imply that loan growth in the most recent month was 1%, and spending was 2.5% this quarter.

John Greene answers both questions asked by Dominick Gabriele, saying that loan fee income is typically made up of late fees and NSF fees and that if unemployment levels increase, it could affect net charge offs. He also mentions that the company is doing targeted promotional activities to drive high generating, high returning accounts.

Discover has seen that people in their target cohort have a quick recovery time when impacted by job situations, allowing them to find equal or higher paying jobs in the current environment. This has not affected their credit situation. Discover will look for opportunities to drive loan growth, and will consider sales data and spending data from consumers when providing guidance. The market opportunity for personal loans is robust, and the mix of new and existing customers is still about 50-50.

Discover Financial Services saw strong consumer demand for their debt consolidation product, allowing them to tighten their credit and raise their prices. They are seeing a mix of new customers and existing cardholders through cross-selling. The competition has pulled back a bit, but there are still a good number of competitors who offer a broader range of services. The call concluded with the IR team wishing everyone a good day.

This summary was generated with AI and may contain some inaccuracies.