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Executives

Craig A. Streem - Vice President of Investor Relations

David W. Nelms - Chairman and Chief Executive Officer

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

Analysts

Richard B. Shane - JP Morgan Chase & Co, Research Division

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

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

Moshe Orenbuch - Crédit Suisse AG, Research Division

Donald Fandetti - Citigroup Inc, Research Division

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

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

Kenneth Bruce - BofA Merrill Lynch, Research Division

David S. Hochstim - Buckingham Research Group, Inc.

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

John Stilmar - SunTrust Robinson Humphrey, Inc., Research Division

Matthew Howlett - Macquarie Research

Brian Foran - Nomura Securities Co. Ltd., Research Division

Jason Arnold - RBC Capital Markets, LLC, Research Division

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

Discover Financial Services (DFS) Q4 2011 Earnings Call December 15, 2011 10:30 AM ET

Operator

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

Craig A. Streem

Thank you, Christine. Good morning, everyone, and welcome to today's call. Let me begin by reminding all of you that the discussion today contains certain forward-looking statements about the company's future financial performance and business prospects which are subject to risks and uncertainties and speak only as of today. Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today's 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, and in our Form 10-Q, for the third quarter 2011, all of which are on file with the SEC. In the fourth quarter 2011 earnings release and supplement, which are now posted on our website at discoverfinancial.com and have been furnished to the SEC, we've 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 to investors. And of course, we urge you to review that information in conjunction with today's conversation.

Our call this morning will include formal remarks from David Nelms, our Chairman and Chief Executive Officer; Mark Graf, our Chief Financial Officer; and then as always, a question-and-answer session. I would encourage you that during the Q&A period, it will be helpful if you limit yourself to one question and one related follow-up. And now, it is my pleasure to turn the call over to David.

David W. Nelms

Good morning, everyone, and thanks for joining us. Earlier today, we reported fourth quarter net income of $513 million or $0.95 per share, driven by continued improvements in credit and receivables growth in all products. Our strong results and positive outlook for Discover led us to announce a 67% increase in our dividend and to continue to execute on our share repurchase program.

This morning, I'm going to start off by discussing our fourth quarter, and then walk you through some of the highlights of our full year results.

First, regarding the fourth quarter, Discover card sales volume grew 8% compared to the prior year. The strong sales performance continues to include higher spending from the revolver segment of our portfolio, helping us to grow card receivables, $47 billion. Our continued success in growing sales and receivables reflects greater effectiveness in marketing programs, cash rewards leadership and expanded merchant acceptance, all of which contribute to increases in profitable growth. One example of this is our recently announced program with amazon.com, in which Discover card members can pay directly with cashback bonus at this site, as well as earn double rewards on their purchases until the end of the year. Since we launched the program in October, we have seen a significant increase in card member purchases at Amazon.

Another highlight this quarter is the continued improvement in card credit, as our 30-plus day delinquency rate had another all-time record low at 2.39%. In addition, the card net charge-off rate dropped to 3.24%. I'm very proud of these strong results which were due in large part, to our efforts in credit risk management, collections and marketing.

In our other lending product portfolios, which include personal and private student loans, we grew loans to $10 billion with the acquisition of approximately $2.5 billion in additional private student loans from Citi. Our ongoing expansion outside of Card continues to drive earnings growth with attractive yields and strong credit performance.

Our Payment Services segment experienced total volume growth at 7% for the quarter versus the prior year. All segments, PULSE, Diners Club, and third-party issuing delivered good volume growth year-over-year this quarter. As it relates to PULSE's strategy to win new PIN debit volume post Durbin, we are responding to numerous RFPs and should have more to report in this regard next quarter.

Our fourth quarter performance provided a strong finish to 2011, an all-time record net income of $2.2 billion for the full year. These results were primarily driven by improved credit cost and profitable loan growth in our Direct Banking segment, and 18% higher Payment Services profits for the year. On our 3 payment networks, we achieved record volume of over $280 billion. Additionally, return on equity for the year was 30%, considerably higher than our 15% long-term target.

Let me now share some thoughts on how we performed against our priorities for 2011. Our first priority was to return to card growth by gaining wallet share and generating new accounts. We returned to year-over-year card growth in June, and ended the year, up 3% from last year. Closely tied to our receivables growth priority was our objective to expand merchant acceptance and marketing partnerships to drive Discover Card sales. Many milestones were achieved along the way, to accomplish this priority, including a record number of card members using us as their primary card, a 10-year low level of attrition, record levels of engagement in our rewards programs and record levels of active merchants. I am very pleased that these accomplishments helped drive us to a record Discover Card sales volume in excess of $100 billion for 2011.

We had 2 principal priorities for our other lending products, to integrate the Student Loan Corporation, and to continue generating strong returns in private student and personal loans. We have completed the organizational integration of the Student Loan Corporation and are on track to deliver the remaining technology and operations migration.

In addition to the 2 accretive acquisitions, we delivered significant profitable organic growth in private student loans and in personal loans.

Staying within Direct Banking, our next priority was to leverage the retail deposit channel to provide liquidity and optimize funding costs. We grew direct-to-consumer deposits by 27% over the course of the year, while reducing our cost of funds and broadening relationships with our customers.

Lastly, we had 2 priorities for our Payments business, the first was to capture opportunities in the changing debit market which remains in process, the other priority was to leverage our strategic partnerships as we continue to build out our global network. For example, our inbound volume from JCB cardholders grew 15%, over $700 million, despite the catastrophic events earlier this year in Japan. We also recently announced an acquiring agreement with WorldPay that will significantly increase our acceptance in the U.K., and Western Europe. Here in the U.S., we made some great progress on increasing acceptance and growing volume. For instance, PULSE full year debit volume grew 19% year-over-year.

To wrap up, we delivered exceptional results for the year, despite a relatively challenging economic environment. Our strong results have positioned us to return excess capital to our shareholders by increasing our dividends 67%, and reducing our share count by 3% through our share repurchase program during the last 2 quarters.

As we enter 2012, I'm looking forward to capitalizing on growth opportunities, such as building out our Direct Banking platform, continuing to drive profitable growth in receivables and winning new business in PIN debit. We look forward to providing you with an update on our 2012 growth strategies at our Financial Community briefing in March.

Now I'll turn the call over to Mark.

R. Mark Graf

Thank you, David, and good morning, everyone. I'll begin my comments by focusing on our Direct Banking segment's fourth quarter results. The segment earned $776 million pretax this quarter versus $554 million last year. Reserve releases contributed only $68 million to pretax earnings in this quarter versus $414 million in last year's fourth quarter, as we saw a slowdown in the rate of credit improvement.

Turning to interest yield on the Card portfolio, we reported a 32 basis point decrease from the prior year to 12.36%. The principal components of the decrease are the same as I've mentioned during prior quarters. First, to the CARD Act impact on higher-priced default balances. Second, an increase in promotional volumes. And finally, an increase in the number of customers who pay their balances in full. These were partially offset by lower interest charge-offs. Total portfolio yield declined 68 basis points from the prior year. This resulted from the card yield compression that I just mentioned, and the private student loan acquisitions in the first and fourth quarters of the year. These acquisitions have the effect of reducing overall portfolio yield. However, it's important to note that we also expect student loans to produce much lower average credit losses than the card product.

Net interest income increased $136 million or 12% versus the prior year, driven by asset growth, lower charge-offs of accrued interest and the benefit of lower funding costs. On a net interest margin basis, we had 18 basis points of compression from the prior year, and 16 basis points from the prior quarter. This was due to the yield compression I noted a moment ago, partially offset by lower funding costs. If you remove the effect of the additional private student loans we acquired in the quarter, net interest margin would actually have been up 2 basis points sequentially. The lower funding costs reflect the benefit from the roll off of higher-priced time deposits. We expect to continue to benefit from this funding cost tailwind through 2012, as we replace these existing deposits with lower cost borrowings through our 3 main funding channels, and as we continue to benefit from the Fed's current monetary policy. The combination of these yield and funding cost trends should drive NIM down slightly from where it is now at 9.1% to around 9% next year.

Other income was $66 million higher than in the prior-year period. You may recall that we recognized a $28 million charge to other income in the fourth quarter of 2010, when we classified our remaining federal student portfolio as held for sale. The growth in other income was also driven by higher discount in interchange revenue, which was partially offset by higher rewards expenses. Our rewards expense dropped to 86 basis points for the quarter. However, going forward, we expect this number to be somewhat higher as we continue to refine our rewards program in the ordinary course of business.

Other expenses for the segment grew by $44 million or 7% over the prior year. $18 million of the increase comes from expenses related to the purchase of the Student Loan Corporation. The remaining $26 million increase from the prior year consists primarily, of higher employee compensation for technology infrastructure improvements, enhancements of our credit and collection processes, and higher call center staffing.

Before I turn to Payment Services, let me comment briefly on loan growth and credit performance for our other consumer lending products. Receivables in our personal loan product were up $770 million from the prior year. Loans greater than 30 days past due increased 2 basis points from the prior quarter to 87 basis points. Personal loans net principal charge-off rate decreased by 15 basis points to 2.58%. The improvement can be attributed to portfolio growth and risk initiatives. We continue to focus on thoughtful measured growth in this asset class by leveraging our established underwriting competencies. Private student loans grew $6.3 billion compared to the prior year, with approximately $3 billion of the growth coming from the acquisition of the Student Loan Corporation in the first quarter, and an additional $2.4 billion from the purchase of private student loans from Citi at the end of September.

You may remember from the initial announcement, the face value of these loans was $2.5 billion. However, since we bought the portfolio at a discount, the loans came on our books at $2.4 billion. Credit losses on these loans will not flow through the P&L, as the accretable yield includes expected future credit losses. Reserves against these loans will only be booked if expected credit losses increase after the acquisition date.

In addition to the acquisitions, we achieved organic growth of approximately $1 billion in net receivables for the year. Our 30-plus day delinquency rate for private student loans dropped 17 basis points sequentially to 63 basis points, excluding the purchase credit impaired loans. The charge-off rate, again, excluding PCI loans, was also down 17 basis points as it decreased to 45 basis points. The decrease in both of these metrics is typical with the seasonality in this product. Having launched the product offering in 2007, we will see an increasing level of loans entering repayment as students graduate, and of course, we will start to experience some degree of credit losses that will eventually increase these rates toward our targeted levels. This phenomenon has contributed increase in our reserve rate.

Turning to the Payment Services segment. We increased pretax profit by 35% year-over-year to $42 million. Revenues increased faster than volume growth, reflecting a bit of a mixed shift towards higher margin volume at PULSE. Expenses were down 8% compared the prior year, primarily due to the timing of some marketing programs.

Before I discuss capital, I want to touch on liquidity and funding. As expected, our investment portfolio ended the quarter at $8.5 billion, down from $9.4 billion at the end of the prior quarter, as we utilized liquidity built up during the third quarter to fund the recent private student loan acquisition. The size of our liquidity investment portfolio from here, will be a function of receivables growth, upcoming funding maturities and seasonal needs. Our total liquidity ended the quarter at $26.2 billion or roughly flat to the third quarter. This includes cash, liquid investments, conduit capacity, our bank credit facility and capacity with the Fed discount window. Our total liquidity has grown by $3.5 billion over the past year. As a result of this enhanced liquidity position, as well as our having obtained a number of new conduit facilities, we've made the decision to terminate our existing $2.4 billion syndicated credit facility. Excluding this, our contingent liquidity position would have been $23.8 billion.

Moving on to funding. Direct to consumer deposits continue to be our largest source of funding at 45%. While we expect them to remain our largest funding channel going forward, we will continue to opportunistically access our other funding channels which include broker deposits and the ABS market. Before the end of the quarter, we closed a $400 million floating-rate 5-year ABS transaction, priced at 1-month LIBOR plus 35 basis points. Pricing for this transaction was 23 basis points better than our last 5-year ABS issuance just over one year ago.

Next, I want to touch on our strong capital position. Our tangible common equity to tangible assets ratio decreased in the quarter to 11.4% which is still one of the highest ratios among large financial institutions. The ratio decreased slightly from the last quarter for all the right reasons, as we deployed capital by closing on the additional private student loan acquisition, declared our regular quarterly dividend and repurchased $227 million of our shares. There is roughly $575 million of capacity remaining under our current share repurchase authorization.

Regarding the 2012 capital planning process with the Fed, like everyone else, we just received around Thanksgiving, the guidelines. We are currently preparing the required submission and we'll provide you with an update our capital plans next March.

In summary, I'm very pleased with our financial performance for 2011, as we were able to deliver outstanding credit performance and strong receivables growth and also, able to responsibly deploy our capital through increased dividends, share repurchases and 2 accretive acquisitions.

That concludes my comments. So at this time, I'll turn the call back to the operator to provide instructions for the Q&A period.

Question-and-Answer Session

Operator

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

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

So I have 2 kind of unrelated questions, so sorry. But just the first one, I was wondering if you could just talk about your reserve methodology, because I look at the reserve rate, excluding PCI loans to charge-offs, that ratio kind of expanded in this last quarter versus the previous quarter, and it seems like your credit metrics are pretty solid and are trending pretty solidly through November, so I was just wondering what the rationale there was? And then just secondarily, on capital, Mark, you just kind of touched on it a little bit, but I was just wondering what the game plan is in terms of next year, and you guys asking for permission in the context of the stress case. I mean, should we expect kind of similar type of action next year, as you guys have done at least on a quarterly basis this year?

R. Mark Graf

Sanjay, I guess with respect to the first question, on the reserving methodology, it's really just mathematics driving that reserve coverage ratio. We reserve based on a forward 12-month rolling loss estimate basis. So as our models show any forecasted turns in that, the reserving responds accordingly. As I've said on the call before and as I've told you before, I wish we had more judgment in how we set reserves. We don't have that flexibility, so it's pretty much an arithmetic process with GAAP being very prescriptive. With respect to the capital side of the equation, obviously, I'm limited in what I can say there. I guess the best way I can answer your question, Sanjay, is to say, well, we've never really formally disclosed our thoughts on a payout ratio. If you look at what it's been historically, we think we have some room to increase it from where it's been.

Operator

The next question comes from John Stilmar from SunTrust.

John Stilmar - SunTrust Robinson Humphrey, Inc., Research Division

Very quickly, to dovetail onto Sanjay's question, should we think about -- when you're talking about return of capital, is it relative to a payout ratio or is it relative to an absolute level of capital that you're kind of targeting in the relative near-term? I'm just wondering what kind of the bogey is it you're using as a target without obviously getting into the specifics that you can't reveal?

R. Mark Graf

Yes, I would say from that perspective, let's call it a multivariate equation. We clearly have telegraphed. We think we're in a somewhat target-rich environment right now. And given our demonstrated ability to earn through some of that excess capital, holding onto some of it right now, while we look across the spectrum, it makes sense to us as long as we can keep running through it. That said, we also recognized, we're accreting capital at a significant rate. So I would say that my earlier comments about our belief, that we can increase the payout ratio relative to historical norms is probably the best guidance I can give you in that regard. We do tend to think about things in terms of a payout ratio internally. But again, we don't tend to disclose that number publicly.

John Stilmar - SunTrust Robinson Humphrey, Inc., Research Division

Okay, perfect. And then the second question has to do, David, I think, more theoretical concept is, we're starting to see momentum certainly building in mobile payments with Google Wallet and some of the shifting plates there. I'm wondering, other than your relationship with Isis, which we've obviously discussed in prior quarters, what should we start to expect from Discover, in terms of this rapidly developing landscape of mobile wallets, mobile payments and sort of the changing landscape, and how is Discover set up to capitalize on it and what should we be looking for as evidence of that in the coming quarters or years?

David W. Nelms

Well, John, obviously, we were the first player involved with Isis. But we had said at the time that we intend to be part of multiple efforts, and in fact, have already been announced to be part of Google as another example as well. And we are continuing to aggressively pursue many opportunities. We've issued a good number of Zip cards to our customers. We continue to make sure that we're integrated with the terminals at the merchants as they deploy the wireless terminals. We're working with multiple handset manufacturers and technology companies, and where possible, we're going to try to do some innovative things to really help us gain market share, both as a network and as an issuer.

Operator

Next question comes from Craig Maurer from CLSA.

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

Two quick questions, one on the tax rate. Mark, where do you see that settling out for '12? It's bounced around a little bit this past year. And secondly, to narrow the focus of the previous question, how do you see Verizon moving forward? Isis has clearly proven disappointing to them as they've had some material setbacks on technology, and clearly, they're not exactly launching in big markets, but they've chosen to play hardball with Google Wallet, clearly, the superior product. So I'm curious as to where you think Verizon comes out on this whole debate. Is this just a revenue extracting tactic to try to gain advertising revs from Google?

R. Mark Graf

It's Mark. I'll tackle the tax rate, and then I'll pass it off to my boss to handle the Verizon and Isis question. From a modeling perspective, I think, we, for the fourth quarter, had an effective rate of about 37.3% or so. I would encourage you, modeling-wise, to kind of maintain that rate through 2012 would be a pretty good estimate at this point.

David W. Nelms

And in terms of mobile, I wouldn't want to comment on a specific company or effort, but more broadly, I would say, we're going -- I expect we're going to see a lot of twists and turns in this as new technologies are offered, and as we see how consumers and merchants and issuers test things, not everything will work, and that's one of the reasons that we're hedging our bets to be involved in a number of efforts so that we are aligned with what ultimately emerge as winners in this. And I also think there are likely to be more -- there's going to be more than one winner.

Operator

The next question comes from Jason Arnold from RBC Capital Markets.

Jason Arnold - RBC Capital Markets, LLC, Research Division

I was just curious if you could give us a little color on the network volume trends this quarter. It looks like most were down sequentially, so curious if this is more macro-driven or perhaps what other factors are at play here. Any color you could provide there would be great?

David W. Nelms

Certainly, I was pleased with the continuing 8% volume growth on Discover sales. And PULSE, if you look at the full year, we were up 19%, as I mentioned on volume year-over-year, which is one of the strongest in the world of debit. We do see quarterly movements in this, partly because there are some chunky volumes that can move in or out. And one of the trends that we saw this year, is that there were a number of large issuer deals that kind of were on hold, waiting to see what the ultimate Fed rules came out related to Durbin. And so second half of this year, there just wasn't a lot of share that shifted hands. And I think, as I mentioned in the call, we're right now, in the middle of a lot of RFPs and I think that by April 1, when the network routing rules go in place, we'll see some more shifts. And so we don't have more to report on that now. But as we've consistently reported, we wouldn't expect to see any volume pickup from that until, hopefully, if we're successful, in the second quarter onward as some of this volume starts to move around in debit.

Jason Arnold - RBC Capital Markets, LLC, Research Division

Okay. It certainly seems like more opportunity than anything else for you to gain share on the PULSE side. Can you comment anymore on that or do you want to save it for the next quarter?

David W. Nelms

Well, I would just say that we have been a leader in the under $10 billion size institutions, and so I think that volume is sort of not particularly at risk. And I would say also, virtually all of our cards have 2 brands on the cards. We're typically a PIN debit and there's almost always someone else's signature on the front. So we do view it as more opportunity versus risk. And how much that opportunity is, is the thing we're working aggressively to try to pursue right now and we just can't comment on where we'll end up.

Operator

The next question comes from Chris Brendler from Stifel, Nicolaus.

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

I have 2 questions. This is just a follow-up on the PULSE question real quick, if I could. Can you remind us what's causing the sharp deceleration in PULSE volumes throughout 2011? I think I'm calculating high 20s rates in the first half of the year and falling down to 8% this past quarter. I just wanted to know if there's anything in there. And on the RFPs that you are proposing for PULSE to be added as a PIN debit network, can you tell us if a lot of the banks are adding or considering adding PULSE as an exclusive on the back of the card or is it going to be PULSE as an addition to an existing network that needs to satisfy exclusivity? If you can give us any color there? And I also have a credit card question as a follow-up.

David W. Nelms

So on your second question, I think it's too early to say. That's one of the things that I think the larger issuers will be determining, whether they're going to be adding or replacing PIN debit networks. And we should have more color on that next quarter. On your first question, we had some very significant growth in the fourth quarter of last year, as we had some big wins and so this quarter, we're now a year from that with -- so we've got a much higher comparable and we're through the annualization of that. And as I said, we didn't have as much opportunity for big wins in the last half of this year, as people waited to see what the new rules were going to be. So that's the reason for the change during the year. But again, I'd point back to the big picture which is, for the year, we're up to 19%. It's well above that market growth rate.

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

Very solid indeed. And then my second kind of question would be, on the credit card side, just to comment on competition for lending volumes and what you're seeing as you market to consumers. I noticed marketing ticked down at least on a year-over-year basis this quarter, your cash advance levels fell a little bit, a little bit reduced teaser activity. And the average loans for the quarter in the credit card business are actually below the last 2 data points, third quarter and fourth quarter ending period. If you could just give me a little help there on what caused that?

David W. Nelms

Well, I think I was pleased with our lending volume. We -- at our Investor Day, we had been targeting 2% to 4% long-term organic growth as our target. And this quarter, we moved up from ending receivables growth year-over-year from 2% last quarter to 3% this quarter, so we're right in the middle of that range. And we're one of the very few credit card companies that is showing organic growth combined with great credit quality. And I think in terms of competition, as I've said, last -- I think on the last call, I do feel like many of our competitors who cut way back on their marketing have restored a lot of that marketing and I don't think the marketing intensity is or is likely to go as high as it was before the great downturn and the consolidation in the industry. But I think we're back to the new normal, if you will, in terms of competitive intensity, and our marketing, I would say, is the same. We had less of a cutback on marketing, but we've restored that and you'll see some changes from quarter-to-quarter, as we sequence some of our promotional activity. But generally, we're at about the run rate we think we need to generate that 2% to 4% long-term receivable growth that we are striving towards.

Operator

The next question comes from Ryan Nash from Goldman Sachs.

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

So just on the NIM, given in the current quarter , you saw card yield fall 10 basis points and looks like the funding declined a little bit more than that, and now you're telling us, correct me if I'm wrong Mark, 9% on the NIM for next year. So can you just help us understand what is going to -- what is actually going to drive it lower? I would've thought that given the size of the funding benefit, that we could have actually seen some sort of stability in the margins. So can you maybe help us understand that? I know you laid out some of the potentials, puts and takes but maybe if you can flush those out a little further?

R. Mark Graf

Yes, I think, Ryan, the biggest delta in what I'm hearing in the question is probably just going to be simply a mix of receivables on the balance sheet and the ultimate effect on NIM as a result of that. We continue to expect a relative magnitude to the funding advantage that we expect to see over the next couple of years in line with what we had guided to before, which anybody who hasn't seen those, you can go to our website and get those off our couple most recent investor presentations where we kind of give a sense on CD maturity and rates. So I think the bigger issue is just going to be some of the stronger growth is likely to come from some of the products other than card and that will just simply have an effect of depressing the NIM somewhat. That said, though, I would reiterate my earlier comment, that despite having a lower margin, we also expect lower credit loss on that product, as well as opposed to a card product. So the profitability metrics are pretty solid.

David W. Nelms

And I would just remind you, we're continuing to have some higher rate balances that are amortizing off. So the CARD Act, as each year goes past, will have less and less impact. But this year, you've seen somewhat of an offsetting factors with higher rates rolling off and the benefit of lower funding costs and lower interest charge-offs.

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

Okay. And just one follow-up, if I can. Just on credit, I think we talked a lot about on last quarter's call, that you guys were going to start building reserves at some point in 2012. Now I understand it is pretty formulaic, but if you think about the economic factor, and we have seen some of the data begin to improve. We see -- a jobless claims down materially today. We've seen a pickup in GDP growth. Are you still comfortable with the guidance that we're going to need to build reserves next year or is there any change in the outlook?

R. Mark Graf

No, I would still be very comfortable with that guidance. I would say that comment was based not so much on a turn in the credit environment as it was based on growth expectations.

Operator

The next question comes from Ken Bruce from Bank of America.

Kenneth Bruce - BofA Merrill Lynch, Research Division

My question also relates to the NIM. I'm hoping you might be able to give us some additional granularity on the quarter-over-quarter changes. How much was being driven by CARD Act? How much from promotional balances and how much from the student loans, please?

R. Mark Graf

Now we haven't provided that level of detail. [indiscernible].

David W. Nelms

But I think in the [indiscernible] mix and some of those components, a little of our [indiscernible].

Kenneth Bruce - BofA Merrill Lynch, Research Division

[indiscernible] comment you made in your formal presentation, you'd indicated that if you remove the student loan impact, the asset yields would've been up quarter-over-quarter. Could you give us just some clarification around that?

R. Mark Graf

The NIM would have been up quarter-over-quarter had we removed the student loan acquisition, that's correct. So in other words, the way to think about it, at a high level, is that the impact to the funding costs, with respect to the credit card book specifically, outran the yield compression that we saw.

Operator

The next question comes from Don Fandetti from Citigroup.

Donald Fandetti - Citigroup Inc, Research Division

David, as you look into 2012, I was just curious if there's anything that you're looking at on the strategic front, in terms of bolt-on acquisitions, any areas you think that look interesting or if you're even looking at any smaller type transactions?

David W. Nelms

Well, we would continue to look for opportunities, given our capital position and our desire to build out our Direct Banking and payment strategies. But I'd also say that we would continue to be very careful on that. You saw what we did in 2011, with the 2 student loan acquisitions. We are looking forward to continuing to build off of that student loan position during this coming year. We're looking forward to closing on during the course of the year and launching our Discover home loan origination area. So I would not say that any acquisition is even required to continue fulfilling the -- our objective. But if the right things available at the right price and terms, then we -- and it fits our strategy, it fits our financial model, then, of course, we'd be interested.

Kenneth Bruce - BofA Merrill Lynch, Research Division

Okay, great. And then quickly on the spend and transaction volumes, were there any -- how did these for end of the quarter look and into December? I mean, are things still moderating in terms of year-over-year growth rates?

David W. Nelms

Well, what I'd say is that we are reporting about a week earlier than we did last year, so I don't think we have as much of a view for the full holiday sales. I think the one general trend I've noticed is continuing good transaction accounts and debit activity on our programs, some moderation in average ticket. Some of that you would expect with falling gas prices, which I think is a good thing for our customers but impacts volume. But it also could possibly reflect a little more discounting by some of the retailers that could impact average ticket. So we'll obviously know more as we finish out this season, it's important, last couple of weeks here.

Operator

Your next question comes from Rick Shane from JPMorgan.

Richard B. Shane - JP Morgan Chase & Co, Research Division

Two quick questions. One, in terms of -- you'd made some comments about marketing in competitive environment, can you just tell us specifically, where you are in terms of your normalized promotional balances? Are you now at the 15% level?

R. Mark Graf

Yes, I would say we disclosed back in the third quarter, that we were at total promotional balances of around 15%. That includes not just balance transfer activity, but it's all promotional activities. And I would say we haven't seen any significant shifts from that level since we last disclosed it.

Richard B. Shane - JP Morgan Chase & Co, Research Division

Okay, great. Second question, this is just a little bit further ahead, you guys are ultimately, a pretty large consumer of the Postal Service business. When you look ahead to the changes in terms of service quality from the U.S. Postal Service going forward, what percentage of your customers are actually mailing their monthly payments as opposed to paying online? Just so we can get a sense of what the impact might be on the industry going forward?

David W. Nelms

Well, we are a big customer of the Post Office and we've been very pleased with their continuing service, so I'm not particularly concerned about that. I would say that a lot of it -- we're not going to disclose the exact numbers, but a lot of our business, whether it's for new accounts, from payments and other activities, customer self-servicing on the Internet, a lot of it is moving to the Internet. And just as a general guide, we had -- a couple of years ago, we had 3 payment processing and statement centers and we've now consolidated down to just one, and a lot of that is because of the big move that we're seeing to the Internet. And I think that is one of the main reasons, main focuses that we have on our future cost position because we think that doing things online can drive an increasing level of efficiency across our organization.

Operator

Next question comes from Bob Napoli from William Blair.

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

On the student loan, I'd like to get a little more color on the Student Loan business and kind of your thought process on the outlook. I mean, I do sense that -- I mean, the opportunity there, but, also, certainly seems to be some concern in the market about that business. And as you did talk that the credit losses are awful low right now, but it's starting to move up to normal levels, what kind of organic growth are you hoping to drive out of that business and over what timeframe? I think people are going to be watching the credit quality on that business, investors pretty closely. Maybe you can give some feel for how that's going to -- how we should expect that to trend over the next year?

David W. Nelms

Well, we've really liked the Private Student Loan business and I think some of the confusion is over the federal student loans, which are about 95% of the market versus the 5% or so that's private student loans. And you have seen some figures come out, industry figures, but in the quarter, and I think on deteriorating credit quality, but I would just remind you that those are on the federal side. As Mark mentioned, our statistics have continued to perform per our expectations, which means that we continued to expect much lower loan losses and much better credit quality than the credit cards or than federal student loans. And I think that we have tried to be very careful in what we do with a lot of co-signatures. So to a large degree, we're lending not just to students, but we're involving the parents which we think significantly helps the credit and makes better decisions. And we're very focused on ability to pay and being cautious to help make sure that our students don't get in over their heads in terms of the debt that they can -- that they're taking on. And so I think in terms of growth, in Investor Day, we said that we had hoped to grow organically by about $1 billion this year, and that's about what we hit. And next year, we think we can do a bit more than that, and we'll be more specific with some targets during Investor Day.

R. Mark Graf

And with respect to the implicit question regarding profitability in light of the changing loss profile, I'd point you back to last year's Investor Day metrics as well. We wouldn't see any reason to give any different guidance on the long-term profitability or the longer-term credit performance of that book.

David W. Nelms

And in fact, on that regard, we said that the Student Loan acquisition we closed on a year-ago, we were looking for a $0.09 earnings accretion, and I'm happy to report that it was right in the $0.09 to $0.10 range of earnings accretion from that. So it's tracking along well so far.

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

And my follow-up question, sorry, it's unrelated as well. On the Payments segment, just some thoughts around there and you talked a bit about the mobile, but one area that you have, that Discover has kind of been going against the grain on, if you will, is it lack of interest in the prepaid market? I mean, certainly Visa, MasterCard, American Express, and I just wondered why, maybe you'd give a little color on -- that is -- it's forecasted to be probably the fastest growing area of payments over the next decade. Why is there this lack of interest in that product by Discover?

David W. Nelms

Well, I actually wouldn't characterize it as lack of interest. I would say we are a big player on the network side, and in fact, there is a -- we don't disclose the exact numbers but we have a significant volume, particularly on PULSE, but also on Discover Network from prepaid, and the largest -- some of the largest prepaid providers in the country operate on our network. And so we may be just a bit more quiet about it, but we're certainly pursuing multiple opportunities in that regard.

Operator

Your next question comes from Moshe Orenbuch from Crédit Suisse.

Moshe Orenbuch - Crédit Suisse AG, Research Division

Following-up on the previous discussion on competition, kind of in your core product, I think you had mentioned that you expected the cost of rewards to drift upward in the coming year. Just talk a little bit about the competitive environment from rewards because I guess there's lot of people out there offering them. I think you're numbers are pretty good and just talk about what you're seeing there and I've have got a follow-up?

R. Mark Graf

Yes, I guess I would say, we -- as David mentioned earlier, we see that the competitive environment is having to return to basically, call it a normalized level more or less, where everybody is once again, competing for activity balances and wallet share. I think -- we do think the rewards cost in the quarter at 86 basis points was unsustainably low. We don't think that's the right number to be looking at going forward. I'm not prepared to give guidance on exactly where I think it will be going forward. But I guess what I would say is, we're disciplined in how we manage that process and we'll continue to be disciplined. We'd expect the first quarter to be a little bit elevated, and we'll monitor the results and kind of see if we need to make any adjustments to the program based upon that.

Moshe Orenbuch - Crédit Suisse AG, Research Division

Mark, I guess I was asking how you see it stacking up against your competitive offers from other issuers who were offering cashback.

David W. Nelms

Well, what I would say is that we've been the leader in rewards and cash rewards specifically, for 25 years. We do have a number of competitors who have been copying some of our features and programs. And so we continue to have innovations. And one of the things that we're very focused on is working with retailers where we have many retailers on our Shop Discover program, that work with us on the 5% program and have more ways to earn and redeem than our competitors. And it's an area that we think we need to continue to be the leaders and we need to have stability. There's an awful lot of competitors that have come in and then gone out when they realize that it's expensive and it's specialized, whereas you've seen us stay the course and continue to be the leader recognized by consumers broadly in this area.

Moshe Orenbuch - Crédit Suisse AG, Research Division

And my follow-up, Mark, you had mentioned that you had wished you had more flexibility on the setting of the reserve. If you had that, what would you be doing differently?

R. Mark Graf

I can't comment on that. That would really kind of run counter. I don't blame you for asking. I don't hold it against you one iota. That's fine.

Operator

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

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

Just earlier, you referenced moving up to top of wallet, becoming a primary card for more of your cardholders. Can you give any sense of how that shifted over time? Maybe give a range or some measure, but just curious as to how that's changed over time?

David W. Nelms

Well, what I'd say is that it probably accelerated during the downturn, and one of the things that if you look at our sales volume on Discover Card the last 3 years, our sales did not drop off as much as any of the other competitors. And now we're growing 8% during this quarter and we've also disclosed in Investor Day and a couple of times, some other metrics, both on growth on active merchants and in growth of sales on primary customers. I can't go into great detail on how we track it, but we certainly are very focused on our wallet share, which we see on the credit bureaus and on getting not only more active customers, but getting our active customers to use us more. And there is great leverage in having a couple of more transactions a month, on our card versus someone else's card and we're very focused on that, usually, using our rewards program.

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

Okay. And just as a follow-up on the M&A discussion, is there any preference for an asset generating acquisition versus a funding acquisition?

David W. Nelms

I think you've seen us do both over time -- well, really, probably 3 kinds. We've done some funding with the E-trade funding acquisition from 2 years ago. You've seen is doing assets and a business which are the student loan acquisitions and then you've seen us announce the home loan, which is more of a fee generating business since we don't intend to keep those on books. So -- and then finally, you've seen us do payments, once with both Diners Club and PULSE over the years. So I think that anything that fits our strategy and has the right financial metrics for our shareholders is something that we would at least pay attention to.

Operator

The next question comes from Brian Foran from Nomura.

Brian Foran - Nomura Securities Co. Ltd., Research Division

I missed the first part of the Q&A, so stop me if this is redundant, but I guess I would've certainly expected revenue suppression to be a little bit bigger tailwind than it seems to have been in the quarter and can you just remind us, I know you don't have the reserve component of your revenue suppression, so that's one big difference versus Cap One and versus the interest charge-off -- interest and fee charge-offs at AMEX, but historically, you were kind of in between Cap One and AMEX, now you seem to be much higher. Is there something structurally that's changed in your revenue suppression rate or is there just a lag factor that's working its way through?

R. Mark Graf

Suffice to say, post the CARD Act, we've obviously seen a lower absolute level of revenue suppression. But the ultimate suppression is going to depend and how low charge-offs go and where they normalize ultimately. And I think the relative degree of suppression we've had is relative to some of those other names you've mentioned is obviously tied to the relative performance on our charge-off line item relative to those folks as well.

Brian Foran - Nomura Securities Co. Ltd., Research Division

Okay. But so I guess if we continue to see charge-offs go down, it would continue to improve. And if we see charge-offs go up, it would start to become a bigger contra revenue line item?

David W. Nelms

All else equal, Brian, that would be the trend.

R. Mark Graf

Yes.

Brian Foran - Nomura Securities Co. Ltd., Research Division

And then I know, you've kind of touched on it in multiple questions, but just given the offers that BofA and Chase have in cashback rewards and to a lesser extent, Capital One, is the rewards commentary kind of about matching those offers or is it about one upping those offers or just how do we think about the offers the big guys are running in the cashback space right now?

David W. Nelms

Well, remember that we have been running at around 90 basis points and have suggested some stability, so part of the comments where the 86 is below that and was intended to signal that we're not is probably a little bit lower level. It will fluctuate, to a large degree, by how much promotional work we do in a given quarter, how much we do in our 5% program and our other programs. And we go through a rigorous process, particularly on the promotional programs, to do testing and see what kind of incremental sales we have, what kind of spend we have that is sustained, both in other categories and in the categories in which we have promotions. So while we certainly look at competitors, I'd say our biggest focus is making sure that we're delivering the maximum value at an achievable cost for us, and I think we've proven that we're the best at that over the long haul.

R. Mark Graf

Yes. As David noted, we've seen the big guys come in and out of this in the past. We're not going to respond, we're not going to beat, we're not going to match. We're going to do what's right to engage our customers and to drive growth. We've stayed the course in this product for a long period of time. We've been innovate -- into it and out of it. We're going to continue to stay the course and we're not concerned about our ability to do that.

Operator

The next question comes from David Hochstim from Buckingham Research.

David S. Hochstim - Buckingham Research Group, Inc.

I wondered, could you tell us what portion of the government guaranteed loans you have are eligible for the refinancing into direct loans and if you have a sense yet of how much that might happen and then what kind of discount you've got the loans on the books for now?

R. Mark Graf

Yes. I would say everything we have in student loan small book is like $700 million, give or take. If I remember the number correctly, it's all in the held for sale category and it's marked to appropriate market rates at this point in time. So I think that has a limited shelf life on our books.

David S. Hochstim - Buckingham Research Group, Inc.

Right. But if you could get them refinanced a way at par, that will be better and I just wondered if you worked out that, that's likely to happen or it's possible to happen?

R. Mark Graf

No. I would say that's not likely to happen at this point in time.

David S. Hochstim - Buckingham Research Group, Inc.

Okay. And then could you maybe go back and provide a little more color in terms of credit card loan growth, sort of what was different in Q3 versus Q4, and the balance growth you had during those 2 quarters, and the average balances, as Chris pointed out, were down, even though period end balances were up in Q4 and Q3?

David W. Nelms

Well, remember, there is obviously, seasonality in credit cards whether it's back-to-school or the holiday period that we're coming into. So I think that the thing we typically point to is the year-over-year growth in loans. And you've seen us kind of consistently move from neutral to 1% to 2% to now, 3% year-over-year. And that was our ending balance. And so I think I wouldn't overly analyze on seasonality. I would suggest that you look year-over-year.

David S. Hochstim - Buckingham Research Group, Inc.

Okay. And then -- but just the average balance didn't go up as much in the fourth quarter as the kind of the ending balance. I guess I'm just curious about that. You painted the average balance for the fourth quarter is below the beginning and the ending balance in between?

David W. Nelms

Well, I think that we've had momentum and if you go from 1% to 2% to 3% ending, then you're going to see bigger numbers at the end than you are during the middle because you're growing during the course of that quarter.

Operator

Today's final question comes from Matthew Howlett from Macquarie.

Matthew Howlett - Macquarie Research

Just a modeling question. Regarding the student loans, I know you've reaffirmed sort of the economic guidance regarding debt portfolio, but is there a default period that may be elevated, let's just say, a couple of years after the payment rates start that could skew the margin temporarily?

David W. Nelms

Yes, as we've discussed in Investor Day, normally, in student loans, there's definitely vintages that you have to look at and you have minimal defaults during the time people are in school. You would expect to have about half of the default, the lifetime defaults during the first 2 years of repayment, and then the other half of the defaults during the remaining life of these loans. And so as the book matures and you have more people in that first 2 years after repayment, you would expect to have elevated losses. And if you look at our what, 45 basis points of losses, that's obviously well below what we'd expect this business to be when it's at maturity and that's why we internally look at the vintage curves. As it seasons, it'll come to up to more normal levels of losses.

Matthew Howlett - Macquarie Research

Is the portfolio still today, would those year -- would sort of a peak years be 2012, 2013 sort of the repayment periods, sort of peak default periods as the portfolio stands today?

David W. Nelms

It's going to obviously depend on how much we grow over the next few years. So I wouldn't want to -- and to a lesser degree, maybe on what's going on in the economy. I mean, we're pleased that it's performing well right now, at a time when unemployment -- employment for new grads is not -- is really not the best. So I wouldn't want to say what year will it be peak. The other thing I would remind you is that the majority of our portfolio is now purchased seasoned loans and so we've got a lot of history. The company that we purchased, Student Loan Corporation has been in the Student Loan business for 50 years, and we're one of the top 3 in the business. So we're originators. So I think we feel we've got a lot of expertise now in-house.

Operator

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

Craig A. Streem

Thanks, Christina. I just want to thank all of you for your attention this morning and your interest. And then certainly, on behalf of my colleagues, we want to wish all of you, a very happy and healthy holiday season and New Year's, and we'll continue to stay in touch. Bye-bye.

Operator

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

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