Earnings Call Transcript - COF Q1 2022

Jeff Norris, Senior Vice President of Global Finance

Good day, ladies and gentlemen. And welcome to the Capital One First Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. Thank you. I would now like to turn the call over to Mr. Jeff Norris, Senior Vice President of Global Finance. Sir, you may begin. Thanks very much, Keith. And welcome everybody to Capital One’s first quarter 2022 earnings conference call. As usual, we are webcasting live over the Internet. To access the call on the Internet, please log on to Capital One’s website at capitalone.com and follow the links from there. In addition to the press release and financials we have included a presentation summarizing our first quarter 2022 results. With me this evening are Mr. Richard Fairbank, Capital One’s Chairman and Chief Executive Officer; and Mr. Andrew Young, Capital One’s Chief Financial Officer. Rich and Andrew are going to walk you through this presentation. To access a copy of the presentation and press release, please go to Capital One’s website, click on Investors, then click on Quarterly Earnings Release. Please note that this presentation may contain forward-looking statements. Information regarding Capital One’s financial performance and any other forward-looking statements contained in today’s discussion and the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements and for more information on those factors, please see the section titled Forward-Looking Information in the earnings release presentation and the Risk Factors section in our annual and quarterly reports, accessible at the Capital One website and filed with the SEC. Now, I will turn the call over to Mr. Young. Andrew?

Andrew Young, CFO

Thanks, Jeff, and good afternoon, everyone. I will start on slide three of tonight’s presentation. In the first quarter Capital One earned $2.4 billion or $5.62 per diluted common share. The results include one notable item, $192 million gain from the sale of two Card partnership loan portfolios in the quarter. Period end loans held for investment grew 1% on a linked-quarter basis and average loans grew 3%. Revenue in the linked-quarter increased 1%. Non-interest expense decreased 3% in the quarter, driven by declines in both marketing and operating expenses. Provision expense in the quarter was $677 million, as net charge-offs of $767 million were partially offset by an allowance release. Turning to slide four, I will cover the changes in our allowance in greater detail. For the total company, we released $119 million of allowance in the first quarter and the total allowance balance now stands at $11.3 billion. We continue to hold an elevated amount of qualitative factors to account for a number of uncertainties. Our total company coverage ratio is now 4%. Turning to slide five, I will discuss the allowance and coverage of each of our segments. As you can see in the graph, our allowance coverage ratio was largely flat across each of our business segments. In our Total Card segment, the allowance balance declined $65 million, driven by our international Card businesses. In our Domestic Card business, the allowance balance remained flat at $8 billion. With the slight decline in ending loans, the flat allowance balance in Domestic Card resulted in a slight increase in the coverage ratio to 7.38%. In our Consumer Banking segment, the allowance balance declined by $16 million, which when coupled with loan growth resulted in a 10 basis point decline in coverage to 2.37%. And in Commercial, the $41 million decline in allowance balance was driven by portfolio credit improvement. The decline in coverage ratio was driven by both the allowance release as well as growth. Turning to page six, I will now discuss liquidity. You can see our preliminary average liquidity coverage ratio during the first quarter was 140%. The LCR remained stable and continues to be well above the 100% regulatory requirement. The investment portfolio ended the quarter at $89 billion, declining by about $6 billion on a linked-quarter basis. Rising rates drove a market value decline of $4.3 billion, with the remaining decline due to our continued efforts to reduce our investment portfolio from the elevated levels during the pandemic. Turning to page seven, I will cover our net interest margin. Our first quarter net interest margin was 6.49%, 50 basis points higher than the year ago quarter and 11 basis points lower than Q4. Relative to a year ago, the increase in NIM is largely driven by a balance sheet shift, as we deployed excess cash to loans. The linked-quarter decrease in NIM was driven by having two fewer days in the first quarter. Normalizing for day count effect, higher yields in both our Card business and in our investment portfolio were roughly offset by the impact of hedges on the balance sheet and lower auto yields. Outside of quarterly day count, the NIM from here will largely be a function of the changes in our balance sheet mix, interest rates and the impacts of competition on loan yields and deposit betas. Turning to slide eight, I will end by discussing our capital position. Our common equity Tier 1 capital ratio was 12.7% at the end of the first quarter, down 40 basis points from the prior quarter. Net income in the quarter was more than offset by share repurchases, the impact of the CECL transition and higher risk weighted assets. Recall that the phasing of CECL transition relief began on January 1. We recognized 25% of our $2.4 billion total after-tax phasing amount in the first quarter. Also in the quarter, we repurchased $2.4 billion of common stock as part of the $5 billion share authorization that our Board approved in January. Earlier this month, in addition to approving our CCAR 2022 submission and our capital plan, our Board of Directors also approved the authorization of up to an additional $5 billion of common stock repurchases that will be available beginning in the third quarter of this year. We continue to estimate that our CET1 capital need is around 11%. With that, I will turn the call over to Rich. Rich?

Richard Fairbank, CEO

Thank you, Andrew, and good evening, everyone. I will begin on slide 10 with our Credit Card business. Year-over-year growth in purchase volume and loans coupled with strong revenue margin drove an increase in revenue compared to the first quarter of 2021. Credit Card segment results are largely a function of our Domestic Card results and trends, which are shown on slide 11. Our Domestic Card business posted strong year-over-year growth in every topline metric in the first quarter as we continued our longstanding strategic focus on winning with heavy spenders and building a franchise across the business. Purchase volume for the first quarter was up 26% year-over-year and up 47% compared to the first quarter of 2019. The rebound in loan growth accelerated with ending loan balances up $16.9 billion or about 19% year-over-year. Ending loans were down just 1% from the sequential quarter, better than the typical seasonal decline of around 7% and revenue was up 20% year-over-year, driven by the growth in purchase volume and loans, as well as strong revenue margin. Domestic Card revenue margin for the first quarter was 18.3%. Revenue margin continued to benefit from spend velocity, which is the purchase volume and net interchange growth outpacing loan growth. Spend velocity is driven by the traction we are getting with heavy spenders. The margin also includes a gain from a Card partnership portfolio sale in the quarter. Credit results remain strikingly strong. The Domestic Card charge-off rate for the quarter was 2.12%, a 42 basis point improvement year-over-year. The 30-plus delinquency rate at quarter end was 2.32%, 8 basis points above the prior year. Gradual credit normalization continued in the first quarter. On a linked-quarter basis, the charge-off rate was up 63 basis points and the delinquency rate was up 10 basis points. Non-interest expense was up 33% from the first quarter of 2021, driven by an increase in marketing. Total company marketing expense was $918 million in the quarter. Our choices in Domestic Card marketing are the biggest, but of course, not the only driver of total company marketing trends. We continue to see opportunities to book Domestic Card accounts and loans that can generate resilient and attractive returns and we continued to lean into marketing to drive growth and build our Domestic Card franchise. Consumer balance sheets and labor markets are strong, and in our own portfolio, credit results continued to be well below pre-pandemic levels and they are normalizing gradually. We are keeping a close eye on competitor actions and potential marketplace risks. And as always, we are underwriting to worsening scenarios, even as we lean into marketing. Our Domestic Card marketing is evolving and increasing as our decade-long focus on heavy spenders continues to gain traction. We increased marketing to grow the heavy spender franchise and drive the successful launch of Venture X. Growth in new accounts and robust customer spending drove an increase in early spend bonuses, which show up in our marketing expense and part of our marketing is focused on strengthening our heavy spender franchise with investments in our new travel portal and airport lounges. And looking across the whole company, our digital transformation is generating new business opportunities like Capital One Shopping in our Card business and Auto Navigator in our Auto business. And modern technology infrastructure and capabilities are driving our digital first National Direct Banking strategy in Consumer Banking. We are marketing to continue to propel these growing digital businesses. Our marketing is paying off across these opportunities. We posted very strong growth in Domestic Card purchase volume, new accounts and loans. We are gaining share and building a long-term franchise with heavy spenders. And away from the Card business, we are growing auto originations and deepening dealer relationships with Auto Navigator and our National Direct Banking business is winning with customers and driving growth. Speaking of our Auto and Retail Banking businesses, let’s move to slide 12, which shows that strong loan growth in our Consumer Banking business continued in the first quarter. Driven by auto, first quarter ending loans increased 14% year-over-year in the Consumer Banking business. Average loans also grew 14%. First quarter auto originations were up 33% year-over-year. On a linked-quarter basis, auto originations were up 20%. Our digital capabilities and deep dealer relationship strategy continued to drive year-over-year growth in our Auto business. We continue to closely monitor competitive and credit dynamics in the auto marketplace. First quarter ending deposits in the Consumer Bank were up $4.4 billion or 2% year-over-year. Average deposits were also up 2% year-over-year. Consumer Banking revenue grew 2% from the prior year quarter, driven by growth in auto loans, partially offset by declining auto loan yields and the early effects of our decision to completely eliminate overdraft fees. The year-over-year decrease in auto loan yields was driven by a mix shift toward prime loans and our focus on booking higher quality loans within credit segments. Across the auto lending industry, the pace of price increases has not kept up with the pace of rising interest rates. The decline in loan yields coupled with the pace of pricing changes has compressed margins in our Auto business. First quarter provision for credit losses swung from a net benefit of $126 million in the first quarter of 2021 to a net expense of $130 million. The allowance for credit losses in our Auto business was flat in the quarter compared to an allowance release in the year-ago quarter. The auto charge-off rate and delinquency rate are gradually normalizing and remain strong and well below pre-pandemic levels. The charge-off rate for the first quarter was 0.66%, up 19 basis points year-over-year. The 30-plus delinquency rate was 3.85%, up 73 basis points year-over-year. On a linked-quarter basis, the charge-off rate was up 8 basis points and the 30-plus delinquency rate was down 47 basis points. Slide 13 shows first quarter results for our Commercial Banking business, which delivered strong growth in loans, deposits and revenue in the quarter. First quarter ending loan balances were up 17% year-over-year, driven by growth in selected industry specialties and increasing utilization. Average loans were up 15%. Ending deposits grew 9% from the first year, excuse me, from the first quarter of 2021, as middle market and government customers continued to hold elevated levels of liquidity. Quarterly average deposits increased 12% year-over-year. First quarter revenue was up 16% from the prior year quarter. Non-interest expense was also up 16%. Commercial Credit performance remains strong. In the first quarter, the Commercial Banking annualized charge-off rate was 6 basis points. The criticized performing loan rate was 5.7% and the criticized non-performing loan rate was 0.8%. In closing, we continued to drive strong growth in Domestic Card revenue, purchase volume and loans in the first quarter. We also posted strong Auto and Commercial growth. Credit is gradually normalizing and remains strikingly strong across our businesses, and we continue to return capital to our shareholders. Pulling way up, we are well-positioned to capitalize on the accelerating digital revolution in banking. Our modern technology stack is powering our performance and our growth opportunity, and it’s the engine of enduring value creation over the long term. And now, we will be happy to answer your questions. Jeff?

Jeff Norris, Senior Vice President of Global Finance

Thanks, Rich. Let’s start the Q&A session. As a courtesy to other investors and analysts who may wish to ask a question, please limit yourself to one question plus a single follow-up. If you have any questions following the Q&A, the Investor Relations team will be available after the call. Keith, please start the Q&A.

Operator, Operator

Thank you. We will take our first question from Sanjay Sakhrani with KBW. Please go ahead.

Sanjay Sakhrani, Analyst

Thanks. So, obviously, the investor sentiment has turned quite cautious on the consumer, but it seems like, Rich, you think credits doing, I mean clearly credit is doing quite well in your loan book and you guys are leaning into growth. Maybe you could just give us some perspective on some of the macro headwinds that the consumer is facing, and sort of how you see it progressing through the portfolio as the year progresses? Thanks.

Richard Fairbank, CEO

Okay. Hey, Sanjay. Yeah. So let’s just talk about the health of the consumer. I think the U.S. consumer continues to be strong. While the savings rate has reverted back to pre-pandemic levels, the cumulative impact of savings over the last two years is still a significant positive. We see this in higher bank account balances and higher household net worth and it is true across the income spectrum. Now, of course, the bulk of government stimulus is now behind us and most industry forbearance programs are winding down. But I think we will see some sustained benefits from consumer deleveraging through the pandemic. Debt servicing burdens are lower than they have been in decades, supported both by deleveraging and by low interest rates. On the other side of the consumer balance sheet, labor market demand remained strong. So in our own portfolio, Sanjay, we see continuing strength in roll rates, cure rates and recovery rates, and even as we see signs of normalization, our credit metrics remain strikingly strong by any historical standard. There are emerging headwinds as well, for example, high price inflation. The inflation has the potential to erode the excess savings consumers accumulated through the pandemic, especially if price increases continue to run ahead of wage growth and also higher interest rates would push debt servicing burdens back up. But if we pull up on the whole, I’d say consumers are in good shape coming out of the pandemic relative to most historical benchmarks. In fact, I have just learned over the years that I have a lot of confidence in how consumers learn from downturns and scares that they have and the choices that they make, and I think we are just seeing very rational behavior by consumers. I worry more about markets and how competitors operate and lending practices and things like that, but we still feel good about the consumer and look it is a natural thing; it would be an unnatural thing for credit to stay where it is. And so normalization, the root word in normalization is nor, and there is quite a journey to really sort of an equilibrium place for credit performance. And one of the reasons that we are still leaning pretty hard into our growth opportunities is our confidence in the consumer and our read of the marketplace at this time.

Sanjay Sakhrani, Analyst

Okay. Great. I have a follow-up question regarding the current regulatory scrutiny. There has been some discussion about Card loan fees and overdraft fees, which I believe you have addressed. Could you share some insights on the conversations about Card loan fees from regulators and how these might impact your business? Thanks.

Richard Fairbank, CEO

Yeah. Well, Sanjay, we as a company have been very focused on minimizing fees, just in general for our consumers. Obviously the overdraft announcement was a pretty dramatic case in point there. But even in the Card business, when you look, what Capital One has is an APR and a late fee, and in some cases a cash advance fee. Both of those fees are really to discourage certain behaviors that we don’t think are in the interest of the consumer. So, yes, our strategy has been to have pricing be upfront and have it be clear and very simple. Now late fees are something that we have continued to have because we wouldn’t want our loved ones ending up paying late on their bill, so just late fee, I think is one of the natural fees that probably makes sense to have on a product. The Fed has created a Safe Harbor with respect to late fees, maybe the industry, well that will be revisited and obviously we will watch that as we continue our business.

Jeff Norris, Senior Vice President of Global Finance

Next question please.

Operator, Operator

We will take our next question from Rick Shane with JPMorgan. Please go ahead.

Rick Shane, Analyst

Thanks for taking my question. Can we just talk a little bit more about the partnership portfolio sale, how to think about that from an asset perspective and the impact on the P&L in terms of revenue and any associated decline in expenses associated with that sale?

Andrew Young, CFO

Yeah. Rick, it’s Andrew. I mean, we disclosed the overall gains between the two portfolios of $192 million. The two portfolios combined, you saw probably last year when they got marked held for sale were roughly $4 billion, but below the surface there we are not going to get into specifically the run rate of revenue or the expenses associated with that in part, because we are growing the rest of the portfolio and you are going to see partnership businesses come in and out over time.

Jeff Norris, Senior Vice President of Global Finance

Next question please.

Operator, Operator

We will take our next question from Bill Carcache with Wolfe Research. Please go ahead.

Bill Carcache, Analyst

Thank you. Good afternoon. Rich and Andrew, you have unique insights into consumers at both ends of the credit spectrum. Could you provide more detail following up on Sanjay’s question? Specifically, what credit normalization trends are you observing at both the high and low ends of the credit spectrum? Can you compare those and highlight any differences? Additionally, do you think inflationary pressures might lead to a faster normalization at the lower end?

Richard Fairbank, CEO

We have consistently mentioned that we should all anticipate a return to normalization. Currently, the signs of normalization are modest and still in the early stages. We find the pace of this normalization to be quite moderate, although we shouldn't rely solely on that observation, as it may change. Normalization appears to be occurring across various credit and income levels, with a more noticeable effect at the lower end of the market in terms of income and credit scores. This segment had previously shown quicker improvements during the pandemic. Therefore, we expect to see a general return to normalcy over time. Regarding inflation, it is a significant concern for us, especially when the cost of living increases at a rate faster than wage growth. This can create additional pressure, particularly on everyday consumers. Consequently, we remain quite cautious about the impact of inflation on consumer behavior.

Bill Carcache, Analyst

Thank you, Richard. It’s really helpful. If I may ask a related follow-up, maybe could you discuss the extent to which positive credit migration fueled by pandemic stimulus, that perhaps may have led you to increase line sizes and then now the extent to which we could sort of see a reversal in that and perhaps as credit normalizes, would you expect negative credit migration to ultimately lead to a reversal of those line sizes or is that not how it worked?

Richard Fairbank, CEO

Over the years, we have focused on bringing in new accounts, and we believe there is significant growth potential that we are gradually unlocking based on customer performance and market conditions. The growth you’re noticing is fueled by strong new originations and a rebound in spending on our existing cards. We have also been cautiously increasing credit lines. It’s not a drastic change, but it aligns with my previous comments regarding consumer behavior. Given the strong performance of our customers, we will continue to increase credit lines selectively, and I don’t foresee any reasons that would change our approach. This is done selectively while anticipating a challenging environment and the normalization of conditions. Therefore, I don't believe we will be caught off guard, and I do not have discussions about reversing this trend.

Jeff Norris, Senior Vice President of Global Finance

Next question please.

Operator, Operator

We will take our next question from John Pancari with Evercore ISI. Please go ahead.

John Pancari, Analyst

Good evening. Regarding the credit on the reserve front, I understand you released an additional $190 million and mentioned that you have more qualitative reserves available. Your current reserve ratio is close to your day one CECL level. How should we view the possibility of further reserve releases from this point? Do you believe we will maintain this level of the reserve ratio, or is there potential for additional releases?

Andrew Young, CFO

Well, John, this is Andrew. When you discuss the reserve levels, remember that they vary significantly by asset class, which influences the total company level. I suggest we break it down a bit, as auto reserves are slightly lower than they were on CECL day one, primarily due to high used car prices and our mix in prime. We're seeing loss rates much lower than 66 basis points this quarter, and typically, you would expect our coverage ratio to be significantly below what it was at adoption. However, it’s only slightly below that due to qualitative factors. The biggest contributor to the total company reserve will be Card. To answer your question accurately, we need to consider several assumptions, and frankly, your guess might be as good as mine. With Card, the first component of the allowance is the expectation of future losses and recoveries, evident in our near-term delinquency bucket. We also assume a relatively quick return to normal loss levels from historically strong highs. The second factor is the balance sheet size, which has been growing at a healthy rate—up 19% in Q1 compared to a year ago, when adjusted for seasonal effects. The third input is qualitative factors, accounting for risks related to inflation and other uncertainties in the broader economy. The future allowance will depend on how these factors play out. I want to highlight what we call the quarter swap effect. As credit normalizes, we'll be replacing a low-loss quarter with one that has a slightly higher loss, which will also create pressure. If positive credit trends persist and the factors affecting qualitative reserves diminish, we could see the allowance either decrease or stabilize. But if normalization unfolds and we maintain significant growth, I don’t expect to see an allowance release; in fact, we might see an allowance build. So, it really comes down to all these factors. I apologize for the lengthy technical explanation, but it's important to recognize how diverse the potential outcomes for the allowance can be.

John Pancari, Analyst

Got it. Okay, Andrew. Thank you. My follow-up question is about consumer spending behavior and volumes. Are you noticing any changes in spending, particularly a shift from discretionary to non-discretionary? Additionally, do you anticipate a slowdown in card spending volume overall as the Fed raises rates to slow the economy? Thanks.

Richard Fairbank, CEO

Thanks, John. I haven't looked into the recent trends between discretionary and non-discretionary spending, so I don't want to make assumptions. However, what stands out is the current state of travel and entertainment spending. To put it in perspective, T&E spending has increased by 90% compared to the first quarter of 2021, which was an unusually low period. It's also up about 20% from the first quarter of 2019, indicating that people seem eager to break free from the restrictions of the pandemic, and we're definitely noticing strength in that area. Regarding your question about the potential impacts of inflation and its downstream effects on Card spending, it's possible that could have an influence. Nevertheless, much of the growth in Card spending seems to be coming from our business focused on serious spenders, and I don't believe a change in inflation will significantly affect the spending habits of these heavy spenders.

Jeff Norris, Senior Vice President of Global Finance

Next question please.

Operator, Operator

We will take our next question from Ryan Nash with Goldman Sachs. Please go ahead.

Ryan Nash, Analyst

Hey. Good evening, everyone.

Andrew Young, CFO

Hey, Ryan.

Richard Fairbank, CEO

Hey, Ryan.

Ryan Nash, Analyst

Hey, Rich, Andrew. So maybe just to start off, Rich, you referenced the competitive landscape out there in Card and Auto, a few times, I think you said larger upfront bonuses and you are closely watching some of the competitive dynamics. Can you maybe just talk about what you are seeing out there? And I think it’s historically it’s been unusual for you to be grown this fast when the rest of the market is also growing? So I am just wondering, can you maybe just talk about on the Card side what you are seeing banks versus non-banks and anything you are seeing on the Auto side would be helpful at this point?

Richard Fairbank, CEO

Okay. Ryan, I appreciate your comment. We often take a different approach than others, and we've discussed the reasons behind that. It's not random; it’s influenced by our analysis of the competitive landscape, which affects opportunities, credit performance, and selection dynamics. Your question is quite relevant. Many companies are recognizing the resilience of consumers, who are increasingly engaging in more typical activities. This is creating opportunities that we are eager to seize. Now, regarding competition in the Card business, we are aware of heightened marketing efforts from various companies. All are stepping up their marketing strategies, and we are closely monitoring how this impacts our opportunities. While marketing levels have risen, competition in the rewards space has remained stable and not irrational, although it's slightly more intense than it was before the pandemic. Top players remain strong, but our perspective on opportunity hasn’t changed, as APRs have generally stayed steady. Turning to fintechs, we’ve noted significant activity in buy now pay later services. It's important to recognize that fintechs involved in lending are operating in a period of unprecedented credit performance in the industry. Businesses based on installment lending can be quite sensitive in such an environment, but we still see substantial activity from fintechs. On the Card side, although competition is keen, it remains predictable. We haven’t observed major shifts in underwriting policies or pricing changes, indicating an intensity typical for this time but nothing alarming that would deter us from pursuing our growth strategies. In the Auto business, competition is fierce, evident among credit unions, large banks, and smaller lenders across all credit segments. Credit unions with increased deposits are gaining market share, as we've seen in past cycles, particularly as interest rates rise. Speaking of interest rates, we usually find that when the cost of goods sold increases, consumer pricing adjusts with some delay. Currently, the auto market hasn’t yet reflected the changes in interest rates, leading to some compression. Historically, competitors respond to rate increases at varying speeds, and credit unions may be among the slower adjusters, but we’ll monitor this closely. We're enthusiastic about our prospects in the Auto sector. Our technology products are cutting-edge and attracting significant traction. I remain cautious about pricing and any overly optimistic assumptions regarding the auto lending sector, especially concerning used car values. We need to watch whether the industry continues to operate rationally as it has over the past couple of years.

Ryan Nash, Analyst

Maybe as a quick follow-up, sticking with things that are unusual, Andrew, you guys are continuing to aggressively return capital. I think you have two different $5 billion asset repurchase programs out there, which again is unusual for you guys. I was wondering, can you maybe just talk a little bit about the timing of the utilization of those and how to think about the use of capital as you are getting closer to the 11% CET1 target? Thank you.

Andrew Young, CFO

Yeah. I recall that in January, we did not have an active program at the time, so our Board authorized $5 billion and capital levels were even higher than they are today at that point. And so earlier this month in conjunction with the approval of the capital plan in our CCAR submission, they authorized an additional $5 billion, which coincides with the capital plan and therefore would be available at the start of the third quarter. But in terms of the pace of that activity, it feels a little bit different than it did when we were at 14.5% over a year ago. To your point, like asymptotically we are sort of heading towards 11% and so the pace of repurchases is, as always, going to be dependent on our primary use of capital for loan growth and then the dividends. But beyond that, we are going to keep a really close eye on just the level of capital and earnings and growth and end market dynamics and take advantage of the fact that we are able to operate under the SCB framework and maintain that flexibility. So nothing specific in terms of the timeline there, but just wanted to be clear about the approvals when we announced it a few weeks ago.

Jeff Norris, Senior Vice President of Global Finance

Next question please.

Operator, Operator

We will take our next question from Betsy Graseck with Morgan Stanley. Please go ahead.

Betsy Graseck, Analyst

Hi. Good evening.

Andrew Young, CFO

Hi, Betsy.

Richard Fairbank, CEO

Hi. Good evening, Betsy.

Betsy Graseck, Analyst

I guess, just switching gears a little bit. I wanted to ask a little bit about what you are seeing with regard to payment rates and is there any differentiation amongst the customer base as to how that’s been projecting?

Richard Fairbank, CEO

We continue to observe high payment rates across our customer base, which have recently started to level off. However, these rates remain significantly above pre-pandemic levels. While not an exact indicator, our trust metrics show that the payment rate in March was nearly 50%. One key contributor to the higher repayment rates is the strong credit environment and healthy consumer balance sheets. We anticipate that consumer credit will gradually return to normal, albeit at a slower pace than expected. I believe that as credit normalizes, we may see a corresponding adjustment in payment rates. Additionally, we are gaining more traction with high spenders each year. Historically, we have avoided engaging with high balance revolvers, aiming to be resilient even if it meant missing out on revenue during prosperous periods. This strategy, combined with our success with high spenders, appears to be contributing to a more sustainable shift in our payment rates. Currently, the main factor influencing this trend is the creditworthiness of consumers and their willingness to direct substantial amounts of money toward payments.

Betsy Graseck, Analyst

Got it. And then just as a follow-up on the marketing piece, I know we spoke about a little bit earlier in the call. But as we are thinking through the opportunities that we have, do you feel like there is an opportunity to lean into marketing kind of Q-by-Q-by-Q to a greater degree? So we should build half off of Q1, such that our marketing is higher year-on-year, full year and that’s what I am getting from the conversation earlier, but I just want to make sure it’s the right takeaway?

Richard Fairbank, CEO

Let me discuss our overall marketing strategy before we revisit the recent quarter. Several factors are currently driving our increased marketing efforts. We are encountering attractive growth opportunities across our businesses and are fully committing to them while they last. In our Card business, we have expanded our product offerings and marketing channels significantly, which is bolstered by our technology transformation. This has allowed us to utilize more data, access additional channels, leverage machine learning models, and create tailored solutions. Consequently, we are seeing strong growth in originations across our business. It's important to mention that our overall growth in the Card business primarily comes from our Branded Card franchise, rather than co-brand and private label partnerships, which are a smaller segment for us. With Branded Cards, we benefit from the full economics and ownership of the customer base. Although industry data on this is not available, I believe our growth in Branded Cards is noteworthy. This aspect of our business emphasizes our brand, and we continue investing in our brand and flagship products. A significant part of our revenue margin strength stems from our Branded Card, where we capture all the economic benefits. However, it also means that our marketing and brand-building expenses fall entirely on us, which is reflected in our marketing numbers. Building a highly valuable franchise is central to our strategy. Another key factor in our rising marketing expenditure is the momentum we have gained over the last decade, concentrating on attracting heavy spenders. We launched our Venture Card in 2010, marking the start of our strategic focus on this demographic. However, our approach extends beyond flagship cards; it involves understanding how to engage heavy spenders by offering exceptional products with generous rewards, outstanding customer service, tailored experiences, and top-notch digital engagement. Over the years, we have consistently gained traction, with our overall franchise growing well, but even more so with heavier spenders. Each year of success gives us the opportunity to reach further into the market, prompting ongoing investments to support this goal. The results of our focus on heavy spenders can be seen in the impressive purchase volume growth we’ve achieved. Across various timeframes over the past decade, Capital One ranks highly, if not at the top, in purchase volume growth metrics. Almost all this growth is attributed to our Branded Cards, contributing to our strong spend velocity and revenue margins. The heavy spender segment carries a different economic profile compared to some parts of our traditional Card business, involving higher upfront marketing and brand-building costs, as well as investments in premium experiences. However, the long-term value of the heavy spender segment is significant, characterized by strong spending, robust margins, minimal losses, low attrition, and a positive impact on our brand and overall franchise. Consequently, the heavy spender segment is already influencing many aspects of our financial performance, representing a long-term advantage from these investments. I would also like to highlight our new digital offerings, such as Auto Navigator, Capital One Shopping, and our National Bank, as contributing factors to increased marketing expenses. Unlike other banks expanding through acquisitions, we are focused on building our bank organically, which naturally requires marketing investment. This explanation outlines the reasons behind the elevated marketing levels we are currently experiencing and the growth opportunities we see for our franchise. The current marketplace environment and our strategic goals, including enhancing our technology and moving upmarket, are driving these increased marketing efforts. This narrative conveys why we are intensifying our marketing initiatives, taking advantage of present opportunities while acknowledging our long-term development efforts. Typically, we see a seasonal decline in marketing levels, and this year, marketing related to specific initiatives, such as launching Venture Cards and early spend bonuses, was an important factor. However, the seasonal impact this year is not as pronounced as in previous years. We are not providing specific guidance for the remainder of the year, but I wanted to clarify our motivations for increasing marketing spend and express my enthusiasm for our opportunities. We are committed to capitalizing on them, much of which involves marketing efforts.

Jeff Norris, Senior Vice President of Global Finance

Next question please.

Operator, Operator

We will take our next question from Moshe Orenbuch with Credit Suisse. Please go ahead.

Moshe Orenbuch, Analyst

Great. Thanks. Rich, I'm curious about what it would take to see a pullback from both lower-end consumers and higher spenders, especially considering the potential pressures you mentioned, such as inflation. What warning signs should we be looking for?

Richard Fairbank, CEO

Certainly. In terms of lower-end consumers, it's less about imagining difficult environments, as there are already signs of consumers facing challenges and competitors becoming more aggressive. Our approach in such cases leans towards cautiously managing risk using credit lines rather than significantly reducing origination efforts. We aim to steadily build our franchise, although not as aggressively as we sometimes do. Over the past 30 years, we have been focused on maintaining our Main Street franchise and managing loan regulations effectively. For heavy spenders, we continue to gain strong traction. The pursuit of heavy spenders isn’t well-suited to quick fluctuations in strategy; it requires a steady commitment. While we may adjust marketing or product choices, truly competing in this market segment involves building a long-term franchise, not just enhancing typical consumer products with rewards or flashy advertising. As we move into the 12th year of our strategy to shift upmarket, it's a gradual process that demands earning trust over time. All of our metrics indicate continued progress and success, including brand and customer metrics, and we've observed positive trends in purchase volumes. We are committed to this ongoing pursuit, adjusting certain marketing and product strategies as needed, while acknowledging that this journey has been a key component of Capital One's strategy in the card sector for many years.

Moshe Orenbuch, Analyst

Great. Thanks, Rich. As a follow-up, could you discuss your perspective on the current state of the industry and Capital One regarding deposit price competition, especially as we begin to see increasing interest rates?

Andrew Young, CFO

Sure, Moshe. It’s Andrew. Considering that retail deposits make up 85% of our portfolio, I will focus on that. Over the past six years, we experienced a declining rate cycle, with betas around 50%. During the last rising rate cycle, from late 2015 to early 2019, our cumulative beta was approximately 40%. Typically, betas increase slowly during the initial hikes. However, in the last cycle, there were eight hikes over 3.5 years, while this time we may experience four hikes of 25 basis points each, potentially reaching 250 or 275 quite rapidly. Therefore, I believe industry betas could differ from historical trends. On one hand, there are high deposit levels across the industry, low loan-to-deposit ratios, and low industry net interest margins, while we are moving away from a zero floor. On the other hand, larger and quicker rate hikes might lead to more aggressive pricing from institutions that depend heavily on deposits for loan growth. We will learn much in the coming months. Based on our current assumptions, we estimate that the situation will align closely with the previous rising cycle, starting around 40 basis points, beginning slowly and then accelerating. However, the initial slow phase might occur over a shorter timeframe compared to the last cycle.

Jeff Norris, Senior Vice President of Global Finance

Next question please.

Operator, Operator

We will take our next question from Don Fandetti with Wells Fargo. Please go ahead.

Don Fandetti, Analyst

I have a quick question about the outlook for the adjusted efficiency ratio compared to Q1 levels. Rich, could you provide insights on the Commercial Card issuing business? I know you have been marketing the small business Card, which has been challenging for banks to implement.

Richard Fairbank, CEO

Thank you, Don. We have been concentrating on enhancing our operating efficiency ratio for several years. The pandemic has also accelerated the technological race and increased the stakes for all players in various industries, particularly in banking. Every company is aware that the clock is ticking on their tech readiness, prompting them to recognize the need for investment. The influx of funding into fintechs is remarkable, and the competition for tech talent is more intense than I've seen in my career across any role. There is a pressing need to respond to the market demands. However, I want to emphasize that this fast-evolving market also presents significant opportunities, and I believe Capital One is in a great position to seize those opportunities, which is why we are investing now. This aligns with the message I shared last quarter. Our focus remains on the long-term potential to enhance operating efficiency. The key drivers are revenue growth and digital productivity improvements. Nonetheless, the timing for efficiency gains must reflect the current market necessities. Delivering positive operating leverage over time is still a crucial goal for us and one of the key outcomes of our technological advancements, contributing to our long-term value delivery. You can observe some of these effects in our first quarter operating efficiency, adjusted for gains from portfolio sales. This is consistent with what I mentioned previously, as we can see evidence of this in our quarterly results, but the current challenges do not alter our conviction in the long-term potential for improving operating efficiency.

Andrew Young, CFO

Don, what was your question on Commercial?

Don Fandetti, Analyst

Yeah.

Richard Fairbank, CEO

You wanted to...

Don Fandetti, Analyst

My question was...

Richard Fairbank, CEO

You wanted to...

Don Fandetti, Analyst

... I know you have been marketing in that small business Card, which has been sort of tough for banks to do.

Richard Fairbank, CEO

When discussing our Commercial business, particularly the Credit Card segment, you may have noticed the advertisements highlighting no preset spending limit. This is a complex way to express that there isn't a fixed credit limit; instead, we utilize dynamic transaction underwriting in real-time. Building this capability has been challenging and took us years to achieve. It is one of the numerous benefits stemming from our technological transformation and our transition to the cloud with modern applications and platforms. Investors often inquire about the tangible benefits of our tech transformation and the investments made. I emphasize that there won't be a single standout feature that encapsulates everything. This is a journey; many years ago, we envisioned various improvements, including enhanced efficiency, better risk management, and more. Remarkably, we have managed to pursue all these goals in tandem, which is not typically the case as it usually involves trade-offs. What stands out in our journey is the coherent advancement towards all our initial goals by developing modern technology throughout the organization. Over time, investors will witness tangible results of this progress. For example, our Auto Navigator product can underwrite every car in America for any consumer in a fraction of a second. Additionally, the no preset spending limit feature is another impressive outcome. Our journey was not focused on any single aspect, but over time, investors will recognize the cumulative results from years of investment in technology. The initiatives, like the Credit Card offering we are discussing, are part of this long-term journey, driven by our commitment to delivering wins for our customers.

Jeff Norris, Senior Vice President of Global Finance

Next question please.

Operator, Operator

Our final question this evening will come from John Hecht with Jefferies. Please go ahead.

John Hecht, Analyst

Thanks very much, guys, for fitting in my question. Rich, you talked a lot about credit in the strength of your customer base. Aside from that, we are seeing you, call it, some of the more modern or emerging platforms, we are observing some delinquency drift there. And in fact, we are even seeing some reactions in the capital markets, some securitization deals are getting canceled or renegotiated as they go. I am wondering what do you ascribe that to and are there any reverberating effects from that type of development or migration into your business over time?

Richard Fairbank, CEO

So, John, I often say with a smile that Capital One was one of the original fintechs. We were a fintech before the term even existed. We built a lending company starting with credit cards and ultimately transformed into a comprehensive financial institution. Our journey was made possible by the emergence of capital markets, which helped us navigate through the mediocre growth of Capital One in the '90s thanks to securitizations. We are very grateful for that. However, we probably surprised our investors when we decided to transition our company to a traditional bank balance sheet to enhance our funding resilience. This is important because while fintechs built on securitization can grow quickly, they also face inherent structural challenges regarding resilience, which both they and their investors need to monitor closely. Regarding the lending results and recent upticks, it’s not surprising to see an increase in delinquencies for companies, be they banks or fintechs. Typically, companies with less consumer credit history struggle more with interpreting past performance. For instance, if a new fintech started in the past couple of years, it would be difficult to assess resilience based on limited historical data, especially since most companies did well overall. This challenge arises due to the lack of a deeper credit history—it's simply a structural issue and not their fault. Also, normalization generally occurs more quickly for new loans than for older ones. Therefore, if a fintech is experiencing high growth, the percentage of its new loans compared to its entire portfolio is likely significant, leading to quicker normalization. Many of us have seasoned portfolios with years of data, which aids in the normalization process. As someone who was an early fintech, I find great interest and respect for what fintechs are doing, but I also recognize the structural challenges they will need to address and that both they and their investors must remain vigilant about.

Jeff Norris, Senior Vice President of Global Finance

Well, thank you for joining us on the conference call today and thank you for your continuing interest in Capital One. Remember the Investor Relations team will be here after the call to answer any further questions you may have. Thanks for joining us. Have a great evening.

Operator, Operator

Ladies and gentlemen, this concludes today’s conference. We appreciate your participation. You may now disconnect.