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

If everyone could take their seats, we'll get kicked off with the afternoon sessions. I'm very pleased to have Capital One Financial with us. From the company, we have Richard Fairbank, Founder, Chairman and CEO; and Jeff Norris, Senior Vice President of Global Finance. And let's just pull up the first ARS question as everyone kind of takes their seats.

But as what we've been asking everyone just what's your position in Capital One. Interesting. So a fair amount of people not involved. Maybe put the next question is just what would you need to be coming to see to become more positive on the shares of Capital One. And then Rich, as the audience answers the question, and we'll kind of weave it into our discussion, as we were just joking about, we both have been at this for a long time. You probably have better analytics than I do. So maybe share your perspective in terms of how a rapidly rising interest rate elevated and persistent inflation as we saw this morning, has impacted customer behavior in past cycles and maybe discuss what your data is telling you about the current environment.

Okay. Thank you. Thanks, Jason. We've been doing this a long time, and it's great to see you again. Great to see you in person. Great to be here and welcome to everyone also on the webcast. So the environment that we're going into is -- let's just savor that. I mean, here, I've been doing this Capital One thing for over 3 decades, which I'm kind of a veteran in the business. But actually, we have not been through a really significant inflationary surge environment like we're in right now. So I think for -- even for us and probably for -- I speak for everyone here, we're a little bit in uncharted territory when it comes to what are the impacts that inflation has. So I'm certainly not an expert on that. One thing that we -- I'll come back to inflation in a minute. But a thing that you also asked is what do we think about the consumer? Where is the consumer right now? And I think the consumer is in a really strikingly strong place. Really, if you compare to, say, the global financial crisis, the consumer was in a much weaker state as were a lot of other institutions around the consumer. But if we look at the consumer, the consumer's balance sheet is particularly strong right now. The cumulative benefit of the savings that have come through the pandemic is really quite significant, the deposits that the consumer has accumulated. So very strong on the balance sheet side, the labor markets very strong and the open jobs right now are at record levels. And obviously, consumers can see the benefit of that. And then if we look inside our company and all the data and metrics that we have on consumer and calibrate that to the long history we've had in building this company, is pretty strong place that we are. The charge-off rate in our card business is in our last quarter announcement was running at basically half of the pre-pandemic levels. Delinquency rates are a higher fraction of multiple than that, but it's quite a strong place. Now we've also said that it is obvious, and we should all be shocked if the consumer credit doesn't normalize from here and it already is. But certainly, the consumer starts sort of ahead of the starting line, if you will, in this race, and that's a good thing. The competitive environment makes a big difference to credit and credit performance. I've often said, I have a lot more confidence in the rationality of consumer behavior than I do in all the institutions who serve them. And you've probably heard me say that from time to time, Jason. And there's an irony in that. But -- so we are big students, if you will, of the competitive environment and the underwriting that goes into that marketplace. In the credit card business, it continues to be quite strong and it's very competitive, but a quite stable environment. So when we then -- so now come back to the economy. Consumer is in a strong place, but the economy is unusually uncertain right at the moment. Inflation, I know that on paper, higher interest rates can be a good thing for banks. Whatever it sort of says on paper, I view it as just a -- bad pretty much across the board. It can create timing disruptions between when our cost of funds goes up versus when pricing goes up in the market, and we'll probably come back to an example of that happening right now in the marketplace. The biggest concern I have about inflation relates to what happens to real growth of consumer income and that appears to be pressured right now. And then also, of course, the impact ultimately on the economy. Probably the biggest driver we found historically so far in the 3 decades of building Capital One, the biggest driver of consumer credit ends up being the unemployment rate. It starts in a great place, but of course, things can change. So pulling way up on that, I think we feel pretty good about where the consumer is and pretty good about our opportunities, which I'm sure you'll have questions about.

Maybe start in terms of kind of against that backdrop, credit card growth, if you look at the July monthly data, and then we'll get August later this week, but July balance is up over 20% year-on-year, 17 of 18 months of accelerating growth in a row against the backdrop of a strong economy, a competitive environment. Why -- I understand Capital One has kind of increased the focus on heavy spender. Just how do you think about underwriting into a worsening economic scenario?

Yes. So Jason, the loan growth that companies like Capital One and really other card players are pretty striking. And as you said, we've sort of had loan growth hitting a 2 handle in recent months. And I just want to say that while that is striking, it's -- I always find it -- every meeting I'm in, we always look not only at the month-over-month data and the year-over-year data, but go back and look to how do things compare to pre-pandemic because so many things have changed along the way it gets a little bit dizzying. So loan growth, while there's -- for us and a lot of card players, really striking 20-plus percent growth rates, at least in our case. It is noteworthy that we are just crossing 0 relative to where our balances were pre-pandemic. So what -- if we kind of pull back and think about it, and there are a lot of implications of what I'm about to say here, but the credit card business is the one banking business for which in tough times, there tends to be a lot of shrinkage. That's, by the way, great from a resilience point of view and a balance sheet point of view and frankly, a commentary on the consumer and their sort of management of their financial situation. So we -- I think really what you're seeing here mostly is the consumer breaking out into normal, not into abnormal but into normal. And that's why we're finally sort of crossing 0 with respect to where we were before the pandemic. And when I look around it, just about everything we see for the consumer, it's in the normal category, not going wild on things category. With respect to Capital One's growth, we have a lot of things that are going quite positively for us. We've invested for a decade now in our technology transformation. And innovations with respect to product and marketing, underwriting, fraud, operations, how we work and the -- how we develop software. All these things have contributed to enhancing growth opportunities that we see. And hopefully, that's a sustainable effect and certainly one of the many benefits of our technology journey. Across the board in our business, in our card business, we see growth opportunities. We talked about the consumer being a pretty strong place. The card business is generally the industry in a reasonably rational place. And we see good opportunities. We see particularly strong opportunities at the high end of the market in the pursuit of heavy spenders, which I'm sure we can talk about when we get there. So we feel quite good about where we are underwriting. From the founding of this company to today, I've said we're going to build a lot of -- we're going to get a lot of data, do an incredible amount of testing and study everything. But we still can't predict the future. We certainly can't predict the economy. So the key for us is building resilience into our underwriting. And sort of in the analogy of the 100-year flood. We can't predict really when the flood is coming, but try to build our properties at a place where they can withstand the 100-year flood. That's worked pretty well for Capital One in the past and for some pretty big floods that have happened in the past is very much what we're focusing on here. But looking at the resilience that we feel that is available in the credit card business, even with the uncertain environment that we face. We're leaning in pretty hard into the growth opportunities in the card business.

I guess you mentioned the importance of the competitive landscape. You mentioned heavy spender. If we think about cards, we've seen increased rewards, early spend bonuses, everyone seems to be building up travel portals, more are now adding airport lounges. I know you're doing that as well. Maybe just elaborate on the competitive environment and perhaps work in how your relatively new Venture X Card is faring?

Yes. Thank you. So lots of card players play in the prime segment and really try to play at the higher end of the market. I believe the really high end of the market where very heavy spenders are is not just an extrapolation from the rest of the market. I think sometimes there's a tendency to take products that are used in the rest of the market, dress them up a little bit and market them as top-of-the-line products. What we concluded years ago, when we decided to make a very, very purposeful quest toward winning at the very top of the market, was that we needed to work backwards from the needs in that marketplace, and it was very different from the mass market and it required building a whole lot of different skills. We're talking about, obviously, on the product side, something far more than offering some cool rewards. So very extensive needs on the product side, the customer experience, which a lot of it is oriented toward things like access, convenience and taking the friction away in a high-end lifestyle. That's a pretty different thing. We've invested pretty heavily in that, in things like airport lounges, travel portal and a whole bunch of experiences at the high end of the market. Also, the servicing experience, the digital experience and the sort of real-time nature of people's needs collective -- as well as then finally the brand that it takes and the credibility it takes to play a time in the market. So years ago, we looked at this and said, this is something if we're going to do it, we've got to go all in. It's a many, many year quest and we're going to sustain that. And that's what we've done. And we've had a lot of traction in this business. You can see our ads on television. And hopefully, some of you in the audience have Capital One cards or maybe the Venture X card in your wallet. So we've been very pleased with that. But again, that is a business of long-term investment, a business of patience and a business of upfront costs in order to get there. So the -- and gradually, we have built shoulders to stand on. And one of those is the Venture product. And then on those shoulders, we built Venture X. And this is -- been a long time in the making, and we launched it last November, and we're very pleased with the traction that we're getting in that business. Jen Garner is telling our story on national television. And it's -- but it's not the creation of yesterday. This is a creation many, many years in the making. But back to your competitive point, it's very competitive, but I -- when I look at it, most of the competition, I draw a distinction between competition that makes it more expensive to get customers, things like more marketing, everybody is out there doing more marketing. People are putting -- spending a lot on things like early spend bonuses. I draw a distinction between that and a marketplace that starts to compromise on more long-term aspects of the economics of the business. When I commented earlier that I think the card business is really quite rational, it's very competitive, but I think a lot of what we all face is more upfront cost for annuities, the stability of which is really quite strong.

I noticed that half the people wanted more clarity on credit trends. So maybe we can delve deeper into card asset quality at least. Before we do that, why don't we put up the next ARS question. Where do you see Capital One's domestic charge-offs for card next year? They were 2 spot, [ 2 6 ] in the second quarter and don't worry, Jeff, I won't make you answer this. But I guess, Richard, across the industry, we're definitely seeing this normalization of delinquencies and net charge-offs of historical lows, and it's certainly most notable in kind of the lower FICO cohorts. You kind of alluded to Capital One's metrics and after declining for 32 straight months to half pre-pandemic levels, you've seen charge-offs [indiscernible] last 3 and July was the largest increase we've seen in a while. So just how should we be thinking about the pace of the normalization, which to date has been much slower than we would have anticipated?

I think it all starts with looking at what took credit metrics in the industry down to such an extraordinary never seen before a place. And it was on the consumer side, consumers being absolutely becoming more conservative, spending less, taking excess funds and paying down debt. Payment rates, which means the percent they pay of their balance each month, these things, skyrocketing, the customers who got really sort of scared in a sense in the pandemic. Certainly, you saw a bunch of behavior change there. You also saw the government [indiscernible] unprecedented levels of stimulus. We saw lenders and landlords across the country providing forbearance on things. So there was an unprecedented set of things that caused credit to get to the best place we have seen in our history of building this company. All of that -- I look at that whole list, and there's not a thing on that list that I would expect to sustain itself. The consumer as we talked about earlier, is going from an extreme pull back to what I would call very, very normal behavior. But along with that, there's more spending, probably more taking down of credit and things like that. The government has pulled back and forbearance is basically over in the lending industry. And so here we are. This, as I sometimes say, normalization has the word normal as it's [ rootword ], this would be shocking if we did not normalize. I think what's been striking in many ways is the pace of normalization has been pretty modest. In our own internal forecast, we have forecasted faster than that, partly just to be prudent about our own expectations. But one thing I think we should all understand it would be shocking if things didn't normalize and they are normalizing, and we can see them right in front of us. And we manage to an expectation in all our business for normalization to continue. So that's -- but in the credit card business, the -- I guess what I would say is with all this normalization going on and, of course, the risk in the economy, we're still leaning into the opportunity in the card business is a combination of where the consumer is, where the competitive environment is, our own opportunities and the resilience that we are able to baked into the credit products. So that's why we are still -- even as things normalize, we're leaning into the growth opportunities.

Maybe shift gears to the auto side...

Sorry, sorry. One more thing. As you mentioned, I forgot to address one thing you said. You talked about the lower end of the marketplace normalizing a little bit faster. Let me comment on that. The -- when we look at our data, we can see the normalization rate slopes somewhat by income and it slopes somewhat by FICO score. Again, for a couple of reasons, that should not be surprising, partly because, in many ways, the rate of improvement during the pandemic was also sloped in that same -- in the direction that the lower end probably got the most improvement. So there's more to return back to normal. But also, I think when we think about inflation, when we think about some of the pressures in the marketplace, when we think about the things that aren't there anymore in terms of the stimulus, the forbearance and a lot of other things. It is certainly our belief that this would be a somewhat of a sloped rate of normalization. So I'll stop there.

And maybe now shift gears to the auto side of the house. We've heard from U.S. Bank. I think PNC at this conference talk about uneven competitive dynamics in that space. If I look at your numbers, you've seen us kind of a slowdown in growth in each the last 4 months. I think on originations are down 20% or so year-on-year in the second quarter. So it looks like you're kind of a pull back as well. Just maybe talk about competitive price dynamics, margins kind of just what you're seeing in that segment.

So the auto business, there are a number of unique things going on in the auto finance business that are not there in the credit card business, things like extraordinarily high used car prices and some of the supply chain, other sort of dynamics in that industry. But the most striking thing to us right now is the thing that I referred to in my -- in answer to your opening question, which is one of the many disruptive things of inflation. If you think back to just the old business model, when the cost of raw materials rises in an industry, how long does it take for the ultimate product price to reflect that? In virtually every industry, it takes a while to get there. It's a little simpler in the world of if the cost of this water bottle or the water that we're selling, water gets a lot more expensive from a raw material point of view, then it's pretty clear and people would you expect pricing maybe to go more quickly. It's more complicated in a lending business because it depends how the players in the business are viewing what is their cost of funds. And then you have always the normal dynamics of how cost of goods sold make their way into pricing. So you've had in this industry, a number of players, money center banks, Capital One, moved pricing really quite quickly. Some players did not and have not moved price that much. And the credit unions for the longest time, didn't move price at all. And maybe have moved it a little bit, and there's been a very significant at the high end of the market, a very significant share change toward credit use. As I recall, maybe even 10% or 11%, I might be wrong on that number, but percentage points of share. So as we have looked at this, we -- to my earlier point, are very, very focused on -- since we can't predict economies, we want to make sure we underwrite to resilience. And that -- and the key thing in the auto business is the relationship between the margin in the business and the expected losses in the business. And so what we have observed is, effectively, our margins in the business have gotten quite a bit tighter. And while I think this is a temporary phenomenon, at the rate that we've been growing for us, we've felt it's kind of prudent to pull back around the edges in this business and hope that pricing equilibrates over time. But in the meantime, Capital One, which was running at a pretty high rate of originations for a number of years, is cooling off a little bit on that metric.

And I guess just with respect to credit quality, we've seen charge-offs begin to normalize in auto as well, though previously that happening occurring quicker in auto than it is in card. Maybe talk about the differences in the auto loss normalization process?

So when normalization is happening, all other things being equal, we should expect it to normalize faster in the auto business than in the credit card business. The reason being that for all of the time -- for the decades I've been doing this, I don't think I've ever seen a case where what I'm about to say isn't true. There's a lot of negatives in that statement. But basically, what we call the front book, new originations tend to normalize faster than the back book because back books tend to be seasoned. New originations reflect all the latest uncertainties, the adverse selection associated with people getting products and all these kind of things. Front books tend to have -- they tend to normalize sooner. We see that in both the card business and in the auto business in terms of where new originations are relative to where back books are. And by the way, again, if that weren't happening, I would be shocked. But to your question, Jason, the auto business has -- the average life of the loans is something like 2.5 years. So therefore, you're turning off -- turning over your portfolio pretty quickly. Therefore, the front book plays a -- more quickly becomes the whole book then happens in the much more long-lasting card business. So just in a sense, the math of normalization would suggest faster normalization in auto than in card, and we are seeing that exact thing. One other little point, but something that I don't think gets a lot of airtime and discussion with investors. One of the things that happens when you have a very -- a period of very excellent credit, the sort of just definitionally, what happens is your recoveries book, recoveries basically are the money that we get back after we've declared a charge-off, but some things that we get back later. The recoveries book become smaller just because there have been fewer charge-offs. So what happens when you're normalizing recoveries are in principle, not as strong as they are normally. And by the way, recoveries play a bigger role in auto than in card. So that's just one more thing that makes it to be a very normal thing that auto would normalize faster.

Didn't think of that. Maybe...

We've only been doing this for 20 some -- yes, I never told you that, you never ask.

I guess maybe just tie that into maybe reserve levels. We saw this $200 million build in the [ allowance ] in the second quarter, although that was really auto and commercial. We actually saw a release in card despite strong growth with auto and card losses normalizing slowing economy, how do we think about future reserve building in a CECL world?

Why don't I take that one? Give Richard a chance to rest his voice. There are 3 things you got to think about with the allowance for credit losses. One is just the growth of the balance sheet and the assets that we have to allow for. Second one is what are the actual credit trends that we're observing. And the third one is what are the qualitative factors we're holding for levels of uncertainty. If you unpack those 3 things, just to look back at the Q2 allowance, we had that small release in card, even though there was upward pressure on card from the normalization trend in credit and we continue to maintain elevated factors for economic uncertainty. And we grew. So we have more assets to allow for it, but that was all -- a little bit more than offset by the fact that the actual credit trends were better than we had assumed when we set the allowance. So you play all those 3 factors forward for the total allowance for credit losses. If we see credit trends continue to outperform our expectations, that could and if we see the uncertainties kind of abate and we can take down some of those qualitative factors, we could see relative stability, even modest release. On the other hand, if uncertainty remains high, which seems to be the case, normalization continues. And if it accelerates more to the levels that we've assumed. And if we continue to grow, that would imply reserve builds. And the net of it all is we just have to see how those forces net out against one another rather than be in the prediction business.

Got it. And maybe turning to deposits, balances declined for Capital One in the second quarter as it did for others. Direct bank appears to have a much higher beta than can kind of traditional branch-based banking at the moment, which is -- it's not a huge surprise. But can you maybe just talk to your expectations for balances and betas looking out?

So let's talk a little bit about beta and then let's talk about beta in this environment. First of all, one thing that I've always felt when people kind of say, "So what's the beta of this business? I think there's no such thing as the beta of a -- any particular deposit business. What it really matters are rates going up or rates going down, that tends to -- we empirically have observed different betas with respect to those and very much also relates to what is the larger environment. And very importantly, what is the -- for an institution as well as the industry, what's the relationship between the growth in assets that are expected versus the growth in deposits. And what's especially important, not so much is, say, Capital One's expectations there because, of course, we want them to be balanced, but from an industry point of view. To my earlier comment that we've not really experienced inflation at this level and this rate of increase sort of in the modern era. I think a really important question is, what will be the relationship between how much loan growth that banks see versus -- and that's an easier one to predict, I think, than the wildcard is how many -- what deposit levels will actually be there in the industry. And a big wildcard in that latter factor is what the Fed does and the impact of what the Fed does on deposits. So I think we have an eye on the overall deposit levels. If over time -- that the industry sort of sees more growth opportunities than sort of natural levels of deposits, you're going to see betas just move faster for the industry and maybe not so fast otherwise. So I think that's a factor and therefore, one that has, I think, a little more uncertainty this time around with the higher rates. With respect to Capital One, Capital One we're enjoying quite a bit of loan growth. And as I talked about, we're still leaning, especially in the card business, into that opportunity. I think we feel blessed by having built a national bank so that we have -- we've built sort of a deposit gathering machine that in some ways, is designed for times like this, and you see us on television talking about our national bank and we invest in marketing there. So I think -- but if I just kind of pull way up back to the deposit question and the beta question, it wouldn't surprise me if over the next number of years as rates, with the amount of rate movement and in some ways, some of the -- what happens to supply across the industry of deposits. It wouldn't surprise me if betas moved a little more than they might have in the past in the upward direction.

We have 5 minutes left. And I have 3 questions I want to make sure I get through. So NIM, marketing and capital.

You know I've never answered 2 questions in 5 minutes.

No, we're doing okay. We'll do okay. So NIM, you talked about strong credit card growth, yet your NIM increase was kind of at the lower end of peers last quarter -- at least the lower end of the bank peers last quarter. Just how do you balance kind of growing loans that may be NIM dilutive, given the funding costs versus kind of managing to NIM, does that matter? Or just how do you think about that dynamic?

Yes. So Capital One has been blessed with a pretty strong NIM. And certainly, powering that is our card business. Our card business also has been differentially growing sort of within our portfolio. So that's helpful on the NIM side. On the other side of the ledger, of course, is cost of deposit, betas, the conversation that we just had. So we're not in the NIM prediction business, but I think Capital One is in a strong position with respect to NIMs. Where exactly that will head over time, we're going to not really forecast that.

Marketing. Spent a full $1.9 billion in the first half of the year, and I get it to some upfront costs tied to domestic card and the like Capital One 360. As we think about the back half of the year and the opportunities ahead and just given the fact that the first half was well elevated, should we expect maybe less of a seasonal increase in the back half of the year? And just how you're thinking about marketing in a slowing economic backdrop?

Yes. So Capital One has really high levels of marketing right now. That's driven a lot by the opportunities that we see that we've talked about here and as we lean into those opportunities, it costs quite a bit of money in terms of marketing, and we are spending that. A second more sustaining reason for the increase in marketing is our increasing investment in going after the heavy spender part of the marketplace. And as I said, that's a fabulous business with amazing annuities, but it has a lot of upfront costs in terms of originating accounts, early spend bonuses, things like that, and brand building, all of that virtually all of it goes into the marketing line. So that's another thing. And finally, we are investing, of course, in our national bank, and we'll continue to do that as we've talked about. So that's kind of what's behind the high levels of marketing we have in Capital One. I'm not going to forecast the second half of the year, but I think you -- I just wanted to share what it is that's driving the pretty high levels of marketing.

And then CET1 ratio of 12.1% at the end of the second quarter, still above your 11% target. You bought back despite buying back, another $2 billion worth of stock. I guess as we look ahead, you still want to grow the loan portfolio, still uncertain economic backdrop. Can you continue that buyback pace? How should we think about capital return?

As you noticed at the end of the -- in the latter part of the last quarter, we dialed back the pace of buybacks. Basically, as we look at this environment, we're growing pretty rapidly. We've for some time been pretty vocal about -- or public about our CET1 target of 11%, and we're well above that. But it's also the case just because something is our target. It doesn't mean we're always going to just mechanically manage down to that. These are times where capital is a valuable thing to have. I've never seen -- heard anybody in a downturn, say, rats, we're in a downturn. I wish it didn't have so much capital. So it's not lost on us some of the uncertainties out there. We've -- we're being a little more cautious in how we manage some of the excess capital and also we're still growing quite a bit.

We did it with 5 seconds to spare. With that, please join me in thanking Rich and Jeff for their time today.