Capital One Financial Corporation ($COF)

Next with us today is Capital One. With us is Chairman and CEO, Rich Fairbank. Along with him is his Head of Finance, Jeff Norris. Rich and Jeff, welcome.

I've been promoted.

So Rich, maybe we can start with the tech transformation story here at Capital One. I believe you began that in 2013. How has that transformation unfolded? Where are we today? And how is it positioning Capital One for competitive advantages across your enterprise?

Great. Thank you, Jeff. Thanks, everybody, for being here in person and also on the webcast. I don't know how many years I've been doing this Morgan Stanley conference, but I'm not sure I've ever missed. So it's great to see everybody. Thanks for the question on the technology transformation. So I think back to the founding idea of Capital One back when I was 36 years old was the belief that technology and data and statistical modeling, scientific testing, we're going to transform an industry based on judgmental decision-making. So we built the battle cry that we had back then was build a tech and data company that does banking, competing against banks who use technology and data, but it's not who they are. So it dialed the clock forward, we built a company on this strategy. And then in 2013, we realized that we were on the wrong side of history that while the strategy still made a lot of sense, the world had changed so much from a technology point of view and where AI was going that we needed to rebuild the entire company from -- and importantly, from the bottom of the tech stack up. And our battle cry then was build a technology and data company that does banking, same battle cry, but we needed an all-new infrastructure. And so what this transformation has entailed, and it has been all in from 2013 on. So we're in the, what, the 14th year of this journey, and I literally mean all in. The key elements of that have been massive bringing in of the most modern technology talent, competing head-to-head with the world's leading tech companies for talent. Additionally, going 100% into the cloud, we got out of data centers in 2020, transforming our data ecosystem. This is the biggest and hardest piece of a journey and -- but transforming the data ecosystem where data can be infinitely scalable and able to be managed with the data management built into the technology and also then data easy to consume on the other side. So a huge effort there. We have rebuilt the company in modern -- not just in modern technology, but in enterprise platforms so that we are able to invest very heavily in platforms that for the critical functions that we have in the company. And so we have invested heavily there. It's been a journey of transforming how we build software to collaborating very closely with the world's leading tech companies and how they build software, very much building the same kind of capabilities with automation. Capital One is now -- vast majority of all of our application components are serverless and continuing to drive toward the destination of continuous deployment. And then also a big investment in AI. And I want to say that AI is the buzzword of the day. But when we did our tech transformation, we were working backwards from the -- where we said the world was going is to leveraging massive data and AI in real time to create instant solutions one customer at a time. And that was what we worked backwards from. So now as the AI revolution has continued to unfold, it has played, I think, very well into the technology infrastructure we have at Capital One. Now where do we see the benefits? One thing I want to say about a tech transformation is I want to contrast it to almost everything else in business, where when a company is saying, it is strategically figuring out where they can be -- build something great in the long term. Typically, you have to choose what it is that we want to be down the road and go invest to that goal. What I find the thing that's so different in this case, depending on whether a company says, we want to be the lowest cost and we want to have the best customer experience or to have the best risk management or the best growth opportunities, my belief is any of those objectives, it's the same path to get there. And that path is the path of rebuilding a modern technology stack driven by modern talent. And so we have done that journey, and we see benefits across all of those objectives. So just on the cost side, while I wave my arms a lot and talk about all the things that we're investing in, in a sense, my right hand is investing very heavily in a lot of things. But on the other hand, I want to talk about the left hand and what's the financial benefits that we're getting along the way. So going all in on the cloud has been tremendous economic savings. Along the way, we have moved away from many legacy technology vendors and saved a lot of money along the way. The operating cost of our retail bank is dramatic reduction in operating costs. The per account servicing costs in our card business, we've had a dramatic reduction there. When we look at our technology costs overall, the run-the-engine costs are only very growing very, very modestly, while the overall real tech costs are growing quite a bit. Therefore, the -- one of the holy grails and the economics of technology is you want to be able to have a maximum amount of technology investment in new capabilities and not running the engine. The running the engine cost at Capital One as a percentage of tech costs have declined dramatically over time. Fraud costs -- in an industry sort of being eaten alive by fraud, fraud cost per account at Capital One are significantly down over time. And these are just some of the examples of -- on the left hand, there's so much economic saving coming out of the tech investments. And of course, on the right hand, we are leaning in and investing in going further down the path of tech modernization and pursuing great opportunities on the shoulders of this tech investment.

All right. Great. Thanks, Rich. And I guess related to the tech investments you're making, it's been a little over a year since the Discover deal closed. You've talked about the debit conversion benefits already showing up with some more of the expense synergies weighted towards 2027. As you think about that integration, all the tech spend you put into the model, what's gone better than expected? What's proven more complex? And maybe you could just give us a quick view on how you see the trajectory of your expenses and efficiency ratio going from here.

So the integration is going very well and strikingly consistent with, I think, what we anticipated upfront. So we projected synergies sum total of revenue and cost synergies to be $2.5 billion. And now way down the path of this deal, that is still our current estimate as well. On the revenue synergy side, we are mostly there because we have completed the 100% conversion of our debit portfolio over to the Discover network. The cost synergies are mostly still to come because most of it is tied to technology conversions, and that is more of a 2027 thing. So we look forward to that. But all of that is going quite well in terms of the timing of the whole integration. We projected getting the vast majority of it done sort of by midyear 2027, and that still is what our plan is. So I think we feel very good about the integration, and we're very appreciative that we have the tech stack that we have to be able to bring the -- bring Discover on, just as an example, for example, and it links back to your earlier question about the benefits that -- the many different types of benefits that come from having a modern tech stack. But just as an example, first of all, just the ability to pull off the Discover integration in the kind of 2-year time frame is massively assisted by having a modern tech stack on which to put Discover's business on there, but also along the way from a customer experience point of view, there will be no requirement to reissue cards, have a new card number or even new login credentials. This is kind of unheard of in integrations of -- in the purchase of card companies, but that comes compliments of the tech transformation at Capital One. And then with respect to the -- how we felt about the economics, the earnings power coming out of the other side of the Discover integration because we knew in buying Discover that we had just raised the earnings power of Capital One significantly. And the -- what we felt -- the earnings power defined by ROTCE that we estimated at the time of our announcement, we feel -- now -- even now, even though so many variables have changed along the way, we feel is -- our current projections are very similar to the original estimations. And that's pretty striking because along the way, we have had a significant sort of increase in the investment agenda of Capital One to pursue the many opportunities we've talked about and build capabilities. But along the way, the earnings power is still intact.

All right. Great. And you brought up a point around not the transition to Discover being rather seamless given your tech investment. You're testing out new originations. You fully -- you're planning to fully transition by the end of September. How do you -- how quickly do you think you can re-ramp that platform once it's up to speed or on your platform?

When you say, can you go back to the fully transition by the end of September...

I think you had mentioned originations being on your platform by the third quarter.

Okay. Yes. So we're talking about -- right. Just when we talk about -- we're talking about Discover coming on to our platform because there are all these things also, of course, Capital One is going on to the Discover network.

Not the network [indiscernible].

But with respect to Discover coming on to our platform -- sorry, yes, the originations will be -- the originations will be fully there by September and the back book by January.

Okay. Maybe just switching to the consumer health. I mean, this has been a pretty big topic on investors' minds of late with higher gas prices and the like. I think you've been known as someone who's been able to kind of identify early turning points in cycle. So against this backdrop, what are you seeing from your consumer today? And what are some of the leading indicators you're watching the most closely right now?

So if we just sort of read the news every day, we would have a very negative outlook for the consumer. But I would say if we didn't read any news and all we did was just really look at the data that we see in the economy and the data that we see on our portfolio, we would have a -- we have a really quite positive view. So let me elaborate on that. First of all, with respect to the consumer and the economy. I think the consumer is that the -- really the strong shoulders the economy stands on. But unemployment continues to be very strong. New job creation, I think, really surprised economists over the last few months. New unemployment claims are lower than they were a year ago. The debt servicing burden of the consumer is consistent with pre-pandemic. Consumer continues to spend at pretty high levels. So I think in that sense, things are strong. The obvious elephant in the room is the -- is oil prices and ultimately inflation. And if we think about inflation for a minute, everybody knows that a credit card company is a bellwether with respect to how the economy is going. And so often, the conversations are about unemployment. And unemployment, you can see just directly links to charge-offs on credit cards and other financial products. The unemployment is experienced by a small number of people in a very extreme way. Inflation is experienced by everyone, each in a more modest way, but yet it's a thing that impacts the whole portfolio. So we believe inflation is an important driver of ultimately the credit health of the consumer. So we are certainly watching with a wary eye toward what happens from an inflation point of view. Let me turn and talk about credit performance. So I'm going to start with the industry and then talk about Capital One. The industry -- and I'll just really speak about credit cards. The industry is, I think, doing quite well with respect to consumer credit. In the 20 -- if we compare to pre-pandemic as a baseline, the credit card industry in the originations in 2021, 2022 and 2023, those originations, it turns out, ended up being significantly -- having significantly higher charge-offs than equivalent vintages pre-pandemic, speaking of the industry. It turns out Capital One -- over those same vintages, Capital One is -- was basically at -- our originations were consistent with pre-pandemic. So there were choices that Capital One made at the time, particularly looking with alarm at the credit score inflation that was going on and intervened on our business to adjust for what we thought were unsustainable credit scores, and that allowed us to end up with results that stayed pretty consistent. So the industry, I think, learned a few things the hard way. But if you look at what's happened recently, I think for the whole industry, credit has kind of settled out and maybe coming in a little bit at least consistent with seasonality, if not slightly better recently. If we look at -- come back to Capital One during this period, the last couple of years, our vintages originated in -- yes, in 2024 and 2025 origination vintages they're actually coming in a little better than pre-pandemic and therefore, a little bit better than the '21, '22 and '23 vintages. So the data that we see shows certainly a consumer, I think, that's in a strong place, but then there's a Capital One effect for choices that we've made and probably the some of the technology and modeling innovations that we've had that have allowed us to have particularly strong performance over this period of time. The final thing that I would say is when we look at delinquencies in 2026, what we're all -- we're looking -- because the credit business and the credit metrics are very seasonal, we look at seasonally adjusted delinquencies. And our combined Capital One and Discover portfolio has pretty consistently through April performed a little bit better than seasonality, which is very good news. Now what's the cause of that? Is that an indication that things are getting better? Or is that a tax refund effect? It's hard to tell. We have pulled out our magnifying glass to look at tax for the tax refund effect. And there are a few things that we see that suggest to us that the beneficial credit that we're all observing is probably not -- it's probably transcends a little bit the tax refund effect. But one thing is when you look at who's getting the tax refund, that's very sloped by income, and it's mostly coming to the higher income folks. So secondly, when we see tax refunds typically, in the past, when we've seen a surge in tax refunds, we've seen people who are delinquent, a higher proportion of them actually make larger payments because they now have an influx of new money, and we're not seeing an outsized effect of that. And the delinquencies we have seen in January and February, which were better than seasonality, happened before most of the tax refund effect was even coming anyway. So if I pull way up, I think at the margin, there may be just slightly good news emerging on the credit front, but all that in the context of a consumer that we think is in a pretty stable place and performance across all of our metrics that indicates the combination of the consumer and the choices that we're making in a good place. And therefore, we're leaning into growing the business.

You've also had Brex now for a full 2 months since closing that deal. Last quarter, you mentioned you'd start leaning in with some marketing dollars as you test and learn with an ability to grow almost immediately. So any early learnings from that experience so far and where -- how you think that supports your long-term vision to compete in the SME market?

Yes. Let's pull up and talk about Brex for a minute. Let me go back to the business card marketplace. Business card marketplace has 2 big segments in it. One is the personal liability card, what we also call the small business card, but that's where the business owner is personally liable. So it's just like, in a sense, a consumer card. And then you have the corporate card, which is a corporate liability product and the business owner is not personally liable there. Brex is in the corporate liability business. Capital One is a small player, but we are a player in the corporate liability business. In the personal liability business, Capital One is one of the top 3 players in that business. Both are trillion-dollar industries, both have very nice growth rates. They're great businesses to be in. Years ago, we watched with great admiration at what Brex had created. And we looked at it and said, this is obviously the strategic -- what their insight and what they created is the strategic destination for businesses, small all the way up to large corporations like ours. And that is -- that an industry that had heretofore and still for most of the industry to this day, a single need of a consumer to manage their -- of a business owner to manage their -- how they spend their money has evolved into 3 different markets. So the current marketplace has an expense management solution. It has an accounts payable solution, and there are other players in that marketplace. And then you have the credit card marketplace as the third, still with the different providers there. The beautiful Brex insight was that this is all part of one solution. And not only are the current players bringing unintegrated solutions, they're also bringing old tech along the way. So Brex brought modern tech, put it into one incredibly easy integrated way to manage your spending in a company. And so that's the killer app. We looked at it years ago, said that that's coming to businesses large and small. We were down a path of building these capabilities ourselves, then the Brex opportunity came. We did the acquisition. As we've gotten to know Brex before we announced the deal and now, of course, afterward, we continue to be just electrified by what an amazing business. They built amazing talent on the team, including Co-Founder, Pedro Franceschi, just an amazing team. And -- but -- and also the tech stack that they built, Brex did a thing that you almost never see a start-up do, and that is they built a vertically integrated tech stack instead of cobbling together various vendor solutions. It's a tough way to make a living for a start-up. I'm amazed they pulled it off, but it is a great thing to now be part of -- for us to connect companies because we spent all our time building a vertically integrated tech stack. They built that. And so what is very clear to us is -- and why Brex came to us is because they saw they had a tiger by the tail, an amazing growth opportunity, but they didn't collect -- they didn't feel they collectively had the resources and the scale and the brand and the market position to fully capitalize on this. So that drew them to us. When we looked at the opportunity, what excited us not only was their company and the -- what we could do together, but the fact that much of what we could bring to the table would not require an integration. It would just require us to bring resources or I sometimes use the phrase, we can add water to their ecosystem. So what are we talking about here? And I'll name them in the order with which we can bring them over time. So right off the bat, they get a big brand benefit. Almost -- most businesses have no idea who Brex is. Obviously, they know Capital One is. So there's a brand benefit. There's immediate funding benefit. They had a high cost of funds, we have a low cost of funds. Then a few months down the road, you then get to the ability to lean in and add marketing dollars because they were spending way less than they wish they could have on marketing dollars. So Capital One is going to be able to do that. Go a few more months down the road and now we can harness the Capital One marketing machine. So it's not just marketing dollars, but the massive 30-some year investment in a tech-based and databased customized marketing machine that we have built, including for our small business card franchise, so we can harness that. But that takes -- you have to connect a few more wires there to do that. And then over time, we also can provide them with a lot of leads from our customers who have really graduated -- our small business customers graduated to the need for their product. And then way down the road, this is more after more integration, the ability to take the Brex capabilities and bring them right into our small business card business. Also along the way, we also see the benefit to take our rapidly growing travel business and connect that with Brex where there's a huge volume potential in business travel. So we're very excited by the opportunity, but we know there's been a wake-up call to all the players across these 3 different marketplaces. And so time is of the essence.

We look forward to see what you guys do there. But maybe just to wrap up with the last question here. I think one of the more interesting dynamics today is your capital position. It appears to be strengthening to levels that are meaningfully above your long-term targets, and you've got a boost coming here from a more favorable regulatory outlook on capital rules. So at the same time, I think your stock trades at a level that some investors would view as a meaningful discount to your normalized earnings power. So with that backdrop, how are you thinking about your capital allocation strategy?

Thank you, Jeff. Let me make 2 big points to give you a view of our capital philosophy and how it applies to your specific question. The first thing I would say is that we bring a very conservative view with respect to capital and believe that it is very asymmetrical what the risk and rewards are associated with capital. It's a terrible thing as everybody here knows, if you end up in a -- during a downturn to be short of capital. Also, if during the bad times, a company is in a very strong capital position, the -- not only the ability to weather the storm and have a lot of credibility and with regulators and with the marketplace, but also very much to lean in and play offense during the very, very best times one will ever have in terms of not only acquisitions, but also organic growth. If you look back at the global financial crisis and look at Capital One's auto finance business, while a number of the competitors were pulling back massively, Capital One really leaned into the business and had some of the really best returns and opportunities we've had in the history of that business. So we believe capital is a very asymmetric thing. So we bring a conservative philosophy to the marketplace. The second big point that I would make is that Capital One and particularly in combination with Discover now, it has a high level of earnings power, and that's a wonderful thing to do. And it's not our intent to just keep taking the earnings and pile up an ever-increasing pile of capital. It is an important part of the -- how we will create value for our investors to, in fact, deploy that capital. And so even though I think it's caught everyone's attention that with the amount of capital that we have, I just want everybody to know that we certainly know share buybacks and capital return are an important part of the equation. And even though, yes, we're maybe famously conservative about capital, we can simultaneously have that conservatism and still lean into capital return, and that's what we intend to do.

All right. Great. Well, unless you have any closing remarks, Rich, Jeff, thanks for joining us today. Appreciate you joining us.

Thank you.

Thanks.

Thanks, everybody.