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Discover Financial Services (NYSE:DFS)

Q1 2011 Earnings Call

March 22, 2011 5:00 pm ET

Executives

Craig Streem - Vice President of Investor Relations

Roy Guthrie - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Treasurer

David Nelms - Chairman and Chief Executive Officer

Analysts

Richard Shane - JP Morgan Chase & Co

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

Michael Taiano - Sandler O’Neill & Partners

Brian Foran - Nomura Securities Co. Ltd.

Betsy Graseck - Morgan Stanley

Jason Arnold - RBC Capital Markets, LLC

Donald Fandetti - Citigroup Inc

Moshe Orenbuch - Crédit Suisse AG

Bradley Ball - Evercore Partners Inc.

John Stilmar - SunTrust Robinson Humphrey, Inc.

Christopher Brendler - Stifel, Nicolaus & Co., Inc.

David Hochstim - Buckingham Research Group, Inc.

Operator

Welcome to the Discover Financial Services First Quarter 2011 Earnings Conference Call. My name is Christine and I will be your operator for today's conference. [Operator Instructions] I will now turn the call over to Craig Streem, Vice President, Investor Relations. Mr. Streem, you may begin.

Craig Streem

Thanks, Christine. Welcome, everybody. Glad you're with us for this afternoon's call. Let me begin, as always, by reminding you that today's discussion 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 Form 10-K for the year ended November 30, 2010, which is on file with the SEC.

In this first quarter 2011 earnings release and supplement, which are now up 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 explained why these presentations are useful to management and to investors. And of course, we urge you to review that information in conjunction with today's discussion.

Finally, let me remind all of you that we will be holding our annual financial community update tomorrow morning at 8:30 here at the New York Palace Hotel. If you want more information about that meeting, please get in touch with me later this evening via e-mail.

With that event in front of us, we are going to keep this call and your questions, hopefully, focused on our first quarter results and performance. We will have much more for you tomorrow regarding our strategies for growth, and we'll have ample opportunity to take your questions in regard to those strategies and issues tomorrow morning.

Our call this afternoon will include formal remarks from David Nelms, our Chairman and Chief Executive Officer; and Roy Guthrie, our Chief Financial Officer. And as I said, a Q&A period following. Now it's my pleasure to turn the call over to David.

David Nelms

Thanks, Craig. Good afternoon, and thanks, everyone, for joining us. As Craig mentioned, we will be holding our annual financial community update tomorrow morning, so we will keep this conference call focused specifically on first quarter results.

During tomorrow's meeting we will give you a full update of the driver of our current performance and on our strategic priorities for delivering profitable growth into the future. After the market closed today, we reported record first quarter net income of $465 million or $0.84 per share. And we are very pleased to announce the restoration of our quarterly dividend to $0.06 per share, making Discover an early mover to fully restore its dividends to pre-financial crisis levels.

Our first-quarter performance can be attributed to strong results in both of our business segments. In Direct Banking, we earned pretax income of $677 million driven by the ongoing improvement in credit. Our Payment Services segment contributed $43 million of pretax income, reflecting growth of 16% from last year's first quarter.

For the company as a whole, I was very pleased that we achieved net worth volume of $68 billion, an increase of 15% from a year-ago.

Turning now to some of our first quarter highlights for each segment. In Direct Banking, Discover Card achieved sales of $24 billion, which represents a 7% year-over-year growth rate. We continue to focus on increasing our merchant acceptance, emphasizing our reward programs and leveraging our marketing investments to increase sales. Our total loan portfolio increased 3% from last year due to the acquisition of The Student Loan Corporation. We continue to be very excited about the growth potential and earning contribution of our Private Student Loan business.

Based on our first two months of results since closing on SLC, we reaffirmed that we are on track for $0.09 EPS accretion in 2011 related to the SLC acquisition, excluding a onetime related gain.

Looking only at our credit card loans, they were down 3% year-over-year this quarter, an improvement over the 5% decrease last year, and trending towards our expected modest card portfolio growth year-over-year by the second half of 2011. Our direct-to-consumer deposit business continued to grow this quarter as we added a net $1.2 billion in deposits.

In February, we announced our intent to acquire $1 billion in deposits from Allstate Bank, which also includes a multi-year banking product marketing relationship. Subject to regulatory approval, we expect the transaction to close midyear.

Our Payment Services segment turned in another strong quarter with 21% volume growth leading to a 16% increase in pretax income compared to last year. I was really pleased with the growth in PULSE dollar volume, which increased 24% over the same quarter a year ago.

In closing, we're off to a great start for 2011 with record first-quarter profits, the successful closing of a very important acquisition, and the restoration of our dividend to prerecession levels. We look forward to meeting with you tomorrow, where we'll share our model for long-term profitable growth, and the initiatives that will help us to achieve our goals. And I will turn over to you, Roy.

Roy Guthrie

Thank you, David. Before I go into detail on the financial performance, I wanted to comment on a couple of things. First of all, the enhancements that we made to our financial supplement, which I think you'll be pleased with. I mean it's simplified reporting. Now that we are one year past FAS 166, 167, we're not looking back on the settlement adjustments. So as a result, we're no longer going to need the as adjusted numbers in that presentation.

We've also added several new disclosures in the financial supplement to provide more detail in other income with credit metrics within the portfolio and we've added a balance sheet. One of the biggest impacts to the Direct Banking segment reporting, as David said, was the introduction of Student Loan Corp.

So let me begin by his taking you through how SLC impacted our financials. Ration on the deal was about $400 million. That was 91.5% of the loan assets, less the assumed liabilities. The difference between the $30 a share or $600 million announced price is a $150 million payment made to Discover from Citi as a part of the overall transaction. The assets and liabilities were set up on our books at fair market value. More on this in our first quarter Q due out in a couple of weeks. But the key point I wanted to make is that the receivables have been recorded at $3.1 billion, which represents about a $700 million discount to book.

The discount on the receivables will be setup in two buckets. One will accrete in the income overtime based on cash flows, and the other bucket will serve to absorb the expected lifetime losses on the portfolio. For that reason, no losses from this portfolio will flow through our P&L, as long as the losses that are being incurred are in line with the initial expectations that we've made around sizing this non-accretable bucket.

The discount will also be applied against debt of about $270 million and it will be amortized to interest expense over the term of the underlying debt instruments. And there is an indemnification asset of about $100 million that was created, which will wind down over time as cash is received from Citi for the expected losses that they indemnified us for.

We had two months of results from SLC in the quarter, which contributed $30 million in pretax income, including a onetime gain of $16 million related to our consent to the commutation of certain insurance policies. And this was previously disclosed for those of you that weren't aware of that in an 8-K at the closing of the SLC deal.

The Direct Banking segment in total earned $677 million pretax in the first quarter. Recall that in the first quarter of last year, we enhanced our reserve methodology, which had the effect of bringing reserve coverage to a full 12 months of losses and that resulted in a pretty sizable reserve billed and a loss in last year's first quarter of $208 million.

Moving to yield, credit card interest yield dipped three basis points from the fourth quarter to 12.65%. The modest compression here was due to increased level of lower yielding promotional balances, the continued reduction of high rate balances and an increase in customers who pay their balances in full each month.

The impacts were mostly offset by lower levels of interest charge-offs. As mentioned last quarter, we expect further car deal compression throughout 2011 due to the same factors. The degree in pace of the compression will depend upon the rate and composition of growth in the card portfolio over the course of the year. And certainly total portfolio yield, which declined 14 basis points sequentially, will be influenced by now the SLC receivables and the growth of that over the course of this year.

Net interest margin for the Direct Banking segment including student loans and personal loans was 9.22% down six basis points sequentially, reflecting the acquisition of student loans and a modest decline in the credit card yield I just referred to. This was partially offset by ongoing lower funding related costs associated with lower levels of cash and liquid assets. We expect the net interest margin to continue to decline and likely at a faster rate than you've seen here in the first quarter, as loan yield compression outpaces the improvements in funding costs and lower charge-offs in the interest line.

Other income which was $6 million up over the prior year included the $6 million gain I mentioned related to SLC. So recurring revenues were down about $10 million year-over-year, and this was driven by lower fees from the CARD Act implementation.

Moving on to operating expenses, we will continue to spend a bit more aggressively as credit improvements allow, particularly for the opportunity to accelerate investments in growth. And you can see this in the significant year-over-year increase in the marketing line.

Total operating expenses for the segment were up $115 million over the prior year, again primarily related to the increase in marketing but also due to our professional fees from collections activities, the inclusion this year of SLC in our results, to mention just a couple. We recorded a onetime credit of $23 million a year ago related to the resolution of our dispute with Morgan Stanley over our Visa/MasterCard settlement issue.

Turning to our portfolio, total loans were up 3% from the prior year due to the acquisition of SLC and again partially offset by lower credit card loans. Credit card receivables decreased 3% from the prior year. However, as you heard David say, we are seeing stability in the portfolio and expect modest growth in the second half of 2011.

In terms of credit performance, card loans greater than 30 days past due dropped 47 basis points sequentially to 3.59%. The card net principal charge off rate decreased almost 100 basis points sequentially to 5.96%. Based on a continued positive credit card performance and the outlook we have for future losses, we released $271 million of reserves for the quarter.

The reduction in the reserve rate and the 30-day plus day delinquency rate for credit cards, those two rates were right on top of each other, if you look at their movement on a sequential quarter basis. And so delinquency continues to be a very good benchmark for the way we're reserving the portfolio.

Personal loans increased $573 million year-over-year as we expanded further into the broad market. In terms of credit performance, personal loans greater than 30 days past due dropped 37 basis points sequentially to 1.20%. And the personal loan net charge-off rate decreased 60 basis points from the fourth quarter to 4.10%. Private student loans increased $3.8 billion compared to last year, again driven by the acquisition of SLC and new originations including $500 million from the combined business in the first quarter, new originations from the combined business in the first quarter.

In our financial supplement, we refer to the acquired portfolio as purchase credit impaired or what I will refer to here as PCI loans, which is the way GAAP characterizes a loan portfolio acquired with a balance of non-accretable discount designed to cover loan losses. So as I mentioned, losses on this PCI portfolio will flow to this non-accreting discount rather than through our P&L. And so as a result, we'll give you measures of loan portfolio quality with and without PCI loans.

Yield on the private loan portfolio increased 222 basis points compared to last year, and this increase in yield was primarily due to the addition of the SLC portfolio. In terms of credit performance of the private student loan portfolio, the 30-day plus delinquency rate was 72 basis points and this excludes the PCI loans. We do need a charge off data for student loans with and without PCI loans, the charge-off rate for student loans excluding PCI was 29 basis points on our Discover originated loans. And you should keep in mind that this portfolio is quite young with very small portion of it in repayment.

Both credit metrics I just discussed decreased sequentially, and this is a result of an increase in the denominator, as we added roughly $500 million of new originations from the combined platform in our first quarter. Shifting gears to the Payment Services segment, pretax income was $6 million or 16% from the prior year to $43 million as you heard David say, a record quarter for our Payment Services business as our PULSE business drove revenue from volumes much higher year-over-year.

2010 was a successful year for the Payment services business, a record year for them, and I think this quarter really represents a great start to what we hope is going to be another great year for our Payments business.

The effective tax rate for the company came in at 35%, lower than recent quarters as we settled a few open returns at the state level and released associated reserves with those settlements. Over time, I would guide you back to an effective tax rate in the 38% to 39% area. Our liquidity position remains very strong, looking forward to second quarter of 2011, the next quarter out, at about $5 billion is the highest maturity quarter over the next 12 months.

At the end of the first quarter, our liquidity investment portfolio totaled $10.3 billion, up slightly from the prior quarter, but down from $12.7 billion a year ago. Including these assets, our overall contingent liquidity has increased $24.7 billion as we brought on additional multi-year conduit capacity from partner banks this quarter to begin to balance the flexibility and economics of various means of providing contingent liquidity.

As it relates to funding, we're pleased with the strength that we've seen on the direct-to-consumer deposit business and remain opportunistic across not just this but all of our funding channels. And just after the quarter ended, we closed a $1 billion floating rate, three-year ABS transaction priced at one month LIBOR plus 35 basis points. This represented our largest non-TALF public transaction since October of 2007 and the tightest spread on a Class A floating rate tranche since the Master Trust was enhanced to be able to issue delayed issuances in 2007. So I think it's a benchmark transaction and indicative of the help of that channel for us. Proceeds of these transactions are going to reflected, as I mentioned, in our second quarter.

Our first-quarter capital account was very strong, tangible common equity to tangible assets was 10.2%. We're pleased to announce the increase in our quarterly dividend to $0.06 a share from $0.02 a share, representing a full restoration of our dividend. Even after this, I think meaningful first step in returning capital to our shareholders. Our capital account leaves us well-positioned to invest opportunistically across our existing businesses to consider opportunities that present themselves in the marketplace and return additional capital to our shareholders including through the use of overtime share repurchases.

So as David said, this was a strong quarter in terms of profitability, in particular credit performance, and further progress in the strategy, more on the strategy tomorrow. But this quarter was also the fourth in a row which we've now exceeded our 15% return on equity target. And clearly this quarter we're above 15%, even excluding the benefit of the reserve release I talked about.

Tomorrow we're going to be going into a heavy focus on the plans and the strategies for the future, and we'll be available to answer questions on other topics. So now I look forward to seeing everyone tomorrow, but I'm going to turn it back over to Christine for our question-and-answer period.

Question-and-Answer Session

Operator

[Operator Instructions] First question comes from Betsy Graseck from Morgan Stanley.

Betsy Graseck - Morgan Stanley

I just wanted to dive in a little bit to the loan growth that you got in the quarter. I know you talked about some of the strategies that you employed to do that. Could you give us a sense as to how much balance transfer added to that, and what other strategies were successful in the quarter?

David Nelms

Sure, Betsy. I'd say the first thing I'd point you to is the sales growth. That increased 7% year-over-year. And if you take that higher sales growth and the lower charge-off, I think those two things were a major factor. Balance transfer continues to be much higher this quarter than it was ago. But I think it's less of an impact sequentially in terms of any increase. And I'd say we're going to talk more about this tomorrow but a big part of our focus is gaining market share and wallet share from existing customers, leveraging our cash back bonus, our service, and our value. And we obviously seen us do a lot more brand marketing, sponsoring the Orange bowl et cetera. So it's no one single thing, but certainly I would not isolate balance transfer.

Betsy Graseck - Morgan Stanley

And then separately, can we talk a little about the type of capital ratios that you're mentioning to over time. I understand there's opportunities to acquire different kinds of portfolios. Could you discuss what type of capital ratio you're looking to manage to eventually. And I know you alluded to buybacks, could you just give us a sense as to at what point you start giving buybacks as opposed to the more acquisitive activities.

David Nelms

Sure, Betsy. What we say is that we've been, if anything, consistent around the way we feel like we should be capitalized. And we really haven't changed through this crisis what the feelings are on that. Today we've talked about an 8% TCE target and obviously we have a tremendous amount of respect for the requirements around the regulatory targets. But in terms of the way you think about loss absorbing capital, solvency through the cycle, all those sorts of things, it's going to be in that 8% TCE range, which does create at 10.2%, some options and alternatives that we have available to us as we sit here today.

Roy Guthrie

And then let me just add, we'll talk more about this tomorrow at Investor Day. But we would certainly prioritize profitable organic growth and then probably attractive acquisition targets. And then after that we think about dividends which you obviously you saw us take action on now, as well as buybacks. We're not at the point of having a buyback program in place. But it's certainly something we are likely to consider later this year.

Betsy Graseck - Morgan Stanley

Okay. Because you could say you want to get to 8% over the course of the next couple of years or you have your eye on a couple of potential opportunities, that if they don't pan out then you start to buyback stuff. I'm just trying to understand how you -- what's the catalyst to getting to that 8% if organic and acquired growth isn't occurring at the pace with which you need to get down to 8% by a certain period of time.

David Nelms

I wouldn't want to give a set time frame at this point. I mean we're very pleased that our ratios improved this quarter even after doing the largest acquisition we've ever done. And so we take note of that. But I don't think there's anything magic, we're continuing to earn a very strong ROE, even with the high levels of equity we're carrying right now. But we're going to want to keep our options open, we're going to evaluate this. And over the course of the next few quarters, I'm sure you'll see us take additional actions to hopefully move a little closer to that target.

Operator

Your next question comes from Michael Taiano from Sandler O'Neill.

Michael Taiano - Sandler O’Neill & Partners

Roy, I apologize if I missed it, but the $700 million discount on the SLC portfolio, did you give the breakout between, was it accretable or non- accretable?

Roy Guthrie

I did not, Mike. And I think it's a little bit of a blur here, there maybe additional disclosure on that in our Q. But I think we'll have to get back with you on that. What's important perhaps, and it might be worthwhile just taking a moment now that you teed this up, is making sure everybody's comfortable with the three components that I outlined. And the transaction itself was an 8.5% discount of $3.8 billion in receivables so we can all do the math on that, we get about $325 million. It broke into those three components: included $700 million of discount, an asset of $100 million due to indemnification, and a premium on the liability of $270 million. So you're going to see all of it but the non-accretable portion that you just asked a question on, find its way into income. But the reality of course is that by absorbing those losses, it shields the P&L from that and is a form of accretion. So I would almost sort of guide you to think about this, almost as all of it one way or another finding its way back to the P&L, one in the form of deferring loss or deflecting losses from entering the P&L, the other's from systematically being introduced as cash flows systematically find their way through the quarters. You got a lot more than you were looking for there. I just wanted to make sure in abundance of caution, that no one walks away confused about that $700 million.

Michael Taiano - Sandler O’Neill & Partners

I mean, it sounds like, it's really, you take the $700 million and you have to subtract off the $100 million and $270 million and that will get you to the number of which some portion is a non-accretable discount.

Roy Guthrie

That's right.

Michael Taiano - Sandler O’Neill & Partners

On the same sort of topic, you mentioned the amount of loans that are in repayment. Obviously, those are probably most relevant from a credit standpoint. Do you roughly have sort of the numbers in terms of both your organic portfolio as well as SLC in terms of how many of those loans have repayment at this stage?

Roy Guthrie

The largest portfolio is the Student Loan Corporation portfolio and about 75% of that is in repayment. So we've got some good history there. I'd say for our own loans, it's a very low percentage have entered repayment. Most of those loans have been acquired in the last three years.

Michael Taiano - Sandler O’Neill & Partners

Just last question, just curious to what extent gas prices helped in terms of volumes this quarter. I know that the big spike came towards the end but I think on a year-over-year basis, it was still up pretty significantly. Can you give us some color on that?

Roy Guthrie

Yes. They did have some favorable impact on sales. But we have been running about 5% or so each quarter. And this quarter we jumped up to 7%, maybe half of that increase could have been gas related. But even if you back out the price of gas, it was a bigger increase over this quarter versus the previous four quarters, each of which have had good solid growth. And I'd say further more in the last six weeks, the growth has picked up even further. And even that is not all the recent gas increase so we're seeing some pretty favorable trends on sales.

Operator

[Operator Instructions] The next question comes from Sanjay Sakhrani from KBW.

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

I had a question on the margin, the net interest margin. Roy, you talked about the margin coming down going forward at a little bit of a faster rate. And I was hoping you could just walk us through the pluses and minuses because I thought there might be -- is it just mix shift related, or is it on a core basis x the acquisition? And then just on a question asked before on capital management, I just was wondering, that 8% TCE, was that part of your -- was that included in your capital plan submitted to the Fed?

Roy Guthrie

Let me take them in reverse order. There's obviously as much transparency there as there is here, and that's always been our target. So you should probably count on that being front and center in terms of the way we deal with all audiences in terms of setting TCE targets. In terms of the yield, I think that the components of this are the same rubric that we've sort of been dealing with really as we've sort of gone through this discussion over the course of the last five quarters. There's a [indiscernible] default bucket that obviously post-CARD Act is not being reinitiated. There are varying degrees of promotional balances that are being introduced to the program. I think Betsy talked about that, you heard David's comments regarding the use of promotional balances among other things to sort of grow the business, there is the suppression. I learned that word from you guys. But the reduction in charge off interest that occurs as charge-offs get smaller. The suppression that occurs within the finance charge line also gets smaller. There are obviously repricing aspects due to CARD Act that began here this month and the month of March as we move forward that will inevitably put some pressure as repricings are pursuant to the CARD Act's specification for repricing accounts that would warrant that downward to their original point. And then there's the usual construct of other forces in the market around revolve and non-revolve. And so one of the things that we struggle with here a little bit, just to be frank, is giving you guys precise answers when there's I think initially when so many things were being governed and dictated by CARD Act, it was a little bit more -- we could be a little bit more prescriptive around, here are the various things that we're looking at. But again obviously, it's a rubric and it's a dynamic market. And to be frank, some of these things have gone at a rate and pace that actually has impressed us, in particular the credit improvement that we've seen over the last quarters. So as we look forward, as I said, I think that, that nets to a headwind. And we're sort of continuing to signal that so there's room for this thing to move downward but the reality is our business model doesn't need this level of finance charge income to be effective. And so it's not a concern to David and I that we have that headwind pressure on us although it's something that we're going to continue to manage. And I don't think we're going to be any more articulate in exactly what the magnitude of that's going to be, but rather you're just going to see that headwind, that net headwind, from all those headwinds and tailwinds continue to be a force that we're dealing with.

David Nelms

One thing I might add to be helpful, that I'll be mentioning tomorrow, is we do expect that 8.5% to 9% is a more normal range for us, and we're obviously above 9% today and so we do expect it to decline over time to that kind of range.

Operator

The next question comes from David Hochstim from Buckingham Research.

David Hochstim - Buckingham Research Group, Inc.

On the loan acquisition, right now it's basically at about $14 million of income pretax for the two months. So $21 million for the quarter and that's kind of a run rate, balances stay down, but you still got accretion coming in faster.

David Nelms

That's roughly right and we would expect to reaffirm that we expect about $0.09 accretion from that acquisition during the course of this year.

David Hochstim - Buckingham Research Group, Inc.

Just to clarify again what Sanjay was asking about, could you give us some sense of how much intro balances increased in the first quarter of this year versus the fourth quarter of last year, and how much you expect that to be increasing as part of that margin change?

David Nelms

We're going to show statistic on that tomorrow. But it's a little bit north of 10% now I think probably closer to 12% but we'll show you what we expect over time.

Operator

The next question comes from Brad Ball from Evercore Partners.

Bradley Ball - Evercore Partners Inc.

Roy, in terms of the effective tax rate this quarter, I think you guided to expect to gradually return back to the 38% to 39% level. Does that mean that some of the benefits this quarter related to the state tax matters will carry into future quarters or will we jump back up?

Roy Guthrie

Yes, that's right, Brad. This is the blessing that we all got from FIN 48 around states, where basically it stays symmetrical the way you need to provide but once you resolve the matter, the carry on that state goes down as well. So I do think it takes a little pressure off the carry as well as the reserves that were settled apart of it. Now it's not a big thing, there are three states, one happens to be a big state. So it's maybe three out of 50 is not representative. But it is a little bit of a relaxation on the future carry. So thank you for bringing that question up. That's why I guided a little lower to 38%, 39% rather than 39% plus minus.

Operator

The next question comes from Brian Foran from Nomura.

Brian Foran - Nomura Securities Co. Ltd.

When we think about revenue suppression or the finance charges billed, but deemed uncollectible, I mean are we at a normal run rate now or are we at a cyclical trough. How should we think about where it's running relative to history. And then also what would correlate with it further declining and/or increasing in the future? Would it just be the direction of delinquencies or should we watch something else?

David Nelms

I would say we correlated it closely to charge-offs and at 5.9% charge-offs, we're still on the high end. So I would expect that this would still have some room to run in terms of some more benefit for reduced interest charge-off as the charge-offs stabilize. But as Roy indicated, that's one reason we expect the net interest margin to kind of decline a bit because we've already seen maybe a fair amount of that normalization already occur.

Brian Foran - Nomura Securities Co. Ltd.

If I could ask one follow up -- funding cost? The LIBOR plus 30 or 35 ABS deal seems like most of your CDs are now being priced below 2%. How should we think about future funding costs? And is that improvement baked into the 8.5% to 9% NIM guidance or our current funding markets more favorable than you would budget it for?

Roy Guthrie

Well I think David's 8.5% to 9% was more of an over- the-cycle. So please exercise some caution if you drop that into the next three quarters. I think there is a good tailwind and we have residual pools of liabilities that were created prior to the Feds sort of movement down to 25 basis points of Fed-effective target. So we've got maturities over this year and next that are going to be a significant tailwind for us. And the longer the rates stay where they are today, Brian, to your point LIBOR plus 35, all the deposits being raised under two. That's going to be a nice piece of support for the net interest margin. With that in mind, then we sort of say that there are a lot of offsets to these other things that I sort of countered as headwinds. But there really is a great tailwind coming though from the liability and funding costs.

Operator

The next question comes from Moshe Orenbuch from Crédit Suisse.

Moshe Orenbuch - Crédit Suisse AG

Thanks for the disclosure on the fee income. I was wondering if you could kind of round that out a little bit because if you look at the revenues from interchange, they're kind of flattish year-on-year and you've got some pretty significant growth in volume and even if you add in the transaction processing revenue, still kind of in the three-ish percent area, significantly slower, could you kind of reconcile that, see if there's either contras to that or other categories that aren't in there?

Roy Guthrie

The big contra is cash back bonus. And we are doing more promotional cash programs, and that's part of what's driving the sales activity and the receivables up so I'd say that's the biggest contra there.

Moshe Orenbuch - Crédit Suisse AG

So it's like the 5% promotions type thing? Or...

Roy Guthrie

It's all of our programs. But in particular, yes. The 5% programs and our other cash awards programs.

Operator

The next question comes from Don Fandetti from Citigroup.

Donald Fandetti - Citigroup Inc

David, I was curious during the quarter we obviously got some proposed rules from the Fed around exclusivity and I wanted to know kind of what your thoughts are on that in terms of Discover.

David Nelms

I would say that we're closely following this. As you know we are not a debit issuer ourselves so interchange is a pass through for Discover and for PULSE. But I'd say that it seems like in the last month or two, things may have gotten a little more uncertain. And I wouldn't want to speculate on the full outcome whether there will be a delay or not, whether there'll be a change on the proposed or not. It would be pretty speculative. I would say we're focused on being prepared for whatever the outcome is and in particular on the routing rules, I am hopeful that regardless of the outcome that some large issuers may conclude that they are smart strategically whether required or not to maybe split their signature and PIN volume. And if they start doing that, I think PULSE is one of the networks that's well positioned to pick up some gains. And so we're in particular, focused on that. Ultimately we believe in competition as the answer, and we would like to be one of the competitors that provides that to the marketplace.

Operator

The next question comes from Rick Shane from JP Morgan.

Richard Shane - JP Morgan Chase & Co

One quick question. When we look at discount at interchange revenue, could you give us the breakout. It does not increase nearly as much as the volume does on a year over year basis, what's the disconnect there, just so we know?

David Nelms

You might have missed the earlier answer, but it's really cash rewards program, and cash back bonuses that contra revenue. And we have certainly ramped up that program as we continue to gain share.

Operator

The next question comes from John Stilmar from Sun Trust.

John Stilmar - SunTrust Robinson Humphrey, Inc.

Just a follow-up on the topic of spending velocity. You have highlighted the spending velocity continues to exist past the February 28 reporting time line. And I'm wondering how much of that is macro, sort of improved economic activity, how much of that is improved effectiveness of cash back marketing, and potentially how much of that effectiveness potentially could come from several large issuers abandoning rewards based debit products. I know that's not all since February 28 but it seems like momentum at least since last quarter on the velocity of card sales volume has picked up. And I'm wondering if there's any sort of statistical or anecdotal or detailed evidence that we can kind of glom on to.

David Nelms

It's very difficult. It's sort of proving how well your advertising is working. I would say on the third hypothesis, I don't think we've seen that yet. We've seen some recent announcements on debit rewards cards going away and so on. But in my opinion there's been very little actual impact to date. So then you get down to what's our marketing and what's the economy. And I believe that it is a mix. I can't tell you whether there is 50/50 or what the number is, but I can tell you we've certainly picked up our marketing spending. We think that our spending is going further with some of our new things like the Discover Orange Bowl and some of our cash rewards programs that we think are giving us really good payback. But certainly, I think we're also picking up some -- the economy is also helping us as well.

Operator

Next question comes from Chris Brendler from Stifel, Nicolaus.

Christopher Brendler - Stifel, Nicolaus & Co., Inc.

Just on credit for a second, it seems, just to be astoundingly good on the credit card portfolio, delinquencies continuing to fall in a seasonally weaker period. Can you talk about if you see any stabilization improvement at some point later this year, how much better was this quarter's trend versus your expectations? And did any of that run through the income statement this quarter and sort of release suppression? And does that fall from here?

Roy Guthrie

Well, I'd say we have been pleasantly surprised. I think about a year ago we really started focusing on new loss of jobs as opposed to the overall unemployment rate. We talked about that before but that seems to be a big driver that the credit is outperforming what one would expect versus the overall unemployment rate. We think that this has some room to continue, to normalize. At some point, it will start slowing down in terms of the improvement and I think it's a bit of an open question as to whether it kind of overshoots or goes to a new normal -- that's a lower level or not. Clearly, one of the things that's happened is we were very careful going into this crisis. A lot of people got pushed over the edge from unemployment or housing prices. And a lot of those losses, though have already been recognized. And so increasingly what we're left with is people that actually survived through this really tough perfect storm, if you will. And so we're seeing the backside of that now. And frankly we've never had such a severe shock to the system. And so it's a little bit hard for us to tell how good it's going to get on the other side. And so we're pleased and we clearly are going to have some continued improvements through this year.

Christopher Brendler - Stifel, Nicolaus & Co., Inc.

Is it fair to say that at this point that you're not seeing any signs of the improvement slowing down, and if you had to guess, losses are probably going below the law of average?

David Nelms

If you look at the sequential improvement, it doesn't show any sense of slowing down yet. But clearly, it will start slowing down and I would expect that over the coming quarters, the quarterly improvement on delinquency and charge-off rate will start to moderate -- will start to approach whenever the trough is.

Operator

This last question comes from Jason Arnold from RBC Capital.

Jason Arnold - RBC Capital Markets, LLC

Just curious if you could give us some additional detail on the other income line. You mentioned at onetime gain of around $16 million, but were there other identifiable nonrecurring items?

Roy Guthrie

Yes, Jason. I think as you look at the first quarter, $16 million is probably the one thing I would point you to. Unfortunately when you look to the quarter that preceded it, there's a few more in there. I mean, clearly other income back there had the influence of the -- I think we had a $28 million charge we took to position the federal loan portfolio to held-for-sale. We had some other enhancements or things that were being run through there, $10 million or $12 million. So if you look at the swing it's not necessarily in this quarter and I think if you take the $16 million out of the $65 million in that other income number, I'd say that's probably a good benchmark. And maybe not to throw past out, but I think the past is chock-full of a lot of issues that's a volatile line, in particular fourth quarter of last year to first quarter of this year. So $65 million, excluding the $16 million onetime gain I think is a pretty good guide of the things that we would expect to see there on a recurring basis. And there'll be a commentary around this in the Q that's out in a couple of weeks that supply additional detail.

Operator

That concludes the question-and-answer session for today. I'll turn the call back to Craig for final remarks.

Craig Streem

Thanks, Christine. And I want to thank all of you for your attention and your questions this evening. And we're certainly excited about tomorrow's meeting, and looking forward to seeing you there. Have a good evening.

Operator

Thank you for participating in the Discover Financial Services First Quarter 2011 Earnings Conference Call. This concludes the conference for today. You may all disconnect at this time.

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