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DFS > SEC Filings for DFS > Form 10-K on 25-Feb-2014All Recent SEC Filings

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Form 10-K for DISCOVER FINANCIAL SERVICES


25-Feb-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this annual report on Form 10-K. Some of the information contained in this discussion and analysis constitutes forward-looking statements that involve risks and uncertainties. Actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and elsewhere in this annual report on Form 10-K particularly under "Risk Factors" and "Special Note Regarding Forward-Looking Statements," which immediately follows "Risk Factors." Unless otherwise specified, references to Notes to our consolidated financial statements are to the Notes to our audited consolidated financial statements as of December 31, 2013 and 2012 and for calendar year ended December 31, 2013, fiscal years ended November 30, 2012 and 2011 and one month ended December 31, 2012.
Introduction and Overview
Discover Financial Services is a direct banking and payment services company. Through our Discover Bank subsidiary, we offer our customers credit card loans, private student loans, personal loans, home equity loans and deposit products. Through our Discover Home Loans, Inc. subsidiary, we offer our customers home loans. Through our DFS Services LLC subsidiary and its subsidiaries, we operate the Discover Network, the PULSE network ("PULSE") and Diners Club International ("Diners Club"). The Discover Network is a payment card transaction processing network for Discover-branded credit cards and credit, debit and prepaid cards issued by third parties, which we refer to as network partners. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs domestically and internationally, as well as point-of-sale terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network of licensees, which are generally financial institutions, that issue Diners Club branded credit cards and/or provide card acceptance services. Our primary revenues consist of interest income earned on loan receivables and fees earned from customers, merchants and issuers. The primary expenses required to operate our business include funding costs (interest expense), loan loss provisions, customer rewards, and expenses incurred to grow, manage and service our loan receivables and networks. Our business activities are funded primarily through consumer deposits, securitization of loan receivables and the issuance of unsecured debt.
Change in Fiscal Year
On December 3, 2012, our board of directors approved a change in our fiscal year end from November 30 to December 31 of each year. This fiscal year change was effective January 1, 2013. As a result of the change, we had a one month transition period in December 2012. The audited results for the one month ended December 31, 2012 and the unaudited results for the one month ended December 31, 2011 are included in this report.
Change in Accounting Principle Related to Off-Balance Sheet Securitizations Beginning with the first quarter of 2010, we have included the trusts used in our securitization activities in our consolidated financial results in accordance with the Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets - an amendment of FASB Statement No. 140 ("Statement No. 166") (codified under the FASB Accounting Standards Codification ("ASC") Topic 860, Transfers and Servicing) and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretations No. 46(R) ("Statement No. 167") (codified under ASC Topic 810, Consolidation), which were effective for us on December 1, 2009, the beginning of our 2010 fiscal year.
Under Statement No. 166, the trusts used in our securitization transactions are no longer exempt from consolidation. Statement No. 167 prescribes an ongoing assessment of our involvement in the activities of the trusts and our rights or obligations to receive benefits or absorb losses of the trusts that could be potentially significant in order to determine whether those entities will be required to be consolidated in our financial statements. Based on our assessment, we concluded that we are the primary beneficiary of the Discover Card Master Trust I ("DCMT") and the Discover Card Execution Note Trust ("DCENT") (the "trusts") and accordingly, we began consolidating the trusts on December 1, 2009. Using the carrying amounts of the trust assets and liabilities as prescribed by Statement No. 167, we recorded a $21.1 billion increase in total assets, a $22.4 billion increase in total liabilities and a $1.3 billion decrease in stockholders' equity (comprised of a $1.4 billion decrease in retained earnings offset by an increase of

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$0.1 billion in accumulated other comprehensive income). The significant adjustments to our statement of financial condition upon adoption of Statements No. 166 and 167 are outlined below:
• Consolidation of $22.3 billion of securitized loan receivables and the related debt issued from the trusts to third-party investors;

• Reclassification of $4.6 billion of certificated retained interests classified as investment securities to loan receivables;

• Recording of a $2.1 billion allowance for loan losses, not previously required under GAAP, for the newly consolidated and reclassified credit card loan receivables;

• Derecognition of the remaining $0.1 billion value of the interest-only strip receivable, net of tax, recorded in amounts due from asset securitization and reclassification of the remaining $1.6 billion of amounts due from asset securitization to restricted cash, loan receivables and other assets; and

• Recording of net deferred tax assets of $0.8 billion, largely related to establishing an allowance for loan losses on the newly consolidated and reclassified credit card loan receivables.

Beginning with the first quarter of 2010, our results of operations no longer reflect securitization income, but instead report interest income, net charge-offs and certain other income associated with all securitized loan receivables and interest expense associated with debt issued from the trusts to third-party investors in the same line items in our results of operations as non-securitized credit card loan receivables and corporate debt. Additionally, we no longer record initial gains on new securitization activity since securitized credit card loans no longer receive sale accounting treatment. Also, there are no gains or losses on the revaluation of the interest-only strip receivable as that asset is not recognizable in a transaction accounted for as a secured borrowing. Because our securitization transactions are being accounted for under the new accounting rules as secured borrowings rather than asset sales, the cash flows from these transactions are presented as cash flows from financing activities rather than as cash flows from operating or investing activities. Notwithstanding this accounting treatment, our securitizations are structured to legally isolate the receivables from Discover Bank, and we would not expect to be able to access the assets of our securitization trusts, even in insolvency, receivership or conservatorship proceedings. We do, however, continue to have the rights associated with our retained interests in the assets of these trusts.
Reconciliations of GAAP to Non-GAAP As-Adjusted Data To enable the reader to better understand our financial information by reflecting period-over-period data on a consistent basis, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this report presents our financial information as of December 31, 2013 and 2012 and for calendar year ended December 31, 2013, fiscal years ended November 30, 2012 and 2011 and one month ended December 31, 2012. Where necessary, we have also provided certain information as of and for the fiscal year ended November 30, 2009 on a non-GAAP as-adjusted basis. Management believes the non-GAAP as-adjusted financial information is useful to investors as it aligns with the financial information used in management's decision-making process and in evaluating the business.
The non-GAAP as-adjusted amounts related to Statement No. 167 show how our financial data would have been presented if the trusts used in our securitization activities were consolidated into our financial statements for historical periods prior to fiscal year 2010.
The following tables display a reconciliation between GAAP and non-GAAP as-adjusted amounts that reflect the full impact the consolidation of our trusts would have had if we had adopted Statement No. 167 retrospectively.

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Loan Receivables Data and Reconciliation
(dollars in millions)
                                                                 As of and for the Fiscal
                                                                        Year Ended
                                                                    November 30, 2009

Total Loan Receivables
Loan portfolio
GAAP                                                             $               23,625
Adjustments for Statement No. 167                                                27,229
Non-GAAP As-Adjusted                                             $               50,854

Loan receivables
GAAP                                                             $               23,625
Adjustments for Statement No. 167                                                27,229
Non-GAAP As-Adjusted                                             $               50,854

Allowance for loan losses (beginning of period)
GAAP                                                             $                1,375
Adjustments for Statement No. 167                                                 1,379
Non-GAAP As-Adjusted                                             $                2,754

Provision for loan losses
GAAP                                                             $                2,362
Adjustments for Statement No. 167                                                 2,761
Non-GAAP As-Adjusted                                             $                5,123

Charge-offs
GAAP                                                             $               (2,166 )
Adjustments for Statement No. 167                                                (2,208 )
Non-GAAP As-Adjusted                                             $               (4,374 )

Recoveries
GAAP                                                             $                  187
Adjustments for Statement No. 167                                                   212
Non-GAAP As-Adjusted                                             $                  399

Net charge-offs
GAAP                                                             $               (1,979 )
Adjustments for Statement No. 167                                                (1,996 )
Non-GAAP As-Adjusted                                             $               (3,975 )

Allowance for loan losses (end of period)
GAAP                                                             $                1,758
Adjustments for Statement No. 167                                                 2,144
Non-GAAP As-Adjusted                                             $                3,902

Net charge-offs %
GAAP                                                                               7.45 %
Adjustments for Statement No. 167                                                  0.32
Non-GAAP As-Adjusted                                                               7.77 %

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                                                                 As of and for the Fiscal
                                                                        Year Ended
                                                                    November 30, 2009

Total Loan Receivables (continued)
Loans not accruing interest
GAAP                                                             $                  190
Adjustments for Statement No. 167                                                   248
Non-GAAP As-Adjusted                                             $                  438

Delinquency rate (Over 30 Days)
GAAP                                                                               4.92 %
Adjustments for Statement No. 167                                                  0.39
Non-GAAP As-Adjusted                                                               5.31 %

Delinquency rate (Over 90 Days)
GAAP                                                                               2.58 %
Adjustments for Statement No. 167                                                  0.20
Non-GAAP As-Adjusted                                                               2.78 %

Delinquency rate (Loans not accruing interest)
GAAP                                                                               0.80 %
Adjustments for Statement No. 167                                                  0.06
Non-GAAP As-Adjusted                                                               0.86 %

Discover Card

Total Discover Card Loans
GAAP                                                             $               19,826
Adjustments for Statement No. 167                                                27,229
Non-GAAP As-Adjusted                                             $               47,055

Total Credit Card Loans
Loan receivables
GAAP                                                             $               20,230
Adjustments for Statement No. 167                                                27,229
Non-GAAP As-Adjusted                                             $               47,459

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                                                                 As of and for the Fiscal
                                                                        Year Ended
                                                                    November 30, 2009

Total Credit Card Loans (continued)
Allowance for loan losses (beginning of period)
GAAP                                                             $                1,318
Adjustments for Statement No. 167                                                 1,379
Non-GAAP As-Adjusted                                             $                2,697

Charge-offs
GAAP                                                             $               (2,097 )
Adjustments for Statement No. 167                                                (2,207 )
Non-GAAP As-Adjusted                                             $               (4,304 )

Recoveries
GAAP                                                             $                  186
Adjustments for Statement No. 167                                                   212
Non-GAAP As-Adjusted                                             $                  398

Net charge-offs
GAAP                                                             $               (1,911 )
Adjustments for Statement No. 167                                                (1,995 )
Non-GAAP As-Adjusted                                             $               (3,906 )

Allowance for loan losses (end of period)
GAAP                                                             $                1,647
Adjustments for Statement No. 167                                                 2,145
Non-GAAP As-Adjusted                                             $                3,792

Net charge-offs %
GAAP                                                                               7.87 %
Adjustments for Statement No. 167                                                  0.13
Non-GAAP As-Adjusted                                                               8.00 %

Delinquencies (over 30 Days)
GAAP                                                             $                1,117
Adjustments for Statement No. 167                                                 1,540
Non-GAAP As-Adjusted                                             $                2,657

Delinquencies (over 90 Days)
GAAP                                                             $                  699
Adjustments for Statement No. 167                                                   694
Non-GAAP As-Adjusted                                             $                1,393

Delinquency Rate (over 30 days)
GAAP                                                                               5.52 %
Adjustments for Statement No. 167                                                  0.08
Non-GAAP As-Adjusted                                                               5.60 %

Delinquency Rate (over 90 days)
GAAP                                                                               2.92 %
Adjustments for Statement No. 167                                                  0.02
Non-GAAP As-Adjusted                                                               2.94 %

Restructured loans (A)
GAAP                                                             $                   73
Adjustments for Statement No. 167                                                   145
Non-GAAP As-Adjusted                                             $                  218

Delinquency Rate (Restructured Loans)
GAAP                                                                               0.31 %
Adjustments for Statement No. 167                                                  0.15
Non-GAAP As-Adjusted                                                               0.46 %

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Average Balance Sheet Reconciliation
(dollars in millions)
                                                                  For the Fiscal Year Ended
                                                                      November 30, 2009

Total average loan receivables
GAAP                                                             $              26,553
Adjustments for Statement No. 167                                               24,577
Non-GAAP As-Adjusted                                             $              51,130

Total loans interest yield
GAAP                                                                             11.31 %
Adjustments for Statement No. 167                                                 1.09
Non-GAAP As-Adjusted                                                             12.40 %

Total average credit card loan receivables
GAAP                                                             $              24,267
Adjustments for Statement No. 167                                               24,577
Non-GAAP As-Adjusted                                             $              48,844

Credit card interest yield
GAAP                                                                             11.69 %
Adjustments for Statement No. 167                                                 0.94
Non-GAAP As-Adjusted                                                             12.63 %

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2013 Highlights
• Net income was $2.5 billion compared to $2.3 billion in the fiscal year ended November 30, 2012.

• Total loans grew $3.2 billion, or 5%, from the prior year to $65.8 billion

• Credit card loans grew $2.0 billion, or 4%, to $53.2 billion in 2013. Discover card sales volume increased 4% from the fiscal year ended November 30, 2012.

• Credit card loan delinquencies over 30 days past due decreased 14 basis points compared to the fiscal year ended November 30, 2012 to 1.72%. The credit card net charge-offs rate declined 41 basis points to 2.21% in comparison to the fiscal year ended November 30, 2012.

• Our capital market activities included issuances of approximately $4.7 billion in public credit card asset-backed securities. Discover Bank issued $1.7 billion in senior bank notes.

• Payment Services pretax income was down $101 million from the fiscal year ended November 30, 2012 to $80 million. Transaction dollar volume for the segment was $196.5 billion, a decrease of 1% from the fiscal year ended November 30, 2012.

• We repurchased approximately 27 million shares of common stock for $1.3 billion, reducing our number of shares outstanding by 5%.

2012 and 2011 Highlights
• We began offering residential mortgage loans through Discover Home Loans following our June 2012 acquisition of substantially all of the operating and related assets of Home Loan Center, a subsidiary of Tree.com, Inc.

• We repurchased 34 million shares, or approximately 6%, of our outstanding common stock for $1.2 billion during the fiscal year ended November 30, 2012.

• During the 2012 fiscal year, our capital market activities included issuances of approximately $5.4 billion in public credit card asset-backed securitizations and a $560 million preferred stock issuance. We also completed two private debt exchange offers involving an aggregate $822 million of outstanding debt.

• In September 2011, we acquired approximately $2.4 billion of private student loans from Citi.

• Our revenues were unfavorably impacted in 2011 by the implementation of certain provisions of the Credit CARD Act of 2009, which included limitations on our ability to reprice accounts, the elimination of overlimit fees and a reduction in the amount of standard late fees.

Outlook
Investments in marketing have contributed to our receivables growth and we are focused on continuing this trend with new account acquisitions, through the Discover itฎ card, and through wallet share gains with existing customers. We are also targeting solid growth and strong returns in our private student and personal loan portfolios. The expansion of our direct banking products remains a priority as we continue to diversify the offerings to our customers, as evidenced by the launch of home equity loans and Discover Cashback Checking in 2013.
Our credit outlook for 2014 remains relatively stable and net interest margin is expected to remain elevated. Loan loss reserve releases contributed to our overall profitability in 2013, but we do not expect to receive a similar benefit in 2014. Funding costs are expected to remain at low levels over the next year as we benefit from the interest rate environment and replace higher-priced time deposits with lower-cost borrowings.
Our Diners Club business experienced challenges in 2013 due to financial difficulties faced by certain licensees in the European market and the impact on our financial results from providing support to these licensees. Although we believe that we have put the most significant challenges behind us, we may provide additional support in the future, including loans, facilitating transfer of ownership, or acquiring assets or licensees, which may cause us to incur losses.
PULSE volumes were flat year-over-year due in part to the changing debit environment, including competitor actions related to merchant and acquirer pricing and transaction routing strategies. We plan to continue to respond to this intensely competitive environment by expanding our focus to target volume historically run across signature debit

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networks. In the fourth quarter of 2013, we received notice that certain contracts related to one third-party issuing relationship will be terminated, effective mid-2014. This loss will have a significant impact on Network Partners volume and profits, but we do not anticipate it to be material to our overall profitability. While we expect that the payment services environment will remain challenging in 2014, we continue to lay the groundwork to drive future volume and profits for the segment.
Regulatory Environment and Developments
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Reform Act") contains comprehensive provisions governing the practices and oversight of financial institutions and other participants in the financial markets. The Reform Act regulates large systemically significant financial firms, including us, through a variety of measures, including increased capital and liquidity requirements, limits on leverage, and enhanced supervisory authority. The Reform Act also established a new financial regulator, the Consumer Financial Protection Bureau (the "CFPB"), and new requirements for debit card transactions, which impact our core businesses. Additional legislative or regulatory action that may impact our business may result from the multiple studies mandated under the Reform Act.
The evolving regulatory environment causes uncertainty with respect to the manner in which we conduct our businesses and requirements that may be imposed by our regulators. Regulators have implemented and continue to propose new regulations and supervisory guidance and have been increasing their examination and enforcement action activities. The FDIC is completing its annual anti-money laundering/Bank Secrecy Act examination of Discover Bank and has notified the company of certain potential program deficiencies, and the CFPB is investigating certain student loan servicing practices of Discover Bank. See Note 20:
Litigation and Regulatory Matters to our consolidated financial statements for more information. We expect that regulators will continue taking formal enforcement actions against financial institutions in addition to addressing supervisory concerns through non-public supervisory actions or findings. We are unable to predict the nature, extent or impact of any additional changes to statutes or regulations, including the interpretation, implementation or enforcement thereof that may occur in the future.
The impact of the evolving regulatory environment on our business and operations depends upon a number of factors including final implementing regulations, guidance and interpretations of the regulatory agencies, supervisory priorities and actions, the actions of our competitors and other marketplace participants, and the behavior of consumers. The evolving regulatory environment could require us to limit or change our business practices, limit our product offerings, require continued investment of management time and resources in compliance efforts, limit fees we can charge for services, require us to meet more stringent capital, liquidity and leverage ratio requirements, increase costs, restrict our ability to access the securitization markets for our funding, impact the value of our assets, or otherwise adversely affect our businesses. The regulatory environment and enhanced examination and supervisory expectations and scrutiny can also potentially impact our ability to pursue business . . .

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