Discover Financial Services' (DFS) CEO David Nelms on Q2 2014 Results - Earnings Call Transcript

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 |  About: Discover Financial Services (DFS)
by: SA Transcripts

Discover Financial Services (NYSE:DFS)

Q2 2014 Earnings Conference Call

July 22, 2014 5:00 PM ET

Executives

William Franklin – Senior Manager, IR

David Nelms – Chairman and CEO

Mark Graf – EVP and CFO

Analysts

Mark DeVries – Barclays

Sanjay Sakhrani – Keefe, Bruyette & Woods

Eric Wasserstrom – SunTrust Robinson Humphrey

Don Fandetti – Citigroup

Ryan Nash – Goldman Sachs

David Ho – Deutsche Bank

Bill Carcache – Nomura Securities

Moshe Orenbuch – Credit Suisse

Christopher Donat – Sandler O’Neill

Robert Napoli – William Blair & Co.

Brian Foran – Autonomous Research

Craig Maurer – Credit Agricole Securities

David Hochstim – Buckingham Research

Jason Arnold – RBC Capital Markets

Vincent Caintic – Macquarie

Sameer Gokhale – Janney Capital

Operator

Good evening and welcome to the Second Quarter 2014 Earnings Call. My name is Bakiba and I will be your operator for today’s call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Please note that this conference is being recorded.

I will now turn the call over to Bill Franklin. Bill Franklin, you may begin.

William Franklin

Thank you Bakiba. Good afternoon, everyone. We appreciate all of you for joining us. Let me begin as always with slide two of our earnings presentation, which is on the Investor Relations section of our website.

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 in an 8-K report and in our 10-K and 10-Q which are on our website and on file with the SEC.

In the second quarter 2014 earnings materials which are posted on our website 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 discussions.

Our call this afternoon 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. During the Q&A period it would be very helpful if you limit yourself to one question and one related follow-up, so we can make sure that everyone is accommodated.

So now it is my pleasure to turn the call over to David.

David Nelms

Good afternoon everyone and thanking for joining us today. After the market closed we reported second quarter net income of $644 million or $1.35 per diluted share, up 13% over the prior year. This was driven primarily by profitable loan growth and share repurchases. We also continued to deliver strong performance with return on equity of 23%.

Our direct banking business continues to deliver solid results and slide four of the earning presentation shows Discover’s total loan growth of 7% over the prior year. This was driven by strong growth in card, personal loans as well as student loans. Card receivables growth of 6% this quarter continues to outpace our peers. We are achieving increased wallet share with existing customers and adding loans from new accounts as well. Our Discover card sales growth also accelerated to 6%.

The overall value proposition of Discover continues to resonate with customers as evidenced by another quarter of double-digit new account growth year-over-year. Additionally, we added some new designs for the card and we rolled out a new cash back reward card primarily to appeal to students. Speaking of students, during the second quarter we enhanced our student loan products by introducing a 1% cash reward for students who achieved good grades. Additionally, in the quarter we announced new lower rates for students applying for loans. We launched an in-school repayment product and we began testing the consolidation student loan product, all of which are showing positive results to-date.

Shifting gears, Discover was recently named the winner of three Call Center Excellence Awards by the International Quality and Productivity Center for demonstrating superior thinking, creativity and execution across the full spectrum of call center functions. I think this service excellence is one of the reasons why we have some of the lowest customer attrition in the industry. And to further enhance the customer experience we implemented our new core banking platform over Memorial Day weekend which supports all of our deposit products. The flexibility and the operational efficiencies that we expected to provide are fundamental to our vision to being the leading [direct] bank.

Moving to our payment segment, volume increased by 3%. During the quarter, two of our newer emerging payment partners went live with transactions. However, I’ll remind you that it will take some period of time for partners to achieve scale. As we have previously discussed, Pulse continues to deal with pressures on volume and margins due to competitive challenges in the debit industry. Despite two consecutive quarters of positive growth we learned that we would likely lose significant volume from a large debit issuer beginning in 2015. While the prospect of losing some business down the road is disappointing, this loss is not material relative to the profitability of the total company.

With that said we are very pleased with the branding and superior returns that our network helps drive for our card business and we do remain focused on improving third party volume over the long term. Lastly, as we previously discussed in the second quarter we entered into a consent order with the FDIC related to our AML and BSA compliance programs. The order does not include any civil money penalties but provides for program enhancements.

In addition, the Federal Reserve has recently notified us that it also intends to enter in to Supervisory Action with the company regarding our enterprise-wide AML and BSA compliance programs. We are committed to resolving these issues with the regulators in a timely manner.

Before I turn the call over to Mark to walk through the details of our second quarter results let me say it that I am proud of our record rate EPS, card loan sales growth and our ability to continue to drive solid revenue growth with expense discipline. Mark?

Mark Graf

Thanks David. I’ll begin my comment today by going through revenue detail on slide five of our presentation. Net interest income increased $159 million or 11% over the prior year due to continued loan growth as well as higher net interest margins. Total non-interest income decreased $28 million to $583 million primarily due to lower direct mortgage-related income and lower protection product revenue. Given our suspension in protection product sales revenue related to these products continues to decline, albeit at a slower pace than initially expected.

These items were partially offset by higher net discount and interchange revenue which increased by $19 million, or 6% year-over-year driven by higher Discover IT Card sales volume. Our reward rates for the quarter was 91 basis points which is higher than last year due to greater standard and promotional rewards, but down from last quarter which included a decrease in the expected forfeiture rate.

Payment services revenue for the quarter was flat year-over-year. Overall, we grew total company revenues by 6% for the quarter.

Turning to slide six, total loan yield of 11.42% was up 18 basis points over the prior year driven by higher card and private student loan yields. The year-over-year increase in card yield primarily reflects a higher portion of balances coming from revolving customers as well as lower interest charge-offs. The year-over-year increase in private student loan yield is the result of better than expected performance in certain acquired pools of loans.

As we discussed on our fourth quarter earnings call, under PCI accounting favorability is recognized over the life of the underlying loans via an increasing yield and that’s what happening here. Overall higher total loan yield combined with lower funding costs resulted in the 40 basis point increase in the net interest margin over the prior year to 9.84%.

Turning to slide seven, total operating expense decreased by $23 million or 3% over the prior year, mainly due to the decline in other expense, which was somewhat offset by an increase in headcount and professional fees. The decline in other expense was caused by the absence of $40 million in Diner’s Club charges which we incurred last year. For the quarter our total company efficiency ratio was below 37%, more than 1% lower than our long-term target, due in part to the timing of certain expenses throughout the year.

Turning to provision for loan losses and credit on slide eight, provision for loan losses was higher by $120 million compared to the prior year due to a $23 million reserve build this quarter compared to a $78 million reserve release during the second quarter of 2013. The reserve build mainly reflects our continued card loan growth. Sequentially the credit card net charge-off rate increased by one basis point to 0.33% and the 30 plus day delinquency rate decreased by nine basis points to 1.63%.

The private student loan net charge-off rate excluding purchase loans was down one basis points sequentially to 1.3% and the 30 plus day delinquency rate decreased by 13 basis points to 1.66%. Overall the student loan portfolio continues to season generally in-line with our expectations.

Switching to personal loans, the net charge-off rate was down 12 basis points sequentially to 1.95% and the over 30 day delinquency rate was down two basis points to 66 basis points. Overall we remain pleased with our strong credit results. One last item I would call out in the income statement is that during the quarter we had a favorable resolution to some outstanding tax matters. And as a result our 36.6% effective tax rate for the quarter was lower than anticipated.

Next I will touch on our capital position on slide nine, our Tier 1 common ratio increased sequentially by 30 basis points to 15.2% due to solid earnings. During the quarter we repurchased $177 million of common shares. One of our top priorities is to drive shareholder value through effective capital management. To that end we still plan to repurchase a total of $1.6 billion of common shares for the four quarter period ending March 31, 2015, the same amount as our CCAR capital action submitted to the Fed.

Also on slide nine is our outlook for 2014, which I would simply say remains relatively unchanged from the guidance we gave back in February at our financial community briefing.

So to summarize, during the second quarter we continue to build on our momentum established at the beginning of the year. Discover drove better than industry loan growth, net interest margin continues to be above our long-term target, the credit environment remains benign and we are effectively controlling our expenses.

That concludes our formal remarks today. So I will turn the call back to our operator, Bakiba to begin the Q&A session. Bakiba?

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions). And our first question is coming from the Mark DeVries from Barclays. Please go ahead. Your line is open.

Mark DeVries – Barclays

Yeah, thanks. Question David, to what do you attribute the 6% card loan growth above the high end of your guidance? Is that, you’re actually seeing signs of acceleration in spend across the industry or is it better than expected traction from the marketing of Discovery card? And then could you actually see it potentially remaining above that rate for the period, or is that a level growth that you at some level would think might outstrip kind of your desire to grow here?

David Nelms

Well, to answer your second question we are not prepared to revise our 2% to 5% long-term target. I mean I am certainly pleased that we actually were a bit above that target this quarter. And I mean you’ve just seen our various competitors announce and I’d say generally I certainly didn’t see that much signs of acceleration across the industry. So I think we continue to gain market share. So I would say that you mentioned the success of Discover IT, that is certainly contributing. But some of the other things that are contributing are lower charge-offs, less attrition, some wallet share build with existing customers as they respond to many programs and higher levels of service, as well as I mentioned growing – putting on more new accounts, and we are getting loans on the new accounts.

So I think we are kind of hitting on all cylinders and it’s showing up in loan growth. And we also saw our sales growth accelerate to 6% this quarter which is the best in a number of quarters.

Mark DeVries – Barclays

Okay, great. And just a follow up on the guidance around reward expense margin give you are still at some of the 100 basis points for the year. I think the first half of the year is only been about 95 bps. Should we assume that there is going to be greater promotional activity in the back half of the year, that’s going to bring you closer to 105 for the back half of the year or should we consider this conservative guidance there?

Mark Graf

Yeah. I would not interpret it as conservative guidance. I would say I feel really good about that guidance. The area of 1% is the right way to think about it. If anything Mark for the year it may trend up a basis points or two higher than that. So I would say it remains good guidance.

David Nelms

But to answer your seasonal question you’ve seen as in year ago, this was a fairly light quarter and then we tended to pick up more moving in to the holidays. And we’d expect to do the same this year.

Mark DeVries – Barclays

Got it. Thank you.

Operator

Thank you. And then our next question is going to come from Sanjay Sakhrani. Please go ahead. Your line is open.

Sanjay Sakhrani – Keefe, Bruyette & Woods

Thank you. I guess you guys built reserves this quarter, and I was just wondering, as we look out, should we just expect that you guys will continue to build reserves? And maybe just on a related note when we think about the seasoning process from the growth that you’ve booked over the course of last 1.5 years, I mean kind of where are we with that process? I mean when do we start seeing that actually be somewhat of a headwind in the face of kind of stabilization in credit? Thanks.

David Nelms

Sanjay I will try and answer this and do them justice here. I would say from a reserving perspective, reserve trajectories still feel like they are being driven by growth. The credit environment, the backdrop itself still feels relatively benign. We don’t see any fundamental churns out there at all. So quarter-over-quarter there might be some variability in that. I think as we said before the gap is pretty prescriptive in terms of how you actually set the reserves. So on a 1.6 billion we may [bill them] 21 and release 20 the next quarter is the way I think about it. We are just sitting flat bumping along the bottom with those kind of relative numbers.

In terms of seasoning and where things are going to come out, what I would say is we’ve been generating real strong loan growth now for over three years. And in light of that if you think about the way our card loan seasons you typically tend to see peak charge-offs somewhere between month 18 and month 30. So we are already well into the seasoning process on the first two years, on those vintages of growth, which I think really speaks to the quality of the loans we are attracting, really underscores that we are operating first of all in a benign credit environment but then really with respect to us, I think it really underscores the fact we focus on a prime bar and the quality of that portfolio that we are building.

Sanjay Sakhrani – Keefe, Bruyette & Woods

Okay, right. I am sorry, one just quick follow-up. Has that the profile of the currency you book changed over the course of the time, I mean have you guys tried to broaden it out a little bit more?

David Nelms

I’d say overall the quality is quite consistent.

Sanjay Sakhrani – Keefe, Bruyette & Woods

Okay, great. Thank you.

Operator

Thank you. And our next question is going to come from Eric Wasserstrom of SunTrust Robinson. Please go ahead, your line is open.

Eric Wasserstrom – SunTrust Robinson Humphrey

Thanks very much. Just a follow-up on the growth. How should we think about the sequential growth, David just given the trend that you’ve mentioned which is sort of above standard growth for three years in a row. It’s starting to lead to dis-inflating sequentially growth rates. So how should we think about that dynamic?

David Nelms

Well, I’m not sure I follow exactly your sequential question. I guess see if you…

Eric Wasserstrom – SunTrust Robinson Humphrey

Sorry, in credit card the sequential growth was about 3.5% versus the 6% year-on-year growth right?

David Nelms

Yeah, well obviously the card business is seasonal. So I personally think the better way to do it is to look at it year-over-year which removes that seasonality and we have been operating near that the high-end of the 2% to 5% target for a while now and I guess this is the first quarter that we have actually broken through that and are above that. I wouldn’t promise that we are going to remain above it but I certainly would suggest that we are going to be at least at the high-end here for a while because I don’t see any of the positive trends that we are achieving, reserving in the next quarter or two.

Eric Wasserstrom – SunTrust Robinson Humphrey

Thanks. And Mark if I can just ask one quick follow-up question do you happen to know the dollar amount of the tax benefit in the period?

Mark Graf

I don’t have it at my fingertips. We can follow-up and get that to you.

Eric Wasserstrom – SunTrust Robinson Humphrey

Yeah, thanks very much.

Operator

Thank you. And that our next question is going to come from Don Fandetti of Citigroup. Please go ahead, your line is open.

Don Fandetti – Citigroup

David you had made some comments about the loan growth. As we look at some of your competitors, I mean it looks like there is a fairly consistent I guess you could call it an uptick in loan growth but it sounds like maybe you’re saying that you’re not really seeing that or is it more you just want to be cautious because it’s a small uplift, I mean are you seeing any increased demand for credit from customers or is it – and we understand that you’re definitely gaining market share, just trying you know parse it out a little bit more.

David Nelms

Well, I am not exactly sure what you are looking at but from our biggest competitors what I’m seeing is that American express is the only large competitor that’s growing close to our levels and the other largest issuers are sort of plus or minus 2% kind of ranges. So I am not seeing an overall industry pick-up to sort of our levels of growth. So it looks – the industry as a whole looks pretty flat. I mean maybe the industry has moved from minus 1% to plus 1% or something but it’s still darn near flat and so I am very pleased with our 6% growth with a flat industry.

Don Fandetti – Citigroup

Got it. And then into July, the spend has that held relatively steady?

David Nelms

It has, the last two months of the quarter and then continuing into this month are pretty consistent with that 6% overall quarter year-over-year. So feeling good about seeing a little higher growth sustaining for now.

Don Fandetti – Citigroup

Got it, thanks.

Operator

Thank you. And that our next question is going to come from Ryan Nash of Goldman Sachs. Please go ahead, your line is open.

Ryan Nash – Goldman Sachs

Hey, good afternoon guys. Mark when I think about the trajectory of the net interest margin, just thinking back to last year, I think there was an expectation of decline in the first-half and then improvement in back half of the year. So while you’re starting base obviously a lot higher at this point just given the seasonal tailwinds that you sometimes see in 3Q, should we expect to see the margin begin to expand again from its current levels?

Mark Graf

Yeah, right. I would say, I would expect flattish is the right way to think about it from where we sit right now for the remainder of the year. I think there are some puts and takes in there. I think from a loan yield standpoint I think flattish is the way to think about that one. I think we have a little bit less funding cost tail wind, if you will in terms of the maturities that are rolling off and little less pick-up on some of this going forward. But I would say we actually would have some margin expansion this quarter just to be transparent with our investor base.

I think we had three basis points of sequential contraction that’s because we chose to take some of the goodness we’re seeing right now and use that to position ourselves to perform well when the environment turns and you have a rising rate situation is well. So we consciously did some of that and I would except you might see us do a little bit more of that as the year goes on. So I would stick to the flattish NIM guidance as you look to the year.

Ryan Nash – Goldman Sachs

And is that driving higher sensitivity to rates, when rates do eventually raise?

Mark Graf

Over time, yes it will.

Ryan Nash – Goldman Sachs

Okay. And then Mark just have one unrelated question, on credit you know when I look at the recovery numbers it looks like we are seeing no signs of slowing. I guess relative to your initial guidance from last year are you seeing any changes on recoveries, obviously they are coming in better if they do continue to come better is it safe to say that we could actually see credit improving over the next couple of quarters.

Mark Graf

Yeah, I would think about recoveries in two different buckets Ryan. The first bucket is what I’ll call the recoveries on the pool of charge-offs from the recession, right. And as we have said before we have continued to realize that recoveries off that bucket for a much longer period of time then you would following a normal downturn. Usually by the time you’re 24 months past a charge-off your recoveries have really peaked and they tail off pretty quickly thereafter. And we’re five years past that point in time and recoveries are still coming off that book and I would say they’re coming at a – they’re attriting at a much lower rate than we would have guessed as you pointed out.

So overtime clearly that’s a finite book, it will attrite, right. So I would over time it’s happening slower than we expected but that attrition will take place. Then you have to look at the new charge-offs that are flowing into the pipe, if you will to refill that bucket and I think it’s a really good thing that we don’t have many of them today. So the fact that we are just not charging-off a lot gives you limited potential for recoveries against a much smaller book of charged-off accounts. So the recovery rate itself when you pass it up a new charge-offs is very good as it’s ever been, the recovery rate on that static pool from the crisis will attrite overtime.

Ryan Nash – Goldman Sachs

Got it, thanks for taking my questions.

Mark Graf

You bet.

Operator

Thank you. And then our next question is going to come from David Ho of Deutsche Bank. Please go ahead, your line is open.

David Ho – Deutsche Bank

Hey, guys. Thanks for taking my question. A quick question on expenses, you reiterated the guidance for the year for $3.3 billion of expenses. If I take the first-half run-rate it seems to imply that the second-half will be up about 6% year-over-year. Is that just kind of the timing of marketing and a little more build another expenses and comp? And how much has the mortgage business been right sized, have cost come out of that business as you’ve seen kind of a tick down in revenues there?

Mark Graf

Yeah, I would say $3.3 billion still feels like a good number on the full year. There is some definitely some seasonality in the expense base, there is no question about that and there is some back end load. I would say with respect to the mortgage company specifically I feel like we have taken the right actions there at this point in time to position that business. Well it’s still burning a little bit of money but not a real measureable amount to be honest, at least not anything that shows up at the top of the company in a meaningful way and we are continuing to work on positioning the longer term strategy with respect to that business within Discover but I feel like we have taken the action that needed to take there.

David Ho – Deutsche Bank

Okay, thanks. And just following-up on Ryan’s question about asset sensitivity increasing, can you remind us what percentage of the books is variable rate loans and of that how much do you expect to be able to re-price or realize the rate changes in a high rate environment?

David Nelms

Yeah, I think there is bunch of moving pieces in there David. What I would say is I think an immediate parallel shock of 100 basis points to rates produces something on the order of $130 million roughly was our last quarterly disclosure. We’ll obviously update in our new Q as well. The vast majority of the loan book is floating. The card book floats at this point in time. Some of the student loans effects and the personal loans as well. So I don’t have the exact rate down at my fingertips but the vast majority of the book is a floating rate book.

David Ho – Deutsche Bank

Right. And you think that would probably rise with the deposits being a little more sticky and the assets being re-priced?

David Nelms

Yeah. I think the one thing we have talked about and I think we just need to continue being transparent about is if you want to continue driving sales growth at some point in time there probably is a cap on some of your floating loans some of the card, right if you are going to charge 40% for cards you are not going to get a lot of field usage but we’re far, far away from when we think that begins to kick in.

David Ho – Deutsche Bank

Right. Thank you for taking my question.

David Nelms

You bet.

Operator

Thank you. And then our next question is going to come from Bill Carcache from Nomura Securities. Please go ahead your line is open.

Bill Carcache – Nomura Securities

Thank you. Good evening. I had a follow up question on expenses, in particular your revenue growth outpaced your operating expenses by over 9% this quarter. I know you guys have an operating efficiency ratio target but I was hoping that you could discuss how you guys are thinking about positive operating leverage as we look at the business beyond this year and into next, is there any kind of a commitment to growing revenues faster than expenses at this point in the cycle or is it really all about the efficiency ratio and expenses overtime will go up or down with revenues?

Mark Graf

The way I would think about it is to really look at the fact that we’ve been investing pretty heavily over the course of the last couple of years, take advantage of the goodness in the environment. So part of some of the negative operating leverage you’ve seen over the course of last couple of years has really been driven by that fact. I can assure you that David is laser focused on positive operating leverage and making sure that revenue growth outpaces expense growth over the long run. I think there is quarters where we will, there is quarters where we won’t by virtue of what’s taking place in that given quarter.

So I would say we will anchor to that efficiency ratio but we are always striving for positive operating leverage in the business model.

Bill Carcache – Nomura Securities

So then just mathematically to the extent that overtime revenues are growing faster than expenses and there could be overtime some potential for that efficiency ratio target to move lower?

David Nelms

Yeah, I might comment that we expect some positive operating leverage but probably more modest than what you just cited and I think that one of the things Mark just talked about taking expenses down in for instance home loans and that sort of a one-time event that’s impacting us benefiting us if you will at this time but on the flip side we’ve got higher regulatory related cost and so I think the way to think about it is we’ve established 38% efficiency margin and we expect to roughly maintain that.

It could possibly go the other way at some point because if we see great marketing opportunities we might choose to go the other way. So we are not promising positive operating margin or operating leverage whatever but if we get off that track it will be for a good reason and for a limited period of time.

Bill Carcache – Nomura Securities

Understood and thank you. If I may on a separate note you guys haven’t had any inverse receivable for the trust in the long time and you’ve talked about this in the past but I think in looking at it I don’t believe that any of your originations from 2009 to 2014 are in there so balance has been gradually decreasing. I’m just hoping maybe you could briefly touch on how you are thinking about the trust and how it fits in the packing order of funding preferences here? Thanks.

Mark Graf

Yeah, it’s great cost effective funding for us to issue a card ABS. What I would say is we have a significant excess of receivables in the trust overall we need for the planned issuances at this point in time and that’s why you haven’t seen it contribute any new assets for the trust in extended period of time. So when we get into – should we get into a situation where we, we would be running up against capacities, we’d obviously be willing to consider putting more receivables in.

Bill Carcache – Nomura Securities

Great. Thank you.

Mark Graf

You bet.

Operator

Thank you. And our next question is going to come from Moshe Orenbuch out of Credit Suisse. Please go ahead your line is open.

Moshe Orenbuch – Credit Suisse

Great. Thanks. I was intrigued David by statement you just made about if you found kind of great marketing opportunities here, you are at a point where you weren’t materially increasing marketing expending you are outgrowing, you are outgrowing the industry, your sales volume growth is accelerating and your cost not certainly well within the range of what you said out. I guess to turn that question around is I mean what, what could you be doing to make it even better, is there anything that could be done here and kind of maybe just if you could talk on just how you assess the credit, the kind of competitive state in your market?

Mark Graf

Well I think we have a disciplined approach to thinking about marginal cost and marginal benefit and we look at that across all of our businesses and across of our programs. And so we think that we’re at a pretty optimal point here and, and so at the margin, we think we have diminished, you know payback from incremental investments and, and that we’ve actually been able to focus as much on a fixed efficiency and effectiveness to outgrow the industry, not doing flips in the industry. And I think what you spend in marketing maybe it’s important but what your product is, the service the back seat that rewards program how good you are at direct marketing and of course we focus all of our efforts on direct, we don’t have channel comp liquid branches and all that. Those things are just as important. So we’re constantly evaluating incremental opportunities and killing things that aren’t payback and adding things to do.

Moshe Orenbuch – Credit Suisse

Just a follow up if you I mean if you were to do something where it would fall short, would it fall short on terms of the cost to produce it or the credit or the spending performance where you think that would be?

David Nelms

You know it’s typically in the cost per new account or cost per incremental marketing effort relative to the loan balances and spending and credit performance that you get.

Moshe Orenbuch – Credit Suisse

Good. Thanks very much David.

Operator

Thank you. And then our next question is going to come from Chris Donat out of Sandler O’Neill. Please go ahead your line is open.

Christopher Donat – Sandler O’Neill

Hi, good afternoon. Thanks for taking my question. Had one follow up on the word spending just the seasonality what the second quarter this year being lowest so far and as I look back in last three years second quarter has been the lowest quarter as percent of card sales volume. Is that solely a function of the, the quarterly cash back bonus program or is there something else going on in that seasonality?

Mark Graf

It’s primarily related to 5% and other promotional programs. And, and...

Christopher Donat – Sandler O’Neill

Got it.

Mark Graf

And the, single factor is what categories are we promoting and we tend to you saw last year we promoted online thing, and big categories like online and department stores therein times and people are doing their holiday shopping and such and then will typically do things like gas programs during the summer and so on but that still tends to a smaller overall category.

Christopher Donat – Sandler O’Neill

Okay, and then just a follow-up on a comment that Mark had made, sort of tacking on in answer to question there, additional spending that you due would be for a limited period of time, like I said think about the run rate you are on for this year at 3.2 so things are looking at just to spend on to get to their $3.3 billion of annual spending or operating expenses. That’s on the variable side right it’s marketing now if you are looking a higher, a whole bunch of new people or anything that would recur immediately in 2015 right?

Mark Graf

Yeah. I think you should rightly assume the vast majority of it, the vast majority of it is variable, that’s the right way to think about it.

Christopher Donat – Sandler O’Neill

Got it. Thanks Mark.

Operator

Thank you. And then our next question is going to come from Bob Napoli. Please go ahead. Your line is open.

Robert Napoli – William Blair & Co.

Thank you. Good afternoon. A question on capital, I know you said you are going to buyback the same amount of stock but I was curious why you didn’t buyback you know as much as you look at your capital level, a way to use that capital that can be and I guess the Fed is more comfortable with is some M&A and I just don’t know I mean you guys have been as you’ve mentioned time and – rewarded investors with discipline and are there opportunities to use that capital in a strategic manner that would add additional growth, long term growth opportunities that you’re comfortable with and are you looking hard, I guess?

Mark Graf

Why don’t I start the answer that one and then I’ll pass it over to David for more specifics. First of all why we ended up buying a little bit less this quarter I would say Bob we haven’t got into the habit of talking about when we’re in the market, when we’re out of the market, why or how much. So I prefer not to get selective on that. I’d rather just say we’re going to – our plan is to take out the $1.6 billion over the course of the four quarter rolling period.

I would say with respect to our approach and our appetite for M&A I would just remind you before I pass things to David, our capital prioritization stack, it’s first and foremost organic growth. It’s secondly returning it to shareholders which as you rightly point out under the current CCAR process is somewhat constrained these days.

Third, it would be financially attractive portfolio acquisitions. They’ve got to be financially attractive because by definition they are tied to their portfolios, so I would say that would be a piece of the puzzle. And then fourth on that prioritization list would be M&A because you introduce the key man retention risk, the diligence risk the integration risk all those other different pieces of puzzle that the others don’t bring forth. So that’s why we’re pretty disciplined around the way we look at M&A, in terms of what we might be willing to consider David I’ll pass that to you for…

David Nelms

Well I would just reinforce that we’re primarily an organic growth story and the reason for that is there is a. I think a limited set of opportunities that would directly fit with our direct banking and payments partner strategy.

Secondly, we have achieved a very strong returns in our business and therefore the hurdles as we think about where to put our incremental shareholder’s capital, we tended to find more opportunities to actually grow organically and build shareholder value in that way.

And thirdly, we do – while we’ve done some M&A overtime we do approach it with a fair bit of skepticism and there is a lot of cases where it has – M&A has detracted from shareholder value versus building that hand. So we’re going to be very cautious in approaching that. I guess the final thing I’d say is that I do think that the – we’re playing a long term game here and I think that it’s likely that as regulators and institutions get more comfortable with the new approach and the new levels of capital and the processes in place that some of this sort of constraints may loosen up overtime and so it’s important not to have money burn holes in our pockets because we may be able to return more of it overtime.

Robert Napoli – William Blair & Co.

Great. And just a quick follow up I guess on the credit card business. Have you’ve been adjusting credit lines. One of your competitors has moved to credit line increases and I think we’ve seen some of that in the Fed data. Given the strong credit, is that a way to get growth, have you been doing, adjusting credit lines or anything else on the credit side?

David Nelms

Our line increased strategy hasn’t changed material over the last couple of years.

Robert Napoli – William Blair & Co.

Great. Thank you. Appreciate it.

Operator

Thank you. And then our next question is going to come from Brian Foran. Please go ahead. Your line is open.

Brian Foran – Autonomous Research

Hi. Good afternoon guys. I guess on loan yields I kind of asked the same question last quarter and you gave a pretty good decent detailed answer on kind of the broad industry dynamics. But I mean I guess when I look at it I mean you’ve got a banking industry where loan yields are 4% and falling fast. You’ve got you guys where loan yields are 11.4% and not falling at all. I mean is there anything you are seeing on the horizon that would lead to increased competition for those loan yields, it’s just you’re in a remarkably good spot where you’re actually able to grow revenue as you’ve grown loan balances, so obviously the risk is that changes?

David Nelms

Well, I think that it’s more a factor of the fact that we focus on direct banking and on more profitable products. And so I think that if you compare our card yield to other card yields we still look attractive for one reason. We don’t charge off as much interest as competitors with higher loan losses but it’s a lot closer. And as we have expanded into other businesses student loans are – is a lower yields than other unsecured loan types but it’s still above secured loan types such as mortgages. Personal loan also tends to be below card but still it’s a lot closer to card than other banking products.

So one of the direct banking strategy has a lot of benefits picking and choosing which products you offer and which you don’t is one of those and we have been judicious in that. I guess the final thing I’d say is where else we have been disciplined. We’re disciplined on our use of promotional rates. We’re disciplined on focusing on revolvers and if you have lot of transactors in your book you tend to suppress the yield because you have zero earning assets in there and we’ve been judicious on credit because writing [enough] interest also deducts from that yield.

Brian Foran – Autonomous Research

As an unrelated follow-up there is a lot changes going on in private label card and can you just remind us how you think about that business long-term as something that potential part of the roster, so to speak?

David Nelms

I think we’ve said overtime that, that could fit the strategy if we ever found an appropriate entry path but the entry paths are very limited and we have not seen any to-date. So I would think about that as opportunistic. Could it happen someday, yes but it may never happen and it’s not a critical product in the way that direct check-in or even some of our mortgage products are to thinking about being a leader in direct banking. It’s more of a nice to have if an opportunity ever happens, but private label has had a rebound of late but still if you look at the long term it’s not necessarily growing relative to general purpose cards and it’s a more limited market sized in general purpose cards and so I think there is only room for a more limited set of competitors to offer that kind of product.

Brian Foran – Autonomous Research

Thank you very much.

Operator

Thank you. And then our next question is going to come from Craig Maurer out of CLSA. Please go ahead. Your line is open.

Craig Maurer – Credit Agricole Securities

Yeah, good evening. Thanks. At the Investor Day, you had talked about looking to significantly enhance your portfolio of spend centric products to try to leverage your network and I was just wondering where you stand in that thought process? Thanks.

David Nelms

I actually don’t remember that comment. I think we certainly have talked about continuing to enhance and differentiate our core card products and I feel very good about Discover It which is our flagship product, the free FICA scores have been very well received by consumers and not widely copied by competitors. In fact I think we’re still the only one to offer it on the statements. We’ve added some security features that are somewhat unique in the industry as an example. We’ve put in the ability for consumers to turn their card on or off with a flick of a button online if for instance they misplaced their card which I am not familiar with other competitors having that. We’ve continue to enhance the rewards program as well.

So we’ve, I think what you heard at the Investor Day was us talking about our focus on good credit quality revolvers and that one of the things that differentiates us is it seems like a number of our competitors are really chasing transactors that look good in today’s rate environment but is not typically driving revenue and that’s one of the reasons you’ve seen in our revenue go up and other card companies go down in revenue because the transactors simply don’t produce as much revenue.

Craig Maurer – Credit Agricole Securities

Okay. Thank you.

Operator

Thank you. And then our next question is going to come from David Hochstim out of Buckingham Research. Please go ahead. Your line is open.

David Hochstim – Buckingham Research

Yeah, thanks. I wondered, David can you give us a sense of the mix of the contributors for loan growth, you mentioned new customers and existing customers and have you done anything with, is there any change in teaser rates and promotional rates this quarter?

David Nelms

I would say our loan growth continues to be quite balanced. We are getting loan growth from new customers. We are also retaining customers and getting higher level of activation and engagement out of existing customers. So we have not done anything dramatically differentially in teaser rates. One way you can see that if you haven’t seen a big change in yield. And so pricing has held up even as growth has held up and even accelerated a bit. So we are constantly testing, adjusting by retaining a very disciplined and balanced loan growth and we have not – in our opinion the quick change your credit or change your pricing could drive a spurt of growth but is not – is easier to execute but the executing a differentiated strategy with all of our customer service, onshore, inside that company better service levels that drive better retention of balances is the way to get both good credit results, good yield and loan growth overtime which ultimately leads to profits.

David Hochstim – Buckingham Research

Okay. And then Mark is there, are any tax benefits coming in the second-half and what’s good estimate for the effective tax rate in the second-half?

Mark Graf

I would use 37.5% as a good estimate for the effective tax rate in the second-half. We always have as any large company does open matters before various taxing authorities and so the possibility always exists but I am not banking on any, how about that.

David Hochstim – Buckingham Research

Okay, thank you.

Operator

Thank you. And then our next question is going to come from Jason Arnold of RBC Capital Markets. Please go ahead. Your line is open.

Jason Arnold – RBC Capital Markets

Hi, good evening guys. I was just curious if you could comment a little further on the competitive side. Are you seeing any competitors doing anything for more aggressive rather or ordinary versus prior periods at all?

David Nelms

I would say that different players are coming in and out in terms of aggressiveness. The general trend in recent years is – there has been huge shift towards everyone focusing on rewards and in particular cash reward but that’s partly because it’s working, consumers love it. They’ve seen competitors see our success and want to get some of that if you will. But that’s not – it’s not a new trend. What we have seen is this year you know there’s one or two competitors that have picked-up their marketing intensity and there is one or two players that have actually reduced their marketing intensity on cash kind of rewards. It is expensive to offer, it is what we focus on and we focusing on delivering great value at affordable cost of the company which allows us to sustain it over the long-term.

And I think one of the things I’m really proud of is how well our top-line advertising is working. Our consumer testing shows that we are getting some of the best results in years and our marketing campaigns are more effective for a given level of spend then our competitors so our commercials and sponsorships like the NHL are working harder for us and that is really helping.

Jason Arnold – RBC Capital Markets

Great. Good to hear that. And just one another unrelated item I know we are still somewhat early on but can you give us an update on the cash back checking product and how things are going there?

David Nelms

Sure I mentioned you know we launched cash back checking last year in a limited cross-sell and what we told everyone at the Investor Day is that we really wanted to get our core banking system in place before we started to really scale that. I mention that we put that in successfully during Memorial Day so we really feel good that it’s going in well and so we are just about a point that it will start ramping up but will be ramping up in a cross-sell manner.

We – there is a new system has allowed us some new capabilities to make it easier to offer to most of our current base and obviously with a large customer base that represents about a quarter of U.S. household that will be the place that cross sell will be the most cost effective to expand it from this point. We have not yet made a decision as to when we are going to launch beyond our current customer base. It’s entirely possible that the rest of this year we are going to focus on and expand cross sell and it maybe next year before we go broad market but stay tuned for that.

Jason Arnold – RBC Capital Markets

Terrific, thanks a lot.

Operator

Thank you. And that our next question is going to come from Vincent Caintic out of Macquarie. Please go ahead. Your line is open.

Vincent Caintic – Macquarie

Hi, good evening. On the gross interchange rate, I’m calculating a 200 basis points rate for this quarter which is higher than it’s been at least since 2011 and despite the lower rewards expenses. I was wondering if there is any one-time or kind of second quarter items there that we shouldn’t think about as a run-rate or this is a kind of good jump start for the rest of the year.

David Nelms

Yes, I would say there is a couple of different things taking place there. First of all as we did a re-class of certain merchant fees in the first quarter so a part of is being is reflective of that re-class that was done. The second piece of the puzzle I would say is just the spend mix over the course of the quarter and the spending tilted more toward merchants with higher discount rates this quarter and a way for merchants who have lower discount rates. So, I would say that tends to move back and forth quarter year-over-year. It feels like MDR is in a decent range at this point in time.

Vincent Caintic – Macquarie

Got it, it makes sense. And follow-up actually on the lowering yield questions that were asked previously and I will take it through another track. You mentioned with the card loan yield to start the lower interest charge-offs were a meaningful benefit to that. So, if you kind of a normalize with the credit being taken out of the equation, do yield point towards a downward structure or how should we think about that? Thanks.

David Nelms

Yes, all right. I was just going to say if you take credit out of the equation yield feels pretty stable. Just look at the ALM positioning we have had for the company we positioned ourselves to absorb the initial phases of rate shocks to our funding cost base. We continue as I mentioned in my commentary in the margin we continue to push out our funding, extending maturities fixing rates positioning ourselves for that so the funding cost component a yield feels pretty good. The actual card yield itself feels pretty good the actual asset yield themselves feel pretty good the stated yield on the product. So it’s really just the interest charge-offs that are the other piece of variability. I would say if you exclude them, feel very stable.

Mark Graf

And remember that’s stable in the shorter-term, we still think over the longer-term we would expect credit to normalize somewhat and then that would push the yields down closer to the levels that we have talked about in the past.

David Nelms

But that would come through the charge-off line as opposed to the stated yield in the asset or the funding.

Vincent Caintic – Macquarie

Got it, thanks very much guys.

David Nelms

You bet.

Operator

Thank you. And that our next question is going to come from Sameer Gokhale out of Janney Capital. Please go ahead. Your line is open.

Sameer Gokhale – Janney Capital

Hi, thanks. You know a couple of questions I guess my first one was, you mentioned one of the competitor who is growing faster than the market or at a decent clip and of course you are growing a pretty good clip in the card business and it looks like most of the larger card issuers really aren’t seeing that much growth on the year-over-year basis. There is a one company Wells Fargo which is actually growing faster than even you are and of course they have a much smaller loan portfolio.

So what I am curious in getting your thoughts on is they’re growing faster than the industry, faster than you are smaller portfolio but I was wondering how we should think about the competitive landscape as they continue to grow. They seem to be taking more share away from your competitors but at some point I have to believe there is a trickle-down effect to the extend your competitors are forced to spend more marketing to defend share then you have to spend more. So how should we think about that? Are you in such a different target market that really doesn’t affect you? Just your thoughts will be helpful?

David Nelms

Yes, I think that we’ve typically referred to the big six because that includes us because there has been such a big gap between the six of us and the next one. We have increasingly started tracking Wells Fargo to a much greater degree. They are growing faster by rate from a smaller base. And I would expect that to continue. And I think over time we may get to a point where we talk about the big seven as opposed to the big six.

That being said, it’s branch-driven. I think it’s probably a wider credit box than we have, they are not national. So we are not bumping up against them in national Internet and direct mail campaigns to as much degree. We are not bumping in with them with national advertising the way we are with really most of the big six. But still they will, as they take share of the total market they will become more of a player. So I expect that it’s likely to may be impact the other branch banks more because they are following that strategy. But it will also have some competitive impact on us.

Sameer Gokhale – Janney Capital

Okay. That’s a very complete and helpful answer. Thank you. And then the other question I had was you answered the question about industry competition and growth in several different ways. And I was wondering if you think that loan growth for the card industry will ever get to 5% plus level? I mean clearly you are there. But you haven’t raised your target range. But it seems like unless there is a significant pick up in personal incomes or something that makes consumers more optimistic about borrowing more and lenders more willing to lend, I just can’t see that dynamic ever changing with industry growth overall exceeding 5%. So I mean is that consistent with your view or do you feel that at some point we really could see the industry growth overall accelerate? And what would drive that?

David Nelms

Well, I think we could see some acceleration from the really non growth today that we are seeing. I continue to believe that it will accelerate to be roughly in line with GDP. And so low double-digits, may be not 5%. Even a couple of percent growth would be a meaningful change from where this industry has been. And I think what’s driving that is, I think the de-leveraging is largely complete with consumers and competitive changes in the market place.

And then I would expect credit card to grow more with the economy with incomes, with retail sales. And I don’t see – if you look at the times when the industry grew really fast historically it was when balance transfer was introduced or when credit was standard for reduced. And I don’t see either of those trends happening to have a fundamental change going forward.

Sameer Gokhale – Janney Capital

Okay. Then it sounds like we’re on the same page. So appreciate your perspective. Thank you.

Operator

Great. Thank you. And we have no further questions at this time.

David Nelms

All right. Thank you everyone. As a reminder the Investor Relations team will be here this evening to answer any additional questions. Have a good night.

Mark Graf

Thank you all.

Operator

Thank you, ladies and gentlemen. This concludes today’s conference. Thank you for participating. You may now disconnect.

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