Bread Financial Holdings, Inc. Q2 FY2024 Earnings Call

Good morning, and welcome to Bread Financial’s Second Quarter 2024 Earnings Conference Call. My name is Towanda, and I will be coordinating your call today. At this time, all parties have been placed on a listen-only mode. Following today’s presentation, the floor will be opened for your questions. It is now my pleasure to introduce Mr. Brian Vereb, Head of Investor Relations at Bread Financial. Sir, the floor is yours.

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 at breadfinancial.com. On the call today, we have Ralph Andretta, President and Chief Executive Officer; and Perry Beberman, Executive Vice President and Chief Financial Officer. 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 based on management's current expectations and assumptions and are subject to the risks and uncertainties described in the Company's earnings release and other filings with the SEC. Also on today's call, our speakers will reference certain non-GAAP financial measures, which we believe provide useful information for investors. Reconciliation of those measures to GAAP are included in our quarterly earnings materials posted on our Investor Relations website. With that, I would like to turn the call over to Ralph Andretta.

Thank you, Brian, and good morning to everyone joining the call. Starting with the highlights from the second quarter on Slide 2. I am pleased to report another quarter of solid results as we continue to navigate a challenging consumer and regulatory environment. Our strong results include net income of $133 million and earnings per diluted share of $2.66 or adjusted diluted EPS of $2.67 after adjusting for the anti-dilutive impact of our capped call transactions, which are related to the 2023 issuance of convertible notes, which Perry will discuss more fully. Notably, our balance sheet continued to improve as we increased our tangible book value by 25% year-over-year to nearly $49 per share, improved our common equity Tier 1 capital ratio by 170 basis points year-over-year to 13.8%, and reduced our double leverage ratio to 110%, achieving our target of less than 115%. Additionally, direct-to-consumer deposits increased 20% year-over-year to $7.2 billion, representing 14 consecutive quarters of growth. During our Investor Day in June, we highlighted the Company's transformation and our energized culture. The strong returns and capital generation that our business model can deliver, and how our responsible capital allocation will build sustainable long-term value for our shareholders. We also announced our newest partnership with Saks Fifth Avenue. In the third quarter of this year, we expect to complete the conversion of the existing Saks portfolio and launch the new and enhanced program. In the second quarter, we made further progress implementing more of our mitigation strategy in response to the CFPB's rule on credit card late fees. Our ongoing discussions with brand partners have been productive, and we now have various pricing changes in the market, including increased APRs and statement fees. We are closely monitoring the ongoing litigation related to the rule, and we'll continue to implement our mitigation strategies given the uncertainty surrounding the timing and outcome. Regardless of the litigation outcome, we are confident in our ability to generate strong results and achieve our long-term strategic objectives and financial targets. From a macroeconomic perspective, consumer spending continues to moderate, reflecting persistent inflation and higher interest rates. As a result, second quarter trends reflected lower transaction sizes accompanied by more frequent shopping trips as well as reduced discretionary and big-ticket spending. Credit sales were also impacted by our proactive credit tightening as we remain disciplined given economic pressures affecting payment capacity. Our credit actions have proven effective as delinquencies have trended lower, and the net loss rate is expected to have peaked in the second quarter. Our second quarter results reflect our position of strength with increased capital flexibility and financial resilience. We are better equipped to address uncertainty than ever before, positioning us well to generate long-term value for our shareholders. Turning to Slide 3. Our disciplined capital allocation strategy focuses on funding responsible, profitable growth, improving our capital metrics, reducing parent debt, and driving long-term shareholder value. Indicative of the success of this strategy is the 410 basis point improvement in our common equity Tier 1 capital ratio over the last three years, as shown in the chart on the left. As I mentioned previously, we have also made progress on our debt reduction, as shown in the second chart. Over the last three years, we have reduced parent-level debt by 53%. And this quarter, we achieved our long-term double leverage ratio target of less than 115%. This is an impressive achievement given where we were just four years ago when I joined the Company. Finally, our tangible book value of $49 per share has grown at a 22% compound annual rate since the second quarter of 2021. Supported by our strong cash flow, we expect to continue to grow our tangible book value over time. Turning to Slide 4, our key focus remains on growing responsibly, managing the macroeconomic and regulatory environment, accelerating digital and technology offerings, and driving operational excellence. As we highlighted during our Investor Day in June, our decisions are focused on creating sustainable value over the long term by effectively managing our credit risk while scaling and diversifying our product offerings, we can grow responsibly. Managing the macroeconomic and regulatory environment effectively is fundamental to our success. Although litigation is ongoing and timing and outcome unknown, we will continue to take actions to mitigate the potential financial impact of the CFPB late fee rule. We are confident in our strategy and have an experienced leadership team that has successfully navigated through regulatory changes in the past. Accelerating our digital and technology capabilities remains a top priority. We are committed to fueling innovation, leveraging data and AI, and scaling our platform to enhance satisfaction for our customers, partners, and associates. Finally, our heightened focus on operational excellence to drive improved customer experience, enterprise-wide efficiency, reduce risk and value creation is embedded in our decision-making. Our goal is to consistently generate operational and expense efficiencies that enable reinvestment in our business, support responsible growth, and achieve our targeted returns. Our experienced leadership team remains focused on generating strong returns through prudent capital and risk management, reflecting our unwavering commitment to drive sustainable, profitable growth and build long-term value for our shareholders through challenging economic and regulatory environments. Now, I will turn it over to Perry to review the quarter's financials and to discuss our outlook.

Thanks, Ralph, and good morning, everyone. Before I dive into the second quarter financial highlights, I'd like to discuss the financial benefits of the cap call transactions we entered into when we issued our convertible notes in 2023. The cap call transactions are set up to reduce the potential dilutive impact of the convertible notes up to a stock price of $61.48. Our GAAP diluted share count does not incorporate the anti-dilutive impact of these cap call transactions, which you can see incorporated in our adjusted non-GAAP figures on Slide 5. More specifically, the share amounts used in calculating adjusted net income per diluted share and adjusted income from continuing operations per diluted share have been adjusted for the anti-dilutive impact of our cap call transactions. Reflecting this, our adjusted net income per diluted share was $2.67 and our adjusted income from continuing operations per diluted share was $2.66 in the second quarter. Moving to Slide 6, which provides our second quarter financial highlights. During the second quarter, credit sales of $6.6 billion decreased 7% year-over-year, reflecting moderating consumer spend and our strategic credit tightening, partially offset by new partner growth. Average loans of $17.9 billion increased 1% year-over-year, driven by growth in co-brand programs, highlighting our continued focus on product diversification. Revenue was $0.9 billion in the quarter, down 1% year-over-year due to reduced merchant discount fees resulting from lower big-ticket credit sales. Income from continuing operations increased $69 million due to a higher reserve release and lower noninterest expense compared to the same period last year. Looking at the financials in more detail on Slide 7. Total net interest income for the quarter remained essentially flat year-over-year, while noninterest income is down $8 million, resulting from the previously mentioned lower merchant discount fees on big-ticket purchases. Total noninterest expense decreased 12% year-over-year primarily driven by a decrease in card and processing costs, including fraud, and a reduction in depreciation and amortization costs and marketing expenses. Additional details on expense drivers can be found in the appendix of the slide deck posted on our website. Pre-tax pre-provision earnings or PPNR increased $48 million or 11%. Turning to Slide 8, loan yield increased 30 basis points year-over-year, benefiting from the upward trend in the prime rate, which caused our variable price loans to move higher in tandem, along with some small amount of CFPB mitigation-related APR increase impacts. Both loan yield of 26.4% and net interest margin of 18.0% were lower sequentially following typical seasonal trends. We expect a seasonal improvement in the net interest margin in the third quarter of 2024. On the funding side, we are seeing total funding costs moderate as deposit costs are stabilizing. Additionally, as you can see on the bottom right chart, our funding mix continues to improve, fueled by growth in direct-to-consumer deposits, which increased to $7.2 billion at quarter end, while wholesale deposits declined. Direct-to-consumer deposits accounted for 40% of our average total funding, up from 33% a year ago. While we anticipate that direct-to-consumer deposits will continue to grow steadily, we will maintain the flexibility of our diversified funding sources, including secured and wholesale funding to opportunistically and efficiently fund and manage our long-term growth objectives. Moving to credit on Slide 9, our delinquency rate for the second quarter was 6.0%, modestly down 20 basis points from the first quarter as a result of our credit-tightening actions. From this point forward, we expect future quarters to largely follow historical seasonal trends until we see broader macroeconomic improvements. The net loss rate was 8.6% for the quarter compared to 8.0% in the second quarter of 2023 and 8.5% in the first quarter of 2024. The second quarter net loss rate was elevated compared to last year due to more challenging macroeconomic conditions, pressure in consumer payment rates, as well as ongoing credit tightening and our slower responsible loan growth impacting the denominator. As anticipated, the second quarter net loss rate is expected to represent the peak for 2024. We anticipate a reduction in the net loss rate in the third quarter to 8% or slightly below before increasing seasonally in the fourth quarter to the low 8% level. Our outlook assumes a slow gradual improvement in the macroeconomic environment as it will take time for the lingering effects of a prolonged period of elevated inflation to dissipate. As expected, the reserve rate of 12.2% remained within the range we have seen over the past six quarters. In this challenging macroeconomic environment, our conservative economic scenario weightings remained unchanged in our credit reserve modeling, and we believe our loan loss reserve provides an appropriate margin of protection. Consistent with what I said last quarter and based on our economic outlook, we expect the reserve rate to be lower at year-end 2024 versus year-end 2023, reflecting an overall improvement in delinquencies as well as improved credit quality in the portfolio. Further, our total loss absorption capacity comprised of the total company tangible common equity plus credit reserve rate ended the quarter at 26% of total loans, an increase of 100 basis points from last quarter and 270 basis points from a year ago, demonstrating a strong margin of protection should more adverse economic conditions arise. Looking at our credit risk distribution mix, the percentage of cardholders with a 660-plus credit score improved 200 basis points sequentially and remained above pre-pandemic levels despite continued inflationary pressures. This improvement is primarily a result of our prudent credit tightening actions as well as our more diversified product mix. We continue to proactively manage our credit risk to protect our balance sheet and ensure we are appropriately compensated for the risk we take. Moving to Slide 10, which provides our 2024 financial outlook. While there is uncertainty surrounding the timing and outcome of the ongoing CFPB late fee rule litigation, our outlook now assumes no impact from the CFPB late fee rule this year. Considering that a stay is in effect, the number of motions, hearings, and other procedural matters, including appeals, expected to take place in the litigation over the coming months, as well as a pursued implementation period following the final legal ruling, our base case is that the rule does not become effective in 2024. Our full year contemplates a slower credit sales growth rate as a result of moderation in consumer spending and credit tightening, both of which pressure loan and revenue growth and the net loss rate in the near term. In addition, our 2024 outlook assumes two interest rate decreases by the Federal Reserve in the second half of the year, which are expected to slightly pressure total net interest income. Based on our current economic outlook, proactive credit tightening actions, higher gross credit losses, and visibility into our new business pipeline, we expect 2024 average loans to be down low single digits on a percentage basis relative to 2023. Total revenue growth for 2024, excluding gain on portfolio sales is anticipated to be down low to mid-single digits with a full year net interest margin lower than 2023, reflecting higher reversals of interest and fees due to expected higher gross credit losses, declining interest rates, and a continued shift in product mix to co-brand and proprietary products. This guidance includes the impact of early CFPB mitigation pricing changes, which are not material to the full year 2024 guidance. As a result of efficiencies gained from ongoing investments in technology modernization and digital advancement, along with disciplined expense management and reduced fraud, we expect expenses to be down mid-single digits relative to 2023. Expenses are projected to increase in the second half of 2024 versus the first half, driven primarily by the addition of the Saks Fifth Avenue portfolio and increased sequential marketing expenses of around $10 million in the third quarter. We would expect fourth quarter expenses to be higher than the third quarter based on seasonally higher employee compensation and benefits costs and further increased marketing expenses. As I mentioned earlier, the second quarter net loss rate is expected to be the peak for the year, and we continue to expect a full year net loss rate in the low 8% range for 2024. With the first half loss rate at 8.6% and a projected improved second half loss rate of approximately 8%, that would currently imply a full year net loss rate of around 8.3%. Again, our outlook assumes a gradual modest improvement in the economic conditions throughout the year aligned with most economists. Finally, our full year normalized effective tax rate is expected to be in the range of 25% to 26%. Quarter-over-quarter variability will continue due to the timing of certain discrete items. We are confident in our ability to successfully manage risk-return trade-offs through this challenging macroeconomic and regulatory environment, while continuing to make strategic investments that drive long-term value for our stakeholders. Before opening the call for your questions, I want to take a moment to reiterate the financial targets that we shared during our Investor Day in June. You can see these targets on Slide 11. Note, this slide assumed an October 1 CFPB late fee rule change effective date. From a debt perspective, as Ralph mentioned earlier, we've already successfully reduced our double leverage ratio to less than 115%. For capital, our goal is to build total risk-based capital to around 16% with an initial CET1 built to approximately 14%. Over the longer term, we plan to optimize our capital mix through additional Tier 1 and Tier 2 capital which will allow us to lower our corresponding CET1 ratio. Overall, we will continue to grow tangible book value with the goal of generating a low to mid-20% ROTCE in the medium term, and mid-20% ROTCE in the long term. While there are many scenarios currently in play regarding our timing to achieve our target, given the uncertainty around the economy and potential regulatory changes, we are well-positioned to deliver responsible growth, strong returns, and capital distribution opportunities over time. Operator, we are now ready to open up the lines for questions.

Our first question comes from Mihir Bhatia with Bank of America. Your line is open.

I wanted to start maybe by talking about just the purchase volume trends. Look, you obviously have a pretty diverse customer base. And you've talked previously about low-income consumers being impacted by inflation. And so, I guess a couple of questions on that. One is, are you seeing those impacts starting to moderate as we've had some wage growth here? And then also relatedly, is the pressure on the consumer spreading up the income scale? Or are you still seeing the pressures concentrated in that segment? Maybe just talk about that a little bit, just from where you're seeing the pressures on what kinds of products, what kinds of retailers or categories maybe?

Yes. Thanks for the question. We're still seeing consumers no matter where they are in the income spectrum help moderate their budget. We see the biggest impact in discretionary and big-ticket purchases. It's where we see the largest impact in terms of spending moderation. But I think as we move forward, as we said, we think we've peaked in the second quarter. I don't think there will be an immediate rush to the point of sale. I think it will be a gradual improvement over time. People are still suffering from high inflation and high interest rates. So, while we anticipate a little bit of improvement, I think it's going to be very moderate as we move forward. But big-ticket and discretionary spending were most affected.

Is there any update on the income side? Is it primarily still focused on low-income consumers?

Yes. So, this is Perry. What I think I'd share with you is that view on the economy overall, I think we've been saying this, and I think we're all saying the consumer has been pretty resilient. But they are definitely feeling the effects of that cumulative prolonged period of inflation and now the higher interest rates that are impacting them with inflation is still about 2%, while it's coming down, that's a positive. Higher interest rates on things like their mortgages, auto, credit cards, personal loans have risen their spending power through higher monthly interest costs. So, you've got that affordability gap that still exists for lower and middle-income Americans. So, I think that's where you're going, it's right? The top third of consumers are just fine. Their higher income, higher scores, and they're not showing any signs of stress. We're seeing that in our portfolio. Those high scores are not being affected. But that doesn't tell us about the other two-thirds, and you are starting to see some of that stress creep up a little bit in the risk scores because these folks are trying to make ends meet, and these other things are putting pressure on them. Now, that said, there are positive signs that we're seeing. And I think we're all seeing it with what we expect to materialize in the second half of the year, led by what we just saw with this quarter, where, as you mentioned, wage growth outpaced inflation. So that is good. That's particularly going to help the two-thirds of consumers who are trying to rebuild their discretionary income. I think that's a positive. Inflation is coming down. So hopefully, again, wage growth stays up, inflation comes down, and that will be more positive. Now you will have a little bit of offset with some modest increase in employment that everybody is expecting to finish the year at 4%. But that's all in our outlook and forecast. But we're monitoring the consumers really carefully. We have a strong credit team that is taking credit actions appropriately. And I think we're all waiting to see how this economy unfolds in the back half of the year.

I would like to shift the focus to credit. The results for the second quarter exceeded your initial expectations, and you've provided insightful commentary regarding your outlook for the third and fourth quarters. However, I'm interested in your perspective as we approach 2025. Do you anticipate that losses will continue to decrease? You've mentioned that losses are somewhat seasonal and that an improvement in the economy is necessary for further progress. My question is whether improvements in the economy are essential to reduce losses towards your target, or if the credit measures you've implemented are already bringing the loss rate closer to your long-term goals. Currently, the rate stands at 8%. If we only experience seasonality moving forward, will we remain above the long-term targets until there is economic improvement?

So, I think you have a couple of things, a number of things that go into that. I'm not going to give guidance on 2025 at this point, but I can give you my thoughts on how this trend is going to play out over time, right? Our credit actions will have their peak benefit in the second half of this year. The full benefit of our credit actions haven't yet materialized completely. So, that will be a run rate benefit into, call it 2025. Then we're expecting a slow gradual improvement in customer behavior. It's going to take a prolonged number of quarters for consumer behavior to improve, given that they're trying to deal with three years of this persistent high inflation and higher interest rates. And that's going to take time to unwind. I mean, there is no fast fix. We're not expecting a big stimulus to come in and all of a sudden, consumer payments just improve dramatically. So, I expect there to be a slow gradual improvement through next year. But to get back to that 6% number quickly seems to be a tough ask of the consumer. But I do think there's going to be continued gradual improvement.

Our next question comes from the line of Jeff Adelson with Morgan Stanley. Your line is open.

Just one point of clarification on the revenue guide. I know you removed the late fee rule implementation from the fourth quarter versus your last quarter guide. But I think last quarter, you also discussed a scenario where the late fee rule didn't go into effect. You were looking for, I think, down mid-single now you're looking for down low to mid-single digits. Can you just talk about where some of the improvement came from there? Is that just continued efforts on the late fee offsets and CITs you've put out there? Or what else may have changed in the outlook?

Yes. It's a modest change in the outlook. To your point, I think part of it is we're only expecting two rate reductions from the Fed. As I remember, we're a little asset-sensitive. So, we will see a little bit of NIM compression when you have that. We also probably feel a little bit more confident about the second half of the year loss rate and what that means in terms of the reversal of interest and fees. And then, we also have the line of sight into the CFPB mitigation actions while not material. We're just trying to get everything down a little tighter to what we expect to see.

And just a follow-up on credit. I know at the Investor Day, you were talking about some nice stability in not only your early stages but your mid- and late-stage delinquencies. Could you just give us an update on what you're seeing there this quarter? And if I could maybe just pick a little bit on the monthly data. It did look like your second derivative on total delinquencies did increase a little bit this past month. Is there anything to that? Or do you probably still expect that trend of slowing will continue to come through?

I would describe the situation as stable and improving. We are in a strengthening economy, and credit actions are taking place. There are some seasonal factors affecting delinquency. Our early stages are stable, and we're beginning to see slow improvement in the mid to late stages. However, roll rates remain high in those later stages because consumers who become delinquent find it difficult to recover. This highlights the need for wage growth and improvements, which we hear from customers as a source of strain. High inflation and stagnant wages are significant issues for them.

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

Perry, could you talk about the data you're examining to determine whether consumer behavior is flat or declining? Do you consider factors like monthly minimum payments or cash drawdowns? There's some confusion, as we've heard from previous questions. While we're hearing that consumer spending is slowing, you are indicating that consumers are generally doing well. Could you clarify what leads you to believe that? Additionally, if interest rates start to decrease, how quickly does that impact consumer health? Does it contribute to an improvement in their financial situation?

Sanjay, great questions in there. The benefits of having as many consumers as we do is that we can monitor through stratification segmentation. We do look at what's happening with our consumers. When you hear the larger banks talk, they have a much fuller view of those high-net-worth customers, they have the view of customers who are not credit eligible that we don't underwrite. So, and you'll hear things from the big networks and they're giving perspectives on spending overall. What we monitor are things like payment trends, how many people are making no payment, how many are making minimum payment, multiples of minimum payment. So, we are starting to see fewer customers at zero pay and more making minimum payments. But that's something we want to monitor very carefully. So you do look at our payment behaviors, off our payment behaviors. When we say the customer is improving, it's from the result of the credit actions and a little bit of this wage growth that's in place. So, I don't want to give an indication that things are improving dramatically. It's stable with modest improvement, and that's what we expect to see in the back part of the year. I mean for us to guide, we're still going to have 8% losses in the back half of the year. That's still a pretty strained environment for the consumer. While improving, it's going to take a slow gradual improvement to return to our, I'll say, through-the-cycle targets.

Can you provide more details on how those mechanisms work and how they influence your ability to offset changes and continue growing book value? I'm curious about the impact on margins and the fundamentals moving forward and your ability to mitigate some of that impact.

Yes. Look, the reason why we took it out of our guidance for this year is because we see where things are going right now. The parties involved with the litigation are still getting over where this litigation should be held, right? I think it's August 27, and that could possibly result in another appeal of the judge's ruling. This is before the courts consider the merits of the lawsuit filed by the industry. That's why we don't think the impact will happen in 2024. We're not taking that assumption of what that could mean to 2025. The teams continue to work very closely with all of our brand partners. We've been very thoughtful about the timing of when we roll out changes to the consumer for changes that we have put in the market. We've taken a half step towards the back part of 2023. It was some pricing already in our guidance. Some of the things that we just put in the market around the paper statement fee and some further pricing APR increases. As you know, APR increases take time, around 18 months to three years to fully get the benefit of that. We're also monitoring any change in customer behavior because you don't want to have the unintended consequence where it more than offsets the benefits you get from it. That's being carefully watched. The rollout will continue throughout this year. We assume the change will go into effect at some point next year. We don't really have guidance on that at this point, but we have teams working as if it will happen in short order right after the litigation gets through. Again, not knowing any outcome of the upcoming elections, we don't want to speculate on that.

Our next question comes from the line of Moshe Orenbuch with TD Cowen. Your line is open.

Most of my questions have been asked and answered. However, returning to the macro issue of the low-end consumer and the timing of the rebounding growth, is there a way to separate parts of your portfolio or your partners to identify what might lead the recovery? How do you perceive that? We’ve observed some of the low-end furniture categories beginning to show signs of recovery. Can you discuss which segments of your portfolio, even those under pressure, might start to rebound and when we could expect to see that?

I'd answer that a couple of ways. One, we'll answer with regard to rebounding growth. We're going to have a number of tailwinds behind us from a growth standpoint. One, think about general macro improvement, like you said, if these consumers start to get wage growth going and inflation comes down, it can free up more discretionary income. That will help the lower-end consumer. Wage growth has been more prominent in the lower income brackets than the high-income bracket. The second thing that will impact our loan growth is as we march back down towards a 6% loss rate versus being over 8%. You think about the interest and fees associated with that, too, that's almost a 3% tailwind as we march back towards that. As the consumer is improving, we can then unwind some of those credit tightening strides that were in place around line increases, higher approval rates, and all that will also be a tailwind to growth. That's not to mention, what Ralph talked about, the terrific business development team that we have out there that are continuing to win opportunistic deals for us.

Maybe just kind of think on that note, as you look out at the landscape, do you see opportunities for additional portfolios, either conversions or start-up opportunities? Now that perhaps the late fee issue is at least on hold for a while, how are the potential partners? What's that channel look like?

Yes, it's Ralph. We do. We announced Saks Fifth Avenue earlier this year, early this quarter, really excited about that to get that in next, in the third quarter. This morning, we just announced HP. So, we're excited about that opportunity. It's a new opportunity for us. If you look at HP, we have Dell, Sony, and even B&H Photo in there; we have a really nice electronic vertical, which we really like. The pipeline is always active. Our business development team, I'll match up against any. I think it's second to none. We're always engaged in deals that are coming due. What I love about our team is it's up and down the spectrum. We have $100 million deals to $1 billion deals, we're able to play very comfortably in that with those guidelines. They're active and busy, and we certainly see we win more than our share as we go forward.

Yes. And you've asked a question about with the CFPB happening or not happening, the one thing that I think is common in the marketplace is that all of our competitors are pretty rational, right? Sometimes it's something that's strategic that somebody wants to win really badly and that won't take lesser economics. But traditionally, you win based on your capabilities and the partnership. The CFPB ruling is contemplated in the economics through the discussions, whether the partner's somewhere else, they stay where they are or they come to us; it has to be contemplated, and we are very capital disciplined. With the amount of opportunity in front of us, we're also making sure we're selective with who we're signing and that it fits with our strategic verticals as well as delivering the right capital return for our shareholders.

Our next question comes from the line of Bill Carcache with Wolfe Research Securities. Your line is open.

Following up on your comments about the resiliency of the consumer. There is a view among some that we could see a delayed charge-off effect as customers that are delinquent today and potentially would have charged off by now in a normal cycle have instead been able to avoid charging off because of all the financial support they received during COVID. Is that a risk that you worry about in your portfolio?

So great question. I think that dovetails into the question earlier. You're starting to see some of the pressure creep up in the risk bands. I think that's something that everybody is watching: are some of those middle-income Americans starting to feel the pressure that the lower and moderate-income Americans felt last year? This has been a theme that we've talked about for over 18 months, that stimulus built up and the savings that were in place for lower- and moderate-income Americans had been depleted. Those consumers are the ones when you see our portfolio. That's why you're seeing the peak losses come through because that has already happened. Now we've taken credit actions to make sure we've taken care of the population that we see at risk. That's why you think there's going to be a prolonged period of time for losses to get all the way back down to the 6% range, because the stress is still there. I mean, that's the issue with our economy right now, this prolonged period of high inflation and high interest rates, consumer debt is high; it's impacting folks. It's a concern, but I don't see it as something where there's going to be this next wave coming through because we're really on top of this.

And then as a follow-up, with your CET1 now at 13.8%, very close to that initial target that you laid out at your Investor Day, is it reasonable to start modeling buybacks as you cross that 14% threshold?

So, what I would say is our first binding constraint is total risk-based capital, and that needs to get above 16%. I would share that I mentioned this previously at Investor Day, but there is a last slug of CECL phase-in that will happen in January 2025. That’s 65 basis points. We've got to care for that, care for the expected growth in the portfolio. That's when you start to think about where we need to be to have considerations of other capital opportunities.

Our next question comes from the line of Vincent Caintic with BTIG. Your line is now open.

First question, I wanted to focus on NIM and specifically the loan yield. So, understanding that the loan yield was down quarter-over-quarter due to seasonality. But I wanted to get a sense of how much you've been able to add price as a CFPB mitigant. So, I was wondering if there's a way to separate out the seasonality versus the pricing you've been able to put in. And then separately, if there's any other impact. So, for instance, the tightening credit underwriting, if that's maybe pushing you up market and therefore, having a lower price?

Yes. NIM, the 18% this quarter being down 70 basis points linked quarter. That was really pressured from the sequentially higher reversal of interest and fees, as well as not delinquencies improving coupled with a mix in the book as we're booking fewer private label cards that tend to have more late fees. We're seeing a little bit lower yield from those. That's a result of having a little bit better early-stage delinquency. And so, you should expect the net interest margin to come back up in the third quarter seasonally, also aided by a lower reversal of interest and fees in the third quarter as you'll have a meaningful reduction in losses. As it relates to your question about how much of the mitigation APRs are built through, again, it takes a long time for APR changes to burn into that full rate yield. We've been consistent on saying that I put that chart together, I think, over a year ago to illustrate how long that can take. It's not a meaningful impact in this quarter. It will just continue to slowly and steadily impact the improving loan yield, but you could also have, like I mentioned earlier, risk mix changes, product mix changes, and you could have a lower interest rate environment at some point.

And then the second question, just on the credit reserve. So, it was nice seeing the credit reserves drop this quarter alongside the execution on losses for the quarter. Just wondering for your expectations for the third and fourth quarter, is your expectations for the full year built into the credit reserves, so we should just expect credit reserves to sort of stay stable at this rate going forward? Or as time goes on and you're actually able to execute on the guidance for the third and fourth quarter loss rate, we should be expecting that credit reserve to continue to come down?

What I would expect to happen is, look, pleased that the reserve rate came down this quarter. It was funny because we had prior questions, do you ever see a point where you could have peak losses and have a reduction in your reserve rate, and it just happens that yes, we can, and we did, right? This quarter, we hit the peak losses and we had our reserve rate coming down. That's a reflection of the better credit quality and delinquency that's in the current portfolio. As the year goes on, if everything holds steady, I expect that we'll have a seasonal drop in the fourth quarter. Again, why we have confidence that at the end of this year, we'll have a lower reserve rate than where we exited 2023. I expect a pretty stable reserve rate, not expecting sharp declines in the reserve rate consistent with what we've said. We expect slow, steady improvement in the portfolio quality over time. I would expect something similar with the reserve rate over time. The other part of this is, I mentioned it in the prepared remarks; our weightings of adverse scenarios remained unchanged at this point. So, the change from last quarter to this quarter is solely due to the improving credit quality. In time, as we have more confidence in a more benign economic outlook, those can get unwound, but that will be much further down the road.

Our next question comes from the line of John Pancari with Evercore IS. Your line is open.

Good morning. On the late fee side, again, I know you removed it from your outlook. I guess just as it is and from what you're seeing in terms of the expected impacts. Has the expected impact to revenue from the late fee? Any of those expectations? Have they changed at all and as well as the magnitude of the offsets that you expect? Anything behind the scenes has it changed at all in terms of the expected impact aside from, I know your efforts to dial in the pricing changes, et cetera?

No, I wouldn't say that anything has changed in terms of our approach or strategies. It's unfortunate that regulations are being altered without a full understanding of the effects on consumers. We are moving ahead with higher APRs for everyone and have introduced additional fees and policy changes. The paper statement fee, for instance, is something we might not have implemented if it weren't for the CFPB's rule change. However, we are rolling this out carefully and observing the changes in consumer behavior regarding APRs and private label products. We haven't noticed any shift in behavior; with the paper statement fee, many are choosing digital statements, which will help reduce our expenses over time. We're excited about the opportunities to encourage 100% digital engagement. Overall, everything unfolding is in line with our expectations.

And then separately, on the funding side, I know you indicated deposit costs stabilizing. Could you give us a little more color there on what you're seeing and your expectations on the trajectory here on deposit costs? And maybe if you could just comment a little bit on how you expect deposit growth to progress in the coming quarters.

Yes. We've got our direct-to-consumer deposits sitting at about 40% of our total funding. We've communicated our goal to get to 50% from direct-to-consumer deposits and expect that each quarter here out, we'll continue to grow thoughtfully. Our pricing, because of the way we are structured, we don't have brick-and-mortar and all these to have checking accounts; we are comfortable being towards the top of the league table as you see deposit pricing come down. Recently, we were just in the market with a small reduction in some of the deposit pricing. We're monitoring it, very actively monitoring to make sure that we're getting the growth in deposits that we expect. I expect it's pretty stable right now. If there are sharp declines in Fed funds and the market moves, we'll be prepared to move appropriately, but we're making sure that we are where we want to be positioned to keep attracting deposits.

Our next question comes from the line of Terry Ma with Barclays. Your line is open.

I think you indicated you don't expect much incremental revenue from the mitigation actions this year. Can you maybe just talk about how the pricing actions and the incremental fees are progressing and when you would expect more meaningful contribution from those measures?

Yes. I believe that when the wedge is in place, it's the best way to describe it. Every month that passes, more of the portfolio's spending volume or balance will be affected by the higher APRs. It just requires time. If you look at the chart I shared earlier, it shows that 12 months after implementation, you’ll only experience part of the benefit. As we move into next year, the impact will be more significant. However, our expectations are not to generate a substantial amount of revenue in the short term while we wait for the litigation to be resolved. We aim to proceed thoughtfully with our brand partners to time these rollouts so that we do not negatively impact consumers, especially before changes like the late fee reduction take effect. If we need to implement some measures sooner, there may be a consideration to reinvest more into the program in alignment with that brand partner.

And then on the reserve rate being lower as you exit this year compared to last year. I think another peer had initially mentioned that earlier this year, but is now indicating kind of like a flat reserve ratio year-over-year. So maybe just speak to your confidence in the macro and the performance of your portfolio to take that reserve rate lower this at the end of this year?

Yes. What I'd say is that, look, I can't speak to everyone else's models, right? But industry-wide, we're hearing something normalization, seasoning of recent vintages, consumer pressure; we're creeping up into different risk scores seems to be a theme for them. Now what I'd remind you of is that we moved our reserve rate up earlier than others based on anticipated impacts to our customers of high inflation, and it proved to be the right action. We've had a stable reserve rate for over six quarters. Based on the expected stable and slightly improving macro conditions, our improved credit quality and resulting delinquencies should allow for modest reductions in our reserve rate over time. Again, with the fourth quarter having a normal seasonal reduction before the first quarter increases back up a little bit. That's what we're expecting to see. We feel very confident in our process; we were, and we use the term conservative. I'd call it just prudent. We have a very experienced team of people at this company who've been through different macro environments. We knew to get ahead of this thing early and anticipate what inflation can mean to our customers. Others didn't increase their reserve rates to the degree we did. They continue to see pressure, and maybe they need to get to where a different spot than where we are. We feel very confident with where we are and confident in the guidance that we're giving.

Our next question comes from the line of Reggie Smith with JPM. Your line is open.

Can you remind us what proportion of your portfolio has been implemented or had the partner agree to some of these mitigation efforts? I have a few follow-ups.

We have not given a proportion of the portfolio. But I would tell you that conversations have happened with 100% of the brand partners. As we had talked about previously, each brand partner is unique. Some are opting for promo fees, some of the companies are discussing partner compensation changes, different revenue share things. Our commercial team is very active with all of the partners. That's why I use the word thoughtful rollout of these strategies.

And I guess with that said, I would imagine that right now, given the uncertainty, that I guess any agreement that hasn't been struck is probably on hold so we get more clarity?

I don't know if I would use the word on hold. I'd say they're all progressing and in a state of readiness to take appropriate action. Look, time is our friend. Let's just call that what it is, right? Every month that goes by and delays our company is getting stronger from a capital standpoint. The macro environment is improving. We're in a better state of readiness for whatever we have to do systemically from a technology side to implement product changes. We feel very good about our ability to get strong returns should a regulatory change be put in place.

When I analyze the model, I notice that processing costs have decreased sequentially and are definitely lower than we anticipated. You've mentioned some efficiencies contributing to this. What is causing this reduction? Is it related to the Fiserv deal? Also, how sustainable is this run rate we are currently experiencing?

Yes. With the expenses, we're at a probably low point for the year, right? We've had benefits year-over-year as our fraud team has done an amazing job getting strategies in place. The whole industry experienced some fraud attacks last year. Most of the industry has got that under control and our team has certainly done so. We're going to see an increase in expenses in the third quarter because you've got Saks coming online, which will incur costs involved with getting that up and going. You'll also see increased marketing, sequential marketing is going to be up about $10 million in the third quarter, and expenses will rise again in the fourth quarter based on seasonally higher employee compensation and benefits costs and further increased marketing expenses.

Ladies and gentlemen, I'm showing no further questions in the queue. I would now like to turn the call back over to Ralph Andretta for closing remarks.

Sure. Well, a couple of thank you to Perry for fielding all the questions today. I appreciate that very much. Thank you to all of you for your continued interest in Bread. We look forward to talking to you again in next quarter. And everybody, have a terrific day. Take care.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.