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

We're ready to go for the next fireside session. I want to thank Jeff Norris from Capital One for being here. When the Discover acquisition was announced, I reached out to Jeff and I said, is this still going forward? He said absolutely. And we obviously had a lot of requests for meetings from clients, and Jeff said "We'll accommodate as many as we can." And I looked at the schedule today, and I think this is the last meeting of the day...

It is.

Close to it. And the Capital One cafe next-door, I was going to say if they serve Espresso Martinis, Jeff. You deserve a couple, because he's been busy all day.

Well, I don't think they do. So we'll have to save that for another time.

We'll spike it. But just in terms of the day being interesting, we've got the final late fee ruling this morning. I know it's not a huge impact for you, but it does have an impact. Talk a little bit about how you guys see it, what it is and what the impact is.

Sure. And let me start by saying thanks to everybody who's here and listening on the webcast. On the late fee rule, what we saw today, I think, was very consistent with what we've been expecting and what we've been talking about for the last several quarters. We had always sort of said the likelihood that we'll get a new rule is high, probably in the second half of '24. We've also said that we would think it's likely that there'll be some form of industry litigation that might delay or block the rule further. And that upon implementation, whenever that happens, we would assume a meaningful near-term revenue impact on the order of a 75% reduction in our late fee revenue. We then went on to say, and continue to believe, that there are mitigating actions we can take that would kind of get us back to where we would have been on a revenue trajectory in about 2 years, plus or minus, from the date of enactment whenever that might be, and that those actions were comprised of product changes, policy changes and investment choices, some of which we've started already. A few more will start before the rule would take effect. But most of them would happen sort of upon the rule taking effect or thereafter. And net-net, in 2 years, plus or minus, we'd be about back to where we would have otherwise been in the absence of the ruling. So no particular surprises. The way the market has been trading today, it looks like it was not particularly a surprise for the markets either.

Any surprise for you in what you saw in the final rule? I know it's fresh, but...

So full disclosure, I was here in sort of getting ready to come over and have meetings with investors, so I didn't have time to really dig into the actual ruling and made a quick phone call to principals of our card business, and just got confirmation that nothing they saw changes the way we feel about it and the things we've been saying about it. So we're sticking with that.

Okay. Okay. Good. And it is notable the stocks are up generally, which is good. We obviously want to talk about the Discover acquisition, but let's talk credit and kind of -- I don't want to say get that out of the way because it's obviously highly critical, but refresh us on what you're seeing from the consumer in terms of overall health and spending trends. Give us that first.

Yes. We continue to see the consumer as a source of strength in the broader economy these days. The labor markets have been incredibly resilient even in the face of inflation. Debt burdens are kind of near historical lows despite higher interest rates. Home prices are kind of back towards historical highs. And just in general, we feel like the consumer is in pretty good shape relative to sort of prior historical periods. In our own portfolio, our delinquency rates in the card business have been tracking roughly in line with seasonality since kind of in the middle of 2023. So we're really comfortable in declaring that delinquencies have stabilized. They've stabilized at about 15% higher than pre-pandemic levels, but stabilized nonetheless. And we believe that we are just beginning now to see charge-offs stabilizing. Delinquencies are our best leading indicator of where charge-offs and overall credit performance are going to go. So after roughly 6 months of stable performance, you'd expect that the charge-offs would follow suit. They've been sort of catching up with that through the second half of 2023. And we're right at the point now where we expect them to stabilize again at about 15% above pre-pandemic levels. Now it's important to note that the delinquency rate metric is a little bit smoother because every month we report delinquencies. It captures sort of 6 months of prior delinquency bucket roll rates and performance. And that smooths out the curve a little bit. There can be more month-to-month variability and volatility and seasonal impacts in the charge-off metric, but sort of accounting for that, we expect that from this point forward, we're seeing the charge-off rates stabilize. All of that commentary is about our card business, I'd say for the record that our auto business has been pretty stable in both charge-offs and delinquencies for about a year, which also gives us confidence that things are settling out. The final comment I'd make is that's not guidance for the charge-off rate for the year. It's basically where we see things settling out. The actual charge-off rate that we booked for the year in 2024 is going to be subject to sort of economic changes for the better for the worst. And the fact that I think we've got a couple of tailwinds that are either abating or potentially even shifting to headwinds. We and the whole industry have been working through this phenomenon we've called deferred charge-offs, which is essentially, after you go through a prolonged period of lower than average cycle charge-off, you tend to live through a period of higher than average for a little while. And that seems to be playing out and running its course. So that's a headwind that should abate. And then specifically Capital One, a bigger part of our net charge-off rate is embedded in the recovery of charged-off debt, which has been unnaturally low following the protracted period of benign credit through the pandemic, which essentially reduced the inventory of charge-off debt we could recover against. That seems to be healing and could shift to a tailwind, all else equal. So we're happy that we see things settling out and then we'll see where these -- the economy and these headwinds and tailwinds take us for where the actual charge-off rate settles out for the year.

Any reason why it's 15% above where it's been historically?

Well, I think part of the reason is the recoveries impact. And part of it is the deferred charge-off impact, both of which we believe have some room to run, but are settling out and moving in the right direction at the moment.

Okay. Okay. Good. On the Discover acquisition, I'm assuming that dominated the questions today for you, is that fair?

Yes, that's a fair assumption. I think I've answered 2 or 3 questions in the last 2 weeks that have been unrelated to the Discover transaction.

You got 2 from me.

That's right. Doubled it.

That's good. What have been the main topics that investors want to talk about. And we can break down each of those, but big picture, what do people want to know?

The 2 dominant conversations that we've been having over the last couple of weeks are, number one, a generally positive conversation about the financial and strategic upside potential of the deal. You've seen that in the way the stock's traded over the last couple of weeks, but the investor conversations we've had have sort of been consistent with that. People are generally positively disposed to the financials, the achievable synergies, the significant, potentially game-changing strategic opportunities that come from the combination of our scale and growth with a network that we can help scale with the possibilities unlocked by the combination of a network at scale and the 11-year investment in technology transformation and the benefits that's delivering. So just a generally positive conversation with investors about the overall aspects of the deal. A close second to that would be questions about the approval process, and everything else is kind of a distant follower of those 2 -- of those 2 topics.

Okay. And like all these sessions, if you have questions, put your hand up and we'll bring the microphone to you. But let's go to that. What is the process from here in terms of gaining approval how did you determine the time line and level of...

We will file our approval applications for the Federal Reserve and the OCC. As part of their approval process, they will consult with the Department of Justice on competition issues. We expect that there'll be a good level of scrutiny on the process. But we feel like we're in a pretty strong position to navigate the approval process and get approval over the finish line. We've targeted roughly a year. We've kind of said we are targeting a close at the end of 2024, early in 2025. And we'll see where that takes us.

Okay. You mentioned competition questions. Just review the market share, pro forma numbers, in the card and payments business. Why do you believe those are reasonable in the overall scheme in the marketplace?

So in the Card business, we will combine the -- the combined entity would create the largest card issuer by outstandings. But in other important categories like payment volumes, we moved from third place today to third place after the combination. The competitive landscape in the Card business, as you all know, is that it's dominated by 6 or 7 large well-funded capable competitors. The competition level is intense, but in our view, rational, that would be the description I'd apply to the credit card market pre-combination and post combination. So we don't think it's a major competitive issue there. On the deposit side, we would be combining Capital One, the 10th largest depository, with Discover, the, I believe, 26th largest, to form the sixth largest, and on an asset perspective, it's similar, the numbers are alike. Capital One, ninth largest; Discover 27th largest. Combined, again, I think, #6. So from a deposits or an overall banking assets point of view, 6th place, but kind of similar in size to the P&Cs insurers of the world. Number 5 would be USB and then the Big 4. So still a fraction of the size of the largest competitors. You could argue that that's a pro-competitive move. And then on the network side, I think it's fairly obviously pro-competitive because we own the fourth largest network, which is the smallest by far, a distant fourth. It's not even half the size of the third largest competitor, let alone the 2 really big competitors, of Visa and Mastercard, we'd be adding scale to that and trying to improve the competitive position of that network. So I think we feel that it's a strongly pro-competitive transaction, across the businesses that we're looking at. And that's the case we'll be making in the approval process when it comes to competition issues.

Okay. And the #1 outstanding position, your view, ultra-competitive market, it doesn't really -- there's really no difference if you're 1, 2, 3 or 4 in that market?

Well, I don't want to overstate that there's no difference. But my personal view is that the overall competitive dynamic in the card space would be virtually the same before and after.

Yes, that makes sense. Okay. Can you talk a little bit more about the due diligence you were able to do on Discover, [indiscernible] of a regulatory and credit perspective?

Sure. So just generally talking about the due diligence, we did it in an accelerated time frame, but we invested thousands of hours. Our due diligence was led by very senior Capital One executives who are experts not only in their fields and the businesses they run or the functions they run, Capital One, but also highly experienced at conducting due diligence and major acquisitions. So I think we were able to be very efficient. We were also able to leverage the extensive documents that are available from a publicly traded company. So historical statements, historical disclosures and all that kind of thing. And we did have a particular focus on credit issues and on regulatory and compliance issues given the sort of prior statements that Discover had made about the consent order and some of the challenges they face there. And we came away satisfied on the credit front that, while they've had a temporary sort of gapping out of credit performance, that that was largely driven by recent vintages where they kind of expanded their view of credit a little bit and had some outsized growth. We've also learned that they pulled back in ways that we thought were really good in terms of addressing those performances. And we'll have to let those moves run their course. Now in the very short term, when you pull back, you create a denominator problem that actually puts upward pressure in the near term on charge-off rates. And we looked at vintage curves and seasoning patterns, and we feel that the combination of that upward pressure from the pullbacks and those recent vintages not yet quite getting to their peak and curing part of the vintage curve performance, is the reason that we adjusted our deal model to sort of take consensus estimates for Discover on the credit front and adjust them to sort of -- we're right on top of 2024 loss estimates in consensus. Consensus has loss rates going down meaningfully in 2025. We've actually held them closer to 2024 levels before doing the extrapolation into '26 and 2027. And on the -- but that we believe that they're probably headed to the similar destination as consensus, just on a longer glide path. And then on the regulatory front, we've included some pretty meaningful investments in regulatory and compliance improvements over and above the $500 million or so that Discover had talked about expanding to address their issues. We believe, as Dave said, that when you start to dig into those issues, you find more. And we've tried to anticipate that in our integration budget and in [indiscernible] synergies.

Okay. But it's challenging to really know that. Is that right?

Well, you can't know everything, but you can sort of build in buffers and prepare.

Feel like it's a conservative approach?

Prudent.

Prudent. Okay. Good. Better word. How much can you do with Discover at this point in terms of communications between the 2 companies and starting to align some of the things you want to align?

So the primary thing to remember is that we are independent publicly traded companies and there's very limited circumstances that we can communicate with each other between now and the close. So what we're doing is extensive planning and preparation on our side so that, when we do close the deal and can interact in a more robust way, we'll be ready to hit the ground running. But the contact -- direct contact between us and Discover between now and closing is pretty limited.

Pretty limited. Okay. You want to do an immediate shift of the debit network, right? Immediate shift of your volume to the debit network. What exactly are you moving? Explain that. How material is it?

So essentially, we plan to move the entirety of our debit spend to the Discover network, largely completing that within the first 3 years after the close of the transaction. Assuming a late '24, early '25 close date, we probably begin moving debt balance, debit spend volumes in the second half of '25. And by the end of 2027, we believe we'll have moved substantially all of it. The Discover debit network with PULSE PIN debit and the Discover Signature Debit is really well positioned to sort of take on all of the debit spend that we have, and is the majority of the $1.2 billion in network synergies that we've talked about. There's a little more work to do on the credit card side. So we're starting with a relatively small portion of our credit card spend during the first 3 years. And we expect that as we lean into investing in the Discover network, particularly in the U.S., leaning into the -- there's a perception gap between the actual acceptance of Discover, which is pretty much on par with Visa and Mastercard domestically and the perceived acceptance on the part of people who aren't Discover cardholders. And so we'll need to sort of invest in the brand to build the perception of the ubiquitous acceptance that exists. We'll probably also make some moves to sort of pull the Discover brand upmarket a little bit. It's not a downmarket brand by any stretch of the imagination, but we can sort of gradually position it as a little bit more upmarket while we're driving the message of ubiquitous acceptance. And as those efforts gain traction, that will enable us to move a growing portion of our card, the credit card spend volume onto the network over time as well. But that's probably going to happen over a period of years, beyond the sort of 3-year horizon for which we've made financial estimates. So there's potential upside from that, beyond what we've quantified. We'll also have to sort of fix the acceptance internationally, which is not quite where it needs to be, for the entirety of our card business today. And so we'll be leaning in there and trying to address -- adding scale a little bit at a time and working to sort of increase international acceptance, in reality as well as the perception thereof. And beyond the initial moves of the entirety of the debit spend and the sort of small portion of card spend, the subsequent moves of volume on the credit card side won't happen in sort of kind of small steps, will sort of increase network capability and brand perception, add a little bit of scale, lean in further to increase international acceptance and perception, add a little bit of scale, and be fairly short footed, a series of small steps over time.

What could that time line look like?

I don't really have a number in my head. That's one of those things that we'll have to see kind of what traction we're getting on our efforts to build brand and acceptance internationally and make it kind of a line of scrimmage call as we go. But the bottom line is we're going to want to be really short footed. We're going to want to minimize the impact on customers of switching networks. We're going to want to make sure that we've got the capabilities and the brand perceptions in place before making any moves. And so it will be thoughtful and short-footed moved.

You'll need some international stars to promote the brand.

We might.

Okay. Maybe Taylor Swift is international enough?

She's pretty international.

Okay. Maybe that will work. What -- in the debit volume, what kind of risks or concerns do you guys have for doing that? Or is it...

So I think it's the same as I was just talking about on the credit card side. We want to minimize the impact to customers. So we'll have some work to do to sort of stage the moves over the first 3 years of post close time frame. We'll want to do some testing and some analytics to identify customers that are happier or at least likely to be unhappy about moving, and move that first, build some credibility along the way. We're going to start sort of building the brand perception, I think, right out of the gate. So some of the benefits of that will -- in order to the debit spend that's moving over in sort of years 2 and 3. But it's the same basic view of minimizing sort of customer disruption.

Sure. And then on Card, similar question, you touched on it a bit, but some of the network concerns, changing networks, what kind of concerns do you have there?

Well, I think I pretty much already said what I have to say about that. Again, it's a combination of brand perception domestically and actual acceptance internationally. The work we've done so far is that I think just adding scale over time will really help the efforts to sort of build acceptance overseas. In some countries, it's actually pretty good already. In some countries, there's a little more work to do. And that's something we'll lean into over time. As we add more volume, we believe that that sort of -- in addition to just sort of adding scale, which increases the value and perceived value and actual value of the network to merchants, that, in turn, sort of makes it -- the more merchants that are on it makes it more compelling for consumers to be on it, and starts that sort of virtuous cycle. And then over time, as we're building scale, we expect that we can leverage our customer base and our modern technology and data infrastructure and do some pretty cool things with analysis and data and consumer and small business customers that really drives that sort of flywheel effect where we can sort of increase the value by increasing merchant sales. We can share some of that increased value in the form of really more compelling customer offers and experiences and, of course, we'll benefit from growing scale and economics of that sort of flywheel. And that starts a little bit with the debit moves and picks up steam as we gradually move some of the card spend volume over there.

Multiyear opportunity.

Yes.

Okay. Pause and see if there are any questions? Anyone? Okay. Quiet group. I did want to ask about the national banking strategy as well, and what kind of opportunities does the Discover network bring to that?

So when we're talking about the overall benefits of the Discover combination, we started with the network and all the really interesting long-term strategic upside that that unlocks. And we'll have to see how that goes. We talked about the complementarity of our card franchises and our effectiveness in that space. And then I think maybe the third thing on the list was the potential to accelerate the growth of our national banking business. I think one of the things that's probably not fully internalized yet outside of Capital One is the traction and the potential of the national digital-first banking strategy. So let me stop and just talk about that in and of itself before I talk about how Discover sort of adds to that mix. What we're creating, I think, is fairly unique. It's a full-service national bank that's digital-first with limited physical distribution, that's really kind of rightsized for a world that's getting more and more digital. A Capital One national banking customer can do almost everything they can do in a branch, digitally. Obviously, we haven't found a way to digitize the safe deposit box yet. But the opportunity there is to grow transactional relationships, checking accounts, not just liquid savings accounts, which is what most people think of when they think of a national sort of mostly direct bank. But I think what we're building is a true full-service national franchise that has 16,000 cash point deposit locations in 21 of the 25 largest metro areas, Capital One cafes, which are like showrooms for the digital capability carriers of the brand, a place that you can sort of physically touch and try out the capabilities that you can do digitally. And it's fueled by a really compelling, simple value proposition. We're the only major bank with no fees, no minimums, no overdraft fees. We've advertised that and gotten a lot of traction, and I think our building towards a franchise that is truly national and reach, truly full service, digitally enabled, sort of appropriate for where we see the world of banking going, and with a fraction of the cost and complexity of a branch infrastructure. And the improved debit economics will sort of fuel the growth opportunity of that part of our business over and above the fact that the Discover transaction actually brings with it $84 billion of largely insured consumer deposits, which is the most sought after funding in banking these days. So we can do all that without any price increases because we'll share in the network fee that would otherwise go to the network. And I think that that just sort of really supports the growth opportunity we see in the banking space, which is probably a little bit underappreciated.

Yes, I definitely think it is. The transactional account push, especially.

Right.

Especially. Okay. Last call for questions. Okay. Anything else, Jeff, you feel like we haven't covered we need to cover?

Not if you don't have more questions, but...

Okay. Thank you for being here. I know it was -- okay.

Can you just talk a little bit more about the synergies on the network side, particularly debit, in terms of you said no price increases, but you talked a bit about being able to charge above the [ Durbin ] caps on the debit side given the Discover structure?

Well, Discover's current price sheet is what we -- to estimate the synergy dollar value, we just took our debit business and that portion of credit cards that we expect to move over in the first 3 years and ran it through their pricing sheets. And that's the result of the $1.2 billion. The majority of that is on the debit side given that that's the majority of the spend that will be moving over. Everywhere in the world where interchange is regulated, there's been a distinction between 3-party networks and 4-party networks, in Australia and Canada and the U.K. and Europe. So Discover currently enjoys that aspect of the regulation, and we expect that to sort of stay the same. And so we don't -- I just wanted to be clear that we contemplate no price changes in their current schedule. But one of the sources of synergy is that, as a 3-party network, their pricing is not subject to some of the same restrictions.

Got it. So the synergies come on avoiding the network fee as opposed to raising interchange?

Right.

We have to end it there, Jeff, but thank you for being here. We appreciate it.

My pleasure. Thanks, everybody, for coming.