Bill Franklin - Vice President-Investor Relations David W. Nelms - Chairman & Chief Executive Officer R. Mark Graf - Chief Financial Officer & Executive Vice President.

Moshe Ari Orenbuch - Credit Suisse Securities (USA) LLC (Broker) Cheryl M. Pate - Morgan Stanley & Co. LLC Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc. Chris C. Brendler - Stifel, Nicolaus & Co., Inc. Donald Fandetti - Citigroup Global Markets, Inc. (Broker) John Hecht - Jefferies LLC Eric Wasserstrom - Guggenheim Securities LLC Mark C.

DeVries - Barclays Capital, Inc. Ryan M. Nash - Goldman Sachs & Co. Bill Carcache - Nomura Securities International, Inc. Scott J. Valentin - FBR Capital Markets & Co. David Ho - Deutsche Bank Securities, Inc. Bob P. Napoli - William Blair & Co. LLC Christopher R. Donat - Sandler O'Neill & Partners LP David Hochstim - The Buckingham Research Group, Inc.

Jason E. Harbes - Wells Fargo Securities LLC.

Good day, ladies and gentlemen, and welcome to the Discover Financial Services Second Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference is being recorded.

I would now like to turn the conference to Mr. Bill Franklin, Head of Investor Relations. You may begin..

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

Our discussion today contains certain forward-looking statements about the company's future financial performance and business prospects, which are subject to risks and uncertainties and speak only as of today.

Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today's earnings press release, which was furnished to the SEC in an 8-K report, and in our 10-K and 10-Q, which are on our website and on file with the SEC.

In the second quarter 2015 earnings materials we have provided information that compares and reconciles the company's non-GAAP financial measures with the GAAP financial information, and we explain why these presentations are useful to management and investors. We urge you to review that information in conjunction with today's discussion.

Our call today will include formal remarks from David Nelms, our Chairman and Chief Executive Officer; and Mark Graf, our Chief Financial Officer. After Mark completes his comments there will be time for a question-and-answer session.

During the Q&A period it would be very helpful if you limit yourself to one question and one related follow-up, so we can make sure that everyone is accommodated. So now it is my pleasure to turn the call over to David..

Thanks, Bill. Good evening everyone, and I want to thank you all for joining us today. For the second quarter we delivered net income of $599 million, earnings per share of $1.33, and a return on equity of 21%. Our net income this quarter benefited from a reserve release driven by a better outlook for our card credit.

Card net charge-off and delinquency rates improved, as card members continue to be careful about managing their debt. And we continue to take action to help them stay current. At the same time consumer conservatism and lower gas prices have resulted in slow U.S.

retail sales growth, and this along with heightened competition, has resulted in a bit slower growth for our card sales and loans. Despite these headwinds to sales we once again achieved another quarter of solid loan growth, building upon more than four years of quarterly card loan growth.

Discover achieved total loan growth of 5% over the prior year, which was driven by growth in card loans, personal loans, and private student loans. Specifically we grew card receivables by 4%, in the middle of our targeted range. Card sales volume for the quarter was up 2%. Excluding the impact of gas prices, sales were up approximately 5%.

Our loan growth continues to be driven by a combination of wallet share gains with new accounts and existing customers. Despite a competitive environment new account growth accelerated through the quarter, as we launched our double rewards offer to new Discover it customers.

In addition to launching new rewards promotions in the quarter we also introduced new features for our card members. For example we launched our Freeze It capability, which essentially allows customers to turn on or off their card in the event that it is misplaced. Over 100,000 customers have tried this feature since launch.

We also announced that our card members will be able to use Apple Pay and Android Pay in the near future. Our goal is to provide our customers the freedom, options, and simplicity of making mobile payments with whatever method they choose.

Mobile payments and digital in all their forms will continue to be an opportunity to further engage with our card members, and we continue to invest in these capabilities. Turning to other direct lending products, the organic student loan portfolio increased 19% and personal loans grew 13% over the prior year.

Both are on track for record originations in 2015, as we launch additional marketing programs with student loans during peak season, and as we see increased personal loan applications from the broad market.

On the regulatory front this week the CFPB and the FDIC announced that they have released us from the protection products consent orders, which we entered into with them a few years ago. This morning we announced a consent order with the CFPB regarding certain student loan servicing practices.

You may remember that we had previously disclosed a CID related to this matter early last year. And we fully accrued for this in the first quarter of 2015. Finally on the AML/BSA and general compliance fronts, we have noted significant expenses this quarter related to our continuing focus on meeting all regulatory expectations from our regulators.

Focusing on payments, total volume was down 3% as increases in our proprietary volume and growth in our business-to-business volume were not enough to offset year-over-year declines at PULSE. The decreased volume at PULSE was mainly due to the previously announced loss of volume from a large debit issuer.

On a reported basis Diners volume was roughly flat. However adjusting for the impact of foreign exchange rates, Diners volume was up more than 10% year-over-year, driven by strong results in several regions, especially Asia Pacific. Lastly, we rebalanced our portfolio of activities in the second quarter.

In Direct Banking we announced the exit of our Home Loans business. In payments and specifically within Diners we announced the sale of our Diners Club Italy franchise to Cornèr's Bank (sic) [Cornèr Bank] (6:09) and announced a new Diners Club franchisee in Turkey.

We are committed to our vision to be the leading direct bank and payments partner and continue to take steps towards achieving this vision. Now I'll turn the call over to Mark, and he will walk through the details of our second quarter results..

Thanks, David, and good evening everyone. I'll start by going through the revenue detail on slide five of our earnings presentation. Total company net revenues this quarter were roughly flat on a year-over-year basis, as higher net interest income was offset by lower fee income.

Net interest income increased $47 million or 3% over the prior year, driven by continued loan growth. Total non-interest income decreased $44 million to $539 million, driven primarily by lower net discount and interchange revenue and a decline in protection products revenue.

Net discount and interchange revenue was down 9%, driven by a higher rewards rate year-over-year. Our rewards rate for the quarter was 105 basis points. On a reported basis, the rate was up 14 basis points year-over-year due to higher promotional rewards and the elimination of the rewards forfeiture reserve in the fourth quarter of 2014.

Sequentially, the rate increased 3 basis points. In both cases, the increase was driven by higher enrollment and spend in our rotating 5% cashback category. Protection products revenue declined $10 million as new product sales remained suspended, consistent with prior quarters.

Moving to Payment Services, revenue decreased $9 million from the prior year due to the previously announced loss of volume from a large debit issuer, which David referenced earlier. This loss is now largely reflected in the run rate going forward and will impact year-over-year comparisons for the next year.

Turning to slide six, total loan yield of 11.35% was 7 basis points lower than the prior year, primarily driven by a 6 basis point decrease in card yield. The year-over-year decrease in card yield reflects a small shift in portfolio mix as high rate balances continue to be replaced by standard rate balances.

Personal loan yield decreased from the prior year as more customers opt for shorter term consolidation loans, and we also instituted some select pricing changes. Funding costs increased 9 basis points as a result of actions taken in prior quarters to extend funding duration.

In aggregate, these factors resulted in a 21 basis point decrease in net interest margin from the prior year to 9.63%, in line with our expectations. Turning to slide seven, operating expenses were up $130 million over the prior year, partially driven by higher regulatory and compliance costs.

Employee compensation increased $25 million, due primarily to higher head count to support regulatory and compliance needs. Reported marketing expenses increased $31 million, $17 million of which was due to the discontinuation of a longstanding annual postage rebate that we typically received in the second quarter.

Marketing expenses were also impacted by a shift in the timing of campaigns as compared to last year. Professional fees increased $41 million, due in part to approximately $20 million in fees associated with anti-money laundering remediation activities and another $10 million in compliance program enhancements.

Other expense increased $29 million, driven by $23 million in one-time charges associated with the exit of our Home Loans business.

We expect additional wind-down in restructuring expenses of approximately $25 million to $30 million in the second half of the year, and we currently expect a fourth quarter tax benefit related to exiting the business that will essentially offset these additional expenses. For the quarter, our total company efficiency ratio was 42.5%.

Excluding the two unusual items I mentioned earlier, the total company efficiency ratio was roughly 40.5%. On an adjusted basis, this is higher than where we want to be in the long-term.

With everything we now know, including the charges related to exiting Home Loans, the legal reserve that occurred in the first quarter, the loss of the postal rebate as well as a modest increase in our outlook for compliance-related costs, we expect our as-reported expenses to be approximately $3.6 billion for the full year versus our prior guidance of $3.5 billion.

We continue to expect that operating expenses will decrease in 2016. Turning to provision for loan losses and credit on slide eight, provision for loan losses was lower by $54 million compared to the prior year due to a reserve release partially offset by higher charge-offs.

This quarter, we reduced reserves by $41 million while last year we had a $23 million reserve build for the same period. This quarter's release was driven by a better credit outlook as overall card member health continues to improve, in part driven by lower gas prices and higher household cash flows.

The credit card net charge-off rate decreased by 12 basis points from the prior quarter and by 5 basis points year-over-year to 2.28%. The 30-plus-day delinquency rate of 1.55% declined relative to both the prior quarter and the prior year, reaching a new record low.

The private student loan net charge-off rate, excluding purchase loans, decreased 28 basis points from the prior year as we continue to benefit from more efficient collection strategies as well as the introduction of several new payment plans over the last year.

Student loan delinquencies, once again excluding acquired loans, increased 12 basis points to 1.78%. Overall, the student loan portfolio continues to season generally in line with our expectations.

Switching to personal loans, the net charge-off rate was up 15 basis points from the prior year and the over 30-day delinquency rate was up 5 basis points to 71 basis points. The year-over-year increase in the personal loan charge-off rate was primarily driven by the seasoning of loan growth.

We had mentioned at our annual Financial Community Briefing in May that we were seeing the potential for credit to be better than we expected at the beginning of the year. We are now comfortable that the underlying financial health of our card members will indeed produce credit results better than we originally anticipated.

While the book continues to season, we do expect our provision rate for the full year to be better than our prior expectations of 2.5% as the credit backdrop remains remarkably benign. One last item I'll call out on the income statement is that we were able to recognize some tax benefits which reduced our effective tax rate to 36.4% for the quarter.

Looking forward, there may be some minor fluctuations quarter-to-quarter as we are able to favorably resolve other tax matters. To close things out, I'll touch on our capital position on slide nine. Our common equity Tier 1 capital ratio decreased sequentially by 30 basis points to 14.4% due to loan growth and capital deployment.

During the quarter, we repurchased $425 million of common shares. In summary, the health of our card members continues to be strong, which will be a positive for our credit performance. This goodness will be largely offset on the expense line, which will be elevated as we continue to address regulatory matters and wind-down the mortgage business.

The competitive environment continues to intensify while retail sales growth has been slower than expected. As the environment evolves, we will address both opportunities and risks that it presents with a continuing focus on driving long-term shareholder value.

That concludes our formal remarks, so I'll turn the call back to our operator, Abigail, to open the line up for Q&A..

Thank you. Our first question comes from the line of Moshe Orenbuch with Credit Suisse. Your line is open..

Great. Thanks. I appreciate that the spending volume you had said was constrained by about 300 basis points and that your margin is still under pressure but you've kind of put a 9.5% kind of floor there.

Could you talk a little bit about what steps you're taking, given all of the expenses that are building this year, to kind of improve profitability? Or do we just – I mean is it just that we kind of have to wait for those factors to abate? Could you just discuss your thoughts there?.

Moshe, this is David. Some of the actions that we're taking now are designed to position us well for the future, even in some cases sacrificing near-term profitability.

So the preparation for a rising rate environment on the funding side is costing us a bit of net revenue right now, but we think it's the right thing to do for long-term earnings growth.

The exit of the Home Loans business will help our efficiency ratio going forward, and certainly we didn't see a path to producing adequate profitability in that business. And some of the marketing changes and cash rewards investments that we're making now are designed to drive growth and return long-term profitability.

So it's focusing on long-term shareholder value, as Mark mentioned..

Moshe, all I'd really tack on to that is a big pressure right now is obviously on the expense front and its regulatory expenses. They were significant in the quarter. They continue to be a pressure point.

We're committed to a constructive relationship with our regulators and making sure that we are operating in accordance with their expectations, but right now that's clearly a drag on profitability..

Right.

So just to follow up, and maybe I was just a little too general in the question, is there a way that you could identify the effects of things that you expect to either abate or turn around in 2016, you're talking about the expenses on some of these compliance, the wind-down of the mortgage, perhaps if you would consider the costs of kind of preparing for the rising rate environment? I mean would you – is there a way to do that?.

Yeah, so let's talk about a couple of those specifically, Moshe, to really hit on the – very pointedly on your question.

I would say let's take a look at the expense growth of $130 million, right? So $23 million of that is related to the exit of the Home Loans business, non-recurring; $17 million of it is related to the postal rebate that we have historically received kind of going away. Right? So that takes me down to an adjusted number.

Then take out another $8 million for EMV costs that we incurred in the quarter, give or take. It takes me down to an adjusted $82 million. There's about, call it, another $40 million in various and sundry different regulatory related costs that are in there.

That gets me down to an adjusted – rough math now, mind you, but for the sake of the call here – an adjusted expense growth number of $42 million as opposed to the headline number of $130 million. Right? So I think that's kind of a key piece of the puzzle to look at.

If you talk about the funding side of the equation, I appreciate your earlier comment noting that the compression in NIM was kind of in line with our prior guidance. We did not take any further activities in this most recent quarter to further extend in any way our funding durations.

So the compression you're seeing is a result of actions we've already taken to position the balance sheet. There's no more further pressure coming from that other than as the quarters roll and you get the comps with that higher funding cost in there, it will be there, and that's why we've given the guidance down to 9.5% going forward.

So hopefully on the NIM side, hopefully on the expense side, that gives you some key pieces that will help you develop some comfort there..

Thanks so much..

You bet..

Thank you. Our next question comes from the line of Cheryl Pate with Morgan Stanley. Your line is open..

Hi. Good afternoon. I just wanted to touch on loan growth for a moment and card loan growth in particular. Obviously we're still sort of towards the high-end of the range, but we've seen some deceleration in the past couple of quarters.

Can you just speak to is that some selective pulling back from some customer segments? Is that increased competition? How should we think about that, and are we sort of at a stable level here or should we think about more to come?.

Well I think this quarter we moved back a bit to the middle of our range. And we cited the broad retail sales growth across the country that decelerated this quarter. And we saw that in many of our competitor announcements as well. We also saw the continuing impact of gas prices, which has impact sales and to a lesser degree loans.

And I would acknowledge that it is more competitive now than it probably was a few years ago. We have been at the top end of our range and the top of the industry for now the last four years.

And so while on the one hand we're still in the middle of our range, a lot of the actions we talked about are designed to try to accelerate that, because I'd rather find a way to get it back to the top of the range.

And that includes the double cash rewards on our Discover it program, which has seen good results in the early weeks of that program, our new Miles program, additional marketing spend, additional features like the on/off functionality that's unique on our card.

So we're taking a lot of actions to try to accelerate loan growth, but I'm pleased that we were in the middle of the range..

Really helpful color. Thank you. I just wanted – and secondly on the personal lending I think you mentioned some change in the pricing strategy.

Is that sort of related to some of the marketplace lending that's coming about? Or more to do with changing consumer preferences for term and shorter duration?.

Well we – I think it's pretty modest, that portion of it. The duration, average duration is the bigger part. But I mentioned that we're expecting all-time record loan originations this year. And so I think that we are looking to continue to grow that business, because it's – unlike some of the new competitors – we're quite profitable and we're growing.

And we want to keep taking advantage of our capabilities in the prime segment within personal loans..

Great. Thank you very much..

Thank you. Our next question comes from the line of Sanjay Sakhrani with KBW. Your line is open..

Yeah thank you. I guess, David, you mentioned the heightened competition in the press release. And obviously we're seeing it in our mailboxes as well.

Could you just talk about how different it is versus what you planned for at the beginning of this year? And kind of how it's affecting the financials going forward? I mean I notice the rewards cost edged up pretty significantly sequentially. So maybe you could just talk about how that's expected to trend going forward, Mark? Thanks..

Well and I mentioned competition is just one factor. And I'm not sure it's so much different than what we planned for. It's just a factor that makes it harder to grow as fast as we'd like. I think that it's still – if you look at mailboxes there's still a lot less intensity than there was pre-crisis.

But I – and there's fewer players here post-crisis left in the market. It's consolidated. But I think that some of the players that were really wounded from maybe credit mistakes and problems that they had made are kind of getting through those and are coming back in the market.

And I think it's not lost on a lot of players that card returns are much higher than almost anything else in banking. And therefore it's an attractive place to compete. And so we are used to facing competition. We've done it for 30 years successfully. And so we view it as a challenge that we're up to..

Yeah. I would say, Sanjay, just adding onto that the only thing I would say that has changed since the planning time is our expectations for overall retail sales growth.

At the time we cut our plan last fall, Moody's, all the external providers, were basically expecting a much stronger retail sales growth climate than we're actually finding ourselves in today. So I would say that is the one major factor that has altered.

In response to your specific question on rewards categories I would say this quarter the driver was active engagement enrollment and the 5% rotating cashback category was the principal driver. I think for the full year the guidance we gave is we expected the rewards rate to be in the 105 basis point range.

I don't see any reason to point you to something radically different. If there is any upward pressure on rewards costs, I would say it's 1 basis point or 2 basis points above and beyond that possibly. But nothing of significant magnitude from a rewards standpoint there..

Thank you. And, Mark, could I ask one follow-up question? Just on the NIM and the tax rate, could you just drill-down a little bit? Like just if you could give us more a specific cadence there, that would be great..

Yeah. So the NIM, I think last quarter we saw from first quarter – from fourth quarter into first quarter we saw 7 basis points of compression. And I think we guided on the last call that we expected to see similar compression this quarter, which would have taken us from 9.69% to 9.62% and we printed a 9.63%.

So I feel like we're pretty much in line with the cadence we were kind of calling out. We do see further compression over the course of the remaining two quarters we're looking at going forward. But we still see ourselves remaining above a 9.5% NIM.

I think if you want to use a linear approach to getting there, Sanjay, that's probably not a crazy way to think about modeling things I would say. And then on the tax rate scenario, I would say the good guide this quarter was simply related to a resolution of a tax matter with a taxing authority.

And it was just kind of one of those things that you'll have from time-to-time as you get favorable resolutions to matters that you've reserved for. So kind of hard for me to kind of guide you in terms of what that looks like going forward for when we might see other such things..

Okay great. Thank you..

Yeah..

Thank you. Our next question comes from the line of Chris Brendler with Stifel. Your line is open..

Hi. Thanks. Good evening. Thanks for taking my question. I'm going to focus on the competitive environment for a second, Mark. We talked about some of the higher spending customers may be getting poached away by some of the aggressive rewards offers out there.

I just want to see from a strategic standpoint, is that getting worse or is it sort of stabilizing, especially if you think about some of the increased efforts you've made on the rewards side both in this quarter's results and also the double promotional points on it.

Are you targeting to get back to the kind of growth you were experiencing in purchase volumes sort of more in line with the industry, or are you okay letting some of this business go?.

Well, I would say that our objective is to get sales growing a little faster. It was – ex gas it was 5%, and as we get to the end of the fourth quarter, that's when I would expect the gas thing to stop being something we talk so much about, because it'll be in the end-of-the-year comps.

But 5% ex gas is still above retail sales growth, but if we can find ways to get that even higher than that, above retail sales growth, we will take actions to do so. And certainly some of our new rewards programs, marketing and so on are designed to do that. The one thing is we're not going to – we are focused on sustainability.

We're not going to be entering an arms war..

Right.

Just from a strategic standpoint, David, is it fair to say at this point in the cycle that the majority of your revenue growth will come from some of the other products rather than card, or is card still going to be the engine for growth here?.

Both are going to be engines for growth. The card is going to be quite important because of its base size. The other products are going to tend to grow faster than card but from a lower base. So as we look out over the next year, the next three years, we need to maximize our profitable growth in all of our products..

Great. I look forward to that. Thanks so much..

Thank you. Our next question comes from the line of Don Fandetti with Citigroup. Your line is open..

David, as the Fed looks like it's about to potentially raise rates, how are you – how do you think the card industry is going to react in terms of card yields? Do you expect a sort of full 100 basis point asset beta, or do you think some of the competitors might actually create a stickier yield to where that doesn't necessarily get passed through knowing they're all floating rate loans?.

No. I mean, post-CARD Act, as far as I know, all cards are variable rate and so we'll immediately reset upward. I think if you just focus narrowly on new account pricing, it might not be a perfect beta. But I would expect those rates to also go up, and it would certainly take a number of years for that to really filter into the portfolio.

So I think that it'll immediately adjust up..

Okay. Thanks..

Thank you. Our next question comes from the line of John Hecht with Jefferies. Your line is open..

Yeah, thanks very much. In your prepared remarks, you guys talked about I think it was somewhat tied that you're seeing the customers still reticent to spend much, to maybe lever up a little bit, and at the same time you're seeing improved near-term credit outlook because delinquencies and loss trends.

If those are tied together at this point, are you – is it possible that there's been a permanent shift or at least an intermediate term shift in customer trends? And if so, does that change long term expectations for both credit and loan growth opportunities?.

I think that – I guess I would answer that as yes. We've already seen that, and I don't think it's going to go back to pre-crisis. We're not counting on huge loan growth in our industry in cards, but we also think that the new normal for credit is significantly different than pre-crisis.

I think that consumer behavior has had a certain amount of permanent change as well as some of what competitors are willing to offer. You just don't see a lot of subprime players the way it existed in the past.

And so the good news is that the industry is – feels like it's going to start returning to slow growth, and that's a lot different than the shrinkage we've seen for a number of years. And even as it does that, credit remains amazingly benign.

And for us to achieve actual reduction in charge-off and delinquencies despite our loan growth this quarter, this far away from the crisis I think is remarkable..

And as a little follow on to that, would that, over time, maybe give you an opportunity to go a little down market, you know, even if you did it very carefully just because it's possible that there's some increased demographic you could approach given the better outlook for overall credit?.

Let me parse it two ways. Right now, the players who are in retailer and subprime kind of credit are seeing a pretty big resurgence in growth. But it's not a market that I'm particularly focused on. We're just not a subprime player.

Now, at the same time, as credit and behavior gets worked into the models and given customers have lower risk, it opens up the universe a bit of people that could have prime performance, that maybe in the past we might not have been as confident that they would have had prime performance.

So at the margin, we are looking for opportunities to expand our prime universe, particularly both in cards and personal loans..

Great. That's very helpful. Thanks..

Thank you. Our next question comes from the line of Eric Wasserstrom with Guggenheim Securities. Your line is open..

Thanks very much. Mark, thank you for the stratification of the drivers of the increased costs in the period.

Just to focus in on that $40 million of regulatory costs, did that include both the personnel related component as well as the professional fee component? Or was it just one or the other? And I guess what I'm really trying to get to is what part of it is going to be sort of sustainable and recurring and what part of it can diminish?.

Absolutely. So let me kind of give you how I'm getting to that rough $40 million number ballpark, and again these are rough numbers. They're not sniper rifle estimates. So you've got about $20 million directly related to the look-back that's been mandated in our regulatory consents.

There was about another $5 million in, what I will call, general compliance type activity. There's about $5 million expense related to our information technology group and work they needed to do related to certain compliance related activities.

And then there's about $10 million in, what I would call, non-volume head count that has come into the model over the course of the last year directly – it's really more second and third order effects.

So you don't see these people sitting in compliance, you don't see these people sitting in corporate risk, but the people in compliance and corporate risk are looking for more information, more reporting, more activity. So that's driving second and third order effects downstream.

I'm, for my purposes, classifying that as, what I'll call, regulatory compliance related activity as well. So if you look about the – if you look at it net-net, certainly 50% of that increase is non-recurring beyond this year as we get through that look-back type activities.

I think we'd all be hopeful that we'd have the ability to pare back some portion of that additional 50% as we get this activity layered in. The head count is not coming out, which was $10 million of it, and I'm sure there will be some ongoing related activity as well. So I don't have the precise number to give you. Clearly, 50% of it is non-recurring.

I'm comfortable saying that some portion of the remainder is non-recurring. What I can't do is give you a real sniper rifle estimate on what the tail on that looks like..

Thanks. Very helpful. Thanks very much..

You bet..

Thank you. Our next question comes from the line of Mark DeVries with Barclays. Your line is open..

Yeah, thanks. Mark, I was hoping I could get you to be a little bit more specific on the revised guidance around the provision.

I think you indicated you expect it to be better than the 2.5% prior guidance, but given how low the first half run rate is, you could technically be above that run rate in the second half and still meet your guidance, but that certainly doesn't seem reasonable given that credit still remains really benign.

Is there any kind of specifics you can give us on what you think the provision rate might look like?.

Very fair question. I would say, Mark, at this point in time, that's one of the things we're trying to get behind ourselves as we kind of see this new normal credit environment creeping in that's offsetting the seasoning.

So I'm not prepared at this point in time to give you a new provision rate, but I would kind of highlight one of the things that I pointed out in our prepared remarks when I kind of said we're going to have this increased level of expenses rounding from $3.5 billion to $3.6 billion because of some of these additional things that have come at us.

But we do expect the goodness on the credit side relative to that provision guidance will pay for that. Right? So comfortable going that far at this point in time. Beyond that, we need to see a little bit more history, a little bit more activity to get a better sense on that front..

Okay.

But are you seeing anything in the data right now that would suggest a materially higher run rate in the second half of the year relative to where we've been in the first half of the year?.

We're continuing to see the book season, which is the key piece of the puzzle. The fundamental question is really on the consumer behavior side of the equation that I don't think we have enough history with yet to really be able to sniper rifle – give you a sniper rifle estimate on that.

So again, I just – I don't want to give you guidance that I'm not comfortable with myself yet because we don't have all the ticking and tying done ourselves. I am comfortable telling you it's going to better than that 2.5%. I'm comfortable saying it'll pay for the expense increase. That goodness will pay for the increased expense guidance.

Is there possibility it could be more than that? Yes, there's clearly a possibility it could be more than that but I need to get a little more facts on my side because I don't want to mislead you..

Okay, got it. Thank you..

You bet..

Thank you. Our next question comes from the line of Ryan Nash with Goldman Sachs. Your line is open..

Hey. Good evening, guys. I guess on my first question, Mark, you noted in the prepared remarks on efficiency that you weren't happy with the level at which you were at, and you walked through some of the math.

But I guess my question is as you think ahead to 2016, do you think the 38% efficiency target is achievable, given all the moving parts on expenses? Clearly, we don't know what the rate environment is going to look like, which could help the overall run rate, but I was just interested in what your early thoughts are on that looking ahead?.

Yeah, Ryan, I would kind of say it's a long term target that we want to hit and that we try to run the business model at.

It's too early for me to give you guidance in next year in terms of where I think it's really going to come out, because there's going to be some – obviously some puts and takes as we go through our strategic planning process and our budgeting process for the year as well where we'll look to take some expenses out of the model.

I think we'll probably look to make some growth investments and I just don't know how all those are going to shake out at this point in time. I'm very confident telling you that, as a management team, we're not happy with an adjusted efficiency ratio with a 40% tag associated with it.

I'm very confident that a significant chunk of the expenses in the model right now are non-recurring. But in terms of giving you guidance on exactly how close we're going to be to that 38%, either up above or below it, it's just too early for me to give you that..

And just maybe one follow-up financial question. I just wanted to make sure I fully understood the net interest margin outlook. Was that for the rest of this year or through 2016? And you made a comment earlier about some of the higher rates in the loan book are being replaced by standard rates.

How far through the repricing process? Does it feel like we're getting close to the end on that? And how much of an impact is that actually having on the overall net interest margin?.

So I would say a couple things, Ryan. The net interest margin guidance I said – I think what we said is it'll stay above 9.5% at least through the end of 2016. So that's one where we have gone out a little bit further on our guidance at this point in time, and I'm comfortable really kind of saying I feel comfortable with that at this juncture.

In terms of the impact of the remixing of the portfolio and the impact to that, I would say in a post-CARD Act environment, the only balances you get to reprice up – or you get to price up are balances – new balances created after such point in time as that customer goes 60 days delinquent.

So you obviously don't refill that higher rate bucket very much. So I think you'll see continued movement out of that promotional category – or out of the high rate bucket rather – into the standard rate category. And that is a big factor in the driving of the margin compression candidly down to that 9.5% level..

Got it. Thanks for taking my question..

You betcha..

Thank you. Our next question comes from the line of Bill Carcache with Nomura. Your line is open..

Thank you. Mark, on the double rewards I don't believe you guys are making those rewards available to customers until they've been with you for a year.

But is the cost of those double rewards hitting the rewards expense line now? Or is that going to come later?.

Yes. That's being accrued in the rewards expense line. You got to accrue that on the fly. So we are handling that accrual, and it is in the numbers you see..

Okay. So earlier you had mentioned that one of the things that drove the rewards higher this quarter was the 5% cash back category.

But that would – another factor would be the double rewards contributing to the higher rewards expense this quarter? Is that correct?.

Yeah. I would say that's absolutely mathematically correct. I would tell you it's a relatively small number, because it's really spending only related to new accounts. Right? So you got the installed base is one issue, but then you got the new account activity that's qualifying for it as well. So I would say the driver is clearly not the double.

The driver was clearly where the 5% category was this quarter..

Got it. Thank you..

You bet..

Thank you. Our next question comes from the line of Scott Valentin with FBR Capital Markets. Your line is open..

Thanks very much for taking my question.

With regard to the student loan, the settlement I guess, or the fine the CFPB announced, is that going to have any material impact on servicing expense of student loans going forward or the profitability of the student loans going forward?.

No. It related to some practices that we actually changed a while back, so everything is in the run rate..

Okay. And then just a follow-up question on M&A. In the past you've mentioned you look at adjacent kind of businesses to consumer lending.

And just wondering if you continue to look? And maybe what areas you're looking in? Or what areas you see as interesting right now?.

So I would say in terms of the areas where we would look, those would be the areas we would generally look.

We obviously don't give any specific thoughts on M&A type related matters, other than at this point in time I would say we've gone on the record and said while we're under a BSA/AML consent order, it's unlikely we would look to M&A type activities. I think we kind of feel we have to get that one rectified.

But I think in terms of generally where we would devote our attentions, yeah, I think natural adjacencies where we can lever strengths we have internally, as opposed to trying to take quantum leaps and say entering the commercial real estate lending business or something. That doesn't feel like our DNA..

Okay. All right, thanks very much..

Yeah..

Thank you. Our next question comes from the line of David Ho with Deutsche Bank. Your line is open..

Hey. Good evening guys. I just want to get a sense of how you measure the payback for some of these new card features.

Does it really lower the cost of acquisition for new customers? Or maybe change the revolving (44:00) or spend patterns relative to some of the legacy cards? And then going forward as you lap some of these expense headwinds, you mentioned perhaps a little more incremental investment.

Is that the case? Do you expect to see additional opportunities in 2016 to really deploy? And kind of where do you think the best dollars would be most efficiently used there?.

So, David, I'll handle the first half and have Mark handle your second question. We look carefully at the net present value expected from all of our accounts. And then we – when we make changes, we run those through. And we try it and we test. And we work to maximize the long-term profitability of any action we take.

Certainly one of those actions and some of our actions do help our cost per account. And even though we've mentioned heightened competition a couple times on this call, you normally would see all other things equal that that would show up as higher acquisition costs, and we have not seen that at this point.

We've actually seen slightly lower average cost per account in our card business this year than in the past. And that's partly because of the marketing and feature functionality that we've taken.

We also see – when we see different performance in some of our products like our extension into Discover it Miles has significantly higher average sales volume per new account. That comes back into the P&L. And for those accounts we could actually afford to pay a little more if we're going to get more over the long term.

So we look at every activity with its own P&L.

And, Mark, maybe you can hit on the second question on capital buyback?.

Oh absolutely. Yeah, so on the buyback activity, what I would say is we continue to be very focused on producing high yield. I think we got close to a 9% total yield right now between dividends and buybacks.

We clearly recognize we have too much capital at this point in time and within the constraints of the regulatory process and the CCAR process, we are very focused on finding ways to return that capital to shareholders..

David, was there anything else on capital?.

Well, I was actually more focusing on kind of where you think the best marketing opportunities would be in 2016..

Oh, for deployment. I'm sorry. I misunderstood the question. My apologies, David. So in terms of the best opportunities for deploying it, I think you see us making a lot of those investments today in the it platform right now would be one key piece of the puzzle I would say is a good place for deploying that capital.

We continue to, as David noted earlier, to see great CPAs and very active, engaged card member behavior there. I think there's a lot of investments going into digital right now, digital and mobile platforms. Our key focus on the information technology side and investments being made there very heavily.

I think in the non-card lending businesses, the direct banking businesses, I think digital investments there are also forefront critical and are consuming capital at this point in time and we're seeing good returns associated with those.

And I think you already know we're actively engaged in migrating all of our banking platform products to a new core banking system as well. So that's a driver also.

So we watch the expected payback and the budgets associated with all these projects very, very closely, and I'm comfortable that we continue to have a disciplined process around the investments we're making..

Great. Thank you..

You bet..

Thank you. Our next question comes from the line of Bob Napoli with William Blair. Your line is open..

Thank you. Good afternoon. Just on the – so I wasn't clear on the postage rebate, the $17 million.

Is that a quarterly or an annual number, that rebate that you were getting?.

It was an annual number, Bob, that tended to generally fall into the second quarter. It was $17 million last year. So the increase this year is pulling up that comp. It varied year-to-year, but last year it was $17 million and this year the postal service chose to not renew that rebate. So it's a once-a-year kind of thing.

It'll adjust this year, and then it will be out of the run rate going forward..

Okay. And then as we look at the marketing spend in the back half of the year kind of the similar trend to what we've seen like, say, last year, the ramp-up from – I mean, you wouldn't have the same ramp-up I guess because of the $17 million, but the same general trend in the back half of the year.

You're not expecting any change in marketing trend?.

No. I actually think the marketing expense kind of hit its high watermark this quarter for the year. We'll actually – I mentioned in my prepared remarks that we had some timing differences in campaigns. So I think you've seen the marketing expense hit its high watermark over the course of the year.

It'll down a little bit from here, although it'll be higher in the fourth quarter than the third..

Okay. Are you seeing anything alarming in the student loan portfolio? Student loan player had brought – had some issues on the credit side with a certain portfolio that was going back into payment.

Have you seen anything alarming in your student loan portfolio from a credit perspective?.

No, we haven't..

Okay.

And then just last question, Ariba, is that going to be a material business, the B2B business? And over what timeframe could it become material?.

I think in the short- and medium-term, it could become material volume, we hope. I think I would not expect material profitability or revenues any time soon, it is B2B. It's low margin, but it's a huge market.

And so, over the long period of time, we hope to build some very large significant volumes and there may be the potential for some ancillary related services that could also be profitable..

Have you been adding new corporations to that business?.

Yes..

I know you signed one very large partner..

We have been adding additional participants..

All right. Thank you. Appreciate it..

Sure..

Thank you. Our next question comes from the line of Chris Donat with Sandler O'Neill. Your line is open..

Sure. I wanted to ask one question around the credit quality and I understand it's better than you'd expected. As we look at the master trust data in your early stage delinquencies, I see that in that bucket delinquency rates around 40 basis points, historically low by your standards.

Should we still be, though, thinking about your broader portfolio, so not just the master trust subset, as reflecting something a little different than that? Because I have trouble making the math work to go from like 40 basis points early stage delinquencies to the kind of provision you're talking about..

Yeah. So I would say there is – Chris, there is a discrepancy between the master trust and the managed book. So if you think about the master book, I think we're coming up on or have just lapped six years since we have added any new accounts to that. So it's a very well-seasoned book.

And one of the things you'll see in a well-seasoned book is on a like-for-like basis, so if you have a FICO score – just pick a random number – a 750 FICO account that's brand-new and a 750 FICO account that's been with you for 10 years, the 750 that's been with you for 10 years performs better. I don't think that's unique to Discover.

I think that's just a phenomena you see in the consumer lending space. So there definitely is a disconnect between the performance of a well-seasoned book and the seasoning of a newly acquired book that you put on there. So absolutely there is a disconnect there.

That's why we give you some of the managed data as well along with those master trust releases on a monthly basis so that you can kind of get a little bit of insight into there..

Got it. Okay. And then separately here, just thinking about reward spending and your quarterly promotions there, this quarter you've got one with Amazon and I think a couple years ago when you did a promotion with Amazon and maybe a broader mix of online merchants around the fourth quarter, you had an elevated rewards level.

Anyway, any early reaction to having Amazon in the mix for about three weeks here? It seems like it interacts very well with your customer base..

It interacts very well with the customer base. We have a great relationship with that firm as well. I guess what I would say is that fourth quarter from a few years back was the result of a very broad category. This is targeted specifically at Amazon, and no, I'm not concerned about a repeat of that event from several years ago..

Yeah, Amazon and home improvement..

Okay..

Correct..

Got it. Okay. Thanks very much..

Thank you. Our next question comes from the line of David Hochstim with Buckingham Research. Your line is open..

Thanks. I had a question, sort of a follow up to the comments David made earlier about competition and consumer behavior.

I wonder at the margin, given your very high returns and very low charge-off and delinquency rate, is it possible to, I guess, modify your credit standards slightly and increase growth, or is there just a sharp drop-off in the behavior of customers? And as Mark, you just mentioned, you do a lot better with seasoned customers than new customers.

I guess I wonder what the tradeoff's like and if you can update us on the mix, how much of the portfolio today at the end of the second quarter is relatively new and how much is older..

Yeah, I think we had an earlier question kind of on that. I think at the margin, I do think there is some opportunity to take a little more risk to get a little more growth to increase profitability.

And in some cases, it's really taking the same risk, but we're basically being able to expand the credit bucket a bit given the confidence that some of those consumer behavioral change that has occurred is here for an extended period of time.

The only thing I would say is I wouldn't take the leap that we're going to suddenly do giant line increases to drive a huge amount of growth, because that will usually come back and bite you. We're not going to just jump into subprime to accelerate growth. So I would just emphasize modest and at the margin, and we're always looking for opportunities..

And how much of the portfolio are the two accounts that are more than, let's say, three years old at this point or two years old?.

Our average customer has been with us for 12 years, which is we believe the highest in the industry. It's one of the reasons our credit is so good. Our focus on service as well as having great credit quality helped with that. About 17% of our book is three years or less of age..

Okay. Thank you..

Sure..

Thank you. Our next question comes from the line of Jason Harbes with Wells Fargo. Your line is open..

Hi, guys. Good evening..

Good evening..

Just quick question on the recent decision to exit the direct mortgage business. You called out some of the charges you took this quarter as well as some additional charges in the back half. It sounds like those will be offset by a tax benefit.

But just for modeling purposes, what was the amount of fee income you booked from that business, and any associated expenses that presumably will roll-off over the course of the next six months or so?.

Yeah, so I'll point you back to some other places to kind of compose it. So in terms of revenues, we've published mortgage revenue in the 10-Qs historically, and it was roughly plus or minus $80 million on an annual basis, give or take.

And then I would say the other thing I'd point you toward is we kind of said that the business was roughly operating at a break-even level. So I think that kind of gets you to sort of how to adjust your model as you're looking into 2016, more or less..

Okay. Thanks for that. And then maybe just a follow up on Diners Club, maybe just an update on what your expectations are for that business? I think typically you see some favorable seasonality in the fee income line from Diners. I just wanted to get an update..

Sure. I think we don't – I think you could look back at previous seasonality where it's typically the revenue's front-end loaded in the first quarter, and we don't really see that changing.

I guess the thing I feel good about on Diners is we've had to take a lot of actions to get stronger franchises in certain markets, to deal with Citi exiting in certain markets that they were in to deal with the economy in Europe, and it feels like we're on a much more level to growing field. We're back in the double-digit growth on volume.

We're seeing some very nice volumes out of our Chinese, Indian, and certain other franchises, Japanese is growing nicely. And we've gotten – we had to step in there at the Italian situation. We've now got a buyer, so we're back into just operating the network everywhere once we close that.

So Diners is still a relatively small part of the overall profit picture, but nonetheless it feels like a much more positive trajectory..

Thanks, guys..

I'd like to turn the call back to Bill Franklin for further remarks.

Thank you, Abigail. I'd like to thank everyone for joining us late this evening. If you have any follow up questions, feel free to give the IR team a call. Have a good night. Thank you, all..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone, have a great day..