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

All right. Up next, we're pleased to have Capital One joining us once again. They've continued to deliver best-in-class growth in the card business through targeted investments. In addition, it continues to leverage the benefits of its tech journey, which has helped it improve efficiency. Here to tell us more about the story is Chairman and CEO Rich Fairbank. And joining us on stage is Head of Global Finance, Jeff Norris. Today's presentation is going to be a fireside chat. So let's get into it. Rich, thank you for joining us once again. I think you've been here every single year that I've ever done this, so it's good to see you.

Maybe to just start with the consumer. We've recently seen a pullback in spend. Savings rates have come down. Credit losses have obviously increased for the last 2 years. So maybe just start off what you're seeing across -- of the consumer across your multiple platforms, whether it's card, auto or the deposits business?

So good afternoon, everyone, and those listening on the webcast. And Ryan, it's great to be here. Yes, we go back quite a ways, and it's been really fun sharing our story together. So I think the consumer is in a strikingly strong place. The -- if you pull way up from a credit point of view, debt burdens are near historical lows. The consumer, obviously, was very benefited in terms of their own savings by what happened in the pandemic from the stimulus, the forbearance and in many ways -- the loan forbearance and even their own savings, they built up on average, quite a surplus. That surplus has been running down over time. But on average, there is still -- their unemployment rates are strikingly strong. Home prices are going up again. So we see a consumer in a strong place. I think also from a credit point of view, I think consumers -- I've often said that consumers are in many ways, more rational than the companies who serve them, the banks that serve them. And I think that consumers now have not one, but 2 things vividly seared into their memory and that is their experience of the global financial crisis and their experience of the pandemic. So I think we see a great sort of rationality in consumer behavior. And even now as they're stepping out and spending more and growing in terms of taking on more loans, I think is a general observation. We have a foundation of a very solid consumer. And when we think about consumer lending, it matters a lot how the consumer is doing, and it very much matters about the marketplace of the companies who serve the consumer, what's the nature of supply relative to demand and the practices and the underwriting in the marketplace. But I really like that these days, the foundation -- the consumer foundation is a very solid one. And by the way, on the banking side also in a good place relative to the penchant for saving.

So Rich, maybe digging into credit at Capital One. In earnings, you noted after close to 2 years of delinquency underperformance that the rate of normalization had slowed for 2 months, and performance was getting closer to seasonality. Based on our data, it appears that continued in October. So can you maybe unpack what is driving this performance, whether in terms of vintages or customer type?

Yes. So let's kind of pull way up, Ryan. Maybe I'll just kind of take a little journey through the last number of years. We always talk about the normalization, what -- before the normalization was the great abnormalization, if you will, where with -- in the pandemic as a result of all the stimulus, the forbearance on so many financial products and the consumers saving, credit losses went to an unprecedented place we'll probably never see again in our lifetime. And this -- and whenever things are extreme, that then can sow the seeds of other things. So we became concerned during this period of time of things happening in the marketplace that could ultimately have a lot of consequences. One thing we were concerned about was the incredible flood of new lending coming from fintechs, not only the supply from fintechs, but also wondering what is the credit model that they're using because they're young fintechs and the data that they're going to have in their rearview mirror is the best credit performance in the history of humanity that they're looking at. So they're worried about some of the underwriting choices and the amount of supply, we went sort of on alert relative to that effect because I've just learned over the years, a flood of supply, especially with looser underwriting has consequences for players in the industry and especially, we were on the look out at the lower end of the market because fintechs had entered in -- as they always do sort of on the subprime side. So the other thing that we were very alarmed about, and many of you will remember our being so vocal about this was the grade inflation that was happening on credit scores. And it's because when consumers suddenly were turning in such amazing credit performance. The models that companies had and the industry had and so on were suddenly making -- these consumers were looking so good that we were alarmed both for our own sake, but also the -- in terms of what the industry would do about this, let's call it, credit score inflation. So what we did with respect to these 2 concerns is we watched very carefully for the places we thought were degrading or would degrade because of the oversupply, particularly on the lower end of the market. And we intervened to normalize our own internal scoring to the best we could. It's not a matter of pure science. We had a way to proxy a normalization methodology to try to normalize for the credit score inflation. As a result of those 2 decisions, we cut back quite a bit in terms of -- around the edges of our originations. Often, when we cut back a lot, we then just cut back across the board. But at the same time, we were coming into meetings like this saying we're leaning into growth. And during the whole time, we were real believers in where the consumer was and the growth opportunity. So we leaned into growth even as we were very importantly normalizing and trimming around the edges. So the other thing that -- and Ryan, you'll see why I'm telling you these things because they all relate now to the question of where credit metrics go. The other thing that we had a very close eye on was how are our origination vintage is doing because at a time when there's so much noise and things are normalizing and so on, what's happening on new originations where you tend to see the most extreme effects on credit, adverse selection, things like this. And we were very pleased that month after month after month, our vintages were coming in on top of each other and in the ZIP code of where they had been pre-pandemic. And that stabilization gave us confidence to keep leaning in hard into this opportunity. And as we often said to investors, the – we're seeing this stabilization, but it's a managed stabilization in the sense that without the trimming around the edges because we would do test sells on the things that we had cut. And some of them -- I was in a meeting yesterday where somebody was showing me some results from some of the things we had cut, they not only did worse than the things we kept, they even did worse than we had predicted. So we had a validation of the benefits of the cutting there. [Audio Gap] As investors, we all saw credit metrics rising kind of vertically, and it certainly gets everyone's attention. The seeds of stabilization were planted by virtue of all those stable vintages. But we were all waiting to see the ultimate indicator of where things would settle out would be the leading indicator, which is delinquency rate, starting in July, our delinquencies basically turned to be pretty much on top of the seasonal movements of delinquency, and that was a great sign as you mentioned, Ryan. So we talked about this in our earnings call. But then since then, we posted the October month that again, had delinquencies sort of right in line with seasonality. So we're now stacking up a number of months that have gone from pretty striking normalization that's well above seasonal patterns to delinquencies logging a number of months now where they're right on top of seasonal patterns. So this is a very good sign.

And in terms of the segments, it's pretty much across the board.

Thanks, Jeff. So I know Capital One generally doesn't provide forecast. But we had Discover and Synchrony both pointing to losses peaking in the middle of the year in '24. Have you seen enough outside of the macro that we've seen most of the normalization? And given the delinquency progression, we could start to see stability in credit loss performance?

Well, I think credit losses just -- my whole life I've pretty much seen the pattern that credit losses follow where delinquencies go. So we've now seen a number of months of -- on a seasonally adjusted basis, the stabilization of credit losses and that's basically an indicator of stabilization on the charge-off side on a lag basis. One other stabilization point -- sorry. Another effect that happened for the industry, particularly a strong effect for Capital One was on the recovery side. So recoveries are an important part. Every company has gross charge-offs, then they get recoveries, which leads to the charge-off figure that you see, which is net charge-offs. The contribution for recoveries from any company is pretty important. For Capital One it's particularly important because I think Capital One has a long history of being -- having a high recovery rate, also because we choose to work most of our own recoveries instead of selling them. We do sell some, but not most of them. Recoveries come in on a lag basis as opposed to right up in front when you sell them. So a thing that's affected our credit metrics all along during this normalization is much lower contribution from recoveries because the inventory to collect on was much smaller because there hadn't been very many charge-offs. So we call this in a sense, the recovery's brown-out. I just wanted to say that another one of the stabilizing factors is that we've gotten to the point where the recovery's brown-out has kind of stabilized. It doesn't mean that it's not there. But the -- it is a stable effect. Over time, recoveries will -- as the inventory gets bigger, recoveries will become -- will, over time, go back to what it was.

Got it. Rich, despite the uncertainty you've been leaning in on marketing. Now the marketing budget has become much broader over the past 10 years, given different segments of card, parts of auto, the national digital bank. Just maybe focusing on card, you talked about the parts of the market you're still leaning in. And what are the areas maybe you're pulling back a little bit as you think about investing in the year ahead?

Yes. Well, I don't think we're pulling back on much because we see good growth opportunities. So our story is mostly the same as what I've been saying for really a long time, but things that particularly impact the marketing number, certainly what we see in terms of origination opportunities. We see very, very good growth opportunities, so we continue to lean in hard there. Additionally, our quest to go after the top of the market toward heavy and the heaviest spenders is something that is very front-loaded marketing heavy and investment heavy. There's a reason that a lot of banks don't necessarily do it because it's expensive and it's particularly expensive up front. But what we believe so strongly about this business is that to go after the top of the market requires a sustained quest, a strategy that works backwards from really what is winning in that marketplace. And it's not the thing one can jump in and out of or try to cobble together a product from vendors and put it out there and see what works. This is something about years and years of sustained investment. In terms of, yes, product development, but the servicing experience and the lead servicing experience, the digital customer experience, the fraud experience of the sort of the card always works phenomenon, which is very tied into advanced fraud modeling, this is about brand development and really being credible as a premium player in the marketplace. It's also about investing to build a leading online travel portal where our customers come and get extra discounts, but it's got to be a customer experience to tell your friends about. This is about building lounges at airports. This is about experiences and access to certain things that aren't available to -- generally in the marketplace. And even in the case of Capital One, also, we have built on the small business side, basically a charge card and no preset spending limit, which is a very different animal that only one of our competitors has, and that's enabled by our tech transformation. So -- these are things that we're leaning into. A lot of those investments we talk about show up on the marketing line, also the promotions, the early spend bonuses, those are things that contribute to a lot of the marketing you've seen although you asked just about card, I do want to say -- well, we'll come back, maybe if you got a question on the bank side, but that's a little window into the marketing investment at Capital One.

So Rich, over the years, you've spoken a lot about the partnership business. When I think about your strategy, it's been to partner with the biggest and best brands out there. I think the media has been reporting that there's a large portfolio that could come to the market. Capital One has not been linked to this. But when I think about the type of companies that you would like to partner with, it does align with your strategy. So can you talk about your appetite for another large portfolio win? And what are the parameters you look at when thinking about that?

So the card partnership business is a natural for a company that's a huge player in credit cards. One thing that is a founding principle of our card partnership business is, while scale really helps, do not go all in for the sake of scale because it massively matters which partner one picks. And I'd much rather have a smaller portfolio of the partners that we want to partner with than a very large portfolio where it may not be fully that. So what -- so therefore, we're selective in terms of our partners. Here's what we look for: First of all, a very successful -- that's successful in its own right, their brand, their franchise, it's a company that's going places. Secondly, it's what is the reason that a company would want a partnership -- would really want to have a co-brand or a credit card. There's a whole continuum. We're much more focused on partnering with companies where they want that card partnership to be at the tip of the spear to drive the franchise of the company and then a very, very important thing is the -- what is the alignment of incentives, what is the cultural alignment and the philosophy and a lot of partnerships get themselves in a situation where the incentives are misaligned and they're constantly going at cross purposes, we look to really get an alignment there. And where that works, we go. A lot of times, it's not there.

Got it. So jumping around a little bit. If I go back in 2019, you laid out a plan to improve the efficiency of the organization. This is after multi-years of improving it, including the retirement into your data centers. I think we referred to it as 42% in '21. It was derailed by the pandemic. However, more recently, we've begun to see efficiency improvement once again. And now you're talking about modest improvement. So the question, Rich, is, as you look ahead, are we back on this -- on track on this efficiency journey? What is the driver of the improvement? And what is the destination over time?

So we -- if you look all the way back to something like 2013, we have generally been improving the operating efficiency ratio of the company. The pandemic came along and as you say, Ryan, sort of threw that thing out of orbit for a little bit. But the same drivers of improvement are there. They were there and they are there. And since then, we've been able to get back on the track of basically modest improvement in efficiency ratio each of the last couple of years. And we, in fact, modified our guidance in the last earnings call to go from flat to moderately down to just moderately down with respect to this current year. So the big driver of the efficiency ratio story is technology. And it's a driver both of what brings it down and sometimes what brings -- what slows it down a little bit. But let's just savor this for a second. We are finishing the 11th year of our massive technology transformation at Capital One. We're finishing the 11th year, well it's a lifelong journey in a sense to continue to transform One's technology. But we've leaned in really hard on that and that tech journey has many benefits to it. But one of them we have always believed is the ability to be more efficient. And here are some of the benefits that we have seen along the way with technology: The ability to reduce vendor tech spend by a lot, especially with legacy tech vendors. In fact, just even external vendors in general, we brought in so much of all the software development and so on in-house. The ability to build scalable platforms for the company instead of all these arbitrarily unique systems we have internally across the company, the ability to drive automation, the -- and the ability to drive customers to digital is -- has been very, very helpful along the way. And of course, also with respect, the technology has really helped our efficiency by allowing us to create better products, leverage machine learning and everything to drive more and better marketing and so on to drive revenue growth that helps efficiency ratio on the revenue side. On the other side, we have continued to invest heavily in technology. And so we're both generating a lot of savings and continuing to lean into technology because it is so much of where our future lies and more of the company is basically technology itself. So the net of those 2 has led to some nice improvement in operating efficiency and the same dynamics exist out into the future, while we're not giving specific guidance out there, the same underlying dynamics exist.

Rich, maybe moving on to auto. Originations were flat year-over-year. You've been a little bit more upbeat recently on both yield and credit. So how are you approaching leaning back into the business? And is this the right time?

Let's talk about the auto business, Capital One for -- if you go back a few years, Capital One led the league tables in auto originations and really had record years for several years. There -- we've always been, even since, a big originator but relative to our high points had dialed back quite a bit over the last few years. Let me just talk about why, and then we'll talk about how much of that still is there. There were several things in the last few years to be paused about with respect to auto originations. One was the flood of supply that came into the marketplace in the subprime side of the business, much of it from fintechs. This is not just auto loans, but credit in general, that -- what we observed in subprime was a significant degradation. I want to make a comment. You often think Capital One, we do some subprime lending on the card side, and we do some on the auto side. We go deeper on the auto side because it is a secured product. So on the card side, most of the damage happened south of where we operated. But within the auto business, there was very significant degradation on the lower end and that -- so that led to pullbacks. We also normalized -- we also intervened to normalize for the credit score inflation. So that led to cutbacks. And additionally, the other thing, Ryan, that happens strikingly in that business, while in contrast, the credit card business is a floating rate business. This, of course, we're selling fixed rate loans. And when interest rates went up, a lot of the card competitors did not -- that did not make its way into pricing. So we saw and flagged to Wall Street a significant reduction in the margin in the business, which is not really a credit point, but it's a resilience point leading us to dial back, pending the resolution of that. So where are we now? The -- I think interest rates have now made their way into auto pricing. So that effect is normalized. We -- our auto results, if you look at them, we talk about stabilization in card, for the auto charge-off rates themselves for Capital One have been stable for most of 2023. So we've been in a very strong place. We are pleased with the choices we made. I think there's some opportunity to lean a little more forward into this. But those are just some of the conditions we have a close eye on.

Rich, obviously, tons of regulations out there that are impacting the banking industry. I think the one that's the most prevalent for the card business is the reduction of late fees where the CFPB is set to reduce them by over 75%. You've spoken a lot about the importance of the fee to incentivize customers to pay on time. Assuming it does go through, how are you thinking about mitigation? Over what time frame? And also, how do you think this is going to not only change the credit performance but also the growth over an intermediate time frame for the company?

Thank you, Ryan. So let's just talk about the late fee proposed rule that was out there, we believe it will be finalized late this year or at the early next year. Then litigation is very likely to follow immediately thereafter. And I think it's sort of the general view that in the second half of next year, if this goes into effect, that would be sort of the timing of when that might likely go into effect. So we -- one thing that we wanted to make sure investors understood was this will have a significant impact on the P&L of Capital One. And there's an irony with respect to this particular fee. Capital One has been a company that has over time driven for the most absolute simplicity of products. Very few fees. We're the only major -- I guess, almost one of a couple of banks who don't have overdraft fees, for example. So we have been very much the bank that believes in low fees. This particular fee is a really important fee because it's the equivalent of a speeding ticket, can you imagine speeding tickets if they became very, very cheap, there can be behavioral consequences there. So that's why we charge it there. But of course, we'll go where the rule takes us, but it will be a significant impact on our P&L. Now we have been really working on creating the mitigating actions for this impact. And we then -- collectively, those actions that we will implement can mitigate the -- can mitigate this impact over time. In other words, the mitigation benefits offsetting things are there and available. Now what are -- those mitigants fall into several categories, they include product changes, policy changes and investment choices that collectively can add up to the magnitude of this impact. Some of those choices will -- we will make before the rule goes into effect. A majority will be actions that we take after the rule goes into effect. Collectively, we -- these mitigating actions will get us there. But this is a thing that will happen over time. So therefore, this hole that gets created, that will get mitigated over time, but not immediately.

Rich, maybe one last one. You guys have had enormous success growing deposits and given the national banking strategy, maybe just talk about how the strategy has evolved, where it's headed. And do you think you've gotten to the point where there's -- given the value that you've created that you'll have the ability to move price around as rates move around?

So let's think -- let's just talk about banking and where -- ever since banks have had the chance to go national, banks have focused on getting there by just merging with other banks and buying branches in various communities and building a national bank that way. Capital One has branch coverage in 20% of the nation. But what we have really focused on is building the bank -- I call it the bank of the future, figure out where banking is going and build that. Now one form that you see it is in the savings business lots of players have, including Capital One, where we're offering on a national basis, very attractive savings products. Let's call that a national kind of savings bank, and we do that. But Capital One for years has been building something much more than a bank for savings. This is a full-service bank like the bank on the corner. But to get there, we have spent years taking all the -- everything that you can do in a branch and digitizing that. There are a few things we can't digitize like nobody's figured out how to make a safe deposit box digitally yet. But to take just about everything you can do in a branch and to make that digitally available nationally. That's been a big effort standing on the shoulders of the tech transformation of Capital One. But what we have built is a full service digitally-led bank with branch distribution in 20% of the nation and showroom cafes in major metropolitan areas across the United States. And then you can see, led by our national television, we're absolutely going for primary banking relationships. This is really just -- I like to call it, that's the bank of the future. As we've always done at Capital One, we try to figure out where the world is going and go build that and that's what we're doing here. And we're getting a lot of traction, and we like our chances.

Great. With that, please join us in thanking Capital One.