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

All right. Thanks very much for joining. I have a research disclosure to read. For important disclosures, see Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley sales representatives. So I'm thrilled to have with us today, Richard Fairbank, Chairman and CEO of Capital One. Thanks for joining us.

Thank you, Betsy. It's great to be here.

It's exciting to be in the flesh, not on the screen?

Exactly.

So let's kick it off with a question that you're very familiar with. What is going on with consumer loan growth. Credit looks like it's been doing pretty well as per some of the disclosures that you're giving out on a monthly basis. Can you give us a sense as to how 2Q is trajecting so far in loan growth, in consumer spending and in consumer credit quality?

Okay. First of all, thanks, everybody. It's nice to be here. Great to see folks and also, of course, those listening in on the webcast. Betsy, we're not going to give intra-quarter indications. However, we do release monthly our for the -- some of our businesses, our credit and volume data. And I think tomorrow is, when they come out. So we don't have to wait very long. But just pulling up and talking generally, the Capital One has been posting some pretty strong numbers in terms of growth, especially in purchase volume growth in our card business. And that continues to be both a reflection of the consumers stepping out and being pretty bullish about their spending, and it's also partly a Capital One phenomenon of the results of years of investment in going after heavy spenders and some of the traction that we're having in that marketplace. Then on the outstanding side, it's been a long journey to get back to where in credit card outstandings that we were at the start of the pandemic. But we're basically very close to that. And that reflects, of course, how much the consumer pulled back, and to some extent, how much companies like Capital One pulled back at the beginning of the pandemic. And then -- so outstandings are almost back. Now also, why is it that if the consumer is really leaning into their spending on cards, why is it that outstandings growth has lagged so far behind. That's because one of the metrics, people didn't talk about that much, but it's become such a centerpiece of the conversations these days is payment rates. So payment rates is of -- what percentage of consumer balances are they paying at the end of each month and payment rates have risen dramatically in the industry for Capital One. They -- I'm talking about over the course of the pandemic, Capital One payment rates have particularly risen a lot. And -- that -- I think that's a very good thing. It reflects healthy consumer paying on their credit card. It does slow down balance growth, and that's why purchase volume has been so far ahead in the race against the outstanding's growth. But if you see it now on a year-over-year basis, both purchase volume and outstanding's growth have been pretty healthy for Capital One.

And loan growth recently has been in the teens, right? That's a pretty impressive. And I guess the question that investors have been asking us is how sustainable is that?

Yes. So let's pull up maybe and talk, Betsy, about the context of leaning into growth in this environment. So when we think about opportunities, it sort of starts with the economy, how do we feel about the economy, and one can make a very bare case or a reasonably solid case right now, but I think there's a lot of uncertainty in the economy. But we are certainly concerned about inflation. And while we're very supportive of Fed intervention to stop the inflation, these are things that can have quite a bit of impact on consumers and in slowing down the economy. Then let me turn to the consumer. The consumer is in a particularly strong place at the moment. So if we look by historical standards, consumer debt levels are at pretty low levels, consumers debt burdens. In other words what they are paying on a monthly basis on their debt are at historically, like 40 year lows. So that's a pretty good thing. Consumers' balance sheets are good. The balance sheets, in fact, swelled during the pandemic, helped of course, by government stimulus. Those balances are running down, but they're generally still by historical standards in a pretty good place. And finally, from a consumer point of view, the unemployment rate being so low, certainly is helpful from a credit perspective. So if we pull way up, there are things to worry about, of course you've got the really stunning Michigan data that came out a couple of days ago that consumer confidence had plunged to the lowest point in the whole history of that thing. So I don't want to overstate my consumer point. But I think the consumer is starting in a pretty good place. So there is room to go. And then finally, we look at the credit marketplaces in things like our card business and our auto business and we look to see, are we comfortable with the competitive practices and the nature in the marketplace. I think the card marketplace is in a solid place. The auto business, we have a few more concerns about. But because price levels have not yet adjusted to the inflation rate, so we'll keep an eye on that. But if I pull way up, Betsy, we have a lot to worry about with the economy, but I think Capital One -- at Capital One, we feel good about the growth opportunities we have, and we continue to lean into those opportunities with, of course, a very watchful eye on the economy.

So I want to dig into some of the asset classes you just mentioned, and then we'll turn to credit. But on the -- let's start with card, obviously, most important, at least from our seat. Last fall, you launched the Venture X card, and it has had tremendous success with significant new account growth. And just wanted to see -- understand what you are attributing that success to? And could you talk a little bit about the type of customer you're attracting?

So Capital One has been on a journey for -- more than a decade long journey with an absolute quest toward the top of the market and winning with heavy spenders. And while every card issuer hopes to succeed with -- the top of the market with heavy spenders, this journey is not one that one can go in and out of or cobble a few vendor-related products and put them together and succeed in this marketplace. This is a journey that I believe is one about declaring a destination and then working backwards from what it really takes to win at the very top of the market, and there's a lot that goes into that. This is about products, of course, that are very competitive and attractive in the context of some very attractive products out there. This is about customer experiences that -- to the highest standard that will really be compelling at the very top of the market. It's about digital customer experiences that also are very much at the high end. Additionally, we've invested in a travel portal that is very highly rated, highly acclaimed from a customer experience and a Net Promoter Score point of view, so that customers can come to Capital One's portal and win extra rewards by signing up for their travel things. We've even begun to put in lounges at airports. So there is a lot to this journey, also a lot of investment in brand along the way. The Venture X product isn't just suddenly something that we came up with. It is a continuing step in a journey that began probably 12 years ago, I think, with the launch of the Venture card, we, of course, had our Saver card and over time, we've continued to invest. You see what's happened on the brand side and this journey in every year as we continue to get more traction and higher growth at the top of the market, we, again, put in the next pieces of that journey. And so we're very excited about the success that we're having, and we are continuing to work hard to win at the top of the market.

So when we think about your card portfolio, there is a barbell to a certain extent, right? You've got a subprime component and a super prime component and the Venture X card and the success there, do you think it's enough to drive up the super prime component such that the subprime will continue to migrate lower in the book or not as a percentage of total?

Yes. I'm not sure the characterization of a barbell is totally accurate. I think I would more describe that Capital One plays relative to a lot of issuers more broadly across the credit spectrum. So we do certainly have a subprime business. If you can see from the companies the disclosures each of the card players have or what percentage of their book is below FICO 660. Ours is currently 30%. Other players are around 20%, 15% to 20%. So Capital One has a higher component of subprime. But I don't want to -- I wouldn't portray it as a barbell, we -- it's just that we have offerings that meet the needs of a fairly broad spectrum. But I think what's striking about Capital One's journey is that even with a subprime business that Capital One is simultaneously on a sustained quest for the very top of the market going after the heaviest spenders in the country and doing the -- sorry, we haven't talked really about brand, but it's obviously an interesting and unusual brand journey to both to be able to serve the mass market and still build credibility and brand at the very top of the market. But I think we like our traction so far in that unusual journey.

One of the other things that you've been doing is testing out your own BNPL product, another type of offering that you're looking at. Are you -- should we be expecting you to launch something in this space anytime soon?

Let's talk a little bit about the buy-now-pay-later marketplace. I really tip my hat to the fintechs who invented buy-now-pay-later. It's a very clever technology solution, but I think the most impressive part of buy-now-pay-later is that these fintechs have one access to some of the most precious real estate you can get, which is having a button on the merchant websites. And the banking industry generally, I give low marks to all of us for just sitting and watching that. And we probably should have been better innovators along the way. Ever since buy-now-pay-later sort of launched into the marketplace, I have both -- I've been vocal about how impressed I am with some of the capabilities, but also cautionary about some structural aspects of that marketplace that I want to again highlight, and I've been pretty consistent in this story. One is the big whopping merchant discounts that fund buy-now-pay-later, I've always felt are just likely headed down just due to increasing competition over time in a marketplace where merchants, of course, are counting every penny. And in fact, we have seen the merchant discounts go down significantly, and that puts a lot of pressure on buy-now-pay-later players. If at some point the discount gets low enough, it could flip that business to being one where the consumer is then charged for this short-term borrowing, and that would change the dynamics of that industry. So one would have to really watch out for that. A second issue in the buy-now-pay-later marketplace is the fact, I think a number of merchants are looking at some of the buy-now-pay-later players and saying, "Wait a minute, whose customer are these? Are these customers anyway?" And so there is, I think, growing merchant concern to make sure that they still own the customer. And you also see buy-now-pay-later migrating from a pay-in-4 products, where you pay over a short number of weeks to where more and more of the marketplace is expanding into longer installment loans, which is a natural place for it to go, but that turns it into much more of a really lending business instead of a very quick turnover transactional business. That's going to be a challenge for the fintechs. It's also going to raise funding issues and other challenges that come along the way. So we look at this marketplace and said we're kind of late to the game, but we have launched a test in this area, and we will watch our test results and decide what to do after that. So pulling way up, I think it's an industry that is undergoing and will continue to undergo quite a few structural changes, many of which will be challenging for the buy-now-pay-later players. But I think this business is here to stay.

So question just on what you're seeing in the credit side of the book, credit quality. And I'm sure you know there's been a lot of debate around where the stress is, it must be working somewhere, and I'm sure you have done a lot to analyze your own portfolio. Maybe you could give us a sense as to what you're seeing across different credit tiers, subprime, prime, super prime, across different age groups, Gen Z, millennials, Gen X, Boomer; and different spend types, the travel card we just talked about with Venture X, the retail partner card, other co-brands that you might have.

Okay. So these days, of course, with the economy swirling the way it is and the consumer starting on such an extraordinary place in terms of low credit losses. We have been saying for some of that time now, normalization has to happen. I mean, it's the rude world where normalization is normal. And -- it's just got -- the consumer cannot sustain the extraordinary credit performance that they have had up to this point. So we look at all the metrics, and we, of course, look at different segments as well. So let me make some observations here. we have been seeing for a bunch of months now, some slow gradual normalization in charge-offs. It's -- I think the most striking thing about it is probably how moderate it is relative to in the rapidly changing world a case could be made that one would expect maybe faster normalization. But the normalization is clearly there. We also look at other metrics like payment rates. I talked earlier about how outstandings have had trouble keeping up with purchase volume because payment rates are so high. Now that slows down growth, but I am always rooting for high payment rates because that's a reflection of a healthier consumer, and that's what we want in our customers, and we encourage them -- the behavior that we encourage them to do. Payment rates have -- are strikingly high and I don't see as much normalization yet happening in payment rates. I -- in the individual months, I say, yes, see, it's happening. But I think, overall, I don't really see a whole lot of normalization happening on payment rates. But of course, I think it's bound to happen. Things like revolve rates are still pretty darn low. The other thing that makes it a little hard for us to interpret the data is, along the way, we've continued to have a migration toward a higher share of transactor business, heavy spender, like we talked about earlier. So some of these changes are a little bit of a mix change happening inside the portfolio at the same time. A couple of other observations to note about normalization. I have always seen in the past over our more than 3-decade journey of building this company, that normalization tends to happen faster on what we call the front book than the back book, the front book being new originations. And that is also what we see in this case, both in the card business and in the auto business. I've never seen it any other way because back books tend to be seasoned and front books tend to be taking all folks, and for whatever reason, they're seeking credit in that moment. So we see more normalization in front books in both our card and auto business. When we tier by income levels, it's monotonic of the differences that lower income is normalizing faster. The differences, they're not dramatic, but they are kind of monotonic when we lay them out there. Again, we find that not surprising, particularly that would be where the government stimulus and that benefit, which led to such significant improvement. In fact, arguably, even greater improvement in those bands than some of the others you're going to -- It would be natural, there'd be more normalization there. Also by FICO score band, we do see more normalization on the lower side. These are relatively -- these are modest differences. The biggest thing that I'm struck by is really the modestness, if there is such a word, of the pace of normalization, but these effects are clear.

So monotonic, I've not heard that word describing a credit change. Could you unpack that?

Yes. Monotonic means if you have -- if you have an effect that you see -- in this particular case, we're looking at regression towards the mean or normalization, what's happening in, let's say, delinquencies. And we're tracking it over time and we divide it by income level, things that are monotonic mean that the rank ordering of the effects you see is exactly consistent with the effect -- so the most normalizing is the lowest income. You take the second lowest income band and that's the second most normalizing, the third most -- sorry to use that word monotonic, I'm still [ scared ] from my math days, I guess. But it's -- the fact that when we see a consistent effect all the way through, it makes the effect a little bit more real than sometimes where we can imagine insights out of data, which we do all the time, which aren't necessarily really there.

Sure. And so to your point, credit tiering and; newness of the loan are really the 2 biggest drivers in that age group, and spend type not so much?

Well, I wouldn't necessarily call these two the two biggest drivers. I haven't recently really looked by age. I would bet those effects are -- those effects correlate with other things. I'm not here to really report on that -- but if we pull up, I again want to stress that everything should normalize. Everything is normalizing. The normalization is strikingly gradual and it's in the directions of what one would naturally assume, given the economy that we know, consumer behavior that we know and where these various customers were at the first half of their journey. And here I'm talking particularly on the income side, where there was on a proportional basis, the greatest benefit came to the lower income of things like the government stimulus. So we're seeing, really, in many ways, the unwinding of that.

Okay. I wanted to turn to expenses and just have a little conversation on that. I thought I'd just see if there's any questions in that room. There's one over here. Okay.

A couple of questions. First of all, there's some view that actually once student loan forgiveness will expire, consumer will have significant hit. If you have any view on that. And second question, what is your view on -- from where consumer will reduce on spending the most, given inflation and higher rates like from both sectors or subsectors?

So your first question is on student lending and if there is forgiveness of student loans. What was the end of your question?

[Technical Difficulty]

Yes. I'll rephrase. So right now today, student lending is on a -- student repayment of debt is on a moratorium. And so the question is when that moratorium goes away and students have to start repaying their debt, what kind of impact do you expect that would have on your book?

I think student loan repayment seems to be at the bottom of the payment hierarchy. That -- of all loan types, if I were to generalize, that's kind of what we have observed. So I'm not sure that first of all, there's a lot of other forces out there that might not cause all this or that might continue the forbearance. But I mean, it's certainly in effect, we would probably see the impact of the effect. I guess the net impression I would leave with you is that student loan in the payment hierarchy have tended to be on the lowest end, and in many ways, often lower than credit cards. But that's a general thing. I think at the margin, certainly, there could be an effect from what you're talking about.

And your second question?

[Technical Difficulty]

Well, I don't know if I'm ready to make predictions about where things are going to go from here, but let's look back at where things have gone up to this point. The big laggard in the COVID era has been travel. So just as an example, I mean, that thing -- that travel spend was so down on our own portfolio that while -- it is -- it has -- I think year over year, it was up like 90% from its lower level there. It is -- and these are directional so don't take them as absolutely precise numbers, but it's from pre-pandemic is now on our book, which also has had underlying growth in it. So it's not a pure economy measure, is up like 20% off pre-COVID levels. But again, there is a lot of Capital One growth underneath that. But just as a calibration, all spending at Capital One is up, I believe, 46% since pre-COVID levels so that even with the surge of everyone bursting out from their COVID days, travel is still, on a relative basis, quite a laggard. So I -- typically, when these things get tougher, you see, the more the staples, and the more essential goods that the things people spend money on and the more discretionary things are, the less they do. So that certainly could happen. Although I will say at the moment, from our own metrics, we still see quite a bit of spending going on.

So Rich, turning to expenses. One of the biggest questions we get is what's your marketing budget going to look like in 2Q, 3Q and 4Q. And I know you can't answer that specifically with a number for us, but help us understand how long -- what the drivers are for continuing to lean in? And at what point -- what are the data points that you would need to see to say, "Hey, let's maybe peel back a little bit on the marketing?"

Yes. So -- Marketing is an important line item for Capital One. And if you think about a lot of banks, a lot of banks have branches on every corner, all across the nation. A lot of banks have the big airline co-brand programs where a lot of the marketing happens inside the partner relationship and things like this. At Capital One, while we do have some co-brand programs and things, we're mostly out on our own. We're doing this ourselves. And so marketing is the way that we generate business. And so marketing has always been an important and big line item for Capital One, and it's grown quite a bit over the last number of years. I think they're kind of 2.5, maybe 3, sort of 3 drivers of that. First of all, and probably most importantly, is the opportunity that we see. Capital One has spent a decade in a comprehensive transformation of the technology of Capital One, starting at the bottom of the tech stack. And as we have worked our way up the tech stack, we've been able to create more opportunities for consumers, more better underwriting and other capabilities for ourselves that has allowed us to generate more business. And so seeing the number of very attractive opportunities in front of us, we are leaning in to capitalize on those and that entails quite a bit more marketing. So that's reason number one. The second reason is the -- another -- it relates to another decade-long journey, which is our journey to really go after the top of the market in credit card space. And as I talked about earlier, that is one that is -- entails a comprehensive set of investments about the servicing, the customer experience, the digital experience, the products, the rewards and the -- and travel portals and experiences across the spectrum of consumers' sort of travel experiences. So a number of those are operating cost investment and a number of those are marketing-related investments. And as we have continued to get success at the top of the market, we have continued to invest further in that. Oh, by the way, one of them is the building of brand, which is extremely important in the card business, but it is primarily important at the top of the market. Now -- so -- many of those investments show up on the marketing side and the -- and as investors experience our journey of continuing to grow at the top of the market, it does affect some of the line items of the P&L along the way. Obviously, it -- there's a lot of marketing investment. There's some operating cost investment. It also starts to change the mix relative to interchange. You can see the tremendous growth of revenue we have there, the rewards that we pay out. And long run, what we love about that business is, while it has very high upfront cost of investment, we love the annuities that come out the other side in terms of low attrition, low charge-offs, very high spend and really good economics. So as we migrate to the top of the market, that's -- there's quite a bit of marketing investment. The last thing I want to say is we have come up with a number of specific innovations at Capital One that we are going to the highest mountain to tell the world about. Things like Capital One Shopping, things like Auto Navigator and things like the National Direct Bank of Capital One that is really going right after core transactional banking without having branches nationally. All of that takes marketing. And so those are some of the reasons, Betsy, as we lean into our growth opportunities, you see quite a lot of marketing spend.

Okay. And it seems like the path is to keep that going. You can just...

I'm not going to give any more guidance than I already have.

All right. Excellent. Well, Rich, thank you so much for your time today. It's been a pleasure.

Thank you, Betsy. Always a pleasure. And it's great to be here in person with folks, and we'll see you soon.

Thanks.