Discover Financial Services Presents at Bank of America Merrill Lynch Banking and Financial Services Conference, Nov-16-2011 09:50 AM

| About: Discover Financial (DFS)

Discover Financial Services (NYSE:DFS)

November 16, 2011 9:50 am ET


David W. Nelms - Chairman and Chief Executive Officer


Unknown Analyst

Kenneth Bruce - BofA Merrill Lynch, Research Division

Kenneth Bruce - BofA Merrill Lynch, Research Division

Our next presentation will be by David Nelms, the CEO of Discover Financial. Discover, of course, is one of the leading credit card issuers in the U.S. and a growing provider of private student loans. 2011 has been somewhat of a breakout year for Discover as one of the best-performing financial stock, with their stock up about 35% year-to-date. Discover, like other card issuers, has witnessed a significant improvement in its underlying credit performance and has been aggressively positioning to grow its core credit card and student lending businesses.

David will run through an update for Discover and take your questions. David?

David W. Nelms

Thank you, Ken. I was asking Ken how the conference is going, he's like, "Oh another one is upbeat," so I'll try to be a little bit more upbeat than some of the other presentations you have heard about, and certainly excited about our story and thank you for attending.

I'll start with the required disclosure, Safe Harbor and legal disclosures that are in your packets and move on to our first slide, with the overview of our company and -- at Discover, our goal is to leverage our unique assets and capabilities to become the leading direct banking and payments company.

First on the Direct Banking side, let me start with our core card issuing business. We now have $46 billion in card receivables, the leading cash rewards program and a loyal prime customer base with penetration in about 1/4 of U.S. households. And by leveraging our brand, our customer service capabilities, our unsecured lending skills, we're -- have been expanding into other businesses in Direct Banking. Most notably, private student loans and personal loans have accelerated growth and diversified our revenues. And you can see, compared to last year, that is changing a lot, we've got $7 billion in student and personal loans, that does not include the $2.5 billion that we just closed on during the course of this quarter. I'll show another slide that includes that. But also, we have increased to about $24 billion in direct-to-consumer deposits. Now are the leading source of funds in the company is the growing source of customer relationships as we also have served their savings needs.

On the Payments side of the business, we have Discover Network with over $100 billion of volume including not only the Discover Card, but a number of other issuers. PULSE, our PIN debit network has over 4,400 financial institution customers and almost $140 billion in volume. And Diners Club International, which provides an acceptance platform for global acceptance.

2011 has been a great year for us. We've got all-time high sales volumes, all-time low delinquency rates and the reemergence of organic growth in credit cards. This strong performance in sales volume and receivables growth has been driven by our continued focus on rewards, service and value. We've also enjoyed the tailwind from ongoing increases in merchant acceptance and very effective advertising campaigns and sponsorship.

And in addition to organic growth, we've enhanced our earnings potential with 2 important acquisitions. First, we closed on the Student Loan Corporation on December 31, which added almost $4 billion in private student loans and added capabilities of a company that's been around in the student loan business for 50 years. Further, this acquisition gave us a considerable amount of data and a larger reach by adding new schools to our distribution. Second, we closed on the acquisition of the $2.5 billion in additional loans, I just mentioned. These loans were purchased from Citi, but were originated by the Student Loan Corporation team that we have bought earlier, so we know these assets well. These acquisitions and growth in personal loans make our mix of non-card assets to nearly 20%.

In terms of funding, we are now over $25 billion of direct-to-consumer in September as our direct-to-consumer deposit business continues to grow robustly. I think we have had over $1 billion of growth every -- just about every quarter since our spinoff when we started with about $3 billion in direct-to-consumer deposits in '07. Dramatic improvements in credit performance have helped us earn an ROE through the year, much higher than our target. And even excluding reserve releases, we are above our 15% target, and even with carrying a substantial amount of equity.

We do remain focused on capital liquidity and funding. We announced a dividend increase in March and initiated a share repurchase program in the third quarter where we repurchased 1.5% of our shares outstanding in that first quarter of our program.

We are working toward extending our momentum by focusing on a number of key priorities. For Discover Card returning to growth, which we achieved in June of this year driven by gaining wallet share with our existing customers as well as by increasing the number of new accounts. We also continue to leverage our proprietary network, both the growing merchant acceptance as well as high-impact cooperating -- co-op marketing with key merchants. For student and personal loans, we have a number of priorities. In student loans, clearly, our top priority is integrating our acquisition of the Student Loan Corporation, which is progressing very well. And in personal loans, we want to continue generating strong returns as well as focus on expanding into new categories. We continue to leverage the direct-to-consumer deposit funding channels to provide liquidity, and we now have an even greater focus on optimizing the cost, now that it is up to over 1/2 our total funding.

In payments, we're responding to a substantial number of RFPs, the new PIN debit relationships. And while it's too early to tell what the ultimate impact will be to our business, we feel good about Pulse's competitive position and ability to continue gaining share. And lastly, we're going to leverage our strategic partnerships to continue to build out our global network.

We shared in our investor conference earlier this year our long-term growth model, both on asset growth and EPS. And we've targeted EPS growth over time of 10% to 15% and asset growth of 5% to 10%. And this may differ quite a bit from other financials that you may have seen and hopefully, it's a little more upbeat than others. But I think it works well that we are targeting Direct Banking, which I think is going to be the growth part of banking, as over the coming 10 or 20 years you're going to see more and more consumers getting their financial services direct in a way that is better value, better service and can be service with lower cost without the expense of branched networks.

The column shows receivables growth targets across asset classes, the card growth range of 2% to 4%, we actually achieved 2% for the first time this last quarter, so we are now in that range. And we expect EPS growth or contribution of 3% to 4% from there. Other consumer lending, we expect much higher growth and we have targeted 20% to 25%, obviously, with the acquisition, we're far in excess of that this year and probably we'll come back and relook at those measures as we come into the next investor day since we have a much larger starting point, but we expect to have significant earnings growth and contribution from that. And we announced, at the time of the acquisition, the immediate accretion in earnings per share.

Our other -- we also continued to grow personal loans products, and all of these things should allow us to grow the EPS in excess of 10%. And then given our targeted TCE ratio of approximately 8%, we'd expect that 15%-plus ROE to be continued.

Two key attributes of our card business: our very attractive customer base and a powerful brand. Our card member base reflects the highest average tenure in the industry, our portfolio is well balanced between transactors and revolvers with very strong demographic characteristics, as you can see on this slide. Discover created the cashback rewards product and continues to be the leader based on outside research, and this position of leadership comes from the consistency, simplicity and integration as a result of over 20-year focus on cash rewards, experience and innovation.

We've got large direct merchant relationships where merchants fund additional rewards, to drive more value for our cardholders without costing us more on our P&L. And then most of all, a superb customer experience and continuous innovation which continues to drive customer engagement and low attrition.

The top right chart shows the percentage of primary customers for each card brand who associate their brand with having the best cash rewards program, and you can see, we've got the strongest position. And among households that have a cash rewards card, we have the highest share despite more competitors entering cash rewards. We are showing strong growth in new accounts despite the additional competition in cash rewards and, in fact, our average cost to acquire new accounts this year is about 10% lower than it was last year.

In addition to cash rewards, Discover has been recognized for outstanding customer service and satisfaction in service. These are validated by numerous outside surveys, we've included 2 here: J.D. Power and Brand Keys. You can see on the left that we were nearly tied with AmEx for overall customer satisfaction. Brand Keys, we edged out AmEx by a good amount on customer service, and we continue to focus on being significantly stronger than our most significant competitors, which are the various bank cards that have much lower levels of satisfaction, service and retention.

And that is helping us with the lowest attrition rate we've seen in over 10 years, and it's one of the reasons that we're 1 of only 2 competitors who are actually growing credit card receivable, you start by not having to charge them off and lose them through attrition, and then you don't have to build -- put quite as many accounts on to grow your program.

Further, our ongoing improvements in merchant acceptance provides a tailwind that adds to our sales volume and receivables growth. You can see in that in our continuing year-over-year increase in active merchants outlet. Our customers are using their Discover Cards at more places in the last 4 years because there's a lot more places that now accept Discover. And not only here in the U.S., but increasingly abroad. One of the success of these efforts has showed that we've increased the number of our most loyal customers. These customers who use their cards 15x or more a month have been steadily increasing over the last 2 years, which is helping our sales and receivables.

Looking at our first 2 months from our fourth quarter, overall card sales volume continues to be up about 8%. Even with a little bit of a drag from declining gas prices, with I actually view as a good thing from a credit and a from a consumer perspective, but obviously, gas is, call it, 10% of total sales. So you do want to look at gas, the gas prices will somewhat impacted overall bottom line, but our consumers are continuing to spend on Discover Card.

We've become a more assertive brand as you may have -- and the several -- noticed several new Discover partnership. I'm not going to play you the Peggy commercial but no doubt, you've seen them, they're quite talked about in the industry and have been testing better than any of our campaigns in many, many years and better than our competitors' programs whether issuers or networks.

We've also selected a number of partnerships that are very relevant to our customers such as college football, including the Discover Orange Bowl, which we'll have for the second time this year, and the National Hockey League, where we are the official card. These are not only increasing awareness of our brand, but also provide opportunities for customers to experience the brand.

Now to sum up our U.S. Discover Card business, we believe we are very well-positioned for profitable growth. Our business model has the resilience to deliver a pretax return on assets at 2.5%-plus, and a return of equity at 15%-plus on a sustainable basis. Our biggest opportunity and our priority for growth is to increase our wallet share with existing Discover Card members, and we're going to continue to do this by leveraging the strength of the Discover brand, our leadership and service and rewards, our unique merchant partnerships, as well as the specific tailwind from our expanding merchant acceptance, all driving towards increase in usage and wallet share from existing customers, even as we increase the number of new customers we're also attracting. And you can see on all the key measures, we've outperformed our competitors over the last several years.

Let me move now to Private Student Loans and I'm going to spend a little more time on this, because this is maybe the area that has changed the most for us over the last year. We expect the market to show good long-term growth as student enrollment and education costs continue to rise. Secondly, college and university students have attractive demographics, upwardly immobile and mostly new to Discover, this allows us to establish an early relationship and build on it. Our underwriting approach leverages the capabilities that have driven our strong performance in credit card. You can see, we've dramatically grown our portfolio to over $7 billion, starting from the ground up in '07 through the acquisition this year of the Student Loan Corporation, and as well as the acquisition of the additional $2.5 billion in student loans that we've shown on a pro forma basis here that will be reflected in our fourth quarter results.

The inorganic growth has been significant and is expected to be highly accretive to earnings, as we previously announced. Additionally, for the inorganic growth, we have increased our percentage of loans in repayment, you can see it's up to about 60% and that means that as we've acquired more loans that are more mature loans, we have a lot of history, about half the loan losses in student loans tend to happen in the first 2 years after graduation and repayment begins. And so we have a good handle around what the long-term credit performance should be on these loans.

We are now in the preferred lender list at over 1,100 schools. We are typically not in the for-profit schools and we're not in all of the other schools. And so as a result of the combination of our Discover Student Loan business and our acquired business, we have a very significant distribution. We've moved from the #5 originator of private student loans to a top 3 originator in 2011.

Education has proven to be a valuable investment as it results in higher income and lower unemployment, which is a good thing when it comes to unsecured loans. Data from the Bureau of Labor Statistics show that this is true, as the unemployment rate for people with a Bachelor's Degree or higher was -- is right now only about 4%, even with a 9%-plus overall unemployment rate.

Our delinquency rate on private loans ticked up a little on the third quarter, primarily due to seasonality and you saw the same thing last year as students first enter repayment and we make sure we have the right new address, and then we get them on the normal payment plan. But as I mentioned, a lot of the losses occur in the first 2 years, and we compare very favorably to the market leader in this space, who is Sallie Mae, you can see our results for the first 2 years vintages, we come at this with very different underwriting skills and capabilities, and we are more targeted in terms of schools and underwriting.

But the thing that's not shown here is public schools. And we have a tough time putting those on the same basis. But order of magnitude, federal loans, currently have about 3x than the default rate than private loans and that's for the industry as a whole. And it's no surprise that, that's the case. I mean, our program has a higher -- high cosigner rate and generally, the government loans don't require a cosigner. We have high average FICO scores, generally, government loans don't even use a credit bureau. We focus on 4-year not-for-profit colleges and graduate schools. A lot of the noise you've heard recently in federal loans has come from the for-profit schools that we don't market to. And like the college, the federal program still [ph], 100% of our loans, our current schools certified, 100% are disbursed through the schools, so we know that is going to be used for education so that we get the students coming out with a good job, with a high income and the ability to pay these loans back.

Our Private Student Loan business is on target to deliver very solid results. We are targeting, this year, net receivable growth of nearly $1 billion. We have a strong pipeline of repeat business as most students end up taking that multiple installments within each loan as they move from freshman to sophomore, et cetera, so we've got repeat business. Our private loans are priced competitively but also generate attractive margin. We are starting to enjoy some of the operating efficiencies as we build up the portfolio to a significant scale in size that will continue to be an opportunity for us over the coming year or 2. And we are also increasing our marketing to both our card customer base and to new affinity partnerships. Looking ahead, we do look forward to continue to target a pretax return on assets of about 2.5% in this business. Largely because the loan-loss provision and the operating expenses are much lower than what we see in the Credit Card business.

Personal loans, is the other area of non-card direct lending, where we are generating good growth and very strong return. It's a natural adjacency to us and a great business for us. We've leveraged our excellent credit risk management capabilities to deliver a debt consolidation product with great value and service. Roughly 2/3 of our personal loans today are to existing Discover Card members. This number is expected to continue to edge down over time as right now we're targeting the mix of about 50-50, 50% cross-sell, 50% new customers. And our -- but the thing is our broad market originations, are also by invitation only. So you can't just go to the website and come to us to get the product. We are target-marketing people on the outside who we think we have the system or characteristics of the people that we've been cross-selling inside.

Our underwriting process focuses on credit quality, not loan volumes. Thus, resulted in a portfolio of personal loans with a significantly stronger credit profile than seen in the industry, and in a few short years, we positioned Discover as a leader and a top originator in personal loan. Again, we think we're a top 3 originator in this category across the industry.

Focusing on risk management has helped us to maintain delinquencies and losses within our target range despite the economic environment. Our 60-plus day delinquencies are down year-over-year, this does include a bit of denominator effect. You saw the high level of growth, but the refinements we've made to our underwriting process are apparent in our delinquency stats and you can see that, that really differentiates us from competitors, and looks very good on a vintage basis as well.

Our personal loan portfolio has grown quickly, but we're again not favoring asset quality, asset growth, in place of disciplined underwriting and profitability that will serve us well over time. In fact, 100% of these loans are judgmentally decisioned by our analysts, not just going through automated systems. We remain focused on meeting our ROE target by leveraging our expertise and marketing operations in unsecured risk management going forward.

Now I want to switch gears from our lending business, can I have that slide up? Okay. I want to switch gears from our lending business to Payments. We are very proud of our robust growth in Payment Services. We expect 2011 to be a record year both in volume and in profit.

Year-to-date volume has increased 15%, profits grew 13%. As indicated on the graph, the business has generated impressive double-digit compound growth rates for quite a few years now through increases in volumes, market share, expansion and improved margins. PULSE represented the most significant portion of the 2010 and 2011 growth. PULSE is the third largest PIN debit network and continues to gain market share. The headline issue obviously for PULSE and our competitors who is responding to the interchange and routing regulations resulting from the Durbin Amendment. We are committed to supporting our more than 4,400 financial institution participants in dealing with this legislation, but for us, we believe the most important implication of the Durbin Amendment is related to the network exclusivity rules, which actually go into effect on April 1. We believe that the expected changes in rules could result in further market share gains for us. As some of the big competitors need to add an alternative network and we are one of the leading alternative networks.

Discover Network volume, which includes our proprietary Discover Card and third-party issuing activities, increased 9% in the third quarter benefiting from growth in the U.S. acceptance and positive contributions from a number of our issuing partners, such as GE and Wal-Mart.

Our Diners Club network continues to enhance our global presence, and volume increased 17% over prior year, although much of this was from the benefit of FX. These results indicate our efforts in building our global payments business are indeed paying off.

Since we have made important progress with our global initiatives since the time of acquiring Diners Club in 2008, we have strengthened relationships with our Diners Club franchise operators all over the world, we've also been working with them on a major global brand campaign. We are executing successfully in Discover Network acceptance in the U.S. and in Diners Club markets across the world. We've also strengthened our footprint by partnering with the leading networks in various countries: JCB in Japan, China Union Pay in China, BC Card in Korea, DinaCard in Serbia. These efforts should lead to broad acceptance in North America and key Diners Club markets and network partner markets and a robust travel and entertainment footprint across the globe for Discover and for our growing number of partners.

Our direct-to-consumer deposit business, growth has been phenomenal. The growth in direct-to-consumer deposits has changed our funding mix dramatically since our spinoff as I previously mentioned. We are emphasizing multi-account Discover-branded relationships and the growth of affinity portfolio such as our AAA relationship. Over 40% of these deposit customers also have Discover card or other lending products relationships with us.

The weighted average maturity of our new deposits this year have been primarily 2 to 3 months -- years, rather. We've been willing to pay a little more for stability by being a bit further out the curve. Decreased reliance and securitizations in brokered CDs has occurred over the last 5 years. Even though we will consider accessing capital markets as opportunities exist, and we entered the broker deposit market as -- from time to time to keep that channel open. But we continues -- the ABS continues to be a robust and available market to us. We did an issuance in September for a $800 million deal, 3 years at 1 month LIBOR plus 21 basis points. We just did one this Monday, that's in the process of closing, let's say, $400 million 5-year deal at LIBOR plus 35.

I'm also very excited about the strength of our capital position. Our capital position is very strong and on a TCE basis, we have one of the highest ratios among the large banks in this country. This slide shows our calendar third quarter change in TCE ratio, which we report in our regulatory filings. In the period, we generated very strong earnings and so even though we have started doing share buybacks, increased our dividends, had the 2 acquisitions with the $2.5 billion that we just closed on, you can see our TCE ratio still remain very strong after all that. But we did manage to put that high level of net income to work over this time period. It is still well over the 8% target, it's about $2 billion over that target, but I think we're well-positioned both for today's rules and tomorrow's. So our estimate of the Basel III assumptions at 9/30 would be a Tier 1 capital common ratio at that -- with those new rates requirement, still at about 12.7%, which is one of the highest in the industry.

So to summarize, before we get to Q&A, our card business is generating strong profitability, as positive credit trends provide flexibility to invest in growth. Our investments in the card business are leading to real increases and wallet share. We've continued to diversify with the acquisition of the Student Loan Corporation, expansion of personal loans and the planned entrance into consumer mortgage origination. We will remain focused on increasing our acceptance globally and exploiting opportunities in debit and emerging payments. And we do expect to continue to generate excess capital and we'll ensure that we are deploying that capital appropriately over time.

So I appreciate your time and attention, and be happy to go to some questions.

Question-and-Answer Session

Kenneth Bruce - BofA Merrill Lynch, Research Division

Great. Well, that's it -- yes, please. Be comfortable. As we -- as the audience prepares questions, I will ask first. There's been quite a bit of concern about the state of the U.S. consumer, as you might imagine, just given unemployment. Obviously, credit trends has been moving in the opposite direction, but there is still a sense that the consumers got no interest in taking on additional debt and I guess I would like to have your sense as to how the U.S. consumer is holding up? How you think the backup for growth is? You show some growth expectations if you think that, that's truly market share or not? Where that's going to come from? But just general sense of where the market is, if you will?

David W. Nelms

Well, first, I think the averages can be a bit misleading. I think we're increasingly in the bimodal period where some consumers have largely completed their deleveraging, are back to the new normal, are spending money again. They're the ones that are with us and didn't write-off 2 or 3 years ago. And they're not as likely to lose their jobs if they didn't already lose them. And the house -- if they had a serious housing problem, the ones who are left -- that our credit card customers are not, on average, in difficult situations. And then you've got this other group who is in a world of hurt in terms of unemployment and maybe housing. So our business is focused on the latter, and that's why I think we're seeing sales growth and even a little receivables growth. We're not expecting much receivables growth in the market. I think the deleverage has happened, we're in a new normal and we expect -- I expect the market, which is still shrinking for credit cards to get back to even, maybe slight growth, and that's why we think targeting that 2% to 4% over time is sustainable. I think that, that may be -- that probably means a little share growth in loans, it's just where we're focused, and but that will allow us to gain some share over time. There are some other asset classes though that I think have very high potential growth and we focused on that and are taking some of that -- those earnings and capital, investing them in these high-growth, high return businesses like student loans and personal loans, deposits. I mentioned the overall trends towards Direct Banking, we're riding that -- we're going to ride that wave. We're -- just as Amazon moved from books to everything, we move from credit cards but use the same brand and the other capabilities, the vertical integration, to provide a broader array of financial services to consumers. And we can pick and choose, we don't have to be on commercial loans. We -- if we were in branches, you sort of have to have that broad portfolio, but I think we can pick and choose which things are going to go direct, be profitable, and so we've got a portfolio of a slower-growing but growing-faster-than-competitor credit card business that's performing very well. And then a bunch of other high-growth businesses that are also high return.

Kenneth Bruce - BofA Merrill Lynch, Research Division

Up front, please.

Unknown Analyst

You were doing -- speaking about student loans, you were talking about having underwriting skills that were a bit different from what Sallie Mae brought to bear -- if we ignore the errors that Sallie Mae made with their nontraditional student lending, which presumably they've gotten past, and you look at their ABS, what are the underwriting skills you will bring to bear that are different from them? And what sort of cause-and-effect relationship do you see in terms of the assets you're producing relative to what they show us through the ABS market?

David W. Nelms

Remember that Sallie Mae and our competitors largely came from originating guaranteed government student loans where servicing was important and doing exactly what the government said was important, but -- it was government-guaranteed. And a number of years ago, all of these companies said, "Okay, as an extension, we can get into private student loans as well." And so it wasn't that they had really any, a number of years, they didn't have any underwriting skills, they've been developed recently and they migrated from a guaranteed to a non-guaranteed product. Even Citi, we were surprised how much -- while there were some sharing between Citi and Student Loan Corporation, which is one reason their credit quality was better. But it was not a perfect sharing. It was an independent company with public shareholders and so we are able to provide underwriting skills that have been honed with unsecured loans or credit cards with analyst involved in many cases, with pulling more Bureau data, more non-Bureau data, with the sophisticated models, with segmentation across schools and by individuals and of course, in many cases, as I said, most of our loans are cosigned, we're looking at the parent, and those parents are credit card customers, they're exactly the -- who can pay back, that we're used to doing. So it's really those underwriting skills and capabilities that are producing the low charge-off rates in credit cards for us that we are applying to student loans. And we're, I think fairly unique on that. And all of our competitors will get better. Sallie will continue to develop more and more underwriting skills, but we think we can stay ahead of them. And we have a cost-of-funds advantage versus them as well, which we don't have in the rest of our businesses, but that can be helpful in terms of our returns.

Unknown Analyst

Maybe sticking on the student lending area for a moment. When you look at the secular growth there, that opportunity looks to be quite tremendous. Yet, there continues to be quite a bit of government tinkering with the student lending business as a whole. How do you have the confidence you investing as you are when you've got Big Brother out there, effectively, that could change the landscape quite dramatically as they've proven in the past.

David W. Nelms

Well, first, I'm glad that we're not in that flow of originating federal loans anymore because we can be in the same position as the banks are in with the mortgages. When they go bad, there is like blame game. We're not originating those. We're not involved with them. Were not servicing them. We've got a small legacy portfolio that is about, that is held for sale. Got -- but I think that was actually a very beneficial change to take us out of that loop. We had to have that to have the private student loans, because of -- even now that they're separate, we are able to focus on private. I think that the selling [ph] forward changes are more likely to be positive for us than negative. I mean, the one possible negative would be a bankruptcy loss change. We factored that in. It's not as big of a factor as one might think, but it would be a negative. But most of the other possible things, this new program that came out, where they're limiting to 10% of your income and forgiven for the federal, arguably that should help us. Because most of our customers have federal loans and then we are also providing them private loans. We encourage our students to max out on federal loans first, because they are better deals, generally. And so if the payments come down on those, it increases their ability to keep current on all their loans. I also think it's more likely that the, at some point, that the government needs to pull back. I mean, there's been huge growth, there's not the underwriting discipline, as I mentioned, and if the federal loan market, which is 90% or something of the market, ever pulls back a bit, that provides us an opportunity to provide more of the need through the private market.

So I think there's going to be a lot of noise, a lot of confusion and people are going to read headlines about student loans blowing up and will not understand -- or assume it must those bad banks as opposed to taxpayer money, but you have to look at the actual numbers behind. And over time, I'm very comfortable that there will be some twists and turns, but it's fundamentally a great product. Where else can you get a 7% unsecured loan to get education, which is going to help increase your income and reduce your unemployment? It's the best investment people can make, on average. And the problems are the extremes. It's the horror story of real high debt with not good income prospects, which is what we avoid. And -- but over time, I think there is going to be some changes, I think we need to see a slowdown in tuition increases, that's continue to increase our demand, and not necessarily healthy though. I think we -- I'd like to see that ratchet back, but I don't see it ever going negative. I mean, tuition is going to be going up, it's -- there's -- in that case a lot of the future of our country is getting more education.

Kenneth Bruce - BofA Merrill Lynch, Research Division

All right. Quiet crowd.

David W. Nelms

They are a quiet crowd.

Kenneth Bruce - BofA Merrill Lynch, Research Division

Well, I've got a few minutes, so I'm just going to make everybody -- oh, I'm sorry.

Unknown Analyst

I wanted to ask about, if you're planning to grow receivables in card faster than the industry, is there something that you're doing where you're -- you want to maybe shift the balance of 40% revolver or 60% transactors to sort of do that? Or you just plan to just grow transactions overall and have it grow with that?

David W. Nelms

I'd say, we're generally focused on balanced growth. I think there are -- a few of our competitors that are really shifting more towards transactors and I -- you look at where our income comes, it comes mostly from interest. And so I think that we certainly have plenty of transactors, they're attracted to our rewards programs, our service. And some of them will occasionally revolve overtime. And that's one of the best customers you can have, if they occasionally revolve, and if they're not going to write-off, then you'll occasionally get some interest income. But I think that we're in this for the long term, in a different interest rate environment, the cost to float becomes a much more material part. In a higher equity requirement, then that are we -- gets affected disproportionately because a lot of what drives the current economics of transactors has been this lack of much equity against it. And there's a question on who else [ph] -- interchange is going to continue to rise? And there's a lot of merchant dissatisfaction with interchange. So I don't think betting on that is necessarily a good thing. So over time, I intend to think about the credit card industry is breaking even on transactors, losing money on your write-offs and making all your money on revolvers who don't write off. And so if you think you're focusing on -- you want to grow your profits, you got to focus on those credit card loans that are going to write off. And that's our primary focus and that's why there are several competitors who are growing faster than us now on sales but not on loans.

Unknown Analyst

I was wondering if you could comment on who your typical depositor is and where they're bringing their deposits from. And maybe how we would expect the behavior to change if interest rates were to rise?

David W. Nelms

Sure, well. The -- they're mostly bringing their deposits from the traditional banks and they're coming from where they're earning zero to where they are earning something. And I think that the whole model is that we have a much lower cost structure, we don't have the branch cost. So we can provide higher, for a given maturity and a given product, 2-year CDs that we can provide a higher rate to the customer, still have a similar all-in cost compared to those branch banks. And so I think you're going to continue to see a migration over the extended period of time out of traditional banks, from people who like the FDIC protection, the safety and want some extra yield without taking any risk. And increasingly, as they come over, they realize it's better service. They can get access to their money 24 hours a day. They can reach someone 24 hours a day. They -- the web tools are better. They can more easily move money around. So I think that's a lot of what we're seeing. I mean, you get the occasional -- there is a couple of big ones, ING Direct, Allied, us, but most of it is just migration from traditional, I think, over time. And I'm sorry, the second part of your question was?

Unknown Analyst

If the behaviors change when interest rates rise, do you expect anything to change?

David W. Nelms

I don't expect so, because I think that the differential between what we can afford to offer because of our cost advantage and what they can afford to offer is going to be maintained. So we'll have to raise -- eventually, we'll have to start raising rates and so will the banks and you're going to see a similar margin.

Unknown Analyst

You've been recently active on the M&A fronts, what sort of deals might you consider over the next year or so?

David W. Nelms

Well, I think we've been very disciplined on the M&A front. And we -- anything has to fit our strategy, first and foremost, being the leader in direct banking and payments, it could be 1 of those 2 sides. We like things that are unique to us and, as an example, I'm not sure anyone else could have bought Diners Club. I mean, it was the perfect fit. We had U.S. acceptance, they had global acceptance. If you get the scale in between and it fits our multi-network strategy. And student loans, we think they're -- uniquely fits us as well, especially around the underwriting skills that I talked about earlier. And -- but I think that we would continue to fill out our Direct Banking if -- and that could be organically or it could be M&A. And Payments is -- we haven't bought anything in the last year in that space, but if you look further back, obviously PULSE and Diners Club were both successful acquisitions. So we've shown that we're willing to buy when it makes sense. We obviously have the capital to buy, uniquely positioned, but I'd start with fitting the strategy and being an economically great deal for shareholders.

Unknown Analyst

On your student loan business, the 1% loss provision that you estimate, is that where the business historically ran or is that an improvement? Just any comments.

David W. Nelms

That's about where it's been running and I'm using plus-or-minus 1%, 1.5%. If you think about -- at our investor day conference, one of the things we look at is what's the lifetime expected loss. And 10%, 11% is kind of what we might expect versus the federal loans historically of running the 30%, 35%, that's the 3x. And you get about half of those losses in the first year, the loans are typically 15 year loans, but with prepayments, maybe they have an average duration of 10 years. And so you kind of get, if you just ballparked it and said 10% lifetime over 10 years, you might get to -- little, over 1%. And I think in terms of go forward versus historical, I think there's 2 contradictory factors. There's higher levels of debt and tuition rising faster than income afterwards, which would tend to make credit worse in the future. But pushing against that is our underwriting capabilities and skills continue to increase. And every generation of model gets better, and so we don't expect dramatic changes and what we are able to do in personal loans. I do think that federal loans are more likely to rise though. I mean, that's where you see them -- 2 years ago when the banks got out of the process, there is less underwriting now going on. And you get that, plus the trend that I mentioned before. And you're -- they're going to have higher losses. So you're going to continue to read higher losses in student loans, you are going to have to look underneath that to see federal versus private, which I think will be different stories, for -- certainly for us, but probably even for the industry, I think.

Unknown Analyst

One more quick one. I think last couple of years, you had a strong tailwind of steadily improving delinquency and charge-off rates. What's your sense as to what point or are we there that we had a more normalized or a stabilization? And where the ongoing rate is more indicative of what you're currently putting on the books?

David W. Nelms

We don't know for sure, because of what -- it feels like we might be kind of reaching that plateau around now. I -- we're not going to go to 0. Some point, you've got to kind of level out and then you eventually got to return back to whatever the new normal level is. And I think we said over the last earnings call that it's entirely likely that we could be adding parallel loss reserves next year. And that would be consistent with reasonable stability in credit but a growing portfolio. And at a minimum, I do think, we're probably past, as an industry, the large low loss reserves releases. And we're past the bulk of the credit improvement. We're at a 25 -year-old -- 25-year record low delinquency rate. So we're only going to go -- we're not going to go that much lower, if at all. It's because, frankly, if we overshot over too much, we will be leaving money on the table in terms of taking credit risk and growing the portfolio, so I think there's some natural push back that would say, credit -- that credit we're going to start lending a little bit more at the margin because we're leaving money on the table. So probably close to stabilization -- short-term stabilization is my guess, that's what I stated last -- they came out this week, seen the show, just for me, some random variation and some stability across the industry.

Kenneth Bruce - BofA Merrill Lynch, Research Division

That's going to be the time. Please join me in thanking David for his time this morning.

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