Capital One Financial Corporation (NYSE:COF) Q3 2023 Earnings Call Transcript

Capital One Financial Corporation (NYSE:COF) Q3 2023 Earnings Call Transcript October 26, 2023

Capital One Financial Corporation beats earnings expectations. Reported EPS is $4.45, expectations were $3.23.

Operator: Good day, and thank you for standing by. Welcome to Capital One Q3 2023 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] 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: Thanks very much, Amy, and welcome, everyone to Capital One’s third quarter 2023 (ph) 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 have included a presentation summarizing our third quarter 2023 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 this presentation. To access a copy of the presentation and the 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 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. 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 Capital One website and filed with the SEC.

Now I’ll turn the call over to Mr. Young. Andrew?

Andrew Young: Thanks, Jeff, and good afternoon, everyone. I will start on Slide 3 of tonight’s presentation. In the third quarter, Capital One earned $1.8 billion, or $4.45 per diluted common share. Pre-provision earnings of $4.5 billion were up 7% compared to the second quarter and 17% compared to the year ago quarter. Both period end and average loans held for investment increased 1% relative to the prior quarter, driven by growth in our domestic card business. Period end deposits increased 1% in the quarter, while average deposits were flat. Our percentage of FDIC insured deposits ended the quarter at 80% of total deposits. We have provided additional details on deposit trends on Slide 18 in the appendix. Revenue in the linked quarter increased 4%, driven by both higher net interest and noninterest income.

Non-interest expense increased 1% in the quarter, as higher marketing expense was partially offset by lower operating expense. Provision expense was $2.3 billion with $2 billion of net charge-offs and an allowance build of $322 million. Turning to Slide 4. I’ll cover the allowance balance in greater detail. The $322 million increase in allowance brings our total company allowance balance up to $15 billion as of September 30. The total company coverage ratio is now 4.75%, up 5 basis points from the prior quarter. I’ll cover the drivers of the changes in allowance and coverage ratio by segment on Slide 5. Relative to last quarter’s assumptions underlying the allowance, the baseline forecast in this quarter for most key economic variables improved.

However, we continue to assume several key economic variables worsened from today’s levels. In our Domestic Card business, the allowance balance increased by $349 million. The coverage ratio was largely flat at 7.79%. The predominant driver of the increased allowance was the growth in loans. The positive impact from the modestly improved economic outlook was largely offset by the impact of replacing the lost content of the third quarter of 2023 with a 12-month reasonable and supportable period that now includes the third quarter of 2024. In our Consumer Banking segment, the allowance balance declined by $136 million. The improved economic outlook and a decline in loan balances drove the release. And in our Commercial Banking business, the allowance increased by $97 million.

The build reflected the impact of rising interest rates and other factors on certain commercial real estate and corporate borrowers, including our commercial office portfolio. On Slide 17 in the appendix, we have included additional details on the office portfolio. I’ll also note that in the third quarter, we completed the sale of approximately $900 million of loans from our commercial office portfolio that were previously marked as held for sale. The commercial — the coverage ratio in the Commercial business increased by 12 basis points and now stands at 1.74%. Turning to Page 6. I’ll now discuss liquidity. You can see our preliminary average liquidity coverage ratio during the third quarter was 155%, up from 150% last quarter and 139% a year ago.

Total liquidity reserves in the quarter were largely flat at $118 billion. Higher cash balances were offset by a decline in the market value of our investment securities portfolio. Our cash position ended the quarter at approximately $45 billion, up about $3 billion from the prior quarter. Turning to Page 7. I’ll cover our net interest margin. Our third quarter net interest margin was 6.69%, 21 basis points higher than last quarter and 11 basis points lower than the year ago quarter. The quarter-over-quarter increase in NIM was largely driven by higher card yields, a continued mix shift towards card loans and one additional day in the quarter, partially offset by higher rate paid on 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%, approximately 30 basis points higher than the prior quarter. Net income in the quarter was partially offset by an increase in risk-weighted assets, common and preferred dividends and the share repurchases we completed in the quarter. With that, I will turn the call over to Rich. Rich?

Richard Fairbank: Thanks, Andrew, and good evening, everyone. Slide 10 shows third 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. The domestic card business posted another strong quarter of year-over-year top line growth. Purchase volume for the third quarter was up 6% from the third quarter of last year. Ending loan balances increased $19 billion or about 16% year-over-year and third quarter revenue was up 15% year-over-year, driven by the growth in purchase volume and loans. Revenue margin declined 31 basis points from the prior year quarter and remained strong at 18.24%. The decline was driven by two factors: First, loans grew faster than purchase volume and net interchange revenue in the quarter.

This dynamic is a tailwind to revenue dollars, but a headwind to revenue margin; and second, charge-offs increased, so we reversed more finance charge and fee revenue. These factors were partially offset by an increase in revolve rate. On a linked quarter basis, the revenue margin increased seasonally by 48 basis points. Domestic Card credit results continue to normalize from the historically strong results we saw during the pandemic, consistent with our expectations. The charge-off rate for the quarter was up 220 basis points year-over-year to 4.4%. The 30 plus delinquency rate at quarter end increased 134 basis points from the prior year to 4.31%. On a sequential quarter basis, the charge-off rate was essentially flat and the 30 plus delinquency rate was up 57 basis points.

Both the monthly delinquency rate and the monthly charge-off rate are now modestly above 2019 levels. Our delinquencies are the best leading indicator of domestic card credit performance and the pace of delinquency rate normalization is slowing. Non-interest expense was essentially flat compared to the third quarter of ’22 — of 2022. Total company marketing expense of $972 million for the quarter was also relatively flat year-over-year. Compared to the sequential quarter, marketing increased 10%. Our choices in domestic card are the biggest driver of total company marketing. We continue to see attractive growth opportunities in our Domestic Card business. Our opportunities are enhanced by our technology transformation and our marketing continues to deliver strong new account growth across the domestic card business.

As a result, we are leaning into marketing to drive resilient growth and enhance our domestic card franchise. As always, we’re keeping a close eye on competitor actions and potential marketplace risks. We expect fourth quarter marketing will be seasonally higher. Slide 12 shows third quarter results for our Consumer Banking business. In the third quarter, auto originations declined 10% year-over-year, driven by the decline in auto originations, consumer banking ending loans decreased about $4.4 billion or 5.4% year-over-year. On a linked-quarter basis, ending loans were essentially flat. We posted another strong quarter in year-over-year retail deposit growth. Third quarter ending deposits in the consumer bank were up about $34 billion or 13% year-over-year.

Compared to the sequential quarter, ending deposits were up about 2%. Average deposits were up 12% year-over-year and up 1% from the sequential quarter. Powered by our modern technology and leading digital capabilities, our digital-first national direct banking strategy continues to deliver strong results. Consumer Banking revenue for the quarter was down about 7% year-over-year driven by the higher rate paid on deposits and lower auto loan balances and margins. Non-interest expense was down about 6% compared to the third quarter of 2022. Lower operating expenses were partially offset by an increase in marketing to support our National Digital Bank. The auto charge-off rate for the quarter was 1.77% up 72 basis points year-over-year. The 30 plus delinquency rate was 5.64%, up 79 basis points year-over-year.

Compared to the linked quarter, the charge-off rate was up 37 basis points, while the 30 plus delinquency rate was up 26 basis points, both of these linked quarter increases were better than typical seasonal expectations. Slide 13 shows third quarter results for our Commercial Banking business. Compared to the linked quarter, ending loan balances were essentially flat. Average loans were down about 2%. The decline is largely the result of choices we made earlier in the year to tighten credit. Both ending deposits and average deposits were down about 2% from the linked quarter, consistent with the general trend we’ve seen for several quarters as we continue to manage down selected less attractive commercial deposit balances. Third quarter revenue was up 2% from the linked quarter.

Non-interest expense was up about 6%. The commercial banking annualized charge-off rate for the third quarter declined 137 basis points from the second quarter to 0.25%. The second quarter charge-off rate was elevated by charge-offs we recognized when we moved the portfolio of commercial office loans to held for sale. We completed the sale of that portfolio in the third quarter. Slide 17 of the third quarter 2023 results presentation shows additional information about the remaining commercial office portfolio, which is less than 1% of our total loans. The Commercial Banking criticized performing loan rate was 8.08%, up 135 basis points compared to the linked quarter. The criticized nonperforming loan rate was essentially flat at 0.9%. In closing, we continued to deliver solid results in the third quarter.

We posted another quarter of strong top line growth in domestic card revenue, purchase volume and loans. The pace of domestic card delinquency normalization slowed. We grew consumer and total deposits. And we added liquidity and capital to further strengthen our already strong and resilient balance sheet. Turning now to operating efficiency. The third quarter operating efficiency ratio was particularly strong. Operating efficiency ratio can vary from quarter-to-quarter, driven by the timing of revenue and operating expense. We expect 2023 annual operating efficiency ratio net of adjustments will be modestly down compared to 2022. Pulling way up, our modern technology capabilities are generating an expanding set of opportunities across our businesses.

We are driving improvements in underwriting, modeling and marketing as we increasingly leverage machine learning at scale. At our tech engine drives growth, efficiency improvement and enduring value creation over the long term. We remain well positioned to deliver compelling long-term shareholder value and to thrive in a broad range of possible economic scenarios. And now, we’ll be happy to answer your questions. Jeff?

Jeff Norris: Thanks, Rich. We will now start the Q&A session. [Operator Instructions] Amy, please start the Q&A session.

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Q&A Session

Operator: [Operator Instructions] Our first question comes from the line of Ryan Nash with Goldman Sachs. Your line is open.

Ryan Nash: Hey. Good evening, everyone. So Rich, you noted several times that delinquency normalization has slowed. It looked like September charge-off performance was better than we would have expected. But we are hearing from others that pressure is becoming broader, not just sub-prime, but it’s also into prime. So can you maybe just talk about what you’re seeing within your portfolio? What do you think about the pace of delinquency normalization? And do you have any line of sight when you think losses will inevitably peak? Thank you.

Richard Fairbank: Thanks, Ryan. So let’s just pull up on the metrics here. Our third quarter domestic card charge-off rate was essentially flat from the prior quarter, up 2 basis points to 4.40%. Our 30 plus delinquency rate increased 57 basis points from the prior quarter to 4.31%. Both our losses and our delinquencies are modestly above their pre-pandemic levels. Now let’s talk about sort of what’s happening at the margin here. The trend of normalization in our credit metrics appears to be slowing. In August and September, the month-to-month movement in our delinquencies was essentially in line with normal seasonality for the first time since normalization began. We’ve also seen some stabilization in new delinquency entries, relative to normal seasonal patterns.

So we are hopeful these stabilization trends continue. Now charge-offs, of course, are a lagging metric, so they have some months of catching up still to do. In auto, we have seen stabilization even longer. Our losses are modestly above pre-pandemic levels, but moving in line with normal seasonality for the past few quarters. So back to our card business for a moment. There’s another stabilization trend that we see as well, which is our recovery rate. Our recovery rate had been falling for several years because of the low level of charge-offs through the pandemic. So we’ve had less inventory, if you will, to recover on. And this was a larger effect for Capital One than for most of our competitors because we tend to have meaningfully higher recovery rates than the industry average.

And because we tend to work our own recoveries, so they come in overtime and not all at once, like in a debt sale. We’ve now seen the recovery rates stabilize, although, it remains at unusually low levels. Now recoveries, of course, don’t impact our delinquencies, but they are a pretty significant factor when — in our charge-offs and particularly when comparing our charge-offs to pre-pandemic benchmarks. Now another Capital One’s specific point here. There’s another factor sort of driving stabilization, but this is — has been going on for a long time and that’s the stability of credit performance in our recent origination vintages. So looking ahead, the economy is, as always a source of uncertainty. In our outlook, we still expect the unemployment rate to worsen over the coming year.

And as always, we remain very focused on resilience in our underwriting and making sure that we build resilience, a lot of resilience into all of our choices.

Ryan Nash: Maybe, Rich, as my follow-up question, so Andrew, you had highlighted that the domestic card allowance was relatively stable. And I think you gave three different factors. Maybe can you just remind us again what is included from a macro perspective in terms of unemployment? And if I take what Rich said regarding delinquency slowing and obviously, charge-offs are catch up a little bit. Do you think we’re at the point where the replacement and the allowance is going to be less of a tailwind — of a headwind going forward. And we can now finally have allowance more closely following — the allowance build more closely following the loan growth? Thank you.

Andrew Young: Sure, Ryan. So to your economic assumption point, I’ll focus on unemployment rate, although recall that a whole lot more is considered a whole bunch more variables, but we are now assuming the unemployment rate moves into the mid-4s by the middle of ’24 and basically hold there for a period of time. But it’s not just the absolute level of unemployment, as we’ve talked about before, it’s also the change that influences underlying credit performance. How that then plays through the allowance, though, like a number of factors are going into the allowance calculation. As Rich said, the projected loss rates are going to be by far the biggest driver. And as we’ve talked about many times, delinquencies are the best leading indicator of credit performance, particularly over the next couple of quarters.

And I won’t go through the reasonable and supportable and reversion process elements that we’ve discussed previously, but I will say beyond the credit forecast, it is worth noting that the allowance framework considers a range of outcomes and uncertainties, which are generally wider in periods of either worsening or improving transitions. So at the core of your question, even in a period where projected losses in future quarters may be lower than today and might otherwise indicate a release. We could very well see a coverage ratio that remains flat or only modestly declined, at least in the near term as we incorporate the related uncertainty into the allowance. And so we’ll go through our process as we do every year to take all of those factors into account and roll forward the allowance each quarter.

Jeff Norris: Next question please.

Operator: Our next question comes from Mihir Bhatia with Bank of America. Your line is open.

Mihir Bhatia: Hi. Good afternoon and thank you for taking my question. I was curious in terms of the health of the consumer, I was curious if you’re seeing trends at all diverge between higher FICO and lower FICO scores, whether it’s on credit performance or spending as we go through the recovery?

Richard Fairbank: Yes, Mihir. Thank you for your question. So let’s talk about credit performance. When credit first started to normalize, we called out that this trend was more pronounced at the low end of the market, whether defined by income or credit score. And strikingly, those were the segments that had improved the most early in the pandemic. So this was not surprising to us. Later, we observed that normalization was becoming more broad-based. And in fact, for many quarters now — for several quarters now, every segment was basically normalizing at about the same rate. In other words, if you look at for any segment where its credit metrics were relative to like its delinquencies, for example, relative to pre-pandemic every segment was kind of on top of each other, everything had caught up.