Earnings Call Transcript - COF Q2 2024

Operator, Operator

Good day, and thank you for standing by. Welcome to the Capital One Q2 2024 Earnings Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jeff Norris, Senior Vice President of Finance. Please go ahead.

Jeff Norris, Senior Vice President of Finance

Thanks very much, Josh, and welcome everyone to Capital One's second quarter 2024 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 the financials, we've included a presentation summarizing our second quarter 2024 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 will walk you through the presentation. To access a copy of the presentation and press release, please go to Capital One's website, click on Investors, and click on Quarterly Earnings Release. Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion in 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 these 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. And with that done, I'll turn the call over to Mr. Young. Andrew?

Andrew Young, Chief Financial Officer

Thanks, Jeff, and good afternoon, everyone. I will start on Slide 3 of tonight's presentation. In the second quarter, Capital One earned $597 million or $1.38 per diluted common share. Included in the results for the quarter were adjusting items related to the Walmart partnership termination, Discover integration costs, and an accrual for our updated estimate of the FDIC's special assessment. Net of these adjusting items, second quarter earnings per share were $3.14. Relative to the prior quarter, period end loans held for investment increased 1%, while average loans were flat. Ending deposits were flat versus last quarter, while average deposits increased 1%. Our percentage of FDIC insured deposits increased 1 percentage point to 83% of total deposits. Pre-provision earnings in the second quarter increased 7% from the first quarter. Revenue in the linked quarter increased 1%, driven by higher net and non-interest income, while non-interest expense decreased 4%, driven by a decline in operating expense. Our provision for credit losses was $3.9 billion in the quarter. The $1.2 billion increase in provision relative to the prior quarter was almost entirely driven by higher allowance. Included in the second quarter was an $826 million allowance built from the elimination of the loss sharing provisions that occurred within the termination of the Walmart partnership. The remaining quarter-over-quarter provision increase was driven by a $353 million higher net reserve build and a $28 million increase in net charge-offs. Turning to Slide 4, I will cover the allowance in greater detail. We built $1.3 billion in allowance this quarter. The allowance balance now stands at $16.6 billion. Our total portfolio coverage ratio increased 35 basis points to 5.23%. The increase in this quarter's allowance and coverage ratio was largely driven by a build in our card segment. I'll cover the drivers of the changes in allowance and coverage ratio by segment on Slide 5. In our domestic card business, the allowance coverage ratio increased by 69 basis points to 8.54%. The substantial majority of the increase in coverage was driven by the impact of the termination of the Walmart loss sharing agreement. In our Consumer Banking segment, the allowance decreased by $23 million, resulting in a 5 basis point decrease to the coverage ratio. Finally, our commercial banking allowance increased by $6 million. The coverage ratio remained essentially flat at 1.74%. Turning to Page 6, I'll now discuss liquidity. Total liquidity reserves in the quarter decreased about $5 billion to approximately $123 billion. Our cash position ended the quarter at approximately $45 billion, down about $6 billion from the prior quarter. The decrease was driven by wholesale funding maturities, loan growth, and declines in our commercial deposits, partially offset by deposit growth in our retail banking business. You can see our preliminary average liquidity coverage ratio during the second quarter was 155%, down from 164% in the first quarter. Turning to Page 7, I'll cover our net interest margin. Our second quarter net interest margin was 6.7%, 1 basis point higher than last quarter and 22 basis points higher than the year ago quarter. The relatively flat quarter-over-quarter NIM was the result of largely offsetting factors. NIM in the quarter benefited from the termination of the revenue sharing agreement with Walmart as well as modestly higher yields in the auto business. These two factors were roughly offset by the seasonal effects on yield in the card portfolio and a slight increase in the rate paid on retail deposits. Turning to Slide 8, I will end by discussing our capital position. Our common equity Tier 1 capital ratio ended the quarter at 13.2%, 10 basis points higher than the prior quarter. Net income in the quarter was largely offset by the impact of dividends and $150 million of share repurchases. During the quarter, the Federal Reserve released the results of their stress test. Our preliminary stress capital buffer requirement is 5.5%, resulting in a CET1 requirement of 10%. However, as we disclosed in our last 10-Q, the announcement of the acquisition of Discover constituted a material business change. As a result, we are subject to the Federal Reserve's pre-approval of our capital actions until the merger approval process has concluded. With that, I will turn the call over to Rich. Rich?

Richard Fairbank, Chairman and Chief Executive Officer

Thanks, Andrew, and good evening, everyone. Slide 10 shows second quarter results in our credit card business. Credit card segment results are largely a function of our domestic card results and trends, which are shown on Slide 11. In the second quarter, our domestic card business delivered another quarter of strong results as we continued to invest in flagship products and exceptional customer experiences to grow our franchise. Year-over-year purchase volume growth for the quarter was 5%. Ending loan balances increased $11.1 billion or about 8% year-over-year. Average loans also increased about 8% and second quarter revenue was up 9%, driven by the growth in purchase volume and loans. Revenue margin for the quarter remained strong at 17.9%. The revenue margin includes a positive impact of about 18 basis points resulting from the partial quarter effect of the end of the Walmart revenue sharing agreement. The charge-off rate for the quarter was 6.05%. The partial quarter impact of the end of the Walmart loss sharing agreement increased the quarterly charge-off rate by 19 basis points. Excluding this impact, the charge-off rate for the quarter would have been 5.86%, up 148 basis points year-over-year. The 30 plus delinquency rate at quarter end was 4.14%, up 40 basis points from the prior year. As a reminder, the end of the Walmart loss sharing agreement did not have a meaningful impact on delinquency rates. The pace of year-over-year increases in both the charge-off rate and the delinquency rate have been steadily declining for several quarters and continued to shrink in the second quarter. On a sequential quarter basis, the charge-off rate excluding the Walmart impact was down 8 basis points and the 30 plus delinquency rate was down 34 basis points. Domestic card non-interest expense was up 5% compared to the second quarter of 2023, primarily driven by higher marketing expense. Total company marketing expense in the quarter was $1.1 billion, up 20% year-over-year. Our choices in domestic card are the biggest driver of total company marketing. We continue to see compelling growth opportunities in our domestic card business. Our marketing continues to deliver strong new account growth across the domestic card business. Compared to the second quarter of 2023, domestic card marketing in the quarter included increased marketing to grow originations at the top of the marketplace, higher media spend, and increased investment in differentiated customer experiences, like our travel portal, airport lounges, and Capital One Shopping. Slide 12 shows second quarter results for our Consumer Banking business. After returning to positive growth last quarter, auto originations were up 18% year-over-year in the second quarter. Consumer banking ending loans were down $1.6 billion or 2% year-over-year and average loans were down 3%. On a linked quarter basis, ending loans were up 1% and average loans were flat. Compared to the year ago quarter, ending consumer deposits were up about 7% and average deposits were up 5%. Consumer banking revenue for the quarter was down about 9% year-over-year, largely driven by higher deposit costs and lower average loans compared to the prior year quarter. Non-interest expense was up about 2% compared to the second quarter of 2023, driven by an increase in marketing to support our national digital bank. The auto charge-off rate for the quarter was 1.81%, up 41 basis points year-over-year. The 30 plus delinquency rate was 5.67%, up 29 basis points year-over-year, largely as a result of our choice to tighten credit and pull back in 2022; auto charge-offs have been strong and stable. Slide 13 shows second quarter results for our commercial banking business. Compared to the linked quarter, ending loan balances decreased about 1%. Average loans were also down about 1%. The modest declines are largely the result of choices we made in 2023 to tighten credit. Ending deposits were down about 6% from the linked quarter. Average deposits were down about 3%. The declines are largely driven by our continued choices to manage down selected less attractive commercial deposit balances. Second quarter revenue was essentially flat from the linked quarter and non-interest expense was lower by about 6%. The Commercial Banking annualized net charge-off rate for the second quarter increased 2 basis points from the sequential quarter to 0.15%. The commercial banking criticized performing loan rate was 8.62%, up 23 basis points compared to the linked quarter. The criticized non-performing loan rate increased 18 basis points to 1.46%. In closing, we continued to deliver strong results in the second quarter. We delivered another quarter of top line growth in domestic card loans, purchase volume, and revenue and a second consecutive quarter of year-over-year growth in auto originations. Consumer credit trends continued to show stability and our operating efficiency ratio improved. We had guided to 2024 annual operating efficiency ratio, net of adjustment to be flat to modestly down compared to 2023, assuming the CFPB late fee rule takes effect in October. And we're on a very consistent path with what we expected when we gave that guidance. If the implementation of the rule is delayed, that would be a tailwind to 2024 annual operating efficiency ratio. One thing that has changed is the Walmart relationship. Our partnership ended in the second quarter, which will increase charge-off rates, but have a positive impact on the operating efficiency ratio. Including the Walmart impact, we expect full-year 2024 operating efficiency ratio, net of adjustments to be modestly down compared to 2023. We continue to lean into marketing to grow and to further strengthen our franchise. In the domestic card business, we continue to get traction in originations across our products and channels and our origination opportunities are enhanced by our technology transformation, which enables us to leverage machine learning at scale to identify the most attractive growth opportunities and customize our marketing offers. We are also getting traction in building our franchise at the top of the market with heavy spenders. It is not lost on us that competitive intensity and marketing levels are increasing at the very top of the market and we know we have important investments to make. We continue to be pleased to see our investments pay off in customer and spend growth and returns. And we're building an enduring franchise with annuity-like revenue streams, very low losses, and very low attrition. In consumer banking, our modern technology and leading digital capabilities are powering our digital-first national banking strategy, and we're leaning even harder into marketing to grow our national checking franchise, which has had industry-leading pricing with no fees and industry-leading customer satisfaction. Pulling up, marketing is a key driver of current and future growth and value creation across the company and we're leaning hard into our marketing investments. We expect total company marketing in the second half of 2024 to be meaningfully higher than the first half, similar to the pattern we saw last year. We are all-in and working hard to complete the Discover acquisition. Our applications for regulatory approval are in process and we're fully mobilized to plan and deliver a successful integration. We continue to expect that we'll be in a position to complete the acquisition late this year or early next year, subject to regulatory and shareholder approval. The combination of Capital One and Discover creates game-changing strategic opportunities. The Discover payments network positions Capital One as a more diversified, vertically integrated global payments platform, and adding Capital One's debit spending and a growing portion of our credit card purchase volume to the Discover network will add significant scale, increasing the network's value to merchants, small businesses, and consumers and driving enhanced network growth. In credit cards and consumer banking, we're bringing together proven franchises with complementary strategies and a shared focus on the customer. And we will be able to leverage and scale the benefits of our 11-year technology transformation across every business and the network. Pulling way up, the acquisition of Discover is a singular opportunity. It will create a consumer banking and global payments platform with unique capabilities, modern technology, powerful brands, and a franchise of more than 100 million customers. It delivers compelling financial results and offers the potential to create significant value for merchants and customers. And now we'll be happy to answer your questions. Jeff?

Jeff Norris, Senior Vice President of Finance

Thanks, Rich. We'll now 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 follow-up questions after the Q&A session, the Investor Relations team will be available after the call. Josh, please start the Q&A.

Operator, Operator

Thank you. Our first question comes from Sanjay Sakhrani with KBW. You may proceed.

Sanjay Sakhrani, Analyst

Thanks. Rich, Andrew, just looking at the credit metrics, as Rich mentioned, it seems like the trends are pretty favorable. I mean, in most segments things are improving, if not stable. And then the U.S. card, there is an improving trend in that second derivative. I'm just curious how we should think about reserve rate going forward because I think even excluding the Walmart impact, the reserve rate went higher.

Andrew Young, Chief Financial Officer

Sure, Sanjay. Well, let me start by covering this quarter's allowance and then I'll talk about the future. So in the quarter, as you said, first, we had the effect of Walmart, the $826 million build that we spelled out as an adjusting item. We also reserved for the growth we saw in the quarter. Beyond that coverage in card, as you referenced, grew, I think it was just over 10 basis points, which is a little over 1% of the allowance balance. As part of that process each quarter, not only are we rolling forward our baseline forecast, but we're also looking at a range of macroeconomic and consumer behavior uncertainties, including things like the changing seasonal customer behavior we talked about last quarter. As a result, in this quarter, we increased the qualitative factors to reflect those uncertainties, and that's what drove the modest increase in coverage this quarter. As I look ahead and talking conceptually here, but in a period where projected loss rates in future quarters are projected to stabilize and ultimately decline might indicate a decline in the coverage ratio, I would say, you could very well see a coverage ratio that remains flat for some period of time as we incorporate the uncertainty of those future projections into the allowance. In a period where forecasted losses are rising, we're quick to incorporate those higher forecasted losses and also potentially add qualitative factors for uncertainty like you saw early in the pandemic, but I would say it is unlikely to be symmetric on the way down. Eventually, the projected stabilizing and ultimately lower losses will flow through the allowance, particularly as the uncertainties around that forecast become more certain. But at this point, I'm not going to be in the business of forecasting when that's actually going to take place for us.

Sanjay Sakhrani, Analyst

Got it. And then, Rich, maybe you could just talk about the consumer and sort of the uncertainties there. Is there any discernible change that you've seen since the last quarter in terms of the state of the consumer? We've obviously seen the spending trends sort of slow somewhat across the industry. But anything else to sort of point out?

Richard Fairbank, Chairman and Chief Executive Officer

Sanjay, what we observe is a strong stability. The U.S. consumer continues to be a key strength in the overall economy, with the labor market remaining notably resilient. Increased incomes have kept consumer debt servicing burdens relatively low compared to historical standards, even with high interest rates. Analyzing our customers, we find that, on average, their bank balances are higher than they were before the pandemic, and this trend spans across various income levels. However, inflation has reduced real incomes for nearly two years, and we have only recently begun to see real wage growth turn positive again. In this environment of high interest rates, the cost of new borrowing has increased across all major asset classes, including mortgages, auto loans, and credit cards. We will certainly monitor this closely. At the margin, these changes are likely putting some financial strain on consumers. Nevertheless, overall, I believe consumers are in reasonably good condition compared to most historical benchmarks. Regarding our credit metrics, we were pleased with the performance this quarter. We had mentioned the seasonal trends, and there might be questions about that, but we see a positive stabilization in the card business, and the auto sector remains very strong.

Operator, Operator

Thank you. Our next question comes from Mihir Bhatia with Bank of America. You may proceed.

Mihir Bhatia, Analyst

Hi. Thanks for taking my question. I would like to discuss the current situation regarding net interest margin. With the Federal Reserve indicating potential rate cuts, could you share your thoughts on the current environment for deposit competition? Additionally, how do you anticipate deposit betas will evolve during the initial phase of the Fed's rate reduction cycle?

Richard Fairbank, Chairman and Chief Executive Officer

Certainly, Mihir. From what we've observed internally, and as evidenced this quarter during a time when deposit balances typically decline, we noted around $4 billion in growth. We are quite satisfied with the investments we've made in developing our deposit franchise over the years, and we're seeing the benefits of that. Regarding future betas, in this cycle, the cumulative beta we experienced this quarter was 62%. If the Fed decides to lower rates next, it's challenging to predict exactly how deposit costs and betas will adjust, particularly regarding the speed of those declines. Market dynamics, competitive pricing strategies, and efforts by companies to maintain net interest margins will all play a role in future betas. However, you can get a clear idea of our pricing and mix from what we observed in the recent upcycle, and that context will influence how our beta reacts in the declining phase.

Mihir Bhatia, Analyst

Thank you for the information. I would like to shift the conversation back to the overall health of the customer. Looking across your portfolio, I've heard discussions about customers reducing discretionary spending, especially among lower-income groups. Are you observing this trend in your customer base as well? Additionally, Rich mentioned his satisfaction with the advancements you're making with higher-income consumers, particularly regarding high-end transactions. How does this impact your portfolio when you consider its growth in the next few years?

Richard Fairbank, Chairman and Chief Executive Officer

Yes. Well, thank you so much. Just with respect to spending, we see pretty proportional movements in discretionary versus non-discretionary spending, nothing really striking there when we look at the portfolio spending metrics. The spend per customer is really pretty flat. When you see spend growth at a company like Capital One, the purchase volume growth is really being driven by the new accounts. So things are really pretty stable, flat and stable, healthy, but pretty flat on a per-customer basis. With respect to the question about the gradual transition of our portfolio to a higher-end customer, let me just pull up and talk about that. We have for decades been a company that sort of serves the mass market really from the top of the credit spectrum through to even down to some subprime customers. We have continued very consistently with this strategy, probably the most striking thing though that's happened over the last 10 or 14 years, I guess, 14 years ago is when we launched the Venture Card. We have systematically leaned into going after the top of the market, not leaving the other behind, but really as an additive strategy. We have continued through our marketing and through the products that we're offering to just keep moving higher and higher in terms of the target customers and the traction that we're getting. By the way, we continue even as we're growing purchase volume overall, where we see the highest growth rates in purchase volume are as we go higher in the market. So we're very happy about that. And when we think about the portfolio effects that happened there, this is one thing that we see is that payment rates have along that journey gone up quite a bit at Capital One. When we look to see our payment rates coming back to where they were pre-pandemic, they probably just aren't going to return all the way because that would be a reflection of the portfolio shift. We just in general have had the kind of mix shift that you'd expect with higher payment rates and higher levels of spend, and that's been very successful. But from an outstanding's point of view, the top of the market business doesn't have that much impact on outstandings because these folks generally pay in full. So when you see the outstandings movements of Capital One, it's pretty consistently driven by the mass market part of our business. It's just that inside some of the portfolio, metrics are moving because of the mix shift toward more spenders.

Mihir Bhatia, Analyst

Thank you.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Our next question comes from Rick Shane with J.P. Morgan. You may proceed.

Rick Shane, Analyst

Thanks for taking my question this afternoon. Look, given the breadth of your reach across the consumer income levels, can you talk a little bit about sort of any patterns that you're seeing? We've heard, for example, some slowdown in spending for lower-income consumers. I'm curious, particularly you had made a comment earlier in the quarter about an increase in minimum payment rates. I'm curious if you're seeing anything in terms of payment behavior that we should consider by income level.

Richard Fairbank, Chairman and Chief Executive Officer

Sure, let's discuss the current state of subprime consumers. Historically, during the global financial crisis, credit metrics for subprime consumers showed more volatility than for prime consumers, although the overall percentage decline in subprime was less severe. In the pandemic, subprime credit deteriorated and improved more rapidly than prime credit, and it seemed to stabilize earlier. This occurred against the backdrop of lower-income consumers benefiting significantly from government aid and financial forbearance, which has since been gradually rolled back. While subprime and lower-income are not identical, they are related, and we observed these trends across various credit and income levels. Additionally, in recent years, subprime consumers have faced increased credit supply from the industry, including competition from fintech companies during and after the pandemic. We were concerned about the potential negative impact on the credit performance of subprime consumers, but overall performance has remained strong. Notably, income growth for lower-income consumers has outpaced that of previous years, contrasting with trends seen during the last financial crisis. Although subprime and lower-income groups don't move in lockstep, they tend to respond earlier to changes but not necessarily to a greater degree than the broader market. Now, regarding payment rates, we've seen an increase throughout the pandemic, not just for us, but for the industry as a whole. Recently, payment rates have declined from their pandemic highs as the influence of stimulus measures has lessened. Although these rates are down relative to their peaks one or two years ago, they remain higher than pre-pandemic levels. We attribute part of this decline to a shift in our portfolio mix, with a greater focus on spenders rather than revolving customers. It's also worth noting the percentage of customers making minimum payments has risen above pre-pandemic levels, which seems somewhat unusual given the overall decline in payment rates. This observation highlights a natural normalization process. We have referred to a delayed charge-off effect in consumer credit, where consumers who received stimulus and forbearance may have deferred charge-offs that would have occurred otherwise. This could explain why credit remains healthier than before the pandemic. There is a segment of consumers paying higher minimum payments, with some potentially facing charge-offs that would have happened sooner in previous cycles.

Rick Shane, Analyst

Thank you.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Our next question comes from Ryan Nash with Goldman Sachs. You may proceed.

Ryan Nash, Analyst

Good afternoon, Rich. I want to ask about marketing. Your guidance indicates roughly $2.6 billion in marketing spend for the second half of the year. You mentioned that competitive intensity at the top of the market is increasing. Can you explain how much of the rise in marketing is due to investing more to acquire customers versus the competition driving up acquisition costs? Also, considering what you said about low-end consumers, are you making cuts elsewhere to offset the higher acquisition costs?

Richard Fairbank, Chairman and Chief Executive Officer

Ryan, let me elaborate on the competitive intensity we’re facing. The card business remains highly competitive across all areas and this intensity has been a constant factor. We've noticed in particular that competition around rewards has intensified in recent years. What I want to highlight is that this is not just a recent observation; it’s been a trend we’ve been aware of for some time, especially at the top end of the market. We see certain competitors that are particularly focused on this segment significantly increasing their investments in lounges, unique experiences, dining options, and marketing strategies. It’s clear to all investors, as they are vocal about their strategies. We recognize these are strong competitors, and we have substantial investment plans in this area as well, while noting that others are also making significant investments. From a marketing perspective, we continue to identify exciting opportunities within our businesses. We’re genuinely optimistic about the success of our origination activities, particularly in our card products and banking channels. Two major areas driving this growth are our marketing expenditures and ongoing technology transformation. This transformation enhances our ability to use ever-increasing amounts of data and machine-learning models to spot the most promising growth opportunities. It enables us to customize our solutions at an individual customer level, ensuring we’re addressing their needs effectively. The first point worth mentioning about our marketing efforts is the impressive traction we're gaining, supported by our technology transformation allowing for more opportunities. Additionally, we’re building a strong franchise at the top of the market among high spenders. We have consistently aimed for this premium segment, and with each passing year, as we gain momentum, we're able to reach even higher. These customers are not only lucrative but also associated with low losses, low attrition, and contribute positively to our brand image across the company. However, we are aware that creating a business focused on this high-end market is costly and requires considerable investment in both upfront costs and sustained customer benefits and branding efforts. In pursuing this segment, we are increasingly engaging with consumers who seek exclusive services and experiences that aren’t available widely, such as airport lounges and access to select properties. Our primary competitors are also heavily invested in this area. While we are also stepping up our efforts, I’ve seen in the past that sometimes marketing budgets must increase just to maintain market position, but I don’t see us in such a situation now. The competitive intensity is rising, particularly concerning high-end investments, which are essential for succeeding in this market. Nevertheless, we’re pleased with the traction from our high-spender business. It’s important to note that a couple of our competitors are also intensely focusing on these strategies. We are committed to pursuing growth through upfront customer acquisition and continuing our investments in branding, exclusive experiences, and benefits. Now, let me address our investment in building our national bank, a journey we’ve been on for many years. When we acquired ING Direct in 2012, we recognized it as not only a good financial move but also a significant strategic shift. With a robust branch network and a national direct bank, we’re laying the groundwork for a unique digital-first national bank. We operate a smaller physical branch network, relying more heavily on our presence in cafes in major metropolitan areas and prioritizing our digital experiences. The role of marketing and branding in establishing this national bank is crucial. We’re pleased with the growth and performance of this business, and the opportunity expands further with our recent partnership with Discover. These are the key factors behind our marketing growth, and we feel optimistic about the success and potential ahead. That’s why we’re focusing more on marketing, particularly as we enter the latter half of the year, a time when we typically see increased marketing activities compared to the first half. We expect a proportional rise in marketing spending, similar to what we saw in the previous year. Thank you, Ryan.

Ryan Nash, Analyst

Thanks for the color.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Thank you. Our next question comes from Bill Carcache with Wolfe Research Securities. You may proceed.

Bill Carcache, Analyst

Thank you. Good evening, Rich and Andrew. Following up on your credit commentary, there had been an expectation among many investors that we would see peak charge-offs somewhere around the second half of this year, given the delinquency trends that you're seeing. Is that a reasonable expectation? And if so, it seems like your credit outlook has derisked somewhat given an improving loss trajectory, but higher reserve rate driven by qualitative factors. Is that a fair thought process? I'll just ask my follow-up as part of this. You mentioned, Andrew, that your capital return is subject to Fed approval, given the pending acquisition. How should we think about the pace of incremental buybacks as we look ahead through the rest of the year? Thanks.

Richard Fairbank, Chairman and Chief Executive Officer

Sure, let me share a few thoughts on credit. I’ll start by posing a question to myself to provide context for your inquiry. Last quarter, I mentioned that we observed emerging patterns in tax refunds which might indicate a new seasonality. At that time, I noted it was too early to draw firm conclusions, but we did perceive some deviations from traditional pre-pandemic delinquency trends, suggesting a tax refund effect. Now, it's important to understand how seasonality functions. Historically, our card business has exhibited seasonal credit trends that are typically more pronounced compared to the industry average, likely due to our higher subprime customer base, which seems more closely linked to seasonal tax refund patterns. In fact, the second quarter generally experiences the lowest delinquency rates, while the fourth quarter sees the highest. Card losses usually lag behind delinquencies, peaking in the first quarter and declining to their seasonal lowest in the third quarter. We believe tax refunds play a significant role in these seasonal variations. In the February to March timeframe, we usually see a notable improvement in delinquent payments, resulting in lower delinquencies in April and May and subsequently lower charge-offs. Additionally, tax refunds contribute to a seasonal rise in our recoveries. There have been changes in the tax code, specifically new withholding rules implemented in 2020, following legislation passed in 2019. However, the pandemic and the subsequent return to normalcy have obscured these seasonal trends, making it challenging to gain clear insights. We have been referencing the pre-pandemic seasons of 2018 and 2019 for benchmarking purposes. After analyzing this year's patterns over several months, we’ve identified some trends. To make sense of the seasonality effects, we apply a method known as de-trending to our credit metrics, allowing us to better observe net seasonal effects. When we look back at last year’s data on a de-trended basis, we see that seasonality exhibited less fluctuation both at its highs and lows than what we previously witnessed pre-pandemic. We believe this reflects new behaviors related to tax refunds. As we analyze this tax season's developments, the patterns in payments closely align with our de-trended projections for 2023, which leads us to believe a new seasonality is emerging. I wanted to share this insight with investors. Moving forward, we anticipate that the seasonal uptick in delinquency occurrences during the latter part of the year will likely be less significant compared to historical trends. This seasonal behavior also applies in the auto sector, albeit at an accelerated pace. Last quarter, we noted some inconsistencies in the credit metrics, but we are now observing a positive alignment with this revised seasonal perspective. Overall, we feel optimistic about the recent performance in card credit relative to this new seasonal curve. Regarding your question about peaks, we are not providing forward guidance on specific peak declarations. From a seasonal standpoint, we expect a downward trend in Q3, followed by a potential rise around October, which can often come with surprises. Lastly, I want to point out that our recoveries inventory is beginning to rebuild, which should gradually provide a tailwind to our losses over time, assuming all else remains constant. Looking ahead, another key factor impacting credit performance for us and our competitors in the coming years will be the extent of the delayed charge-off effect stemming from the pandemic. Thank you.

Andrew Young, Chief Financial Officer

Okay. And then, Bill, well, with respect to the derisk comment, Rich just provide a lot of color on our view of losses. I would just say, given the accounting rules, we forecast losses under a variety of scenarios and use qualitative factors for uncertainties around that. I would say, therefore, like we are appropriately reserved for all of that. With respect to your question around repurchases, I'll just note that our agreement with Discover doesn't prohibit us from buying shares. The only restriction is that we'll need to be out of the market during the S-4 proxy vote period. However, we are not operating under the SCB. As I said in my prepared remarks and we laid out in the last Q, the announcement of the intention to acquire Discover did constitute a material business change. Therefore, like we did in this recent quarter, in the second quarter, we're subject to Fed pre-approval of our capital actions until the merger approval process has concluded. That's what's going to dictate the pace at which we repurchase until that process has concluded.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

Thank you. Our next question comes from Don Fandetti with Wells Fargo. You may proceed.

Don Fandetti, Analyst

Yes. Rich, can you talk a bit about how you're seeing loan growth in auto? And also as banks potentially come back in, are you seeing or worried about spread or yield compression on new originations?

Richard Fairbank, Chairman and Chief Executive Officer

So, Don, it's an interesting development. We tend to move differently in the auto business compared to others. As we mentioned last quarter, we have a positive outlook on the auto sector. We're experiencing considerable success and our infrastructure investments are yielding significant benefits. In terms of numbers, our originations increased by 21% compared to last year in Q1, and this trend has continued in Q2 with an 18% year-over-year growth. Our loss performance has stabilized and normalized. Importantly, we made adjustments for credit score inflation we noticed during the pandemic. We reduced our lending in 2022 and 2023, believing that some reported credit scores were artificially high. This strategy allowed our vintages during that time to perform well. We're pleased with the economics of the loans we originated and the overall portfolio's performance. Regarding challenges, interest rates are still high and coupled with elevated vehicle values, they are impacting affordability. While used car prices remain high compared to historical averages, they may gradually start to decline, which we will monitor closely. We had concerns about margins because competitors hadn't adjusted for the higher interest rates in auto loans. We pulled back significantly during that time, but we've since seen margins return to previous levels, which is a positive indicator. Overall, while we keep an eye on used car values, we see promising opportunities in the auto sector with robust margins that have improved since we were previously concerned about the sector's resilience. Thank you.

Don Fandetti, Analyst

Thanks.

Richard Fairbank, Chairman and Chief Executive Officer

Thank you.

Jeff Norris, Senior Vice President of Finance

Next question, please.

Operator, Operator

And our final question this evening comes from the line of Moshe Orenbuch with TD Cowen. You may proceed.

Moshe Orenbuch, Analyst

Great. Thanks. When you discussed the increase in the reserve rate, not the dollar amount or the reserve itself, but specifically the reserve rate, Andrew, you didn't mention the mix of receivables. Has there been any shift towards mass market or subprime from super prime within the card business?

Andrew Young, Chief Financial Officer

Not in any material way that would have a significant impact on the allowance, Moshe.

Moshe Orenbuch, Analyst

Got it. Okay. And just as a follow-up, Rich, given what's happened with Walmart and the pending Discover acquisition, could you talk a little about your thoughts on the partner or private label business kind of in the current environment? What are your thoughts now in terms of your existing contracts and the tendency to want to get new ones or any thoughts on that in this environment?

Richard Fairbank, Chairman and Chief Executive Officer

Thank you. The Walmart partnership is quite unique, and it may not be applicable to other partners. We are in a position where the loss share has turned out to be beneficial. Our portfolio will carry loss rates that are around 40 basis points higher due to this. We have a comprehensive understanding of the business, and the portfolio we took over is now well-established while the other portion comes from our own origination. We feel confident about it. The partnership model is highly individualized, and challenges often arise when there is pressure to achieve a certain scale. Although scale is important in the credit card sector and partnerships, we've learned that each partnership has its own unique characteristics. We’ve experienced both successful and less successful partnerships. We prioritize partners that are healthy franchises. The credit card business has a default structure that protects us; if a partner struggles, we take over their portfolio, as with Walmart, which is a strong company. Another key factor we assess is whether a partner's motivation for the co-brand or private-label business is profit-driven or focused on utilizing the card partnership to enhance their franchise. The partner's behaviors and incentives reflect their position on this spectrum. We have passed on many opportunities that appeared overly focused on profits rather than building a franchise. While we are firm believers in the card partnership model, we will remain selective and recognize that this business operates like an auction, which means we must be prepared to walk away if the deal isn't right. Those are my thoughts.

Jeff Norris, Senior Vice President of Finance

Thank you, Rich, and thanks everyone for joining us on the conference call today. Thank you for your continuing interest in Capital One. Have a great evening.

Operator, Operator

Thank you. This concludes today's conference call. Thank you for your participation. You may now disconnect.