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Discover Financial Services (NYSE:DFS)

Q3 2013 Earnings Call

October 21, 2013 5:00 pm ET

Executives

Bill Franklin

David W. Nelms - Chairman and Chief Executive Officer

R. Mark Graf - Chief Financial Officer and Executive Vice President

Analysts

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division

Mark C. DeVries - Barclays Capital, Research Division

Craig J. Maurer - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Christopher C. Brendler - Stifel, Nicolaus & Co., Inc., Research Division

Kenneth Bruce - BofA Merrill Lynch, Research Division

David Ho - Deutsche Bank AG, Research Division

Bill Carcache - Nomura Securities Co. Ltd., Research Division

Betsy Graseck - Morgan Stanley, Research Division

Moshe Orenbuch - Crédit Suisse AG, Research Division

Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

Scott Valentin - FBR Capital Markets & Co., Research Division

David S. Hochstim - The Buckingham Research Group Incorporated

Ryan M. Nash - Goldman Sachs Group Inc., Research Division

Donald Fandetti - Citigroup Inc, Research Division

Robert P. Napoli - William Blair & Company L.L.C., Research Division

Christopher R. Donat - Sandler O'Neill + Partners, L.P., Research Division

James E. Friedman - Susquehanna Financial Group, LLLP, Research Division

Daniel Furtado - Jefferies LLC, Research Division

Operator

Welcome to the third quarter 2013 earnings call. My name is Robert, and I will be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded.

I would now like to turn the call over to Mr. Bill Franklin, Investor Relations. Mr. Franklin, you may begin.

Bill Franklin

Thank you, Robert. Good afternoon, everyone. We appreciate all of you for joining us on this afternoon's call. Let me start on Slide 2 of our earnings presentation, which is on our website and we will be referencing during the call.

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

Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today's earnings press release, which was furnished to the SEC today in an 8-K report and in our Form 10-K for the year ended November 30, 2012 and in our Form 10-Q for the quarters ended March 31 and June 30, 2013, which are on our website and on file with the SEC.

In the third quarter 2013 earnings materials, which are posted on our website at discoverfinancial.com and have been furnished to the SEC, we have provided information that compares and reconciles the company's non-GAAP financial measures with the GAAP financial information, and we explain why these presentations are useful to management and investors. We urge you to review that information in conjunction with today's discussion.

Our call this morning will include formal remarks from David Nelms, our Chairman and Chief Executive Officer; and Mark Graf, our Chief Financial Officer. After Mark completes his comments, there will be time for a question-and-answer session.

Now it is my pleasure to turn the call over to David.

David W. Nelms

Thanks, Bill. Good afternoon, everyone, and thanks for joining us today. After the market closed, we reported third quarter net income of $593 million or $1.20 per diluted share, with a return on equity of 23%.

EPS was down versus last year as the prior period included a large reserve release. Excluding the impact of reserve actions and onetime items, core earnings per diluted share increased by 12% over the prior year, driven by loan growth and share repurchases.

During the quarter, we returned approximately $450 million of capital to common shareholders through share repurchases and common dividends.

Card receivables grew 4% over the prior year, which, along with the combined 11% increase in private student and personal loans, drove total loan growth of 5%. These results show that in a tepid economic environment, Discover continues to achieve profitable loan growth.

Card sales volume for the quarter was up 3% over the prior year, but on a day adjusted basis, sales were up over 4%, in line with card loan growth.

Increased wallet share and new accounts continue to drive card loan growth at the upper end of our targeted range despite tougher comps. Discover it is generating good response rates and resulting in a more purchase active card member with less reliance of balance transfers at acquisition.

We expanded our product suite by launching Discover Home Equity Loans in August. While it will be some time before this product contributes to the bottom line, launching the product at this point in the housing recovery makes sense.

We were also pleased with the origination volumes in student and personal loans. Private student loan origination volume is on track to overcome the absence of the CitiAssist brand, which made up nearly half of the originations in 2012. Through card, student loans, personal loans, home loans and online deposits, Discover is offering consumers a broad spectrum of financing and savings alternatives to meet their needs.

In payments, year-over-year total dollar volume growth slowed as PULSE volume decreased by 2%. Diners volume also decreased 7%, mainly due to the impact of currency exchange rates. The debit environment remains dynamic, especially with Judge Leon's ruling, which will likely slow down the rate of new deals signed in the industry.

This, combined with the economic environment in Europe and potential pressure on Discover Network partners' volume, as we mentioned last quarter, continues to keep our near-term outlook for Payment Services muted. However, we remain optimistic about the segment's long-term potential.

Overall, our results for the quarter were positive as we once again exceeded the industry average card loan growth, organically grew revenue, and charge-offs continued to improve, producing an outstanding return on equity.

Now I'll turn it over to Mark, who will walk through the details of our third quarter results.

R. Mark Graf

Thanks, David, and good afternoon, everyone. As I've done in the past, I'll start my prepared remarks by going through the revenue detail on Slide 5 of the earnings presentation.

Net interest income increased to $122 million or 9% over the prior year, driven by loan growth and a higher net interest margin. Net discount and interchange revenue increased by $23 million year-over-year or 9% due to Discover card sales volume growth, as well as a lower rewards rate.

The rewards rate was slightly lower compared to the prior year but increased sequentially from 86 to 98 basis points, driven by the timing of promotional cash back programs. As we've said in the past, you should expect to see quarterly fluctuations in the rewards rate as we look to further engage our customers and drive profitable sales.

Protection product revenue declined by $14 million over the prior year due to the discontinuation of new product sales in late 2012. Other income decreased by $58 million due to lower direct mortgage-related income and the inclusion of a $26 million gain on sale of a minority investment in the third quarter of last year.

As expected, Discover Home Loan originations slowed down during the third quarter as rates increased and refi volumes decreased significantly across the industry. After the quarter end, we eliminated some positions to better align our cost base with lower mortgage volumes. As we've said before, home loans are a key direct banking product for Discover, but due to the relatively small size of the business, they have been and they will remain relatively immaterial to our overall earnings profile.

Payment Services revenue decreased 11% year-over-year, mainly due to lower transaction processing revenue for PULSE.

Turning to Slide 6. Total loan yield of 11.29% declined 10 basis points over the prior year, mainly due to card yield compression. This year-over-year compression was split between an increase in promotional rate balances and a decline in higher rate balances. Lower funding costs and, to a smaller degree, lower interest charge-offs, more than offset this yield compression, resulting in a 25-basis-point increase in net interest margin over the prior year to 9.64%.

Operating expenses, as shown on Slide 7, were down $58 million or 7% over the prior year. The increase in employee compensation was primarily related to a higher headcount to support growth, as well as new product initiatives.

Despite maintaining higher advertising in support of the it card, marketing expense remained flat with the prior year. Other expenses were down $76 million as the third quarter of 2012 included a $96 million addition to legal reserves.

Operating expenses for the Payment Services segment increased by $10 million over the prior year, mainly due to increased operating costs associated with Diners. This increase in cost is primarily related to the second quarter Diners acquisition, which will continue to have a modest ongoing operational drag for some period of time.

Overall, I remain pleased with our expense control as we managed our expenses in line with our target efficiency ratio of approximately 38%.

Turning to provision for loan losses and credit on Slide 8. Provision for loan losses increased $197 million from the prior year, driven by an increase in loan loss reserves. Our reserve build during the quarter mainly reflects 2 things: first, lower expected recoveries on well-aged charge-offs; and second, loan growth. Since we didn't sell any of our charged-off accounts during the recession, we experienced strong recoveries on a large inventory of charged-off accounts as the economy improved. But as we get further away from the recession, the benefit of these elevated recoveries is diminishing. You can see the slow decline in the recovery rate in our Trust filings over the last year.

So the key takeaways with respect to the reserve build in the quarter are that, first, we're growing our receivables base well; and second, we aren't refilling the charge-off bucket at a rate sufficient to maintain recoveries at the levels we have seen over the last several years. To be abundantly clear, our credit outlook for cards remains relatively stable.

Sequentially, the credit card net charge-off rate decreased 29 basis points to a record low 2.05%, and the 30-plus day delinquency rate of 1.67% remains fairly close to the record low established last quarter.

The private student loan net charge-off rate, excluding purchase loans, increased 59 basis points from the prior year due to a larger portion of the portfolio entering repayments and decreased sequentially by 25 basis points due to seasonality.

Student loan delinquencies, excluding acquired loans, increased 22 basis points sequentially to 1.6%. Switching to personal loans, the net charge-off rate was down 23 basis points sequentially, and the over 30-day delinquency rate was 0.65%. The sequential decrease in the personal loan charge-off rate was primarily driven by growth.

Moving to Slide 9. We returned $450 million of capital to shareholders, grew total loans by 5% and ended the quarter with a strong Tier 1 common ratio of 14.7%. Our outlook for the rest of 2013 remains relatively unchanged.

Looking forward, we expect the credit environment will remain benign, net interest margin will remain elevated and we will continue to remain disciplined with our expenses and our investments for growth.

That concludes our formal remarks. So I'll turn the call back to Bill.

Bill Franklin

Thanks, Mark. As a reminder, everyone, please limit yourself to one question and one related follow-up question. Robert, we'll take the first call.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Sanjay Sakhrani from KBW.

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division

I was wondering if you could just talk about charge-offs. I think it sounds like you guys expect gross charge-offs flattish for the foreseeable future but recovery rates to decline, causing some mild pressure on net charge-offs. Is that right? And then on the recovery rates, could you just talk about what a steady-state recovery rate looks like and how long it would probably take to get there? Because I look back and it looks like the recovery rates used to be around 90 basis points versus 120 basis points year-to-date.

R. Mark Graf

Yes. Sanjay, if I don't catch all that, use your follow-up to bring me back to it. I would say with respect to charge-offs, I would take you back to our earlier commentary, we believe the credit environment is going to remain relatively benign. The key issue that caused the reserve build, with respect to charge-offs this quarter, again, was very clearly what we perceived to be something good, and that is that our current book is not having enough migration into the charge-off buckets to replace the level of recoveries that we've been enjoying from the large block of unsold accounts post the recession. So realistically, I would say benign credit environment with no turn in sight, as we see it right now. Absent some exogenous variables is kind of what I'd be thinking about. In terms of normalized recovery rates, I would say the number you use in normalized terms is probably a pretty decent number. I think the bigger challenge is we obviously aren't in a normal time at this point in time. So it's kind of hard to say exactly where it's going to be. None of us in our working lives have ever come through nor been in an environment like we're in today. So -- but that's as good a number as any to use on a normalized basis, I would guess.

Operator

Our next question comes from Mark DeVries from Barclays.

Mark C. DeVries - Barclays Capital, Research Division

I actually wanted to follow up on the charge-off question. I'm just kind of wondering about the broader need to take up your reserve rates this quarter when, granted, delinquencies were up Q-over-Q, but they're actually up less than seasonality would normally dictate, suggesting you still may not even have found a trough yet for charge-offs. Could you talk a little bit more about that, Mark?

R. Mark Graf

Sure. Yes. We -- just to remind everyone, we set our reserves on a 12-month forward-looking basis. So I know one of the key metrics you guys all have to look at is that reserve coverage ratio, that's really more of a rearward looking metric. Just to remind everybody, we don't focus on that at all. It's not a factor in our reserve setting decisions or discussions. And as we look at what's going on, I would, again, echo the comments that we see a very benign credit environment. We don't see any situation where there is any type of a meaningful deterioration in credit in the near-term horizon at all. I would say the reserve increase itself is driven again by those 2 primary factors I noted before, specifically, just we're not refilling the recovery buckets. So the net charge-offs will increase, if you will, as opposed to the gross charge-offs because you'll lose the benefit of some of those recoveries. But I don't think that's a fundamental turning credit by any stretch of the imagination, it's losing the benefit of those accounts we didn't sell at the peak of the recession. And then I would say secondarily, the other thing driving it is asset growth. We have been the only folks driving significant asset growth in the card industry now for a period of years. And ultimately, the cumulative effect of that is you have to provide for that growth as those loans season. Again, I think that's a good thing.

Mark C. DeVries - Barclays Capital, Research Division

Got it. And then I've got a follow-up on inorganic asset growth. Sallie Mae in their earnings call last week commented that they were looking at a private student loan portfolio. Without commenting on any specific opportunities, although feel free to if you'd like, is that something that would interest you, potentially adding private student loans that are out there to your portfolio?

R. Mark Graf

Yes. I can't comment specifically. I guess, Mark, what I would say is that we're always on the lookout for good opportunities for our investors. And if we saw some of those type things, we would clearly look seriously at them.

Operator

Our next question comes from Craig Maurer from CLSA.

Craig J. Maurer - Credit Agricole Securities (USA) Inc., Research Division

Speaking of good opportunities for investors, I was curious, your network for quite a while, looking at the different assets, it's -- Discover seems to be lagging the major peers we look at in terms of volume growth. Diners is certainly lagging. PULSE is hurting. With it only contributing $28 million to the bottom line, I mean, what's the thought process regarding not monetizing that network through a sale and converting over to a major network like Visa or MasterCard, where you double your acceptance and likely increase your sales? So I'm just -- I'm struggling with this. Is it the opportunity that something like PayPal brings? Or what are we looking at? Because continually, it seems like the -- in the near term or even in the medium term, perspectives are kind of bleak for the network.

David W. Nelms

Well, I wouldn't go quite that far, Craig. I'd say for a period of probably 5 years plus, we were gaining share, if you looked at what happened -- what PULSE's track record was in debit and the purchase of Diners Club. But our profits have been growing quite significantly, and it's really been only the last 2 quarters that you've seen us really take a hit on growing PULSE. And we've talked about some of those issues before. So I wouldn't want to take any decisions based on the business in a very short time period. But you did mention PayPal. But there's a number of other deals that we've signed with Ariba. We're doing some interesting things with Facebook and Amazon. So we're doing other networks around the world. So we've been planting a lot of seeds for the future. And as we have built out acceptance and extending our product line and partner set, we are very optimistic in the long-term potential for this business. So I guess that's -- that -- the short-term pressures on PULSE don't change that at all.

Operator

Our next question comes from Chris Brendler from Stifel.

Christopher C. Brendler - Stifel, Nicolaus & Co., Inc., Research Division

My question is on the Diners Club network. And could you just give us any more detail on what's going on in Europe and of the Diners Club franchise as a whole? Volume seems to be going the wrong way, and the revenue impact seems even worse. Is there any more you can tell us there? And how long do you expect this drag to continue? And then just a follow-up on the charge-offs and the reserve build. I just want to ask, is there a change in your forecast that happened with respect to recoveries on these older loans or is it just a pool? It seems like when you build reserves, you're taking a forward-looking metric. So I'm wondering, is there a change in the behavior of some of these older loans or just the fact the portfolio of loans has shrunken us?

David W. Nelms

On Diners, there's a couple of factors. The first is, the most important factor for us when we purchased Diners was it allowed us to become a global network with global acceptance and to have -- to facilitate signing additional deals, net to net, to allow our card members to use their card globally versus just in North America, as had been the case in the past. And we're very pleased with how dramatically our acceptance has widened around the world. In terms of Diners itself, it's relatively immaterial to the overall company, but it's taken a number of hits. Obviously, we mentioned exchange rates moved against us during the quarter, which was a factor. We have a number of franchises that are struggling. I think that's particularly the case in Europe, where there's a lot of institutions struggling with liquidity issues and so on. But also, Citi has continued to divest some of their franchises that they historically issued on, and that's been a headwind. But -- and meanwhile, we've signed the largest issuers in China, India and Russia in the last year, and those kinds of deals take a while to kick in. So we're facing some headwinds, and we've got some what should become tailwinds over time not yet kicking in. So we continue to manage that very well for both the short term, minimize any losses, but for the long term, to get some of the benefits of truly having a global differentiated network that's fairly unique in the world. In terms of the pool of recoveries, let me try it a little bit different way. I mean, to some degree, we've been growing far faster than the industry. And so we've been having to essentially set aside loan loss reserves for growth over time. That's continued. We've also seen, over time, a gradual reduction in recoveries, and that's continued this quarter. What -- those 2 factors had been covered a year ago by the dramatic improvement in delinquencies and the charge-offs overall. So they've been swamping those first 2 factors. And remember, it's really an improvement in charge-off outlook and delinquencies that causes a reserve release. So even if you just flatline and stop improving or slow improving, you don't have a large release that covers the 2 factors that we called out this quarter. So I would think about the lack of improvement. And when you get down to 2% charge-off, in a credit card business, it's hard to -- you're just not going to improve forever.

Operator

Our next question comes from Ken Bruce from Bank of America Merrill Lynch.

Kenneth Bruce - BofA Merrill Lynch, Research Division

My question relates to the -- what has been a very impressive net interest margin for the last several quarters. And I guess I'm trying to reconcile a couple of different statements that you made, David, specifically around Discover it and the pickup that, that should have in terms of having growth without the use of teasers, yet the promotional rates are still moving higher. Can you just kind of reconcile in terms of what's driving the yields here within the credit card portfolio, specifically, and how you see those offsetting aspects of promotional balances and Discover it playing out over the next several quarters, please?

R. Mark Graf

Yes, Ken, it's Mark. What I would say is with respect to NIM, specifically, as it relates to those promotional balances, I would say the Discover it card member is coming on with a much lower level of promotional balances. What's keeping the overall level of promotional balances higher is portfolio BTs and portfolio promotional activity as opposed to the new card member acquisition on the it card side. So the it card member continues to be significantly more engaged and continues to come on at very low CPA with much more active behavior and requiring much less promotional stimulation, I would say, than we've seen in the past. So as I look at NIM more broadly going forward, I would tell you, as we look to the fourth quarter, I see room where NIM could be up slightly from the level we're printing in the third quarter. Beyond that, I think I'll reserve judgment until our Investor Day where we'll give some broader commentary beyond the fourth quarter. The one thing I would be remiss if I didn't do, is to remind everybody that the model is built over the long haul to deliver an 8.5% to 9% margin. We're clearly operating well north of that today, see an ability to continue doing that for some period of time.

Kenneth Bruce - BofA Merrill Lynch, Research Division

And just as a follow-up in terms of the cost of funds. That's obviously been a big release valve for NIM as a general point. Can you maybe discuss what your incremental funding options are and what those costs are so we can begin to factor that into our calculus, please?

R. Mark Graf

Yes. I would say the fundamental channels we're leaning into are obviously going to be the consumer deposit channel directly. That one is always a winner for us because it comes with a customer attached to the other side and build synergy between the right and the left-hand side of our balance sheet. And it also, again, comes with a customer you can cross-sell to. The other big channels we're using obviously are the ABS channel, as well as the banknote channel. To a lesser degree, we use the broker deposit channel as well, really more around the edges at this point in time. We've been shrinking in that book over time. In terms of the potential impact and everything else, I would point you back to the schedule from our Investor Day presentation that's out there on our website. It's got the upcoming maturities, as well as the rates associated with those maturities. And I would assume no major gigantic shifts in mix over the near term. And you can just use your market rates to plug into your models there.

Operator

Our next question comes from David Ho from Deutsche Bank.

David Ho - Deutsche Bank AG, Research Division

I wanted to touch base on the non-card growth and personal loans and maybe touch base on some of the early indications you're seeing on the home equity installment loan side, what the dynamic will be with home prices increasing and personal income levels rising. How do you view that kind of mix playing out maybe in the medium term?

David W. Nelms

Well, I think in terms of personal loans, we've seen good opportunities to have quite strong growth. It continues -- we continue to see consumers deleveraging and wanting to pay down debt, consolidate loans and pay down debt over time. And so that product has continued to be a very big winner for us. I'm also pleased with the growth of student loans. It's been more modest growth in part because we needed to replace the Citi brand. But the fact that we've gotten the kind of originations we have, while replacing that brand that a year ago represented half of the originations, I feel very good about. Home equity, it's really way too early. I think we'll probably have a lot more to talk about at Investor Day with that because we're just out for the last 2 months. I think we feel very good about the timing because home equity, the consumers have in their homes, is now starting to grow, both from pay-downs and real estate pricing recovery. I think that consumers are going to, in a rising rate environment, are more likely, if they need home equity, to take out the home equity loan versus refinancing their whole first mortgage, given that they may have already locked in a lower rate for their first mortgage. And it fits very well. So we've got -- I feel very good about the launch so far, the pipeline and where we stand. And maybe we'll have some more metrics for you by the time Investor Day comes along.

David Ho - Deutsche Bank AG, Research Division

Okay, great. And just 1 follow-up. I just want to talk about the competition you're seeing in card. You mentioned before that you're seeing a lot of competition in the rewards space. Have you seen any acceleration in terms and condition or pricing over the last couple -- couple of months?

David W. Nelms

No. We've had very strong competition in cash rewards for several years now and I think we do see, in any given quarter or year, one competitor will tend to get stronger while another one is backing off and vice versa. But I think -- if I think about -- as I think about, overall, the level of competition, it's high, it's been sustained and I expect it to continue to be sustained at this kind of level. And that's one of the reasons we're so excited to launch Discover it, is to be the best competitor out there and that we've certainly been pleased with our results.

Operator

Our next question comes from Bill Carcache from Nomura Securities.

Bill Carcache - Nomura Securities Co. Ltd., Research Division

You haven't added receivables to your trust in some time, so it's hard for us to see how loss curves look for some of your more recent vintages, but I was hoping you could maybe share with us what peak loss rates you're seeing, I'd say the 2011 vintage, which should be nearing peak levels now, just so we can kind of get a sense of how the trajectory of your charge-off rates is shaping out.

R. Mark Graf

Yes. Bill, I would say, we haven't provided color on that in the past. We'll take that under advisement as we look forward to our Investor Day coming up in the spring time. What I would say is they are performing in line with our expectations. We're not seeing any development -- any loss development that is deteriorated from the expectation we had at the time we originated those credits.

Bill Carcache - Nomura Securities Co. Ltd., Research Division

Okay. And can you say '12 -- whether '12 is directionally trending better than '11? I guess, I'm just trying to get a sense to -- just directionally.

R. Mark Graf

I think what I would say, to kind of get back to the question, again, we haven't provided color on that, so I want to be careful on how and when we do that. But I would say is that harkening back to our expectations for the credit environment, it remains very benign. The new vintages are performing absolutely in line or better than our expectations and the reserve actions this quarter don't have anything to do with any adverse development under any of those vintage curves.

Bill Carcache - Nomura Securities Co. Ltd., Research Division

Okay, that's fair enough. Lastly, can you talk about the 5% cash back bonus program that you currently have in place for online shopping, how that's going? And perhaps also talk about the change relative to last year, which also included retail? Just trying to get a sense for what kind of impact the exclusion of retail could have and how we should be thinking about that.

David W. Nelms

Well, I think we're pleased and, so far, meeting expectations. I think that it is more typical for us to have one category versus multiple categories. So I'd say, probably a year ago was more the aberration, and so we're comfortable that we can continue to stimulate our base with Internet. Also, I would just say that Internet has grown a lot even this year versus a year ago, in terms of how much consumers are using it. So that's probably a more important opportunity for consumers given the growth in the Internet space.

Operator

Our next question comes from Betsy Graseck from Morgan Stanley.

Betsy Graseck - Morgan Stanley, Research Division

A couple of questions. One is just on spending growth. You came in at 3.2% year-on-year in third quarter. And that is a little bit different from some of the peers, your spending growth came down from second quarter, which was 4.4%. So I'm just trying to understand what might have driven a deceleration in the growth rate and spending?

David W. Nelms

Yes. Well, I'd say, Betsy, the -- if you day-adjust it, it was about 4%, which was pretty on top of our loan growth and that's been true for us over the last several quarters, that our loan growth and our sales growth have been similar. And haven't seen any particular trend. And yes -- I mean, obviously, with the government shutdown and so on, we have been looking for, is there anything going on with consumers? And I really haven't seen anything. When I look across competitors, I'm seeing some up and some down from their run rate. But as a general prospect, we're seeing the same thing. Competitors are not growing their loans, but they're growing sales and they appear to be, to a much larger degree than we are, going after different transactors.

Betsy Graseck - Morgan Stanley, Research Division

And then on the -- okay. And the follow-up is just on the expense side on marketing, you're down obviously 6% Q-on-Q. I would -- is it fair to expect that you'll be ramping that up into the fourth quarter and looking to drive up the spending growth rates?

R. Mark Graf

Yes. Betsy, I think that's a -- probably, that's a pretty fair assumption. We definitely tend to take them up in the second half of the year and into the fourth quarter, tends to be a big time on the marketing side. What I would say is we've put out some revised guidance around total expenses last quarter at $3.2 million. I would say I still feel good about that. I don't see any reason that we won't be able to accommodate that level.

Betsy Graseck - Morgan Stanley, Research Division

Okay. So if you're taking up marketing expenses in 1 place, you might be lowering it elsewhere, is that your point?

R. Mark Graf

For non-marketing expenses elsewhere, yes, correct.

Operator

Our next question comes from Moshe Orenbuch from Crédit Suisse.

Moshe Orenbuch - Crédit Suisse AG, Research Division

I was wondering if you could talk, Mark, about whether the reserve rate -- the percentage of loans is likely to be increasing. I understand that the things you talked about, I guess, as we go forward, is that likely to be a higher percentage of loans as we go into the fourth quarter in 2014?

R. Mark Graf

Yes. I would say, at this point in time, don't see it being a meaningfully higher percentage of loans as we head on in. Again, I would drive you back to the earlier comments that everything we're seeing in the portfolio right now is consistent with a benign credit environment and the factors affecting the reserve this quarter are really those more exogenous factors, related to the fact that we're growing the receivables base well and we're getting seasoning under those curves and, as well as the fact that we aren't generating enough new charge-offs to refill the bucket to be available for use in recoveries.

Moshe Orenbuch - Crédit Suisse AG, Research Division

Got you. And as a follow-up, David, I'm sure that if you wanted to kind of spur additional volume from people that are transactors, you could do it. Could you just talk about the thought process, I mean, what are the benefits or the risks of actually trying to do that?

David W. Nelms

Well, what I'd say is that we follow a very disciplined process to not just chase volume growth but to deliver profitable customer relationships and that means that the best opportunity seems to be people that at least have some propensity to occasionally revolve, because the primary revenue producer in the industry, and for us, continues to be the net interest margin, whereas the interchange, by the time we cover rewards and expenses, is a much smaller piece. We also are keeping very disciplined, because I think transactors look particularly good to some people today because we're in such a low cost of funds environment and, obviously, in a different environment, the cost to float is something that changes those dynamics a lot. And so we will continue to evaluate it and make sure there aren't some additional incremental opportunities to go after people that are more transactor-based or have higher sales. But if you look at our track record on growth on loans and return on loans, we're best in class on both of those 2 factors and that's good because those are the 2 things we most try to optimize.

Operator

Our next question comes from Sameer Gokhale from Janney Capital.

Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

I guess just one of the things I just want to flesh out, and you did talk about it at length. But just one thing I want to clarify in terms of that recovery rate, I mean, should we think of it as this quarter, there was kind of a onetime true up to your recovery -- expected recovery rate and in going forward, all else equal, it's going to be more -- provisioning is going to be more a function of your loan growth? Is that the way to think about it, that there was kind of a onetime issue element from a recovery standpoint this quarter as you trued up the reserve for a lower recovery, am I thinking of that correctly?

R. Mark Graf

Yes. I think what I would say, Sameer, is the situation, obviously, continues to evolve. I prefer not to go into conversation of quarter-over-quarter changes in reserving estimates, specifically at this point in time. I think we don't know what we'll know as the quarter moves forward and we'll set our reserves based on the best information we have at the -- near the end of the quarter, as opposed to trying and to guesstimate what that's going to be right now. What I would say is that recovery rate expectation, we have brought -- we've brought down meaningfully, quite honestly, from the level at which it's been operating. And we continue to see good growth in the portfolio. The best guidance I can give you, I think, is to take you back to the earlier comment, that is that the credit environment remains benign, that we would expect the underlying performance in the portfolio to reflect that.

Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

Okay. And then just another question was, in your other expenses, I know last quarter, you had some expenses related to Diners. But this quarter, also, I mean, if you look at last quarter's numbers, strip out the Diners charges, you have maybe kind of close to $100 million-ish run rate in the other expenses, this quarter I think about $118 million, is there anything else flowing in, maybe as residual expenses from the Diners charges or something else this quarter?

R. Mark Graf

Yes, Sameer, we've got some Diners charges like with the elevated payment services expenses that we called out flowing through there, and a little bit more on the global acceptance side and I think then there's just some cats and dogs, but that makes up the delta.

David W. Nelms

Remember, we essentially purchased the Italian franchise, for instance, last quarter, taking the onetime charge, called out at that time that we would be then operating it. So you've got the normal operating costs that were expected and an ongoing operating loss because we now own those.

Operator

Our next question comes from Scott Valentin from FBR Capital Markets.

Scott Valentin - FBR Capital Markets & Co., Research Division

Just with regards to your protection and product revenue. It was up slightly, quarter-over-quarter, and it's been trimming down for several quarters in a row. Has it kind of reached the bottom and this should be kind of a base and then it grows from here?

David W. Nelms

No. I'd say we are continuing not to sell that product and so you would expect then attrition into gradually reduce that line until such time as we should start to sell those products again. There will be fluctuations from one quarter to the next but I'd think the longer-term trend for now would be a gradual decline.

R. Mark Graf

It has been slower than our expectations to your point. The attrition is definitely been slower than we expected.

Scott Valentin - FBR Capital Markets & Co., Research Division

Okay. And then just a follow-up on personal loans. The yield's up about 16 basis points from a year ago, it's up almost 16, I guess -- sorry, 6 basis points linked-quarter. Just with the growth you had, I guess you're getting -- the competition level in that product, I would suspect that with a lot of growth you'd see, maybe loan yields come down on a linked-quarter basis, but that's not been the case?

R. Mark Graf

Yes. I would say that, that product continues to perform particularly well for us. We're very ,very happy with the yields we're seeing there. I would say without any significant credit expansion, we're able to command some very good pricing in that marketplace. Right now, we feel very good about it.

David W. Nelms

Yes. And we’re also seeing some payoffs as the older vintages mature, which were at slightly lower rates and newer vintages have come on over the years at probably higher rates.

Operator

Our next question is from David Hochstim from Nomura Securities.

David S. Hochstim - The Buckingham Research Group Incorporated

I don't think I changed...

David W. Nelms

David's from Buckingham, right?

David S. Hochstim - The Buckingham Research Group Incorporated

Yes. I'm still at Buckingham. But I wonder, could you talk a little bit about what we saw over the course of the quarter in terms of spending behavior and lending? You said that loans attract spending but loan balances declined in the month of September, I think, and they grew nicely in July and August and for the quarter overall, but is there something -- did you see some changes in behavior during the quarter end and how about in October, so far?

David W. Nelms

I would say that I've seen a fair amount of stability both in sales and loan growth. Obviously, how a weekend falls or what promotions we have going on one year versus another, can certainly have an impact on 1 month. As I look at the day adjustments and everything, I haven't seen any particular trend in either direction for either sales or loans.

David S. Hochstim - The Buckingham Research Group Incorporated

Okay. And so do we think that the decline in loan balances in the amount of September is kind of unusual and it's not reflective of some new trend with October be...

David W. Nelms

Well, I would say that you're better off looking at the full quarter to take out that noise and I feel good that we're continuing to be towards the top end of our 2% to 5% targeted range in credit card loan growth. And I think it's -- I believe that, once again, it was the best in the industry.

David S. Hochstim - The Buckingham Research Group Incorporated

Okay. So September is not consistent with that as a month, but look at the quarter and think about Q4, obviously Q4 seasonally should be pretty good?

David W. Nelms

Yes. I mean, by looking year-over-year, we sort of take out the seasonality. And -- but I would say, we feel good about last quarter and we're continuing to work hard to stay towards the top end of that range.

Operator

Our next question is from Ryan Nash from Goldman Sachs.

Ryan M. Nash - Goldman Sachs Group Inc., Research Division

Just a follow-up on the credit questions. Mark, I take your point that the credit is likely to remain benign, but is the normalization in the recovery rate outside the Master Trust happening at a faster pace? So is the actual recovery significantly lower in that part of the portfolio?

R. Mark Graf

No. I would say that the Master Trust is a pretty decent representation. In that sense, Ryan, I would say a couple of different things. Remember, we're not -- we're rearward looking on recovery rates. When we're setting our reserves, we're looking at what we expect those recovery rates to be over the ensuing 12-months period of time. So we're looking at trending in that recovery rate and what we expect that trying to be, going forward. The other thing I'd really be cautious onto is if you're thinking about that last month in the trust, you'll note there's a footnote there noting that, had we not done the account removal that we did, that recovery rate fell pretty significantly, I think it was more like 107 bps as oppose to the 116 bps that got published by virtue of the math. So recovery rates continue to decline. I thing the trust is a reasonable -- not a perfect, but a reasonable proxy for what we're seeing there.

Ryan M. Nash - Goldman Sachs Group Inc., Research Division

Got it. And just one quick follow-up, on the reward cost, it seems like it came out a bit better than we would've expected again. Given these quarters online shopping, are you still targeting 1% reward cost for all of 2013?

R. Mark Graf

Yes, I think somewhere in that neck of the woods is a pretty good estimate. I think we'll probably come in a little below 1% on the full year, would be my current observation place.

Operator

Our next question comes from Don Fandetti from Citigroup.

Donald Fandetti - Citigroup Inc, Research Division

Yes, David, I was curious what your appetite for acquisitions is currently? And in what areas, if you have an appetite, where you might focus?

David W. Nelms

Well as Mark said, we would always be open to great opportunities. If you look at our track record, we've been selective. We've made acquisitions where they fit most strategically and financially. We fit -- they obviously have to fit the Direct Banking or payments partner strategy. But I'd say, we focus most of our attention on organic growth than growing the businesses that we've currently have and have built, and we would be cautious. But we would certainly look at opportunities.

Operator

Our next question comes from Bob Napoli from William Blair.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

David, I was hoping you can give, maybe, some thoughts on your partnerships, PayPal, Ariba, Facebook, Amazon, maybe, I mean you haven't -- didn't give any update on PayPal. Well just maybe some thoughts around the strategy and working with those companies in particular, Amazon payments, Facebook payments, the Ariba business-to-business. I'd love some thoughts on those partnerships and over what time period you expect them to start generating some real numbers for you?

David W. Nelms

Well, I'm pleased with the progress that we're making. They -- as we've said in the past, there's 2 things that are good. One is we are a building portfolio of partnerships, so we're not counting on any 1 and not all of them will work, but we think we've got enough of our portfolio -- building enough of our portfolio, that some of them will work and, hopefully, some of them will work really well. I think that these -- we're talking about some very new areas. We are coming at them from a very differentiated approach. For instance, no one, I think, has ever come at the Ariba opportunity the way we are. And so these things will take time to get ready to launch. Then once they launch, we expect the volume to come first and the profits will be a ways out. So I think that one way to think about it is that it's like having a whole number of options and those are the long-term options that we think some of them will pay off really large, but I wouldn't think about them really as being that meaningful even through next year, at least in terms of the profit side of the equation.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

What is, maybe just as a follow-up, I mean, what is unique about what you're doing with these partners and maybe using a Ariba as an example?

David W. Nelms

Well, it opens up -- Ariba is business-to-business, so it opens up a whole new category that's not -- if you think about the size of the credit card industry, it's all spend that's not even there. It's not part of the industry as we know it today. And so it's a way to leverage our existing network, infrastructure, acceptance capabilities in a totally new marketplace. But with -- because it's leveraging our existing infrastructure, it's a relatively low cost and is a better value and better service than companies paying other companies achieve today through other means. And so what's, I think -- each one of these new opportunities are differentiated. They're not copying anyone else. They don't exist today. Some of them are really hard, I mean, we have to -- PayPal as an example, turning on a new network for 8 million merchants is not easy and I don't think it could be done without our help, but the payoff, we believe, will be very large over time.

Operator

Our next question comes from Chris Donat from Sandler O'Neill.

Christopher R. Donat - Sandler O'Neill + Partners, L.P., Research Division

Buried within the CFPB's report that they put out earlier this month on the CARD act, they mentioned that some issues and practices related to rewards and marketing promotions have become an area of concern. I'm just curious if this is something that's come up in your conversations with regulators and how do you feel about where your positioned relative to peers on rewards and -- most specifically on rewards, not too much on marketing.

David W. Nelms

Well, I feel very good about our focus on consumers and disclosures. We are looking at everything that we do and -- as our regulators, and I would say that I'm pleased that most of the areas that came at -- that were addressed during that study are areas that we don't have involvement with, like deferred interest cards or fee harvester cards, we're not currently marketing fee products. But obviously, rewards was mentioned. I think that you need to think about the fact that rewards are so prevalent, they're now on most cards in the industry. And so it's not surprising that, that would be an area of focus. One of the reasons I feel good about us is that cash is more straightforward than points or some other complicated programs. They're easy to use and redeem. We've particularly put in features to make them even easier to redeem and add value when they're redeemed and it's a great value to consumers overall. We've got about $1 billion a year of cash rewards. That's a huge value to consumers.

Operator

Our next question comes from James Friedman from SIG.

James E. Friedman - Susquehanna Financial Group, LLLP, Research Division

I think, Mark, on Slide 7, you called out employee compensation increases and you talked about higher headcount. I was just wondering where that headcount is going? And David, I'll just get the 2 in upfront. So with regard to network partners, how should we be thinking about -- or phrased a different way, how do you measure your success in network partner initiatives, so we can kind of harmonize with how you grade yourself?

R. Mark Graf

Yes. I would say -- I'll start off in response and let David take up. If you're looking at the higher employee compensation expense, I would say the headcount is really, Jamie, in support of our growth initiatives that we have across the company. So that's going to be everything from the launch of the home equity product to the further build out of a number of other different initiatives, there's also obviously some heads involved in the emerging payments partnerships, the second part of your question as well. So between our growth initiatives, new product initiatives we have and then I would say there's obviously, just like with everybody these days, a little bit that's go into the regulatory climate and make sure that we are dotting Is and crossing Ts and doing everything that's expected of us as a responsible player in the industry. So those would be the key drivers there.

David W. Nelms

And then in terms of network partners, I would divide it into 3 areas. I think, first, I measure what are the deals that we're signing and what's our track record for signing deals with some really strong partners compared to others, and I feel particularly good about that. I think in the medium-term, which is not yet, I would measure volume. What kind of transactions and dollars are these deals as they get implemented, producing? And then in the long-term I measure profitability, that's ultimately what you're after and how much money do we make in these deals, but that's a long-term.

Operator

The last question will come from Daniel Furtado from Jefferies.

Daniel Furtado - Jefferies LLC, Research Division

I just was curious if there we're any changes in the way you report delinquencies? And if not, do you feel this quarter was the inflection point for the 30-day bucket?

R. Mark Graf

Yes. I would say there's been no changes to the way we report delinquencies. From the standpoint of an inflection point, no, I don't think anybody around here is prepared to say, we think that's the inflection point. We're obviously at uncharted territory. We're not used to seeing car delinquencies in this level. And as I've said before, the models are built off a history and the predictive capability of those models is driven off of that historical set they have as well. So I think it's going to be even more difficult to call a turn in this environment than it would normally be and we'd be very cautious about doing that. I guess in response to really, I think, what's behind the question, I'd point you again back to my thoughts that the credit environment is definitely very benign right now. We could see improvement from here. We could see deterioration from here. But what I would say is that's going to be around a mean as opposed to some giant movements based on what we see right now.

Operator

And thank you, ladies and gentlemen, this concludes today's conference. Thank you, all, for participating. You may now disconnect.

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