Earnings Call Transcript - BFH Q4 2022

Operator, Operator

Good morning, and welcome to Bread Financial's Fourth Quarter Earnings Conference Call. My name is Charlie, and I'll be coordinating your call today. It's now my pleasure to introduce Mr. Brian Vereb, Head of Investor Relations at Bread Financial. The floor is yours.

Brian Vereb, Head of Investor Relations

Thank you. A copy 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 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 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.

Ralph Andretta, CEO

Thank you, Brian, and good morning to everyone joining the call. We set ambitious goals in 2022, and I'm extremely proud of our associates for moving our company forward by executing on our initiatives to achieve these goals. I'll begin on slide three, which highlights several major accomplishments achieved in 2022, as part of our ongoing business transformation. To begin, we rebranded from Alliance Data Systems to Bread Financial. A tech-forward financial services company providing simple personalized payment, lending, and saving solutions to consumers. Following our multi-year corporate transformation, Bread Financial has emerged as a more modern, nimble, and streamlined company backed by leading technology and custom platform solutions that empower today's consumer. Coinciding with our rebrand, we launched our direct-to-consumer, Bread Cashback American Express Credit Card and we branded our buy now, pay later platform to Bread Pay, which offers installment lending and split pay solutions to an omnichannel approach. We also rebranded our retail deposit platform to Bread Savings. These enhanced products provide industry-leading benefits and complement our existing suite of financial offerings, ensuring our customers across generational segments have access to payment and saving solutions. We continue to sign new iconic brand partners, including AAA and the NFL, while renewing valued long-term relationships like Victoria's Secret. We have secured renewals with brand partners representing approximately 85% of our year-end 2022 credit card balances through 2025, after adjusting for the anticipated sale of the BJ's portfolio. We also saw success with de novo program launches in 2022 such as B&H photo, which exceeded our initial performance and growth projections for the year. We look forward to working with our new and existing brand partners to drive incremental sales growth and customer loyalty through our sophisticated data and analytics capabilities, enhanced value propositions, and comprehensive product suite. In 2022, we invested more than $125 million in technology modernization, digital advancement, marketing, and product innovation. Major achievements included transitioning our credit card processing services to Fiserv, converting to the cloud and integrating Alberia, a state-of-the-art solution that enhances the productivity of our customer care and collections efforts. Our digital advancement continued to progress, as well as we expanded mobile and web-based customer servicing capabilities and launched a virtual card with web-to-wallet provisioning to provide our customers a more simplified user experience. These upgrades supported our transformation, enhanced our strategic differentiation, and are essential to driving operating efficiencies and innovation. We remain committed to ongoing technology investment with a focus on further digital advancement. As part of our investments, we increased our marketing investment in 2022 to bolster spend through joint marketing campaigns with our brand partners. Developing strong collaborative relationships with our partners has underpinned our decades of successful growth, as these investments build loyalty with both our partners and their customers, as well as expand sales opportunities. Additionally, by leveraging our sophisticated data and analytics capabilities and efficient targeting channels, we were successful in driving new acquisition and engagement with our Bread Cashback American Express Credit Card, Bread Pay, and Bread Savings offerings. We will continue to invest for the future to deliver value for our brand partners, customers, and shareholders. Finally, I'm proud to announce that Bread Financial was recognized for our prioritization of environmental, social, and governance across our entire business, earning a spot on Newsweek's 2023 list of America's most responsible companies. Our commitment to advancing our ESG strategy, objectives, and accountability is evident within the organization and remains core to our sustainable business practices. Turning to slide four, we are pleased to have achieved our 2022 financial targets, driven by organic growth from our existing brand partners, as well as the addition of our new brand partners and product offerings. Average loans grew by 13%, compared to 2021, revenue growth exceeded average loan growth at 17% year-over-year. Pretax pre-provision earnings increased 19% versus 2021, highlighting the quality of the growth we are generating and the underlying value we are creating. We remain disciplined, generating more than 200 basis points of positive operating leverage for the year, as we managed our expenses in alignment with our revenue and growth outlook, while continuing to invest in our future. Our net loss rate of 5.4% remained within our full-year guidance range and below our historic average of approximately 6%. Along with accomplishing our 2022 targets, we significantly strengthened our balance sheet and bolstered our financial resilience through greater product and funding diversification. We increased loss absorption capacity and growth in capital and tangible book value. Retail deposits on our Bread Savings platform increased to $5.5 billion or 72% year-over-year. We plan to build on these achievements in 2023 through continued execution of our long-term strategy. Moving to slide five, I'll highlight some of our most recent business development successes. I am pleased to announce that we have signed a new long-term credit card relationship with Hard Rock International, a well-recognized hotel, casino, and restaurant operator. Hard Rock attracts a broad demographic given its diverse offerings, further expanding our reach across generations. We will offer Hard Rock customers a new way to pay while incentivizing loyalty and brand affinity through our co-brand credit card. During the quarter, we announced a new agreement with the New York Yankees. This exciting relationship rewards Yankee fans for their purchases and provides enhanced benefits to our New York Yankees co-brand credit card while further diversifying our brand partner base. Also during the fourth quarter, we signed a multi-year renewal with long-term partner Helzberg Diamonds, underscoring our strong market share position in the jewelry space. Helzberg Diamonds has more than 100 years of diamond expertise and operates online at over 200 stores nationwide. We will continue to leverage our advanced data and analytics to enhance the shopping experience for Helzberg's customers. Turning to Bread Pay, we continue to add new brand partners to our platform and importantly, we have now extended nearly 50% of our current loan origination volume with new long-term renewals. Because these contracts historically have been short-term in nature, having long-term extensions will reduce volatility and promote long-term sustainable growth. Additionally, our strategic relationship with CECL continued to outpace our expectations with now more than 200 live merchants and installment loan origination volume exceeding our initial goal. We are pleased with our many accomplishments in 2022 and plan to build on this momentum in 2023. Our business development pipeline remains strong and we are confident in our ability to grow responsibly in 2023, despite a more challenging macroeconomic landscape. As always, we remain vigilant in responsibly driving sustainable profitable growth. Perry will outline our specific 2023 financial targets, which include continued strategic investments aligned with quality loan and revenue growth. Our 2023 outlook assumes continued inflationary pressures and gradually rising unemployment levels. Headwinds that we expect will result in a full-year net loss rate above our long-term historic average of approximately 6%. This corresponds with our expectations that the net loss rate will hover above our historic average during more challenging economic periods and drop below our historic average during more favorable economic periods. With three decades of experience, our differentiated and tested underwriting and credit risk modeling is purposely structured to navigate the full range of economic scenarios, focused on producing positive annual earnings and strong risk-reward margins even during periods of economic stress. With the changes we have made over the past three years to strengthen our credit profile, we remain confident in our long-term guidance of a through-the-cycle average net loss rate below our historic average of 6%. Our seasoned leadership team is experienced in managing through credit cycles and every cycle is different. Some factors like inflation are impacting all consumers and cannot be fully controlled or mitigated. We will manage what we can control. In these instances, we run our business with a long-term focus as we have done effectively in previous downturns. We have and will continue to proactively adjust our underwriting and credit line management to account for the anticipated challenges faced by consumers. We manage our business with strong governance and controls intact and remain aligned and confident on our objective to deliver long-term value for our stakeholders. With that, I will turn it over to Perry Beberman, our CFO to review the financials.

Perry Beberman, CFO

Thanks, Ralph. Slide six provides our fourth quarter financial highlights. Bread Financial's credit sales were up 16% year-over-year at $10.2 billion. Average and end of period loans were each up 23%, driven by our new program additions, as well as new products and organic growth from existing brand partners. Revenue for the quarter was $1 billion, increasing 21% versus the fourth quarter of 2021, resulting from higher average loan balances and improved loan yields. While total non-interest expenses increased 28% as anticipated. As we signaled previously, EPS was materially impacted this quarter by the higher provision for credit losses, reflecting seasonal loan growth in the quarter, coupled with the required upfront CECL reserve build from the acquisition of the approximately $1.5 billion AAA loan portfolio. Turning to slide seven, I'll review our full-year 2022 financial highlights. Bread financial credit sales were up 11% year-over-year to $32.9 billion and average loans increased 13%. Revenue for the year was $3.8 billion, an increase of 17%, compared to 2021, while total non-interest expenses increased 15%, driven by portfolio growth, inflation, and ongoing investments in technology modernization, digital advancement, marketing, and product innovation as Ralph had discussed earlier. Income from continuing operations was $224 million and diluted EPS from continuing operations was $4.47 for the year, both of which were materially impacted by the higher provision for credit losses in the year as a result of our strong loan growth, portfolio acquisitions, and a higher reserve rate. Looking at the financials in more detail on slide eight. Total interest income was up 30% from the fourth quarter of 2021 resulting from 23% higher average loan balances, coupled with improved loan yields. Non-interest income, which primarily includes merchant discount fees and interchange revenue net of the impact from our retailer share agreements and customer awards was negative $97 million. Total non-interest expenses increased 28% from the fourth quarter of 2021, driven by three primary factors: first, card and processing expenses related to incremental card issuance volume; second, information processing and communication as a result of the transition of our credit card processing services and other software licensing expenses; and third, higher employee compensation and benefit costs. Additional details on expense drivers can be found in the appendix of the slide deck. Overall, income from continuing operations was down $195 million for the quarter versus the fourth quarter of 2021 as the improvement in pre-tax, pre-provision earnings or PPNR was offset by a higher provision for credit losses in the quarter, including the previously discussed upfront CECL reserve impact from the AAA portfolio acquisition in the quarter. Taking out the tax and provision impacts, we are pleased to report that our PPNR improved 13% year-over-year marking the seventh consecutive quarter that we have generated year-over-year double-digit growth in PPNR. As we have said, we remain focused on making responsible decisions to produce quality earnings. Turn to slide nine. The left side of the slide highlights our earning asset yields and balances. The fourth quarter loan yield increased 80 basis points year-over-year, driven by the increases in the prime rate, but decreased 120 points sequentially due to seasonally higher balances in the quarter, the addition of the lower yield, higher quality AAA portfolio, and an increase in reversals of interest and fees revenues from higher gross losses. Net interest margin increased 30 basis points to 19.1% year-over-year as the benefit from loan yields more than offset the increase in funding costs. On the liability side, we saw funding costs increase in the fourth quarter in line with our expectations given the Fed interest rate increases through December of 2022. As you can see from the stacked bars on the bottom right, our direct-to-consumer deposits continue to grow and now represent $5.5 billion or 26% of our total interest-bearing liabilities. We expect that our retail deposit balances will continue to increase, providing a stable funding base as retail consumer deposits become an even more meaningful portion of our funding over time. Moving to slide 10, starting in the upper left with the delinquency rate. The fourth quarter rate of 5.5% was slightly below the third quarter rate, following typical seasonality. On the upper right, the net loss rate was 6.3% for the quarter, slightly better than our earlier projection due to lower-than-expected losses in November. The loss rate in December of 6.7% was more in line with our expectations given continued payment rate pressure. If we think about where the consumer is today, we have to look at how we got here. Earlier in 2022, we still saw some of the benefits from the late 2021 stimulus aid coming through in terms of both spending and very strong payment rates. If you look at a trend line from our low point in Q3 ’21 to today, you could see the upward movement or normalization of loss rates from both the wind down of stimulus, which has largely run its course, and the influence of elevated inflation. We saw lower scoring and lower income cohorts normalize first. However, given the broad impact of inflation, we're seeing impacts across the full credit spectrum and all income groups. As you would expect, we continue to proactively manage risk-reward decisions at the margins for both new account underwriting and existing account line management. This is an ongoing and evolving situation as the macroeconomic environment unfolds. Moving to the bottom left, the reserve rate increased 10 basis points sequentially from the third quarter to 11.5% as a result of continued elevated inflation increasing consumer debt levels and weakening macroeconomic indicators pulling down the base case scenario outlook. This was modestly offset by the addition of the higher quality AAA portfolio and seasonal transactor balance growth in the fourth quarter. Our intention is to maintain a conservative weighting of economic scenarios in our credit reserve model in anticipation of the increase in macroeconomic challenges and the expected potential impact on our credit performance metrics. We estimate that our reserve rate could increase up to approximately 100 basis points due to the continued macroeconomic trends, seasonality, and the impact from the anticipated sale of the better credit quality BJ's portfolio. In nominal dollar terms, we would expect a meaningful decrease in our allowance balance and therefore a provision for credit losses released in early 2023, again due to the anticipated sale of the BJ's portfolio, as well as projected seasonal decline in loan balances from year-end. Our credit distribution improved from the third quarter, with economic consumer headwinds offset by the benefit from the AAA portfolio acquisition. We would expect our overall portfolio or overall proportion of 660 plus advantage score customers to move down when we exit the BJ's portfolio. A fundamental element built into our business model includes having controls in place to manage our risk tolerance with the objective of ensuring that we are properly compensated for the risk we take to underwrite and manage our portfolio. We closely monitor our projected returns with the expectation that we generate strong risk-adjusted margins above fewer levels. As Ralph alluded to previously, we remain confident as a management team in our ability to manage credit risk and drive sustainable profitable growth through the full economic cycle. Slide 11 provides our financial outlook for the full-year 2023. For the full-year, average loans are expected to grow in the mid-single-digit range relative to 2022. Our expectation includes projected new and renewed business announcements, visibility into our pipeline, the anticipated sale of the BJ's portfolio, and our current economic outlook. The range is contingent on credit strategy actions that will leverage macroeconomic conditions. We expect revenue growth to be consistent with average loan growth in 2023, excluding the anticipated gain on sale, with a full-year net interest margin similar to the 2022 full-year rate of 19.2%. The first quarter NIM is expected to be below our full-year guidance given the inclusion of the lower loan yield BJ's portfolio and a larger headwind from the reversal of built interest and fees related to expected elevated first quarter credit losses. Our outlook assumes additional interest rate increases by the Federal Reserve will result in a nominal benefit to total net interest income. We expect to deliver nominal positive operating leverage in 2023, excluding anticipated gain on sale. As Ralph highlighted, we will continue to strategically invest in our business to fuel growth opportunities and create operating efficiencies while balancing these investments with responsible revenue growth in order to achieve sustainable profitable growth. First quarter 2023 total expenses are projected to be sequentially down from the fourth quarter of 2022 benefiting from seasonally lower transaction volume and lower marketing expenses. At this time from a dollar perspective, we expect second-half 2023 total expenses to be flat to down from the first half of the year, driven by lower intangible amortization expenses and improved operating efficiencies related to our technology modernization efforts. We anticipate the full-year 2023 net loss rate will be approximately 7%. As you can imagine, there's a broad range of outcomes for net charge-offs for the year based on potential economic scenarios. Given persistent inflation and rising interest rates, borrowers are making decisions to pull back on discretionary spending and drawing down on savings, pressuring their ability to pay. Despite low unemployment, moderate-income households are increasingly noting payment difficulties during the collections process. Our outlook assumes inflation remains elevated and that these pressures will persist throughout 2023. At the same time, our outlook contemplates a gradual increase in the unemployment rate in 2023. We will continue to closely monitor macroeconomic indicators as we gain clarity on the Fed's efforts to tamp down inflation. We'll update our expectations accordingly. We expect the first half 2023 loss rates to trend upward given the current inflationary pressures, as well as the impact of the sale of the BJ's portfolio. Our first half net loss rate is projected to be above 7% inclusive of the impacts from the previously discussed customer combinations we made in the second half of 2022 in connection with the transition of our credit card processing services. Finally, we expect our full-year normalized effective tax rate to remain in the range of 25% to 26% with quarter-over-quarter variability to the timing of certain discrete items. Looking forward, we intend to host an analyst event later this year, where we will further highlight what we believe are the strategic differentiators and competitive advantages of our business model, including the potential for capital generation. At that time, we plan to provide new long-term financial targets, as well as more detail around our capital priorities and capital allocation going forward. Regarding current parent capital levels, our TCE to TA ratio temporarily dropped in the fourth quarter of 2022 due to the timing of the acquisition of the AAA portfolio. Given the anticipated sale of the BJ's portfolio, our TCE to TA ratio is projected to increase to a level above the 3Q ’22 figure of 8% after the sale. In keeping with our business transformation over the past three years, we made strategic decisions to enhance our financial resilience as indicated on slide 12. We improved our credit quality, product and funding diversification, loss absorption capacity through our loan loss reserve, and capital positioning and increased our tangible book value. Our tangible equity plus credit reserve ratio as a percent of loans is up nearly 200 basis points since 2020. Our parent level debt is down 33% over the same time period. These enhancements and improvements to our underlying credit portfolio mix strengthen our confidence in our ability to sustain more challenging economic outcomes and outperform our historical results through the entire economic cycle. Our experienced team will continue to manage our portfolio proactively. We're utilizing our recession readiness playbook for both new and existing accounts with a heightened focus on open-to-buy authorizations and helping consumers manage their credit lines and balances in a healthy manner. We believe that our improved risk profile coupled with our more diverse portfolio and brand partner base make us better positioned than ever to manage through a recessionary period. We look forward to building upon our successes from 2022 and we'll continue to make strategic decisions to create long-term sustainable value for all our stakeholders. Operator, we are now ready to open the lines for questions.

Operator, Operator

Our first question comes from Sanjay Sakhrani of KBW. Sanjay, your line is open. Please go ahead.

Sanjay Sakhrani, Analyst

Thanks. Good morning. I guess, I have some questions on the loss assumptions in reserve rate. Perry, you talked about the reserve rate possibly going up another 100 basis points in 2023. So I'm just making sure I got this right. So you think by the end of this year we're probably closer to 12.5% and then the 7% charge-off rate for the year. Can you maybe just separate what the processing, conversion impacts are versus sort of the deterioration you're seeing as a result of normalization? Thanks.

Perry Beberman, CFO

Sure. Thanks, Sanjay. Let me start with the reserve rate first. We're always trying to provide our best insights based on our current perspective of our portfolio and the economic environment. As I mentioned earlier, we expect the rate to rise in 2023 due to the sale of the BJ's portfolio and possible ongoing economic challenges. When BJ's exits, our reserve rate will increase, as it is currently based on a portfolio that has lower averages than we have at present. A lot is expected to happen in the first quarter, along with seasonal effects that could also influence that period. Regarding the risk overlays, we are taking proactive steps to address potential future weaknesses, which is the purpose of the CECL economic risk overlays. One thing we recognized early on is that all industry loss models have been historically calibrated based on changes in unemployment and unemployment-driven recessions. The current high inflation situation impacting consumers is not accounted for in these models. This necessitates a different level of judgmental overlays, which is why we discuss leaning into more severe scenarios in our updates. In our severe scenarios, we project an unemployment rate reaching 7.8% over the next 24 months at its peak, and in more severe adverse cases, it peaks at 8.9%. However, these may not be realistic outcomes, but we consider them in our assessments due to the inflation factor. It’s important to differentiate between the judgmental component and the unemployment aspect, as this is a new context for our models. By the end of this year, we believe we will end with an unemployment range of mid to high 4%. Apologies for the length, but that's the reserve rate overview. Now, regarding the 7% loss outlook, that's an increase of 150 to 175 basis points year-over-year, driven by three factors. First, the macroeconomic pressures affecting consumers, with ongoing impacts from inflation, which may ease in the latter half of the year, but we anticipate elevated unemployment; second, the influence of BJ's, which has a lower NCL rate than the overall portfolio, leading to an upward adjustment; and third, we are also seeing some lagging conversion-related issues from customer accommodations that are simply the timing of credit losses expected in 2022 being pushed into the first half of 2023.

Sanjay Sakhrani, Analyst

Are those equally weighted or unequal? Like is there a more prominent impact from one over the other or?

Perry Beberman, CFO

I'd say macro is definitely the more than half.

Sanjay Sakhrani, Analyst

Okay. And just maybe one follow-up question for Ralph. Just on the processing conversion, I'm just curious, are all the residual impacts over at this point, all the kinks ironed out? I'm just wondering if we should think about anything else? Thanks.

Ralph Andretta, CEO

Hey, Sanjay. How are you? I think a lot of the growing pains are in the rearview mirror. And now we're going to reap the benefits of why we moved quicker to market, better capabilities, and less expensive to operate. So unfortunately, we had these kinks, but I think a lot of that is in the rearview mirror. And we're focused on continuing to stabilize the system and then take full advantage of all the capabilities that we signed up for.

Operator, Operator

Thank you. Our next question comes from Robert Napoli of William Blair. Robert, your line is open. Please proceed.

Robert Napoli, Analyst

Thank you. I have a question about your target capital ratio. Do you have a formal target, and when do you plan to reach it?

Perry Beberman, CFO

Yes. So what we've been communicating is that we're striving to get to a 9% TCE to TA ratio is a good low-end mark. The first priority of our capital has remained to provide in support of profitable growth. And then the second priority is to pay down debt. And we will provide more information about our capital priorities and plans at the investor event later this year.

Robert Napoli, Analyst

Thank you. I would expect that buybacks or capital return would not occur until you reach that target. Is that accurate?

Perry Beberman, CFO

I don't want to give specifics, but again, our priorities are to support our growth, get our capital levels up, and then start to pay down our debt.

Robert Napoli, Analyst

Thank you. And then can you give any color on the competitive environment? There has been a lot of portfolios. Obviously, that have changed hands? Are you guys have resigned a lot? You've added a lot? What's going on with the competitive environment and the returns that you and your competitors are requiring for deals?

Ralph Andretta, CEO

I think no matter what the economy is, the competitive environment is always hot, and that never changes. So that never changes. But when we look at things, we look at things saying, can we grow the portfolio for the partner? Can we do it profitably, and does it contribute to growth for us in the right way? That's how we look at our portfolio. So portfolios changed hands; the portfolios we signed and acquired, we have a lot of confidence that we'll grow those portfolios. We'll grow them responsibly and we'll have good consistent growth.

Operator, Operator

Thank you. Our next question comes from Moshe Orenbuch of Credit Suisse. Moshe, your line is open. Please go ahead.

Moshe Orenbuch, Analyst

Yes. Great, thanks. And one of the things you talked about a little bit in the prepared remarks was the idea of consumer spending. Could you talk a little bit about how you kind of formed your expectations for receivables growth in terms of what you're seeing in consumer spending and payment rates and how those two interact over the course of ‘23? And I've got a follow-up.

Ralph Andretta, CEO

Yes. When I started that, I'll ask Perry to chime in. We noticed strong consumer spending in January. However, due to the current environment, there is pressure on sales that will counteract some of the improvements in payment rates. This reflects the reality of the macro environment we are entering.

Perry Beberman, CFO

Yes. I'll expand on what Ralph just mentioned. Considering the context of slowing spending, consumers are making selective choices in different categories to cope with inflation. Additionally, the overall cost of debt is increasing, leading them to reduce their spending as well. We anticipate that, along with the elevated credit losses throughout the year, will hinder your growth rate, which has decreased by 1.5% compared to last year’s increase of 1.5%. Moreover, we are being more strategic about our credit approaches and tightening our underwriting, which influences our marketing strategies since marketing returns now vary for different customer groups. All these factors play a role in shaping our outlook on receivables.

Ralph Andretta, CEO

And the last thing I'll say is our book is changing, and with the spend shift to non-discretionary to essential. Years ago, we would have been able to catch that because we didn't have the products. We now have the products and co-brands and buy now, pay later and other things that are and direct-to-consumer, we're catching just general spend that we wouldn't have bought that before. Brand launches and new products are going to also help us drive sales growth over the course of the next year.

Moshe Orenbuch, Analyst

Great. And as a follow-up, you mentioned kind of an unemployment outlook of 4.5% to upper 4s. How do you think about the variability around that if unemployment is either better or worse than that? And as we sort of think about the economic performance over just beyond ‘23 as well?

Ralph Andretta, CEO

Unemployment is a key indicator of creditworthiness. If the unemployment rate improves, we anticipate credit performance will also improve. Conversely, if the rate worsens, we expect the opposite. However, we do not foresee a significant increase in 2023. Our current expectations align with our forecasts, suggesting that the exit rate for 2023 will influence 2024.

Operator, Operator

Thank you. Our next question comes from Vincent Caintic of Stephens. Vincent, your line is open. Please go ahead.

Vincent Caintic, Analyst

Thank you for taking my question. I wanted to ask about late fees, so a two-part question. The main one being just your overall thoughts about that given potential regulation that might challenge late fees. So just your thoughts on what the potential impact is and how you can maybe work around that? And then a follow-up question is, so saw that this quarter, part of the yield decline quarter-over-quarter was from the reversals of interest and fees. So just wondering if you might be able to quantify that and what are your thoughts on that for 2023? Thank you.

Ralph Andretta, CEO

Yes, it wouldn't be an analyst call without the question about late fees, so I'm happy to address it. I see this as no different than the Card Act. The industry was able to adapt, and we will do the same in response to any regulations. As we consider late fees and other regulatory changes, we have the capability to collaborate with our brand partners to renegotiate terms if necessary. There are also other options available, and we will adjust in line with how we handled the Card Act. Perry, would you like to address the second part of the question?

Perry Beberman, CFO

Yes. So as it relates to net interest margin, which is where late fees reside for us. When we see some delinquency increasing, you see the late fees materialize in net interest margin early and then when the delinquency manifests itself into elevated charge-offs, the reversal of some of those interest and fees occur in that period. So if you have a period where you're going to be above 7%, which is what we've indicated for the first half, you should expect that you're going to have some more reversals of interest and fees impacting that quarter relative to the prior quarter where losses were lower, and you had less interest and fee reversal, so you actually had a little bit higher net interest margin. So that's going to be the dynamic throughout the year, and that's normal when you're going through periods of rising and falling delinquency and charge-offs.

Vincent Caintic, Analyst

Okay, that’s great. Very helpful. Thank you.

Operator, Operator

Our next question comes from Jeff Adelson of Morgan Stanley. Jeff, your line is open. Please go ahead.

Jeff Adelson, Analyst

Hi, thanks for taking my question. Perry, I just wanted to dig into the new loss guide. I think a lot of your competitors are still at or below their cycle averages, and you're not guiding to something that's above that. I know we've got the noise coming through the portfolio, but you talked about some of the changes you've made over the past three years, how you've kind of enhanced the credit profile of that book. Just wondering what gives you confidence that that's going to drop back down to a below 6% level by the end of this year after this year?

Perry Beberman, CFO

I want to make sure I understood your question correctly. There are two parts to it. First, why are we providing a higher guidance? The increase in basis points aligns with what we are observing industry-wide. Our portfolio has normalized more quickly than expected. Each company has a unique portfolio composition, and we operate as a full spectrum lender. Over a year ago, we indicated that we anticipated our portfolio would normalize faster, as consumers utilized their stimulus funds early, which has indeed occurred. Regarding the noise in our numbers, this primarily relates to BJ’s departure and the residual effects of customer accommodations that we provided. When discussing our confidence in achieving an average below 6%, it's important to note that our predictions for the second half also factor in some early-year noise. The outcomes will vary based on economic conditions, such as if inflation eases and unemployment rises gradually. The 6% average we refer to is intended as a long-term cycle average; some periods will fall below that while others may rise above it. During recessionary periods, it is expected to exceed 6% to maintain a 6% average over time. The real question is how long this recessionary phase lasts, whether officially recognized or not, and its depth. If the recession is mild and brief, a return to the mean will occur more quickly.

Ralph Andretta, CEO

Yes. I would say the thing to remember is we have improved our portfolio over the last three years. But our portfolio is still a bit riskier than our competitors because we underwrite deeper. That said, we get paid for that risk and managing that risk as we move forward. So although we've improved our portfolio, we are still casting a wider net than others, and we get paid for the net that we cast.

Operator, Operator

Got it. Thank you. And then just in terms of the credit sales this quarter, just wondering how much of the boost that you saw at the credit sales was driven by AAA?

Perry Beberman, CFO

Yes. That was a significant amount of the increase. I mean, there was a slight increase in credit sales if you were to exclude AAA.

Operator, Operator

Thank you. Our next question comes from Bill Carache of Wolfe Research. Bill, your line is open. Please go ahead.

Bill Carache, Analyst

Thank you. Good morning, Ralph and Perry. Perry, I wanted to follow up on your comments regarding legacy credit models, which were built around the idea of rising unemployment, rather than the inflationary pressures consumers are currently facing. There is a belief that delinquencies will continue to rise, but due to the strength of the labor market, they may stabilize once we reach levels similar to those before the pandemic. Given your earlier point, do you expect that delinquencies might continue to exceed these normalized levels because of inflationary factors, even if labor market conditions remain strong? I just want to confirm that I understood your point correctly.

Perry Beberman, CFO

Yes. The point I was making about the models was focused specifically on loss forecasting models, not credit underwriting models. Credit underwriting models consider a variety of consumer attributes, including income, stable employment, and existing debts with other issuers. You’ve highlighted an important issue regarding inflation, which the Fed is trying to manage as it disproportionately affects moderate to middle-income families. Even though these families may be gainfully employed and experiencing wage growth, that growth isn't keeping pace with the financial pressures they face. This situation is reflected in rising debt levels, which ultimately affects their ability to repay. While we are seeing some moderation in inflation, it is primarily due to lower fuel and used car prices, which benefit some, but not everyone. Meanwhile, costs for housing, food, and utilities have risen significantly both month-over-month and year-over-year. Therefore, even in a robust job market, many Americans are feeling the strain and making difficult spending choices. This is likely contributing to a slowdown in overall spending and a shift from discretionary to nondiscretionary expenditures, placing further pressure on households.

Bill Carache, Analyst

Understood. That's super helpful, Perry. Thank you. And separately, Ralph, I wanted to follow up on your late fee commentary. I appreciate all the color. But I wanted to ask if I could follow up on the comment you made last quarter that the safe harbor you thought surrounding late fees was more likely to be reduced rather than eliminated. Is there any way you could give us an update there and maybe frame the potential magnitude of any reduction or impact that you think we could see?

Ralph Andretta, CEO

I understand the situation with the CFPB, and I believe we saw some developments in the third quarter. I don't want to speculate about future outcomes, but whatever comes our way, we are prepared to handle it and will manage it effectively.

Operator, Operator

Understood. Thank you. Our next question comes from Mihir Bhatia of Bank of America Merrill Lynch. Mihir, your line is open. Please proceed.

Mihir Bhatia, Analyst

Excuse me. Good morning, and thank you for taking my questions. I wanted to go back on to the credit guidance. And following up a little bit on Jeff's question earlier. I just wanted to better understand the reason you have a high degree of confidence that the back half of ‘23 would be below 7% at least. Right, just given your implied guide of 1H above the 7%. So like given the high unemployment, you have BJs coming out. I understand you have some noise in the first half, but if I recall, that's about a 30, 35 bps impact there. Why would the back half come in below the first half, just given the macroeconomic pressures you are pointing to, right, with unemployment increasing throughout the year? And then relatedly, just in terms of your delinquencies and losses, like when do you expect delinquencies to peak, and in terms of losses, given you've normalized faster than peers, do your losses peak before your peers who've all talked about that happening maybe in 2024? Any additional color you can help us with on some of that? Thank you.

Perry Beberman, CFO

I want to clarify that when we mention potential losses of around 7%, it doesn't necessarily mean that the second half of the year will be significantly worse than the first half. The numbers could still hover around seven, be slightly lower, slightly higher, or remain flat. I want to temper expectations about the second half being substantially lower. There's considerable economic uncertainty ahead, especially regarding inflation and unemployment, and we'll continue to refine our expectations as we progress. Regarding normalization, I hope we reach a peak sooner. While the higher-end consumer is lagging in normalization, we manage losses very carefully at a low level, especially compared to the super prime sector. With larger lines and less open to buy, we experience less severity risk as unemployment rises, meaning we may face less volatility.

Mihir Bhatia, Analyst

Okay. Thank you. Thanks for taking my question.

Operator, Operator

Thank you. Our next question comes from David Scharf of JMP. David, your line is open. Please go ahead.

David Scharf, Analyst

Hey, good morning. Thanks for taking my questions. Most have been answered. Perry, I guess I just wanted to follow up a little on the NIM outlook, which is effectively flattish from fourth quarter throughout the year. I mean, I believe, historically, the company has always had a sort of a net asset-sensitive model. And notwithstanding the repricing rates, I'm wondering, given the fact that deposit funding has continued to increase as a part of the mix, and we've successfully had a number of months past now where we can flatten out the impact of the abrupt changes, the abrupt Fed rate rises and passing it along to consumers? Why wouldn't throughout this year, especially if we're not looking at any surprise increases from the Fed beyond the current outlook, why wouldn't there be a net positive impact in NIM? Is it primarily related to expectations at late fees first get reversed out with higher losses and maybe tempering kind of the late fee modeling as well based on what the CFPB might propose?

Perry Beberman, CFO

What I would say is that our outlook doesn't contemplate anything with the CFPB changes because, as Ralph said, we can't speculate from what that means. But as it relates to net interest margin, you kind of touched on it. We have been slightly asset sensitive. Our objective is to be close to neutral. And then as you think about NIM, there are many components from the asset mix, meaning the product mix, risk mix that goes into there, and then when you enter a period of rising losses as you kind of said it is that the increase in late keys that you get or rollover is partially dampened when the losses come through because of the reversal of billed interest and fees. So it's all those things together, and then on top of that, we will have a changing funding mix throughout the year as we work through our debt stack and then you continue to shift to more deposits and things. So we're just giving guidance for what we think is a good way to model a base case for it.

David Scharf, Analyst

Understood. Appreciate the detail. And then just a quick follow-up. I know, and I'm sure on the upcoming investor event, we'll get updated background on the vertical mix and other ways to sort of slice and dice the portfolio profile. But I noticed in the slides on new signings, there was another jewelry vertical retailer involved. Can you update us on kind of what percentage of balances are associated with that vertical, which has always been so prominent for you?

Perry Beberman, CFO

Probably for us, the low double-digit in terms of receivables.

David Scharf, Analyst

Got it. Perfect, thanks so much. That’s all I got.

Operator, Operator

Thank you. Our next question comes from Dominick Gabriele of Oppenheimer. Dominick, your line is open. Please proceed.

Dominick Gabriele, Analyst

Great. Thank you so much for taking my questions. I want to talk about the spending trajectory throughout 2023. And do you think it would make sense that the consumer would continue to slow their spending given what we're seeing in inflation coming down because that's going to hurt nominal dollars, right, the grow-over effect of nominal dollars being dampened? And really, the fact that would you expect spending to slow down through the period before up until we hit peak unemployment? And then I just have a follow-up. Thanks.

Perry Beberman, CFO

Yes, I believe that's somewhat accurate as we are beginning to notice a decrease in spending. This situation is affecting individual consumers, as we've mentioned earlier. With utility and food costs increasing by about $100 in a month, consumers need to cut back on spending in other areas. This is definitely a contributing factor. For our company, we have continued to bring on new partners in 2022 and have ramped up our marketing efforts. Despite the departure of BJ's, we still see overall spending and originations growth. However, losing that high transactor portfolio will slow our growth slightly more than it would have otherwise. Overall, consumers remain employed, there are job opportunities available, and small businesses are hiring, despite reports of layoffs in larger companies. This gives me confidence that we will navigate through what appears to be a milder economic situation.

Ralph Andretta, CEO

Yes. And I mentioned it before, the shifts in our portfolio help us maintain spend, right? So if they move from discretionary to nondiscretionary, we have products and services that the spend will be sticky to us.

Dominick Gabriele, Analyst

Great. I really appreciate that. I want to walk through this formula with you. Consider the growth math and the significant growth that many of you and your peers have experienced over the past few years, which influences this growth dynamic. If unemployment rises, it would impact both the front and back book. I feel this could lead to an increased effect on the net charge-off rate, as the situation worsens in the back book due to unemployment. Does that make sense, or am I misunderstanding something?

Perry Beberman, CFO

No. I think in general terms, sure. But I'll speak specific to us. When you think about the growth that we've taken on over the past year, a good chunk of that was due to two portfolio acquisitions of the NFL and AAA in 2022. Those are already seasoned portfolios. So when you hear others talk about all this growth and they've got vintages, they're going to get peak losses in the next 24 months. That's not the case for us because they came in seasoned, we were taking losses in the first month they were on the book. So start with that for us. And then if you think about the product mix, that also influences that growth math seasoning concept because of the degree that we have private label cards, they start to season and peak in the, say, month 12 to 18 months, whereas many of those co-brands and other things peak 24 to 36 months. So ours within the first 12 to 18 months, we peaked in season. So we season a lot faster.

Ralph Andretta, CEO

Yes. I think the other thing I would say too is we haven't been sitting still. We've been proactively managing the back book and the front book with the right line assignments, right treatment for card member underwriting for the right vantage score. So we've been managing our recession handbook for the last two and a half years. And so as I think about it, it puts us in good shape to know what's in the book and know where to focus.

Dominick Gabriele, Analyst

Great. No, that's really, really helpful. Ralph, maybe just really quickly one more for you. Just you have really great co-brand and private label portfolios. How do you see the dynamics playing out between the two? And as far as net charge-off rates and where you may decide to pull back in your underwriting one versus the other in the downturn? Thanks for everything.

Ralph Andretta, CEO

Yes. So it's the private label portfolios have terrific margins, but they also have a little bit more risk in them. While the co-brand portfolios have good margins, but the risk is less. So if you think as you go into the economy, we certainly want to be fair with all our partners. It's important that we work through and make sure that we are doing the right thing by all our partners. But to me, it's really a balanced approach and making sure that we're taking the right risk for the right reward.

Operator, Operator

Thank you. Our next question comes from John Hecht of Jefferies. John, your line is open. Please go ahead.

John Hecht, Analyst

Good morning, guys. Thanks very much for taking my questions. Just your newer partners, the NFL, the Yankees, and the AAA. It's a different, I guess, characteristic relative to some of your older traditional retail counterparts. So I'm wondering, given that they represent slightly different kinds of associations, is there different some characteristics with the usage of the credit cards or the credit relationship with the customers from those different channels?

Ralph Andretta, CEO

Yes. Some of those cards are top-of-wallet cards. For example, AAA is a top-of-wallet card. It's important to ensure we have the right approach for the right audiences. These cards have higher usage and encompass both discretionary and non-discretionary spending. That's part of their product offering. We need to provide appropriate strategies for those co-branded cards, which may vary somewhat from those used for private label cards. Diversification is crucial for us, and we don’t treat every card the same. Instead, we tailor our approach based on the behaviors of the customers and the specific products.

John Hecht, Analyst

Is the general line extension and utilization rate consistent with some of the other platforms or is there anything to point out there?

Ralph Andretta, CEO

It depends on the creditworthiness of the individual, right? So that's how we look at it. We don't look at it on a portfolio basis. We look at it within the portfolio and the performance of the individual and their creditworthiness.

Operator, Operator

Thank you. Our final question of the day comes from Regi Smith of JPMorgan Chase. Regi, your line is open. Please go ahead.

Regi Smith, Analyst

Thank you for taking my question, especially since the call is running late. I wanted to shift the focus a bit to credit quality. I'm curious about the proportion of your business that is related to Bread, including both spend and revenues. This encompasses options like buy now, pay later and the Amex card. I’d also like to broaden this to include any digital-first card offerings. I'm trying to understand the potential story here that might be overlooked. Could you share how significant this business segment is and its growth rate? I believe this could become a more prominent and intriguing part of the narrative over time.

Ralph Andretta, CEO

Well, the cards business, right? Things take time to grow, right? So we've been with both those products a year or last or just about a year. So I could tell you that 40% of our new accounts are digital channels, right? So and I expect that 40% to grow given our new capabilities, and given the capability we're going to put in place. So we expect those digital channels to grow. And we do expect direct-to-consumer to grow. I think that American Express product, 2% cashback is a really good quality product out there. The virtual card was just introduced that will have some traction in 2023 and 2024. So while it's not the biggest part of our portfolio today, it is a growing part of our portfolio.

Regi Smith, Analyst

Got it. And if I could sneak one more in. Have you guys ever provided, I guess, a longer-term target for efficiency ratio? I know you talked about margin expansion. That's been a theme every year, you kind of mentioned that. But is there a long-term target that you're driving towards?

Ralph Andretta, CEO

We talk about it in terms of positive operating leverage for now. As we think about the future, potentially. But right now, we talk about positive operating leverage, which also helps our efficiency ratio. We have some internal targets, but primarily, we're looking at making sure that our expenses outpace our revenue growth.

Operator, Operator

Thank you. Thank you all. I know we ran a bit over, but I think it's time well spent with you. I really appreciate the interest in Bread Financial. I look forward to talking to you all soon. Everybody, have a good day. Ladies and gentlemen, that concludes today's call. You may now disconnect your lines.