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Executives

Craig Streem - Investor Relations

Roy Guthrie - Chief Financial Officer

Analysts

Sanjay Sakhrani - KBW

David Hochstim - Buckingham Research Group

Kevin Stiroh – Sanford Bernstein

Howard Shapiro - Fox-Pitt

Moshe Orenbuch - Credit Suisse

Darrin Peller - Barclays

Steven Wharton - JP Morgan

Mike Taiano - Sandler O’Neill

Dan Arlow – Omega

Noel Levy - Tyndall

Discover Financial Services (DFS) Business Update Call October 28, 2008 8:30 AM ET

Operator

Good day, ladies and gentlemen and welcome to the Discover Financial Services litigation settlement conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s conference, Mr. Craig Streem. Please proceed, sir.

Craig Streem

Good morning, everyone and welcome to this call. We certainly appreciate all of you joining us today.

The discussion today contains certain forward-looking statements about the company’s future financial performance and business prospects, which are subject to risks and uncertainties and speak only as of today.

Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today’s press release concerning the litigation settlement which was furnished to the SEC in an 8-K report and in the company’s Form 10-K for the year ended November 30, 2007 as supplemented in the company’s Form 10-Q for the quarter ended May 31, 2008, all of which are on file with the SEC.

I am joined this morning by Roy Guthrie, Executive Vice President and Chief Financial Officer of Discover, who will provide some comments about yesterday’s announcement and respond to your questions.

As is our custom, we will take as many questions as we can, but I would strongly encourage you to limit yourselves to one question each. Our comments will be relatively brief and we want to try to wrap up the call by [8:15] New York time, just to give you a little parameter on that.

With that, let me ask Roy to begin the discussion.

Roy Guthrie

Thanks, Craig and thanks to all of you for joining us today. As you saw in yesterday’s press release, we have settled our litigation with Visa and MasterCard for $2.75 billion. Discover will receive approximately $862 million in the current -- our fourth quarter -- year up to $472 million per quarter during the course of 2009. Each payment will be reported in other income in the respective quarter, and will be reflected in our earnings per share on an after-tax basis.

The quarterly payments are contingent upon achieving certain quarterly performance levels in our network sales volume, and based on past performance, management here believes that we clearly are going to be able to reach these goals readily.

I am confident most of you are aware of the circumstances of this litigation which was filed after the successful conclusion of the Department of Justice lawsuit challenging the legality of Visa’s and MasterCard’s rules which prevent banks from issuing cards on our network.

Since the final ruling in late 2004, we’ve made significant progress in growing our overall network volume, signing a number of third-party credit and debit issuers and importantly, acquiring PULSE, a leading debit network and most recently Diners Club International.

In addition, one of the most significant initiatives launched since that final ruling was to put in place agreements with acquirers; those signed to-date representing about 98% of Visa and MasterCard sales volume in the United States. None of these initiatives would have been possible prior to those favorable rulings in 2004.

This morning though we want to look ahead and the focus I want to give you is on the importance of this settlement which will strengthen our ability to build revenues and further strengthen our earnings and capital base during this period of economic certainty. Most importantly, I believe the settlement provides us with tremendous flexibility.

First, it will help us fund our efforts to build out the domestic market acceptance and our international acceptance.

Secondly, we will seek to accelerate our growth in third-party network volume through signing additional third-party issuers and through cooperative marketing programs with both our domestic third-party issuers and global Diners Club licensee partners.

The third point I want to make regarding our business-building opportunities is our intention to direct some of the proceeds to further build out our deposit gathering capabilities which have taken on increasing importance in our overall funding strategy.

So while we have a number of significant business opportunities where we can invest a portion of the proceeds, we will evaluate these during the course of our 2009 and beyond, but our intention at this point is to see the great majority of these proceeds go towards earnings and therefore into the capital base.

I certainly don’t need to remind you that the U.S. economy continues to weaken and consumers remain under a tremendous amount of stress. As we have previously told you, we except to see our credit losses continue to rise through 2009, reflecting this weaker state of the economy.

The settlement proceeds and related gain that we except to earn each quarter through 2009 will help to cushion the impact of the higher level of loan loss provisioning that likely will be required in this environment.

Similarly, we talked to you about the current high cost and difficult conditions in the asset-backed securitization market and we will have to replace some or all of our maturities with deposit funding. In fact, these conditions make it likely that the entire $2.6 billion of fourth quarter maturities will be funded by our deposit programs rather than through new asset-backed transactions

We’ve explained that bringing the asset-backs on balance sheet will require incremental loss provisioning to establish reserves against these receivables, as well as have a negative impact on the IO strip valuation. This is likely to occur in the fourth quarter as well as during 2009. Here again the settlement proceeds and related gains will help to cushion the non-cash impact of these charges.

Since our last earnings call on September 25, the dislocation in inter-bank lending has led to an extended elevation in one-month LIBOR. Our funding costs for asset-backed bonds is principally based upon one-month LIBOR, which reset on October 10 at 4.59%. This is in contrast to the September reset which was 2.49%, so we are looking at a sequential quarter funding cost impact of 210 basis points, affecting with this reset the last two weeks of October and the first two weeks of November. So we have a total of almost $20 billion of one-month LIBOR based floating rate bonds outstanding, so this elevation of one-month LIBOR from the October reset will lead to a sequential quarter impact of about $39 million here in the fourth quarter.

As of yesterday, the one-month LIBOR reset was at 322, or 172 basis points over Fed Funds, so there could be some additional impact associated with the November LIBOR reset.

In closing, before we open this to Q&A, the lawsuit and settlement is now behind us and we are looking forward to realizing the potential of Discover’s franchise, in part as we invest the proceeds of this settlement but also as we continue to focus on our commitment of creating value for our shareholders.

I want to thank you for your attention and turn it back over to our operator for Q&A.

Question-and-Answer Session

Operator

Your first question comes from the line Sanjay Sakhrani - KBW.

Sanjay Sakhrani - KBW

Since funding is a pretty sensitive issue, perhaps Roy could just talk about where you stand with the implications of any of the Fed programs? Also I was wondering if you could just elaborate on the piece that you talked about, growing out the deposit franchise. What does that exactly mean? Is that potentially looking for M&A targets or is it just spending to build out the direct deposit gathering franchise? Thanks.

Roy Guthrie

Clearly the TARP programs and all the other government programs are out, we’re giving them all full consideration. At this point of time, I really don’t have anything further to report on that and clearly as we progress with our views on that, we’ll keep our investors informed.

In terms of deposit-gathering programs, I think your insight is the good one. We have relied tremendously on our deposit program. It is a good balance we have between both our broker channel and our direct to consumer channel. The third quarter was a good example of what that direct to consumer channel is capable of; 50% of our deposit gathering was secured through that channel. We have a high interest in continuing to develop out that infrastructure and its market reach to give it an improved franchise. That’s really what I am referring to here.

It’s an opportunistic time for us in that regard and we do plan to use some of the proceeds to further that franchise.

Sanjay Sakhrani - KBW

Are you just out there looking at potential M&A targets, opportunistically?

Roy Guthrie

I’m not going to openly comment on our M&A views. We monitor the market obviously very closely, and I think to the extent that direct to consumer type opportunities emerge those would clearly be in our wheelhouse. Beyond that they would be somewhat more episodic or less likely to secure our focus. Our focus right now is on what we have and developing that franchise, improving its reach, making it more efficient.

Operator

Your next question comes from David Hochstim - Buckingham Research Group.

David Hochstim - Buckingham Research Group

Could you elaborate on what seems to be a disagreement between Discover and Morgan Stanley on a substantial portion of the settlement proceeds?

Roy Guthrie

I am really not in a position to comment on this. Just to be clear for the benefit of our audience, in 2007 when we were spun-off from Morgan Stanley we did enter into an agreement that governed the manner in which this antitrust case with Visa and MasterCard was to be pursued and settled and how the proceeds of that litigation were to be shared.

We have notified Morgan Stanley that they are in breach of that agreement and Morgan Stanley has taken steps to have the dispute resolved in court. The amount, to be clear, of Morgan Stanley’s dividend -- if any -- is what is in dispute.

As you read our press release, the settlement proceeds are all going to come to Discover as laid out there and be recorded as revenue to us; we then of course tax affect that; for each quarterly payment and the after-tax amount would be added to our capital and then to the extent any dividends would be paid to Morgan Stanley, they would then in turn come out of our capital account.

David Hochstim - Buckingham Research Group

So there could be litigation over whether you pay anything to Morgan Stanley? That could take sometime.

Roy Guthrie

I am just really not in a position to comment on that, David.

Operator

Your next question comes from Kevin Stiroh – Sanford Bernstein.

Kevin Stiroh – Sanford Bernstein

A follow-up on the Morgan Stanley question, just so I have the technical details right. In your documentation it says that the payments by Discover to Morgan Stanley will be net of taxes payable by Discover with respect to such proceeds. So should a special dividend be paid, does that mean that Discover would be paying any tax liability for Morgan Stanley? How does the tax accounting work?

Roy Guthrie

As I mentioned, all the proceeds are received by Discover. They are recorded as revenue, they are earned by Discover. The taxes will be paid by Discover. All amounts that would be paid -- if any -- to Morgan Stanley would be on an after-tax basis.

Kevin Stiroh – Sanford Bernstein

So you are not paying Morgan Stanley’s tax liability?

Roy Guthrie

Correct.

Operator

Your next question comes from Howard Shapiro - Fox-Pitt.

Howard Shapiro - Fox-Pitt

Can you give us a sense of what you would consider a normal TED spread, something we could look at or benchmark against to see exactly how elevated your funding costs are relative to that normal spread?

Roy Guthrie

Howard, we’ve traditionally thought about this as rather than a TED spread it’s a LIBOR Fed Funds spread. Fed Funds is in lockstep with prime which is the foundation for our revenue in our cardholder agreements. LIBOR is the foundation for our trust resets, as I have articulated. Historically those have been maintained in the 10 to 12 basis point range. Obviously all bets were off in September 2007; we saw that maintained with some stability in the spring of this year at 40.

As I mentioned in my prepared remarks, it was 45 over in the third quarter, 45 over in September, elevating dramatically with the October reset. So I think on a sequential quarter basis we are measuring against a 45 over benchmark; on a historical benchmark we are measuring at 8 to 10 over Fed Funds.

Howard Shapiro - Fox-Pitt

I just want to make sure I understand all of the elements that are negatively going to impact earnings. You’ve got the movement of $2.6 billion of receivables on balance sheet with the consequent need to provision for those; you’ve got the impact of higher funding costs and higher losses on the IO. Is the increase in the spread in October now the third element? Should we look at it that way? Those are the three elements that are impacting it?

Roy Guthrie

Let’s talk about this in two segments. In terms of the interest rate environment, the impact falls in three particular areas. One is the level at which LIBOR resets which is the foundation for our master trust bonds. Asset-backed commercial paper tends to track somewhat in line with LIBOR and so we have some exposure to the asset-backed commercial paper market through our conduit partners. Those are the two that affect the servicing income; or on a managed perspective, interest expense. The spread associated with the excess spread at the end of the quarter will be valued and that will be a part of the IO mark. Those three components relate to the interest rate environment.

One of the things that I want to come back and make sure I make clear in my prepared remarks, was that also we are going to have asset growth on the owned basis as perhaps the entire $2.6 billion of maturing bonds are funded with on balance sheet tools, our deposit programs that I talked about. When that occurs, reserves need to be established against those and an IO will be marked down. That’s quite different than interest rate related, although it’s maybe a close cut when you talk about market dislocation.

Operator

Your next question comes from the line of Moshe Orenbuch - Credit Suisse.

Moshe Orenbuch - Credit Suisse

Not to harp on this, but the issues between yourselves and Morgan Stanley, are they things that by reading the agreement we would be able to monitor? Or are they things that would just be between the two parties?

Roy Guthrie

They’re clearly just things between the two parties, to my knowledge. You may check in with Morgan Stanley on that. I think it’s just right now there is very little out there and we have very little to say about it.

Moshe Orenbuch - Credit Suisse

So there is no way we could kind form any sort of opinion as to the likelihood of success between the parties?

Roy Guthrie

I think that’s fair, Moshe.

Operator

Your next question comes from the line of Darrin Peller - Barclays.

Darrin Peller - Barclays

The lump sum payment coming in in roughly November from MasterCard and then fourth quarter payments from Visa, you said that’s going to be flowing through revenue. Where do we see that on the expense line? You mentioned a lot of that’s going to be coming through specifically with regard to spreading your acceptance. So, are we going to see [inaudible] up somewhat? Can you give us a sense of what percentage you expect to actually spend on the reinvestment business versus passing down to the bottom line?

Roy Guthrie

I think you are saying, what do you mean by substantially all? I think that really what we are saying is these are large amounts of money. We’ve outlined for you the $472 million a quarter during the course of 2009 is likely to flow through. I think the main thing I want to emphasize is that there are no spending programs that are going to create much of a dent in that. We have natural things that we have invested in historically and those are the same things that prospectively we will be investing in; I outlined those in terms of global acceptance, domestic acceptance, new partners and the deposit programs.

So those will take up some of that lift that we get from the payments and they will naturally fall into their P&L categories: business development, professional services, information processing and to a certain extent, in marketing. As we get our heads around this in terms of 2009, we will be forthright in communicating further and expect to do that on our fourth quarter call.

Darrin Peller - Barclays

You had already guided towards very modest marketing growth for next year for ‘09, I think in the past you had mentioned that. Is that something we can still keep in our models?

Roy Guthrie

I think that’s fair. We are going to be very cautious in this environment and it’s not a time here to go out too aggressively. We’ve got a little air cover from the settlement but I would not really say that there is going to be a material change in the profile that you have probably been monitoring, I would really suggest you may be waiting to hear more from us in the fourth quarter.

The big thing I think that’s happening here and the big thing I want to reinforce, the point I want to reinforce from my prepared remarks is the positive impact this has on the income and capital of the company in a very difficult market environment.

Operator

Your next question comes from Steven Wharton - JP Morgan.

Steven Wharton - JP Morgan

I just wanted to follow up again on that Morgan Stanley dispute. First of all, I’m a little surprised you are not thinking of a litigation reserve of some sort, considering that this is a dispute and based on the original terms that were laid out, I think in the separation document, you should owe them a certain amount of money?

I just want to clarify on the tax again, because I thought it was a little confusing. So you are taking the whole gain to your P&L and you’re tax effecting it; it is going into your capital and then in the event something changed and you had to pay Morgan Stanley, you would pay them a dollar amount that you had already paid tax on and they would get it tax free? That doesn’t make sense.

Roy Guthrie

First of all, I think what might be worthwhile is for all of our listeners to understand that the 10-K has a very detailed summary of the existing relationship that’s being challenged and it does include a description of what the payment is and how the payment will be calculated, if any is paid.

What is in dispute here is the dividend, and dividends flow from capital; they are not P&L charges. So the construct of this was engineered in such a way that it would flow all the way through our P&L into our capital account and then be recorded as a dividend to Morgan Stanley. It would be no different than a dividend that would be otherwise paid to a shareholder. They were our shareholders prior to the spin.

But I do think a fresh read of that would be good and I would remind you that here again that’s the dividend that is in dispute. So any dividend that we may pay them would be governed by this dispute we are involved in now.

Steven Wharton - JP Morgan

There is no interest in setting up some sort of legal reserve, or in case it ended up that you had to pay them? Do you feel like its capital throughout your equity base?

Roy Guthrie

It is the latter and I think to the extent that we have an obligation that would be provided for but it’s clearly way too early to talk about that. I think we’ll leave it where we have it and proceed with no comment any further. Certainly in the fourth quarter we will give any further color that we can.

Steven Wharton - JP Morgan

The only reason I ask is because, I mean, it has to drive your thinking to a large degree, I would think, in terms of how you are going to spend the money, in your capital ratios -- I mean, that is a big dollar amount that’s in dispute, I believe, from my reading of the original document.

Roy Guthrie

What I would guide you to is the actual addition to our capital is going to be determined by a number of things, including our effective tax rate. If you use a 38% tax rate -- that’s roughly what we’ve been running during the course of this year -- the benefit to Discover of the settlement is at least $850 million. Then I would add, it could be more depending on the outcome of the dispute with Morgan Stanley.

Operator

Your next question comes from Mike Taiano - Sandler O’Neill.

Mike Taiano - Sandler O’Neill

A couple of questions around the net interest margin, Roy, could you talk about if there were any incremental costs in terms of funding from the $2.8 billion that’s coming out of securitizations and is going to be funded by deposits? In other words, is there a higher cost on the deposit side than what it was being funded at via securitization?

Also, could you comment as to there being potentially some offsets with the fed rate cuts, the one last month or earlier this month and the one expected this week?

Roy Guthrie

Sure, Mike. I think as I mentioned before a number of times, the maturing profile of our bonds is at a spread to one-month LIBOR or significantly below where new issuance would be today. So if you go back pre-June 2007, the market was very robust; so yes, replacement costs are higher. We are replacing with deposit programs and our deposit programs, as I’ve said many times, have tremendous liability liquidity. We are out two, three, and four years, so we are way off the curve and so in that regard, you’re moving from floating to fixed as we reposition the portfolio for what we believe to be, over time, the next major move the Fed is going to take.

So yes, the replacement cost is higher and we would expect that as the portfolio turns that replacement cost over the next two to three years will find its way into our net interest margin. But it’s not significant enough to make much of a debt in any one given quarter.

The second question you had Mike?

Mike Taiano - Sandler O’Neill

The Fed rate cuts and the potential offset that could have.

Roy Guthrie

I think what we need to see is inter-bank lending move more in lockstep with Fed targets. Clearly since September 15 that has not been the case. Very good signs, obviously. I had mentioned that yesterday LIBOR posted at 322; three weeks ago it was 459 for October resets so tremendous movement is being made in banks loosening up their inter-bank lending. That is facilitating a lower interest cost for us and the rest of the industry that posts off of that.

I think what’s more important now is where LIBOR goes as opposed to where the Fed resets go.

Operator

Your next question comes from the line of Dan Arlow - Omega.

Dan Arlow - Omega

Are you seeing any other opportunities out there at this point along the lines of Diners Club? Thanks.

Roy Guthrie

We are making a lot of progress, communicating with our franchisees and mapping out our strategy, Dan. I think it would be premature for me to open that up here, but clearly by the fourth quarter conference call we should have more color for you.

Operator

Your next question comes from the line of Noel Levy - Tyndall.

Noel Levy – Tyndall

Could you explain in a little more detail the schedule A with the quarterly payments next year? You have a percentage of Discover Financial Services volume target which looks like 5% for the first three quarters and then 21% for the final period; which is only, it looks like 21 days. I don’t quite understand why it changes so much in that last period?

Roy Guthrie

The performance target that we need to meet is 5% of Discover Financial Services volume. That’s defined within the agreement that’s also filed as an exhibit to the 8-K, but as a proxy you might just use the total volume off the statistical supplement we provide you each quarter. In the third quarter that was just over $60 billion.

So 5% of that target, subject to the maximum payout that’s contained within that schedule is the performance criteria and the maximum amount. Since the fourth period is a 21-day performance period rather than a 90-day performance period, the performance target is adjusted and it’s the same relationship if you gross that up to 90 days, you will get basically the same target.

It’s only higher because there is a different duration of the performance period.

Unidentified Analyst

There was a mention somewhere that Morgan Stanley paid to MasterCard I believe $35 million. Could you comment on why that occurred and what that involved?

Roy Guthrie

I have no knowledge of what that’s about.

Operator

You have no more questions. I would now like to turn the call over to Mr. Craig Streem for closing remarks.

Craig Streem

I want to thank you all for your participation and your interest, and as always, any follow-up questions please come back to me and we will do our best to get them covered. Have a good day.

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