Capital One Financial Corporation (COF) Earnings Call Transcript & Summary

Thank you so much, everybody, for joining us this afternoon. I'm here with Richard Fairbank, Chairman and CEO of Capital One, on our audio webcast. Richard, thank you so much for joining us today.

Well, thank you, Betsy. And also, Jeff Norris is joining us, too. He's our Head of Investor Relations. So -- and Betsy, it's always good to do this as we do just about every year.

Yes, it's fantastic. Thank you so much for being here with us. And I look forward to next year, live and in person. Before I get into the questions, I'm just going to read a very quick disclosure that I have to read. For important disclosures, please see the Morgan Stanley Research Disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative.

Okay. Rich, well, with that out of the way, we're sitting here 3 quarters, maybe 7/8 almost of the way through 2Q '21. And I do have to ask the question, have you ever seen the consumer behave like they are today? Does bankruptcy rule change feel familiar? Does prior recession feel familiar? Or is this all a unique category?

So Betsy, the U.S. consumer certainly continues to demonstrate striking resilience. Now but I'm not sure that the consumers themselves are behaving in an unusual way. It may be the circumstances that -- of the environment that they're in. Let me explain this. So in my experience, consumers typically act rationally during downturns by spending less, saving more and paying down debt. I call this the trilogy of behaviors that consumers do when the times get tough. Now we've obviously been seeing that during this downturn. But the big difference this time is that cautious consumer behavior has been amplified by unprecedented government stimulus and industry forbearance across many financial products. And we haven't seen stimulus and industry forbearance implemented with this kind of speed and scale before. Now on top of that, consumers went into this downturn with twice the savings rate compared to before the Great Recession. They had lower payment obligations and none of the structural issues that we faced a decade ago with the housing sector. So we see exceptional strength in the consumer during this pandemic. Now one cautionary note that we're keeping an eye on, after the bankruptcy law change and the Great Recession, is the reverse, actually, Betsy, of an effect that we saw after those 2 things because in the earlier cases, we saw a pull-forward. So when the bankruptcy law changed, then people rushed, in a sense, to go bankrupt before the law changed. There was a pulling forward of something that otherwise would have happened over time. So too in the Great Recession, when consumers were in various degrees of struggling. When something in the magnitude of the Great Recession came along, a bunch of people just ended up charging off maybe quite a bit sooner than they otherwise would have. So it was a pull-forward, and what we saw in both after the bankruptcy law change and the Great Recession, they were followed by a period of strikingly benign credit. And I think a bunch of that really was sort of that pull-forward effect. And it was the survivors who were still there. I think we have to be on the lookout for the reverse of this effect this time because you have consumers in varying stages of stability in their financial relationships. They get the benefit of these windfalls from the government, and that allows them, in many ways, to avoid what otherwise might have happened to some of them. And so it's the reverse of the pull-forward. There's probably a deferral going on here, and so we should just keep that in mind. But that's not to take away sort of, right now, there is a particularly, really strikingly, sort of good performance by the consumer. Yes, go ahead, Betsy.

Yes. No, it's an interesting point you're making because you have also a pretty good jobs market right now, but obviously, we don't know how long that will all last. And I suppose the underlying question here is how do you underwrite to the consumer today? Are you in a spot that is in line with pre-COVID? Or do you somehow value this excess liquidity that they have right now? And just maybe you can give us a sense as to how you're thinking about that.

So we see a lot of strength in the consumer. And we feel that the consumer is just leaning forward and doing what they can to break out from this sort of lost year that they have had. And so I think there is a robustness to the consumer and a forward lean for them that creates a good opportunity for banks like ours to continue to build our business. From an underwriting point of view, we need to be sure. This is something we're doing that I worry whether the industry is looking at it this way, but I'll start with how we're looking at this. We've got to make sure that the credit models that we have don't get faked out by what they just saw because I think when a credit model looks backwards at the recession that ended up with such good credit performance, there can be a lot of sort of wrong conclusions drawn. And so for a company like Capital One, we are intervening to not put too much reliance on what we've seen in the last year or so and to put much more reliance on what we've learned about downturns and consumer behaviors from the many years that we have been in business. I think there is a danger in the industry of credit scores being sort of overinflated, and credit models have trouble really determining what is credit risk given the totally unique things that we've observed in the last year. So I would add that concern to the sort of deferral of charge-offs concern I mentioned earlier as 2 things that we need to keep an eye on for things that can take a positive environment and turn them into something that would be more concerning from a credit point of view.

Got it. Okay. So just to close loop on that idea, relative to pre-COVID, would you say your credit box is pretty similar to what it was pre-COVID? Or is there a difference that we should understand?

Our credit box is pretty similar to pre-COVID.

Okay. All right. Let's get back to the consumer and how they're behaving. Can you give us a sense as to what you're seeing in your book of business? And you define it the way you want. I mean investors come to us and ask, well, how is it between prime and subprime and superprime or Gen Z, millennial, Gen X, boomer. I'm sure you have your own lens that you look through. What are you seeing in differences in behavior of the consumers that you serve?

Yes. I would say, in this pandemic, the similarities across different groups have been more striking than the differences. Across the board, we saw this trilogy of behaviors: consumer spending less; saving more; and paying down debt. And credit performance has been remarkably strong across the board as well in just about every product and segment. I think that we're on a relative basis, where there's a little more weakness, and this is something we flagged for years as highly indebted consumers. People with a lot of credit card debt are less benefited by the stimulus just because there's -- it doesn't make that much of an impact on some of the obligations that they have. So that group has not been as benefited as other groups across the board. But that's more of a relative point here. On the purchase side, we saw a sharper drop on the higher end of the market, where we tend to see a higher skew toward discretionary spend like travel, but that difference has been shrinking more recently as those spend categories have recovered. But for the last number of months, if you separate out the travel and entertainment and dining categories, everything else has been spending -- every other category has been at spend levels higher than pre-pandemic. These laggard categories are pretty rapidly making up for lost time, but they're still behind. And we haven't -- and finally, in terms of other differences, we haven't seen that much in the way of general -- generational differences. Although I think that younger consumers have been quicker to use things like buy-now, pay-later options. But I think, overall, the really striking behavioral trends that we've seen span a lot of the different segments.

Has T&E come back like in full for you at this stage? Or is there -- is that one still lagging?

It's still not back to pre-pandemic, but it's getting close.

And then, I guess, the other piece here is you've got other categories that are above pre-pandemic. So is the right run rate for T&E to be equal to pre-pandemic or above? What do you think about that?

Well, I think it's a little hard to predict. But one thing, I more look anecdotally at what I see in just my friends, my family, myself, when we -- I think there are a lot of people looking for opportunities to go out and get back to the life that they had before. So I think that we're going to -- I think it's likely that this category will be more fulsome in the coming months. When we think about T&E over the longer term, the one area that I look at and say, structurally, this may not return to what it was before, is business travel. And with all the remote work and really the changes in how work is done, it really has implications for how travel, how much business travel happens. So I think that, that is the one area that I wouldn't expect to return to the way life used to be.

Okay. All right. Let's move on to the single biggest question that we get from investors, which is, drum roll, will consumers ever borrow on their card again?

So I know it can seem like a big secular change when we see the extraordinary payment rates that are happening in the credit card business. Now I don't believe that there has been a secular change in consumer behavior related to credit cards. The sharp increase in payment rates and strikingly strong credits we're seeing are more a function of the significant stimulus and widespread industry forbearance that we've discussed. So I would expect consumer behavior to return to normal as the world continues to emerge from the pandemic, and we're certainly starting to see those signs. Now as we talked about, purchase volume is rebounding all over the place. Payment rates remain historically high, in large part, likely due to the big government stimulus, and that still has a number of months to run. But I believe that, that should moderate as the stimulus moderates. Now as we've said, the flip side of high payment rates is strikingly strong credit performance, which drives strong profitability and capital generation. So I think, in a sense, we're going to get paid in a different way to the extent that continues, but I don't believe what we're seeing is something that is a longer-term sort of behavioral change with consumers.

And what's your sense on the stimulus when it will be fully utilized. Do you see it at kind of the same pace as last year and it's just a larger amount so it will take a little bit longer to get through? Or are people spending their stimulus more rapidly? What's your thought on that?

Well, one thing was striking, when we went back and looked at the -- for the 3 big stimulus programs or the 3 big stimulus events that happened, when the stimulus went into effect and consumers saw money coming into their accounts, we looked at how big was the impact on payment rates. And what is striking is how much the third stimulus, the recent one, had the most visible impact. And my hypothesis is that early on, those payments were going to the more basic needs that people had, the more immediate and urgent needs. The more now that the stimulus has happened in the context of a recovering economy and with strength in a lot of areas, it is striking how an increasing amount of that has gone to the second-level things like paying down debt. So I don't have a proof of this effect, but it would be consistent, Betsy, with kind of the behavioral hypothesis of consumers.

Okay. Got it. I wanted to dig down into what Capital One is doing to incent new card openings to increase spend, to incent revolve. What kind of strategies are you employing for this part of the cycle?

Well, we're still in an unusual time for the payment and sort of credit-seeking behaviors of consumers, but we're not really trying to alter consumer behavior. We're focused on originating new accounts to build the franchise and position ourselves to grow as consumer behavior continues to normalize. And as the pandemic has played out, even as the outstandings have been so modest, we're seeing attractive origination opportunities. And these opportunities are enhanced by our technology investments, and we're continuing to lean into marketing to help drive originations. So I think that the -- where the balances will go is, I think, going to be more a product of how payment rate plays out. I think, for us, we have our eyes focused on let's continue to build because there's an opportunity to do this, let's continue to build the underlying franchise to book more and more accounts. And then, over time, in their own natural course, that will lead to the balances, so that's really what we're focused on.

Got it. Okay. Maybe we could just speak a little bit about some of the competing types of products out there in the market. You alluded to this earlier. The BNPL, paying for -- you've got BNPL lenders, you've got fintechs like Square and merchant-funded programs, and they're all trying to get out a piece of your pie. So I just wanted to understand how you think about those products: a, do you think that they would actually have an impact on slowing the borrowing opportunities, the lending opportunities from your end that you have; and b, is there something that you think you should do, that Capital One should do, to ensure that you can compete as efficiently as you can with them?

Yes. So buy-now, pay-later hasn't had a big impact on our numbers yet, but that doesn't mean that we should discount what's going on. It is a fast-growing marketplace. And it's fueled mostly by younger consumers switching from debit cards to buy-now, pay-later. So -- and I want to stop and favor on that one. So far, what we have seen is that the majority of cannibalization is from debit cards. And probably, when you think about the reasons for that, consumers are younger as our -- sorry, the buy-now, pay-later consumers are younger as our debit card users typically. And also, credit cards offer hefty rewards that buy-now, pay-later doesn't offer. So we are watching this marketplace closely. And credit cards were one of the original buy-now, pay-later products. And they have coexisted with traditional point-of-sale lending for some time. Now the buy-now, pay-later phenomenon is not just an ordinary point-of-sale lending thing. It's a pretty dramatic thing that has happened. And we think about what has led this to really take off. It has a great frictionless customer experience that is now placed right in the digital shopping cart. Buy-now, pay-later players are leveraging the use of lots of data, and that's really helping their performance. And a really big effect is the willingness of merchants to pay for these loans at this point in time with a big merchant subsidy, a subsidy which, on average, is significantly higher than interchange. And that has enabled the industry, the buy-now, pay-later players, to make these loans interest-free, which, in turn, has led to it being such an attractive product for consumers and created some positive selection with respect to who's taking the product. So the elephant in the room is the sustainability of this whopping merchant subsidy. And right now, merchants believe that they're getting incremental volume and they will pay a lot for it. But competitors are amassing at the border, and it is likely they will bid down the level of merchant discount. So I predict margins will come down significantly over time. And depending on how far that goes, that could alter how the business works. There's an inflection point, and I'm not predicting it will get all the way to this, but we should just note there's an inflection point at beyond which -- where the business can't sort of support itself, where then the product may have to be charging consumers for the loans. And then that would -- that if it got that far, that would change the selection dynamics of who's taking them, the credit performance and a bunch of things. So I think that the -- I think this is a very clever and elegant business solution that was created by the buy-now, pay-later players. The strategic question, I think we are most looking at and trying to watch carefully, is what happens to the discount and therefore what happens to that marketplace over time.

Got it. There is a question on this topic that came in over the web, that is basically asking how you're thinking about the risk of cannibalization in the future, meaning you get the BNPL, starting out with younger consumers using debit, but then that BNPL platform is expecting to expand into other products like credit card down the road. So does BNPL potentially threaten your credit card balances through the cannibalization that could occur if BNPL is successful in expanding their product sets.

Yes. Well, that's a great question. If we look at all the fintechs, whether it's BNPL or virtually any consumer fintech, what they're doing is trying to build a business on -- starting with one product and then as fast and furiously as they can, expand into other products. And this is a very natural thing to do. And I think it's an important thing for the buy-now, pay-later players to do, particularly in a world, as we've said, that the core margin, the business and -- the core margin might compress by quite a bit in their business. Interestingly, the other players that are amassing on the border tend to be players with broader product sets like maybe other financial institutions. They're also going into this space. I think that will probably bid down the merchant discount, but in either case, for the buy-now, pay-later fintechs or the other companies going into this space, as the core buy-now, pay-later business offers less of a profit opportunity directly, the more of the key to success is going to be how can one monetize those customers, how can one create multiproduct relationships. So it's pretty clear to me that this -- for players coming from both ends of the marketplace, this is where it is going. I think back to your fintech point, I think that -- one thing I've often stressed is Capital One was one of the original fintechs before there was such a word, Betsy. But I think Capital One's experience indicates that fintechs can be pretty successful in starting with one product area, building traction and then going from there. So I think that fintechs are having a lot of success in a number of areas, and it's something for us to keep an eye on competitively to learn from and to heed the success that they're having and make sure that we are mobilized to take advantage of opportunities that they indicate there.

Okay. Great. I have 2 other themes I want to touch on. One is tech infrastructure and one is your strategy. So just honing in on the tech infrastructure side because, to your point, you were the original fintech, I read a book about that, and I know you lived it and created it. So maybe -- and you're really not done yet, right? You are still continuing to invest in technology to enhance your product offerings. Could you give us a sense as to what -- where you are now with your tech infrastructure? You've mentioned many times the path to being fully cloud and how that's going to help you. Could you just give us a sense as to how far along you are and what we can expect from the investment spend that you're doing in the cloud and your tech platform more broadly?

Yes. So we often use the term "tech transformation." And as if there is a date where it ends and that's -- I think at the rate tech is changing, that this is a lifelong journey, and probably, the biggest tech companies in the world are also spending a lot of their time transforming as well. So we are in our 9th year of an intense tech transformation and a transformation that was benefited by starting with Capital One itself, who had only come into the world a couple of decades earlier and which was built on a vision of technology and information, transforming the world of financial services. So I think these were good shoulders to stand on. But nonetheless, it has been a very big undertaking to transform, starting at the bottom of the tech stack, Capital One and to -- really, the way to think about it is we are systematically building the modern technology stack that -- similar to what the leading tech companies in the world have. Now a key part of that is the -- going to the cloud. And as you know, we are all in, in the cloud, 100% in the cloud and that journey. In a sense, we're done with that journey, although the opportunities that we're finding in the cloud, the opportunity to optimize in the cloud, to leverage the cloud, to keep moving up the tech stack of abstraction of the infrastructure to free up our software developers to focus on what they came here to do, that is a journey that continues and continues to have leverage. There's been a lot of work on transforming our data ecosystem and modernizing that, a journey, one application at a time, to modernize each application upon which the company is built. So it's a long journey, and it's not -- we don't arrive at -- on a sloped basis. We've been getting in a sense across this canyon and being able to do really significant things on the other side. So let's talk a little bit about where we are seeing opportunities. Our new marketing platforms leverage big data streaming in real-time to reach more customers with the right offers and improving our conversion rates. Our new credit decisioning platforms enable us to use lots more data and more sophisticated machine learning algorithms to make better credit decisions. Our new fraud platform enables us to improve -- approve more transactions for our customers while simultaneously reducing fraud costs. We're delivering innovative products to the marketplace like Auto Navigator, Capital One shopping, CreditWise. We're strengthening our customer experience and our customer franchise, evidenced by increasingly high Net Promoter Scores and J.D. Power naming Capital One the leading mobile banking app. Let's see. We're winning partnership opportunities where, increasingly, we're finding retailers are focusing on digital capabilities as an important condition for doing business. We are increasingly partnering with tech leaders like Snowflake. In Snowflake's case, we are their largest customer. But my point is there are a lot of innovative tech companies who themselves are on the frontier of where data and technology are going, and we have found very good partnership opportunities that are helpful for us, for the partner and financially valuable for both. And the digital productivity gains are powering our speed to the market, revenue generation and the opportunities to be more efficient, both with respect to analog, but also legacy tech costs. So that's kind of a long answer, but the technology transformation is, over time, changing the trajectory of Capital One, and it just happens on little cat feed in a sense, but comprehensively, it makes a big difference.

No. That's great. And I appreciate the detail and color there. I guess last question is on the consumer client offering. And I contrast it to -- you've got these neobanks that are coming in or fintechs, one product, pitching that they're going to do every product in the future. And here you are with extremely good top-class share in a variety of key consumer financial services, the question is do you keep with what you've got, or is there room or interest? What's the strategy here for opportunity set beyond the financial sleeves you're in? Would you consider moving into personal loans or mortgages, investing, et cetera?

So since our founding days, we've carefully chosen to be in specific businesses rather than trying to do it all. And of course, when the Capital One started, we started with just one business, which was credit cards, and we carefully chose that one since we had to start with something and we love the industry structure of that, still do today. So we focus on banking businesses that have several key attributes and attractive industry structure and economics, typically markets that are consolidating and going national and digital, opportunities to build consumer and product franchises where our information-based capabilities and digital capabilities have the greatest leverage and businesses where we can achieve scale where it matters most. Because in this world, scale has always mattered, but it's -- increasingly, it matters more and more in a digital world. Although we're a small percentage of the overall size and complexity of the money center banks, we have achieved head-to-head competitive scale in card and in auto. We have a national digital bank, and we're building a national-scale commercial business centered around industry specialties. And we built a national brand. So we have built the narrowest collection of related products that are very strategically synergistic. And we have national scale in those. So that's a little -- that's the sort of the method in the madness of how Capital One has pursued a very different strategy than most financial institutions our size. So we have built a bank which is in the businesses we're in, as more like a money center bank, but were the size of regional banks who do way more broad book of business than we do, but they don't do it at national scale. So with Capital One, we do less, but we do it in national scale. And that's by design because we believe that scale is just preemptively important, and it's hard to have it in everything. There are some attractive businesses in banking, which we're not in, but they are very scale-driven and there isn't a clear attractive path for getting there. So I think it's more likely that we will continue to go bigger in what we have, and our new opportunities are more likely to be tech-related opportunities than expansions into other banking businesses.

Got it. Okay. Well, that sets you up as well for -- over the next couple of weeks as we get through CCAR and the SCB goes into play, sets you up for some shareholder return, I would expect, given the fact that just on the April earnings call, you mentioned that you have $8 billion of excess capital.

Yes. And that's correct. At this point, we continue to believe that 11% CET1 is a good target level. Now the timing for when we get down to 11% will depend on what we see in the economic environment, the opportunities for growth we have and the pace of our share repurchases.

Got it. All right. Well, Rich, thank you so much for being with us at the Morgan Stanley conference. And next year, I look forward to having you live on stage.

That will be fun. I look forward to it. Thank you, Betsy. Good luck to you and to -- thanks, everyone, for listening in today.

All right. Thank you so much. Bye now.