Capital One Financial Corporation (NYSE:COF) Q4 2023 Earnings Call Transcript

Capital One Financial Corporation (NYSE:COF) Q4 2023 Earnings Call Transcript January 25, 2024

Capital One Financial Corporation misses on earnings expectations. Reported EPS is $2.24 EPS, expectations were $2.5. Capital One Financial Corporation isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good day, and thank you for standing by. Welcome to Capital One Q4 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 fourth quarter 2023 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 fourth-quarter of 2023 results. With me today 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 the 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. 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 of our annual and quarterly reports accessible at Capital One’s website and filed with the SEC.

Now, I will turn the call over to Mr. Young. Andrew?

Andrew Young: Thanks, Jeff, and good afternoon everybody. I’ll start on Slide 3 of today’s presentation. In the fourth quarter, Capital One earned $706 million or $1.67 per diluted common share. For the full year, Capital One earned $4.9 billion or $11.95 per share. Included in the results for the fourth quarter was a $289 million accrual for our current estimate of the FDIC special assessment. Net of this adjusting item, fourth-quarter earnings per share were $2.24 and full-year earnings per share were $12.52. On a linked-quarter basis, growth in our Domestic Card business drove period-end loans up 2% and average loans up 1%. Period-end deposits increased 1% in the quarter, and average deposits were flat. Our percentage of FDIC-insured deposits grew to 82% of total deposits in the fourth quarter.

Revenue in the linked quarter increased 1% driven by both higher net interest and non-interest income. Non-interest expense was up 18% in the quarter. Operating expense increased 15%, with roughly half of that increase driven by the FDIC special assessment. The full-year operating efficiency ratio, net of adjustments, improved 99 basis points to 43.54%. Provision expense was $2.9 billion, comprised of $2.5 billion of net charge-offs and an allowance build of $326 million. Turning to Slide 4, I will cover the allowance balance in greater detail. The $326 million increase in allowance brings our total company allowance balance up to approximately $15.3 billion as of December 31. The total company coverage ratio is now 4.77%, up 2 basis points from the prior quarter, largely driven by a higher mix of card assets.

I’ll cover the drivers of the changes in allowance and coverage ratio by segment on Slide 5. Outside of interest rates, most of our economic assumptions are largely unchanged from the third quarter and we continue to assume several key economic variables modestly worsened from today’s levels. In our Domestic Card business, the coverage ratio decreased by 16 basis points to 7.63%. The allowance balance increased by $336 million. The predominant driver of the increased allowance was the loan growth in the quarter. In our Consumer Banking segment, the allowance was essentially flat at roughly $2 billion. Coverage increased by 4 basis points to 2.71%, driven by a decline in auto loans in the quarter. And finally, in our Commercial Banking business, the coverage ratio declined by 3 basis points to 1.71%.

The allowance decreased by $37 million, primarily driven by the charge-offs of office real-estate loans in the quarter. We have included additional details on the office portfolio on Slide 17 of tonight’s presentation. Turning to Page 6, I’ll now discuss liquidity. Total liquidity reserves in the quarter increased by $2.3 billion to about $121 billion. The increase was driven by a higher market value of our investment securities portfolio, partially offset by modestly lower cash balances. Our cash position ended the quarter at approximately $43.3 billion, down $1.6 billion from the prior quarter. You can see our preliminary average liquidity coverage ratio during the fourth quarter was 167%, up from 155% in the third quarter. The increase in the LCR was driven by holding more of our cash balances at the parent company versus our banking subsidiary.

Turning to Page 7, I’ll cover our net interest margin. Our fourth quarter net interest margin was 6.73%, 4 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 a continued mix-shift towards card loans and higher asset yields, 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 12.9%, approximately 10 basis points lower than the prior quarter. Asset growth, common and preferred dividends, and the share repurchases more than offset net income in the quarter. And with that, I will turn the call over to Rich. Rich?

Richard Fairbank: Thanks, Andrew. Good evening, everyone. Slide 10 shows fourth 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. Top line growth trends in the domestic card business remained strong, even with growth moderating somewhat in the fourth quarter. Purchase volume for the fourth quarter was up 4% from the fourth quarter of last year. Ending loan balances increased $16 billion or about 12% year-over-year. Average loans increased 14%. And fourth-quarter revenue was also up 14% year-over-year, driven by the growth in purchase volume and loans. The charge-off rate for the quarter was up 213 basis points year-over-year to 5.35%.

The 30-plus delinquency rate at quarter-end increased 118 basis points from the prior year to 4.61%. On a sequential-quarter basis, the charge-off rate was up 95 basis points and the 30 plus delinquency rate was up 30 basis points. For the month of December, the charge-off rate was 5.78%, including a one-time impact of 15 basis points, described in a footnote in the monthly credit 8-K. Adjusted for this impact, the monthly charge-off rate for December would have been 5.63%. Pulling up on Domestic Card credit, we believe that normalization has run its course and credit results have stabilized. The 30-plus delinquency rate has been stable on a seasonally adjusted basis for a number of months now. Since August, our monthly delinquency rate has been moving in line with normal seasonality and at stable ratios relative to the same month in 2018 and 2019.

And at this point, we have a pretty good window into January as delinquency entries in December indicate continuing delinquency rate stability in January. We’ve always said that delinquencies are the leading indicator of where charge-offs are going. Charge-off rate tends to follow delinquency rate by about three to six months. Based on the stability, we’ve seen in our delinquencies since August and extrapolating from our current delinquency inventories and flow rates, we believe the charge-off rate is stabilizing now and settling out to about 15% above 2019 levels. I give this window, because investors have been asking for quite some time when will charge-offs level off. So this is the point where we see that happening, meaning charge-offs should move more or less with seasonality in the coming months.

This window comes from modeling the flows in our delinquency buckets which have stabilized, and our recoveries which have also stabilized and started to rebuild. This isn’t designed to be longer-run guidance but rather to indicate that charge-offs are finally moving more or less with seasonality over the near term. In the longer run, there could be additional forces such as potential pressure from economic worsening and potential benefits from the depletion of deferred charge-offs from the pandemic and recoveries picking up over time from increased inventory. Non-interest expense was up 11% compared to the fourth quarter of 2022, with increases in both operating expense and marketing expense. Total company marketing expense of about $1.25 billion for the quarter was up 12% year-over-year.

Our choices in our card business 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. Our marketing continues to deliver strong new account growth across the Domestic Card business. And in the fourth quarter, marketing also included higher media spend and increased marketing for franchise enhancements, like our travel portal, airport lounges, and Capital One Shopping. We continue to lean 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. Slide 12 shows fourth-quarter results for our Consumer Banking business.

In the fourth-quarter auto originations declined 7% year-over-year. Driven by the decline in auto originations, consumer banking ending loans decreased about $4.5 billion or 6% year-over-year. On a linked-quarter basis ending loans were down 2%. We posted another strong quarter of year-over-year growth in federally insured consumer deposits. Fourth-quarter ending deposits in the consumer bank were up about $26 billion or 9% year-over-year. Compared to the sequential quarter, ending deposits were up about 2%, average deposits were up 11% 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 consumer deposit growth and gradually increase the percentage of total company deposits that are FDIC-insured.

Consumer Banking revenue for the quarter was down about 17% year-over-year, largely driven by lower auto loan balances and higher deposit costs. Non-interest expense was down about 3% compared to the fourth 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 2.19%, up 53 basis points year-over-year. The 30-plus delinquency rate was 6.34%, up 72 basis points year-over-year. Compared to the linked quarter, the charge-off rate was up 42 basis points, while the 30-plus delinquency rate was up 70 basis points. Both of these linked-quarter increases were in line with typical seasonal expectations. Monthly auto credit began to stabilize even earlier than domestic card credit results.

On a monthly basis auto delinquency rate and charge-off rate had been tracking normal seasonal patterns since the first half of 2023 and continued to do so through December. Slide 13 shows fourth-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 earlier in the year to tighten credit. Ending deposits were down about 9% from the linked quarter. Average deposits were down about 7%. The declines are largely driven by our continuing choices to manage down selected less attractive commercial deposit balances. Reducing these less attractive deposits also drove the 14 basis point linked-quarter improvement in our average rate paid on commercial deposits.

Fourth-quarter revenue was down 5% from the linked quarter. Non-interest expense was also down about 5%. The Commercial Banking annualized charge-off rate for the fourth quarter increased 28 basis points from the third quarter to 0.53%. The Commercial Banking criticized performing loan rate was 8.81%, up 73 basis points compared to the linked quarter. The criticized non-performing loan rate was down 6 basis points to 0.84%. Commercial Banking credit trends were largely driven by continuing pressure in our commercial office portfolio. Slide 17 of the fourth-quarter 2023 results presentation shows additional information about the remaining commercial office portfolio, which is less than 1% of our total loans. In closing, we continued to deliver solid results in the fourth quarter.

We posted another strong quarter of top line growth in domestic card revenue, purchase volume, and loans. Domestic card and auto delinquency trends were in line with normal seasonal patterns, a continuing indicator of stabilizing consumer credit results. We grew consumer deposits and total deposits. And we added liquidity and maintained capital to further strengthen our already strong and resilient balance sheet. Our annual operating efficiency ratio, net of adjustments for the full year 2023, was 43.54%. In 2023, we saw incremental opportunities and made choices to grow revenue and tightly manage costs to achieve a 99 basis point improvement in our annual operating efficiency ratio. The actual improvement was better than the “modest improvement” growth we had been expecting.

Over the last decade, we’ve driven significant operating efficiency improvement even as we’ve invested to transform our technology. And we continue to drive for efficiency improvement over time. For the full-year 2024, we expect annual operating efficiency ratio, net of adjustments, will be flat to modestly down compared to 2023. Our expectation includes the partial year impact of the proposed CFPB late fee rule, assuming that rule takes effect in October 2024. Pulling way up, our modern technology capabilities are generating an expanding set of opportunities across our businesses. We continue to drive improvements in underwriting, modeling, and marketing, as we increasingly leverage machine learning at scale. And 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: Thank you, 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. So if you have any questions after the Q&A session, the Investor Relations team will be available after the call. Amy, please start the Q&A.

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Q&A Session

Operator: [Operator Instructions] And our first question comes from the line of Sanjay Sakhrani with KBW. Your line is open.

Sanjay Sakhrani: Thank you. And, Rich, thank you for the color on the charge-offs. I know you cited the pluses and minuses from here, from stabilizing charge-offs. But I’m curious if you feel like the consumer positioning leans towards improvement here as inflation declines, real income growth has resumed. And should interest rates come down? This coupled with the recoveries could benefit the charge-off rate, correct? And I’m just thinking sort of how to think about the reserve rate going forward.

Richard Fairbank: Yeah. So, Sanjay, yeah — so first of all, my comments, I just want — I wanted with my credit comments in my sort of extrapolated look at our delinquency buckets, I really wanted to share where our charge-offs are settling out, which is about 15% above 2019 levels. And we should also note, by the way, that in any year first-half losses are seasonally higher than second-half losses. So within any normal year, the first half is the peak. Now, as I said, we’re not really giving longer-run guidance. But let’s think about the dynamics about how things could go from here. From an economy point of view, we’re certainly in a strong economy, unemployment is at a pretty remarkable place. So, I think if anything, unemployment could add more downside than it adds upside.

Perhaps inflation has more upside than it does downside. But I don’t have any more insight to those than anybody else does. I think, I also would want to kind of reinforce your point, there are two good guys that should play out over time. And we’ve been talking for a long time about the delayed charge-off effect from the pandemic. And when you think about that the pandemic had such a just absolutely unusual experience for consumers, with all of the stimulus and the forbearance and so on that, we certainly have believed that charge-offs that were otherwise going to happen at that time, some got averted permanently, but I think some got delayed. And so this phenomenon that we call delayed charge-offs, I think, it’s not a really quantifiable effect, but I think it’s very much been a part of what’s happening with — in the normalization and something that intuitively will run its course.

And the other thing is recoveries. So recoveries — our recoveries, while the rate per charge-off dollar remained strong, the number of charge-off dollars in inventory, thanks to the pandemic, were at a really depressed level. And so we have bottomed out there and they’re starting to — now inventories are starting to increase, of course, as credit has normalized and that should also gradually be a good guy. Also when I look at our origination strategy and the underwriting choices we make, these are consistent with longer-term losses that are lower than where we are now. So we consciously sort of focused our credit commentary to really focus on where things settle out. And then there is a list of forces that could work in either direction, but I think you certainly point out to some of the good guys.

Sanjay Sakhrani: Okay, just a follow-up. Maybe, Andrew, could you just talk about the reserve rate on a go-forward basis and how we should think about it? Should it stabilize? Can it come down? And maybe just also on the NIM with rates coming down, how we should think about the movement over the course of the year? Thanks.

Andrew Young: Sure. Sanjay, let me compartmentalize those two things, NIM will be a whole separate answer, but with respect to allowance. Well, let me first start with just a tactical housekeeping item, which is a reminder that in Q4 we have seasonal balances that quickly pay off in the first quarter and therefore have negligible coverage. So the coverage ratio in Q4 is modestly lower as a result of that dynamic and it reverses itself in Q1, but again a real modest effect there. Longer-term though, projected losses are really going to be the biggest driver of coverage. And as we’ve said before, delinquencies are the best leading indicator of that and Rich just provided a fulsome description of all of the forces at play there.

So from a reserve perspective, every quarter we’re just going to be looking at the next 12 months of projected losses with the first six more consequential in the calculation, but also far more predictable, given the visibility that we have through delinquencies. And then the remainder of that window really informed by economic assumptions, and then the reversion to the long-term average. And so over the last few quarters, things have played out consistent with or slightly better than what we’ve expected and you’ve seen the coverage ratio in card roughly stay flat. So, I think it’s important to note that even in a period where projected losses in future quarters are lower than today and might otherwise indicate a release, we could very well see a coverage ratio that remains flat or only modestly declines as we incorporate some of that uncertainty into the allowance, but eventually in a scenario like that, after a period of coverage stability like we’ve seen, you would see coverage coming down in the release of non-growth related reserves.