Discover Financial Services Q2 2023 Earnings Call Transcript

Quartr
Provided by Quartr
July 20, 2023

There are 16 speakers on the call.

Operator

Good morning. My name is Todd, and I will be your conference operator today. At this time, I would like to welcome everyone to the Q2 2023 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

Thank you. I will now turn the call over to Mr. Eric Wasserstrom, Head of Investor Relations. Please go ahead.

Speaker 1

Thanks, Todd, and good morning, everyone. Welcome to this morning's call. I'll begin on Slide 2 of our earnings presentation, which you can find in the Financial section of our Investor Relations website, investorrelations. Discover.com. Our discussion today contains certain forward looking statements that are subject to risks and uncertainties that may cause actual results to differ materially.

Speaker 1

Please refer to our notices regarding forward looking statements that appear in our Q2 earnings release and presentation. On our call today will include remarks from our CEO, Roger Hochschild and John Green, our Chief Financial Officer. After we conclude our formal comments, there will be time for a Q and A session. Now it's my pleasure to turn the call over to Roger.

Speaker 2

Thank you, Eric, and thanks to our listeners for joining today's call. I'll begin by reviewing some of our highlights for the quarter and then discuss the regulatory matter that we've disclosed in our press release. John will then take you through the details of our second quarter results and our updated perspectives on 2023. Last night, we reported 2nd quarter net income of $901,000,000 or $3.54 per share. The quarter was characterized by strong asset and deposit growth, while credit is performing right in line with our Importantly, we advanced several operational priorities this quarter.

Speaker 2

One key milestone occurred in May when we relaunched our cash back debit product. We're excited by the positive early results we're seeing so far. In the 1st few weeks, we opened over 30,000 new accounts and plan to begin national marketing in support of this product in the fall. The relaunch advances our goal of becoming the leading direct bank and over time we expect cash back debit will be a significant entry point into the Discover dives. We also continue to expand the Discover global network.

Speaker 2

This quarter, we announced 5 new partnerships in the Asia Pacific region and added a new partnership with Guava Pay in the UK. These strategic partnerships underscore our commitment to building out our international acceptance. And lastly, we continue to invest in our human capital. We're honored to have been recognized as a 2023 Best Places to Work for People with Disabilities. This builds upon our recent recognitions as one of Fortune's 100 Best Companies to Work For, Best Workplaces for Parents and Best Workplaces for Women.

Speaker 2

As you may have read in our press release last night, beginning around mid-two 1000 and certified certain card accounts into our highest merchant and merchant acquirer pricing tier. We are taking actions to correct card product misclassification going forward and are preparing a program to compensate affected merchants and acquirers. While the financial impacts of this misclassification are not material, it underscored deficiencies in our corporate governance and risk management. We're in discussions with our regulators regarding these matters. We have received a proposed consent order from the FDIC in connection with consumer compliance, which does not cover the misclassification topic.

Speaker 2

We believe additional supervisory actions could occur. I want to emphasize that we take our business practices and compliance very seriously. We've made significant progress and investment in this area and look forward to working with our Board and our regulators to achieve further advancement. Now I'll hand it over to John to review our results and updated outlook in more detail.

Speaker 3

Thank you, Roger, and good morning, everyone. I'm going to open by addressing the financial implications of the card misclassification. We have established a liability on our balance sheet of $365,000,000 to accrue for estimated compensation owed to merchants and acquirers. In establishing the liability, we adjusted retained earnings by $255,000,000 net of tax. Dollars 11,000,000 was taken this quarter and is reflected in discount and interchange revenue.

Speaker 3

The first half twenty twenty three impact was $22,000,000 With that, I'll transition to our financial summary results on Slide 4. From this, you can see that Financial performance of the business remains solid. In the quarter, we reported net income of $901,000,000 which was 18% lower year over year. Our results reflect strong revenue growth, partially offset by a provision increase driven by receivable growth and higher expenses. The trends for the quarter were robust loan growth, a low efficiency ratio even as we invested in compliance management and technology and strong capital and liquidity positions.

Speaker 3

Further details are reflected on Slide 5. Net interest income was up $567,000,000 year over year or 22%. Our net interest margin ended the quarter at 11.0 6%, up 12 basis points from the prior year and down 28 basis points sequentially. The benefits from higher prime rates were offset by higher funding costs and increased promotional balances. Receivable growth was robust.

Speaker 3

Card increased 19% year over year, reflecting a lower payment rate versus the prior year and modest sales growth. The card payment rate remained stable quarter over quarter and about 200 basis points over 2019 levels. Sales volume grew 3% in the quarter. Through mid July, growth continued to slow and was up about 1%. Turning to our non card products.

Speaker 3

Personal loans were up 27% driven by strength in originations over the past year. We continue to experience strong consumer demand while staying disciplined in our underwriting. Deposit growth in the quarter was solid with average consumer deposits up 20% year over year and 4% sequentially. Our direct to consumer balances grew $2,000,000,000 and consumer deposits made up 66% of our total funding mix. We continue to target 70 plus percent of funding from deposits.

Speaker 3

Looking at other revenue on Slide 6. Non interest income increased $98,000,000 or 16%. This was partially due to a $42,000,000 loss on our equity investments primarily driven by loan fee income. Moving to expenses on Slide 7. Total operating expenses were up $181,000,000 or 15% year over year and up 2% from the prior quarter, primarily driven by our investments in our compliance management systems.

Speaker 3

These investments impacted several of our expense line items. Looking at our major expense categories, compensation costs were up $73,000,000 or 14%, primarily due to increased headcount. Marketing expense increased $14,000,000 or 6% as we prudently invested for growth, particularly in our deposits and personal loan products. Our commitment to disciplined cost management has not changed and we continue to target an efficiency ratio in the high 30s. Moving to credit performance on Slide 8.

Speaker 3

Total net charge offs were 3.22%, 142 basis points higher than the prior year and up 50 basis points from the prior quarter. Consistent with our expectation, We are seeing credit normalization across all of our lending products. Looking ahead, in card, We continue to expect the seasoning of new accounts vintages and normalization of older vintages to result and higher losses through the back half of this year and into 2024. Turning to the allowance for credit losses on Slide 9. This quarter, we increased our reserve by $373,000,000 driven by our double digit loan growth.

Speaker 3

Our reserve rate remains flat at 6.8%. Our outlook on the macro economy has improved modestly. We continue to monitor economic conditions. We'll make adjustments to our expectations as needed. Looking at Slide 10, our capital position remains robust.

Speaker 3

Our common equity Tier 1 for the period was 11.7 percent, well ahead of regulatory requirements. The cumulative impact of the correction to the financial statements related to the card misclassification reduced our CET1 ratio by approximately 20 basis points. In the quarter, we repurchased 6,800,000 shares of common stock and declared a quarterly common dividend of $0.70 per share. As Roger indicated, we are reviewing our compliance, risk management and corporate governance and are in discussions with our regulators on these topics. While this is ongoing, we have decided to pause share repurchases, Including on Slide 11 with our outlook.

Speaker 3

There has been no change to our loan growth expectations to be in the low to mid teens. We are updating our NIM expectations to be around 11% for the full year, reflecting a combination of slightly lower asset yields driven by promotional mix and higher funding costs. We are raising our guidance for operating expenses to be up low double digits. As previously indicated, we are seeing upward pressure on expenses from the build out of our compliance management systems. And we are lowering our expected range of net charge offs to 3.4 to 3.6% based on our current delinquencies and roll rates.

Speaker 3

To wrap up, our business model continues to generate solid financial results and our capital, funding and liquidity positions remain strong. We continue to invest in actions that drive sustainable long term performance enable us to achieve excellence in all parts of our business. With that, I'll turn the call back to our operator Todd to open the line for Q and A.

Operator

Thank you. At this time, we will open the floor for questions. We'll take our first question from Rick Shane of JPMorgan. Please go ahead.

Speaker 4

Thanks guys for taking my questions this morning. Look, I'd love to understand a little bit the link between what you identified in terms of the miscalculation and then how that precipitated the sort of inquiry into governance and consumer tracking.

Speaker 2

Sure. So the FDIC matter is not linked to the misclassification. And so the misclassification is a separate issue that the FDIC matter is broadly around our compliance management system. May not result in further regulatory action, but I don't want to speculate on that.

Speaker 4

Got it. And is the expectation when we've seen these in the past that They result in things like memorandum of understanding and can do things like either constrain growth, limit repurchases and capital actions. How do you see this playing out? And most importantly, I think what everybody really wants to know is What is a reasonable timeframe to get some further clarity here?

Speaker 2

Yes. I don't want to speculate on the timeframe of regulatory actions. I would say to your point though, they can take many forms. And so we're Working through the draft with our regulators and we'll make more information available and the consent order will itself be public once that's Completed.

Speaker 5

Got it. Okay.

Speaker 4

I realize there's you have to be pretty circumspect about what you say here. So thank you.

Speaker 2

Thanks.

Operator

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

Speaker 6

Yes. Hi. Thanks. This is Jeff Adelson on for Betsy. Just appreciate all the sensitivity around this and understand you're pausing the buyback.

Speaker 6

I guess This is similar to what we saw last year in terms of regulatory issue and getting ahead of the buyback, freezing the buyback. Just wondering maybe if there's a way to speak to how these two issues kind of compare to the last year student loan servicing issue maybe In terms of scoping complexity?

Speaker 2

Yes. I'll cover that piece and then maybe John can talk a bit about the buyback. So I would say the consent order in student loan servicing was a compliance matter. And so I think there's a link between that and the broader focus on our compliance management system. With that, maybe I'll let John talk a

Speaker 7

bit about the buyback.

Speaker 3

Great. And thanks, Roger. And as it relates to the buyback, We had robust conversations internally whether or not to pause the buyback and What management recommended to the Board was that we paused the buyback as we work through the details of these compliance and risk management issues and are in conversations with our regulator. I want to reiterate the following though. Our capital allocation priorities remain consistent.

Speaker 3

So 1st invest in the business and growth and certainly through this year and into next year into compliance and risk management. And second, the priority will be to return excess capital to shareholders. So no change in terms of the 2 primary capital allocation priorities. I also want to focus your attention on to the strong capital generation that The business delivered in the quarter and has delivered historically. So, we're hoping that we Going to work through these issues in an expedited fashion, but timing, I can't be specific on.

Speaker 3

So With that, the buyback will provide as much clarity on the timing of resumption when we have information on that.

Speaker 6

Okay. Thank you. And just Maybe shifting gears a bit here. Just wanted to see if we could get an update on what you're seeing in the consumer in your book today. Could you maybe also give us an update on the spend trajectory you've been seeing so far in July?

Speaker 6

I know you talked about the growth rate slowing down to 3% in Wondering if we're seeing something similar from here.

Speaker 2

Yes. So it has slowed down further So far in July, so probably closer to 1%. Not necessarily as bad as it Sounds in terms of the health of the consumer because you've got some very challenging comps compared to last year's growth As well as the very, very high level of new accounts we put on last year. And I think overall in terms of payment side, delinquencies and losses, as John said, are sort of normalizing right on the path we thought they were. And here I think that the strength of the job market is very constructive for our sort of prime consumer base.

Speaker 6

Got it. Thanks for taking my questions.

Operator

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

Speaker 8

Hey, good morning, guys.

Speaker 2

Good morning.

Speaker 8

Roger, Again, I know that we're probably limited in what we could say here on the compliance side, but I guess just a broader question. Can you maybe just help us understand What are the areas that you feel that the company has under invested in? And maybe just give us a framework for what you guys are doing internally to fix these? I understand that John had talked about raising costs, but can you give us a little bit more color in terms of what the investments you're making and what you think the timeline is to get these done?

Speaker 2

Sure. John may provide more color on the timeline. I would say it's a multi year, but it's also something that we have been investing in Thanks again, over the last couple of years. So as you think about your compliance management system, it's everything from risk identification sort of process mapping, building controls or change management processes, the resources you have around risk management in the first line, the resources you have in the second line in terms of the compliance function, testing, The internal audit, your governance processes. And so we are determined to be as strong on the client side and it's excellent there as we are around customer experience, data and analytic, every other aspect of our business model.

Speaker 2

So this is our top priority. And the investment is both on the technology side, outside consultants, but also in terms of headcount here at Discover.

Speaker 3

Yes. And then, hey, Ryan, on the trajectory, and so I made this comment publicly about a month and a half ago. 2019 to 2023, we increased Our spend in compliance and I'll say tangential items to ensure compliance Works as we wish it to work. I indicated it was about an increase of $250,000,000 As we relooked at it, We were going to accelerate that spend to probably $300,000,000 increase from 2019 and $200,000,000 increase, dollars 22,000,000 to $23,000,000 Now the implications for that on 2024, Where we sit today, we expect once we achieve that level in 2023 to be relatively consistent in the 2024 and then as we It's going to shape this piece of our business into something that we desire, regulators desire and our Shareholders deserve, we expect that that expense burn to reduce.

Speaker 8

We appreciate all that color. And then maybe just on credit, I think Roger might have talked about the normalization of the front book as well as expectations for the For the back book to continue to normalize, but you took the credit loss range down a bit. So can you maybe Talk about, one, where are you seeing the improved performance? And John, as you look out, maybe just talk about your confidence in the curve on losses bending as we approach sort of the midpoint of next year. Thanks.

Speaker 3

Yes, great. So Yes. The tightening in the range was reflective of a couple of things. So first, As time moves on, we get more and more comfort with our forecasting on it. And To date, our forecasting has been right on top of actuals or actuals have been right on top of the forecast.

Speaker 3

So that gave us comfort. 2nd is, as time goes on, we can move from The analytical model to a more kind of traditional roll rate model that gives us a greater level of comfort around The charge offs and delinquency rates, 30 days out to 180 days out. So that gave us comfort to tighten that range. And then on top of that, certainly the Jobs data and the forecast around employment gave us additional comfort. In terms of what we're seeing with the portfolio, exactly what I said in the prepared comments.

Speaker 3

So the newer vintages, seasoning to expectation and older vintages basically normalizing to kind of 2019 levels. In terms of the shape of the curve, What we expect charge offs to do in the back half of this year is The acceleration in terms of the rates of charge off to begin to slow. And Currently, we're expecting kind of charge offs to peak in the second half of twenty twenty four. It may push a little bit into 2025, but right now we're seeing it in the second half of twenty twenty four And then reach the level which likely will stabilize that for 2 to 3 quarters after.

Speaker 9

Great. Thanks for all the color.

Operator

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

Speaker 10

Good morning, guys,

Speaker 11

and thanks for taking my questions. First one is that we've talked about you've given us some sort of good trajectory of the normalization of the credit trends, which I guess occurs later this year, early into next year. I'm wondering, Given kind of the comps and stabilization of inflation and so forth, when do you expect to see normalization of loan growth? And your guys opinions, what is kind of the normalized level of loan growth?

Speaker 3

Yes. So Certainly, real robust loan growth in the first half of this year and the last quarter of 2022. We expect the rate of increase to slow Certainly in the 3rd Q4 and also against really, really strong comps from 2022. And traditionally what this business has delivered is loan growth somewhere between 2 and 4 times GDP growth. Now, we don't know what GDP is going to look like right now into 2024, but I would say this, we did cut the edges on the lower credit quality, which This will impact new account growth in card for the balance of this year.

Speaker 3

We're seeing, as Roger indicated and I mentioned in my comments, sales growth to slow and probably stabilize in the single digits. So that will also impact loan growth for the balance of this year and into next year. So, the stabilized number is a multiple of GDP typically, Unless there's some change to the macros that indicates it's a good investment to either open up credit or appropriate to tighten credit.

Speaker 11

Okay. That's a helpful framework to think about. And then with respect to the expense guide, I think you talked about some investment in compliance and Investment in technology and so forth. I'm wondering is there maybe talk about the competitive climate at this point relative to the past Is there any spending required from a competitive perspective or do you have any characterize the overall competitive environment as well?

Speaker 2

I think we continue to see good results from the money we put to work on the marketing front In terms of our cost per account, obviously, we've talked about the relaunch of cash back debit. We'll put some money against that, including the mass market campaign in the fall. But have been excited with what we're seeing in terms of the cost per funded account there. So while the competitive environment is always intense across all of our businesses, we feel good about how our value proposition It's competing out there across all of our consumer products.

Speaker 11

All right, guys. Thanks very much.

Operator

Thank you. Our next question comes from Don Fandetti with Wells Fargo.

Speaker 7

Hi, John. I was wondering if you could talk on the merchant miscalculation. Was that found internally or was that brought to you by a regulator or third party?

Speaker 3

It was found internally.

Speaker 7

Okay, great. And then on NIM, it sounded like the trajectory was Pretty good in general and now, it's going to be around 11%. Is there more promotional than you thought or more deposit competition. Can you talk a bit about that?

Speaker 3

Yes. It's a little bit of both tact actually. We ended 2022 at 11.04%. We said that we would be Initial guidance up modestly. And then in the Q1 call, we said NIM has likely peaked And then it would begin to move downward and what I'll say, normalize likely to a higher level than it has been historically.

Speaker 3

So in the quarter, the reason that we tweaked that guidance was We are investing in promotional balances, so attracting new customers or building balances with existing customers. Now the returns on those offers are fantastic. The impact on NIM in the short term in the promotional period, it's minor, but Given our activity there, it took a few points of net interest margin out and we thought That was an important impact to communicate. 2nd, in terms of deposit competition, We had said that we thought the beta would come in somewhere around 60% to 70%. What we've seen In late in the Q1 and into this quarter was Our competitive set being more aggressive in terms of price increases.

Speaker 3

And as I've communicated in the past, We don't seem to be a price leader here. We try to compete on our brand, our customer offering, our digital assets that are 1st class in order to attract deposit customers. And we've been very successful as you can tell by the numbers there. But part of the proposition is also price. So what we're seeing now is beta is likely to to be north of 70, which is impacting net interest margin to the extent I just talked about in the guidance point.

Speaker 3

So, those two factors are playing most substantially on the revised outlook.

Speaker 10

Thank you.

Operator

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

Speaker 12

Thanks. Good morning. I have a follow-up on a couple of points made on the consent order. Maybe the first one, just on the share repurchase pause, Is that action taken in terms of prudence or out of an abundance of caution? Or do you think that there could be a material impact to your capital position.

Speaker 12

And I guess secondly, just on John, you talked about the pressures on expenses into 2024. I guess like are there is there a leverage on other expense lines to sort of moderate the overall implications for the year?

Speaker 3

Yes. Thanks, Sanjay. So, the decision on the share repurchase was out of prudence. We have done a number of tests internally stressing a number of factors. So that For example, the CCAR process we go through includes extreme stress.

Speaker 3

We tested that off and ran some simulations and the output of that was that both capital and liquidity Even in an extreme situation, remain well above regulatory requirements. So we feel comfortable about our capital liquidity. The issue on the share repurchase was again out of prudence given what we have going on in the organization and we wanted to make sure that our actions are consistent with The right message in terms of being conservative and dealing with the first level of priority. In terms of expense leverage, we continue to look at All of the lines and all of the investments we make in our expense base and The incident management situation we're dealing with in terms of resources to get that under control, that's a significant investment. Some resources supplement technology, people and consultants certainly an investment.

Speaker 3

On the indirect side, we continue to leverage our procurement organization and ensure that First, we concentrate on demand management and second on making sure there's a fair value exchange. So, that's the plan right now and will be in the plan through the balance of this year. Okay.

Speaker 12

I guess follow-up just for Roger. I know you've gotten this question in the past and I'm just thinking about the higher teasers and such. I mean, what makes you comfortable growing sort of mid teens, high teens above the really strong lapping of very strong growth a year ago? I mean, I'm just thinking about just the complexion of the accounts you're bringing in that makes you very comfortable here because it's obviously having some implications on the NIM.

Speaker 2

Yes. Good question, Sanjay. You have seen that growth start to slow a bit. And I think It isn't necessarily that far out of line with what you're seeing from our other, I'd say sophisticated prime focused competitors. It is really strong demand for the product.

Speaker 2

And as we've been clear, we have been tightening, not loosening credit And are watching the accounts we booked very carefully. And so we're always ready to make adjustments, whether it's on the card product, the personal loan or elsewhere. Again, we feel good and are closely monitoring the performance. Within the credit, we're making adjustments continuously both on the portfolio side and the new account side. But these are very strong new accounts we're bringing in.

Speaker 2

And I think part of it is the differentiated value proposition that Discover offers continues to resonate well with our target customer.

Speaker 5

Thanks.

Operator

Thank you. We'll take our next question from Kevin Barker with Piper Sandler.

Speaker 13

Great. Thanks for taking my questions. I just wanted to follow-up on the expenses in particular. You said you continue to target ratio in the high 30s. Could it be a time where you may have to make additional investments, particularly around compliance that would have you go above the high-30s efficiency ratio for a short period of time before returning back to it, just given the near term impacts of both additional marketing spend on the debit account and the compliance issues.

Speaker 13

Thank you.

Speaker 3

Sure. So as we sit here today, we feel comfortable with What we shared in terms of low double digit expense growth this year. We've taken a preliminary look at next year. We'll share that at appropriate time after we kind of review and get our plan approved by our Board. But I'm feeling like It's very, very achievable and that's why we enunciated that target or that goal.

Speaker 3

But I would say this, as we see opportunities to grow profitably And not no contradiction to Roger's point earlier about the demand for our products. But we'll continue to take a look and invest for the medium term and longer term. And we're going to do that on the growth side. We're focused right now on the compliance side and We'll dial each of the expense levers in order to ensure we achieve the results that our shareholders want, that our Board expects and that the management team expects.

Speaker 13

Are there any particular areas where you see the most opportunity to create efficiencies, whether it's Marketing or headcount or anything that out there that you see that Can you allow you to continue to hit your goals?

Speaker 3

Yes. So, we're investing in advanced analytics that We're driving efficiencies in our rewards cost. We continue to look at 3rd party spend and have Cheaved great results in terms of year over year reduction in unit costs. The situation this year is that We've invested heavily in resources, people. So we're up about 3,000 people this year.

Speaker 3

So, when you bring on additional people, both in collections and customer service as well as salary personnel, There's other costs that go along with it. So, as we manage through this situation, I continue to believe there will be opportunities to drive efficiencies by combining like activities, taking a look at how resources are deployed, organizational structures and over time optimizing that. But right now With the situation we're in, we've decided that the first priority is get the right resources in to focus on the issues we've talked about and then we're going to be able to drive efficiencies in the future.

Speaker 13

Thank you for taking my questions.

Operator

Thank you. We'll take our next question from Mihir Bhatia with Bank of America.

Speaker 10

Hi, good morning. Thank you for taking my question. Wanted to start maybe just on the business and the application quality of new applicants that you're seeing. I think you mentioned in response to John's question tightening underwriting. I guess firstly, was that the new action you took in the Q2?

Speaker 10

And then just related to that tightening of underwriting and education quality. I was wondering just if you I know you've talked in the past about actively monitoring the health of the consumer and the portfolio. Was there something you're seeing that is flashing red or caution that's making you tighter underwriting further here? Or Just trying to understand who is the demand environment, who is applying for a new loan currently, what's driving some of the underwriting changes?

Speaker 2

Yes, good question. So the tightening was not in the Q2 and was not in response to something we're seeing. And actually in terms of applicant quality, whether it's for home equity, personal loans, student loan or in card, where we're seeing very stable characteristics In terms of average FICO, in terms of the custom scores we use. So it was a series of changes we made, I would say in prior quarters, But a lot of stability in terms of the quality of applicant over the course of this quarter.

Speaker 10

Got it. And then maybe switching gears to the debit product that was relaunched. Can you talk just longer term strategically? What is the, I guess, the thinking behind that product? What is the goal?

Speaker 10

Is the idea there? Yes. This is opportunity to deepen relationships with customers and lower. And how will that benefit you? Will it be through better NIM?

Speaker 10

Because They're offering rewards, you can you don't necessarily need to offer as higher interest rate. Like just talk a little bit more strategically about Why that product makes sense to invest in for Discover and how you expect the growth trajectory of that product to go over the next few quarters here?

Speaker 2

Yes, great question. So our aspiration is to be the leading digital bank. And so when you think about a digital bank, you think about the core DDA or debit product. And because we have a proprietary network, we can offer rewards and debit in a way no other large bank can. And it builds on our heritage around cash back and as the inventor of credit card rewards.

Speaker 2

So it's not just to cross sell to our card customers. We think that this can pretty quickly become a significant entry point into the franchise for new customers. And then over time, much as we've done on the card side, if you can provide a superior value proposition and customer experience. They will want to buy other products from you, whether that's a savings account and savings accounts where you also have the checking count tend to have a lower beta or the card product. So again, a very important initiative for us.

Speaker 2

I think over time, we'll help continue transforming Discover And we're excited for the potential and you'll see significant marketing against it this fall.

Speaker 5

Got

Speaker 10

it. And then just my last question, just coming back to the compliance issue. Look, I appreciate it's difficult to I won't provide too many details right now, but maybe just on the timing, give us some frame of reference, like given that this It sounds like the FDIC consent order also is related to compliance issues. You have the student loan issue, now you have this issue. Does that entail a much longer review period or do you think this can go pretty quickly like a quarter or 2 to go through?

Speaker 10

Again, I'm not saying when you resume buybacks, but at least like when you Expect the review to be complete. What are you trying to how quickly are you trying to complete the review internally? And then I understand maybe the buyback discussion Probably involves regulators and could be it's a little bit harder to cite, but at least the review maybe you can tell us what your target is for like when you're trying to complete the review?

Speaker 2

Yes. And to frame the compliance issue, I would not over focus on the regulatory portion. This is something where we as a team know we are not where we want to be and it is our top priority. So it is aligned with the views of the regulators, but our focus is taking many forms from Simplifying our architecture, automating manual processes, streamlining and standardizing business processes, Bring on some great new talent, as John talked about, into the firm. And we know that the result will not just be Better compliance, but a better customer experience, a more efficient organization.

Speaker 2

So the regulatory piece is important, But I would say what most is most important is the commitment from me, the team, the Board on achieving excellence in this area. That'll be a multiyear initiative. But again, I think critically important to the future of the company and one that we as a team are very excited about. I would also separate that from the buyback. But again, it will be a journey on the compliance side, but one that we are 100% committed to.

Speaker 10

Okay. Thank you.

Operator

Thank you. We'll take our next question from Erika Najarian with UBS.

Speaker 9

Hi, this is Nick Holoco on for Erika. Just one more around the consent order and compliance issues. As you think about the operational There may be an opportunity to take a closer look at some of the businesses you operate in, whether that

Speaker 3

might be student loans or anywhere else? Thank you.

Speaker 2

Yes. I'll talk maybe more broadly about operational complexity and then John can talk about I think there's a great opportunity to simplify, whether it's we may have a similar process that is Done differently. And again, we have a much more, I would say, homogenous set of businesses than just about any other bank our size. So we think there are significant opportunities to simplify. And again, those won't just help from a Client standpoint, over time, once the investments are made, it also help on the efficiency side.

Speaker 3

Yes. And then Regarding our businesses and products, we think about this in line with Our capital allocation priorities, our connections to our customer base and what we can manage and manage well. So we didn't start today. Historically, we've Looked at all our products, our returns and as we look at those, we've made decisions to invest in order to Drive Growth OR Achieve Compliance Excellence. So we're going to continue to look at that.

Speaker 3

And You know, if something's below our return targets, then We'll fix it and invest or we'll look at other alternatives. But certainly, The focus today is to take our existing products, make sure they're good offering that we can Deliver those in a compliant way and drive a good return for our shareholders.

Speaker 9

Got it. Thank you for taking my question.

Operator

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

Speaker 5

Thank you, and good morning. Just from a big picture perspective, with The competitive environment, the compliance environment, Roger, as you look at your business, what is your confidence that Discover can deliver the types of returns that it has, that investors have come used to Over the last 10 to 20 years, is there are you confident in delivering those returns with The higher compliance bar or the competitive set.

Speaker 2

Yes, I'd start by saying yes, Right. This is an investment we need to make. It is the top priority for the company, But one that I think we will be able to do to fix. And again, over time, we'll see benefits, not just in compliance, but in a better customer experience as well as more efficient. If you step way back, I've never been more excited about Discover's business model and how it compares.

Speaker 2

I think you're seeing the strength of our deposit franchise at a time when many banks are being tested. We have the scale and resources to compete with anyone. We're making the investments to be at the leading edge around data and analytics. Our winning awards for our customer experience, not only just the card side, but also our deposit products. We have the relaunch of cash back debit.

Speaker 2

So in terms of the business model and the returns we can give to our owners, in my 25 years at Discover, I've never been more excited. To get to all of that though, we need to get to where we need to be on the compliance standpoint. That's Critical part of operating a bank, a financial services organization. We are not where we need to be and we are going to get there.

Speaker 5

Thank you. A follow-up, just on compliance, having followed Discover for a very long time, Coming out of the great financial crisis, there was a lot big investment in compliance across the industry, including Add Discover. Has it become more difficult? Mean, I know there's been a number quite a few consent orders put out by regulators, but has it become maybe give us some color on what you're investing in compliance today, I don't know if it's people or percentage of expenses versus historically and has it become a lot more difficult?

Speaker 2

It certainly is a challenging environment, but I'm not going to blame that, right. As I look back, I do believe we underinvested And that's something I take accountability for, but we are very focused on it now. And as John, I think, highlighted that investment takes many forms, right, from bringing in some highly talented folks within the compliance area, Building out our monitoring and controls, investments on the technology side to standardize, simplify, automate manual processes. As you think about it, compliance and a lot of the folks, it's risk management, Right. And traditionally, we have been very strong around credit risk management, around liquidity risk management, but have not necessarily made the investments we needed, especially as the complexity of our business increased.

Speaker 2

As we got into more new products, I think there was gap there in terms of our capabilities and that's what we're focused on now.

Speaker 5

Thank you.

Operator

Thank you. We'll take our next question from Arren Cyganovich with Citi.

Speaker 14

Thanks. On the net charge off peak that you highlighted for into second half of twenty twenty four and possibly into twenty twenty five. Is that an expectation that it would go north of kind of your normal underwriting charge off rate?

Speaker 3

Thanks, Aaron. No, I mean, we gave the charge off range. Now there's a numerator and denominator impact on that calculation, of course. But our underwriting It is focused on prime revolver, prime revolver behavior in our targeted segments looks Very, very consistent to where it's been historically. Tations remain high and we've been able to deliver on that.

Speaker 3

So in terms of Is it going to be north and where it was historically? We have seasoning of those new vintages, But our credit box has been relatively consistent, our analytics to Kind of target customers and understand kind of risk factors. I feel like it's improved Over the 4 years I've been here and certainly a longer journey than that. So, the trajectory to me looks Very, very comfortable in terms of continuing to be able to deliver high returns and generate capital.

Speaker 14

Okay, thanks. And then just to clarify on the expense commentary, it sounds like you're not planning to pull back on marketing opportunities as your compliance costs Arising and then if you could just clarify the numbers that you gave earlier. Are those annual numbers? I think

Speaker 10

you said like $50,000,000 up

Speaker 14

to $250,000,000 And then $350,000,000 and then down to $200,000,000 I was just a little confused on the trajectories there.

Speaker 3

Trajectory of the compliance management cost Was that your question, Aaron, or overall? Yes. So I'll start with marketing and I'll focus on the compliance second. We haven't made a decision to pull back on marketing. We still See opportunity to generate positive returns from the customers that we're targeting in that Prime Revolver segment, and we're also putting money towards helping people understand our deposit products and hopefully find that we're compelling there.

Speaker 3

We also have the campaign on the cash back to debit program slated for the second half of the year. So, The marketing dollars, how we thought about them at the beginning of the year remains consistent with where we are today. And frankly, I think it would have been shortsighted to pull back in order to manage to a particular number given the high returns we're able to generate there. In terms of the compliance cost, what I was referencing was 2019 to where we are in 2023. And so about a month ago In a public forum, I said that that increase from 2019 to 2023 was about $250,000,000 As we've looked at the work in front of us, We're dedicating an incremental, call it, dollars 20,000,000 to $30,000,000 maybe as much as $50,000,000 Over and above that here, so it could be the delta from 2019, not 250, but maybe as much as 300.

Speaker 3

Year over year, so 2022 to 2023, we're up about 200,000,000 in total compliance and related costs. Does that provide clarity? Yes.

Speaker 10

Yes, I

Speaker 14

got it. I got it now. Thank you.

Speaker 3

Great. Thank you.

Operator

Thank you. We'll take our next question from Dominick Gabriele with Oppenheimer.

Speaker 15

Hey, great. Good morning, everybody. So when I look at your loan growth guidance, you talk about Low to mid teens. And to me that means 14% basically. And so if you think about 14% or that range that you're discussing, it would percent or that range that you're discussing.

Speaker 15

It would indicate, the second half loan growth would be roughly 7%. And given the trajectory of loan growth in general, it would and spending being at 2.5% this quarter moving to 1 in the most recent month. It would suggest the 4th quarter's loan growth would be probably low single digits or something along those lines to make that guidance range. And so I was just curious if that's the right math that you are thinking about or roughly, If we could talk about that, that'd be great.

Speaker 3

Yes. I learned a long time ago not to give quarterly guidance because I found that I was not as accurate as I would have liked and other people would have liked. So The range of kind of the double digit growth that we talked about, You can take a look at the portfolio. We made some comments on what was driving it. So new accounts and certainly New account growth 22% to 23% has slowed.

Speaker 3

Sales, while still very robust at an absolute level, Have slowed and slowed into July. We're doing targeted promotional activities to drive high generating, high returning accounts. And The comp in the Q4 of 2022 versus Prior quarters is certainly a tougher comp. So your math is Certainly, your math and I don't want to get into any more specifics than what I just did.

Speaker 15

No problem. Thanks a lot. And then there are some signs that the national unemployment rate could start to move higher. If you look at some of the state data, if you saw a seasoning and the unemployment rate rising at the same time, Could it have a more additive effect for ultimately higher net charge offs than otherwise, the book without the seasoning effect? And maybe just to relate to that, your loan fee income has been quite robust in its growth and it beat our by quite a lot this quarter.

Speaker 15

Is that kind of an indication of the seasoning effects that are going on with the late fees in that bucket.

Speaker 7

Yes.

Speaker 2

So,

Speaker 3

yes, Aaron, the answer to both questions is yes. So, The loan fee income, typically late fees and NSF fees. And in terms of employment levels, if unemployment was to increase, that would Certainly impact net charge offs. But I would say this, in the cohort of folks that we typically target, What we've seen is if they are impacted by a job situation, Their time of recovery is pretty quick. So by recovery, I mean finding a new role.

Speaker 3

So The fact that this cohort of prime revolvers isn't in the upper tier of income levels allows them to have a greater opportunity to find jobs of equal pay, Equal or more, Patty, in the current environment. So the employment early indications of employment or Some challenges in some states. We don't see any sign of that translating And do a credit situation for us.

Speaker 15

Okay, great. I'm going to sneak one more in here. Is it Discover spending growth has typically batched its loan growth trajectory over time given the stability of your business model. If we don't see a normalization of And meaningful fashion of payment rates, is there any reason that the spending growth and loan growth Trajectories would be uncorrelated as they have been in the past.

Speaker 3

Yes. So we'll look at kind of opportunities to drive loan growth. And part of that is the sales data or the spending data from consumers and Reflect that in our next set of guidance that we provide, but specific and correlation In this form, I'm not going to get into.

Speaker 13

Okay. Thanks so much. Appreciate it.

Operator

Thank you. We'll take our next question from Bill Ryan with Seaport Research Partners.

Speaker 15

Good morning and thanks for working me in here at the end. Question on the personal loans business. Last quarter you talked about there were some Marginal tightening, Mitch did, but you had fairly robust loan growth this quarter. Could you talk about the market opportunity that you're seeing there? And also The mix of new versus existing customers, I believe the historical mix was about fifty-fifty.

Speaker 15

Just curious if that's still the case.

Speaker 2

Yes. So in terms of overall competition, I'd say there's been a little bit of a pullback on the supply side from, I would say, Marcus and others as they pulled out. But there are a good number of competitors. A lot of them are much More broader spectrum than us in terms of how far down they go. I think what you're seeing is really strong consumer demand.

Speaker 2

As rates have gone up and our product is primarily used for debt consolidation, people are looking to consolidate and pay down their credit cards. And so we're seeing very strong demand that is giving us ability to tighten credit and even at the margin raise our prices And still see strong demand. So it's a product where underwriting and credit is everything. The mix is largely new, but a good amount are cross sold to our existing cardholder base. So it's customers where we also have experience with them.

Speaker 8

Okay. Thank you.

Speaker 1

So I think we are going to conclude our call there. Thanks very much for joining us. If you have any follow ups, please reach out to the IR team and we wish you a very good day. Thanks very much.

Operator

This does conclude today's Q2 2023 Discover Financial Services Earnings Conference Call. You may disconnect your line at this time and have a wonderful day.

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Earnings Conference Call
Discover Financial Services Q2 2023
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