Capital One Financial's CEO Presents at Goldman Sachs Financial Services Conference (Transcript)

Dec.10.13 | About: Capital One (COF)

Capital One Financial Corporation (NYSE:COF)

Goldman Sachs Financial Services Conference Call

December 10, 2013 3:20 p.m. ET

Executives

Richard Fairbank - Founder, Chairman, Chief Executive Officer

Analysts

Ryan Nash - Goldman Sachs

Ryan Nash - Goldman Sachs

We are going to get started now. We are pleased to have Capital One joining us today at our conference. In a little over two decades, Capital One has transformed itself to one of the nation's leading consumer franchises with over 45 million accounts and a strong deposit franchise that combines both branch and internet deposits. Despite a challenging environment for the consumer, Capital One has focused its efforts on tightly managing cost, improving operational efficiency, and having a strong commitment to returning capital to shareholders.

Joining us for a discussion today is Founder, Chairman and CEO, Rich Fairbank, along with Daniel Deets [ph] from Investor Relations. I am going to turn over to Rich for a couple of opening remarks and the remainder of the presentation will be a fireside chat. So with that I will turn it over to Rich.

Richard Fairbank

Okay. Thank you, Ryan. Just a couple of minutes opening remarks. Thanks by the way to everyone in the room for coming today and for those listening in on the webcast.

Over the past few decades we have transformed Capital One and positioned ourselves to compete effectively as banking dramatically evolved. Capital One is well positioned to deliver value today and in the future. We have build scale positions where scale matters most. In products like credit cards and auto finance, and in digital and in brand. By being focused we have achieved these scale positions with only a fraction of the overall size and complexity of big money center banks.

We also have attracted positions in a thriving commercial banking business in our local banking markets and national reach with Capital One 360, formerly ING Direct. Our business had continued to deliver attractive and sustainable returns and generate capital on a strong trajectory. And our capital and liquidity positions have never been stronger. Capital One is earning very attractive risk adjusted returns today and we expect that will continue in 2014. We remain focused on important levers that will sustain and improve our profitability. We are committed to tightly managing costs across or businesses and we have continued to focus on disciplined underwriting which pays special attention to resilience.

And growth is a high priority for us but, of course, only in the context of ensuring attractive, sustainable and resilient returns. We continue to expect that capital generation and distribution will be important parts of how we deliver superior and sustainable returns to our investors. Risk and uncertainties related to capital allocation requirements are higher today, but that doesn’t change our view of our own capital strength and trajectory or our intent to distribute capital to shareholders. As we have indicated, we expect to request capital distribution in the upcoming CCAR process, that if approved would results in a total payout ratio well above industry norm of 50%.

Pulling up, we have assembled the businesses and the capabilities we need to succeed and to deliver value as banking continues to evolve. And we are highly focused on delivering that value as quickly and as effectively as possible. Now, Ryan, we are happy to take questions.

Question-and-Answer Session

Ryan Nash - Goldman Sachs

Thanks, Rich. So I guess just starting, thinking about the consumer which, you know the post the recession the consumer has continued to deleverage and we really haven't seen a big pickup in growth to this point. Now our economists are calling for a decent pickup in consumer spending into 2014. Do you share that you and you do you see this translating into both higher card spend and higher loan growth in 2014?

Richard Fairbank

Well, I think that you know cautious is certainly the word that I would use to describe the consumer. I think ever so gradually you have seen the consumer step out a little bit and certainly we have seen spending pick up. And I don’t see any reason to think that that gradual trajectory wouldn’t continue into next year. Let me talk about what this means for the credit card business.

I first of all, sometimes say, just be careful what you wish for. A very conservative consumer is a great thing for a credit card company. And the same thing that is causing consumers to hold back a little bit -- you know when you think about how are they holding back, what they are doing is using their money to pay down debt and be extra careful. And while that puts pressure on balances, you can just look at the just extraordinary credit quality in most company's credit portfolios and frankly across the consumer business in general.

So that, I think that we will be paid with good credit quality but I think also that, I think if anything, the growth prospects for the industry might look up a little bit over time. I certainly feel our growth prospects within the context of the conservative consumer. I like our chances there as well.

Ryan Nash - Goldman Sachs

Great. So just digging a little bit deeper into your growth expectations. Just starting with the card business. You obviously have some strategic run offs from the deals that had been done. But I am assuming that you are seeing some good growth in some of the overall underlying segments. Can you talk about where you think you are taking share in the segments that you are targeting?

Richard Fairbank

Yes. First of all, there is two things that, two choices we make that actually put us behind the skirting line each year with respect to growth. One of those is the choice to, as we planned all along to run off some of the highest risk and high returning parts of the HSBC portfolio that we bought. But also we continue to avoid high balance revolvers. And these are the more highly indebted credit card customers with big balances. They have a lot to do with the movement and the growth in balances among one player to the next. But going into the great recession, we were very cautious about that. Seeing what happened to high balance revolvers in the recession, we are even redoubled in our caution about that.

So what is going at Capital One is not only sort of the avoidance of high balance revolvers but to continued kind of running off of that part of the business, along with some run off of the HSBC, parts of the HSBC portfolio. Beneath that, now Ryan to get to your question, where we are investing, we see really nice opportunities in some continuing traction. That includes at the top of the market in the transactor segment. That includes the revolver business in the medium and lower balance revolver business, the small business business. All very nice traction and kind of growing traction there.

And then in the partnership space where we just bought a big private label partnership business from HSBC. While we put most of our energies into the integration, we are certainly hopeful to grow that business. That really comes one partner at a time.

Ryan Nash - Goldman Sachs

Rich, just digging deeper into a couple of those points. If on the high balance revolver your avoidance side is the underlying driver that your resiliency through the good times and the bad, just the risk-adjusted returns are not as high and there is more volatility relative to the core part of your business.

Richard Fairbank

Yes. The high balance revolver, you know if you could guarantee me there wouldn’t be a big recession out in the future, I would book that stuff very aggressively all day long because it generates very nice current returns. The issue is really one of resilience. And you know over the 20 -- more than 20-year history of building Capital One, we have just been absolutely obsessed about resilience and doing our own kind of poor man's stress test, if you will. But there is a big difference between current performance sometimes and the ultimate resilience of certain assets in a recession. And we start with what is resilient and then work backwards from that.

Ryan Nash - Goldman Sachs

Rich, you mentioned the deeper push into the transactor part of the card market post crisis. Where do you think you are right now in terms of investment, building out that part of the market and how do you think about returns in that part of the market relative to the more traditional Capital One customer?

Richard Fairbank

Well, you know the franchise that one builds there, it's a very very attractive franchise. I mean this is a business where the customers have very low attrition, wonderful credit performance, great resilience in the recession and great spending dynamics and everything else. The issue there is the cost to acquire these accounts. So anyone who goes and invests in that business is spending money upfront for the sake of building longer-term franchise. And the other thing about that, it's not a business you can kind of turn on and say, this quarter let's get some of them there, you know top of the market customers. This is one about building a brand and a presence, and product capability and servicing and everything.

And that’s very much about commitment to a segment. And we now have been doing this for a number of years and we are getting increasing, really nice traction at the top of the market. We have got some really tough competitors of course, that you know about. But we like the financials of this opportunity and we love the franchise characteristics of that. But we are really past that point where you do a lot of initial investment and to the point where the traction continues to pick up in that space.

Ryan Nash - Goldman Sachs

And then just on through the cycle returns in that business, how do they compare to the other parts of the card business?

Richard Fairbank

Well, I mean in a downturn, through the cycle the top of the market, heavy spender business, was the very very most resilient thing that we saw and I am sure every other card player would see that. So it's not an accident. It's pretty obvious to all the players that this is a really attractive segment. It's all about how really do you get customers in that segment and I think the marketing apparatus of Capital One and on the brand side the things we are doing and the sustained focus on it, is something that I think pays off.

Ryan Nash - Goldman Sachs

Rich, just closing the loop on the card business. You talked about getting into the partnership business and clearly the focus over the last couple of -- you know the last year and half or so has been retaining. But as you look out, clearly there would be a use of capital to go and acquire some portfolios. But are you seeing any portfolios out there that meet the three criteria that you have outlined in terms of portfolios Capital One would be interested in? And what are the biggest impediments to your acquiring those right now?

Richard Fairbank

Well, I think the biggest impediment to acquiring portfolios is the fact that most contracts are like five or seven years long. So there is just only a small portion of them are going to be coming along at any one time. The next thing that we would say is, while scale really matters in this business and all you have to do is look at some of the marginal economics we showed with respect to our Best Buy portfolio where we chose not to continue with that. Scale really matters in this business but scale is not the most important thing in the business. The most important thing in our mind is to try to really grow but selectively. And our selectivity is about finding companies who in their own right are really great solid companies.

Secondly, where the motivation and objective function of the partner is, in our opinion, sort of the right one and one that’s focused on building a franchise over time. And there could be a lot of different sort of motivations in how short-term versus long-term focus of a particular, on the partners side. And finally and very importantly, the nature of the contract themselves. And we are always very cautious about auction driven businesses and I think you have to go to auction driven businesses not with a sense of manifest destiny but really a sense of what we like the business at the right price, and just as importantly the right terms in terms of how the economics are shared.

We have seen a lot of different -- it's all over the map in terms of partner profitability, the attractiveness of contracts, how incentives work. So we want to patiently go after and build this business with the right partners. And when done correctly, this is going to be a great business.

Ryan Nash - Goldman Sachs

I guess, Rich, switching to the auto business, this is obviously a business that’s gotten extremely competitive over the past couple of quarters. And I know you have talked about some weakening of standards and credit potentially moving, annual credit losses moving higher. Do you think we are actually getting closer to an inflection point? Because I know you talk a lot about inflection points. And are you starting to pull back at all any maybe can you talk a little bit about the prime and the subprime space.

Richard Fairbank

You know I think every lending business has two inflection points in its cycle. It's sometime through the, in the sort of throes of the bad times you hit an inflection point. And it doesn’t always match the cycle itself. Where actually the lending tends to be more positively selected, the competitive dynamics such that you start a period of your best opportunities up to the other inflection point in where the flip side if that happened. We are definitely not yet in the auto business at the inflection point, beyond which -- and when the next inflection point, typically when you hit that more overdosed inflection point, what happens is, performance turns out worse than your own metrics would expect. And the inverse happens on the first inflection point.

The auto business, while we worry about the competitiveness, it is really not about crossing the inflection point. It's about going from a probably once in a lifetime situation in the auto business where everything lined up in terms of consumer behavior, competition with a lot of people fleeing the space, car manufacturers and some of the things going on there, and the used car pricing being at such extraordinary highs. You had a confluence of things that led to, I would call it lifetime best kind of performance in the auto business.

What is happening on pretty much every metric is a regression towards the mean. But that’s not the same thing -- at some point, yes, it will hit the mean and cross the mean, but let me just give you a little bit more commentary about that. So from a pricing point of view. If I talk about the subprime and the prime parts of the auto finance business from a pricing point of view, it's already at or slightly below the probably cyclical mean, pretty close the cyclical mean on the pricing side. In subprime it is coming down but it's still above the cyclical mean.

In terms of underwriting, really important lever of LTV. LTV is still strong in all parts of the market. Strong meaning, underwriters have been very disciplined about loan-to-value and that really matters in the auto space. The kind of FICO scores and sort of the credit quality, the choices about credit cuts, I think the industry is being pretty consistently good about that. Where you see the leakage is on the term of the loans. So more and more you are seeing growth in the over 72 month loans. It's still a minority of the total, but that’s going into a space the industry really hasn’t kind of gone before.

I think that we have a close eye on that. I would not -- but I think all in all, this is an industry that is regressing toward its mean. But we like it and we will continue to work to grow in the business but our growth will be mitigated by reacting to some of the things we see there.

Ryan Nash - Goldman Sachs

And, Rich, just as a follow up, just regulatorily wise. And so the CFPB is looking at things like dealer premiums, are you seeing -- are you feeling any heightened concern regulatorily? Anything that you are looking closer to at this point?

Richard Fairbank

Yes. I mean we focus on all matters regulatory across all of our business all the time. But I don’t want to comment about any particular regulatory thing there, but certainly the CFPB is focused on dealerships. And remember that CFPB does not regulate dealers. So therefore they want to regulate through the banks and that will be an important area of focus for them.

Ryan Nash - Goldman Sachs

Switching gears. Some of your biggest forward priorities are returning capital to shareholders and managing the expense base. And just starting with capital returns. Your intent has remained for a while now that you want to get your pad above the industry norms, but clearly there has been some heightened uncertainty today just given the Fed's modeling process. So can you just talk specifically what are the biggest areas of concern that you have today relative to when the Fed -- when you came out with your initial guidance of wanting to return on materially more capital.

Richard Fairbank

Well, the most important thing I want to say is that we are in the same position with respect to capital generation. The amount of capital that we have, we have an extraordinary amount of capital that’s accumulating at a pretty breathtaking rate. And a very important way to create value for our shareholders is to distribute this capital. So, and that gives us a great deal of passion and confidence about going out and talking about distribution. To your other point -- the only other comments that we have said about CCAR is, we continue to watch the process as the Fed gives more clarity on their process. Years ago the Fed went out and modeled losses and then pretty much took the companies numbers for other things. Then they went to income statements and now are modeling balance sheet this year.

So our primary point was, the more the Fed takes over the modeling process, the more -- on their different choices they are going to use averages as opposed to company specific things. I think in Capital One's case, a lot of I think what has made Capital One differentially some of the best aspects of our performance or things that are uniquely Capital One. So therefore there is more uncertainty when the more and more of the modeling that becomes really the Fed's model instead of our own. And all of that is not at all related to the continuing, powerful and obvious thing that we have a lot of capital, a lot of capital generated and we need to get it out.

Ryan Nash - Goldman Sachs

And Rich just as a quick follow up on that. In terms of mix you obviously, last year was about materially restoring the dividend and you had an opportunistic chance to buyback some stock post the Best Buy sale. Do you think to this year, any material changes in the mix shift? Do you want to -- is the priority to hit the dividend closer to bank peers or should we expect more of a stable dividend with most of your incremental capital which are incoming in the form of buyback.

Richard Fairbank

We have really focused our conversation more about on the buyback side and I think that’s where investors should anticipate our primary focus for increased distribution next year.

Ryan Nash - Goldman Sachs

Switching gears to expenses for a little bit. You have had some guidance out for a period of time when you put out the capital guidance. And you have talked a lot about the longer term digitizing of the business, can you talk about how that's transforming the card business? And over what timeframe do you think this is going to happen and what it's going to mean for your efficiency in both the card and the retail business and why that’s in there.

Richard Fairbank

Well, it's an interesting thing. You can go look at companies like Amazon, and though they have a cost structure that’s massively different from a company like Barnes and Noble. And just kind of everybody can intuitively look at this and say digital. The more companies become digital, you got to believe that that’s going to make its way into their economics in a pretty dramatic way. So it's an interesting thing. I will make a prediction to you, and that is that the tendency of banks is going to be to add digital as a channel. And in fact if you -- unless one really actively goes to a destination that says, we have got to become a digital company, there is just lots of stuff to invest in and it now becomes another channel. And customers are offered all channels and if you don’t watch out it becomes more costly not less.

So in driving towards a digital destination, the first thing is, one has to create capabilities for the customer to be digital. I put a caution there though, that’s not just about little checklists of yes, I might to do list, I now offer for most deposit capture or other things. Any of you who do digital stuff probably know that you try to do it and then you get stuck. And I think a number of times I get stuck on my digital journeys just as a consumer it's striking to me. So our first objective is create a digital experience that enables customers to choose digital as their primary channel and that’s a lot more than just creating capabilities.

If you build it, they will not necessarily come. So the second thing about this, there is huge need to systematically, as a conscious and high priority strategy, is to drive customers to digital. And so that’s whole part of the thing. And then another component of this is to really digitize how one does work. So to take the whole back office and all the things that are there. And along the way with that there is a lot of kind of foundational technology that is really necessary in terms of digital capability, data related capabilities. Talent, talent that’s necessary in the whole thing. So this is -- I look at this thing, I know your question was more oriented to cost, to me the opportunity to really create a company where digital is not a little channel that’s added on but it's who we are and how we do business, even as we support some other channel. That is we are absolutely focused on that destination.

As a byproduct of that, I think over the longer term you can get a bunch of cost benefits. We wouldn’t do it solely for the cost benefits, but I think in the end there is an extraordinary transformation. I think banks are going to struggle though because on one end of the continuum having it be just another channel and the other end really creating a digital company that really gets to -- in many ways this is sort of like the things we have led through for 27 years. We set out -- the founding concept of Capital One was that banking was going to become an information based, technology-based business. And so we set out to, given that we were starting from the ground up, we set out to build out an information-based company in terms of how you hire and what the culture is and the technology you build and all that kind of stuff.

And I think a lot of the banks along their way have looked at, how do we add information based capabilities to our bank. So I understand the difference between creating an information company from the ground up and adding some nice capability and smart people on the side of a bank. Well, here we face the challenge that we are actually now an incumbent and one of the biggest players in the space. So I think there is a lot of work and a lot of challenging of our own conventional wisdom to actually truly now build a digital company. I think, I love our chances relative to our heritage as mostly direct company, our heritage of an information-based thing. The talent model heritage of the company and now the whole bone structure we have for digital banking, thanks to ING Direct. So there is lot of opportunity but you have to spend on the way also to those gains as well.

Ryan Nash - Goldman Sachs

I will ask one more question before I open it up to the audience. Rich, you talked about reversion to the mean in the auto business that we are seeing. Obviously, we are really not seeing reversion to the mean in the card business right now. And I guess the question I would pose to you is, what do you think we need to see in the card business to have reversion to the mean over the next couple of years in card losses? And given all the changes we have had from the CARD Act to the changes in the dynamics of your portfolio, more transactor oriented. What do you think a normalized loss rate in the business will end up looking like?

Richard Fairbank

Well, loss rates have kind of been running around in 3's in the card business, which is just an extraordinary kind of level. So ones first intuition would be, well look, if things can't be this good for that long, they have to regress upwards towards the mean there. I do want to say that it may not regress as, I might take the under on that one in the sense, even though it's hard to argue against the principle but there is a couple of things at work here.

First of all, we should look at why our credit card loss rates for companies like Capital One and others, why are they so low. First of all, our portfolio, we haven't grown a lot over the last few years. In fact there was lot of shrinking in the great recession. We have a customer base that survived the great recession. There is lot of credit resilience in these folks. We, you know years of conservative underwriting of conservative customers has led to the recent vantages in the last few years. I will speak for ourselves but I am pretty much sure I speak for other companies, are pretty extraordinarily kind of low risk.

And then you have the consumer. The consumer is -- it's the flip side of all. And we talked about it earlier, the flip side of, the lament of consumers aren't spending a lot and all that kind of stuff. Yes, what they are doing is being very careful about debt. And you can feel that and see it in all the ways that we interact with consumers. So I look at that and say what among that is really going to change in the near term. I don’t see that much sort of changing. So I think I think for pretty low credit losses is quite good.

I would say one other thing though. As companies hopefully, company like Capital One will get more growth trajectory over time. Growth trajectory originating in newer accounts that tend to have higher losses early on. Some of that can make our own numbers go up along the way. But I think in many ways the big thing that’s going on the banking for the last number of years is the extraordinary credit story in the midst of all the other noise and craziness in the industry. Should we take any questions.

Ryan Nash - Goldman Sachs

Yes. We have about five minutes of questions.

Unidentified Participant

I will just follow up on Ryan's question and your response. Given that very good outlook in cards, what does that mean for your strategy on pricing and also whether you can actually relax the underwriting standards a bit and capture a slightly lower quality consumer if you feel very good. And also what are seeing competitors doing there?

Richard Fairbank

So I think the card industry is pretty rational competitively, right now. I think everybody has the great recession to look back as the recent experience and pretty much see where people got whacked and where they didn’t. I don’t see a big opportunity in the card business to go out and relax all over the place and build more business. I think that because our trip to the great recession was pretty non-violent one in the card business, we are pretty much doing what we did before in the segments we did them before. Including mainstream America, we do a lot of credit cards to them as well. So I think the opportunity is really not about expanding risk but really building on the things we have done for many years about micro-segmenting the customer and putting the marketing machine of Capital One behind this thing. And as we divert our attention from the HSBC integration which is now pretty much done, and put it back on growing the business, I think I like the prospects even more.

Unidentified Participant

Thanks. Do you envisage banks using telematic data or other forms of big data? Would it help? And if banks were able to get such data, would Capital One have any advantages in using it?

Richard Fairbank

Well, I think generally the more the world goes digital and the more the world goes towards more and more information, the more I like our chances, as a general statement. Because we built the company from the ground up that’s all about data, analytics and highly talented people. And also have been a company that can actually go out and deal with the data and so something with it and capitalize on it. There is a lot to that and it's again, that’s in a sense who we are. Let me make a comment a little bit about big data because we see things where Google is out there predicting how diseases are going to spread by this amazing use of big data and stuff like that.

I don’t believe any bank is just right now saying, oh, my gosh, big data, look at all this on an unfettered basis. Let's just bring it on and see what it tells us. You know we are starting to work backwards from what the opportunity of big data would be. But for a company like Capital One that use information based strategy to -- in the context of relational databases, and test cells and long incubated kind of result. Big data is really a different world. But what I would want to say is, I look at that thing and see a new lever out there. We are working backwards from what that means but you have to change a lot of the foundational and infrastructural capabilities one has to be able to do that. And there's sort of a lot to it. But the spirit of your point is, the more data, the more digital. And the faster moving things the more I like our chances.

Ryan Nash - Goldman Sachs

And we have time for one more quick question.

Unidentified Participant

It's not meant to be a pointed question at all, but could you share with us your reasons for -- if I am not mistaken, for selling a block of stock in the last month or so.

Richard Fairbank

Yes, sure. I have, if you look back at my history now, I guess we are -- I am 19 years into the public company, Capital One's whole journey as a public company. And for most of that journey, for as long as I could, I took all may pay in equity. I didn’t want it any other way. Sometimes with all the various requirements that are out there my pay packages over time have -- the mix has changed the things that are a little bit more, sort of normal in that sense. But I have always wanted to make sure I am aligned up exactly with shareholders with respect to what my interests are and I love the prospects of the company and so on. So really in many ways what we had there was options that are getting to the end, very near the end of their life. And a little bit of, sort of cumulative move from a heritage of taking all my pay for so many years in equity. I have a big position in Capital One and my favorite investment and biggest by far that I hold in my life and that’s the way I want it to be. Thank you.

Ryan Nash - Goldman Sachs

Very well. Please join me in thanking Rich.

Richard Fairbank

Thank you.

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