Discover Financial Services Q4 2023 Earnings Call Transcript

Quartr
Provided by Quartr
January 18, 2024

There are 15 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 Q4 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

The Please press star 1 on your telephone keypad. Thank you. I will now turn the call over to Mr. Eric Wasserstrom, Senior Vice President of Corporate Strategy and Investor Relations. Please go ahead.

Speaker 1

Thank you, and 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. Please refer to our notices regarding forward looking statements that appear in our Q4 2023 earnings press release and presentation.

Speaker 1

Our call today will include remarks from our Interim CEO, John Owen and John Green, our Chief Financial Officer. After we conclude our formal comments, there will be time for a question and answer session. During the Q and A session, we request that you ask one question followed by one follow-up question. Call. Now it's my pleasure to turn the call over to John.

Speaker 2

Thank you, Eric, and thanks to our listeners for joining today's call. 2023 was a year of significant change for Discover, and we believe the actions we've taken position the company to continue driving strong long term performance. When I stepped into the interim CEO role, I had 3 priorities. My top priority was to advance our culture of compliance. We have made meaningful strides in our corporate governance and risk management capabilities.

Speaker 2

That said, this is a journey that will take time and continued investments over the coming years to further enhance our compliance and risk management capabilities. My second priority is to continue delivering a great customer experience at every touch point, which we do by providing our customers award winning service and products. I'd like to thank our 20,000 employees for delivering a great customer experience to help our customers achieve a brighter financial future. In 2023, we were recognized for the first time as one of Fortune 100's best companies to work for. This award adds for accolade for working parents, women, people with disabilities and members of the LGBTQ plus community, And we're proud to be an inclusive workplace.

Speaker 2

My third priority is to sustain our strong financial performance. Reported net income of $2,900,000,000 for full year 2023 and earnings per share of $11.26 This makes 2023 the 3rd best year for EPS performance in our history. In delivering these results, We achieved several important milestones. We exceeded $100,000,000,000 in card receivables, grew deposits by 21% year over year, successfully launched our cash back debit account on a national scale, and we announced our intent to exit the private student lending business. On December 11, We announced a new leadership, and we're excited to have Michael Rhodes joining us for our incoming Chief Executive Officer.

Speaker 2

Michael is an experienced leader the deep background in the financial services industry. He has managed all aspects of our consumer banking business with deep experience Credit Card Space, Payments, Online and Mobile Banking and served as Group Head of Innovation and Technology. His appointment marks the conclusion of a rigorous search process, and we look forward to Michael's arrival. When Michael arrives, I will return to my prior role on Discover's Board of Directors. In conclusion, I'm proud of the progress we made in 2023.

Speaker 2

Financial performance and maturing risk management and compliance capabilities physician Discover well for 2024 and beyond. With that, I'll now turn the call over to John Green,

Speaker 3

Thank you, John, and good morning, everyone. I'll start with our summary financial results on Slide 4. In the quarter, we reported net income of $388,000,000 down from just over $1,000,000,000 in the prior year quarter. There are 3 broad trends to call out. First, we grew revenue 13%, reflecting 15% loan growth, Partially offset by modest NIM compression.

Speaker 3

2nd, provision expense grew by $1,000,000,000 charge offs increased but landed at the low end of our expected range. Strong loan growth and higher delinquency drove the increase to our reserve balance. Finally, expenses increased 19% year over year reflecting investments in compliance and risk management, campaign. We'll get into the details of these topics on the following pages. Turning to Slide 5, Our net interest margin ended the quarter at 10.98%, down 29 basis points from the prior year and up 3 basis points sequentially.

Speaker 3

The decline from the prior year quarter was driven by higher funding costs and higher interest charge offs, financial results, which were partially offset by higher prime rates and increases in revolving balances. For the full year, financial results. Net interest margin was 11.07 percent, up 3 basis points from the prior year. This margin performance reflects the improvement in our funding mix over the past several years and a reduced level of balance transfer financial and promotional balances as we tightened underwriting. Receivable growth remained robust.

Speaker 3

Card increased 13% year over year due to contributions from the prior year new account growth and a lower payment rate. The payment rate declined about 110 basis points from the sequential quarter and is now 100 basis points above 2019 levels. Overall, new account growth declined 9% as a result of credit actions. Sales were up 3% compared to the prior year quarter. Personal loans were up 23%, driven by continued strength in originations and lower payment rate versus the prior year.

Speaker 3

Student loans were flat year over year As we prepare for a potential sale of this portfolio, we will cease accepting applications for new loans call on February 1. Our deposit business delivered outstanding performance in a challenging year. Average deposits were up 21% year over year and 4% sequentially. Our direct to consumer balances grew $3,000,000,000 in the period and $14,000,000,000 in the year. Looking at other revenue on Slide 6.

Speaker 3

Non interest income increased $74,000,000 or 11%. This was primarily driven by an increase in loan fee income, higher transaction processing revenue from our Pulse business financial results and higher net discount and interchange revenue. Our rewards rate was 137 basis points in the period quarterly quarter and a record quarterly quarter of $1,000,000,000 in a quarter of $1,000,000,000 in a quarter of $1,000,000,000 in a quarter of

Speaker 4

$1,000,000 in a quarter of $1,000,000 in a quarter of

Speaker 5

$1,000,000 in a quarter of $1,000,000 in

Speaker 3

a quarter of $1,000,000 in a quarter of $1,000,000 in a quarter of $1,000,000 in a quarter of $1,000,000,000 in a The decline reflects lower cash back match from slowing new account growth and our active management of our 5% categories. Moving to expenses on Slide 7. Total operating expenses were up $280,000,000 or 19% year over year and up 22% from the prior quarter. Looking at our major expense categories, compensation costs increased $73,000,000 floor 13% from higher headcount. Marketing expenses increased $59,000,000 or 19%.

Speaker 3

Professional fees were up driven by continued investment in compliance and risk management capabilities, while other expense reflects a reserve customer remediation. Moving to credit performance on Slide 8. Total net charge offs were 4.11%, 198 basis points higher than the prior year and up 59 basis points from the prior quarter. In card, as anticipated, delinquency formation is slowing as more recent vintages season. We added a slide detailing some of the drivers of our credit performance in the appendix to the earnings presentation.

Speaker 3

Turning to the allowance for credit losses on Slide 9. This quarter, we increased our reserves by $618,000,000 in our reserve rate increased by 17 basis points to just over 7.2%. The increase in reserves was driven by receivable growth and higher near term loss content from higher delinquencies. Under CECL, reserve levels increase as you approach peak losses. We expect our losses to rise through the mid year and then plateau through the back half with some seasonal variation.

Speaker 3

In terms of our macroeconomic outlook, Our view of unemployment was relatively unchanged, while household net worth projections increased slightly. These changes provided a small benefit to reserves. Looking at Slide 10, our common equity Tier 1 for the period was 11 0.3%. The sequential decline of 30 basis points was driven largely by asset growth. We declared a quarterly cash dividend of $0.70 per share of common stock, including on Slide 11 with our perspectives on 2024.

Speaker 3

These exclude the impact of a potential student loan portfolio sale. We expect end of period loan growth to be relatively flat, while average loan growth will be up modestly year over year. We expect full year net interest margin to be 10.5% to 10.8%. We're currently anticipating 4 rate cuts of 25 basis points in 2024. This is 2 more rate cuts than in our forecast in December.

Speaker 3

Each cut reduces NIM by approximately 5 basis points subject to a deposit beta. We expect total operating expenses to increase by a mid single digit percent. This contemplates our expectation for compliance related costs We expect net charge offs in the range of 4.9% to 5.3%. Finally, call regarding capital return. We will participate in this year's CCAR process and believe the results financial results.

Speaker 3

For 2024, we will continue to advance our compliance financial and financial measures that drive sustainable long term value creation. With that, I'll turn the call back to our operator to open the line for Q

Operator

Our first question will come from Rick Shane with JPMorgan. Please go ahead.

Speaker 3

Good morning, everybody, and thanks for taking my question.

Speaker 6

Excuse me, I'm a little under the weather today, so I apologize. The loan growth expectations, Is that organic loan growth or is that net of the portfolio sale of the student loans?

Speaker 3

Hey, Rick. John Green here. That is organic loan growth. So all of the guidance Excluded the impact of a potential student loan asset sale.

Speaker 6

Okay. That's it from me. Thank you, guys.

Operator

Floor. Thank you. Our next question will come from Moshe Orenbuch with TD Cowen. Great.

Speaker 7

Thanks. John, maybe just to follow-up on Rick's question. I mean, given the strong growth that you're currently seeing in personal loan business and the fact that you're still adding accounts, albeit at a lower level in the credit card business. You did mention kind of lower balance transfers, but is there something else going on? Can you talk about kind of deconstruct that loan growth expectation for us a little bit?

Speaker 3

Call. Sure. Sure. Thanks Moshe. So the bonus alone growth, sales, new account generation, payment rate trends.

Speaker 3

And so What we're anticipating for sales given the slowdown through 2023 in terms of sales. Although we did have a pretty strong holiday season, is that sales will be relatively flat year full year. New account generation relative to last year, certainly down, but overall positive new account growth. And payment rate, what we've tried to do here is kind of derisk the forecast. So we assume that 100 basis points of payment rate that's elevated versus 2019 We'll remain elevated.

Speaker 3

So those three components reflect end up coming in and reflecting on our projections. Now loan growth could actually come in higher If payment rate continues to decline, but overall, our basis for guidance, loan growth, financials. Our next question comes from the line of Robert W. Baird. Please go ahead.

Speaker 3

Thank you. Thank you. Thank you. Thank you. Thank you.

Speaker 3

Thank you. Expectations on those ranges.

Speaker 7

Great. Thanks. And maybe just as a follow-up, as On the credit side, I mean, you did talk a month ago and then mentioned again today that you expect kind of losses to peak around the middle of the year. How do we think about the performance after that peak? I mean, you said kind of flattish.

Speaker 7

What's driving that? Why isn't that something that improves? And how do we think about reserving in that context?

Speaker 3

Sure. Yes. So there's a couple of different components that are driving that. So if you go back in time, we had about 2 years of unusually low charge offs and delinquencies, so from the pandemic. And that process of normalization typically will take about the same amount of time, 2 years.

Speaker 3

The vintages 2021 2022 are seasoning and that's why we expect it to plateau. The 2023 vintage actually was relatively large, but too early to call whether it's going to outperform our expectations, but certainly a highly profitable vintage from our vantage point today. So What you're actually just seeing is a period of normalization. My expectation is that charge offs will plateau and then beginning in 2025, I would expect those to step down. Now, you will know from this past year and the prior year, what we've tried to do in terms of the guidance is be conservative in terms of the range and throughout 2023, we tightened the range and They came in at the low end.

Speaker 3

So my hope is that we'll be able to do the same thing in 2024.

Speaker 7

Great. Thanks.

Operator

Thank you. Our next question will come from Ryan Nash with Goldman Sachs.

Speaker 8

Hey, good morning, everyone. John, maybe to dig a little bit deeper on some of the commentary you gave regarding loan growth, maybe just focusing on the account growth. The market clearly thinks there's a better chance of a soft landing right now. We're seeing peers who are talking about mid to high single digit growth. And I'm just curious on the account growth, is this more just conservative underwriting?

Speaker 8

Are you trying to make sure that you make more progress on risk governance and compliance before you increase growth, maybe just a little bit more color on why you're seeing such a slowdown in terms of the account growth relative to the last few years?

Speaker 3

Yes. Thanks, Ryan. So our approach in 2023 and then early into 2024 financials that we took a look at underwriting and performance of what I'll say buckets within our underwriting box We're seeing here in terms of account growth, at least projections today is us full year 2020 and 2019 levels as we continue to watch the 2022 and 2023 vintage Perform and 6 months from now, we may end up stepping in a little bit more aggressively. But what we wanted to do certainly was Let's get further confirmation that the delinquency trends that we have seen in terms of slowing rate of delinquency formation continue to persist and that the charge offs, the forecasted come in at or better than our expectations. If those two factors are at play, there will be an opportunity to be more aggressive in terms of new account growth.

Speaker 8

Got it. And maybe as my follow-up, can you maybe help us understand where you stand with the student loan sale and How would you foresee that impacting the outlook as well as capital return over the next 4 to 6 quarters? Thank you.

Speaker 3

Yes. Thanks, Ryan. So good news. So it is actually progressing to schedule. So matter of fact, Last evening, we signed a servicing agreement with Nelnet to become the servicer of this portfolio.

Speaker 3

So that was great news. It was a competitive process and certainly Nelnet show that there is a commitment to continue to dedicate resources and service that portfolio at a high level. The next step will be to continue the servicing migration activities. We expect those activities will take around 6 months. Conservatively, it may take a month future longer.

Speaker 3

And then as we're doing that, our advisor will begin to market the portfolio. So our expectations are that it will sell in the second half. And the implications for the business are as follows. So there's $9,500,000,000 of receivables. That equates to risk weighted assets of about $10,800,000,000 We expect That will be the exit of that will be have a positive impact on net interest margin by somewhere between 10 bps and 20 bps on a full year basis.

Speaker 3

Charge off rate could tick up mildly, So under 5 bps. And as of twelvethirty one, we had $858,000,000 full year of reserves. So with a successful exit, those reserves will drop. And the sale price, the market will determine that, but we expect it to go above par.

Speaker 9

Thank you for all the color.

Operator

Thank you. Our next question will come from Mihir Bhatia with Bank of America.

Speaker 9

Hi, thank you for taking my question. I'm looking to start with loan growth also. And I just want to go back to the building blocks a little bit. I think you Essentially, sir, in terms of the building blocks, you're expecting payments rates to be elevated like flat to stay at this elevated level and sales to be flat. You're also adding accounts.

Speaker 9

So I'm just like trying to understand, like, I guess, what's the bad guy? Like how Has loan growth stayed flat given the IPO, you're at 15%. I'm just trying to understand There's some piece I'm missing, I feel like, and I'm just trying to understand that.

Speaker 3

Yes. So let me try to give a little bit of call that hopefully gets folks comfortable with our view of loan growth today. So in 2023, really, really strong loan growth. Financials. Much of that was driven both by new account growth, but also a slowing payment rate.

Speaker 3

That payment rate in our assumptions is holding flat. And as a result, What we expect to see is the 2023 vintage will begin to kind of build in terms of assets, but there's likely going to be some impact from sales. And then also as we cycle through the 2022 vintage, we're not expecting significant new balance builds from that vintage. Now maybe there will be, but overall, What we've tried to do here is reflect our view of our underwriting box today, Not reflect any potential openings of our underwriting box in the later part of 2023. And if we out deliver on loan growth, that'll be fantastic.

Speaker 3

The other element that has come into play here as we pulled back on balance transfers and promotional balances in the 2nd part of 2023. We don't anticipate significantly increasing that level of financial balance transfer promotional balances. Now, if we do, that will certainly be accretive to loan growth as well. So What you're hearing in the guidance is that our expectation is that there's an opportunity to deliver better, But certainly, we've positioned both the guidance and the business to be conservative, at least for the next quarter or 2.

Speaker 9

Got it. And then I wanted to go back to the expenses and the reserve for customer remediation that you mentioned that you took this quarter. Can you just provide some more color on that? Like is that related to the merchant mispricing issue? How much was the reserve this quarter?

Speaker 9

Where does that leave the reserve overall? I think you had $365,000,000 in 2Q. I'm just trying to understand how the estimate for the cost Related to that issue change, I think you also mentioned it could be higher expenses could be higher in 2024. If you need to take more reserves there, like Where are we with that investigation? Just give us an update on that merchant mispricing issue too.

Speaker 3

Yes. Okay. So let me start with the reserve. So And the remediation reserve that we put up. So they're unrelated.

Speaker 3

So the merchant tiering reserve, we booked $365,000,000 as a liability. That has moved It's now about $370,000,000 just as we've had some payments and other flows in through the interchange that we had to correct manually for. So the progress there in terms of discussions with our merchants is positive. We'll We don't have enough data points to make a material change to that reserve level yet, but it's progressing my view positively through the end of the year and today as we speak. Now separately, we put up $80,000,000 for a, as we described it, a customer remediation reserve.

Speaker 3

Now, some context to that is, As part of this compliance journey, we put in a significant number of resources to help us identify and correct issues. And as we prepare, the business to continue to move forward to drive organic growth, We're getting much, much better at identifying issues and we identify an issue. What we've done here is if we think there's It's appropriate to refund customer payments, we're going to do that. So We identified a particular issue largely within servicing for our student loan business. There was a tangential impact in another business line.

Speaker 3

We continue to look across our business. But The lion's share of that reserve relates to student loans and essentially what we're doing is trying to position the business And that product for successful exit.

Speaker 10

Thank you for taking my questions.

Speaker 9

I'll get back in queue.

Operator

Floor. Thank you. Our next question will come from Sanjay Sakhrani with KBW.

Speaker 5

Thanks. Good morning. Sorry, multipart question on the same topic and then a follow-up. Can you update us, John, on the progress made with the regulatory agencies? I think That was sort of alluded to in the previous question, but maybe just the firmness around capital return post CCAR, What exactly happens, to the CFPB consent order when the loan servicing is transferred?

Speaker 5

And then just Qurious, the loan growth expectations, was that any part driven by any regulatory related matters?

Speaker 2

Yes, this is John Owen. I'll take part of that and John Green will take the capital part. What I would tell you is over the last 18 months or so, we've made significant progress improving our risk management and compliance capabilities. We've increased our investments on risk and compliance 2020 2 to 2023 up to about a $500,000,000 level. And as John mentioned earlier, we think expense growth and that will be in the mid single digits in line with other guidance we've given.

Speaker 2

We've made improvements in risk and compliance, but we still have quite a bit of work One thing I'd point out, the FDIC consent order, which we did get and was made public, It does not include the misclassification issue in that scope of work. We're working closely with our regulators on that topic and really don't have Anything further to add on that topic at this point in time.

Speaker 3

Okay. Sanjay, I feel like your question is a 5 part question, but we'll do our best to answer it. So the loan growth aspect that you asked. It is completely unrelated to any regulatory issues. So Nothing to connect on that point.

Speaker 3

In terms of capital return, our commitments to financials. Capital return and capital allocation have not changed. So first to invest financial results in profitable organic growth and second to return excess capital to shareholders. So as we Kind of progressed through the Q4, we remained on pause with our buybacks. And Given we've got a new CEO coming in, we are contending with a number of different compliance and risk management matters, the merchant tiering reserve.

Speaker 3

We don't have any feedback from our regulators on that point. We decided that it would be most appropriate to remain conservative in terms of our guidance related to buyback. We will go through CCARs, as I said in my prepared remarks. That will form a view of capital under significant stress As it always does. And then we're going to have the exit or hopefully the exit from the student loan business, which will provide free up at least $2,000,000,000 worth of capital.

Speaker 3

So what you're hearing here hopefully Some indications that, 1, we're committed to returning excess capital to shareholders 2, that There will be excess capital generated and available. And 3, we're going to go through a diligent process internally, share it with our Board and then take the Board's direction in terms of buybacks.

Speaker 5

The consent order?

Speaker 4

And with the loan servicing, like does that move? Yes.

Speaker 3

That was part 5a, I think. Yes. So that remains in effect. And our chosen provider Nelnet is fully aware of the consent order requirements in terms of kind of servicing excellence. And They were chosen because they've got a track record in terms of being able to kind of service a portfolio such as this and They've dedicated both technology and resources to ensure a seamless transition.

Speaker 5

Okay. Then my follow-up just question is, sorry, to my 5 part question, is the reserve rate Moshe

Speaker 4

sort of asked about a

Speaker 5

little bit, but How should we think about that reserve rate migrating over the course of the year given that the charge off rate plateaus. Does the reserve rate start coming down and where does it come down to in a normal environment? I'm just trying to think about how we model that Because that's really important.

Speaker 3

Yes. Thanks for that. We are hoping that that question would come out. So Let me talk about the reserves for the quarter and then I'll give some perspective on 24 and what could potentially happen there. So we grew receivables in the quarter $5,700,000,000 Now some of that was transaction balances that are reserved like.

Speaker 3

But one thing that we've been Consistent on in terms of our communication is that as we approach peak losses, reserve levels increase. And what we've said previously is, typically we hit the highest reserve rate level 1 to 2 quarters before peak losses. So That's the path we're on. Let me provide some details on some assumptions that were used financials that set the reserve levels this year, at year end. And then I'll give a perspective on what we financials, what could happen in 2024.

Speaker 3

So the macro is relatively benign. So unemployment levels, We ended the year at 3.37. What we've assumed is an unemployment level of 4.2. So a mild increase. Household net worth mild decrease, savings rate mild increase and GDP to be in 2024, it would be about 1.3%.

Speaker 3

So relatively conservative, but not overly optimistic set financials of assumptions. Now what will come into play in 2024 is obviously the macros, which continue to be important, the portfolio performance. And by the way, it is tracking to our expectation with month over month delinquency formation declining. The credit quality in the book remains relatively consistent with What we've done historically. So, our expectation is that assuming the macros remain financials and the portfolio performance remains to our expectation that there will be some level of opportunity to reduce the reserve rate in 2024.

Speaker 3

Now that's subject to significant amount of governance and We're going to make sure that we comply with our internal processes and generally accepted accounting principles. So they're my caveats, but There's a lot of things that are different today than day 1. This step down will be aligned with those points I just mentioned.

Speaker 9

Okay, great.

Speaker 5

Thank you very much.

Operator

Thank you. Our next question will come from Bill Carcache with Wolfe Research. Please go ahead.

Speaker 11

Thank you. Good morning and thanks for taking my questions. John, I wanted to follow-up on your credit commentary given that it is such an important area of focus for investors. So you've been saying all along that You didn't move down the credit spectrum, but the concern for many investors had been that other card issuers also experienced outsized growth as we emerge from COVID and they had also experienced some normalization headwinds, but they were now starting to see delinquency rate formation start to roll over as Discover's DQ rate formations is recently as prior months data Showed that your formations remain on and up until the right trajectory. So I guess the question is, does the new disclosure on Slide 14 confirm that Your delinquency rate formations are indeed now also starting to roll over.

Speaker 11

And if so, does that Really just reinforce your confidence that we could see peak NCOs hit in 2024 all else equal.

Speaker 3

Yes. And thanks for the question, Bill. So just to give you kind of the benefit of some data here. From September through December this year, so the 30 plus delinquencies have declined month over month. So in September, We peaked at an increase month over month of 26 bps.

Speaker 3

What we said in the 4th quarter is we expected that to decline. October formation increased 20 bps, so relative decline to the prior month, November 15 bps, December 11 bps. And our expectation is that that will continue to decline. Where it becomes negative, we're not going to get into that because it will be subject to a number of different things, including

Speaker 12

kind of

Speaker 3

our origination path and broad macro. So to get to the essence of your question, we do have a level of confidence regarding kind of what's happening in the portfolio and the trend. And as we progress in 2024. That'll be reflected in hopefully tightening guidance and then also tightening guidance to the lower end and then also, hopefully, reserve rate changes.

Speaker 11

That's helpful. Thank you. And following up on your expense commentary, I believe you said that expenses may need to increase further potentially maybe if you could frame the possibility of there being what You would view as another step function higher from here or how should we think about the risk of further increase in expenses and How are we how should we think about your sustainable long term efficiency ratio? Yes, I think as we look at historically, Discover has been very much had lowest efficiency ratio in the industry. To what extent is that still something that we can expect?

Speaker 3

Okay. Yes. Thanks, Bill. Our expectation is that the long term efficiency ratio will be sub-forty percent. So There's still a view that, that will happen.

Speaker 3

The reason we put the what I'll call is the caveat in the 2024 expense guidance was. A number of different institutions What the actual compliance and risk management spend would be. We had that remediation reserve in the 4th quarter. There were some indications that we might have to put something up for that, but we didn't know. There's still Some level of unknowns, unknowns.

Speaker 3

And I wanted to make sure we're clear the people listening to this call that there is some level of risk to the expense guidance. Now that said, 5% on our expense base is a significant amount of dollars. We feel like we have nearly a full complement of resources around risk and compliance today, which is good news. Our issues management capabilities significantly improved. Our path to improving overall governance is certainly on the right trajectory.

Speaker 3

So those factors give me confidence that we're not going to have a huge surprise. But maybe there could be, just we just Don't have enough certainty given where we are on our compliance journey. Now the rest of the cost base, There's a couple of things to keep in mind here. So right today, we have nearly 3,000 resources dedicated at risk and compliance management. A significant amount of those resources are dedicated to issues related to student loan servicing, Which with a successful exit and transfer, it will give us an opportunity to scrutinize the cost base in a different way.

Speaker 3

So that's certainly on the list of planned activities for the Q2, Q3 and then hopefully we begin some execution in the Q4. So overall, I feel comfortable with the expense guidance that we've provided. And we're going to do our best to make sure that every dollar we spend is wise and that the shareholders get the benefit

Speaker 11

Very helpful. Thank you for taking my questions.

Speaker 6

You're welcome, Bill. Thanks. Floor.

Operator

Thank you. Our next question will come from John Pancari with Evercore ISI.

Speaker 6

Good morning.

Speaker 12

Regarding the new $80,000,000 remediation charge, Did all of that remediation relate to the student loan business specifically? And was that in part tied also to the July 22 disclosure around the student loan issues That surfaced then. And did any of that $80,000,000 relate to the other business that you point that you mentioned That could have had a tangential impact and what was that business? Thanks.

Speaker 3

Yes. So The $80,000,000 was related to servicing issues. The lion's share of that, the significant share of that was related to student loans. There was a small amount that we put up related to personal loans upon reviewing that There may be an opportunity to release that reserve, very small though. The $80,000,000 is not connected to the issues that we discussed in July.

Speaker 3

So what I tried to do is provide as much context as I could. So we dedicated a number of resources This is symptomatic of that progress. So we've got folks that are coming through Every single bit of our business to make sure we're executing consumer compliance at a high level. An issue was found. A cross functional team reviewed it and we made an election that we are going to accrue something at year end to cover potential remediation payments.

Speaker 12

Okay. And just related to that, So this is a newer issue versus what was discussed in July. And is it also newer

Speaker 3

Yes. What we disclosed in July was a broad program around financials and compliance management activities. The specifics of the particular issues weren't discussed in any details. And what I've shared with you right now is probably as much information as I'm going to share at this point. So the takeaway should be is that we're progressing on the risk compliance management activities.

Speaker 3

We're getting better at identifying issues. When we find an issue, we're going to deal with it. And we found an issue. We've put up a reserve for that issue and we're going to work through further details on it in order to ensure that consumer compliance is where we want it to be. So with that, I think I'll probably close this particular item out, if you don't mind.

Speaker 12

No, that's fine. Thank you for that. And my last thing was a very quick one on the loan growth guidance. You guided the average balances for 2024 up modestly. Can you help Maybe quantify the help modestly, if you could maybe help frame it.

Speaker 12

Thanks.

Speaker 3

Yes. So 5% to 6% On average.

Speaker 12

Okay, great. Thanks, Sean.

Operator

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

Speaker 13

John, it's good to see the delinquency formation showing some progress. Can you talk about later stage delinquency rates? I mean, they seem like they're still going up On a year over year basis, like how are cure rates? I'm still trying to get my arms around this like potentially 5% NCO rate. It just seems high for Discover.

Speaker 3

Yes. The later stage buckets are kind of modestly improving. We're seeing improvements across every bucket. The first bucket The ability to cure just becomes more challenging because of the situation that consumers in. But We are seeing mild improvements there.

Speaker 3

So that also is encouraging.

Speaker 13

Okay. And the 2023 vintage, can you talk a little bit about what your early read is on that.

Speaker 3

Yes. The net of it is that it's early. It's performing profitably and we're going to continue to keep our eye on it.

Speaker 9

So does that

Speaker 13

mean it's not really trending that well relative to your expectations or is it kind of in line?

Speaker 3

No, no, I didn't say that. It's just it's early. So it's performing Generally, in line with expectations.

Speaker 9

Okay. Thanks.

Operator

Floor. Thank you. We'll take our next question from Jeff Adelson with Morgan Stanley.

Speaker 4

Hi. Thanks for taking my questions.

Speaker 7

John, I just wanted to kind

Speaker 4

of follow-up on the charge off guide. I know you've mentioned that you're hopeful this could come in at the low end, but Could you maybe just dive into what would take us to the low versus the high end here? And if this delinquency formation slowing continues throughout the year. Is that kind of what's embedded in your expectation at getting at the low end here?

Speaker 3

Floor. Yes. Thank you. Yes. So our baseline is that it's going to

Speaker 6

come in at the low end. Now,

Speaker 3

I shared the information in terms of the macros financials that we use for reserves pretty consistent in terms of what we used for our What I'll say the second half view of charge offs. So what could make that worse? Certainly, a change to the macros, some servicing issues, which highly unlikely or a miss in terms of forecasting. I'm comfortable with our forecasting team. I'm comfortable with our servicing team and we've got a number of programs and we've dedicated lot of dollars in terms of analytics, in terms of call frequency and best time to call.

Speaker 3

And we've worked on our call scripts to ensure they're compliant, but also effective in terms of prioritizing payments. So I Feel good about that. So the range just reflects a level of kind of broad uncertainty that we're going to tighten.

Speaker 4

Got it. And just as my follow-up, As we think about the NIM guide this year, I know you mentioned you're embedded in an expectation of 4 rate cuts. If I think about where NIM exited the year though, it feels like, the range of rate cuts using your five basis Q1 of 2019. It seems like there's more rate cut embedded in there. Can you maybe just help us understand the drivers is, there may be a little bit more Interested for reversal going on and maybe help us understand what you're assuming in positive betas on the way down.

Speaker 4

Is it going to be a little bit slower And what we've seen in the last four rate cuts on the way up?

Speaker 3

Yes. So good question. So Let me start off with 2023 and then the Q4 of 2023. So, as a business, My view is great execution in terms of being able to kind of manage net interest margin. So year over year we were up.

Speaker 3

I think we're an outlier and that's from that standpoint in Financial Services. What we saw in the Q4 was cost of funding increased as lower rate CDs term out and higher rate CDs would come in. Expectation on beta is that it will be in the mid-70s in a declining rate. And I hope that the beta on the declining rate is higher. Also, something that's Not baked into the elements of the guidance, but certainly with the exit of student loans or proposed exit from the student loan business.

Speaker 3

That's going to throw a lot of liquidity back into the business. That will give us an opportunity to be slightly more aggressive in terms of deposit pricing. Again, that will be a second half activity. So the 4 rate cuts that we put into the baseline assumption, again, 2 more than what we had forecasted in December. It could be as many as 6, Which if it is, that will certainly impact deposit betas and deposit pricing and consequentially net interest margin.

Speaker 3

So the guide here, I think, It's appropriate, perhaps a little conservative and our baseline expectation is that we're going to deliver to the upper end of the guidance range.

Speaker 4

Okay. Thank you for taking my questions, John.

Operator

Thank you. We'll take our next question from Terry Ma with Barclays.

Speaker 10

Hey, thanks. Good morning. Maybe just want to touch on the loan growth guide for 2024 a little bit. Aside from the balance transfers and promos. How much control do you actually have on growth?

Speaker 10

Going from 15% loan growth to 0% just seems like a hard pivot to me. So maybe can you just talk a little bit more about that? Then my second question is just what needs to happen before you can actually grow again? And is there a way to think about what that growth rate flake as we look out toward 2025 and beyond. Thank you.

Speaker 3

Okay. Thanks, Terry. I think it's important to take a look at the quarterly trends on loan growth full year, because each quarter, what you will see is that the amount of loan growth decrease quarter over quarter. And that was partly due to payment rate, partly due to underwriting standards And partly due to kind of sales activity slowing as well. So financial results.

Speaker 3

In 2024, we've guided to loan growth to be flat. Again, payment rate is 100 basis points higher than it was in 2019. That could be a positive if it holds where it ended the year. It's not going to impact loan growth. So, I feel like What we've tried to do here is put something on the table that's reasonable that doesn't reflect a level of undue risk taking in a time where consumer behavior is actually changing relatively dynamically if you think back 2.5 years ago coming out of the pandemic to kind of where it is today and also the impact of inflation that hit Certainly all consumers, but certainly in terms of our prime revolver consumers, the lower third of those consumers were impacted fairly significantly by inflation.

Speaker 3

So we do want to kind of watch, as I said previously, watch delinquency formations and our other metrics before we press on the gas on generating high level of new accounts in 2024.

Speaker 10

Thanks. And is there a way to think about what growth would look like before when you reaccelerate?

Speaker 3

Yes, I would go back to kind of historical growth rates. The company's typically delivered somewhere between 3% 8% year over year growth. And then we feel like our underwriting and credit and the opportunity to lend profitably at a rate higher than that, we will do that. So what an important thing for our investors to remember is we seek to generate high returns over the short, mid and long term. And that's essentially what this plan is seeking to deliver.

Speaker 6

So Todd, I think we have time for one more please. Floor.

Operator

Thank you, sir. We'll go next to John Hecht with Jefferies.

Speaker 14

Good morning, guys. Thanks for taking my question. And Yes. I know you've answered a lot on credit, so I apologize for one more. But your 2018 2019 charge off levels were in the low 3% range.

Speaker 14

And I think we've all kind of said that was a good environment, but a relatively normal environment. You're guiding toward a relatively higher closer to 5% charge off rate this year despite Low unemployment. I know you kind of called out the 2022 vintage is something to think about there. But maybe can you talk about the attribution of The difference in charge off rates between that period and now. I think the kind of the reason for the question is just to give us a sort of level of understanding Of where we are in the credit cycle and give us comfort that things will stabilize if not improve from here.

Speaker 3

Yes, happy to, John. So a few points. So we're in a significantly different environment today than we were back in 2018 2019. So we're coming off of 4th 2 years of abnormally low losses, so sub-two percent. We had an incredibly high payment rate Going back 2 years ago, that is normalized.

Speaker 3

What we're seeing is that consumers You had significant amount of savings. Those savings levels have been depleted. You had a spending pattern With the consumers across the board that was reflective reflecting kind of pent up demand. And as savings rate came down, consumers needed to adjust their spending patterns. Some did successfully, some did not.

Speaker 3

And then you're also seeing inflation, if you go back a year and a half to 2 years ago, inflation significantly outpacing wage growth. And that put certainly the lower quartile of the consumers in a significant amount of stress. And that's across all sectors of the economy, so not specifically to our prime revolver segment. And on top of that, you also had in 2021 2022, 2 very large vintages. And so, you put all those together, what naturally is going to happen is you're going to have charge offs, what I'll say is peak before they normalize back to levels that you're accustomed to seeing So my sense is that given real wage growth, our consumers will end up in a frankly a better spot in 2024 and 2025 than they were in 2022 and 2023.

Speaker 3

And our charge off forecasts and reserves reflect view that the consumers will manage through this and delinquency formation will continue to slow. So anyway, I hope that this color is helpful.

Speaker 14

Yes, that's super helpful. And maybe could you give us a sense of the charge offs by product or maybe like the Is the mix going to be consistent with historical mix just to give us a sense from a modeling perspective?

Speaker 3

Yes. The only piece of information I'm going to give is In the Q4, we expect student loan charge offs to be significantly lower

Speaker 9

because we're accretive. Thank you.

Speaker 13

All right. Well, I think we're

Speaker 1

going to conclude the call there. Thank you for joining us. I know there was a few of you still in queue who Thanks for joining us and have a great day.

Operator

And this does conclude today's 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 Q4 2023
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