Discover Financial Services (NYSE:DFS) Q4 2022 Earnings Call Transcript

Discover Financial Services (NYSE:DFS) Q4 2022 Earnings Call Transcript January 19, 2023

Operator: Good morning. My name is Todd, and I will be your conference operator today. At this time, I would like to welcome everyone to the Fourth Quarter and Full Year 2022 Discover Financial Services Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session. Thank you. I will now turn the call over to Mr. Eric Wasserstrom, Head of Investor Relations. Please go ahead.

Eric Wasserstrom: Thanks, Todd, and good morning, everyone, and welcome to today’s call. I’ll begin on Slide 2 of the earnings presentation, which you can find in the financial section of our Investor Relations website, investorrelations.discover.com. Our discussion today contains certain forward-looking statements that are subject to risks and uncertainties that may cause actual results to differ materially. Please refer to our notices regarding forward-looking statements that appear in the fourth quarter earnings press release and presentation. On our call today will include remarks from our CEO, Roger Hochschild; and John Greene, our Chief Financial Officer. After we conclude our formal comments, there will be time for a question-and-answer session.

During the Q&A session, you’ll be permitted to ask one question followed by one follow-up question. After your follow-up questions, please return to the queue. And with that, it’s my pleasure to turn the call over to Roger.

Roger Hochschild: Thanks, Eric, and thanks to our listeners for joining today’s call. I want to begin by reviewing the highlights and key metrics for the year, and then John will take you through the details of our fourth quarter results and our perspectives on 2023. I’m very pleased to say that 2022 was the second strongest year for earnings in our company’s history. We reported net income of $1 billion or $3.77 per share for the fourth quarter and $4.4 billion or $15.50 per share for the full year. This was accomplished against a fluid and unusual macroeconomic and monetary policy backdrop and I want to thank the entire Discover team for their solid execution. This performance gives us significant momentum going into 2023 and beyond.

I want to give a few highlights that underscore these strong results. First, we grew new accounts by 23% and loan receivables by 20%. This demonstrates the appeal of our consumer value proposition and advancements in our consumer targeting and acquisition capabilities while maintaining our conservative approach to underwriting and credit management. We’re also prudently investing for growth, including an acquisition and brand marketing, the continuing build-out of our data and analytic capabilities and increasing field personnel for both servicing and collections, all while achieving a 39% efficiency ratio. The combination of revenue expansion and disciplined cost management contributed to our 31% return on equity this past year and underscores the highly capital-generative nature of our business model.

Over the course of 2022, we repurchased $2.4 billion in common stock and increased our dividend by over 20%, and we expect to sustain attractive levels of capital return to our shareholders into the future. As we look into 2023, we expect a less favorable macroeconomic backdrop. Nevertheless, we intend to maintain an appropriate level of investment in our organization. For example, we have several initiatives that will improve our digital marketing capabilities, and we anticipate the broad market launch for mass market cash-back debit product. And of course, we’ll continue to invest in our brand and in account acquisition in a manner consistent with the environment. We’re very aware of the climate in which we are operating. And should there be changes in economic conditions, we will adjust.

Our model with its focus on prime lending and through-the-cycle underwriting has historically supported resilient returns through the economic cycle. These factors, combined with our earnings power, reserves and capital, underpin our strategy of being the leading consumer digital bank. I’ll now turn the call over to John to review our results in more detail.

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John Greene: Thank you, Roger, and good morning, everyone. I’ll start with our financial summary results on Slide 4. The takeaway of the quarter is largely about strong asset growth and net interest margin expansion, partially offset by growth-based provisioning. Asset growth combined with a NIM rate improvement, increased revenue 7% sequentially and 27% year-over-year. Similar to last quarter, asset growth also drove an increase in our reserves of $313 million. This increase has our reserve coverage ratio relatively flat at 6.6%. In the prior year, we released $39 million of reserves. So while our reported net income was down 3% year-over-year, adjusting for the reserve change, our net income would have been 23% higher on a year-over-year basis.

Let’s review the details starting on Slide 5. Net interest income was up $584 million year-over-year or 24%. Our net interest margin expanded, benefiting from the higher prime rate partially offset by higher funding costs and increased promotional balances. NIM ended the quarter at 11.27%, up 46 basis points from the prior year and 22 basis points sequentially. For the full year, NIM was 11.04%, up 28 basis points from the prior year. Receivable growth was driven by card which increased 21% year-over-year, reflecting continued strong sales, new account growth and payment rate moderation. Sales increased 8% in the period, a deceleration from the 15% growth we experienced in the prior quarter and the 20% in the first half of the year. New card accounts grew by 17% from last year’s fourth quarter.

Similar to the prior quarter, the sales growth decline was mitigated by a decrease in the payment rate, which fell 150 basis points in the quarter. We expect payment rates to continue to decline through 2023, but at a more moderate pace. Turning to our non-card products. Organic student loans increased 4% as a result of peak season originations. Personal loans were up 15%. We continue to stay disciplined in our approach to marketing, underwriting and pricing of this product. Our attractive value proposition has positioned us well in the market that is experiencing strong consumer demand and some improvement in competitive conditions. In terms of funding mix, our customer deposit balances were up 10% year-over-year and 5% sequentially. Deposit pricing continues to be in line with what we expected in a rising rate environment.

Recently, we have seen some moderation in the pace of pricing changes. Looking at other revenue on Slide 6. Non-interest income increased $212 million or 47%. This was partially due to a $138 million loss on our equity investments in the prior year quarter, compared to a $6 million loss this quarter. Adjusting for these, our non-interest income was up 14%. This increase was primarily driven by two items. First, loan fee income was up $51 million or 39%, driven by volume. And second, we had higher net discount and interchange revenue, which was up $23 million or 7% reflecting strong sales and a favorable sales mix, partially offset by higher rewards costs. Moving to expenses on Slide 7. Total operating expenses were up $183 million or 14% year-over-year and up 8% from the prior quarter.

Compensation costs were up primarily due to increased headcount and wage inflation. Marketing expenses increased $42 million or 15% as we continue to prudently invest for growth in our card in consumer banking products. Premise and equipment expense was elevated this quarter due to a onetime write-off related to the exit of our Phoenix servicing location. Adjusting for this, premise and equipment would have been flat to the prior year quarter. With this recent action, we have resized or exited three of our four major call center locations, and we’ll continue to evaluate our footprint going forward. Moving to credit performance on Slide 8. Total net charge-offs were 2.13%, 76 basis points higher than the prior year and up 42 basis points from the prior quarter.

In the card portfolio, the net charge-off rate of 2.37% was 87 basis points higher than the prior year and 45 basis points higher sequentially. As expected, portfolio loss rates are normalizing, reflecting seasoning of new account vintages from the past two years, normalization of older vintages and mild deterioration and low credit bands, largely inflation-driven. These trends are within our expected risk tolerances and are consistent with our historical approach to underwriting and credit management. Among our core prime revolver segment, we don’t see evidence of broader stress given the robust labor market. I’ll cover our 2023 view in a moment. Turning to the discussions of our allowance on Slide 9. This quarter, we increased our allowance by $313 million driven by the increase in receivable balances.

Our reserve rate declined slightly to 6.6%. Adjusting for the elevated level of transactor balances in the fourth quarter, our reserve rate would have been near sequentially flat. Under the CECL accounting standard, we are required to contemplate life of loan losses and adjust our reserve levels accordingly. For us, the changes to employment conditions pose the most significant risk to our forecast. For the year-end 2022 reserve, our baseline assumption was unemployment in 2023 between 4.5% and 6.5% and with alternative scenarios above 6%. Looking at Slide 10. Our common equity Tier 1 for the period was 13.3%. Our longer-term target remains at 10.5%. We expect to make progress against this target over the next four to six quarters. Yesterday, we announced a quarterly common dividend of $0.60 per share.

And in the fourth quarter of 2022, we repurchased $602 million of common stock. Concluding on Slide 11 with our outlook. Momentum is strong, which should help to generate double-digit revenue growth and positive operating leverage. We expect end-of-period loan growth to be in the low double digits with average loan growth somewhat higher. This is driven by three factors: our prior year growth in new accounts moderation in the payment rate and sales volume trends. Through mid-January, sales are up 13%, but we expect deceleration to the high single digits over the course of the year. We expect net interest margin to be modestly higher than the full year 2022 levels. More specifically, we expect NIM to be above the fourth quarter levels in the first half of the year driven by continued loan re-pricing benefits and decline in the second half.

We are looking for total operating expenses to increase less than 10%. Salary and benefit expense will increase due to hiring in the second half of 2022. Additionally, we expect marketing to be above our full year 2022 level. We expect net charge-offs will average between 3.5% and 3.9% for the full year. The low end of the range is more in line with our base case, while the high end is more consistent with a weaker employment scenario. Lastly, we have $2.8 billion of remaining capacity under the $4.2 billion share repurchase program that expires in June of this year. We expect to repurchase around $2.2 billion of shares in the first half of 2023. We’ll provide an update on future share repurchase authorizations after we complete our stress testing process and review recommendations with our Board.

In summary, receivable growth continued to benefit from new account acquisition, payment rate moderation and positive sales. NIM continues to benefit from prime rate increases with funding costs consistent with expectations and credit is performing in line with our approach through-the-cycle underwriting process and conservative credit management. Our perspective for 2023 reflect our focus on advancing our strategic priorities generating high returns and capital while remaining disciplined in our credit and expense management. With that, I’ll turn the call back over to our operator to open the line for Q&A.

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Q&A Session

Operator: We’ll take our first question from Moshe Orenbuch with Credit Suisse.

Moshe Orenbuch: Great. And John, thanks for kind of outlining the parameters of the range of expected credit loss. But could you talk a little bit about the past kind of from here to getting to the 3.5%? Like what either has to happen that’s bad or not happen, that’s good. And at what points along that way, would you know whether that 3.5% base case is too high or too low?

John Greene: Yes. Great. Yes. Thanks for the question, Moshe. So the range is some unlocked, right? 3.5% to 3.9% for ’23. And — we certainly have a great deal of visibility through the first six months of the year through a roll rate methodology. Post six months, so in the second half of the year, we use our analytical models which anticipate a number of different possible outcomes but used as historical data that’s been tested significantly to make a projection of what we expect to happen. So as we get through the first quarter, we’ll be able to see what’s happening with our roll rates in terms of is it a roll to one bucket and the roll to two bucket, consistent with our expectations on the base case on the reserve. Beyond that, we’ll certainly look at the macro environment and what’s happening with unemployment levels and the overall job market.

That will give us some perspective. And then an important component of this, and I know there was some questions in terms of the step-up from where we ended ’22 to where we’re projecting ’23. We have fairly significant vintages that are going through the normal seasoning process right now. So for example, our end-of-period card portfolio, so last year 12/31 to this year 12/31 increased by $15.7 billion. And if you think about kind of a maturity cycle of a credit card, typically within the first year to two years, you hit peak losses. So that is some of what we’re expecting here, and therefore, the guidance that we’ve provided. We do expect that in a stable macroeconomic environment, in the second half of the year, we should see this slope of the curve begin to bend down a little bit with perhaps top losses coming through in ’24 and then returning down.

So overall, what we’re seeing here is just a strong portfolio, very significant vintages that came through in ’21 and ’22 that are seasoning at levels that were — that are completely within our expectation of total return thresholds. And then, we’ll see the overall portfolio normalized. So hopefully, that provides some clarity on both the trajectory as well as what we’re seeing in the portfolio.

Moshe Orenbuch: Perfect. And just as a follow-up, the reserve rate was down. You mentioned that was largely a result of transactor balances. But I guess even with that, it wasn’t up. And so when you think about that, kind of how do you — I mean, how should we think — it doesn’t feel like you’re anticipating a deteriorating environment if you’re keeping your reserve certainly no worse than flat. And how do we think about that going through ’23 as well?

John Greene: Yes, great question. And they’re connected, so happy to cover them in the same set. So CECL reflects life of loan losses as we all know, right? And so, what drives that is the portfolio performance and the — our view of the macroeconomic environment today and going forward. And we haven’t had any substantial changes to the macroeconomic environment. And essentially, the portfolio is performing within our expected ranges of outcomes. So, as we look at the fourth quarter receivable balances in the aggregate, and the portfolio performance, a stable macro, we felt most appropriate reserve levels would be fairly consistent with what we did in the third quarter. And essentially, without taking you through a ton of detail that the teams spend weeks and weeks working through, that’s essentially how we arrive at the answer.

Operator: Thank you. Our next question will come from Sanjay Sakhrani with KBW.

Sanjay Sakhrani: Maybe just a follow-up question to the credit question is Moshe asked. John, you talked about the seasoning. Is there any way to parse apart the impact of seasoning in your range versus the actual degradation as a result of just the deteriorating delinquencies on a base case? And then you mentioned sort of the slope of the curve decelerates, I think you said in the second half, but I just want to make sure to understand sort of how the seasoning will impact us for the next two years. Does it still weigh in on you in the first half of 2024?

John Greene: Yes. So in terms of the impact of the vintages, I explicitly called out the card vintage in 2022, so the $15.7 billion to give the folks that are listening here, a place to anchor on in terms of thinking about the vintage and then you can run out peak losses for our portfolio in terms of what typically happens after a significant vintage and in a stable macro. So that should help you at least in terms of the thinking in terms of the vintage. As we think about this year, we gave that range of 3.5% to 3.9% on the loan base — on the average loan base. So you should think about the ultimate kind of range here. It will depend first on the macro. Second, we’ll continue to give updates in each of the quarters in terms of what we’re seeing. But ultimately, we expect this vintage will mature in 2024. And then, we should see in a stable macro, the curve not only slope pending, but actually inverting slightly.

Sanjay Sakhrani: Okay. Follow-up question on loan growth. Obviously, you mentioned the strong growth driving the seasoning, but you guys are still expecting double-digit growth in the face of maybe a tougher economic backdrop. What gives you the comfort here? Maybe Roger, speaking to the growth in the past, and I know every cycle takes on a different complexion. What are you guys looking at that makes you comfortable to grow here? Because that’s a question I get quite a bit from investors.

Roger Hochschild: Yes. Good question, Sanjay. I think you’ve seen us operate this business through multiple cycles and the disciplined approach we take both in good times as well as in bad. And frequently, the accounts that you put on during a challenging economic time, perform extraordinarily well, and you can see very good cost per account as competitors pull back. So, we have been pretty clear that starting in the back half of last year, we started tightening credit standards, and you can expect us to continue to look at that and adjust according to economic conditions, both for new accounts as well as the portfolio. Nevertheless, we’re seeing great returns on the marketing investments we’re putting out there. And so, that’s what gives us the confidence to keep investing in growth.

Operator: Thank you. Our next question comes from John Hecht with Jefferies.

John Hecht: Not to beat the dead horse, but maybe just one more question on the kind of the provisioning and the credit. John, I think you kind of detailed the unemployment assumptions. I think they were kind of in the 4.5% to 6% range with maybe somewhere making the 5% range, kind of the middle of the fairway. Just maybe can you tell us what’s the sensitivity for the — either the charge-offs or the ALL at say unemployment moves to level like 100 basis points higher than that.

John Greene: Yes. So in our kind of primary case here, we assumed a 100 basis points increase in unemployment. Now that that was specific to our charge-off forecast. In terms of kind of reserve levels, we actually used a composite of multiple scenarios. The more heavily weighted scenario reflected a loss rate of 4.5% and then going up all the way to 6%. So, I’m feeling actually like we’re down the middle here in terms of appropriateness in terms of overall reserve levels and more specificity in terms of sensitivity. I don’t think that would be a service given if we’re seeing unemployment kind of creep up in that sort of matter or that sort of quantum that would indicate that the macro environment has changed, and we have to change our view on that, which could change our perspectives on life of loan losses.

John Hecht: Okay. That’s helpful. And then you gave annual guidance with NIM, and it sounds like maybe an elevated NIM in the first part of the year coming down second, what are the drivers of that with respect to the yield and the cost of capital?

John Greene: Yes. Yes. So I’m going to run through the primary drivers. So first would be the Fed rate changes in the second half of ’22 as well as what we’ve anticipated either two or three increases in 2023. Second impact is the yield on our investments, which is improving with the increase in the rate environment. And then, the third piece has been some pricing actions we took in the consumer banking products. So, think about the non-card products. So offsetting that would be kind of the cost of funding. So DTC and external funding costs have increased. And then we’re also anticipating an impact from credit, all of which the net of those gives us a high level of confidence that certainly, we’re going to see peak NIM in the first quarter and then stepping down from there through 2023.

Operator: Thank you. Our next question comes from Mark DeVries with Barclays.

Mark DeVries: I have one more credit question for you. I know you don’t generally give out guidance more than one year out, but I think some of the commentary around the charge-off guidance has some implications for 2024. I just wanted to try and clarify I mean if you look at the guidance range, it seems to imply you kind of exit 2023 at a charge-off rate at 4% to 4.5%. I think, John, you indicated 2024 is kind of a peak year? Should we expect — is it reasonable to assume that that’s implying kind of a charge-off rate north of 4% for 2024?

John Greene: Yes. So you were right on your call here. We gave a range for 2023 of 3.5% to 3.9%. I talked about the curve and what we think will happen to the curve and the slope of that. So, Mark, as a matter of prudence, I think that’s probably as far as I’m going to go here.

Mark DeVries: Okay. Fair enough. Thanks for that color.

Operator: Thank you. Our next question comes from Betsy Graseck with Morgan Stanley.

Betsy Graseck: Maybe a slightly different way to address this question is you perhaps could give us some color on where you have seen your fully seasoned vintages peak in terms of net charge-off rates and around what kind of month within the seasoning path that happens in a range of months that would be helpful to understand.

John Greene: Yes. So typically, we’ll see it around 18 months. And it varies based on credit quality. So, the highest credit quality. So, I think FICO would typically peak a little later. And then the weaker, I’ll say, the weaker credits typically peak a little bit earlier. But on average, I think, about 18 months or so.

Betsy Graseck: And the level that you’ve been seeing, it would be helpful to understand how historically, the vintages that you want to write to are trajecting in terms of peak. And maybe if you could comp 2022 vintage in 2021, what you’re seeing there would be helpful?

John Greene: Yes. So — the first part of that answer would be it would depend on the vintage. So if you go back to our 2020 vintage and remember, there’s COVID, right, we were locked down. We ceased underwriting kind of the near prime and lower prime and concentrated on upper prime that vintage will season at a peak loss level below what Discover historically has done. If you look at ’21, ’22, we were essentially back to an underwriting standard consistent with history. And you can use that information to get some level of comfort around what can be expected in ’24 on this vintage.

Betsy Graseck: Okay. Because you’re basically saying ’22 is a normal — is exhibiting behavior that is more normal pre-COVID type of vintages?

John Greene: It is. Yes. Yes. The one difference that I think is important for folks to codify in their minds is that we’re coming off an abnormally low base, right? So the entire portfolio is normalizing. We’ve talked about that consistently actually, since the beginning of last year that we thought the portfolio was normalizing. And what you’re seeing here in the 2023 guidance is essentially the portfolio normalizing.

Betsy Graseck: The current reserve ratio level is consistent with this normalization whereby peak losses hit in ’24?

John Greene: Yes. Otherwise, my controller would have taken an exception to our reserve process.

Betsy Graseck: Right. And this is — I know we’re talking about card, but is this the same kind of expectation across the other asset classes as well, student and personnel?

John Greene: Yes. Although what we’re seeing in personal loans is, again, loss rates below historical norms. Payment rate is beginning to normalize. And we had talked about the fact that we perhaps overcorrected on that product in terms of underwriting, in terms of the pullback. We pulled back significantly. So I expect some seasoning and normalization there. But again, we’re very, very confident about the loss performance of that product. We understand where it is on the payment priorities for folks. So we’re going to be mindful of the economy on that. And student loans, yes, that’s normalizing. We did have and likely we’ll have a little bit of impact when we see the full impact of the student debtors on the government programs having to pay back loans, but it’s underwritten to a high standard. 80-plus percent have cosigners. So, we feel very comfortable about that product as well.

Operator: Thank you. Our next question comes from Rick Shane of JPMorgan.

Rick Shane: Look, this is an interesting milestone where the reserve rate is 658 basis points. It basically is apples-to-apples seasonality versus CECL day one and up 50 basis points. I’m curious when we think about your economic outlook and how you build a CECL reserve where you compare to CECL day one on a like-for-like basis, would you build the same allowance? Or have you made adjustments and then compare your economic outlooks in each of those points in time, please?

John Greene: Yes. So good question, Rick. So we’ve referenced CECL day one in the past, but I’d like to remind folks, day one was first time we rolled this new standard out. We were using new models. They’ve been tested extensively. And the macros were late cycle with higher unemployment levels. So as we look at kind of where we are today or as of the fourth quarter, right, 6.58 in terms of total loss reserve rate. That seems appropriate based on kind of what we’re seeing in the macros and how the portfolio is performing. So, do we specifically reference day one only from the standpoint of where it was back on January 1, 2020, to where it is today, but we don’t use that as a decision point whatsoever.

Rick Shane: John understood. I’m more curious that if you like were you’ve described that the models have evolved. And I think that, that’s fair, and I think everybody appreciates that. What I’m asking is, on a like-for-like basis, would — do you think that reserve rates are lower today using the same assumptions as you refine them versus CECL day one?

John Greene: Yes. No, no, they’re not lower. We’re looking at the portfolio performance. It’s performed extraordinarily well. We’re seeing a bit of seasoning now, as you would expect in this type of product. And the macros are contemplating a minimum level of increase in unemployment of at least 0.5% and more likely 1%. So what you’re seeing here is a CECL reserve for the quarter that reflects those macros.

Operator: Thank you. Our next question comes from Bob Napoli with William Blair.

Bob Napoli: Many — some commentary, Roger, on the competitive environment for rewards. I mean, you’ve seen very strong growth out of a number of players in the industry, including yourselves. Can you — are you seeing more competition? Where are you seeing more competition, more people getting more aggressive, if you would?

Roger Hochschild: Yes. Thanks Bob. It remains, I would say, intensely competitive. But as you’ve seen from the growth and especially the performance in new accounts, our value proposition is competing well. And again, I want to give credit to some of the advancements on the analytics that let us sort of personalize the marketing messages across different channels. I guess where competition has lightened a bit is in the personal loan space. I think there are a lot of non-bank funded folks there who may have some challenges on the other side of the balance sheet. And obviously, one big player who had been active is pulling out. On the deposit side, I would see there, I think you’re starting to see the gap between the direct banks, the branch banks really get wide enough that you’re seeing flows to the direct system, right?

It’s now at 3.3% for a savings rate. It’s now a lot more worth your money. So again, really excited about how our products are competing across every segment. And so that’s part of why we’re optimistic going into 2023.

Bob Napoli: What new products, I mean your cash-back debit is something that you’ve talked about? What new products are you most excited about?

Roger Hochschild: You’re highlighting probably the big launch for next year, which will be the re-launch of cash-back debit and we hope to be doing some mass-market advertising of that. Beyond that, I really believe we have the right product set. We’re seeing great demand, for example, on the home equity side, given how rates have moved and the lack of cash-out refi. So I think part of how we keep our costs as low as they are, is a very simple, lean operating model. So I wouldn’t expect anything other than the re-launch of the cash-back debit and we’ll put a lot of weight behind that.

Operator: Thank you. Our next question comes from John Pancari with Evercore ISI.

John Pancari: Back to the credit topic, anything about the charge-off guidance that baked into your guidance, that is a surprise at all in terms of what you’re observing. I know you talked about the seasoning and the vintages and it sounds like there’s nothing there that really surprised you. But I’m wondering, anything about the credit migration within the vintages, within the portfolio in the past dues and/or customer behavior that surprised you that led to the increase in the charge-off guidance that seems to be well above where The Street was expecting?

John Greene: Yes. Thanks, John. Actually, no surprises in the portfolio performance whatsoever, and I want to reiterate that. And that’s essentially why the reserve rate is flat, right? So, they are connected. So what that says is that charge-off guidance was essentially contemplated in the reserving of life of loan losses. So, we feel very good about that and there is consistency. I did talk about in my prepared remarks that the lowest end of the credit spectrum that we have in our portfolio. So some near-prime and some folks without FICO scores or those who fell below 660 are certainly feeling the impact from inflation. But internally, we completely anticipated that we had run some analysis on inflation shocks and what it would do to some of the card members, and it’s performing essentially where we thought it would come out.

So I’m actually quite pleased about that. The other important thing that I want to make sure that the audience here is I think what 2022 did for us is it increased the earnings power of the firm. And there’s a lot of focus from these questions on kind of the charge-off and peak good assets consistent with what we’ve done historically. So loans increased $18 billion. So, there’s going to be some seasoning, but overall, the earnings power of the firm has increased as a result of great execution by our teams.

John Pancari: Okay. That’s helpful. And then, again, just — I know this gets to CECL and the whole spirit of it. But given your commentary and that you just indicated reserve flat, so if the macro outlook progresses within your scenarios and the loss migration progresses as you described here into 2024 of this 2022 vintage, and no other surprises elsewhere, then would you expect accordingly that the reserve at 660 would generally remain around that level in that case? Or could there be incremental upside to the reserve, assuming that macro backdrop remains as they’re within the scenario bands.

John Greene: Yes. So, there’s — I appreciate the question. A lot of assumptions in there, but as you laid out, I would expect the overall reserve rates to be relatively close to kind of where they are today.

Operator: Thank you. Our next question comes from Bill Carcache with Wolfe Research.

Bill Carcache: First, I wanted to ask if you could give us a sense of what kind of delinquency rates you’d expect based on that 3.5% to 3.9% NCR rate outlook?

John Greene: Yes. I mean we don’t typically forecast the delinquency rates. You would — what I suggest you do is take a look at the trust data and the relative difference between the trust data historically and where the total company is coming out, that will give some insights. And then also, the trends in delinquencies typically are pretty consistent, right? You can go point to point to point. And then I’ve given some views in terms of where we see the slope starting to flatten and then perhaps spend. So, I’d use that information in order to — if you’re interested in calculating overall delinquency rates for firm.

Bill Carcache: Okay. That’s helpful. I guess just the spirit of the question was, there isn’t anything unique happening with that increase in charge-offs that would lead to a breakdown between the historical relationship that exists between delinquencies and charge-offs. In other words, the sharp increase that you’re expecting in delinquencies — or sorry, in charge-offs, it would be reasonable to expect sort of a commensurate sharp increase in delinquencies as the data start to come through?

John Greene: Yes, there obviously, a relationship there, certainly. Although remember, you should have — you should take into account the kind of the vintage impact and what I’ll say normal seasoning, right? So, there’s $18 billion of incremental loans. Some of those are just going to perform extremely well and a small percentage will season, out as we typically see. So, I would consider that in the analysis, but nothing at it. There should be no substantial break.

Bill Carcache: Okay. And my follow-up is, if I might have missed this, but why did an increase in early-stage delinquencies drive higher credit card and zero rates this quarter. Is my initial thought was that early stage delinquencies would have to flow through the various delinquency buckets before charging off? So what was it following how that early stage increase this quarter impacted NCOs? Just a clarification there would be great.

John Greene: Yes. Yes. Well, there’s a couple of different components, right? There is — there’s a bankruptcy bucket. There’s a non-bankruptcy bucket that just flows through the buckets. And then there’s also the recovery element. So if you put those three together, sometimes the bankruptcy bucket is it will pop in a particular quarter, depending on flow of work in the court system and the non-bankruptcy just flows quarter-over-quarter. So, I would certainly look at this quarter, prior quarter and what comes out in the first quarter, and that will be the insights you’re looking for.

Operator: Thank you. Our next question comes from Mihir Bhatia with Bank of America.

Mihir Bhatia: I wanted to just talk a little bit more about credit. So specifically, I think you mentioned a little bit of mild deterioration in credit among the lower bands. Does your guidance contemplate that stress in your prime core revolver portfolio at all as unemployment increases, I guess said differently, what I’m trying to understand is, do you think we go from credit formalization to deterioration for DFS overall? Or is it just normalization with just the vintage seasoning impacts that we’ve been talking about?

John Greene: Yes. Thank you. It’s the latter. It is normalization and seasoning, which we contemplated fully in both our kind of origination strategy, our reserving strategy and obviously in the guidance we’re providing.

Roger Hochschild: Yes. And maybe just to clarify, the lowest income segments which are a pretty small portion of our base are the ones that get additional pressure from inflation, right? By and large, a prime book can adjust. They trade down, they readjust their pattern. So I think John was referring to incremental stress there. But there’s no reason to believe that the vast majority of our portfolio will be driven by the traditional drivers of losses, which is charge-offs — I’m sorry, which is unemployment.

Mihir Bhatia: Got it. And then, I did want to offer maybe a little bit of a big picture question, just longer term. I think — we appreciate that you have added a lot of business and increase the earnings power because some of these assets will obviously last a long time past and into seasoning. But the portfolio has changed a lot and your guidance for the next year and it sounds like potentially even ’24 is a little bit above where credit losses have been running. So maybe just remind us, what is the normal loss rate for DFS or for the card portfolio or something like that? Maybe give us a range. Just trying to understand where a typical portfolio settles out? Is it in that 3%, low 3% range where does that settle up?

John Greene: Yes. Thanks, Mihir. So — we’ve been asked that question over the years many, many times. And what I typically refer people back to is, if you take a look at the details of the kind of the charge-off history, you can go back through 2008. And see kind of quarter-over-quarter what’s happening on the charge-off front, you can discern kind of normalized charge-off rate from that and then make adjustments for economic periods or kind of vintage-based seasoning.

Operator: Thank you. Our next question comes from Kevin Barker with Piper Sandler.

Kevin Barker: And in regards to your employment forecast and your base assumptions, you’re pretty clear that the low end, the 3.5% assumes the 4.5% to 5% unemployment rate. But can you help us understand or just confirm that the — is it the 3.9% higher end of the range, implying a 6% unemployment rate or some other scenario out there within your expectations?

John Greene: Yes. So the high end does not weight the 6% entirely. It actually could reflect a scenario with unemployment is actually higher than the 6%, but it would depend on the depth of it and kind of what industry. So, there’s multiple scenarios in there. So, the guidance I provided in terms of 4.5% or over 6% is intended to kind of get the kind of the meat of the scenarios that were contemplated and weighted.

Kevin Barker: Okay. And then with your baseline assumption of 4.5% to 5%, is that something that we make our way to throughout the year and then maintain that level or something where you expected to peak there and then startly drift lower?

John Greene: Yes. So it would run through slowly increase through 2023 and how we’ve thought about it.

Operator: Thank you. Our next question comes from Don Fandetti with Wells Fargo.

Don Fandetti: Can you dig in a little bit more on the credit card spend growth rate and kind of what you’re seeing in terms of any pattern changes. I think the last update through November showed a little bit of a step-down in the growth rate. And can you talk about December and I think maybe you touched on January?

Roger Hochschild: Yes. I’ll start. January is off to a very strong start. So, we’re seeing about a 13% year-over-year growth in sales, and again, reflects the new accounts we put on last year, but also, again, for those who aren’t employed a robust environment. We have been seeing increases in the day-to-day category commensurate with inflation and so more spending shifting there. And a lot of what you heard from retailers in terms of softness around home improvement, and hard goods, but a lot of that was just, I think, some of the challenging comparisons to really robust levels from before. So, overall, I’d say, stable, but we’re certainly encouraged by what we’re seeing so far in January.

Operator: Thank you. Our next question comes from Arren Cyganovich with Citi.

Arren Cyganovich: On the marketing outlook, you had indicated that you expect to spend more than 2022 levels, which obviously was a very strong acquisition year for you. What’s the thought process there in terms of expecting to increase spend after such a strong year?

John Greene: Yes, great question. And you know what, I’m going to hit kind of give an overview on expenses and now I’ll specifically talk about kind of marketing and our thinking there. So, we said overall expenses would increase less than 10%. So, what that contemplates is a double-digit increase in marketing and single digits for the non-marketing spend. And what that reflects is, we continue to see opportunities to acquire profitable new accounts that are consistent with what we do. So that — in that prime revolver credit card. We also are intending to spend some money on the launch of the debit checking product. So that will include dollars for new accounts as well as advertising to bring awareness to the product. And then, it’s important to also kind of have a view on the marketing in that this is our guidance.

If we see the macroeconomic environment change or we don’t see ample opportunity to spend this money wisely then we will make calls in terms of the level of spend, and it could be less than what’s — what we’ve guided to. But overall, we’re very, very pleased with kind of our targeting and the effectiveness of the marketing and gave us confidence to continue to increase that.

Arren Cyganovich: And then on the personal loan side, you had indicated that it’s — it’s clear that it’s performing better than historically. With respect to the guidance, does the personal loan net charge-off rate, is that expected to go as high as credit cards in 2023? Or are you still expecting it to be somewhat better?

John Greene: Yes. I’m going to stick at the top level of the guidance we provided. And then, we give details by product in the supplement. I would use that information and impute kind of the charge-off rate there. But again, product has been performing very, very well, loss rates significantly below kind of what’s happening out in the industry. And it’s a kind of a — it’s a prime customer set. So that should give a view of kind of at least a way to think about expectations for that product.

Eric Wasserstrom: So, I think we’re going to conclude our call there. Any additional questions, please reach out to the IR team, and thanks very much for joining us this morning.

Operator: Thank you. This does conclude today’s call. We thank you for your participation. You may disconnect at any time.