Capital One Financial's CEO Discusses Q4 2011 Results - Earnings Call Transcript

Jan.19.12 | About: Capital One (COF)

Capital One Financial (NYSE:COF)

Q4 2011 Earnings Call

January 19, 2012 5:00 pm ET


Jeff Norris -

Richard D. Fairbank - Founder, Executive Chairman, Chief Executive Officer and President

Gary L. Perlin - Chief Financial Officer


Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division

Joel Houck - Wells Fargo Securities, LLC, Research Division

Moshe Orenbuch - Crédit Suisse AG, Research Division

Donald Fandetti - Citigroup Inc, Research Division

Christopher Brendler - Stifel, Nicolaus & Co., Inc., Research Division

John W. Stilmar - SunTrust Robinson Humphrey, Inc., Research Division

David S. Hochstim - Buckingham Research Group, Inc.

Betsy Graseck - Morgan Stanley, Research Division

Brian Foran - Nomura Securities Co. Ltd., Research Division

Robert P. Napoli - William Blair & Company L.L.C., Research Division


Welcome to the Capital One Fourth Quarter 2011 Earnings Conference Call. [Operator Instructions] Thank you. I would now like to turn the call over to Mr. Jeff Norris, Senior Vice President of Global Finance. Please go ahead, sir.

Jeff Norris

Thanks very much, Dana, and welcome, everybody, to Capital One's Fourth Quarter 2011 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 and follow the links from there. In addition to the press release and financials, we have included a presentation summarizing our fourth quarter 2011 results.

With me today are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; and Mr. Gary Perlin, Capital One's Chief Financial Officer and Principal Accounting Officer. Rich and Gary 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 obligations 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 Factor section in our annual and quarterly reports accessible at the Capital One website and filed with the SEC.

With that, I'll turn the call over to Mr. Perlin. Gary?

Gary L. Perlin

Thanks, Jeff, and good afternoon to everyone listening to the call. Let me provide a few highlights from the quarter and full year on Slide 3. Capital One earned $407 million or $0.88 per share in the fourth quarter of 2011. We saw strength in loan growth and stable revenue. Earnings declined, however, due to increases in non-interest and provision expense, the latter reflecting stabilizing credit trends. There were an unusual number of unique items impacting revenue and operating expense, which I'll review in a moment.

While full year 2011 results also had some noise, they provide a somewhat clearer picture of where we stand as we approach the integration of ING Direct and U.S. Credit Card business of HSBC in the first part of 2012.

After falling in 2010, Capital One loan balances grew by some-8% over the course of 2011, resulting in a constant level of average loans.

Interest expense fell by about 30 basis points and margins remained stable. As credit improved, a substantial reduction in provision expense more than offset a significantly increased level of investment in marketing and operations to restart our loan growth engine.

We also accelerated our buildout of top bank infrastructure especially in the second half of 2011 to ensure our readiness to execute on very attractive acquisition opportunities.

Although we expect considerable noise in our 2012 financials from the purchase accounting effects, integration expenses and partial year impacts of these acquisitions, the economics of the deals are compelling and we remain excited about the sustained value creation they will enable. When the deals close, I will be able to provide you with a detailed view of how they are likely to affect our financials this year and beyond.

Now let's turn to Slide 4, and I'll focus on the fourth quarter. Capital One earnings per share were $0.88 or $407 million in the fourth quarter compared to $1.77 or $813 million in the third quarter of 2011. The decline in linked quarter earnings was driven by lower pre-provision earnings and increasing provision expense.

Revenue in the quarter was down about $100 million or 2%, owing to a few unique items. Linked quarter revenue was negatively impacted as we recorded a very modest increase in our finance charge and fee reserve after an unusually large $83 million release in the FCFR in Q3 of 2011.

Q4 revenue was also hit by a further build in reserves to cover higher expected expenses related to past sales of payment protection insurance, or PPI, in our U.K. business. This resulted in a contra-revenue of approximately $81 million.

In addition, non-interest income in Q4 was negatively impacted by a representation of warranty expense of $38 million.

Stripping out these impacts, revenue increased over the third quarter by about 2.5%, in line with average loan growth.

Moving to non-interest expenses. They were up quarter-over-quarter due to a seasonal ramp in marketing spend and an increase in operating expenses. The $213 million increase in operating expense recorded in Q4 included $92 million in litigation expenses, 2/3 of which relates to our U.S. Card business. We also had approximately $40 million in asset write-downs and other costs as we rationalize some facilities and equipment, principally related to acquired banking businesses.

The remaining increase in operating expense reflects, in large part, continued investment in growing our businesses and the acceleration in building our top bank infrastructure as we prepare to integrate ING Direct and the U.S. Credit Card business of HSBC.

In view of our considerable progress on both these fronts, we expect our run rate operating expenses to remain at a level similar to the run rate of Q4.

Provision expense increased in the quarter. While our outlook for credit performance improved modestly, the growth in loan balances and seasonal effects led to both a lower allowance release than in Q3 and a tick-up in charge-off dollars.

Turning to Slide 5. Let's take a quick look at balances and margin highlights. End-of-period loan balances grew in the quarter by almost $6 billion or 5%, reflecting growth in our Domestic Card, Commercial Lending and Auto Finance businesses. Average loans were up by $2.5 billion, as much of that quarterly balance growth was concentrated in the last few weeks of the year.

Net interest margin declined 17 basis points in the quarter to 7.22%. Benefiting the NIM was a shift from cash to loans and a reduction in funding costs attributable to lower deposit rates. However, these benefits were more than offset by a decline in loan yields, driven largely by onetime effects, such as the absence of a large finance charge and fee reserve release, which benefited Q3 interest income.

Turning to Slide 6. Let's take a closer look at year-over-year performance. Strong and stable margin performance and a significant credit improvement led to a 7% increase in net income from continuing operations between 2010 and 2011. On a total company basis, earnings rose by 15%.

Pre-provision earnings decreased in 2011 as non-interest expenses grew. Emerging from the recession, we invested in additional marketing in the rollout of new product offerings across our businesses. We also made significant progress in the buildout of our top bank infrastructure.

A substantial improvement in credit led to a 40% decline in provision expense in 2011. Charge-offs fell dramatically, the effect of which was somewhat offset by the lower level of allowance release as we see credits stabilize at historically strong levels.

And we returned to loan growth in 2011 with an 8% increase in end-of-period loans. As expected, the majority of that loan growth came in the back half of 2011, which resulted in average loans being largely flat year-over-year.

Moving to Slide 7. The strong loan growth at the end of the fourth quarter also had an impact on risk-weighted assets and related capital ratios.

Despite an increase of $500 million in Tier 1 common equity, our Tier 1 common ratio decreased 30 basis points in the quarter to 9.7%, using Basel I definitions. Using known Basel III definitions, our Tier 1 common ratio would be approximately 10 basis points higher than that.

Over the course of 2011, we generated substantial amounts of capital by retaining $3.2 billion of earnings and recapturing $700 million of deferred tax assets previously disallowed in the calculation of regulatory capital. Our Tier 1 common ratio rose 90 basis points in 2011 despite a 22% increase in risk-weighted assets.

We continue to be comfortable with our strong capital levels and our capacity to generate healthy amounts of capital going forward. In the near term, closing the ING Direct acquisition and related capital transactions will cause our Tier 1 common ratio to rise. We still expect that our Tier 1 common ratio will be in the mid-9% range in the quarter we close on HSBC and complete the necessary capital actions.

With that, I will hand the call over to Rich. Rich?

Richard D. Fairbank

Thanks, Gary. I'll begin on Slide 8 with a look at loan volumes. Domestic Card loan balances grew just under $3 billion or 5% in the quarter and for the full year. Fourth quarter growth was driven by seasonal spending and balance building on our growing account base.

Growth for the year resulted largely from the addition of the Kohl's private label partnership, as well as a return to modest growth with normal seasonal patterns in our general purpose card business in the second half of the year.

The expected runoff of Installment Loans was a drag on Domestic Card loan growth of about $400 million per quarter in 2011. Excluding the Installment Loan runoff, our Domestic Credit Card loans grew by a more robust $4.7 billion or about 9% for the full year.

Beyond loan growth, there are continuing signs of traction in our Domestic Card business. New accounts booked in the fourth quarter of 2011 were more than double the new accounts booked in the fourth quarter of 2010, and growth in our purchase volume outpaced the industry in 2011.

Fourth quarter 2011 purchase volume grew 15% from the fourth quarter of 2010 excluding purchase volumes in the Kohl's portfolio.

Fourth quarter Domestic Card revenue grew 5% from the fourth quarter of 2010, driven by seasonal growth in loans, strong purchase volumes and stable margins. The Domestic Card business posted $2.3 billion in net income in 2011, driven by significant credit improvement, the return to modest loan growth and stable margins.

In addition to the continuing traction in our current Card business, we expect to close the acquisition of the HSBC U.S. Card business in the second quarter. We expect to acquire HSBC's portfolio, resilient card loans with strong returns, and the acquisition will also greatly enhance our partnership's business and capabilities. After the initial increase in loan volumes, the acquisition may mute our Domestic Card growth trajectory somewhat because of the expected runoff of portions of the HSBC portfolio.

In Consumer Banking, loan balances were up modestly, as strong growth in Auto loans was partially offset by expected runoff of the Mortgage portfolio. Auto Finance originations were $3.6 billion, up 5% from the third quarter and 62% from the fourth quarter of 2010. Auto Loan balances at the end of 2011 were $22 billion, up 22% from the prior year. We expect that Auto originations will remain strong and drive continuing growth in Auto loans.

We continue to gain traction in consumer deposits as well. Deposits grew 7% from the prior year while interest expense improved by 29 basis points. Deposit growth in the fourth quarter was essentially flat.

The Consumer Banking business delivered $810 million in net income in 2011, driven by the strong performance of the Auto Finance business and growth in deposits with improving interest expense rates.

We expect to complete the ING Direct acquisition in the first quarter. This acquisition will have a significant impact on Consumer Banking loan and deposit growth trajectories. We expect that sizable runoff of the ING Mortgage portfolio and the continuing runoff of our legacy Mortgage portfolio will more than offset the growth in Auto loans, driving a declining trend in Consumer Banking loan volumes. Mortgage portfolio runoff is expected to mute total company loan growth rates as well.

With the acquisition expected to add $80 billion in deposits with attractive all-in costs, our Consumer Deposit businesses are shifting their emphasis toward solidifying franchise-building customer relationships and realizing the financial benefits of the ING Direct acquisition. The deposit volume trends in the fourth quarter of 2011 reflect this evolution in our deposit strategy in anticipation of the ING Direct acquisition.

Our Commercial Banking business delivered another quarter of steady loan growth. Ending loans were up 5% from the prior quarter and up 14% from the fourth quarter of 2010. Growth in loan commitments, an early indicator of future loan growth, was even stronger. We're targeting in achieving the strongest growth in those areas in which we built specialized expertise and capabilities, including rent control, multifamily real estate in Metro New York City and selected middle-market industry segments, such as energy and commercial finance.

Commercial deposits grew 5% in the quarter and 17% year-over-year with modest improvements in interest expense. The combination of improving credit and growth in loan and deposit volumes drove 2011 net income of $533 million in our Commercial Banking business.

The growth we're delivering today continues to focus on franchise-building customer relationships and accounts all over Capital One. These include rewards customers and new partnerships in our Domestic Card business, Commercial Banking customers and deposit customers and Auto dealer relationships in our Consumer Banking business.

While loan balances and revenues from these customers ramp up gradually over time, we expect the growth of these franchise-building customer relationships to drive strong and sustain bottom line earnings and capital generation through sustainably lower charge-off levels, low attrition and long annuity-like revenue streams that build gradually but stick around for years.

Slide 9 shows the credit results across our Consumer businesses are stabilizing at relatively strong levels and exhibiting expected seasonal patterns.

Domestic Card charge-off rate increased 15 basis points in the quarter, consistent with expected seasonal patterns. Compared to the fourth quarter of 2010, charge-off rate improved by over 300 basis points, resulting from the significant cyclical credit improvements we experienced in 2011.

The delinquency rate as of December 31 was essentially flat from the prior quarter at 3.66%. The delinquency rate improved 43 basis points from the end of 2010. We expect the Domestic Card credit metrics will continue to follow normal seasonal patterns in 2012.

In our Consumer Banking business, the charge-off rate in the Home Loans portfolio increased 37 basis points in the quarter. As we discussed last quarter, we moved a portion of our mortgage loans from third-party servicers onto our own platforms. The quarterly increase in charge-off rate resulted from updated property values on these loans. This is a onetime impact that is not expected to impact charge-off rates going forward.

Compared to the prior year quarter, the Home Loans charge-off rate was flat. Home Loan delinquency rate increased modestly in the quarter and year-over-year but remains very low at just under 1%.

For the approximately $5 billion of Home Loans that were marked at acquisition, actual credit performance since the acquisition has been better than the assumptions in the original credit marks, keeping our reported credit metrics very low.

In the Auto Finance business, charge-off rate and delinquency rate increased in the quarter, consistent with expected seasonal patterns.

As you can see in the year-over-year improvements in both charge-offs and delinquencies, Auto Finance credit performance remains strong with the most recent originations continuing to perform better than originations from 2007 and 2008.

Strong credit performance continues to reflect the actions we took to retrench and reposition the business, tighten underwriting and loss mitigation actions through the recession and continued strength in used car auction prices.

We believe we reached the cyclical low point for Auto Finance charge-offs, and seasonal patterns will drive quarterly credit trends in 2012.

The choices we made in underwriting and managing our businesses through the Great Recession continue to drive strong credit performance. We made tough choices to tighten underwriting, focus only on the most resilient businesses and aggressively manage and mitigate credit losses. As a result, our internal portfolio of credit metrics remain strong with normal seasonality re-emerging after a long period of cyclical improvement.

Slide 10 shows credit results for our Commercial Banking business. The nonperforming asset rate for the Commercial Banking segment improved in the quarter despite an uptick in the NPA rate in our runoff Small-Ticket CRE portfolio.

The Commercial Banking NPA rate improved 38 basis points in the quarter and 63 basis points year-over-year. Excluding Small-Ticket CRE, nonperforming asset rates improved across our Commercial Lending businesses as we continue to see a slower flow rate into nonperforming loans.

The charge-off rate for the Commercial Banking segment was 63 basis points, down 80 basis points from the same quarter last year. Excluding the runoff Small-Ticket CRE portfolio, the charge-off rate in our core Commercial Lending businesses was 47 basis points in the quarter, an improvement of 53 basis points from the prior year.

Commercial Lending charge-offs were up 20 basis points from the third quarter, driven by a small number of impaired CRE loans related to a single troubled relationship. We had reserved for these loans in the prior quarters, so these charges did not have a significant P&L impact in the fourth quarter. The slower flow rate into NPL and stable property values are driving lower charge-offs.

Commercial Banking credit metrics have stabilized and improved over the last 6 quarters. We expect continuing strength in commercial credit with some quarterly choppiness in commercial charge-offs and nonperformers.

I'll close tonight on Slide 11. In 2011, Capital One delivered strong and stable margins and revenues. The bottom line benefit of significant credit improvement offset an increase in non-interest expenses.

We gained strong momentum in loan growth in our Auto Finance and Commercial Banking businesses. And in our Domestic Card business, we returned to a modest growth trajectory with more normal seasonal patterns. We grew deposits with improved interest expense rate.

Taken together, these trends produce strong underlying profitability across each of our 3 business segments and for Capital One as a whole. And we sustained and improved the strength and resilience of our balance sheet. We put ourselves in a strong position to act on 2 game-changing acquisitions with significant strategic upside and attractive economics.

Fourth quarter results were somewhat noisy with several unique items and continuing growth in non-interest expenses even after adjusting for unique items.

Let's pull up and talk for a moment about the growth in expenses, what we're getting in return and why we believe that the growth trend in expenses will not continue. The increasing trend in non-interest expenses in 2011 resulted from choices we made to build our infrastructure, ensure that we're ready to integrate significant acquisitions and to prime the pump to restart growth.

We've made significant investments in our infrastructure in 2011. We became a top 10 bank by acquiring and integrating 3 great local banking franchises. But none of the franchises we acquired had an infrastructure appropriate for a top 10 bank, let alone the top 5 bank we're set to become with the expected completion of our announced acquisitions. Therefore, we've been investing to build an infrastructure that's commensurate with the size, complexity and growth potential of the top 5 bank we'll soon become.

In 2011, we also made significant investments to restart growth across our lending businesses after a long period of cyclical declines in loan volumes.

In our Card business, the natural cyclical decline in loans provided significant resilience through the downturn, but also now requires investments to prime the pump to restart growth coming out of the downturn. We ramped up marketing and bolstered operating infrastructure for new private label and partnership growth platforms in our Card business. We rolled out several successful new products including Venture, Cash and Spark cards. And we launched and ramped up new partnerships with Kohl's and Sony in the U.S. and Hudson's Bay Company and Delta Airlines in Canada.

In our Auto Finance business. We grew our sales force and enhanced our capabilities to build deep relationships with auto dealers, and we invested in infrastructure to attract and serve primary banking relationships in our Commercial Banking business.

We're seeing these investments gain traction in the growth in franchise-building customer relationships across our businesses. In Domestic Card, we return to modest growth with expected seasonal patterns in the second half of 2011. Growth trends in purchase volumes and new accounts are even stronger. New account growth is a leading indicator of future growth in loans and revenues as spending and balances build on these accounts over time.

Our Auto loan originations are at a run rate of about $14 billion annually and Auto loans and revenues are growing as well. And our Commercial Banking business continues to grow loans, deposits and revenues as we attract new customers and deepen relationships with existing customers.

For the full year, we posted growth in ending loan balances of 9% in Domestic credit cards, excluding Installment Loan runoff, 22% in our Auto Finance business and 14% in Commercial Banking.

As we enter 2012, we expect noise in our results, driven by significant purchase accounting impacts, ramp up of integration expenses and partial year impacts on nearly all P&L line items as we complete our announced acquisitions.

Looking beyond the noise, we expect continuing strength in our legacy businesses. We expect that our Domestic Card business will continue to post strong returns and modest underlying growth with seasonal patterns. In our Auto Finance business, we expect the strong 2011 trajectory in loans and revenues will continue. And we expect our Commercial business to continue the strong and steady performance trends it delivered throughout 2011.

Even as these businesses grow, we expect to hold run rate operating expenses to a level similar to the fourth quarter of 2011 because we've made significant progress on our infrastructure build and we're ready to begin the sure-footed integrations of 2 highly attractive acquisitions.

We believe 2011 annual marketing expense is roughly in equilibrium given the opportunities we see today in our legacy business. The growth trends we've seen in 2011 show that priming the pump has already taken hold.

While these legacy trends will not be visible as a result of the expected acquisitions, they will remain an important part of how we deliver value in 2012 and over the long term. In addition to the legacy trends, we expect to add significant new customer relationships, loans and deposits when we close our announced acquisitions. We expect to close the ING Direct acquisition in the fourth quarter and to close the acquisition of HSBC U.S. Card business in the second quarter.

We continue to expect that the combination of both acquisitions will deliver compelling financial performance in the near term and over time. We remain on track to achieve the expected acquisition synergies and earnings accretion in 2013. And we expect that the acquisitions will be accretive to Capital One's long-term returns and capital generation as well.

The choices we made and the results we've delivered in 2011 put us in an even stronger position to deliver and sustain shareholder value through growth potential, strong returns and strong capital generation.

With that, Gary and I will be happy to take your questions. Jeff?

Jeff Norris

Thank you, Rich. We will now start the Q&A session. [Operator Instructions] Dana, please start the Q&A session.

Question-and-Answer Session


[Operator Instructions] And we'll go first to Sanjay Sakhrani with KBW.

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division

I have 2 questions. I think I'll try to hit them first, and then you guys can answer them. I just wanted to drill down on that expense discussion a little bit more. And I just wanted to be clear on some of the numbers. When you guys talked about the fourth quarter run rate being the approximation of what we'll see in 2012, you're probably talking about that x the onetime item. So when we think about operating expense, it's somewhere in the neighborhood of $2 billion. And then just on the marketing dollar spent this year, I mean basically you're saying it's equivalent in 2012 relative to 2011. And then maybe if you could just talk about how we should consider it out to 2013 with the combined entities in place. And then just on some of the onetime items, I wasn't clear, is that PPI -- I'm sorry, the protection insurance charge kind of onetime, all else equal, if nothing changes from a collection standpoint? And then just on the uncollectible fees and finance charges, I recall we talked about this last time and it would -- and we thought -- I thought it would be that it would trend with credit quality. And it seemed to have gone up despite the fact that credit improved, so I just wanted some clarity on that.

Gary L. Perlin

Okay, Sanjay. It's Gary. Why don't I just clarify some of the numbers for you, and then I'll hand it over to Rich to perhaps take up the marketing question and anything else you may want to follow-up on. So specifically, with respect to fourth quarter run rate, you are correct, we would simply back out the onetimers. And with a total operating expense in the quarter of about $2.2 billion, I described about $150 million of unique items in the expense line, not exactly that number but good enough, about $92 million in litigation expense, about $40 million in some asset write-downs and other costs. And in fact, some of the U.K. PPI even hit the expense line item as well. So I think if you were in the, say, $2 billion, $2.50 billion kind of ballpark, I think that would be an appropriate understanding of what we consider to be a run rate. As long as I'm on the topic of the onetimers, let me just speak quickly to the U.K. PPI and what happened in our finance charge and fee reserves. So with respect to the U.K. PPI, you may remember this from the second quarter of last year where some new retrospective regulatory requirements had come in that enables consumers to see compensation for PPI that was sold in certain years. With respect to certain products, that included both ILs that were originated by Capital One in the U.K. as well as the company that we acquired, as well as some credit card products as well. We built a reserve back when those requirements came in based on our estimate of what our claims experience and redress costs would be. Now that it's been a couple of quarters, we have had increased volumes of complaints driven by, I guess, what we would consider to be both media and regulator comments in the area. And so we had to increase our reserve based on the fact that we now believe it's probable that we'll have a higher rate of claims. So I can't say exactly what's going to happen. It's obviously, like all of our estimates, our best view of what's probable and estimable, but it is certainly consistent with the experience that we have seen to date. Most of that shows up as a contra-revenue, either in net interest income or non-interest income depending on the nature of the refunds. There's also a small amount that hits operating expense. But what we've done now is to kind of bring it up to the level that we think is appropriate. Finally, on the finance charge and fee reserve, levels or the level of suppression, Sanjay, I would say the change in the quarter was effectively nil. It was a $3 million or $4 million increase to the reserve. As I indicated last time, when we made the onetime change, about $80-some-odd million in Q3, that was to get us to what we thought was a more appropriate estimate of uncollectible fees and finance charges, a couple million either way in any given quarter. I wouldn't read any trend in that. So I think what we said was you'll basically see suppression be reflecting the actual reversals and recoveries without much change in the reserve. And that's just what happened.

Richard D. Fairbank

And Sanjay, this is Rich, just to comment to your question about marketing. We always manage marketing really to the size of the opportunities that we see available, and that would be no different going forward. The reason for my comment here was to draw a distinction between what I've said over the past year or 2, where I've said as we go from the significantly retracted state that we were through the Great Recession and start to now invest in testing and over time, rolling out programs, there you will see a continual build of marketing. And that build will often will inherently be in advance of some of the benefits that come from that. My point is really that we've kind of -- we're now kind of rolling out those programs. I think the level of marketing represents kind of an equilibrium. Now if we see more opportunity out there going forward or if we see less, we will adjust accordingly. But it's just the real sense in the sense that -- I mean the pump is in many ways kind of primed after quite a lot of quarters at work on this. And I sense, you can feel the -- we're pretty optimistic about the traction we're getting in our programs across the company certainly. But my point here on marketing is especially credit card related, but I think we're kind of in our stride at this point, and I think that will continue.


We'll go next to Brian Foran with Nomura.

Brian Foran - Nomura Securities Co. Ltd., Research Division

I think people are still struggling with the expenses just solely, I guess at least based on the number of questions I'm getting. And maybe if you could just clarify again these $2.05 billion base, one would be the comment in the press release that you're ensuring readiness to execute on attractive acquisition opportunities. Is that referencing ING and HSBC? Or are you talking about further acquisitions? And then two, how does that $2.05 billion base change as the deals fold in? I think people are struggling to figure out if some of these kind of pulling forward expenses for those deals? Or do we still just take the expense base of HSBC and ING and add them on top of the $2.05 billion?

Gary L. Perlin

It's Gary. I appreciate the question, the opportunity to go a little deeper. So as I said to Sanjay, first thing we need to do is take out the onetimers. I mean over the course of 2011, we had a bunch of unique items in expense, and it was unusually high in the quarter. So that's why I kind of took those off the top. The increase in expenses that has occurred, and again, if you kind of take away a lot of these other expenses, the unique ones, what you'll see is we've had a pretty steady growth in our salaries and benefits. You'll see in the results this quarter that we had about a $60-some-odd million increase there. And as Rich and I have said, those investments are of 2 kinds, one certainly is supporting the rollout of new products and the growth in our businesses which, of course, also carries some marketing expense. On the infrastructure side, Brian, let me kind of clarify the kinds of things we're talking about there. So for example, we were long on our way to becoming a mandatory Basel II bank. With ING Direct, we will trigger that, and so we need to move quickly to make sure that Capital One is ready for that, just in terms of the size and greater diversification of our balance sheet, which brings both some risk management responsibilities, but also some opportunities, quite frankly, to generate more returns by good balance sheet management. So we're bulking up on that and, of course, we are already positioning ourselves for the acquisitions as a result of that. The third area, probably much bigger than the other 2 in terms of dollars. If you think about the IT and sales and servicing infrastructure that we need to have as a company, not for individual products, but with the 2 acquisitions we're talking about, and yes, the point in the press release was referring to these 2 large transactions, we're going to be adding tens of millions of new customers, increasing our overall customer account base by more than 1/3. The infrastructure required for something that big and that complex is something we would -- have been building over time. We've accelerated some of these efforts simply to make sure that we're ready, not only to be able to integrate well but also to make sure we generate the opportunities that both of these acquisitions bring with them. I would not at this moment suggest that the integration expenses or synergies that we expected out of the 2 deals will have changed dramatically, because so many of those are unique to the franchises that we're buying. So I wouldn't consider this to be a pull forward as some of those expenses. But I'd say, it's an acceleration of where we as a top 5 bank, as Rich described, simply need to be, and we would have been there anyway, we've just moved a little faster. And so we certainly are raring to go and looking forward to integrating these acquisitions, and we're just going to have a more robust infrastructure, which is something that we and all big banks are going to need going forward.


We'll go next to Betsy Graseck with Morgan Stanley.

Betsy Graseck - Morgan Stanley, Research Division

So a little bit of a follow-up on the last question. You're readying for the integration. And the first question is, how far through the preparedness would you say you are at this stage? How many more quarters of investment spend should we expect to be fully ready to bring on the deals?

Richard D. Fairbank

Betsy, I think kind of the point of our comment that the run rate that you see in the fourth quarter is reflective of the run rate that we see out in '12 and '13 on legacy Capital One, it sort of definitionally implies that we're not building off that run rate from here. So of course, soon there's going to be noise on those numbers as we bring forward, bring the acquisitions into the company. But that is exactly our point that this build has been very sizable, frankly, in the quarter before this and this quarter. And we're at a level that that's going to be our run rate for an extended period of time.

Betsy Graseck - Morgan Stanley, Research Division

Okay. And then, are the regulators waiting for any of this buildout to occur in order to approve the deals? Is there any checklist with regard to Basel II readiness that you have to supply to them?

Richard D. Fairbank

No, this is just our own preparedness.


We'll go next to John Stilmar with SunTrust.

John W. Stilmar - SunTrust Robinson Humphrey, Inc., Research Division

Just real quick question, and I hate to go back on expenses. Gary, if I could just be crystal clear of my understanding, $2.050 billion in expenses plus the dollar expenses from 2 acquisitions, also then taking into account the synergies that you expect to have, that's what's you're guiding us towards in terms of an expense base of Capital One legacy plus the 2 acquisitions together, ultimately when we kind of get through the other side, is that really the message you're trying to send?

Gary L. Perlin

That's the message, John. Effectively, we are talking about the condition of Capital One as we enter a period of time of obviously intense integration activity. And so needless to say, we're going to be looking to introduce some sure-footed integrations. There will be some integration expenses. I'm sure those estimates will change as we get into the process. We'll bring you up to speed on those. It seems premature for us to assume any changes there. And then we believe there are going to be some synergy opportunities to take run rate expense out of the combined companies going forward and especially given our knowledge and experience in both of these businesses. So I think you got the message exactly right.

John W. Stilmar - SunTrust Robinson Humphrey, Inc., Research Division

Perfect. And then just a follow-up. Rich, in terms of the comments that you made around the Consumer Banking segment itself, in which the runoff of Mortgages was going to be offset a little bit by the growth in Auto, but you guided us towards, I believe, a lower overall balance for 2012. One, can you confirm that goes over that again? And two, how should we be thinking about the yield in that segment? Because I would imagine that some of those mortgages have a pretty high yield given where you bought them and took the mark. And how should we think about the transition and the mix of those businesses together, both on a balance and a revenue perspective?

Richard D. Fairbank

John, yes, I mean we really -- the segment, interestingly, is a blend of something that's in pretty ferocious runoff mode and another that's in pretty ferocious building mode. So I think that I just -- we just wanted to point out that while some of the core businesses we're investing in are -- have a lot of growth trajectory, mortgage runoff is going to be a word we're going to spend a lot of time talking about because we have this runoff in this segment now added to the some -- a very big runoff portfolio that we're going to be picking up on the ING side. So Gary, you want to comment on the yield dynamics including the mark?

Gary L. Perlin

Again, before you go there, Rich, just that I think John, to clarify, Rich was talking about the growth trajectory, not the sort of balances. So think about it as the legacy Mortgage portfolio runoff partially offsetting the growth in Auto. That's the trend we've seen in '11. That trend probably will continue, then we'll add ING mortgages with the acquisition. And that will be a much bigger portfolio, but then the trajectory will be sort of modestly downward because that will sort of double down on the runoff piece so that the Auto growth probably won't fully offset that.

Richard D. Fairbank

And with respect to the future yield dynamics there, John, needless to say, there will be a significant purchase accounting impact on those mortgage loans. We'll be getting it into greater details as we close and know the fair value and so forth, but there will be the impact of some accretable yields in those ING mortgage loans that will get accounted for under SOP 03-3, so there will be some yield impact going forward. The other thing to remember about the ING Mortgage portfolio, like a large percentage of our existing Mortgage portfolio, that was also acquired from our previous transactions. We will take a credit mark, so there should be relatively a little charge-offs there. So the dynamics of the segment and of the product will change to the extent these numbers are big and material. We will spell them out for you as we go.


We'll go next to Chris Brendler with Stifel, Nicolaus.

Christopher Brendler - Stifel, Nicolaus & Co., Inc., Research Division

A question on expenses. I know it's been beaten up a little bit here, but last quarter I believe you were pretty clear that expenses will be flat sequentially. And I was wondering, with some of the investment spending you did in the fourth quarter above and beyond to the onetimers, just opportunities in the market, and it seems to be on TV a lot, has that been a big part of the growth in expenses in your marketing budget? And a related question, can you talk a little more about some of the market share gains? It seems like you're moving up market in your brand message with the double miles and really trying to target the transactors. Is that really, I think, part and partial to the increase in purchase volume you're seeing? Do you feel like you're getting follow through in that spending?

Gary L. Perlin

Yes, Chris, Gary again. So indeed, we were at just under $2 billion in operating expense at the end of our -- in Q3. Around $2.2 billion in Q4. I've identified $150 million or thereabouts of unique items. Fourth quarter, sometimes we get a little extra boost to expense. There's a lot of things find their way to the expenses as well. Is it slightly faster growth in expense than we might have anticipated? Perhaps. But again, we've had better business growth opportunities and we're certainly trying to get ahead of what's common, not just because of the acquisitions, but the higher regulatory expectations all around. So I don't think we're far off of what we were expecting, at least on the operating expense line. If you go back to the marketing line, there was $100 million or about 1/3 increase from Q3 to Q4. We don't -- I certainly wouldn't consider that to be an unusual quarter-to-quarter move based on the opportunities, especially knowing the historical trend towards higher marketing expense in the fourth quarter. But as far as what that means going forward, Rich?

Richard D. Fairbank

Yes, Chris. On the market share, again first of all, I think as we look across our big businesses, I think we're gaining share in Commercial. We're significantly gaining share in Auto. And by our tally, we're gaining share in the Card business as well. And I think we're gaining share in the Card business across several categories, including purchase volume originations and loan growth. Now some of these, the metrics are a little bit soft, so it's a little bit of imagination required in interpreting some of the numbers that we collect. But I mean you can see the very strong numbers that are coming on the purchase side -- purchase volume side. And Chris, you are correct, this is pretty directly coming from the big push that we have been making for some time in the heavy spender, really top of the market in credit cards. It's a very competitive space obviously, but we believe that our products and our marketing approach can and in fact -- can be and in fact is being very successful in that space. And you've seen that we've now got 3 launches out there with -- in addition to the Venture card. We also now have our Cash card. And we just recently launched a Small Business card as well. So all of these -- I mean some of these are kind of early days still, but there's good response there and the needle is really moving on purchase volume and of all the purchases going on in our portfolio because there's kind of a migration toward transactor gradually and a little away from the heavy revolving, that is a greater share of that purchase volume is coming on the rewards. The best way to think, though, about Capital One and our marketing is, a little bit to phrase, the more things change, the more they stay the same. We -- because we had a pretty resilient experience through the recession, we are pretty much doing what we did before. Now it's obviously informed and enhanced by everything that we've learned in the recession. And the competitive dynamics in each of the segments have also been kind of changing as well, and of course, you have the overlay of the CARD Act. But with respect to Capital One, I think that the real word is really continuity. And pretty much all the segments, where we were playing before and gaining share before, we are doing pretty much the same thing now with very similar approaches. Some of the places where we have been cautious and especially in the big, big line heavy revolving prime revolver space, we continue to probably lose share at the margin in that space because we worry about resilience in some of those segments. But overall, I think what is clear to us is that, and I've been saying this quarter-after-quarter, you kind of probably could detect the, I would say, each quarter look, not too much to write home yet about but I can just feel the traction growing in the Card business, and we certainly see that this quarter as well.


We'll go next to Don Fandetti with Citi.

Donald Fandetti - Citigroup Inc, Research Division

Rich, I was wondering if you can talk a little bit about recoveries in the Card business in terms of the outlook. I mean, obviously, the pool shrinks as you come out of a downturn, but there's been some talk about whether it's legal or regulatory issues. Do you foresee any problems in the industry around that?

Richard D. Fairbank

So with -- yes, you make a good point on recoveries by the way. Just first of all, the recovery numbers. Recovery dollars have been coming down at Capital One. And it's a cyclical thing. It's just a mass of a shrinking inventory of fresh charge-offs against which to recover. And we still -- our recovery rates still are coming in strong, but it's on a smaller base. And so in a way, it's a flip side of the good news that's going on out there. There's a lot of noise in every credit product, an incredible amount of noise about the collections area. And certainly, the scrutiny of credit card is certainly in that category. And we have put a huge amount of work over the years to make sure that we have very rigorous and buttoned down, disciplined collections processes. And I feel -- I think we feel good about where we are. We have seen some changes out there. I know that it appears that one of our competitors changed their practices in how they do collect, how they prosecute collections and so on. I'm not sure what was behind that one. We are continuing to use the same collections practices that we have and just work to be very sure that we are very, very buttoned down in every aspect of what we do.


We'll go next to Joel Houck with Wells Fargo.

Joel Houck - Wells Fargo Securities, LLC, Research Division

It looks like the last couple of years, your return on tangible equity has been close to 20%. Obviously, there's a lot of reserve release in those numbers. So if you could kind of look forward, I mean how you look at the business, obviously assuming there's not another recession, with normalized reserves, is it close to a kind of a 15% return on tangible equity? Or do you think with the synergies you're getting from these 2 large acquisitions that you can get close to the 20% area?

Richard D. Fairbank

Well, Joel, I mean I'm pretty optimistic about what we -- what I think we can produce when all the dust settles from all the dust storms that we live through. But the way I look at Capital One is that we have worked very hard to put ourselves in the position to have very competitive scale positions in the key businesses that we're in, and when I -- and to massively build, as we've done for 23 years, a very rigorous net present value discipline that frankly looks for well above hurdle rate returns. When I pull up on this and look at our Card business, while it's an industry that certainly had a lot of pressure on it, I think we feel very good about the ability to continue to generate significantly above -- well, well above hurdle rate returns in that business even though I've often said, "Look, I think net-net from all the effects that are going on, they are a little down, probably off of our historical levels, but still well above hurdle rate." In the Auto business, we have generated a very profitable, successful operation there. And in Commercial business, you've kind of seen some of the numbers that we have here -- there. So when I pull it all together and then, Joel, look at the acquisitions that -- and the value-creation opportunity here, I believe that our positioning in the marketplace should be the company that can generate at the high end of industry return levels. And even as profit pressures are pulling down returns in banking overall, I like our chances to be at the high end of the return on tangible equity metrics when the dust settles for this company.


We'll go next to David Hochstim with Buckingham Research.

David S. Hochstim - Buckingham Research Group, Inc.

Wondering, Gary, could you just update us on what you expect to need in a way of additional capital for HSBC? Is that smaller than you thought before? And then sort of a follow-up to Joel's question, could -- Rich, could you speak a little more to your comment on Slide 11, just how we should or how you will be measuring the strong returns qualitatively? And so you're investing for high returns, but when do those show up in reported earnings as you keep investing?

Gary L. Perlin

Sure, David. Very quickly, I really don't have much of a change to our outlook for the capital that we would add for the purposes of capitalizing the HSBC portfolio. We have the same target that we've had since we announced the deal, which is to be in that mid-9% range in Tier 1 common in the quarter that we closed. I have no reason at this point to suggest any change in the previously announced estimate of $1.25 billion of capital. But there's lots of moving pieces. One of them that we'll be able to fix over the coming period of time here is any effect from closing ING, the purchase accounting related to ING, the capital transactions, the balance sheet management actions that we've taken, and so we'll just have to keep you posted on what that final outcome will be. But I'll just go back to where we started on the deals, which is there's a wide range of capital required for these deals, under which we would find both of them to be and together to be very attractive. So we'll be able to get to that. And as I hand it over to Rich, just thinking about this question of returns, I think if you survey all the banks as to what kind of equity requirements are going to be out there, I think it's going to be a pretty big part of the equation in terms of what that return on equity will be. But we'll obviously be learning about that over the course of the next couple of years. The key here is the returns will be good, and that's what Rich was talking about.

Richard D. Fairbank

David, we are very focused on delivering what, the term I use is, destination economics. And we have worked very hard to get our company to competitively a very good state, and I think strategically are in a place where I've said we don't need to go to a different place to be able to compete and generate the returns that we need. So we're working, we're very focused on generating destination economics. We have had to build. There's been pump priming over the last year to 1.5 years, and we're more -- we now are kind of hitting our stride in terms of the growth opportunities. There's still a coiled spring in terms of the balance build on some of the accounts we're building, but we're pretty much hitting our stride there. Our point about expenses here is even as you look at the sizable run rate kind of expense after onetimers expense build in the last couple of quarters, our point is really to say that don't take that line and go extrapolate that thing upward. That is really a -- there's a story behind that expense build, but think much more that's sustainable from where we are. So the other thing that's a little delayed gratification, of course, is the 2 big acquisitions that we've done and that's going to create a lot of noise but we are very focused on as soon as we can to work to drive great financial return out of these acquisitions, because that value creation is there, and we are committed to delivering on it.

Now along the way, we'll keep our eye out for unique acquisitions that could come along. But frankly on the acquisition front, we're not really trying to go anywhere. And frankly, our focus is really on the deals that we have, not on the deals that could be. So we are very focused on destination economics. And we are -- and we believe strategically, we're in a great place in order to deliver that.


We'll go next to Chris Kotowski with Oppenheimer & Co.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Two little things. One is the Auto delinquency rate on Page 9 of the handout. I mean it looks like it's gone up a lot this quarter, and that's also been the most rapidly growing portfolio. So I just wanted to confirm that you said basically, this is just the seasonal impact you see. This is not -- is this -- is the delinquency experience in any way out of the bands of what you would normally expect after you've grown the portfolio the way you had?

Richard D. Fairbank

The Auto delinquency -- first of all, I want to say, Auto delinquency itself is a poor -- we have learned to -- that it's not a very good predictor, frankly, of losses in general, but -- unlike the credit card business. But that said, all the credit performance that you see in our Auto business is entirely seasonal. We are at an extraordinarily kind of low point in the kind of long, long view of Auto in terms of just how good this industry's credit performance is. And I think it's a reasonable thing to do to expect industry losses to -- probably to migrate up a bit from here. That's partially offset by some of the growth opportunities that we have at Capital One, and we're doing quite a bit of growth in the prime space with -- and that's helping pull down the losses. But overall, we are seeing very good results from our recent vintages, really from the whole portfolio now that's had such an extraordinarily strong -- looking from a credit point of view. We're at the point now that given the average life in autos like 2.5 years, you're looking at the last couple of years of auto originations and their extremely strong credit performance. And the credit results are really at this point just seasonal effects that you're observing.


We'll go next to Moshe Orenbuch with Credit Suisse

Moshe Orenbuch - Crédit Suisse AG, Research Division

I hate to go back to the expenses, but it sort of looks like you're a little under $2 billion in the third quarter before marketing, if you're saying $2.50 billion. I guess that seems like there's about $65 million a quarter, that $250 million kind of round numbers sort of run rate of annualized expenses that relate to the set of new projects, I guess, that we didn't really know about before. Is it fair to say that that's kind of in the neighborhood of 5% or 6% kind of off the accretion of those deals? Is that what caused you to need to make those investments? I mean am I interpreting that right? Or is there something else that we -- some other way we should be thinking about that?

Gary L. Perlin

Moshe, it's Gary. I mean, again, if you take a look at what's been underlying some of the expense growth, you'll see that we have had considerable growth in our level of employment. Some of that is just some acquisitions like the Hudson's Bay Company. Some of them are in-sourcing and on-shoring, some other roles as well. But we had a significant increase in the third quarter in our hiring of net jobs. And obviously, that kind of goes into Q4 as well. I think the issue just to be clear, not to try and focus on the semantics, but to make sure that the understanding is absolutely clear, again, I think if you would look at any bank that is growing in the way that we are, Rich described it kind of going from top 10 to top 5, the bar is being raised in terms of expectations on the controls and management and regulatory interactions that take place. We think these are things that would have happened even with organic growth. They may be happening a little faster than that because of the growth and the size of our balance sheet along with the acquisitions. We were not in a position in looking at those deals to include in those deal numbers things that are really all about infrastructure of a company. So again, what I'd say is we're accelerating a little bit of the expense. But rather than thinking about it as specifically deal related, I would think about it as what does it take to be well positioned, well controlled, prepared for opportunities when you're going to have tens of millions of additional customers and what kind of support you need for that. That is something that we would have been building over time. We're building it a little faster. So that's why it's hard to link some of our preparatory work here, which is really just about being a bigger and better bank, and attribute that to individual deals other than the timing. And I think that the timing of this has been accelerated from what it might have been, which is why, you've seen it in a couple of quarters in a row but -- which you've heard Rich and me saying is that we've made really good progress. Certainly, will we look for better synergies as we go forward? Absolutely. But I think if you take a look at what's going to be required of any top 5 bank, we intend to be there. We're just getting there a little faster, and that's where it's coming from.


And we'll take our final question today from Bob Napoli with William Blair & Company.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

Just a follow-up on the Auto business. Some of your big competitors, Wells and JPMorgan, their growth in Auto, and Wells pointed out a lot more competition coming in online in the fourth quarter. I think we've seen a fair amount of private equity come in to the Auto business over the past year. Should we expect to see that business, the growth rate for Auto slow down? And I mean are you seeing the same competitive pressures that Wells in particular was talking about?

Richard D. Fairbank

Bob, I -- there is no doubt that competition is intensifying. What happened in the Auto business is a lot of players headed for the hills. And the Auto business was sort of the first into the Great Recession to be worsening and it was the first one to sort of come out the other side. And I think though the competitive dynamics have been positive over this period of time, and I support your point that competition is increasing and it's a very natural thing, and we completely plan for that. The Capital One growth is -- there's a growth strategy that's happening at Capital One that's maybe not -- that was maybe quite differentiated from some of the competitors in that we are doing a significant still geographical expansion in the company. The exact thing we do in some geographies, we've been expanding across the nation. The most sure I've found in all my years of experience, the most sure-footed sort of business growth opportunity is to take something you've proven in certain geographies, test it in the next geographies, and then roll them out from there. So the growth play at Capital One is a blend of geographical expansion and more prime to supplement a lot of the subprime that we already have in that space. So it's something we've been actually doing for years. You see it picking up momentum because we've done a lot of testing and we are in rollout mode now. So the confidence that I have about growth in the Auto business is more, Bob, driven by continuing that sort of Capital One growth strategy. I think on top of that, I think that even normalized for that I think there's some continuing success we're seeing in penetrating our dealers. And so I think it's a good story at Capital One. But I think all of you would be well served to take a more cautious outlook about where pricing and competition will take this Auto business over the next 12 months.

Jeff Norris

Okay. Well, I'd like to say thank you to everyone for joining us on the conference call today, and thank you for your continuing interest in Capital One. The Investor Relations staff will be here this evening to answer any further questions you may have. Have a great evening.


Again, that does conclude today's presentation. We thank you for your participation.

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