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

This is Jason Goldberg, and I cover the U.S. large cap bank stocks here at Barclays. And this is our 19th Annual Global Financial Services Conference. Next up, I'm very pleased to have Capital One Financial with us. And from the company, its Founder, Chairman and CEO, Richard Fairbank. Before we jump in, a couple of housekeeping notes is, first off, this is audio-only. So you won't be able to see us, but it will give you a break from actually looking at my mug. [Operator Instructions] And then secondly, there's a button called Survey, with our typical automated response questions, and please answer those at any point, during the course of the presentation. There is a delay in me getting the questions when you ask them, so the sooner you ask in the presentation increases the likelihood we get to them.

Rich, maybe we could just jump right in here. And clearly, I think the #1 topic on people's mind at the moment is loan growth. And just looking at the monthly data through July, domestic card loans have seen both year-over-year and month-over-month growth rates accelerate in each of the last 5 months. And I know we'll get August data in a couple of days. But just I think more broadly, as you look out, given strong sales volume growth, do you expect this trend to continue despite historically high payment rates. And just what are you seeing around payment rates in general?

Yes. Thanks, Jason, and good afternoon, everyone. It's a pleasure to yet again, be here on this -- in this conference. Maybe someday, we'll actually do it in person, hard as that is to imagine right now. So Jason, we're feeling good about the trajectory of our business. In loan growth, loans were down about 1% year-over-year in July. And if you exclude the impact of moving a partnership portfolio to held for sale, we were actually up around 1% year-over-year in July. When you think about the 3 classic growth elements, spend is growing very strongly. Revenue is growing. Payment rates are still high, and that slowed the loan growth. But the flip side of high payment rates, of course, is strong credit and a healthy consumer, and that's a trade that we're very happy to take. Spending has recovered and was up, I think, 48% in the second quarter year-over-year. But of course, the second quarter 2020 was severely impacted by the early part of the pandemic. A better comparison is to look at spend growth compared to 2019. And that spend growth was up 25% in Q2 versus 2019, and this trend has continued into Q3. And we continue to see the rebound in purchase volume from heavy spenders. Turning to payment rates. They remain historically high. The government stimulus has been amplifying payment rates. And while those programs have been winding down, customer balance sheets are healthy and payment rates remain elevated. And of course, you can see the payment rate trends in our reported trust metrics. And while they're not a perfect reflection of our total portfolio, they remain at historically high levels in Q2 and as you saw also in the July results. And these payment rates are muting the balanced growth even as spend overall is strong. Now growth is also, of course, driven by the traction we're getting in the marketplace, including what happens with originations and line increases. We're seeing attractive origination opportunities. These opportunities are enhanced by our technology investments. We're also gradually increasing credit lines. And given the opportunities, we're leaning further into marketing, and we are seeing some very good results from our marketing. Now while we focus on growth, we'll also be keeping an eye on competition. And right now, competition, as one would absolutely expect given the environment, has been heating up. It is still generally rational. And in this current environment, with great credit and a strong consumer and the strength of bank balance sheets, competition is likely to intensify, potentially to irrational levels as lenders reach for growth in such a benign credit environment. But pulling way up, Jason, we are pleased with our opportunity to continue to grow our customer franchise.

That's helpful. Can we just talk to -- are you seeing any changes in terms of specific categories, leading -- kind of leading in the spend versus those that are lagging? And just any changes over the last couple of months, as this Delta variant is coming down, as we kind of go shift from kind of the summer season to kind of the back-to-school season?

Yes. So well, let's start with Q2. Through Q2, spend had recovered across all categories and, as we said, was up 25% compared to the second quarter of 2019. T&E spend growth turned positive compared to 2019 in June. And we saw a rebound in purchase volume from heavy spenders. In July and August, spend has remained strong across categories and is up around 25% from the same period in 2019, similar to what we saw in Q2. Seasonally, things tend to slow down in August. So we'll take a look and watch trends as they continue. And in addition to the industry-wide recovery in spend, the strong purchase volume is also the result of real traction Capital One is getting in our spender businesses, our increases in marketing and some of our choices on credit lines. So there's a lot of things going into this that led Capital One to be near the top-of-the-league tables in spend growth.

You mentioned kind of leading in the credit lines and increasing marketing. You've made some changes to some of your rewards program. You're now offering rewards on student cards. You enhanced rewards for Savor cardholders. There's been some competitive responses to that. Maybe just expand upon just how you see competition in the rewards space. It is -- you said it could get more intense. And just how does that impact profitability, particularly in light of kind of lower [ revalued ] balances at the moment?

Yes. Well, competition and rewards space, I'm trying to remember times where it wasn't intense, but I think it is intense now. And I think it's getting somewhat more intense. And that's a very natural thing, I think, given the environment that banks find themselves in and the nature of the consumer. But what we see out there is that marketing, which tends to be focused on, especially on the spender segment across the industry, it is at or approaching the high levels we were seeing pre-pandemic. Product structures and overall reward levels continue to be fairly aggressive. There have been a number of refreshed products in the market recently with enhanced rewards, particularly in the cashback space. And upfront bonuses remain at high levels but are broadly fairly stable these days. We, ourselves, have done a modest amount of refreshing of product rewards. Now so far, the profitability impact has been minimal. We watch carefully to monitor the collective impact of the industry price changes. And pricing, meaning reward level changes. But we feel good about our performance in originations and in purchase volume. Product is clearly important, but we know there's a lot more that goes into being successful in this space beyond products such as customer experience, including the digital experience, marketing, brand and really, the sustaining of investment and commitment in this segment over a long period of time. And that's what we've done at Capital One. So we like our strong positioning and our brand and our leading digital experiences. We continue to come out with various innovations. And we -- so pulling way up, we've got our eye very much on the competitive intensity meter. It is going up. But I think we still feel good about the heavy spender business, and we like our chances there.

One segment that comes up a lot on a significant competitive environment is the whole buy now, pay later firms. I know it's still a small portion of the industry, but high growth rates and really high market caps. But just how are you, I guess, responding competitively to the growth of buy now, pay later? And does that kind of -- how do you think about that space?

So I've often said that credit cards were one of the original buy now, pay later products, and they have coexisted with traditional point-of-sale lending for a long time. And over the past few years, we've seen some pretty impressive growth with this new generation of point-of-sale lending. And there are a lot of things sort of propelling this like the improvements in merchant technology from companies that themselves are platforms like Shopify, Stripe and PayPal, really, a great low-friction customer experience and the access, of course, to lots of venture capital. And really strikingly, the willingness of merchants to pay for these buy now, pay later loans, which makes these loans interest free for consumers. So the elephant in the room is the sustainability of the merchant subsidy. Right now, the merchant is really kind of fully paying for the economics. The consumer is not paying, and it's a really good time for this particular business. And this is fueled by merchants' beliefs that they're getting incremental volume and we'll pay a lot for it. And whatever is the market clearing price for what buy now, pay later players will -- can negotiate with merchants. But competitors are amassing at the border and it's plausible that they will bid down the level of the merchant discount. And I think as there is a drop in margins, it could alter how the business works, who pays for the loans and which customers ultimately choose the product. Now another observation I would say about buy now, pay later right now is most of the growth is coming from debit card users. Now that said, we're watching this product closely and certainly not taking this growth lightly, especially as many of these buy now, pay later providers form new financial relationships with a large number of consumers and merchants. And so we're watching carefully how the margins in this business are evolving. And the other issue that everyone is going to closely watch is what happens to credit over time. This is the absolutely best time of credit, almost for decades really in the consumer lending business. A lot of these customers are young. They don't have credit cards. And the credit performance will be further affected, of course, by whether the product continues to be free. Now later this year, we will be testing a beta version of our own buy now, pay later product that will be available to a subset of our existing customers at the point of sale across a select set of merchants. Based on our learnings from this test, we'll decide our next steps as we continue to innovate and look for new ways to create value for both merchants and consumers.

Interesting. And I guess, when you look to merchant, are these merchants that you have like existing private label co-brand relationships with? Is that the way to think about that?

Well, we're not going to -- that -- we're going to kind of stick with that announcement that we just said. It's really -- we're just testing with a select number of merchants. And no, it isn't really, frankly, just a subset of a private label partner.

Got it. I guess, interesting news, something we'll keep an eye out for. I guess on -- in the kind of the private label co-branded vein, we continue to kind of see movement of sizable partners. You recently adding Williams-Sonoma, you kind of giving up or losing GM and Costco Canada. Just maybe talk to your outlook for that segment and just how you're positioning yourself to be competitive.

Well, we feel great about the partnerships business, and let's kind of pull up the historical journey here. We entered the partnership business in 2012 via the acquisition, which I'm sure you remember, Jason, our acquisition of HSBC's credit card business. And along the way, we not only inherited their customer relationships. We also inherited their tech stack. And because there's a lot of very customized technology associated with partnership business versus just the regular customer to -- I mean direct-to-consumer credit card business. So for a number of years, we were limited by the technology that we inherited. And as part of our technology transformation, we have converted -- over the past year, we've converted our partnership businesses onto the same technology as our core credit card business, which means our partners can avail themselves of all the technology innovations that we're enjoying at Capital One. So that's been a nice propulsion forward and sort of a long time coming in our tech strategy. But we are very focused on building a business, a partnership business that itself is very technology-focused. We -- and we believe with our differentiators in technology, marketing, brand, underwriting and customer experience, we're able to not just have to go to the auctions that are just on price alone. And so some of the recent traction that you've seen in our business is really a manifestation of some of the new opportunities that we're seeing, thanks to our technology strategy. So we're excited about the partnership business. It's a very natural sibling to our credit card business, but it became quite a bit more natural with finally the sharing of the same tech stack.

Got it. And maybe shift gears, no pun intended, in terms of auto. Growth in this segment has been strong, but you hear of auto manufacturing continue to face chip shortages. Competition in this space has also increased. Stellantis going captive via an acquisition. Maybe just talk about your outlook for that lending segment and just the competitive landscape there.

Yes. So first of all, retail auto sales have been very strong, driven by consumer demand through this pandemic. And auto unit sales hit a 20-year record for April before reverting in June closer to historical averages. Now in addition to heightened unit sales, vehicle sale prices and amount financed have also increased, driven by a constrained supply of cars as dealer inventory continues to tighten amid the ongoing chip shortage. So this combination has increased overall industry dollar originations. Now beyond industry growth, Capital One's share of the auto lending business has grown quarter-over-quarter primarily in prime and near prime. And while I think the whole tide of the auto industry has been going up, we also have, I think, differentially benefited from leveraging our leading technology, data and underwriting capabilities to identify market opportunities that we think have attractive and resilient risk-adjusted returns to be able to leverage more data and machine learning and real-time underwriting. And of course, taking advantage of the consumer-facing technology we've built for -- to help consumers buy cars online and do a lot of the -- not just research on the information associated with cars, but also to understand the financing and dealer terms that they could get. And so that's also been something that's helped propel our auto business. So we're pulling way up. A lot of planets have aligned in the auto financing industry. I don't think these planets will always stay aligned. We've certainly enjoyed them while they are. But I think beneath the alignment and the -- over and above the alignment of the planets, I think there are strategic benefits that Capital One is in a position to take advantage of. But I want to put a caution out there, too, and that is, of course, that the strength of the auto business, I've just been around long enough to know that too much of strength in the lending business can lead to behavioral changes among the industry players. And so we'll have to keep a cautious eye out for changes in the competitive dynamics, which, as I've always said, has more impact in the auto business than the card business because the dealer is there to amplify the changes that are made in the competitive landscape.

And I guess maybe turning to asset quality. You mentioned it's kind of the best ever. And I guess it's -- we've -- banks and Capital included aggressively built loan loss reserves in the first half of last year, then stabilized. And then we received, we've seen releases. I guess, as losses kind of just remain lower for longer, I guess a couple of [indiscernible] earlier today, someone mentioned that they thought consumer credit losses were not going to be structurally lower going forward. So just how you think about the overall loss rates? And then in that vein, just how do you think about the expectations for further loan loss reserve releases?

Yes, I'm not in the camp that consumer losses are going to be structurally lower. I can believe an industry could believe that, but we can talk about that in a bit. But our allowance increased sharply in the first half of 2020. And of course, that increase was driven by a sharp economic worsening and the expectation of a lot more to come. And of course, our actual credit performance has been strikingly benign, so we've been releasing our allowance over the past few quarters. But the pace of those releases has been moderated by significant remaining uncertainty. Uncertainties about the pandemic, the economy and especially about how consumer credit will play out on the other side of stimulus and broad-based industry forbearance. So we are maintaining large qualitative factors for these uncertainties. We're also making concerted judgments in our outlook for the other sources of uncertainty. For example, assuming some elevated long-term risk for customers who had improved customer characteristics during the pandemic and renewed declines in vehicle values in our auto business. Now all else equal, if favorable credit trends continue and the uncertainties I mentioned subside, we would expect further allowance releases in coming quarters. But releases would likely play out over time. On the other hand, if we see newer growing uncertainties or economic worsening, that could push in the other direction. And also, loan growth, of course, could push up our allowance, all else equal. And remember that allowance is not just larger, but also more front-loaded under CECL.

I guess, that helpful on the allowance. And I guess, look at it this way, just -- clearly, credit costs or charge-offs and for card auto will normalize. I guess what impact do you think all the stimulus that you've seen will have on the next credit cycle? I guess there's -- I touched on one view that losses will be structurally lower in the future. There's another view that they're going to be higher than they would have otherwise just given anyone who wanted to repay has repaid given all the government stimulus we've seen. So I guess just how do you feel -- think about just the normalization process we're going to see over time?

Yes. So our credit card metrics have been exceptionally strong, obviously. And consumers continue to build resilience through the economic recovery from the pandemic, improving their balance sheet in ways that could lead to some sustained credit benefits. And the consumer savings rate was a whopping 18% through the first 8 months of 2021. And that's more than double what we saw before the pandemic, and many times what it was in the years before the Great Recession. And although forbearance is winding down in card and auto, it's still relatively widespread for student loans and mortgages. And then, of course, on confidence, we've seen strong labor markets so far this year, even with some lost momentum related to the spread of the Delta variant. So we've -- obviously, we've seen high levels of government stimulus and high levels of industry forbearance. But these are not the only thing supporting the credit quality. U.S. consumers built resilience through the pandemic by saving less -- excuse me, spending less, saving more and paying down debt, improving their balance sheets in ways that can sustain themselves even as -- to make the impact on the other side of the government stimulus ending to make that a more gradual effect. So there are a lot of effects going on here. But let me turn to the question that you asked is do we -- are we at a structurally lower level or not. I've been in the credit business for 3 decades, and I -- I've always got to watch out for whether that brings wisdom or conventional [ wisdom ]. So -- but let me just share with you a few thoughts here that when times are good, and they're really good right now, that tends to lead to more aggressive competitive behavior and often lose your underwriting. And I think it's kind of the physics of how credit cycles work. And I want to flag in the spirit of pattern recognition that the seeds of the next credit worsening cycle are likely to be planted in this period of unusually strong credit. And to some extent, that's kind of just the physics of how these cycles work. The benign rearview mirror is already encouraging lenders to reach for growth. And that tends to be followed. We haven't seen it too much yet, but it tends to be followed by loosening underwriting standards, which can invite adverse selection. Credit models are likely to over extrapolate the strong credit performance of the past year. That could also encourage more aggressive lending. You also have the fact that consumers' FICO scores in general, the tide has risen as the consumers have shown such amazing performance over the last number of months. We've had, on the auto side, auto auction prices are another example. It's great that the collateral values are high, but underwriting at those high levels takes more discipline just at a time when a benign rearview mirror tempts lenders to be less disciplined. So we know that what goes up tends to come back down, and we build that into our underwriting decisions. So if I pull way up on, do I think things have really structurally changed with respect to the consumer. I think the consumer, through the scars of the Great Recession, has been a whole notch wiser about credit and sort of more cautious. And I think now, put a pandemic on that, I think consumer behavior, I would believe that you're going to see quite a bit of rationality in consumer behavior. But I think consumers are ready to break out from the pandemic. There's a lot of evidence they're going back to a more normal environment. And most importantly, I think the lenders are headed at pretty good speed here towards their own normalization. And so I think, really, what we're seeing is much more a cycle phenomenon than anything that looks to me like a structural reduction in credit losses. The one best counterargument, I think to what I'm saying, is just the wisdom and the behavior of the consumer that's been through the 1-2 punch of a Great Recession and then the pandemic. But we certainly are planning for normalization. And in fact, there is an argument that some of these seeds can create a normalized and then some kind of environment down the road.

Interesting. We only have like 6 minutes left, and I want to make sure I touch on expenses and capital. So we'll move along. But I guess, you mentioned earlier increasing marketing spend. I guess, how should we think about kind of your view of marketing kind of as we look out into the back half of this year into next, particularly against the more competitive backdrop? And then can you maybe just talk to kind of what returns you think you're getting on kind of the marketing that you saw in the first part of this year?

So we are seeing attractive opportunities to grow our underlying franchise. We've talked about how outstandings growth is going to depend a lot on payment rates and things like that. But we're very focused on growing the underlying franchise, which really means growing customer relationships. That's all about account originations. Account originations are very much about marketing. And we feel very good about the opportunities we have in account originations. The consumer is in a good place. Our own Capital One unique opportunities are particularly strong right now on the back of some of the technology innovations and the tech stack that we have built. So we're taking advantage of that. And the competitive environment is in places like card, especially, I would describe as intense but rational. So I think there's a window of opportunity to continue to lean into growth opportunities. All of what we do, Jason, is just rather than just set growth goals, we never set growth goals. By the way, we take what the market will give us. At the very same time that we're leaning into opportunities, we also have a watchful eye on the natural competitive things that happen in the marketplace to make sure we're not surprised by how things can change. But right now, we see good opportunities. And with respect to the results that we are seeing from the increased marketing, we're very pleased with the results that we're seeing.

And then I guess, at what point do you think you feel comfortable kind of reinstating a time line for that 42% operating efficiency ratio you talked about pre-pandemic?

So we've been focused on improving operating efficiency ratio for years. And as you know, we delivered over 400 basis points of improvement from 2013 through 2019 with a combination of revenue growth and tight expense management while investing in our tech transformation along the way. The pandemic interrupted our progress, particularly on revenue growth. As it turns out, the pandemic also accelerated the technology raise, and raised the stakes for all players across many industries and certainly, in banking. And for every player, the clock is ticking on their tech readiness and companies are waking up to the investment imperative. And we also look around and see the investment flowing into fintechs, which is breathtaking. And where that leads is to the arms race for tech talent is the fiercest I have ever seen in any job family and is raising compensation costs. So we are continuing to invest in our tech journey. We are really pleased with the opportunities that are, in many ways, accelerating for Capital One on the -- as we get further along in our journey for the world. We all are going to have to confront certain things on the expense side that are realities, not just the need, of course, to continue to really invest in technology, but the actual unit cost of labor are pretty breathtaking. So those are just a little window into some of the -- some of the sort of things we encounter along the way, but we are still very focused on efficiency. And we believe that the tech journey that we are on will continue to be something to help drive enhanced operating efficiency over the years.

And then maybe for the last question, we'll wrap up with capital. But you have the special dividend this quarter. You have the increase in the quarterly dividend. You have a decent sized share repurchase program. And yet, you still have a sizeable amount of capital above the 11% target, which is kind of well above what your kind of regulatory requirement is. With then kind of improved -- with the very low credit quality or loan loss backdrop, and I know there will be a normalization process, but what's holding you back from further capital redeployment and how quickly could we actually see capital ratios come down?

So at this point, we continue to believe that 11% CET 1 is the right long-term capital level. While we are happy with our lower stress capital buffer from our latest CCAR, we're not going to overreact to the results of any one CCAR cycle. And frankly, the SCB is only one of many considerations to our overall capital need. As you know, our Board authorized a $7.5 billion share buyback program in January. We were limited by the Fed's earnings restrictions during the first half of the year, and we completed the maximum amount of repurchases allowed under those rules, which was almost $2.2 billion through the second quarter. And now we're operating under the stress capital buffer rule, which does have more flexibility. So we've always understood the importance of capital return, as you can see through our share repurchases and the recent dividend increase.

Got it. Seeing we are actually over time, we'll end it there. Rich, thank you so much for joining us this year. And to the way you started it, I hope next year, we can actually do this in person.

We will all put that beacon in our -- on our calendar. But anyway, Jason, thanks so much. I want to thank everyone listening in today, and good luck, and we'll talk soon.