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

Good afternoon, everybody. Today, we have with us Jeff Norris of Capital One. Jeff, welcome to the Morgan Stanley Financials Conference. Before we get started, just going to read off some disclosures real quickly. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. The taking of photographs and use of recording devices is not allowed. If you have any questions, please reach out to your Morgan Stanley sales representative.

So Jeff, so kicking off with the big topic on everyone's mind here. Four months ago, Capital One announced what you called a game-changing deal to acquire Discover. You've laid out expectations out there for synergies, 15% EPS accretion. You have a compelling opportunity to scale your own network. Can you talk a little bit about how this deal further drives the evolution of Capital One over the long run?

Sure. I'd be happy to do that. First of all, let me say thanks everybody who's here listening on the Internet. And Jeff, you have a future as a public speaker. As a guy who reads the disclaimers for every quarterly earnings call, I thought you did a fantastic job.

I tried to copy your method, I think.

That works. But more to the point, we did call the Discover opportunity. I think the word we used was singular opportunity, and something that has game-changing potential. And I think a lot of that is embedded in the long-term opportunity created by the Discover payments network. As you all know, it's 1 of only 4 global payment networks based in the U.S. It's a rare and valuable asset in financial services and payment space, and one that if you try to build organically would be extremely difficult, if not impossible to do. So the opportunity to be in the network business with a player like Discover and their network, where they've done really a remarkable job over the last several decades building it from scratch and competing, even though they're kind of a distant fourth in terms of the size of the network. It's a wonderful asset and a great partner with which to sort of continue that journey. And I think what we bring to the table in a combined company is the investment capacity, the technology and analytical capabilities and the customer base of more than 100 million people that can really accelerate the progress in sort of building out that network and making it more competitive and really changing the sort of destiny of Capital One in the following way. The biggest opportunity that we see is the opportunity to have direct interaction in a deeper and much broader sense with merchants. Now it's a little harder to see from the outside in, but that's a strategic quest we've been on for a long time. In large part, the reason that we're in the retail partnership space is because of the opportunity that affords to have a more direct set of interactions with a selected group of merchants. But having a network business broadens that sort of by orders of magnitude. We've also -- that's been a driving impetus behind Capital One Shopping, which is a fast-growing and digitally enabled part of our business today. But it's a different game to be in the networks business because with a very large number of merchants, you have the direct interactions that will enable us to sort of as opposed to being sort of just an issuer on the other end of an intermediary network, to have these direct relationships. And we believe that we can add scale to the network. We can drive insights and analysis and leverage the 100 million-plus customers we have in our analytical and technology capabilities to really create a lot more value for merchants in the form of increased sales, lower fraud costs and just an overall sort of better experience. That value that gets created can then get shared with consumers in small businesses, which will attract even more of them to the network and sort of kick off this flywheel effect of this upward spiral of value creation and opportunity that I think can really drive growth of a new revenue stream at Capital One over the long run. And there's some -- you get better overall economics from vertical integration in the payment space. And the revenues that come from this particular business don't come with assets or credit -- consumer credit risk. So there's a lot of sort of really appealing attributes to this. And we have some investments to do, some capability building to do, but we have a really wonderful place to start. And the combination of Discover and Capital One building that forward, I think, looks like a great and potentially game-changing opportunity.

Just digging into the network here a bit more. You've talked about how you're going to need to invest a little bit more of your own dollars into addressing some of the issues there, their international acceptance, perception of acceptance in the U.S., even though they're pretty much at parity in the U.S. Can you talk about your plans there to bring the Discover brand more upmarket? And how to think about the investment required to do that at this point?

Sure. So the long pole in the tent is international acceptance. Let's come back to that a little bit later. I think the reality of acceptance of the Discover Network domestically, in our view, is pretty much at parity with the other large network competitors. And so this is an exercise in our view of changing the brand perception and the perception of acceptance. All of our brand folks would tell you that if you're starting with a reality, that's a good one. You're in a pretty good position to change the perception through management and advertising of the brand. And I think that's where the kind of the initial stages of investment will be. Now I'll point out that the synergies numbers that we've quoted in association with the Discovery transaction are what I call net synergy number, so they contemplate some fairly significant [ conscious ] synergies to cover the investments we expect to make initially on sort of building the brand and changing the perception of acceptance. But that's probably where we'll focus our efforts on the capability building initially. Changing the international acceptance reality and perception will probably be something that takes a little bit longer. But I still think we'll be in a position to essentially move all of our debit business over to the Discovery Network in fairly short order following the close of the transaction. And while we start with a meaningful allocation of our card spending volumes, the capability building, the brand building will sort of enable more meaningful chunks to move over time as well. And I think that's how we'll see that play out.

And that debit part will be by '27 or maybe depending on the actual deal time closing? And then is the goal to maybe get the credit, most of the credit over time? Or like...

So I don't think I'd speculate about specific timing and patterns of moving the credit volume other than to say, we'll start with a meaningful chunk so that in combination with the debit scale, we're injecting a nice little boost of scale kind of in very short order, and that more meaningful parts will move over time. But it will be a little bit kind of in lockstep. You can envision a world where we make some investments, build some of the credibility, and the acceptance perception add a little bit more. We build some of the international acceptance at some additional segments. And I think you'll see those two sort of streams of activity, the investment and the movement of volumes, kind of happening simultaneously but sort of in kind of the latter fashion one, one step on each path.

Okay. That's clear. So you've been also clear about the pro-competitive, pro-consumer aspects of the deal. As everyone here knows, I think you have a meeting with the regulators in a month, public meeting. Give us a quick update on where you are in the process, how that dialogue with your regulators is going? And maybe touch on any learnings you've had since deal announcement about 4 months ago.

Sure. So I think most of this is a matter of public record, but we've submitted our applications for approval to the Fed and the OCC. And we continue to be in kind of what I'd call from a process perspective, a normal set of interactions with those two regulators and with the DOJ in their role as consulting to the Fed and the OCC throughout this process. We received a few rounds of questions and request for additional information. We've responded and I think continue to be actively engaged in that dialogue, which is very consistent with what we would have expected in any approval process for a merger of this size and scope. You did mention the public hearing that's scheduled in July. I think that we would expect an approval process to take several months, and that's playing out kind of along with our expectations. There's nothing I can say about the specific content of those conversations. That's obviously confidential supervisory information. But from a process perspective, it's kind of in line with what we had expected. And we continue to believe that we'll be in a position to close the transaction later in 2024, early in 2025, and we'll continue to work back from that.

Okay. And if we could maybe pivot to the recent news that hit the other week, Walmart. A few weeks ago, you both announced an end to your card partnership. You're retaining the $8.5 billion loan book, planning to convert those or at least a bunch of those cardholders over to your proprietary offerings. This struck me as a bit of an unusual outcome. Typically, the retailer wants to hang on to that book. But nonetheless, it does look like a more positive outcome for you. Can you just walk us through the decision to retain that and what you're thinking on the go-forward strategy from here?

Sure. I suppose it's unusual but it's not sort of precedented. We've actually exited some early retail partnerships in the earlier part of the 2000s, where we've retained the portfolios and converted them over time to Capital One-branded products. So it might be a little unusual, but it's something we've actually done before and have some experience within our distant past. I think that of the options to move forward, this was one that was a good outcome for us. As we've kind of released in an 8-K announcing the transition from the partnership to us kind of retaining ownership of the portfolio, about 40% of the balances we're retaining are things we've originated. The 60% remaining is stuff that was originated by a prior issuer. We've watched that season for 5 years. We've been able to sort of manage and impact the performance and are very comfortable on an overall basis with the ongoing sort of resilience and profitability of what we're retaining. Over the several coming months, we will kind of begin the conversion process, where we'll transition many of these customers from their Walmart products to Capital One-branded product. And I think we were fairly disclosatory in the 8-K, where we kind of talked about the revenue impact and the charge-off rate impact on a pro forma basis for Q1. So I think net-net, this is an $8 billion-ish portfolio with attractive economics and resilience, and we're happy to have it be part of our book. And in the context of kind of $150 billion overall card business, the sort of near-term effects around kind of the impacts on charge-off rate and revenue margin we'll fairly quickly absorb and move forward. Now I'd be remiss if I didn't sort of say that there is, of course, the potential for a fairly significant allowance build. That will be onetime in nature, and we sort of gave it a pro forma estimate of that as of Q1 as well. That's not sort of a statement about the allowance build we expect to book. It was literally a pro forma thing for Q1. And the actual allowance will depend on all the things that it normally depends on and includes sort of the Walmart impact. But again, I think that's an impact we'll kind of absorb and move forward, and we'll be happy to have these customers and these accounts on our books.

And if we think about the U.S. consumer at this point, you've talked about the consumer being in reasonably good shape versus historical standards. At the same time, though, we have seen some evidence out there of slowing spend as consumers maybe trade down and are still dealing with the last several years of inflation. So what are you seeing? Maybe you could touch on both spending trends and some of the credit trends you're seeing today.

Sure. Let me start with credit. The strength of the -- we still, I think, view the consumer as a relative strength in the current context of the economy and credit cycle and how they're sort of playing out and how they're likely to move forward. On any historical basis, consumers today are looking relatively good. So I think the biggest driver of that is really healthy labor markets, which have maybe defied expectations and maintaining their strength for so long. We have seen basically kind of modest net improvement in consumer balance sheets in the aftermath of the pandemic. And while the amount is falling on an aggregate basis, customers that we have in both our card and deposit businesses still have kind of marginally higher savings and bank balances than they did before the pandemic. So that's, I think, supported some of the strength. I think wages have sort of softened -- increasing wages have softened the blow of inflation for a while. And in the recent sort of year or 2 have essentially kind of, in many ways, offset it in some of the segments. So net-net, everything looks pretty good. Now persistent inflation over a fairly long period of time, higher-for-longer interest rate environment, it is increasing the cost of borrowing for consumers. And I think there are some very preliminary signs on the margin that are consistent with what you've talked about as some early signs of potential pressure. For example, we have seen a modest increase in the percentage of customers who are making the minimum payment instead of sort of something larger to pay down their balances. But that's not in and of itself kind of a reason to change our view. I think it's just a very early and a fairly modest sign that the intuition that I think anybody would have, a prolonged period of high prices and high interest rates is bound to put some pressure on consumers. But on a credit perspective, the trends we've been seeing across our segments, across our portfolio in delinquencies, delinquency inventories roll rates and extrapolating forward from that sort of charge-off stabilization, are all sort of still very strong and I think consistent with the net view that consumers are in a reasonably good place versus historical context. And then on spending, if you pull up and look at the period of time over the last couple of years since the pandemic, our spending trends have, on average over time kind of outperformed the card market. They've slowed down. We're down to sort of 6% net spending growth in Q1, and that was essentially entirely driven by new account origination. So if you look at it on a spend per customer basis, that's more flattish, which I think is kind of consistent with what we've been talking about after a long period of sustained inflation and high interest rates. So that, to me, looks like consumers behaving rationally, which is kind of a hallmark. Consumers are generally the most rational players as economic cycles play out, and I think the sort of deceleration in spend is consistent with that.

And as you think about the consumer being rational here, you've also talked about credit stabilizing modestly above 2018, 2019 levels. But last quarter, you did call out lower tax refunds as potentially adding a little bit of a near-term pressure point there. How is that playing out at this point now that we've had the tax refunds kind of more fully come through at this point? And any sort of updated view?

So no, not an update, but I think a couple of clarifications. The first clarification is, I think some people got a little confused that we were thinking about this year's pace and amount of tax refunds versus last year, which hasn't essentially fully caught up. The point we were making was actually about the pace and magnitude of tax refunds going back to like 2018 or 2019. And in nominal terms, the timing and overall size of tax refunds in 2024 continues to lag 2019, for example. And if you adjust it to 2019 dollars, the lag [ in the gap ], it's actually even more meaningful. That's the bad news. The good news is that the trend is at least directionally catching up. So there is that. The point we're making was if you're a long student of Capital One credit trends, you know that our seasonal trends are generally more pronounced than the industries. And part of -- a big driver of that, the trends tend to be sort of improvement in the first half of the year followed by some worsening in the second half of the year on a kind of a seasonal powder and all else equal. I think we've seen less net improvement this year, driven by the fact that there have been fewer tax refunds and a lower overall amount of tax refunds compared to pre-pandemic years. And so when a consumer gets a tax refund, that enables them, in many cases, to get current on their credit even if there are several delinquency buckets past due. But if that economic benefit comes to them sort of in 12 -- throughout 12 months of the year as just a slightly higher net pay check, it doesn't have that same sort of credit impact or delinquency curing impact that we've seen. And so we've just seen a little bit less of that in the first half of this year. We believe that at least for this year, the sort of typical seasonal pattern is a little bit disrupted. We're pretty far short of declaring that there's a new normal seasonality. We'd have to see a much longer sort of dataset to draw that conclusion, but we're pretty confident that it looks a little different this year. And that probably affects the net timing and potentially the net amount of what modestly above pre-pandemic means. But I think the salient point and the one that matters most in terms of our internal decision-making and choices is stabilizing modestly above pre-pandemic levels, and that's been a view we've held throughout.

Okay. And as you think about the competition for credit at the point, everyone is still broadly in that tightening mode. But we all know that Capital One likes to zig when others zag. What are you seeing from the competition today? And how are you reacting to that?

So in the domestic card space, I think we're in a position of zigging while most of the other major players continue to zig as well. I think that while there's some tightening and trimming around the edges as there always is, the net position of us and most of our competitors is still pretty much leaning in to origination and growth opportunities in the marketplace. So that's a testament, I think, to the long-term value creation and resilience of the origination opportunity that we and others are seeing at the moment. From a competitive standpoint, that plays out at the very top end of the marketplace as a continuation of a competitive environment that I'd characterize as one that's been pretty intense since the pandemic. And you've seen many competitors kind of increasing the rewards rate. You've seen maybe a tick up in some of the advertising for top-of-the-market products. And we continue and others are doing things like building out airport lounges and creating really compelling value propositions for that very top end of the marketplace. So that competitive environment remains fairly intense. We've probably seen a more moderate sort of consistent competitive environment in some of the other places we play. And on net, we continue to sort of see great opportunities. And as I said, kind of when you look at our choices, the conclusion you draw is that we continue to lean in despite the fact that we are doing some trimming as always around the edges.

And I think you just mentioned a more moderate competitive environment in other areas. What other areas might those be at this point?

Well, we're sort of still focused on places where we've always focused, which is these days, primarily at the very top of the marketplace with heavy spenders and on revolving customers that don't necessarily have very high balances across a number of cards, but sort of more moderate revolve behaviors. That focus begins what I call it the upper end of subprime and through prime. So the one place where we're kind of leaning out and trying not to sort of have a lot of growth is in this cohort of kind of high-balance revolvers.

And what about in auto? We've heard a few others highlight some increased willingness to lean in there. What are you seeing there?

Yes. So auto is, I think, more of a mixed bag. We've seen and heard some competitors kind of leaning in. We've seen some increasing pressure at the upper end of subprime and auto from some of the smaller players and even some of the regional banks. We have seen a couple of larger players may be pausing or moving a little bit the other way. So it's -- there's a fairly dynamic and sort of mixed competitive read, I think, in our view. And when you juxtapose that with our portfolio trends, we've -- as you recall, Jeff, we pulled back really significantly a couple of years ago in the face of kind of industry margin pressures. Those margin pressures have kind of essentially resolved themselves. And when we -- we're kind of looking at three things. Based largely on the pullbacks we made a couple of years ago, we've actually seen very good credit performance that's tracking at or better than expectations is pretty strong relatively in the industry. That creates some opportunity to think about growth opportunities. The competitive environment, as I said, has puts and takes. But generally, it looks like there's some attractive pockets where we could sort of kind of resume more of a growth posture. And Rich told me this one, never sort of prenumber your points because you get halfway through in the first two and you forget the third one, and so I've forgotten the third one. But anyway, on net, we see an opportunity to sort of resume more of a growth posture. And we actually did see year-over-year originations growth in Q1. As you know, we'll have to sort of see that continue for a little while before that translates to sort of loan balance growth. But we're cautiously optimistic. And if kind of conditions and competitive intensity holds, we might see some continuing opportunities there, but we'll have to see how that all plays out. And we really are kind of back in -- back-leaning into selected pockets as opposed to across the auto marketplace.

And as we maybe think about technology, you're well-known for your being what you call the original fintech, I think. And a year ago, Rich was here talking about the AI opportunity, what he described as with all its breathtaking advances at that point in time. So can you talk about how AI fits within your tech stack, how that evolution is going to Capital One today? And where you've been able to take advantage of this tech so far, where you see that going?

Sure. That's a potentially big answer, but I'll take it on. We've talked a lot about the tech transformation we've undertaken over the last decade or more. We've talked about building it up from the bottom of the tech stack up. So in-sourcing essentially all the talent in what I'd call sort of one of, if not the, sort of core function that's going to define competitive advantage and opportunities going forward. So we have literally tens of thousands of software engineers, data scientists and similar sort of technology and digital-native associates bringing that capability and that advantage in-house. We've rebuilt our data infrastructure and our technology infrastructure. We're essentially 100% on the public cloud. We've got data streaming in real time. We're probably the only financial institution that I know of in the United States, at least, that's actually done that full of a transformation to be a modern technology company and also be a financial institution at scale. And I think that puts us in a really unique and strong position to take advantage of the sort of emerging benefits and trends and things like AI. So we were already, based on that sort of tech capability, applying machine learning and artificial intelligence at scale in some of the core processes of our business. It's informing and driving our underwriting models that are looking at way more data and way more algorithms. It's informing and driving our marketing and targeting models, which are getting ever more precise and effective, which tends to sort of offset the sort of otherwise kind of competitively rising pressure of things like cost to acquire. We're getting way better compliance outcomes. We're driving efficiencies as we kind of discontinue analog processes and replace them with sort of end-to-end digital processes. We're a faster time to market. All those things are happening today, and a lot of it is on the back of machine learning and AI at scale. And that's a slightly different thing than generative AI, which is where a lot of the sort of current excitement lies. But I think we're equally well positioned to take advantage of those benefits as they are generated in the marketplace. And as the focus of the world turns to sort of how generative AI can be applied into business context, we're going to, again, I think everybody is going to benefit from that to a certain extent. Everybody can sort of leverage the capabilities of a ChatGPT or a Copilot kind of AI, generative AI-driven product. But I think you really have to have that modern tech stack, that modern data infrastructure and that sort of focus on technology and digital transformation as a core capability to fully drive the benefits of generative AI into the core processes of the business and how you come to the marketplace and make decisions and choices as opposed to sort of seeing it kind of on the periphery and sort of gradually working its way in. So I think we're uniquely and certainly very positively positioned to sort of take advantage of that as it plays out. And it's one of the things that's most exciting about Capital One. I'd also be remiss if I didn't point out that one of the key sources of that game-changing value that we started with, it's the combination of the network, business relationships and scale that Discover has built with the technology capabilities and digital capabilities that we've built in combining those two things is really what creates a lot of that sort of game-changing potential. The ability to apply that investment that we've made and the benefits over a much larger enterprise drives both a bunch of sure-footed sort of near-term benefits like the synergies and that sort of long-term upside opportunity. So I don't think we'd be talking about the Discover opportunity if not for the technology capabilities that we built over the last 10 years.

And just one on capital. So can you talk about how you're thinking about capital return from here? I understand you do have some deal-related blackout periods in a near-term dividend cap. But are you waiting for a little bit more clarity on capital rules or the pending deal before you think about any kind of meaningful increase in buybacks at this point?

So I think to your point, there are some technical considerations around share repurchase blackout dates, driven by sort of the proxy being in effect and other things that are going to come into play along the approval process, which would sort of largely keep us or maybe even from quarter to quarter be a little bit below the trajectory we've been on, which is fairly modest, sort of regular quarterly level of repurchases. I think what we've said all along is still our view, which is we continue to be watching largely for things like the final resolution and implementation of Basel III regulations and how that's implemented specifically for U.S. institutions. We'd like to get through at least one more CCAR cycle and see how that plays out. And we continue to have an eye on kind of inflation and how that might drive sort of economic trends going forward juxtaposed to the kind of continuing organic growth that we see. So there are a number of things that we're kind of watching and assessing, and that continue to have us be a little bit more comfortable running above our long-term CET1 equity ratio target so that we're prepared for a number of eventuality, some defensive and some kind of offensive. But the net of it is I don't think we're going to want to run with excess capital levels forever. And I do think that over the long term, returning pretty significant capital to shareholders is going to be an important and continuing part of our value proposition to investors. But for the time being, watching some of those uncertainties play out and the sort of current trajectory is probably more we're likely to see.

And then just real quick on CCAR. We have the results coming up in a few weeks. To us, the variables this year, the test looks pretty similar to last year. Any sort of nuances for Capital One to be aware of?

Nothing. I think we'd probably wait and see how the Fed's modeling comes out before we have much to say about that.

Got it. And just one last one on maybe wrapping up here in the late fee rule, probably your favorite topic of discussion but..

I love all the topics, Jeff.

Yes. And you've got some offsets out there already, but it sounds like you're holding on -- holding off on most of them at this point until the rule is actually implemented. Maybe just speak to any opportunity -- I mean, any examples you've actually taken so far, of actions you've taken so far, what the response rate from consumers has been like so far on that?

Sure. So what I'd say about the CFPB late fee rule is we, just like everybody else, continue to watch a fairly uncertain environment play out as it sort of bounces around in sort of litigation and so forth. What we've said all along is that if and when it does become a rule and gets implemented, that will have a significant negative impact on our revenue and that our responses are likely to be focused on things like product changes, policy changes and investment choices. I think the nuance is, I don't think it's quite right to characterize it as we're just kind of wait and see what happens. We're in a far more active mode than that. But rather than take a bunch of preemptive actions, what we're really using this time for is more testing. Because in addition to sort of a revenue impact, we believe that the implementation of this rule would have a pretty meaningful and significant impact on the marketplace, things like competitor and consumer behaviors and things like volume and credit. And we're doing what we can to test some of those outcomes now. There's only so much you can test at this stage. So we will want to sort of see kind of how these marketplace effects begin to play out after the possible implementation of the rule. But the combination of the testing we're doing now and sort of the marketplace impacts as they play out are going to dictate choices that we make. And when we make those choices, we're going to be working back from that context and the sort of goal or objective function of really preserving the value of the customer franchise that we've invested for years to build. We believe we've got a loyal and valuable customer franchise. We've worked really hard, in essence reducing the kinds of fees and the levels of fees so that we're down to only 2 in the credit card space, and we have probably the most simple products in the industry. We believe we're getting paid for that now in the form of higher growth, lower attrition, better credit selection. And we want to continue to sort of reap those value-enhancing benefits. So we're going to work back from that. We're going to work back in the context of testing the marketplace effects of how this thing works. And when I pull all of that together, I still think we're going to be in a place where we've essentially resolved the negative impact on a P&L basis in a couple of years.

Okay. Great. Well, Jeff, I think that's all the time we have for today. So thank you for coming, and please join me in thanking Jeff.

Thanks, Jeff. Thanks, everybody.