Earnings Call Transcript - COF Q2 2021

Operator, Operator

Good day, ladies and gentlemen and welcome to the Capital One Second Quarter 2021 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 conference over to Mr. Jeff Norris, Senior Vice President of Finance. Sir, you may begin.

Jeff Norris, Senior Vice President of Finance

Thanks very much, everyone, and welcome to Capital One's second quarter 2021 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've included a presentation summarizing our second quarter 2021 results. With me today are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; Mr. Andrew Young, Capital One's Chief Financial Officer. Rich and Andrew will 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.

Andrew Young, CFO

Thanks, Jeff. And good afternoon everyone. I'll start on Slide 3 of tonight's presentation. In the second quarter, Capital One earned $3.5 billion or $7.62 per diluted common share. Included in the results for the quarter was a $55 million legal reserve build. Net of this adjusting item, earnings per share in the quarter was $7.71. On a GAAP basis, pre-provision earnings increased slightly in the sequential quarter to $3.4 billion. We recorded a provision benefit of $1.2 billion in the quarter as $541 million of charge-offs offset by a $1.7 billion allowance release. Revenue grew 4% in the linked quarter, largely driven by the impact of strong domestic card purchase volume on non-interest income, and the absence of the mark on our Snowflake investment a quarter ago. Period-end loans held for investments grew $6.5 billion or 3%, inclusive of the effect of moving $4.1 billion of loans to held for sale during the quarter. The loans moved to held for sale consisted of $2.6 billion of an international card partnership portfolio and $1.5 billion in commercial loans. Turning to Slide 4, I will cover the changes in our allowance in the quarter. We released $1.7 billion of allowance, primarily driven by observed strong credit performance and an improved economic outlook. Turning to Slide 5, we provide the allowance coverage ratios by segment. You can see allowance coverage declined in the quarter across all segments, largely reflecting the dynamics I just described. However, coverage ratios remain well above pre-pandemic levels due to continued economic uncertainty as our allowance is built to absorb a wide range of outcomes.

Richard Fairbank, CEO

Thanks, Andrew. And good evening everyone. I'll begin on Slide 10 with our Credit Card business. Strong year-over-year purchase volume growth drove an increase in revenue compared to the second quarter of 2020, more than offsetting a modest year-over-year decline in loan balance and provision for credit losses improved significantly. Credit Card segment results are largely a function of our domestic card results and trends, which are shown on Slide 11. Second quarter results reflect building momentum in our domestic card business. As we emerge from the pandemic, consumers are spending more and continuing to make elevated payments. Accelerating purchase volume growth partially offset the impact of historically high payment rates resulting in strong revenue growth and a more modest year-over-year decline in loan balances. Domestic card purchase volume for the second quarter was up 48% from the second quarter of 2020. Purchase volume was up 25% from the second quarter of 2019, which is an acceleration from the first quarter when we saw growth of 17% versus 2019. T&E spending continues to catch up to overall spending and accelerated through the second quarter. In June, T&E purchase volume was up 3% compared to June of 2019. At the end of the quarter, domestic card loan balances were down $4.1 billion or about 4% year-over-year. Excluding the impact of a partnership portfolio moved to held for sale last year, second quarter ending loans declined about 2% year-over-year. Compared to the sequential quarter, ending loans were up about 5% ahead of typical seasonal growth of 2%.

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 follow-up questions after the Q&A session, the investor relations team will be available after the call. Holly, please start the Q&A.

Operator, Operator

Absolutely. Thank you so much. Our first question today will come from John Pancari with Evercore ISI.

John Pancari, Analyst

Good evening. Want to see if I can get your thoughts on the payment rates. Did you see a peak in the quarter? And if not, if you can talk about the timing of inflection? And then separately, how does that impact your growth assumption for card receivables and the timing on that front? Thanks.

Andrew Young, CFO

In our card business, payment rates remain at historically high levels. Government stimulus has been boosting these rates, and even as those programs wind down, customer balance sheets are very strong. You can view the payment rate trends in our reported trust metrics. While it's not a complete reflection of our total portfolio, payment rates for Q2 are still historically high, which is affecting balance growth despite strong spending. On the positive side, high payment rates lead to excellent credit performance, contributing to strong profitability and capital generation. We appreciate when our customers are making high payments, as it indicates a healthy consumer base, and these rates are linked to the strong credit results we're observing. However, looking at the monthly numbers, we notice some slight easing in payment rates. While this might not indicate a clear trend, it's possible that as consumers increase their spending and return to more normal activities, payment rates might ease somewhat, and credit metrics could begin to normalize as well. We've noticed the first signs of this, but payment rates are still extraordinarily high.

Jeff Norris, Senior Vice President of Finance

Next question, please?

Operator, Operator

Our next question will come from Moshe Orenbuch with Credit Suisse.

Moshe Orenbuch, Analyst

Great. Thanks. Rich, putting together the comments you made about the significant amount of excess capital and then the comment in the release about seeing increasing near-term opportunities to build your franchise, could you talk a little bit about whether you're looking at primarily kind of organic opportunities or inorganic ones as well?

Richard Fairbank, CEO

Moshe, you've been with us from the beginning and have great insights. We built our company to focus on organic growth, implementing what I refer to as horizontal accounting from the start. This approach allows us to track every action and cohort based on lifetime economics, measuring outcomes at every stage to gauge performance. Organic growth remains our top priority. While many national banks have grown through acquisitions, we are committed to a national growth strategy driven by organic means. As I mentioned earlier, we see strong organic growth opportunities influenced by the current market conditions and supported by the technology and innovations we've developed. Regarding acquisitions, we are not prioritizing bank acquisitions at this time; instead, our focus is on technology acquisitions. There is a spectrum when it comes to technology involving FinTechs and tech companies, ranging from partnerships to investment and sometimes acquisitions. We have actively participated across this spectrum in recent years and have seen significant traction and success. Looking back at our smaller FinTech and tech company acquisitions, we are very satisfied with their performance, often exceeding our expectations. One of our major advantages is our modern tech stack, which aligns well with the FinTechs and tech companies we acquire. This compatibility enhances our ability to attract and retain talent beyond contractual agreements, which works to our advantage.

Jeff Norris, Senior Vice President of Finance

Next question, please?

Operator, Operator

Absolutely. Next, we'll hear from Kevin Barker with Piper Sandler.

Kevin Barker, Analyst

Thank you. Considering what we saw during 2020, do you expect normalized credit to maybe run below pre-pandemic levels as we go into 2022 and eventually into 2023?

Richard Fairbank, CEO

Kevin, I understand your question. Currently, we are at an exceptionally low level that hasn't been experienced in modern times, and there is still a distance to cover before things return to normal. We're not making a prediction about where that normalization will occur not out of evasiveness, but because it is quite challenging to forecast at this time. What we prefer to focus on are the underlying factors. The consumer is currently in a robust position. Notably, while the average consumer experience may vary, the overall surplus that consumers have built up suggests that even as government stimulus benefits decrease, there is still some accumulated balance that will support credit performance. Therefore, the only direction credit can realistically take from here is towards normalization. The pace of this normalization will likely be closely tied to consumer payment choices. It seems natural for payment rates to decline gradually while credit returns to normal. While the directions are clear, the timing remains uncertain. Our perspective during this period is to seize the market opportunities that exist while also being mindful of how credit markets function and staying alert for signs of potential overheating.

Jeff Norris, Senior Vice President of Finance

Next question, please?

Operator, Operator

Thank you. Next, we'll hear from Rick Shane with JPMorgan.

Rick Shane, Analyst

Hey, everyone. I appreciate you taking my question this afternoon. We've discussed this topic a few times. We're examining the reserve rates with respect to day one reserve levels. I'm interested in how you view day one allowance coverage and its potential long-term implications as we revert to normal. Specifically, I'm curious if you believe the policy initiatives we've seen during the crisis will alter your long-term outlook regarding potential loss rates.

Andrew Young, CFO

Thanks, Rick. This is Andrew. I'll take that. I think as we look at the allowance; every quarter we're going to take into account a large number of variables and assumptions, which would certainly take policy and other factors into account. As I reflect back on the ratio that we had upon adoption, a lot of things have changed since then. Within every single asset class, the mix is going to impact coverage needs, and then you look at the overall balance sheet mix across each of those asset classes, that will impact things. I look at all of those factors and don't think the ratio at adoption is necessarily a destination. However, I still believe that the pre-pandemic coverage ratio can still serve as a rough benchmark of what coverage ratios might look like. But again, it will take into account each successive quarter and all the things we are looking at in terms of the mix and broad economic assumptions, including policy as you mentioned.

Jeff Norris, Senior Vice President of Finance

Next question, please?

Operator, Operator

Thank you. Next, we'll hear from Betsy Graseck with Morgan Stanley.

Betsy Graseck, Analyst

Hi. Good afternoon.

Andrew Young, CFO

Hey, Betsy.

Betsy Graseck, Analyst

Just a question here on how you're thinking about the opportunity to invest for that account growth. You indicated the account growth is up; maybe give us a sense as to how much more it's up unusually? I know you usually don't give numbers for that, but it would be helpful to understand the benefit that those marketing dollars are generating today? And then how much more you think the opportunity set is here to ramp up the marketing in the back half of the year given the opportunity set in front of you? Thanks.

Richard Fairbank, CEO

Betsy, yeah, we don't tend to give out specific account growth numbers or origination numbers. But they are strong right now. They're not the strongest we've ever seen. We're pleased that they're really quite strong because obviously, there was some weakness a year ago in those kinds of numbers. We have seen very solid performance. We feel really good about the account originations. So, we are leaning further into marketing to drive future growth and also to continue to build the underlying franchise. As we've said, these opportunities are partly because of what the market has to give right now and partly opportunities that are enhanced by our technology transformation. The marketing is especially targeting the card side of the business but also, just look on TV, you've seen us steadily investing in national banking. We're very happy with how that's going. You may have seen for the first time this quarter that we have now gone on National TV in the auto side. These advertisements are debuting some of the technology innovations we have at Capital One, some of the exceptional customer experiences we've built. We're seeing good traction in the origination side of the business. So, we continue to lean into marketing.

Jeff Norris, Senior Vice President of Finance

Next question, please?

Operator, Operator

Thank you. Next, we'll hear from Don Fandetti with Wells Fargo.

Don Fandetti, Analyst

Hey, Rich. I was wondering if you could talk a bit about the tech spend outlook. I saw a report that Capital One was hiring a large amount of software programmers to take advantage of the public cloud move. And then you mentioned FinTech, I was just curious if you thought that the regulatory landscape would ever balance out or if that is something that is not going to happen?

Richard Fairbank, CEO

Thank you, Don. Let me discuss technology and our hiring efforts in that area. Succeeding in technology fundamentally relies on attracting exceptional tech talent. While it's simple to talk about, it can be incredibly challenging to achieve in today's business environment. This principle holds true across all sectors, but it's especially pronounced in technology, where demand for top talent far outpaces supply. We have developed a strong tech brand and have successfully attracted leading talent, competing directly with top tech firms in the U.S. We've focused on tech hiring for several years, and this year is particularly strong for us. Most of our new hires are in engineering roles related to software development, cloud infrastructure, and machine learning, which are highly coveted positions. We're making headway in these areas. It's important to note that we are building a technology-driven company that functions like a bank, akin to what Capital One is. Technology and data are at the core of our business, and the tech talent is central to this transition. I should also highlight that the cost of tech talent is rapidly increasing, which is something I'd like to bring to the attention of our investors. This rise is a natural outcome of demand surpassing supply, making it difficult for many companies to hire the personnel they need. We are actively addressing this issue and believe we are in a strong position, though it is necessary to compensate talent fairly. Regarding FinTechs and the regulatory environment, I have a keen interest in this sector, partly because Capital One was an early player in FinTech before the term even existed. I observe that some FinTechs are introducing significant innovations to the market, and we analyze these developments closely, viewing them as both threats and opportunities. We partner with some FinTechs and are even considering acquisitions in certain cases. We are also closely monitoring the regulatory landscape. Today's FinTechs leverage modern, cloud-based technologies and possess an innovative spirit that helps them disrupt markets, supported by substantial funding. However, I don't believe their success is solely because they are less regulated; it stems from other factors I previously mentioned. As we foresee these rapidly growing FinTechs becoming major disruptors, we need to consider regulatory implications, their capital structures, regulatory requirements, and the necessity for fairness. We are well-positioned for success due to our modern technology infrastructure and other advantages that many FinTechs lack. Therefore, I believe both we and FinTechs are set up for success, but the banking landscape is evolving quickly. The competition is becoming increasingly well-funded, and we must invest where necessary.

Jeff Norris, Senior Vice President of Finance

Next question, please?

Operator, Operator

Thank you. Next, we'll hear from Sanjay Sakhrani with KBW.

Sanjay Sakhrani, Analyst

Thanks. I guess I had a follow-up question on the opportunity in US card for growth. I assume a lot of the account growth you're seeing right now is coming in the super-prime or the transactor space because of the growth in transaction volumes. Is that correct? And if we think about the subprime consumer, maybe you could just talk about what their behaviors are today, and how you see growth from that segment unfolding? Thanks.

Richard Fairbank, CEO

Sanjay, certainly, the biggest newsworthy aspect happening in the short run is the surge in the super-prime side. The return to travel and entertainment spend is powered a lot by heavy spenders. You can feel the world pent-up and bursting out. That's the biggest news we see in our numbers. On the other hand, the subprime business has been more characteristic of the sort of mass-market of America. Things have not been as dramatic in terms of pullbacks nor are they dramatic in terms of leaning in. We continue to take the same strategy we've had in the subprime and prime businesses for years and are carefully leaning into originations and growing the underlying franchise. We are gradually opening up credit lines because we see good results and the consumer is in a good position. Our customers are in a good place. We've talked about holding back on this for years. It's not like we're unleashing credit lines right now, but we are net-more on the opening up side than the tightening side with a watchful eye on key indicators that will change.

Jeff Norris, Senior Vice President of Finance

Next question, please?

Operator, Operator

Thank you. And our next question comes from Ryan Nash with Goldman Sachs.

Ryan Nash, Analyst

Hey. Good evening, everyone.

Andrew Young, CFO

Hey, Ryan.

Ryan Nash, Analyst

So, Rich, you mentioned several times that you're leaning into marketing. I guess from the outside looking in, how should we assess the return on these investments? Should it come in the form of accelerating growth or improved efficiency? And I guess, Rich, just on the efficiency point, we saw improvement year-over-year for the first time in several quarters. It seems like the top line should be improving. This combined with the technology investments you're making, at what point do you think you'll be ready to reintroduce the 42% efficiency target or what do we need to see for you to reinstate a timeline for that? Thanks.

Richard Fairbank, CEO

Okay. Thanks. Well, first a word on marketing. We are leaning into marketing right now and sort of leaning a little further into it because what we do is always so window-driven. From an efficiency point of view, you notice high levels of spending on marketing. Marketing goes up and down, but at the moment, we've seen it on the upside. One thing I want to say about competition because this is very relevant to these growth conversations and then our pivot to the efficiency point. Most competitors have also been leaning into opportunities they see at the moment. We see competition heating up around us, especially in rewards. You see this in marketing and media activity, in direct mail numbers, and in rewards offerings. Competition is intense right now, but not yet irrational. The banking industry is experiencing a period of historically good credit and a great consumer position. The longer this persists, the more competition will likely extrapolate these trends to inform their decision-making. This could embolden them to make more aggressive offers, market more intensely, and might lead to looser underwriting standards. In this current environment, the benign rearview mirror could encourage lenders to reach for growth, and it could exacerbate credit modeling that relies on consumer credit data unique to the downturn. We remind ourselves that the seeds for the next challenges are being planted right now. We closely observe the key indicators of these inevitable changes and will act accordingly without wanting to be surprised. Let me turn to talk about operating efficiency. We've been focused on improving our operating efficiency ratio for years and have delivered significant improvements since 2013. Of course, the pandemic interrupted our progress, particularly on revenue growth. The pandemic accelerated the technology race and raised the stakes for all players across industries, particularly in banking. The investment flowing into the FinTech world has raised the need for companies to be tech-ready. We are very well positioned on this. However, our tech transformation is the engine of long-term efficiency gains through revenue growth and digital productivity gains. Therefore, we are still driving towards the same destination of operating efficiency, while the timing of improvements incorporates current marketplace imperatives.

Jeff Norris, Senior Vice President of Finance

Next question, please?

Operator, Operator

Absolutely. Next, we'll hear from Bill Carcache with Wolfe Research.

Bill Carcache, Analyst

Thank you. Rich, as you think about the process of normalization of payment rates and revolve rates that you described, would you expect that to provide an incremental tailwind to loan growth such that we could actually see loan growth outpace spending growth as we look ahead?

Richard Fairbank, CEO

I believe the banking industry has gained an important insight about payment rates, which have a significant effect on both loan growth and credit performance. This relationship is both empirical and intuitive. We tend to favor higher payment rates as they indicate a healthier consumer, benefiting us on the credit side. The normalization of credit may coincide with decreasing payment rates, which could mathematically enhance loan growth compared to other metrics. However, for loan growth to substantially surpass other growth metrics, it would require a considerable journey and timeframe.

Jeff Norris, Senior Vice President of Finance

Next question, please?

Operator, Operator

Thank you. And our final question today comes from Bob Napoli with William Blair.

Bob Napoli, Analyst

Thank you and good afternoon. Rich, appreciate your comments on FinTech and how you're looking at partnering, buying, etc. But I was hoping to get a little bit more color on your thoughts around what areas of FinTech? There’s been a focus on a broad array of investment areas; whether it’s buy now pay later, B2B payments, wealth management, business spend management, and areas such that. So I just wondered what areas are most attractive to you where we would see partnerships or acquisitions?

Richard Fairbank, CEO

Bob, instead of prioritizing specific areas, we massively study the FinTech marketplace across all the areas we are leaning into, and beyond, because the learning alone is valuable. We explore a wide range of opportunities for partnerships, investments, and acquisitions. However, we focus on understanding the talent, culture, and business model of potential investments. The success of our past acquisitions has been driven by the talent that comes, stays, and leads within Capital One. While we might not pursue any specific area, the ongoing learning and exploration keep us open to opportunities.

Jeff Norris, Senior Vice President of Finance

Thanks, everybody for joining us on the conference call today. Thank you for your continuing interest in Capital One. Remember, the Investor Relations team will be available in just a few minutes if you have any further questions. Have a great night.

Operator, Operator

And again, ladies and gentlemen, thank you for participating. You may now disconnect.