The company reported a 6 percent increase in revenues. Credit performance continues to be exceptional, and the company expects that losses are at or near a bottom. It believes it will return to growth in the reserve in the next 9 months, but the growth will be in loan growth, not by a change in the credit environment.
In Direct Banking, total loans grew 9 percent over the prior year. Card loans grew by 4 percent. Discover Financial continues to focus on profitable revolver sales through cash rewards, promotions, partnerships and advertising. Although the overall card industry is flat, Discover Financial had strong receivables growth. At the same time, it reached new historic lows for 30-plus delinquency (below 2 percent) and net charge-off rates (below 1 percent). The spend growth on cards will continue to be greater than the loan growth.
In cards, Discover Financial Services recently announced an affinity partnership with Ducks Unlimited, a conservation group with more than 600,000 adult members committed to wetlands and waterfowl conservation. Affinity cards will not be its primary strategy, but an extension of its strategy. Its primary strategy is to be the leader in cashback bonuses.
In student loans, Discover Financial Services Management has started to offer a fixed-rate private student loan product, which is designed to have rates comparable to federal unsubsidized Stafford and PLUS Loans for qualifying students without the upfront origination fees of up to 4%. This product has been on the market for only a month. So far, the response from customers and financial aid offices are positive.
Discover Financial Services Management also started to market residential mortgages under the Discover Home Loans brand. It purchased this business from Tree.com and closed on the acquisition on June 6. The purchase gave it a team of 750 employees and a technology platform. Discover Homes Loans will be selling prime, fixed- and variable-rate, conventional and FHA loans, which will be sold to the secondary market with servicing released. The residential loan program will not be accretive or dilutive in the near term and instead will be break even. It is not a capital intensive business since it will be selling the loans within 15 days, but is a good source of fee income.
In Payments, PULSE grew by 14 percent. It added 129 new relationships in 2011. Discover Financial Services Management is concerned about the actions of one competitor in the market (VISA?) who had 70 percent of market share. That competitor is tying products together and launching a variable/fixed pricing to take advantage of the market share. The Department of Justice has launched an investigation of this competitor.
Financials.
Revenues in Q2 increased by 6 percent year over year.
In Direct Banking, yield on the card portfolio declined by 22 basis points to 12.35 percent. The APR mix is moving away from higher balances but at a slower rate than expected. Promotional volumes have increased.
Total portfolio yield was 11.55 percent, a decline of 38 basis points. The decline was the result of yield compression and the purchase of the additional student loan portfolio in Q4/2011, and the decline was partially offset by the sale of Discover Financial's remaining federal student loans in Q1/2012. Although student loans have lower yields than credit cards and personal loans, they also have lower charge off rates and operating expenses.
Net interest income increased by
10 percent over Q2/2011 as the result of asset growth, lower interest
expenses on its funding and lower charge-offs.
Net interest margin on receivables was 9.31 percent, an increase of 16 basis points driven by lower charge-offs of accrued interest and continued funding cost improvement. Funding costs declined by 50 basis points. Discover Financial Services Managements expects the net interest margin to stay around the same level for the remainder of the year since card yield has held up better than expected. A normalized margin for Discover Financial is between 8.5 and 9.0 percent. It expects to move down to the high end of that range next year.
Total operating expenses increased by 18 percent, primarily due to a $71 million increase in legal reserve expenses. The PPI matter has not been resolved although Discover Financial Services is having a constructive dialogue with the CFPB and the FDIC.
Excluding the increase in reserves, operating expenses increased by 6 percent. Discover Financial expects marketing and business development expenses to increase in the second half of the year. In addition, the acquisition of the Home Loan Center and the launch of the residential loans will raise operating expenses by $35 million per quarter.
In Lending Products, credit card sales grew by 5 percent in Q2. The total loan portfolio grew $4.5 billion, $2.4 billion of which was attributable to the private student loan acquisition in Q4/2011. The net charge-off rate for credit cards declined 28 basis points versus the prior quarter and the 30-plus delinquency rate declined 31 basis points. The card reserve rate declined by 32 basis points.
In student loans, the net principal charge-off rate, excluding the purchased portfolios, was 67 basis points. The charge-offs will rise slightly as the portfolio gets older as a significant portion of the portfolio is currently in the deferral stage.
For personal loans, loans greater than 30 days past due fell 2 basis points sequentially. The personal loan net principal charge-off rate was down 35 basis points.
In Payments, pretax income increased 10 percent as a result of higher-margin point-of-sale volume from Discover Financial's PULSE PIN debit network business and third-party issuing volume. Volume increased by 12% against the prior year, driven by 14% growth in PULSE and 19% growth in the Discover Network third-party issuing volumes. This gain was offset partly by Diners Club performance.
Discover Financial had total available liquidity of $27.6 billion at the end of Q2. Its on balance sheet liquidity portfolio was $11.3 billion at the end of Q2, an increase of $2.6 billion from Q2/2011 but down from Q1/2012. The change from Q1 was the result of prefunding a number of Q2 maturities in Q1.
During Q2, Discover Financial completed an unsecured debt exchange, exchanging $322 of 10.25 senior notes due in 2019 for 5.2 percent senior notes due in 2022.
Discover Financial spent $500 million in share buybacks and dividends in Q2. The $450 million in buybacks in Q2 was a bit of a catch up from the first quarter. Discover Financial Services Management has used a little more than half of the authorized share buyback.
The full transcript of the earnings conference call can be found on Seeking Alpha at the following link:
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