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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good afternoon. My name is Mike and I will be your conference operator today. At this time I would like to welcome everyone to the Q4 2017 Discover Financial Services Earnings Conference Call.
All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. [Operator Instructions]. Thank you.
I will now turn the call over to Craig Streem. You may begin your conference.
Mike, thank you very much. Welcome everybody to this afternoons call. I will begin on slide two of our earnings presentation, which you can find in the Financial Information section of our Investor Relations website, investorrelations.discover.com.
Our discussion today contains certain forward-looking statements about the company’s future financial performance and business prospects, which are subject to risks and uncertainties and speak only as of today.
Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today’s earnings press release, which was provided to the SEC in an 8-K report and in our 10-K and 10-Qs which are on our website and also on file with the SEC.
In the fourth quarter 2017 earnings materials, we’ve provided information that compares and reconciles the company’s non-GAAP financial measures with GAAP financial information, and of course we explain why these measures are useful to management and investors. We urge you to review that information in conjunction with today’s discussion.
Our call today will include remarks from David Nelms, our Chairman and Chief Executive Officer covering fourth quarter highlights and developments and then Mark Graf, our Chief Financial Officer will take you through the rest of the earnings presentation. After Mark completes his comments, we will of course have time for a Q&A session and we’d ask that during that time you limit yourselves to one question and one follow-up, so we can accommodate as many participants as possible.
Now, it’s my pleasure to turn the call over to David, who will begin his remarks on page three of the presentation.
Thanks Craig, and thanks to our listeners for joining today’s call. Before I get into my review of our full year 2017 results and accomplishments, I’d like to comment on the recently enacted tax legislation. While the new law did have a negative impact on our fourth quarter results, which Mark will discuss later on, I am truly excited about the clear benefit to Discover’s future earnings and the ability to make incremental investments in our business, our people and the community in which we do business. I also believe that the legislation will stimulate economic growth in 2018, which will tend to benefit consumers and Discover.
Now let’s turn to slide three and get into our review of full year 2017 results and key accomplishments. In 2017 we delivered earnings per share of $5.42 and a return on equity of 19%, which included a number of one-time items primarily related to the passage of new tax legislation.
Adjusting for these charges, EPS was $5.98 which was in-line with our expectations. Benefiting from the ongoing strength in the economy and more specifically on our own ability to deliver attractive products to our customers, we accelerated revenue growth in 2017, resulting from faster loan growth and a disciplined approach to credit.
Our card portfolio loss rates have risen, but remain well within our risk adjusted return parameters and the economic outlook for consumers’ remains favorable. I’ll talk more about loan growth and credit trends a bit later.
In payment services our PULSE, Diners Club and Network Partners businesses all drove increases in volume and revenue, while reducing operating expenses. I’m pleased that volume for the segment was up 12% year-over-year which contributed to a healthy increase in profit before tax.
In PULSE, growth continued to come primarily from our core point of sale business and was driven by merchant and acquired routing decisions, as well as the addition of new issuers and incremental volume from existing issuers. In Diners, some of our newer franchises made meaningful contributions to growth in 2017.
Shifting to expenses, in 2017 we continued to make important and impactful investments in our people, marketing and technology to drive growth and new capabilities, resulting in a 5% increase in operating expenses. Our direct banking strategy produces an efficient operating model, resulting in a best in class efficiency ratio.
In 2017 we grew revenue 4% faster than expenses, and our efficiency ratio was 38%. Finally we returned $2.5 billion to shareholders in the form of dividends and share repurchases, resulting in the payout ratio of 123% and bringing us closer to our capital targets.
Moving to slide four, total loans increased 9% in 2017 to $84 billion, with the card business generating more than 80% of this growth. We achieved these results by continuing to focus on prime revolvers and maintaining discipline and pricing, rewards and credit. Card loan growth continues to come from a balanced mix of new accounts and existing customers.
The student loan business originated $1.6 billion in new loans in 2017, another record year, up 12% from the prior year. With faster growth than the other large student lenders, we believe we are now the second largest originator of private student loans in the country.
We continue to expand our presence in the student loan market, focusing on early awareness with the website collegecovered.com designed to help students and their families prepare for making decisions about college and how to pay for it.
Personal loans remain an important part of our product offering, generating strong returns while providing a helpful tool for customers looking to consolidate debt and manage their finances. As we have discussed the last several quarters, we have taken actions to curtail growth in some segments and we expect that the growth rate in personal loans will continue to slow. Our strategy will remained focused on originating profitable quality loans. We will not pursue growth simply for the sake of growth.
After several years of historically low net charge off rates, charge off rates rose in 2017 reaching 2.7% for the full year. One factor contributing to the higher levels was higher loss severities. The increasing supply of credit from lenders and greater demand for credit from consumers have contributed to rising debt levels and larger losses when a customer defaults. Consumer debt service burdens while rising are still near historic lows, while consumers are re-leveraging both creditors and borrowers are still generally behaving responsibly.
The other factor playing a role in rising net charge offs is the seasoning of growth. In fact each vantage since the crises has been larger than the preceding vintage for us, which while driving revenue growth also puts upwards pressures on net charge offs as each new vintage reaches peak losses. Of course our commitment to disciplined profitable growth in the prime revolver segment remains unchanged and we are quite comfortable with how those vintages are performing.
As we think about tax reform, it not only enhances our current profitability, but also affords us the opportunity to build incremental shareholder value by investing further in growth, our people and the community.
The first investment we made was in our people. All non-executive full time employees, over 15,000 people, received a one time, $1000 bonus to recognize the critical role they play in deliver exceptional service to customers.
Further later this year, we will be increasing our starting hourly wage to $15.25 for all full time U.S. based employees. We expect our shareholders will benefit in the long term from these incremental portfolio growth initiatives and investments in our people.
In summary, our consistent focus on the customer, strong momentum across our businesses and favorable economic conditions continue to drive strong revenue and loan growth and profitability.
I’ll now ask Mark to discuss our financial results in more detail.
Thanks Dave and good evening everyone. I’ll begin by addressing our summary financial results on slide five. Earlier today we reported earnings per share of $0.99 for the quarter, including a number of one-time items primarily related to the passage of new tax legislation. Adjusted for these charges, EPS was $1.55 for the quarter and $5.98 for the full year. Our adjusted fourth quarter EPS was nearly 11% higher than last year’s comparable period.
Looking at key elements to the income statement, our 11% revenue growth in the fourth quarter was driven primarily by a combination of strong loan growth and margin expansion. The increase in provision is largely consistent with ongoing supply driven normalization in the consumer credit industry, as well the seasoning of our last several years of loan growth. Operating expenses rose 15% year-over-year driven by investments to support new growth and capabilities, as well as an unusually low level of expenses in the fourth quarter of last year.
Turning to slide 6, total loans increased 9% over the prior year driven by 9% growth in credit card receivables. Growth in standard merchandise revolving balances drove much of this increase in card receivables, spurred by strong sales growth particularly among revolvers. Promotional balances also contributed to growth.
We also achieved strong loan growth in our other primary lending products. Personal loans increased 14% from the prior year, down from the peak of 22% in the second quarter of 2017 as a result of the tightening of underwriting standards in certain segments that we talked about in for the last several quarters. We expect that personal loan growth will continue to slow in coming quarters as a result of these changes. Private student loan balances rose 2% in aggregate, but our organic portfolio increased 11% year-over-year with strong performance during 2017 peak season.
Moving to the results from our payments network, on the right-hand side of slide six, you can see that proprietary volume rose 7% year-over-year, driven primarily by an increase in active Discover card accounts. In our Payment Services segment, PULSE volume growth continued to increases with 19% higher volume compared to the prior year. Diners Club volume rose 14% from the prior year on strength from newer franchises.
Moving to revenue on slide seven, net interest income increased $228 million or 12% from a year ago, driven by a combination of higher loan balances, market rates and our balance sheet positioning. Total non-interest income was up $28 million as a result of increased card sales volume and a slightly lower rewards rate this year resulting from changes to the rotating 5% category we opted to feature in the fourth quarter.
Discover card sales volume showed 9% growth this quarter, in part due to a greater number of processing days in 2017 when compared to 2016. If we adjust for the number of processing days, sales growth would have been closer to 6%. We expect to see the reverse impact in the first quarter of 2018.
As shown on slide eight, our net interest margin rose 21 basis points from the prior year and was flat sequentially ending the quarter at 10.28%. Relative to the fourth quarter of last year of higher prime rate and a tighter credit spreads on refinanced long term debt drove margin higher, offset in parts by an increase in promotional balances and higher interest charge offs. Relative to the third quarter, the impact of higher loan yields and tighter credit spreads on new long term debt were offset by higher charge offs and deposit rates.
Total loan yield increased 26 basis points from a year ago to 12.14% driven by a 17 basis points increase in card yield and a 63 basis point increase in private student loan yield. Prime rate increases, partially offset by a shift in portfolio mix towards promotional balances and higher charge offs drove card yields higher. Higher short term interest rates drove the increase in student loan yields.
On the liability side of the balance sheet, we once again generated robust growth in our consumer deposits. Average balances increased $3.4 billion or 10% year-over-year. Consumer deposit rates moved slightly higher during the third quarter, rising 7 basis points sequentially and 18 basis points year-over-year. We expect deposit betas will continue to rise gradually toward more normalized levels with any future rate hikes.
Turning to slide nine, operating expenses rose $139 million from the prior year’s unusually low level. Employee compensation and benefits was higher driven primarily by higher headcount to support business growth, the $16 million per tax cost of the one-time bonus granted to eligible employees David mentioned a moment ago, higher average salaries and adjustments to reflect changes in certain compensation policies.
Marketing expenses were higher as a result of higher acquisition costs and increased brand advertising. Professional fees were also higher as we continued to invest in digital and mobile capabilities, as well as advanced analytics and machine learning technologies.
I’ll now discuss credit results on slide 10. Total net charge offs rose 54 basis points from the prior year and 22 basis points sequentially. For the full year, the total net charge off rate was 2.7%, which is the low end of guidance we provided in the second quarter call. As we’ve talked about it for the last several quarters, supply driven credit normalization along with the seasoning of loan growth in the past few years have been the primary drivers of the year-over-year increase in charge offs.
Credit card net charge-offs rose 56 basis points year-over-year and 23 basis points from the prior quarter. Private student loan net charge-offs rose 3 basis points year-over-year and fell 11 basis points sequentially.
Personal loan net charge-offs increased 92 basis points from the prior year, and 43 basis points sequentially. As we indicated last quarter, we identified several segment of the broad market personal loan book that were not performing in line with expectations and took actions to curtail those originations.
Last quarter, we told you that we expected up to $30 million in incremental exposures over the remaining lives of these loans and $10 million of this amount is reflected in the fourth quarter reserved build. In addition, you can see the impact begin to flow through the net charge off rate in the fourth quarter. The personal loan net charge off rate is also impacted by the denominator effect associated with pulling back on originations in the effected segments.
30-day delinquency rates were up sequentially across all of our primary lending products. Looking at total loan receivables, our 30-day delinquency rate increased 15 basis points sequentially and 23 basis points year-over-year.
Looking at capital on slide 11, our Tier 1 common equity ratio declined 90 basis points sequentially as loan balances grew and we returned $657 million of capital to shareholders through common stock dividends and share repurchases.
To sum up the quarter on slide 12, we generated 9% total loan growth with a significant contribution from all three of our primary lending products. Our consumer deposit business posted equally strong growth of 10%, while deposit rates increased 18 basis points.
With respect to credit, while our charge off rates have risen as credit conditions normalized in loan season, they remain below historical norms and well within our return targets and we are continuing to execute on our capital plan with strong loan growth and the leading payout ratio helping to bring our capital ratio closer to target levels.
Our commitment to disciplined profitable growth fueled strong operating performance with 11% revenue growth and a 2% increase in profit before tax despite ongoing credit normalization. In addition, expenses remain well managed though they were elevated this quarter due to the timing of investments in growth and technology.
I’ll now move to 2018 guidance on slide 13. We’ve established a loan growth target range of 7% to 9% based on opportunities that we see to continue driving disciplined profitable loan growth. As we’ve discussed, the actions we’ve taken will result in continued deceleration of growth in the personal loan business. So achieving our overall target will require relatively greater contributions from both card and student loans.
In order to support that level of loan growth, we expect operating expenses to be in a range of $4 billion to $4.1 billion next year. This reflects higher base levels of expenses to support growth in the business, as well as continuing investments in digital and mobile capabilities, advanced analytics and machine learning technologies.
Planned operating expenses for the year include the reinvestment of 20% to 30% of the year one savings from tax reform. Roughly three quarters of this amount will be reinvested in marketing and other initiatives to spur incremental growth with the remainder allocated to investments in our people and our communities.
We expect the rewards rate to come in between 128 and 130 basis points for 2018. We’ve enhanced some of the 5% rotating categories this year and we are also making further improvements to the customer experience. In addition, as we originate all of our new accounts from the Discover It platform, the portfolio mix will continue to shift towards the Discover It product which has a slightly higher average rewards rate. Competition in the rewards space did seem to plateau last year; however, it remains to be seen how peers may choose to invest the benefits of tax reform.
Moving to our outlook for net interest margin, we expect it to increase and be between 10.3% and 10.4% for the full year 2018. The prime rate increase from December of last year is not fully reflected in fourth quarter results due to timing and that alone should result in NIM expansion in 2018. Further rate increase would also result in NIM expansion due to the asset sensitive position that we built into the balance sheet and we are currently expecting a couple more based on the market implied forecast.
Somewhat offsetting the benefit provided by the rate environment will be higher deposit betas and modestly higher interest charge offs. We expect the total net charge off rate this year to be in a range of 3% to 3.25% as a result of continued supply driven credit normalization, as well as the seasoning of a growing portfolio. Let me reiterate that the overall consumer credit environment remains constructive.
Finally, we expect a significant drop in our effective tax rate as a result of the tax cuts and jobs act. In 2018 we expect that our effective tax rate will be approximately 24%. In conclusion, we are pleased with our performance in 2017 and are looking forward to continued momentum in 2018.
That concludes our formal remarks. So now I’ll turn the call back to our operator Mike to open the line for Q&A.
[Operator Instructions]. We will pause for a moment to compile the Q&A roster. Your first question is from David Scharf from JMP Securities.
Hi, good afternoon. Thanks for taking my question. Listen first one is, I want to – with the benefit of three more months having passed since last quarter’s commentary and pulling back on the personal loan growth, obviously the outlook for card and student loan growth remains very robust in your guidance and I’m just wondering, is there anything in the personal loan borrower profile you see that often serves as any kind of leading indicator of credit and other payment patterns for your other products?
Yes. We think a fair amount of what we are seeing in personable loans has to do with a lot more growth and supply. Many of the fin tax that are out there in the lending business are focused on this product in part because it’s the easiest product to offer compared to a credit card or a student loan, much more easier operationally and so we think that in some cases there has been an over-supply of credit and we are reflecting that not only in our personal loan business, but also in our credit card business where we see the incidence of personal loans and maybe higher debt levels that may impact peoples performance across the board.
So it on average a more indebted consumer, because sometimes people get a consolidation loan from a competitor and then maybe not reduce their original balance, but they end up with a higher balance from the same income and we are not sure that FICO fully picks up this effect, because it’s a fairly new phenomenon and FICO scores take a number of years to really even out with when there has been a big change in supply or demand of our type of loan product.
So I might just tag on to that David, by noting that we do expect we will continue to grow the personal loan portfolio, albeit at a slower rate I think is what we were telegraphing in our commentary.
We’ve said pretty consistently over a number of years that this is a product we are attempting global domination and it can be challenging and you have to be disciplined and I think at the end of the day the actions we’ve taken reflect that discipline. They were insolated in a few segments, right. It wasn’t the personal loan book more broadly. It really is a few segments where we are seeing this disconnect and I think it highlights we are managing it prudently.
And just one more comment. I would just point out that it’s very profitable to us which is in contrast to some of the other players who are not making money even in a very attractive part of the cycle. So we are pleased overall, it’s really just one segment as we mentioned of about 5% of the portfolio that we saw unacceptable performance and we took action on.
Okay, that’s helpful, and maybe just a quick follow-up on the rewards side. You highlighted that it still remains to be seen whether or not the plateauing we saw over the course of the last year whether that might reverse itself if some competitors decided to deploy some of the tax act saving towards the rewards wars again. I’m just curious, do you feel like you may have built in a little bit of a cushion in the rewards rate guidance for this year or is that potentiality still something that’s just an unknown and we’ll have to wait and see.
Now there is no kind of a cushion built in there David. We try and give our best guidance at the time we give it and that reflects what we expect to be going on in the business this year as represented.
Got it, thanks very much.
You bet.
The next question is from Sanjay Sakhrani with KBW.
Thanks. Mark, a question on provision expense for 2018. I appreciate the charge off rate guidance, but obviously a lot of the provision expenses this year is likely for next year’s charge offs and some of the growth map impacts sort of kick in at that time. Could you just talk about how we should think about the adequacy of reserves as we move through the year as it relates to sort of your expectations? And then also just the range on the charge off rate, could you just talk about what gets you to the lower end versus the higher end? Is the expectation – is there a buffer built into this range?
There is a lot in there Sanjay, I’ll try and touch on it all, if I miss anything come back at me. The first thing I would touch on is there a buffer in that range. I would say similar to the comment I just made to David on the rewards right now, I mean when we give guidance we try and give the best range of guidance we possibly can. So there is no buffer built in there that reflects in our best expectations of where we think the business will land as we move forward.
I would point out that if you think about that, we saw 54, 55 basis points of increase in our charge off rate this year. If you take a look at the guidance we are giving right now, you’d have to hit the very high end of that range to see a similar increase in charge offs in 2018. So I think there is an element of that that should probably reflect on how we think the business is likely to perform over the course of the year.
In terms of thinking about provisions, we don’t provide guidance on provision, so I have to be really more circumspect around the answer to that one unfortunately. I guess what I would say Sanjay is I think about a couple of different things. First of all I would say, we manage credit very much with a through the cycle risk adjusted return focus. So it really governs who we target, the acquisition costs will extend, how much credit will extend, how we are going to price for the risk?
We could manage to an arbitrary charge off level, but that would probably leave a pretty significant amount of money on the table. So if we think about transitioning that in the provisioning, the way to think about it is the losses that are on the balance sheet today, that we expect to recognize over the coming 12 month period of time. So one piece we did give a little bit of guidance in my comments I can speak to, maybe help you think through it is we said specifically on that personal loan, the sub segments of the personal loan book. Last quarter we said we expected $30 million of incremental exposure associated with that, right.
We took $10 million of that was reflected we said in our comments in the reserve rate this quarter, right. So that should imply to the listener that further $10 million of that $30 million of incremental exposure we expect to recognize over the course of the coming 12 months, right from where we sit today.
So that additional $20 million piece is still out there. So we are looking at loss content on the balance sheet. We are reserving for what we see coming at us in the coming 12 months and we feel in all respects our reserves are adequate in conformity with GAAP and we are very comfortable with their current levels.
Okay. On the NIM, you guys are sitting here in the fourth quarter at the low end of your guidance range, and you mentioned that you are expecting a couple of rate hikes and you are asset sensitive. Could you just reconcile that with the NIM range you have given?
Sure so as we sit here right now, I would say the fourth quarter Sanjay doesn’t really reflect the impact of the move in December, because you don’t get the card accounts repricing until their next cycle date after that prime rate move. So you will really see the benefit of the December rate increase in the first quarter of this year.
The other thing I would say is we continue to be positioned to be asset sensitive, continue to expect that further rate increases will benefit us. The one thing that’s a little bit different than at the time we gave guidance last year is this time last year deposit betas were exactly zero I believe or close to it. As we sit here today, I think on the savings product the cumulative beta now is at 36 – 35, 36 something like that.
So deposit betas will chew into that a little bit. So I would expect you would probably see as a rubric, I think of about seven or eight basis points of margin expansion associated with every 25 basis point movement that we get from the fed.
Our other impact to that obviously is as we see slightly higher charge offs, we will see slightly higher charge offs of accrued interest as well. So that will also contribute to that muting effect getting us down to that seven or eight bps.
Got it, thank you.
Absolutely.
Your next question is from Bill Carcache from Nomura. Your line is open.
Thank you. Good evening. Mark I recall you using the term, you know bumping along near the bottom during those years, where you know the year-over-year change in delinquency rates was hovering near zero and would periodically bounce around. And I wonder if, when we look at the year-over-year change in the delinquency rates today, they are certainly not you know continuing to inflect up into the right. They are actually you know, they seem to be on a downward trajectory some months. They kind of may go up a little bit, but then kind of move up sideways. Could you comment on the overall trajectory of how should we be thinking? Is there kind of a downward bias to that year-over-year change as we look forward from here give the (a) the healthy macro environment that we are in (b) the fact that you serve prime customers and I guess all else equal?
Yeah, I guess Bill there is a lot embedded in there. Grab [ph] me if I miss any of it. I guess what I would say is, you know I pointed out a second ago in response to Sanjay that our guidance for charge offs, we’d have to hit the very upper end of that range in order for us to match the increase we saw this year and obviously delinquencies are a [inaudible] sort of charge offs, right. So I think a reasonable person could come to a consumer that we do see a little bit of flatting in the trajectory there. I think you saw that reflected in our reserve bill this fourth quarter versus last fourth quarter right. The reserve bill was lower despite the seasonally high level of balances in the fourth quarter as growth in delinquencies moderated, right. So I think that is something that is reasonable now.
What I would say is you know that can change from time to time. So at the end of the day there’s lots of factors. I always encourage people, you know really if you’re looking for return in credit watch delinquency trends over a period of time. Don’t just react to you know point estimates in delinquency trends. Watch macro economic trends through time, again not just reacting to point estimates and then always ask about incidents rates in the portfolio, right and if we think about a card product or student loan product you know our incidence rates are down a year flat, personal loans are also very flat if you pull out the segment, so that implies a degree of stability there.
So given your comments Mark and the fact that we’re growing off a larger base of reserve building in 2017, is it reasonable to expect that the reserve build in 2018 will be lower than ’17 and you know all else equal that that trajectory should continue as we look forward from here?
We don’t guide on provision Bill, so I got to disappoint you on that one with apologies. So I can’t comment on this trajectory. I think put the pieces together and you can come up with your assessment, but I have to say sorry on that one.
Okay, understood. Maybe on the last leaf I could with my follow up on how should we think about operating leverage and skill benefits? You know in the rising rate environment you know there’s just a lot of questions on whether we can expect revenues to grow faster than expenses and perhaps see some downward pressure exerted on your efficiency ratio, perhaps to the point where we can see it fall below 38%. And can you just clarify like the rate hikes that you do have? You have the forward curve implicit in your NIM guidance, the rate I got looked its implicit in your NIM guidance. That’s it, thanks.
Yeah, the rate hike outlook, there’s three hikes, April, August, December in the forward curve that we’re working off of and obviously December increase wouldn’t really impact ’18 if indeed it were to materialize. So that’s why I mentioned earlier we kind of have a couple of more hikes in our cadence.
As far as the operating leverage question is concerned you know, we’ve seen you know a pretty meaningful improvement you know pushing on towards a 100 and some odd basis, over 100 and some odd basis points in our efficiency ratio year-over-year and we deliver 9%, or rather a 4% positive operating leverage this last year with 9% revenue growth and 5% expense growth. So we feel very good about the leverage embedded in the model and are happy to continue with the focus on managing expenses diligently and driving revenue growth in the current environment to the extent we see great credit opportunities to do so.
That’s great Mark. If I could just…
Bill, Bill, Bill, let’s make sure everybody gets a chance and we can follow-up later on.
Your next question is from Ryan Nash from Goldman Sachs.
Good evening guys. I’ll make it quick. David, I was wondering on tax reform, you know we had a competitor last night who was talking about how he thought he would be competed away very quickly. So you know I’m interested in your view on what you think will happen competitively. Obviously you talked about taking the steps reinvesting 20% to 30% in the business and then related to that, unless you guys are going to go tighten underwriting I guess this can vary. It should open up the credit box or could this lead to better growth across the industry and then I have a follow-up.
Well I think that having some faster growth in the industry would make sense, because at least the way we look at it, all of our marginal returns have just increased as we dropped that lower tax rate into our models and that means that you know that market in – those accounts that we just missed marketing to now are profitable, meet our hurdle rates to market too and I would think that other issuers would find the same and so I would expect that there’d be some, you know some further growth above whatever it would have been, certainly that’s the case for us.
In terms of whether things would be competed away, I think that it’s likely that some will be competed away. I personally think it would not be reasonable for it all to be competed away or for anything to happen very quickly. I mean this was a big change. It’s not what I view as a temporary change. I mean if you look at our returns we’ve been averaging 20% plus return on equity for a bunch of years and I think you know that’s the top of the industry, but even the industry tends to have a better return than other parts of financial services and so if you just you know, if you were a theorist and said well, all excess profits get competed away, that would not be sustainable and it has been, because we’re differentiated, we’re a brand, there’s a lot of reasons.
So I think we’re just going to stay disciplined post card. You know there’s one more discipline post card act. Some of these competitors need to drive higher returns to cover other parts of their business that aren’t doing so well. So I think you know we feel like at least in the near term it’s going to be – it’s just a big opportunity for us.
Got it and if I could have one follow-up. Mark, so you guys have done a great job in growing loans, which has led to significant pre-provisioning growth, but obviously substantially all of that has been eroded by higher provisions. Like you know you’ve had your own version of growth mass. So you know from the outside looking at it, it’s hard for us to see the profitability of these newer vintages. So do you expect that on the other side of this we will see an earnings acceleration once provisions begin to level off and what do we need to see for that to happen. Thanks.
Yeah, I mean I think at the end of the day Ryan, I’d point to a couple of different things there. Number one I would say and we’ve talked about this pretty consistently that we have a very defined rubric for how we will go after growth, right and our acceleration isn’t so much that – well, it really isn’t in any way that we have changed our model and what we’re willing to do. It’s really more a reaction to how intensely competitive the market has been and what others have been willing to do, right.
So you go back a few years ago, our growth rate was below the industry for prime card receivables at a period of time when folks were willing to pay acquisition cost through a number of channels that just wouldn’t work on our model. So we had slower growth not because you know we decided to slow growth just because we weren’t willing to chase what we didn’t see as growth that was meeting our return hurdles. Today you see a lot of folks who pull back in that regard and so things that met our return hurdles would you know now meet those same return hurdles we had in place previously, are back to meeting them.
So you know I think there’s a discipline that underlies the way we approach these things and I think we prove them when we see things don’t meet our profitability model, that’s why we pull back. You know I would point to the student loans segments that we talked about earlier where credits are not meeting and as a result the return is not meeting and I would point to, you know that card space where we didn’t chase acquisition costs where they didn’t meet our return hurdles.
So I think we’ve demonstrated in a couple of instances here the discipline we’re applying in the way we grow and I think you got a sense for our acquisition strategy or decisioning strategy. We want the returns on those investments to exceed the return on the buyback program plus the risk premium and you know we’re looking for them to break even inside of five years. So I think we’ve got pretty strong criteria that governs that, that I think is pretty meaningful and should give you a high degree of comfort.
And the one thing I would just add is that while you have a right to point out that provision has been a headwind over the last 12 months, the very strong revenue growth and our positive operating leverage has meant that the results we just reported in the fourth quarter on an adjusted basis have an 11% growth in EPS even during this normalization. So I think that’s strong.
Got it. Thanks for taking my questions.
Thanks Ryan.
Your next question is from Moshe Orenbuch with Credit Suisse.
Great, thanks.
Hey Moshe.
How are you Mark? So maybe a quick follow-up on the reserving. Not trying to kind of pigeon hole you into a forecast, but if you were to just think about the improvement in the economy that you expect to come about as a result of these tax law changes and no other effects, how would you describe that effect on the reserve?
So I would say right now we have not factored in any expectations of improvement on the part of the consumer in our modeling and in the guidance we provided. I would say we’re hard pressed to see that it could produce the major negative on the borrower, but we don’t know quite how to figure out yet as we’re still processing through things, whether there is real upside there.
Okay. And maybe you know, you started to discuss this question about other lenders kind of spending too much to acquire in your traditional you know favored space and then pulling back some and I guess, I mean what – as you put together that 7% to 9% growth forecast, you know what is it that you see about other lenders that gives you that confidence because you know it’s a healthy forecast and its wonderful, especially given that you’ve now been able to you know see the volume ramp you know to kind of be consistent with the growth of receivables. You know from the competitive standpoint, why haven’t you know they made better in-roads and how do you get comfortable if that’s going to continue?
Well, look I think we’ve now had a full 12 months where we’ve seen some of the craziest subside and you know the things that affected us in 2016 and caused us to go a little slower as we maintained our discipline, as some people backed off, 2017 we’ve had consistently strong growth and we don’t see anything in the recent trends and even the announcements on peoples first quarter calls, I’m not hearing any restoration of huge upfront points or cash back or opening new accounts or what have you.
So I think we’re going to have to keep watching through the year to see if anything restores, but my sense is that most of these players are a little focused on getting the profits up to more reasonable levels, because some of them are really low, are aways in their card business compared to us now and I think rewards is part of it.
The other thing I’d say is you know everyone is having somewhat higher charge offs and I don’t see interchange rising from here. So I think there is sort of an upward bound you know where people need to both improve profitability and cover some rising credit costs.
And Moshe, I’d just stack onto that Moshe. At the end of the day if we’re wrong and if competition does reemerge and start doing things that we don’t think makes sense I would harken back to my comments a minute ago, we’d go ahead and revise the guidance, miss the guidance and we’re going to book quality loans that make sense for our shareholders.
Got it. Good job. Thanks.
Your next question is from Bob Napoli with William Blair.
Thank you. Good afternoon. Just to be, I want to be clear on the reinvestment of the tax reduction. I mean that reinvestment of 20% to 30% is embedded within the guidance on page 13?
That is correct Bob.
Okay, and so where – and that is in the primarily, that’s an accommodation of rewards and operating expense?
That would be specifically operating expense that we’re referencing in that piece of the guidance and I would say from that perspective, 75%, three quarters of that benefit roughly is going into specific investments in growth. The remaining 25% of that windfall is really going into what I would describe as investing in our employees. David alluded to the first piece which was really the first pieces which were the $1000 bonus that was actually last year, moved to the $15.25 an hour minimum wage that will be happening this year and then some other things that we are thinking about for our employees as well that we haven’t really aired at this point in time yet, as well as some investments in some of our communities.
So that’s really to think through the way we’re parsing it and we really do view those as investments in our employees, right. When you really have a customer service, customer centric business model that is so heavily focused on surprising and delighting the customer, part of the way you do that is by having who we think are the very best customer service contact personnel and paying to attract and retain those folks makes all the sense in the world to us.
It’s also in the growth lines where you know we’re obviously expecting some more loan and revenue growth than we otherwise would have had, even though it’s a little bit lower than the you know the very strong growth that we recently had that was far in excess of our original targets in ’17.
Thank you. And just my follow-up, your spend growth did pick up in your payments business and your proprietary businesses. Do you sense that is competition pulling back or do you sense that that is somewhat strengthening in the economy or just you know the marketing efforts of Discover.
I think it’s a combination of things. I would caution you that I think about us having the same day sales increase of around 6% this year, this quarter versus the 9% that we posted just because of the number of days and that’s going to flip around the other way in the first quarter of this year, so we don’t want to call that out.
But we’ve taken some specific efforts to get sales growth up to closer to loan growth. We also think that when we talk about competitors back in the Op book, you know some irrational rewards programs they were maybe depressing some of our sales growth before and that’s less of a depression now as they are stealing fewer customers and we’re getting more new customers coming into our program with more spend.
On the network side, you know the big growth obviously was PULSE and you know there was one was large player that helped with the growth, but over half the growth came from a whole lot of our other customers and you know we’re pleased that after several really tough years that the PULSE is back to some really nice growth.
Thank you.
Your next question is from John Hecht with Jefferies.
Thanks very much for taking my questions guys. Mark, I guess we’ve been talking about normalization for quite some time now and we’re still below long term charge off averages but we’re starting to get in the zone. I guess from your perspective is those 18 gear that were fully normalized or you know do we hit normalization in this cycle below long term averages or how do you just think about the trajectory of credit?
Yeah, I think just being intellectually honest, I don’t think anybody knows where new normal is until we go through a cycle, because none of us have been here post card act to understand how the much more disciplined behavior across the industry is going to impact some of that. You know I think what we’ve said in the past is that we clearly see losses this cycle being lower than what you would have seen in normal cycles because they were so low for so long and the industry has been very disciplined.
Clearly at this point in time I’m not going to call, we’re not going to call when we think the cycle will actually reach a normalized peak or a normalized point. What we do know is you know we are not underwriting to anything like the current loss rates we are seeing. We are underwriting to what we believe through the cycle loss rates embedded in that book, embedded in those accounts to be, so our originations, our underwriting, our credit decisioning has never been tied to where we are at a point in the cycle. So we’re taking a long view and originating stuff that in our acquisition modeling drives very profitable long term returns in very different environments than we’re in today.
Okay, that’s helpful. And then the second question is related to the growth guidance, the loan growth guidance. Forgive me if you have provided details, is there any change in the composition of whether it’s aligned advances or new customers or maybe utilization rates or is that fairly consistent in terms of the composition of that this year versus last year.
The composition on the current side is about close to 50/50 on growth coming from new accounts as well as from the portfolio, which is in our minds very healthy because you want growth to come through your legacy customers. You don’t want them to think they have disengaged. You also want to attract new accounts that exhibit the right behavior. So that feels really healthy to get a balanced mix.
The other thing I would say is with respect to the businesses overall, the one thing I didn’t call out in case you missed it is I didn’t say the growth rate in personal loans will decelerate. So a greater portion of the growth going forward will be picked up by card and student loans.
Perfect. Thanks guys.
Your next question is from Rick Shane from JPMorgan.
Hey guys, most of my questions have been asked, but just wanted to revisit that growth composition a little bit. Mark you said private – excuse me, that the personal loan growth is going slow. The organic growth for the industry on private student lending is about 5%. So I am curious, do you think that you’re going to go above that or is the confusion that really the bulk of the growth is going to come from the US card business.
I would say that you know the bulk of our growth is going to come from the hard business just because of size and I think that I would expect that in the last year as I mentioned we think we grew faster than the other large student loans business as competitors and moved into second place. I would expect that we would try to continue to grow somewhat faster than the industry in private student loans for this coming year, you know not triple the rate kind of thing, but faster as we did this year and card the same way.
As we mentioned personal loans, we think we’re probably still going to grow, but it will just be at a much lower rate than we have in the last two years where we had much higher growth in that business than any of our other businesses.
Got it, okay. And what I am really trying to draw out is of the three businesses that’s striking it’s the only one that’s actually going to be above that 7% to 9% growth rate for the US card.
Student loans could be as well. I mean if you take out the acquired loans, it was above that level as well. Our organic portfolio grew 11% this past year.
Got it, okay. Thank you very much guys.
You bet.
Your next question is from Betsy Graseck with Morgan Stanley.
Hey Betsy.
Hi, good evening. Two questions; one on digitization. I think you mentioned that some of the investment spend that you’d be doing is around digitization. I think your app is pretty well highly rated. So I am wondering what plans you have there? What you’re looking to do with it?
You know we’re very pleased to have been recognized as the top app and top by customers and independent groups JD Power who looks at the digital capabilities of us versus competitors and we need to keep investing and enhancements making simpler ad functionality to consumers. You know just as an example I think Apple yesterday announced a new business messaging and we were one of only two financial institutions in that initial launch and so you know for having additional digital ways for our customers to communicate with us and manage their account and manage their security with the alerts that we put in this past year as an example. We’re going to be heavily investing in all those.
The other thing I would think about is that Mark mentioned some investments in areas like machine learning and artificial intelligence and so on and we’re using those increasingly in our call centers to help with compliance, efficiency, effectiveness to aid our customers and so even the sort of traditional phone service is being impacted by digital, recognizing what people are saying and then queuing up a suggested script information and so on. So it’s a fantastic trend for us and it was a big part this year of that positive operating leverage with revenues growing faster than expenses.
Okay, all right that’s helpful. And then secondly on the dividend, could you give us a sense as your thinking, I know its CCAR period and you know we don’t know what the rules and tests are going to be. So if you can help us understand how you’re thinking about the payout ratios dividend, especially going into next year. Do you think that you’d keep the dividend going in line with earnings growth until payout ratio is similar to what it is now or do you feel like you know given where the stocks have gone, there is more of an interrupt on the digi payout versus buyback?
So without being too specific because I don’t want to guide on that topic, what I would say is we’ve established a track record of increasing the dividends and I think you know we’ve also said publicly our goal is to be an S&P dividend achiever and I think that takes 10 years of consistent movement of the dividend. So I think a reasonable person should be assuming we’re thinking about adjusting that dividend as we look forward.
One of the really perverse things Betsy that no gift comes without a dark side I guess. If you think about tax reform, it actually has an unintended consequence in its interaction with CCAR. Specifically it’s going to increase losses expressed in areas because you’re going to have a larger after tax loss due to the lower tax rate and you’re going to have a larger just allowed DCA as NOLs can only be carried forward now the tax law limited carry backs. So I think it’s likely that the stress capital consumption for the industry goes up, unless the fed changes their instructions, particularly around the fed severely adverse which some people refer to as the brain dead scenario you known the 2018 instructions if they don’t revise those I think there could be some impact.
You know we’re encouraged by commentary coming out of the fed publicly that they are looking at this, so we’re hopeful that there won’t be a real negative impact coming from that, but you know it remains to be seen exactly what that will be.
The good news is repurchases for the first two quarters this year are governed by the existing CCAR filing that we did last year and don’t see any reason we would need to make any change there. So again, none of this would mean we wouldn’t be in a position to move the dividend, none of this would mean we wouldn’t be in a position to return capital. It’s just a perverse interaction that I thought you all needed to be aware of.
Yeah, no that’s helpful. Thanks.
Your next question is from Ashish Sabadra with Deutsche Bank.
Thanks. My questions was about the card reserve bill, you talked about that moderating. The reserve rate also declined specifically from the card business from 3.29% to 3.19%. So just want to better understand what drove that decline in the reserve rate is that the delinquency data that you are talking about, the monthly delinquency data coming in better than expected and just you know what drove that improvement in your view from third quarter to fourth quarter.
Yes so, just to remind everybody, just so everybody keeps in mind that we don’t manage to reserve rate, it’s a mathematical outcome of how we establish reserves, right. So we are basically reserving for the lost content we see embedded on the balance sheet in the 12 month forward period and then the reserve rate kind of falls out.
I think that said, you are on the right track. One of the big impact was what we saw happen with the rate of delinquency formation, the increase in the rate of delinquency formation and the trend variant. We also – the loss forecasting models look at 100 and some odd variables. I don’t remember the specific number here. But there were a couple of others in addition to delinquencies that caused us to set the reserve where we set the reserve. But again as I said earlier, we feel very good about the level of the reserves. I think it adequately reflects the loss content imbedded in the portfolio today and we are encouraged by the trends in the rate of delinquency formation.
That’s helpful, thanks. And then my question was going to be about growth. Just to follow up to earlier questions asked about the growth in the card business. Is there a way to think about how much of it comes from existing versus new customers? And when you think about capturing new customers, are you thinking about expanding your credit bucks just because of the stimulus that we are going to get from the tax reforms, so any thoughts there. Thank you?
So I would day the breakdown in the growth in the portfolio, its right now roughly 50/50 new accounts in the legacy portfolio which feels really healthy to us, so we are very pleased with that.
In terms of any expansion to the credit marks, in relation to the tax reform, I think our perspective is you live with bad credit decisions for an awful long time. It’s a lot easier if you return hurdles moves to say maybe I’ll spend a couple shackles more for every account I bring in, or something like that, then it is to convince yourself that you can start opening up the credit box dramatically.
So I would think incremental investing we would make, would be really more towards the advertising and acquisition cost side of the equation.
Thank you, very helpful. Thanks.
The next question is from Chris Donat with Sandler O'Neill.
Hey, good afternoon. Thanks for taking my question. Just wanted to ask one expenses, and see if I could pass out some of the movement on the income statement for 2018 with your guidance, because it seems like you will be having some higher compensation expenses related to the activities like the – I don’t imaging some big number but for the minimum wage employees and then you got the investment in there. What are the sort of off sets there, anything you are expecting to reduce going forward or is just the numbers aren’t that big on the investments of the $3.8 billion you had for 2017?
Yeah I would say I think you goal is to remain very disciplined in what I would call the core service delivery areas and I’m thinking that really more the support functions within the company. And so that the incremental lift you are seeing is really outwardly focused on those folks who actually support the revenue growth in the call centers and the like with the minimum wage increase, as well as that increased marketing and advertising expense we talked about earlier.
So really the comp piece to our employees is something that let’s just say wouldn’t have a real big toggle level associated it. It may increase marketing spent and what we are willing to put towards brand advertising and acquisition costs. If you saw the environment turn on to you, those are the things you could pull back on pretty quickly.
And I would just add, I think you are were kind of implying why aren’t expenses up more if you got reinvestments in there as well and I would say that could conclude that are base plan involves some fairly aggressive expense manage net loss still grow in the revenues and so and one of the reasons things like the reinvestment with the employees to a higher minimum starting pay isn’t bigger, is because we expect some real benefits from that as well.
Turnover is very expensive. We spent a lot of money on training and so on. The quality of the calls matters a lot to us and so we actually expect some paybacks in terms of attracting and repaying talent that can help support these revenues and that’s why to some degree tax reform, passing on to employees is partly, because we need more, we need people to really help grow those revenues to achieve the higher returns over time from the additional investments we are making. So we think it’s just– we do think of it as an investment not just kind of slicing out a piece of the pie.
Got it. Thanks very much David.
Your next question is from John Pancari with Evercore.
Good evening. On the tax reform reinvestment of 20% to 30%, what is the timeframe of that? Do you think it will be 100% in the run rate by the end of this year or do you think it will some carry over into the next year?
No, I would expect that is actually dollars of spend we expect to see over the course of the year this year.
Okay and then, is that any of that capitalized?
There might be a small portion of it, that is capitalized depending on some the choices we make, some decisions we make. But I would think for modeling purposes I just assume it’s not and flow it through. And I’d remind you again in the thought process because you brought up the notion of a run rate, a lot of these things are increased brand advertising, increased marketing spend, they aren’t necessarily things that go into a run rate per say. They are things you look at and think about every year. So I wouldn’t think about this is as a reset of the overall cost bases, other than maybe some that employee spend.
Got it, and thanks Mark and then lastly on the loan growth outlook, the midpoint of the guidance implies a little bit of moderation off of the 2017 level. Is that entire moderation the personal loan growth slowing or is there some other factors that you are talking into consideration? Thanks.
I would say a second component is just the year-over-year period is a tougher comparison given our strong growth last year. And so I would say it’s mostly those two things together.
Okay. Thank you.
Your next question comes from Don Fandetti with Wells Fargo.
Make or David, curious what your thoughts are on external growth, whether its portfolios or acquisition. I know you had the consent order. I think it was lifted a while ago, so maybe a little more flexibility. And then as you sort of look at the payments businesses, obviously it’s changing very rapidly with digital. Do you feel like you need any assets out there or would it just be more of an opportunistic sort of move if were. I know in the past you’ve expressed valuations have been pretty high.
Well, I think to take payments first, I think we see great opportunity in partnerships and I would say whether it’s with suppliers, with other networks around the world, with some FinTech players, I would say we’ve see a lot of opportunity to partner or have vendor relationships. Maybe some small investments over time and some of them could make sense, but probably less likely that we would know you – that it would make economic sense for us to start buying a bunch of stuff in that space.
On the banking side, you know we will continue to, we’ve not been restricted from buying portfolios and even under the consent order and obviously we bought some student loan portfolios over time. We would continue to be opportunistic as consent orders come off. We would open up presumably more optionality. But I would just say that there is not a lot of direct banking stuff that’s attractive out there and you know I think that the few direct banking things out there probably don’t make money, which is usually a negative for us and most of what’s out are traditional banks that are also in the direct banking space.
So I would say that we are, we’ll keep looking at things, but we are primarily focused on organic growth and we’ll be opportunistic on anything else, but it has fit financially and strategically.
Thanks. The last question at this time is from Henry Coffey with Wedbush.
Good afternoon everyone and it’s a very interesting call. I just wanted to narrow in one area of really just personal interest. Student loans, when you say you moved to the number two sport, you means in terms of loan origination or loan balances and then as you think of.
Go ahead.
Oh no I’m sorry. And then as you think of growth opportunities you are very good in the direct in school businesses. Have you started looking – it’s not as profitably from a yield point of view but have you started looking at the refinance side of the equation.
Well on – to answer the second question first. We’ve done a little bit consolidation loans, but as you point out, the pricing seems really hard to make money at and so we’ll – I think what you should expect from us is primarily to continue to focus on the in school channel. And the in school channel is very specialized, there is only a few players because you know you have to do special underwriting, there is co-signers involved, there is disbursement only though school. So its operationally pretty unique and so there is only a few of us that can do that and we do that very well and so we think that’s where we can really help students actually pay for their education and get degrees and do it at the lowest APRs of any kind of unsecured loan out there.
Your first question was?
It was origination.
Yeah, so originations and I would say Sallie Mae is number one and we have now moved into the number two spot of originations and even versus Sallie our originations grew faster by a good margin than the originations did in the last year. So we are pleased with how that business is performing.
Great, thank you very much.
I will now turn the call back over to the presenters.
Thanks Mike.
Thank you all very much. Have a great evening and of course for follow up you know how to reach us and we’ll be available for you. Thanks.
This concludes today’s conference call. You may now disconnect.