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

All right. We're going to get started here. Up next, we're excited to once again have Capital One joining us. Capital One has driven best-in-class growth over the past year across its card business, their target investments and margin and continued to leverage the investment made as part of its tech transformation. I believe we first began talking about it almost 10 years ago at this conference. Here to tell us more about where we go from here is Chairman and CEO, Rich Fairbank. He's joined on stage by SVP of Global Finance, Jeff Norris. Today's presentation is going to be a fireside chat. So Rich, how are we doing? Good to see you.

I'm good, Ryan. Great to see you and great to see you in person.

Absolutely. So a lot of uncertainty out there regarding where the economy is headed, inflation at 40-year highs. While the consumer has been in good shape, we've had other banks talking about spend decelerating a bit. Others [indiscernible] appreciates 6 to 9 months from now. So maybe just start off, talk about what you're seeing across your multiple platforms to the consumer, or any noticeable trends across different products?

So thank you, Ryan. Great to see everybody here, and welcome to the folks on the webcast as well. So the consumer -- let's just start with the consumer. I think the consumer is in strikingly good place, when I compare certainly to before the great recession, the consumer back then was not in nearly as good a position as the consumer is now. But obviously, for starters, the consumers' balance sheet is has been tremendously helped by government stimulus, forbearance on all the -- on so many loans, forbearance on rent. The consumer also pulled back on spending for much of the pandemic. So that led to an accumulation of savings that, across the income spectrum, we could see on average out there. Now that accumulated savings is gradually depleting, but that certainly still has been a position of strength. The consumer debt servicing burden is at 40-year lows right now. So that's a good thing. And additionally, the unemployment rate, of course, is at extraordinary lows. So consumer starts in a good place. The elephant in the room, of course, is inflation. And as I remind everybody in the company, and I remind investors, I and probably all the investors sitting here at the conference, the last time inflation was ranging like it is now, we weren't in the jobs that we're in. So I think for all of us, we're going to sort of learn this as we go along. I think a striking thing about inflation, when you think about -- like the biggest driver of credit performance for economic indicators we have found is, not surprisingly, unemployment. And unemployment happens to a subset of the population. Before that subset, it's a very big thing and often is accompanied by charge-offs. The thing we don't know is inflation is different. It's a smaller effect, but it happens to everybody. And the impact on reducing, as we're certainly seeing right now with negative real wage growth, these effects have us concerned, and we'll -- we'd very much just keep an eye on that. But in terms of our own credit metrics, credit -- as we've been predicting for a long time now, credit continues to normalize. Delinquencies are still at levels that are below where they were pre-pandemic. But they're unmistakably normalizing, and they're getting quite a bit closer. The -- where we see more normalization is in lower income, lower FICO. So the normalization sloped by income and by FICO, although the -- that -- those normalization differences are converging lately. They're getting closer to the same, which is an interesting effect. We also see -- and this is always the case, normalization happens more quickly on the front book, in other words, new originations than it does on existing seasoned portfolio. We certainly see that effect going on in our book as well. But overall, Ryan, and I'm sure you'll have more questions to ask on these things, we are leaning -- continuing to lean pretty strongly into the card business and card growth, card originations and marketing. In the auto business, we have dialed back a fair amount. So we can talk about that.

Great. Great overview, Rich. So when it comes to spend, you have many ways to see what is going on with the consumer, whether it's the high end, the near prime checking, savings or customer paying their loans. Can you maybe just talk high level what you're seeing from a spend perspective? Are you starting to see any shifts? And more importantly, when do you think we're going to start to see the impact of potentially 5% interest rates coming through on your customer base?

So let's talk about spending. When the pandemic hit, it was really striking how much the consumer pulled back in spending. And then as the pandemic has played out, the consumer has come roaring back. Along the way, Capital One has posted some very significant growth in spend. In fact, our -- in the last quarter, we -- the spend levels we posted were 46% higher purchase volume than pre-pandemic, which is obviously much bigger than the overall effects going on in the economy. So what's happening underneath that is a lot of growth at Capital One and a lot of growth in our spender businesses. But if we separate out the effects of growth that comes from growing more accounts versus what's happening on an individual account per account level, you can see spending moderate on a per account basis. This would be almost surprising if it didn't happen, I think, in some ways, but it's certainly something we've seen over the last number of years. And that effect, you can see across income levels, but it's a bit of a bigger effect at lower income.

Rich, pre-pandemic, you were spending about $1 billion a year on marketing. And I think this year, if my model is correct, it will be a little over 4. Maybe just talk about what has driven the increase? How much is this internal for customer acquisition versus competitive forces? You just mentioned leaning in the past few quarters. How are you thinking about marketing and [ leaning with ] where the economy is at this point in time?

So there's a number of factors going on would be obviously striking levels of marketing that we've had at Capital One. First of all, we continue to get a -- have a lot of success in our new originations. Marketing, most marketing is going toward new originations. And so a big driver of our marketing level is the continued traction that we have in our card business. Now that traction is coming from several things. I think the consumer is in a good place. We also are benefiting from our decade-long investment in technology and in data and machine learning models to, I think, do a better and better job in terms of credit modeling and also leveraging technology and sophisticated analytics on the marketing side. So marketing, credit, fraud, all the kind of the sort of deeply analytical side of the card business, all of those have really been benefited by technology improvements. And I -- while it's hard to tease out the effects, I think there's a lot of benefits there. So good opportunities is one important category. Another very important thing that's going on is less of a momentary thing and more of about a change, over time, in the strategy of Capital One. It's been our continued investment in going right after the top of the market at heavy spenders. So we've always, at Capital One, had a part of our business that's going after spenders. But about 10 years ago, when we launched the Venture card, that's when Capital One really set its sights on being a real player at the top of the market. And one thing that we knew back then, and we have known it and lived it ever since, is that is not a business where you can just show up, and I'm here, this is the product, spend some money on marketing and hope it works out well. This is about creating an overall experience in the brand, [ the ] products and access to working backwards from what people really need at the top of the marketplace, and we've been doing that for 10 years. So you can see the evolution of products, the various flagship products that Capital One had built, like our Venture card, our Savor card, our small business, Spark card and so on, you see advertised on television recently. Then -- and as we continue to move up, we went ahead and [indiscernible], which is $300 to $600 annual fee cards with our Venture X card. Along the way, it's not just investing in products. We're building -- we have worked to create a, I think, really industry-leading travel portal experience through which discounts are offered. But just -- this offering, it's really important that the travel portal experience be a great one, not just that it offer discounts. And we've invested heavily in that or even now putting lounges in airports. You saw that we were the sponsor of Taylor Swift's concert, the sales of which was probably the biggest [ we have seen since ] many, many years ago. But these are examples of Capital One. My point is that Capital One continues to go upmarket. And along the way, there's a lot of investments [indiscernible] there. We love this business because, while it has very high cost of entry and cost of origination, including the marketing, the brand, the early [indiscernible] and a lot of things that stressed the P&L in the short term, we love the annuities, we love the very low attrition rates, the amazing charge-off rate, the spend levels and the overall performance. So we said this last years ago, we're going after the top of the market. And each year, we've continued, as you've seen our spend grow, the thing that you don't see behind there is the fact that the growth rate of spend is higher at every higher spend band. So we're still in the early innings of that journey, but something -- the reason I flagged this is this business is a heavy marketing level business between brand and origination costs and the [indiscernible] of various [ amenities ]. So that's the second reason for the high marketing levels, and a third one would be the continued investment in things like our national bank. So we are the only major bank that's really not in the quest. Well, most banks, the way they build a bigger national bank is through buying other banks. While we launched our banking journey buying a few banks, we are really out there building a national bank organically, not just a savings bank, but checking, the whole thing, you see our ads on television. The only way to get there is through marketing, and we continue to do more of that. So the long answer to your question, but that's sort of why the marketing level is a lot higher than it used to be.

And maybe we could talk after about Taylor Swift's tickets for my kids, but we'll put that aside for now. And maybe let's get Jeff involved in the conversation. And Jeff, you were one of the few issuers that took the reserve ratio, [indiscernible] your allowance [indiscernible] day 1, seasonally, that's [indiscernible] point in time. None of us have been through a true downturn with the current holes in place. But can you maybe just talk about some of the moving pieces on the allowance. And given that such a high level of economists are expecting a recession at some point and unemployment to rise, what do you think this means for the allowance? And what are you guys planning internally for the economy?

This is a cool joke. Rich gets to talk about Taylor Swift, and I get to talk about the allowance for credit losses. So I think the thing to do is look at the -- when we set the allowance each quarter, what are the factors that drive it? First one is balance sheet growth, loan growth, and we've been growing. Second one is the assumption of credit normalization and mobilization has been continuing. And the third one is what's our economic forecast beyond the sort of reasonable supportable period we can more model directly. And then a fourth one would be qualitative factors to capture uncertainties that we can't capture in the model. So if you look at each of those 4, you get a clue of the allowance, maybe in the future, as long as growth can [indiscernible]. As long as we continue to move forward on the normalization path, every quarter, we replace a lower one in the quarter and one in the future that's got [ higher loss ] and that drives units up. Our economic forecast can go in either direction, it can get better or it can get worse. [indiscernible] qualitative factors is the wildcard. And last time I checked, there's still a fair amount of uncertainty in the marketplace. But in fact, the qualitative factors have been coming down a little bit as we've been able to take more of that uncertainty into the [ model ] portion. So you just have to see those things play out each quarter to make a guess at the direction of the allowance. And that's -- we continue to believe that the allowance on periods of growth under CECL will be rising in a way that's a little bit more procyclical than it used to be. And we'll just keep an eye on those things as they play out.

So Rich, you spoke earlier about -- you spoke on earnings calls about tightening some underwriting, trimming around the edges on credit. You talked about the piece of machine learning to identify early signs of stress. Maybe just talk a little bit more about how you [ unite that ] technology, what you saw what you thought? And what would you need to see for further timing within the portfolio?

Yes. So Ryan, we sort of talk at these aggregated levels like we're leaning in or we're pulling back. But the way it really works, other than sort of like right when the pandemic began, we really got together and said, we just need to go back until we know where this thing is going. The pulling back does really happen at the top of the house by big declaration. It happens that the margin 1 subsegment at a time. And it is both the case that we are leaning really hard in our growth opportunities and, at the same time, dialing back around the edges. Now in the journey of how people monitor a business is sort of the most basic level you get reports and look at reports like vintage curves and based on that, make decisions. At the next higher level, there's a sort of a whole set of variables that one monitors. And specifically, look to each of these and the performance of these and where we've moved, and that's -- we built a lot of our company at that level. With learning, we've moved to a more real time, more unstructured way to look at the data and look for patterns and anomalies, and to have those anomalies flagged as soon as possible as well as the things that appear to be driving them so that we get earlier insight at a much more granular level. And also, the benefit of our technology transformation is we're able to move much more quickly with an insight. And so it's not just the benefit of being able to move quickly. And I've always said, if you want to -- if you want to drive -- if you want to lean into growth and step on the gas, you need a good brake in your car. I think it's a very important part of fast cars, so to speak. But here is the thing, not only are we able to get insights more specifically and sooner than [ hatch ] on them, what it actually helps us do is not make the cuts on a more aggregated basis because the last granular one's insights are when you see certain vintage curves gapping out. Unless you have granularity beyond that, you could kind of pull back on that segment. So that's part of why we've been able to grow is the granularity of the monitoring and the surgical nature of what we've been dialing back. And so what we have done is both had our monitoring times, trying to flag around the edges anything that might be aberrational. And then at the same time, we overlay judgment and sit around in a group and say, what do we think that some segments and the things that would start to -- that would be most vulnerable in environment like this? Let's actually search our book for those and see if we can see an effect. I just took a bunch of those and found out that we didn't add any value, any insight to what the models already were showing us. But even nonetheless, we are making judgmental cuts, for example, around the income side to step in and just in an environment, where, intuitively, that looks like to be harder on lower-end customers, just making some incremental hard cuts that would be over and above the model. So this is all part of why it is that we're able to still lean into the business at a time like this.

Rich, you talked before about normalization, delinquencies being sort of long relative to -- heard from others that the near-prime-oriented customers are kind of back to pre-pandemic levels. It's really the prime customers that are doing better. I guess, given that dynamic and the tinge of inflation, are you expecting normalization to accelerate from here given the impact, obviously, not just curious on the use of what we could see. But are you actually expecting normalization to accelerate from here? Or do you think we're going to continue along this gradual path?

We're specifically not giving a prediction on normalization. But let me, first of all, say, it would be very abnormal if we were not seeing normalization. So we should start with that. I've often kind of said the root word of normalization is normal. So this -- everything that we're seeing, we would have expected probably to happen faster. But everything that we're seeing is happening there. Now the question, I think, everybody, at a time when it's sort of the good news, bad news, right, the good news is that credit metrics are still better than they were in the past. But the bad news is the trajectory, if you look at the trajectory and it travels down the line and would soon get on the other side of that. So the question is, how does one -- how do we think about that? So we start with -- this is a very normal thing. The -- we then take a very -- we look at delinquencies. We look at delinquencies, the entry into delinquency buckets, sorry, consumers rate of entry into delinquency into the first couple of stages in delinquency. And we look at the rolling rate that -- by which things roll into, ultimately. Charge-offs, which, consumers that are at delinquency, is still a little bit lower than the pre-pandemic, but it's certainly getting closer. Roll rates from stage to stage seem pretty much normalized. We look at our back book. And if you look at the front book, front book, the term we use just to talk about new originations. New originations are always the part of the business where you're going to see the most early indicators about how the economy is working, because think about it this way intuitively. In a seasoned back book, we've got the same customers month after month, and there are not too many surprises. When we're out originating in the marketplace, these are all new customers and who's applying for credit, why are they applying and lead to big swings over the years in terms of how much sort of effort to let them there can be on the origination set. We take a very close look at that. Our origination level, the -- our front book is definitely more normalized than the back book, but the thing that's kind of striking is we see stability month after month in terms of what we're looking at that continues to support, give us confidence about the choices that we're making right now. So -- but along the way, we continue to trim around the edges. It wouldn't surprise me at all if we -- I'd be surprised if we didn't continue from time to time to trim around vulnerable things that we see. But also, what we see right now, we still see growth opportunities.

And Rich, earlier conversations you were talking about looking at normalization trends through the [ front of the line ] versus the delinquency loans. Make a comment about that.

Yes. So in the end, we -- charging off is the financial event that's particularly costly to companies. But the metric that we most look at, if there was a single metric that we look at is delinquency rates. The charge-off rates are found -- charge-off follows delinquency. And it doesn't follow exact one-to-one, you can't trace back for 6 months earlier, and this was the delinquency rates to the charge-offs. But generally, the leading indicator to look at the most is the delinquency rate. So charge-offs tend to be a more volatile measure. Charge-offs also are net charge-offs. So you're experiencing gross charge-offs but then you net out whatever recoveries we have from prior charge-offs. One thing that we should just note for our consumer businesses is it's lopsided of the great news that we have enjoyed in the last couple of years. But the inventory of charged-off loans is a lot smaller than normal, so that the recovery rate is lower in our consumer business. It is just something we'll have flip side of a good thing, but it's -- that's also a factor. But the #1 thing to look at is -- that we look at the delinquency rate.

Rich, maybe to shift gears a bit. So you came out on the earnings call, you talked about flat efficiency for this year and modest improvement for next year. Before the pandemic, you want a journey towards 42% operating efficiency. You have the pandemic [indiscernible] a bit. Are we back on the journey towards that goal? Or have things changed and such that's no longer the goalpost?

It's the same journey. It's the same journey. It's not the specific goalpost within exact timing. It's something that we have not declared. Let's talk about the elements that drive the journey. So our efficiency ratio since 2013, around the time we started our tech transformation, our efficiency ratio, Jeff, has gone down by 440 basis points, something like that. I might be slightly wrong on that. But -- so we're talking about operating efficiency ratio. So there's been some benefit over time. That has really been 2 effects that continue to -- going up. On the spending side, we have invested very heavily in technology, and we continue to do so. And even as we get to sort of the other side of the canyon, if you will, metaphorically with respect to our tech formation, we see opportunities that we like there. So we certainly continue to invest on the tech side. At the same time, along the way, the ability to generate efficiencies with respect to tech costs itself, what we call tech on [indiscernible] efficiency benefits, is really significant and mostly in the form of a whopping legacy. The cost of legacy technology and legacy tech vendors that increasingly we're able to move beyond, obviously, getting out of the -- our existing data centers, moving to the cloud with a pretty big financial move there. Along the way, we've been driving customers to digital, working very purposefully on that big boost to our efficiencies. The biggest driver, and I think the banks drive efficiency in 2 ways. One is we just keep driving cost down, and the other, to do it even more so through revenue growth. I want to say that the Capital One and the way we're doing things, there's cost efficiencies that we're enjoying. But probably the biggest driver of efficiency over time is revenue growth. When I think about -- so now to the question, so where does this all go from here? While we don't have any specific targets, we believe that the tech transformation and the strategy of Capital One enables us to have a nice growth trajectory over the years and the opportunity to drive efficiencies along the way.

Rich, maybe to talk a little bit about the auto market, which is an area that you've talked a lot about. Maybe just talk about where you're seeing opportunities. And last time we had a downturn 15 years ago, auto was a big outperformer. Given some of the things that you commented on, you see the [indiscernible] being an underperforming asset class as you see this inevitable [indiscernible].

Really interesting to experience the auto business in the -- through the -- in the great recession, let's go back and take a look. Auto was one of the first, very first canaries in the coal mine, if you will. It was one of the first areas that worsening showed up in the credit marketplace. So it was very early in, but it ended up being a standout performance. And I think there are a few reasons for that standout performance. And then we'll think about how would it be this time around. So one reason was where auto loans were in the payment hierarchy for a consumer. They were way at the top and one could argue, and we saw evidence of this that, in some cases, it was even higher than on people's mortgages. So a second reason for the standout performance is, competitively, many of the players in the business headed for the hills because auto worsened quickly. And so the competitive environment was uniquely kind of vacated. And the third reason is that used car prices in that downturn and people couldn't afford new cars and so on, used car pricing went up quite a bit, which is an incredible growth in that business. Look, for players like us that are more shifted towards -- have a higher mix of used car. So that was then. Let's talk about it this time. Like the payment hierarchy is likely to -- it probably won't exceed -- be higher than mortgages. But I think that the auto will likely be way at the top on payment hierarchy. That's a good thing. With respect to the competitive environment, I'm pretty confident that, this time around, we're not going to see a [ magic ] [indiscernible] at the competition so I would put that as maybe the biggest difference this time around. The used car prices, there's a case to be made that, in downturns, a mitigating factor might be the tendency for people to buy used cars before those prices, they relatively go higher. That might happen. We can count on it. Our mix of new versus used, we ironically have been shifting a little bit. We still have more used than new, but we've been shifting a little bit more towards new lately only because at the really whopping prices of used cars out there. We just -- some of the credit exposure is a little more than we want to take. So if I pull way up, I don't think it's going to be as good as last time around, but some of the dynamics that make auto resilient, I think, could be arrogant.

Great. Well, unfortunately, we're out of time. But please join me in thanking Rich and Jeff.