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

Up next, we're pleased to have Capital One, who's been a staple at the conference for many years. It's been a busy year at Capital One, highlighted by the announced acquisition of Discover, which is expected to close in early '25. In addition, they've continued to deliver best-in-class growth and has had peer-leading credit performance across Card and [indiscernible]. Here to tell us more where we go from here is Chairman and CEO, Rich Fairbank. Today's presentation is going to be a fireside chat. Rich, thank you for joining us. I think this is our 15th straight year of doing this. And I think each one of them, we've actually started a similar way. So maybe let's start with the state of the consumer.

You noted that we saw some softness for a period of time as the cumulative impacts of inflation weighed. Recently, we've seen things start to level off and signs of stability. So can you just start off with what you're seeing in the consumer and how you think they're positioned as we move into 2025?

Thank you, and Ryan. It's great to be here. And it's always a highlight for me to come to this conference. Thanks, everybody, for coming, and thanks to those of you listening in on the webcast. So I think the consumer is a source of strength in the economy these days. I think it's been that way for quite a long period of time. But let's just kind of pull up with respect to the consumer. The labor markets are, I think, in a very strong place. The consumer has -- wages are now finally growing in real terms for consumers. The debt burden or the sort of essentially, debt -- consumer indebtedness. Hey, Jeff, how are you -- indebtedness as a percentage. Thanks for coming along -- of their income that is at very stable levels, consistent with pre-pandemic and on a historical perspective, actually kind of on the low side. You also have -- the savings rate is still pretty healthy, assisted by a recent revision in the savings rate number. And the savings levels, sort of deposit levels for consumers are pretty strong and higher than pre-pandemic. So if we pull up, I think the consumer is in quite a good place. This has been a story for a number of years. Obviously, our business is very focused on consumers and providing credit to consumers, but we continue to be positive and are leaning into this opportunity.

So maybe to build on that, you noted at earnings, that credit performance has been consistent with seasonality and settling out, but obviously, at levels above pre-pandemic. I think you've been pointing to certain factors, lower recoveries, cumulative effects of higher inflation and rates and also this delayed charge-off impact. As you look ahead, where do you think the card credit is headed? And how do you see these variables impacting your performance?

So let's just pull up and talk about where credit is and where charge-offs in the industry are and think about that pre-pandemic. If all I knew about was the economy, I would think that consumer credit should be pretty consistent with what I recall, economic conditions were back in the pre-pandemic time period. But yet, charge-offs are quite a bit higher these days for Capital One and for the industry, higher than pre-pandemic. And let's talk a little bit about why that is. The first thing I want to say, though, is that credit is very much settling out. So for a long time, credit was -- during the pandemic -- was at never seen before, good levels. Then we had the sort of great normalization and credit was rising almost vertically for a while, and we were all looking to see where it would settle out. And I think it's very clear that credit -- and I'll certainly speak from Capital One perspective, very clear, that credit has settled out, and that we've been seeing this effect for the course of the whole year. So -- but why is it settling out higher than pre-pandemic, even though the economy is in such a good situation? There's really just a couple of drivers of this. One is sort of a mathematical thing, and that is that recoveries. Recoveries of charged-off debt are running at -- have been running at much lower levels than pre-pandemic, and that is because the inventory of charged-off debt is substantially less because of the pandemic. So if you think about recovery levels is driven by the amount of inventory to recover on and the rate of recovery, the actual recovery rate is running at or a little bit higher than pre-pandemic levels, but the inventory amounts have just been lower. And so that has led to just lower recoveries and therefore, gross charge-offs as they turn into net charge-offs, that recovery deduction has been lower. Now the good news is -- or sort of the flip side of the normalization of credit is the inventory is returning back to normal levels. So therefore, this recovery brownout, if you will, is running its course and should sort of really diminish as a factor. The other important driver, I think, of why charge-offs are higher than they were pre-pandemic is the delayed charge-off effect from the pandemic. So if we go back to the pandemic, we had an unprecedented government stimulus and forbearance for consumers' financial payments and even their rent payments. And so there was a massive surplus that came to consumers. And for many who may have been on the verge of charging off, that was a lifeline that allowed them to sustainably stay out of trouble. But I think for a number of consumers back in the pandemic who were in a vulnerable situation, this might have tided them over for a while, but maybe their underlying circumstances are still the same. And so we are probably seeing charge-offs that otherwise would have happened earlier, play out on a delayed basis. And if you think about the area under the curve of the -- think about charge-offs and what they would be in a normal economy. The area under the curve is an enormous area under the curve of charge-offs that didn't happen. We're not at all saying that, that whole area under the curve is going to play out on the other side of this. Some subset of that whole area, I think, will play out on the other side. But I think it's an important factor in why charge-offs in a very pretty strong economy are running at the levels that they are. And one of the problems of the delayed charge-off effect is while we can intuitively believe that it's happening, you can't measure it. And so therefore, it's something that we're going to have to live with just a little bit on an intuitive basis. Now one way it manifests just to just kind of saver this one point is, we see another effect going on, which is sort of the difference between what's happening on average versus what's happening at the margin. And credit plays out. Credit losses play out by things that are happening at the margin. So when we look at a very important metric that is an indicator about credit for us, which is payment rates, which is the rate at which people, each month, pay on their -- relative to their balances. The higher the payment rate generally, the better the sort of credit indicators there are. We are running at Capital One on notably higher payment rates than we saw pre-pandemic. So that's a thing on average. At the same time, we are also seeing the percentage of people who are paying a minimum payment is also higher, which would suggest some stress at the margin. And I think in a sense, this is probably the way that the delayed charge-off effect is manifesting itself. So that effect strikingly, one might think we would be seeing on the low end of the market. It's actually something happening more in the sort of the middle of the market. It's not a huge effect. It's a small effect, but it probably explains a little bit why it is that the elevated charge-offs are playing out.

So maybe we'll get Jeff involved in the conversation a little bit here. So the allowance rose for 8 straight quarters as credit losses were increasing. Obviously, things have started to settle out. So the question is, in a more stable macro, have we seen the peak in the allowance? Then what will it take for it to actually start to come down?

Thanks, Ryan. So I have to start with a caveat, which is we're never probably going to put -- find ourselves in the business of calling peaks. But I think you recap kind of is the answer to the question. During the period of normalization that Rich was just talking about when we saw charge-offs and delinquencies worsening, we were making additions to the allowance. As we reached this place where we started to believe there was stabilization, but we weren't sure, those additions to the allowance tended to level off. And then last quarter, when we had a much stronger conviction that the new seasonality was a real thing and that we were, in fact, in a period of stabilization, that sort of unlocked the ability for a fairly modest allowance release. So our conviction remains high and if we continue to see the improvement trend in delinquencies, that could provide an environment where we see some further releases from the allowance, but we'll have to see how those things play out. That's why we always encourage our investors and analysts to look at the delinquency trends because while there are a lot of things that go into the allowance, the macro and growth and so forth, the single probably most key indicator of the direction of travel for both the credit metrics and the allowance balance is probably delinquencies.

So Rich, purchase volume in card was up about 5% in the third quarter, and I think you've been highlighting that a lot of the growth has been coming from new accounts. However, you recently noted that while same-store sales has been flat, it's actually begun to uptick a little. We had American Express here this morning, made some upbeat comments about spend. Maybe just -- you have a great view of the consumer of all different types. Can you maybe just talk about what you're seeing? Obviously, you've had a big move up into the top of the market in terms of -- to drive growth. Maybe just talk about what you're seeing in terms of some different cohorts.

So it's really striking in the credit card business, if you stand back and think about when the pandemic came along, there was a pretty dramatic pullback in purchase volume. But since then, obviously, consumers have sort of come back and then some. But I look at Capital One's purchase volume, and if I recall the number properly, our purchase volume versus pre-pandemic is 45% higher. And now that's not because each consumer is doing that. Obviously, much of that is Capital One's growth. But I am really struck by just how much momentum there has been on the purchase volume side sustainably over several years here. And a bunch of that, again, is things that are maybe specifically going on at Capital One. If we look behind the 5% purchase volume growth year-over-year that you referred to, Ryan, we actually see that spend per consumer or per customer is basically flat and that pretty much all of that growth is coming from new originations. We also saw that the -- any weakness that we saw on the purchase volume side was coming at the lower end of the market. And so some -- in the earlier months of this year, the folks on sort of the lower end of the credit spectrum at Capital One were a little under. They were sort of going backwards a little bit on that. We've actually seen that trend reverse and they now have moved to the positive side a little bit. So we -- the general takeaway I would have is, though, that things are pretty stable on the purchase volume side on a per customer basis, and it's really all about growing the business.

So Rich, it's been about 10 months since you announced the Discover acquisition, which will hopefully close in the first quarter. Well, I'm sure you've been busy working on getting approvals for the deal. As you've had time to reflect on the decision to acquire Discover? Does it feel any more or less compelling of an acquisition versus the announcement time? And why so?

So this is a deal that when we announced it, we said this is really going to be strategically a game changer for Capital One. We obviously -- when we announced this deal, we're very excited by the possibilities. Since then, we continue to be very excited. What we see -- we haven't gotten a chance to get inside and take a very deep look at Discover because they're still an independent company and a competitor. But we -- everything that we can see, and we also have been hiring a lot of experts to teach us about the network business and learning everything that we can about that one part of the business that we don't have -- didn't really bring any initial experience into. We continue to be very excited about the deal and what we expected going in is still pretty consistent with what we feel at this point. So we feel it's an opportunity to bring more scale in the credit card business, give a boost to our banking business. And, of course, bring a whole new dimension on the network side.

So maybe to dig in a little bit further. I think at earnings, you talked about you now expect to hopefully close in the first quarter versus the prior expectation of late '24, early '25. Maybe just any update you have on things that are progressing? How are you dealing with the issues that may have caused the delays? And any sort of thoughts on the timing from here?

So we have completely -- we finished submitting everything that we need to do for the banking regulators. It's the OCC and the Fed that are the decision-makers in this deal. That process continues to move along in a natural way. We also are engaging with the Justice Department, which has an advisory role to play relative to the competitive aspects of the deal. So in terms of the Capital One side of things, things continue to move along well. Obviously, on the Discover side, there's been a bit of a challenge with the SEC, and the SEC has asked Discover to, in fact, do a -- file a restatement of their financials relative to their issues that they had on the network pricing side. So the key thing there is, while that caused a delay, there's no impact to the cumulative earnings or the capital of Discover. Discover announced a couple of weeks ago that they are expecting within this year to do the refiling with the SEC. Then when the SEC approves that, the 2 companies will put out a proxy, and then it's about 40 to 45 days from there that there's a shareholder vote. And so we're talking about in the early part of next year.

Got it. So Rich, when you originally announced the deal, you referred to Discover's payment network as the holy grail. Can you maybe just talk about your aspirations for the network? I know you talked about you're hiring experts to learn about it. Do you have any sense of what type of investment it's going to require? What are the different strategies you might consider to build out the network? And is the end goal to have all of your volume on the Discover network?

So the network is a -- we've used this term a rare and valuable asset. So when you think about this, there are so many financial companies, so many credit card companies. But in the United States on the credit card side, there are only 4 networks. There's Visa and Mastercard and then, of course, American Express and Discover. And if you really look worldwide actually, there really aren't a large number of issuers who are also networks. So this is really a unique thing from a strategic point of view, both by the fact that an issuer can be a network, but also just because in this very critical piece of the incredibly important payments value chain, you have just those 4 players. And of course, we all know the really strong position, Visa and Mastercard is in and American Express does a beautiful job as well. So we look at this -- the network as this piece that connects a credit card issuer with all the merchants out there. And we, as a company that independent of this, have worked so hard to build a direct access and direct relationship with merchants to bring our 100 million customers and the benefits of our 100 million customers to merchants and who are trying to drive more volume and we are trying to get better deals for our customers. There's a whole -- there's an incredible sort of business opportunity connecting a huge credit card franchise with a massive network of merchants on the other side. So independent of this and well before it, Capital One has really been leaning into this with things like Capital One Shopping, for example. So we've always just been very focused on really trying to connect directly with merchants. So let's pull up and think about this network business. There's a reason there are a very small number of networks. It's a massive scale driven business, and it's a chicken and egg problem. If anybody wants to go out and create a network, you go to the merchants and say, "Would you like to sign on?" And they say, "Well, what customers do you have?" "Well, none yet, but we'll start with you," and you go to the customers and wait what merchant accepts it. "Well, none yet, but we're starting with you." It's kind of a miracle. How did any network get started? You had to be there in the window when networks were created. And I have just marveled at what an incredible job strategically that Discover did led by Phil Purcell way back when it was Sears back right at the time. Also, the founding time of Capital One, they were out creating this extraordinary thing. So through several different kind of financial owners, they finally spun off in 2007, memo-ed himself, 2007, don't spin yourself off into, but they did a great job. But when we look at this incredible franchise that they have built, they have -- right at the heart of it, this network that is as I kind of -- the term I would use, our Card business is really scale-driven. A network business is desperately scale driven. And Discover has this incredible gem of a business, but they just didn't have enough scale of their own to really turn it into what it could be. And over that period of time from 2007 until today, their market share on the credit card side has gone from 6%. The network volume share from 6% to 4% in a business where scale matters so much. So Capital One, I think it's a unique opportunity for Capital One to come in and bring the assets and the scale that we have into a beautiful gem of a business, but something that really needs scale. Now it's not as easy as it might sound on the face of it to say, wow, with all of Capital One's volume, you put these companies together. That's really quite a powerhouse. There are a number of challenges that we're going to need to invest in, in order to put ourselves in a position to get the most volume that we can onto this network. And one challenge is acceptance. Domestically, Discover has amazing acceptance. They -- and I marvel at how a franchise, without that much scale, pretty much has universal merchant acceptance in the United States. Internationally, they've worked backwards from getting acceptance where their customers spend. But in terms of ultimately a big spender franchise, one needs quite a bit more international coverage. So we would need to invest in that. The other challenge is that despite having universal acceptance domestically, they don't have the brand perception of universal acceptance domestically. And before we did the deal, we did the research where we, first of all, asked Discover customers and Mastercard and Visa customers and all this stuff, asked everybody, "Is your card accepted everywhere?" And it was just -- and the Discover customers is like, absolutely. But when we asked noncustomers, there was this belief that Discover is not accepted everywhere. Now any brand person I know would say, give me a good reality and we can build you a good brand. Don't give me a bad reality and ask me to like do a lot of ads and turn it into a great brand. So our view from -- even before we did the deal and it's confirmed here, we love their underlying reality of acceptance. What we need to do is go out and build the network brand credibility. And in a sense, this is a utility that's going to be accepted everywhere. We believe that's a very doable thing. You probably noticed Capital One spends a lot of time and investor money on branding, and so we're excited for that challenge. But therefore, if you pull up, we've got this gem of an asset. We really got to drive more acceptance internationally. We really have to build the brand. And then we're also going to do a lot of testing, once we get on the other side of the deal to see how customer reaction to various things. Existing customers, new customers, putting them on the network because we want to make sure this is a very good customer experience. So with those investments in that testing, we'll then move business over there. What we announced at the time of the deal was -- and we -- this is still our expectation that we're going to move 25 million customers, which is a lot of scale because it's not just purchase volume, but when you show up at merchants, it's like how many customers are running around with these cards? 25 million customers and $175 billion of combined credit and debit card debit card volume. That's going to comprise all of our credit -- debit volume, we're going to move it all over there and some of the credit card volume. Why are we moving all the debit volume over there? Discover as -- is in a very good place with respect to their debit card network because they have not only the Discover, shall we say, signature debit network, which you know is sort of the credit card network. But they also, in a brilliant acquisition in 2005, bought the Pulse network, which is really one of the nation's leading PIN debit networks. So on the debit -- which also has a bunch of coverage internationally. So on the debit side, they're in a really good place. We're going to pick up our debit card business and move it over there and continue to lean into growing our national bank and therefore, our debit business. On the Credit Card business, the move is going to be more surgical and starting with folks that are probably less on the international travel side. And in certain other things, we're going to crab walk our way, move lift in one leg at a time, so to speak. But that's how you get to the $175 billion to start with. And then as we continue to invest in the strength of this network and the brand of the network, we hope to move a bunch more volume over time. The other thing, just to your question, Ryan, I do want to say that Visa and Mastercard are amazing franchises. You all know that. And we have a wonderful relationship with Visa and Mastercard. And at the high end of our franchise, we continue to believe that Visa and Mastercard play a very important part in Capital One's future, but that we can build a network and a network story that over time can take more of our volume.

So maybe I'll ask one for Jeff. That was a very insightful answer, Rich. I guess, obviously, a lot has changed since the deal was announced. Maybe just any updated thoughts on economics of the deal, if they've changed at all? And how do you maybe think about destination returns or earnings power over time, Jeff or Rich?

Well, I'll give you the hard one.

Yes. No kidding. I'll start a little bit with what has changed. I mean, over 10 months, lots of things change. And in our initial deal model, we took some great pains to sort of think through a wide range of scenarios when we made our estimates for synergies and so forth. So I think we're very much still within the ranges that we thought about. And while some things are coming in a little bit differently, some are coming in a little bit better, some are coming in a little bit worse. And it's all sort of in a place where we're still extremely comfortable and confident with the estimates we made in the deal model. And when we get to closing the deal, we'll provide appropriate updates at that point in time. And I'll let Rich talk a little bit about destination economics.

Well, we believe that we've built Capital One. If you think about Capital One, having built this sort of in the modern era, we knew we couldn't be -- we couldn't do what most banks do, which is to do everything. We knew scale mattered massively. So we chose very carefully what businesses we're going to be in. And we worked backwards the businesses that have really good structural economics and also, strategically very attractive as a combination to build a winning franchise. And that's why we built the businesses that we're in. We're leaning really hard into credit card, really leaned hard into building a national bank. We've got a great auto business and a few things around the edges and now a network coming our way. Part of what drove that choice was to make sure that we chose businesses that had good structural economics to them, and there were reasons behind the good structural economics. So as we bring on now the Discover business, that's a business that collectively has good structural economics, and they've demonstrated that. And now we can get scale, more scale and some synergies along the way. At the same time, we know that there are really a number of things we're really going to have to invest in, and we'll share all that with you. But when we pull up and think about the combination, we think one of the really most attractive aspects of it is the inherent earnings power of the businesses we're in as a structural matter and the actual franchise that we're building as a specific matter.

I guess maybe one last question maybe. Once this deal closes, obviously going to be rich with excess capital. And you've talked about closing somewhere around 14% and then managing down to 12.5%. Just maybe your updated thoughts on how you think about returning capital to shareholders over time.

So one sort of modest correction. I'm not sure that we'll manage down to 12.5%. 12.5% was just the end result of the deal model. Our current long-term target is still in the 11% range for CET1. Until the approval process plays out, I wouldn't expect much change in our capital distribution strategy. Upon conclusion of the approval process, will essentially be back on the stress capital buffer regime. As a combined company, we would expect to do an internal sort of bottoms-up stress test and at that time, sort of figure out what the combined company capital need is. But I think we're on pretty safe ground to say we're going to find ourselves in a pretty strong excess capital position. And I think it's -- that served us well. It's -- there's a level of prudence to that, that has served us well through our history. And I do think that there'll be opportunities for us to sort of increase capital distribution at that point in time. I wouldn't want to set any particular expectation about how much or how fast, other than to say that it's not lost on us that generating and distributing capital to shareholders is a long-term part of our value proposition for investors. And I think that will still be true as a combined company.

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