Bread Financial Holdings, Inc. Q2 FY2022 Earnings Call

Good morning, and welcome to Bread Financial's Second Quarter Earnings Conference Call. My name is Amber, and I will be coordinating your call today. At this time, all participants are placed in a listen-only mode. It is now my pleasure to introduce Mr. Brian Vereb, Head of Investor Relations at Bread Financial.

Thank you. Copies of the slides we will be reviewing and the earnings release can be found on the Investor Relations section of our website. On the call today, we have Ralph Andretta, President and Chief Executive Officer of Bread Financial; and Perry Beberman, Executive Vice President and Chief Financial Officer of Bread Financial. Before we begin, I would like to remind you that some of the comments made on today's call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and uncertainties described in the company's earnings release and other filings with the SEC. Bread Financial has no obligation to update the information presented on the call. Also on today's call, our speakers will reference certain non-GAAP financial metrics, which we believe will provide useful information for investors. Reconciliation of those measures to GAAP are included in our quarterly earnings materials posted on our Investor Relations website at breadfinancial.com. With that, I would like to turn the call over to Ralph Andretta.

Thank you, Brian, and thank you to everyone for joining the call this morning. I will start on Slide 3 by highlighting a few key updates from the quarter. We continue to make progress towards our long-term financial goals driven by our focus on sustainable, profitable growth. In the second quarter, consumer activity remained strong with credit sales up 10% from the second quarter of 2021 with particular strength from our beauty and jewelry verticals and our co-brand and proprietary cards. This growth was a result of increased shopping trips, not just transaction size, which indicates that consumers continue to shop and engage. We are seeing an increase in customer spend in both discretionary and nondiscretionary categories across both our co-brand and proprietary cards. We are pleased with the continued acceleration of our loan growth with end-of-period loans up 13% on a year-over-year basis. We are building on the momentum from our new brand launch with remarkable growth in our consumer deposit balances through our Bread savings offerings with retail deposit balances up 75% year-over-year. Additionally, we are seeing early success with our American Express Bread Cashback Card offering within the millennial and Gen-X consumer base. Launched in April, we are experiencing strong top-of-wallet behavior, with the majority of cardholders spending in everyday categories, and we are acquiring customers in their channel of choice with an emphasis on mobile new accounts. Our business development wins to date, including our AAA multicard program, reflect the successful execution of our growth strategy. We are excited about our recent new business additions and renewals and given our strong pipeline, we anticipate continued growth into the future. We continue to improve our strategic positioning bolstered by our technology modernization and business transformation efforts. Perry will highlight our actions to enhance our financial resilience and recession readiness, which are critical as a potential economic recession looms. Our seasoned leadership team has extensive experience successfully navigating the full economic cycle, including economic downturns and continuously monitors economic data and the financial health of our customers. The consumer overall remains in a good financial position. While consumer sentiment has weakened, retail sales continue to rise, the unemployment rate is very low and wage growth has been trending upward, especially in the lower income segments. However, we recognize the growing concerns about a potential recession coupled with the expected normalization of delinquencies and payments creates uncertainty, and we have reflected that in our conservative CECL reserves. Payment and delinquency rates are normalizing coming off historical lows of 2021, and we remain confident in our full year guidance. Moving to Slide 4, I will highlight some of our business development success. This morning, we announced a new long-term relationship with AAA, one of North America's largest and most trusted membership organizations serving more than 56 million U.S. members. We also reached a definitive contract to acquire AAA's existing credit card portfolio expected in the fourth quarter. As one of the largest full-service leisure travel organizations in North America, providing a wide range of travel services and discounts as well as a variety of insurance products, the addition of AAA further diversifies our portfolio. Through 2 unique co-brand offerings with enhanced cardholder value propositions, we are excited to help AAA drive top-of-wallet usage, loyalty, and growth. Also during the quarter, we signed a multiyear renewal with a longtime valued brand partner, Torrid, a direct-to-consumer apparel and intimates brand in North America that serves over 3 million customers through its e-commerce platform and their over 600 stores nationwide. We will use our expertise in specialty retail, coupled with digital modernization to further drive spend, acquisition, and loyalty in this fast-growing industry. Additionally, we expanded our Caesars Card Rewards program, introducing an improved value proposition designed to enhance loyalty and improve cardholder experience. Caesars Rewards remains the largest loyalty program in the industry. Turning to Bread Pay, we signed over 50 new small- and medium-sized partners in the second quarter and we continue to grow our platform with a focus on profitable and disciplined lending. Also, our partnership with Fiserv launched in the second quarter, providing us with access to sales of an extensive merchant network for installment lending. As I mentioned previously, we are encouraged by the continued strength of our business development activity and pipeline success. We believe we are well positioned to continue to add additional quality partners while further diversifying our portfolio. Slide 5 highlights our technology modernization progress. Our digital modernization efforts have helped us drive convenience and choice for the consumer. Our full product suite, coupled with our data and analytics expertise, provide personalized experiences offering the right product to the consumer in their channel of choice. At the end of the quarter, we migrated to the cloud and transitioned our core processing system including tens of millions of data records to Fiserv, further simplifying our business model and increasing our flexibility and capabilities. While any systems migration of this magnitude comes with some degree of anticipated conversion challenges, our teams are working to ensure the fair resolution for all cardholders and brand partners that may have been impacted during this time. By completing this major milestone to modernize our technology, Bread Financial is better positioned to drive enhanced capabilities, long-term operational efficiencies, scalability, and faster speed to market going forward. Overall, we are pleased with how our business transformation efforts have materialized. We have achieved many targeted milestones, including expanding our product offerings, advancing our digital capabilities, enhancing our talent, strengthening our balance sheet, and adding and renewing iconic and diversified brand partners to support our continued growth. We remain focused on providing financial resilience and sustainable, profitable earnings growth for years to come. I will now turn it over to our CFO, Perry Beberman, to review the financials.

Thanks, Ralph. Slide 6 provides our second quarter highlights. Bread Financial Credit sales were up 10% year-over-year to $8.1 billion as consumer spending remained strong. Average loans were up 11% with end-of-period loans up 13% driven by continued double-digit credit sales and moderating payment rates. Revenue for the quarter was $893 million, inclusive of a $21 million write-down in the carrying value of the company's investment in Loyalty Ventures, Inc. driven solely by Loyalty Ventures share price at June 30. Revenue increased 17% versus the second quarter of 2021, while total noninterest expenses increased 12%. Credit metrics remain below historical averages with delinquency and net loss rates of 4.4% and 5.6%, respectively, for the quarter. The net loss rate included a 30 basis point or $13 million increase from the effects of the purchase of previously written-off accounts that were sold to a third-party debt collection agency and remain subject to ongoing legal dispute with the debt collection agency as disclosed in our May credit statistics. Our net income of $12 million and diluted EPS of $0.25 were impacted by our reserve build in the quarter. The $166 million CECL reserve build resulting from both loan growth in the quarter of nearly $1 billion and a higher reserve rate had a $2.57 impact on diluted EPS. The combined Loyalty Ventures write-down of $21 million and the purchase of written-off accounts of $13 million had an additional $0.53 impact. These items, combined with the reserve build, reduced diluted EPS by $3.10 in total for the quarter. Looking at the second quarter financials in more detail on Slide 7. Total interest income was up 17% from 2Q '21, resulting from 11% higher average loan balances, coupled with improved loan yields. Total interest expense declined 5% due to 20 basis points lower cost of funds, which you can see on the following slide. Noninterest income, which primarily includes merchant discount fees, and interchange revenue, net of the impact from our retailer share arrangements and customer awards was negative $85 million, inclusive of the $21 million write-down in the carrying value of our equity method investment in Loyalty Ventures. As we have said, excluding the Loyalty Ventures impact, this line item is most closely correlated with credit sales for the quarter, which increased 10% from the prior year period. Total noninterest expenses increased 12% from the second quarter of 2021 due to increased employee compensation and benefits costs, marketing, and the previously announced investment in our Technology Modernization efforts. Additional details on expense drivers can be found in the appendix of the slide deck. Overall income from continuing operations was down $251 million for the quarter versus the second quarter of 2021. This was largely a direct result of our $166 million reserve build in the second quarter of 2022, driven by higher end-of-period loan balances and a higher reserve rate sequentially compared to a $208 million relief in the second quarter of 2021. Taking out the provision and tax volatility, we are pleased that our pretax pre-provision earnings or PPNR improved 24% year-over-year, marking the fifth consecutive quarter that we have seen year-over-year double-digit growth in PPNR. As we have said, our focus continues to be on making the right decisions to produce quality earnings. Turning to Slide 8. The left side of the slide highlights our earning asset yields and balances. Second quarter loan yield increased 110 basis points year-over-year and declined sequentially with normal seasonality. Net interest margin improved approximately 130 basis points year-over-year. On the liability side of the slide, we saw funding costs slightly increased sequentially in the second quarter, in line with our expectations given the Fed's recent interest rate increases. As you can see from the stacked bars on the bottom right, our direct-to-consumer deposits continue to grow, now representing 22% of our total interest-bearing liabilities, up 13% in the year-ago quarter. We expect our retail deposit base will continue to increase, becoming an even more meaningful portion of our funding over time. Moving to Slide 9. I'll start on the upper left. Our delinquency rate increased approximately 30 basis points sequentially, generally in line with historical quarter-over-quarter trends and was up approximately 110 basis points versus the historical low in the second quarter of 2021. On the upper right, you can see that we had a loss rate of 5.6% for the quarter, including the 30 basis point increase from the effects of the purchase of previously written-off accounts that were sold to a third-party debt collection agency. While not significant to our full year guidance, our system conversion will create minor timing impacts in our monthly credit metric trends. Turning to the bottom left of the page, our reserve rate increased from the first quarter of 2022 to 11.2%. We maintained a conservative posture with regard to our reserve rate. Since 90 days ago, according to economists, the probability of a recession has increased from approximately 25% to closer to 50%. Our economic scenario weightings in our credit reserve model reflect the increased probability of recession, leading to our prudent decision to increase our reserve rate. We believe the inclusion of the severe economic scenario overlays provide sufficient future loss absorption capacity given the harsh economic conditions included in these scenarios, including a rapid rise in unemployment. Overall, we remain pleased with the improvement in the underlying credit quality of our portfolio from pre-pandemic levels. You can see this improvement in the chart on the bottom right-hand side of the page, highlighting that our revolving credit risk distribution has improved over time and remains consistent to the first quarter, outside of a period of significant economic uncertainty. In other words, during a period of forecasted economic growth, low inflation, and low interest rates, our portfolio as it is composed today would produce a reserve rate below pre-pandemic levels given our enhanced credit risk management and product and brand partner diversification. That said, until we pass this period of significant economic uncertainty, we expect our reserve rate to remain elevated. Slide 10 provides our financial outlook for full year 2022. Our outlook assumes a continued moderation in consumer payments throughout 2022. We expect the ongoing Fed interest rate increase will result in a nominal benefit to total net interest income. Our full year average loans are expected to grow in the low double-digit range relative to 2021 driven by strong sales activity. We expect end of year 2020 loan growth to be stronger than our average loan growth, given the success of our new business activities throughout the year. This outlook includes expected end-of-year balances of greater than $2 billion from our 2022 new signings, including the addition of the AAA portfolio acquisition expected to close in the fourth quarter of this year. We expect revenue growth to be consistent with average loan growth in 2022 and anticipated full year net interest margin around 19%. We continue to target full year positive operating leverage in 2022. We expect increase in expenses throughout the remainder of the year, which will bring our full year operating leverage down to a more modest level. As we've previously discussed, our outlook includes incremental strategic investments of over $125 million in Technology Modernization, Digital Advancement, Marketing, and Product Innovation to fuel growth opportunities and future operating efficiencies. A large portion of the $125 million investment will be evident in employee expense as we continue to hire digital engineers and data scientists to further advance our continued business transformation. We also plan for higher marketing expenses in the second half of 2022 as a result of increased spending associated with higher sales and brand partner joint marketing campaigns as well as expanding on our new brand products and direct-to-consumer offerings. Information processing costs are increasing as a result of our ongoing Technology Modernization, including near-term costs related to the conversion of our core processing system to Fiserv and continued investment into the Bread Pay platform. As Ralph mentioned earlier in the year, the Fiserv conversion will result in both expense and revenue synergies in 2023 and beyond. We expect total expenses will increase sequentially each quarter throughout 2022 as our business grows and we continue to invest and add talent. We are making ongoing investments now to stay ahead of customer expectations. Regarding our net loss rate outlook, we continue to anticipate the full year 2022 loss rate will be in the low to mid-5% range. I would also reiterate our confidence in the long-term outlook of a through-the-cycle average net loss rate below our historical average of 6%. We expect our full year normalized effective tax rate to be in the range of 25% to 26%, with quarter-over-quarter variability due to timing of various discrete items. Moving to Slide 11. Through our business transformation efforts, we have improved our balance sheet, loss absorption capacity and funding mix. Second, we've enhanced our credit risk management and underlying credit distribution. And third, we've ensured we have a proactive and refined recession readiness playbook in place. These changes strengthen our financial resilience, better positioning Bread Financial to deliver sustainable, profitable growth with an expectation to outperform historic loss levels throughout an economic cycle. Through our prudent decision-making, we have strengthened our balance sheet and capital ratios, including an improvement in our TCE to TA ratio nearly 400 basis points in just 2 years. Our higher capital position combined with our increased credit reserves positions Bread Financial to weather more difficult economic conditions, if need be. We have been deliberately reducing our debt levels and proactively increasing our mix of consumer deposits to strengthen our position and will continue to do so. Enhancing our credit risk management and underlying credit distribution is a key element of our business transformation. We have diversified across products and partners leading to a credit mix shift towards higher quality customers who have 60% of our portfolio above a 660 Vantage score. We manage our portfolio proactively; we have a recession readiness playbook in place and have implemented elements swiftly as early as the onset of COVID with a focus on managing open-to-buy and helping customers manage their credit lines and balances in a healthy manner. While we continue to see a very strong overall consumer in terms of spending and payments, we do place extra emphasis on customers who are more sensitive to these high and persistent inflationary pressures to ensure they can manage their credit while maintaining purchasing power. We've also benefited from our implementation of enhanced risk stratification and technology enhancements to build additional resilience in our portfolio. When you combine our improved risk profile with a more diverse portfolio and brand partner base, we believe that we are better positioned than we have ever been for a potential recession. We will remain proactive in our approach as we continuously update our risk management models and underwriting criteria in this rapidly changing macroeconomic environment. We continue to make the changes necessary to strengthen the financial resilience of our company while maintaining the tools necessary to successfully manage through an economic cycle. Operator, we are now ready to open the lines for questions.

Our first question comes from Robert Napoli with William Blair. Robert?

Thank you, and good morning. Ralph and Perry, just on the credit outlook on your reserve build, I mean, you sound awfully confident on your portfolio mix and credit outlook through cycles. But what do you build? It sounds like you're an outlier versus peers on your forecast of unemployment? What have you built in? You said, I mean, a rapid rise in unemployment. What does that mean?

Yes, let me address that. Starting with the reserve role, we have strong confidence in the portfolio we've built. We're seeing robust consumer behavior, which encourages us regarding their payment habits and spending trends. However, we remain cautious and prudent in our outlook. This means that when we assess our reserves and models, it's important to consider not just the current credit criteria or performance of the existing portfolio, but also the potential impact of severe scenarios over time. With ongoing high inflation and uncertainty about its duration, we rely on Moody's economic outlook. Their scenarios indicate significant increases in unemployment within a short period. Each recession is unique; the last one was largely driven by housing issues and high unemployment, while currently we are in a relatively stable job environment. Nonetheless, we must incorporate these considerations into our models. Given a shift from a 25% recession probability to 50%, it's crucial to remain prudent and not react hastily. We have to stay aligned with suggested outlooks. As mentioned in my earlier remarks, applying our pre-pandemic economic outlooks to the current portfolio yields a CECL reserve rate considerably lower than what we've experienced in the past.

I have a follow-up question. Your targets for return on equity are an average of 20% to 25% over three cycles. How confident are you, Ralph and Perry, in the reasonableness of those targets as you assess your business? Given that recessions can vary greatly and with a strong consumer, it seems unlikely we will experience a deep recession, but it's hard to predict.

Yes, we continue to aim for a return on equity in the mid- to high 20% range at appropriate capital levels. The variable impacting this is the pace of our growth. During periods of high growth, we face what we refer to as a CECL growth tax, which can reduce returns. However, as growth moderates and the CECL growth tax decreases, along with expected loss rates through the economic cycle, we are certainly focused on building this company for profitable and responsible growth over time.

If I could just sneak one last one in. The AAA, can you give a commentary on the size of the AAA portfolio and kind of some of the pluses and minuses on portfolio and runoff or additions?

Bob, yes, a couple of things. So first, let me say we are thrilled to have announced this portfolio in partnership with AAA more than 56 million members in the U.S., an iconic brand, a brand that is trusted and we're excited to help AAA grow this portfolio with a couple of new exciting value props. We don't comment on the size of the portfolio. But I will say we have growth of $2-plus billion in the back end of the year, and this is a significant part of that.

Our next question comes from Sanjay Sakhrani with KBW. Sanjay?

Maybe to follow up on Bob's first question. I guess, Perry, if we look forward now, obviously, we got another negative GDP print. But technically, I guess we are in a period of recession. So how should we think about that reserve rate moving from here? Like do you feel like you've incorporated sort of a mild recession now? And what would be the next step for the reserve rate if it has to go higher?

Thank you, Sanjay. When considering the reserve rate, there are several factors involved, including the specific modeling methods used by different companies. It's important to account for the portfolio and the additional measures we've implemented for expected economic stress. At this moment, we believe we have factored in what we anticipated. While GDP isn't the sole indicator of how a recession impacts our consumers, our main focus is ensuring we're not overreacting. I believe we're currently in a favorable position for our expectations. If conditions were to worsen significantly, there might be a chance for an increase, but based on our outlook, we feel confident and expect to maintain this elevated level until this phase passes.

I have a follow-up question about the portfolio yield. When we look at the year-over-year progression, it declined sequentially even though rates increased. Could you clarify how we should expect that yield to progress moving forward? Are you able to pass on some of the rate increases? Additionally, could you discuss the positive data and how cost considerations will unfold not only for the rest of this year but also as we head into next year?

Yes, that's a good question. Let's discuss what happened sequentially. The second quarter typically exhibits seasonality in our net interest margin yield. Generally, we experience lower late fee yields that affect our net interest margin, combined with tax payments that occur during this quarter, which can decrease that aspect. Additionally, this quarter saw a couple of Federal Reserve rate increases—a 50 basis point hike in May, which we passed on to higher deposit rates, and another 75 basis points in June. When we raise deposit rates and grow those deposits, that adjustment happens quickly, often within a week. However, when the prime rate increases, it affects consumer loans on the asset side based on the last published date of the Wall Street Journal for the month, starting to build in the following months. Therefore, the 75 basis points from June won’t be reflected in consumer billing until July, leading to a slight lag. Overall, when considering our net interest margin, we are more asset sensitive, meaning that as interest rates increase, we see a slight positive effect in that process.

Our next question comes from Bill Carcache with Wolfe Research. Bill?

Ralph and Perry. So I wanted to follow-up on some of the earlier questions and kind of drill a little bit more into the trajectory of the reserve rate from here. So when we think about the reasonable and supportable period under CECL, as long as the recession and rising initial claims is still in front of us, and there's a lot of uncertainty and we don't know exactly how that's going to look. But you've got the overlays in there that sort of contemplate some degradation. Is it reasonable to expect that the trajectory of the reserve rate as long as that's in front of us is essentially flat to up? But once we get past peak initial claims, then that's kind of when we could start to look for the reserve rate to start coming down again. Is that kind of broadly speaking, a reasonable way to be thinking about it?

Yes, that's a reasonable perspective to consider. Every recession varies and affects consumers differently. Traditionally, unemployment is a key factor in increasing credit loss, so viewing it through that lens during this peak period makes sense. As unemployment claims start to decline, it could lead to a more positive economic outlook, allowing for reserves to be released. The goal is to reach a peak and then look forward to a more favorable period, which would enable us to reduce the reserve rate while maintaining a conservative approach.

It certainly indicates that you are proactive, which is refreshing to see in a quarter when many of your competitors allowed their reserve rates to continue to decline. I'm curious if you are confident in outperforming your 6% average over the cycle in the long term, but since it is an average, would it be reasonable to anticipate periods during a downturn when the NCO rate might exceed that 6% level?

Yes, exactly right. You're going to have periods of time when we're in the good times, we should expect to be below 6% and you have a short period of recession, you can be above 6%. And that should we expect that's exactly what through-the-cycle means.

Understood. And last one for Ralph, if I may. Ralph, following up on some of your earlier opening remarks, I wanted to ask you if you could take us maybe a little bit more inside the performance of your different cohorts and give us a sense of the spending and just overall trends that you're seeing across those groups and how they're being impacted by inflation.

Yes. If you look at our product offerings, we have private label credit cards and rent-to-consumer products like the Bread Cashback Card and our co-branded partners. We're observing positive spending with private label products, although they feature lower spending limits. We remain optimistic about this trend. Additionally, we're experiencing exceptional spending on our proprietary card and co-branded cards, encompassing both discretionary and nondiscretionary spending across Vantage loans. This indicates a steady flow of transactions rather than just significant single purchases, showing that consumers are actively engaging with our products and considering them their primary choice.

Our next question comes from Jeff Adelson with Morgan Stanley. Jeff?

I was just wondering, Perry, if we could follow up on the NIM commentary a bit. You're talking about the nominal benefit in being asset sensitive here but also talking about this 19% or around 19% NIM for the year. Wondering if you could maybe help us understand what kind of band around the 19% you're talking about here? Because I think as we think about that to get to 19%, it implies you have to have some sequential decreases here going out. And maybe as a part of that question, is it reasonable to assume that until the Fed start slowing down the Fed hikes that you're maybe going to lag that with your funding costs going up ahead of the asset yields like you referred to earlier?

Yes, I believe there will be some seasonality involved. Additionally, there is likely to be a lag effect. As the Federal Reserve raises rates, like the recent increase, we may experience a delay of about a month before we fully adjust. This is why we are estimating around 19%. We don't expect it to drop significantly below that or rise much above it; it will likely remain around that figure.

Okay. And so would it be reasonable like as we maybe get past that, that you'd see a much more material benefit as maybe in 2023 your asset yields catch up beyond that?

I believe we are slightly accretive. It's important to focus on the material aspects and the factors that will influence this. As we've discussed, a significant win today, along with future wins, will affect our portfolio composition, which will lead to different net interest margins. For instance, if we integrate lower credit risk portfolios, they will result in a lower NIM. We are also expanding our private label offerings, which yield higher margins. Ultimately, the composition of our portfolio will be crucial as we progress through 2023.

Our next question comes from the audience. That's my bad, sorry. I see none in the queue. We'll now turn it over for further closing remarks to Ralph Andretta.

Thank you all for joining and for your ongoing interest in Bread Financial. I appreciate the questions. We feel positive about the quarter and the adjustments we've made, and we are optimistic about the future. Have a great day, everyone.

That concludes today's Bread Financial Second Quarter 2022 Earnings Conference Call. Thank you for your participation. You may now disconnect your lines.