Capital One Financial Q1 2007 Earnings Call Transcript

Jul.19.07 | About: Capital One (COF)
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Capital One Financial Corporation (NYSE:COF)

Q2 2007 Earnings Call

July 19, 2007 5:00 pm ET

Executives

Jeff Norris - IR

Gary Perlin - CFO and Principal Accounting Officer

Richard Fairbank - CEO

Analysts

Laura Kaster - Sandler O'Neill

Craig Maurer - Calyon Securities

Michael Cohen - Nova Capital

Meredith Whitney - CIBC World Markets

Scott Valentin - Friedman Billings & Ramsey

Chris Brendler - Stifel Nicolaus

Bob Napoli - Piper Jaffray

Moshe Orenbuch - Credit Suisse

Presentation

Operator

Good day, everyone and welcome to the Capital One Second Quarter 2007 Earnings Call. Today's call is being recorded. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (Operator Instructions).

Thank you. I would now like to turn the call over to Mr. Jeff Norris. Please go ahead, sir.

Jeff Norris

Thank you very much, Katie and welcome everyone to Capital One's second quarter 2007 earnings conference call. As usual, we are webcasting live over the internet. To access this call on the internet, please log on to Capital One's website at www.capitalone.com and follow the links from there.

In addition to the press release and financials, we have included a presentation summarizing our second quarter 2007 results. With me today is 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 will walk you through this presentation.

To access a copy of the presentation and the press release, please go to Capital One's website, click on "Investors" then click on "Quarterly Earnings Release."

Please note that this presentation may contain forward-looking statements. Information regarding Capital One's financial performance and any forward-looking statements contained in today's discussion and the materials, speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise.

Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on these factors, please see the section titled "forward-looking information" in the earnings release presentation and the risk factor section in our annual and quarterly reports accessible at the Capital One website and filed with the SEC.

At this time, I'll turn the call over to Gary Perlin. Gary?

Gary Perlin

Thanks, Jeff and welcome to everyone joining us on today's conference call. Let's jump straight into the highlights of the quarter, on slide 3 of the presentation.

Capital One delivered diluted earnings per share of $1.89 in the second quarter of ‘07 up 6% from the second quarter of ‘06. We had a larger than usual number of non-operating items affecting our second quarter results, so, we've highlighted them for you.

The items with a downward impact on earnings were either anticipated at the beginning of the year or disclosed recently. The former category is in $79 million or $0.13 per share in integration expenses and core deposit intangible amortization.

Restructuring charges associated with the cost initiative announced late in the second quarter were $101 million or $0.16 per share. While the announced transition in our banking management team had a $40 million or $0.06 impact on the quarter as a result of accelerated vesting of executive stock options.

Partially offsetting these expenses were two items that positively impacted quarterly results. $69 million or $0.16 per share in lower than normal taxes related to changes in our international tax position and $17 million or $0.03 per share from the extinguishment of debt, which occurred when we called high coupon trust preferred notes originally issued by North Fork Bank Corp and Hibernia.

As I indicated on the first quarter call, we executed a $1.5 billion accelerated share repurchase plan effective April 2nd. In addition, we executed an incremental $250 million of open market repurchases during the quarter under the same $3 billion share buyback authorization. These actions coupled with quarterly share count growth reduced our share count by a net 18 million shares.

The restructuring charges I mentioned a moment ago are associated with an enterprise-wide cost initiative begun during the second quarter and announced on June 27th. We anticipate that the result of this effort will be a reduction in the annual operating expense run rate by $700 million in 2009. I'll give you more details about this initiative in a few moments.

I also mentioned the transition of our banking business leadership team. Our broader integration program remains on track, and Rich will provide some detail when he offers his update on the bank.

Moving on to slide 4, let's refresh our outlook for the full year. We are maintaining our 2007 earnings per share guidance of $7 to $7.40 with non-operating items moving us to the lower end of the range.

Our outlook for 2007 has always included a projected $240 million post tax or $0.60 impact in integration and CDI amortization costs associated with our bank acquisitions. However, the other non-operating items called out in the box on slide 3, were not anticipated when guidance was last updated in April. The fact that the projected full year impact of the negative non-operating items are only partially offset by the positives, and by accelerated share repurchases, we expect earnings towards the lower end of our current guidance range of $7 to $7.40.

Let me also use this opportunity to reground the assumptions that support our current guidance. First, we assume that the notable business trends in the second quarter continue for the balance of 2007.

As you will hear from Rich, these trends include declining year-over-year balances with expanding revenue margin in US Card, and elevated loss levels in the dealer prime auto finance business.

Our outlook also assumes no change in the following market conditions. Continued pressure in secondary mortgage market pricing with whole loan bids at or around current levels. Continued US consumer credit normalization in the wake of the late 2005 spike in bankruptcies, a more stable UK consumer credit environment and a solid US labor market and a yield curve which remains at currently flat levels.

If you turn to slide 5, I would like to provide a bit more detail about the cost initiative which we announced a couple weeks ago.

At Capital One, we have long been focused on the importance of operating efficiency to enhance our competitiveness, and to help us achieve sustained earnings growth. Capital One experienced positive operating leverage each year between 2003 and 2005.

While operating expense levels increased in 2006 and early 2007, as we began the integration of our bank acquisitions, and made sizable investments in the infrastructure, which supports our legacy businesses, we are now well placed to move aggressively to improve operating efficiently.

It was with this in mind that we recently announced an enterprise-wide initiative expected to generate $700 million in operating expense savings by the end of 2009. This initiative will cost us approximately $200 million in 2007 and $100 million in 2008, which will appear in a new line item for restructuring expenses.

Now let me give you a sense of where these savings will come from. About $400 million of the $700 million in savings will be coming from our national lending and local banking business lines. In many of our national lending businesses, we will be leveraging the benefits of infrastructure investments we've made over the past year through process redesign and complexity reduction.

In our local banking segment, we will deliver on the $110 million in net cost savings associated with the North Fork acquisition as we look to complete that bank integration in 2008. As you know a critical part of this integration will occur in the first quarter of 2008, when we look to integrate our banking businesses on to one deposit platform and rebrand the North Fork franchise.

About 150 million of the $700 million of savings will come as a result of targeted reductions in staff functions largely as a result of organizational streamlining. We will also look to save an additional $150 million by implementing and maximizing shared services across business line.

Examples of projects, where we think we can harvest savings include placing many of our smaller businesses with similar asset profiles on the same servicing platform. We will also be conducting supplier and vendor contract reviews on our top 100 suppliers and will be renegotiating many contracts, where we believe we can achieve better pricing.

As previously disclosed, we plan to eliminate approximately 2000 jobs across all of our business and staff functions. A similar number of positions will largely be reduced by not filling current vacancies. Half of the job cuts have already been identified. Affected people have been notified and are in the process of receiving severance benefits inline with our commitment to treat all our associates with respect.

Before leaving the cost initiative, I would like to remind you that we are also committed to investing in the growth of our businesses. That said, we currently expect to reduce the actual level of operating expenses exclusive of restructuring charges in 2008 by 100 to $200 million compared to 200 to 2007. We will be updating you on our progress on these cost saving initiatives on our quarterly earnings conference call going forward.

Now let's take a look at performance in the quarter starting with credit metrics on slide 6. If you can see on the chart on the left of the slide, quarterly losses from our local banking segment, which represents a mix of commercial and consumer loans, remain stable and low at 19 basis points for the quarter. In our national lending segment, losses for the quarter were 3.45%, down 20 basis points compared to the prior quarter driven largely by a change in grace period terms in our U.S. Card business. You've already seen this impact in our Master Trust Data.

Without this change in account terms, the charge-off rate in our national lending segment would have been 3.61% reflecting expected credit normalization. On the chart to the right, you will see managed 30 day plus delinquencies for our national lending segment and non-performing loans as a percent of loans held for investment for our local banking segment. The delinquency rate experienced similar trends to those we saw in our managed charge-off rates, again reflecting expected credit normalization.

Now let's turn to the next slide for a look at the income statement in the balance sheet. If we look at the income statement and balance sheet, please keep in mind that almost all of the year-over-year comparisons are affected by the acquisition of North Fork on December 1st, 2006.

Let's start with the income statement. First, total revenue is up on a linked quarter basis driven largely by revenue margin expansion in our U.S. Card sub segment. You'll be hearing more about this from Rich.

Provision expense was up quarter-over-quarter and year-over-year driven by the normalization of charge-off post bankruptcy spike. The increase in provision included an allowance bill of about $15 million. Operating expense declined in the quarter by $29 million. This includes pretax expenses of $26 million related to bank integration, $53 million of CDI amortization, and $40 million of accelerated vesting of stock options related to the transition of our bank management team. Thus, the balance of our operating expense experienced a greater decline largely reflecting a move down from elevated levels of infrastructure investment in our national lending businesses.

As highlighted on an earlier slide, we recognized a significant positive tax impact in the second quarter. This impact was driven by changes in our international tax position, and we expect to return to a more normal tax rate for the remaining quarters of 2007.

Now briefly looking at the balance sheet total, deposits at quarter end decreased on a linked quarter basis driven by the expected runoff of public funds in the bank and especially our deliberate decision to let higher costs brokerage CD's roll off. However retail and commercial deposits were up slightly on a linked quarter basis.

Managed loans held for investment increased modestly on a linked quarter basis driven by growth in our US Card and GFS subsegments, and by our move of approximately $1.2 billion in mortgage loans from held for sale to held for investment is a result of our decision to hold these loans on balance sheet instead of selling them into the secondary market.

These loans now show up in our local banking segment, and our mortgage banking subsegment. Rich will touch on this as well in his business reviews, which we are now ready to begin. Over to you Rich?

Richard Fairbank

Okay, thanks Gary. And I'll begin on slide 8, with an overview of our national lending and local banking business segment.

On a year-over-year basis, sustained profit growth in our US Card and Global Financial Services or GFS businesses more than offset declines in auto finance, mortgage banking and local banking.

As I discuss each of these businesses in a moment, you'll hear some common things. The expected normalization of credit continues in our US business. Loan growth especially in prime markets in US Card and Auto Finance continues to be challenging. When adjusted for changing product mix, margins are holding up or increasing modestly across many of our lending businesses. And we are improving operating leverage across many of our businesses, as we pass the peak of infrastructure investment spending, and we begin to leverage the new infrastructure platforms and our cost restructuring initiative.

Each of our businesses faces its own unique combination of market consolidation, competitive, and cyclical forces. While some businesses are well positioned to sustain and grow profits today, others are hard at work addressing challenges and improving their position to win in the long-term. All in all our businesses delivered modest profit growth versus the pro forma profit from the second quarter of 2006.

I will discuss the key trends and results in our US Card business, on slide 9. US Card delivered strong year-over-year net income growth powered by growth in revenue, reductions in non-interest expenses, and a modest decline in provision expense. Loan grew modestly from the year ago quarter. Loan growth resulted from improving year-over-year attrition trend, and growth in targeted segments.

Our year-over-year loan growth rate was reduced by a decision to pullback further on our already low marketing of teaser led products in the prime space and the $600 million portfolio sale in the first quarter.

We continue to see intense competitive pressure in the prime space with little abatement in marketing intensity. Our focus up market is and has been to sustain strong economic returns and to grow revenues over the long term. This focus has led us to reduce investments in marketing to sub segments like prime revolvers. We continue to believe that the headline pricing in these sub segment requires secondary pricing moves offered the rates well above the go-to rates to achieve profitability.

Instead we continue to concentrate more heavily on marketing through transactors. As always we will continuously evaluate the market and competitive environment and the growth and profit potential of all customer segments. We will adjust our product strategies accordingly as we see opportunities.

For the balance of 2007, we expect that our strategies will drive growth in margins and revenue, even as prime balances decline. That's because our assessment of the marketplace today indicates that the most asset-rich opportunities are not always the most profitable.

In the sub-prime part of our business, competitive pressure continued to intensify in the quarter, but we remain confident in our efforts to generate modest growth in loans and revenues. Our focus in this part of the market continues to be providing competitively price revolver products targeted to customers at the upper end of sub-prime.

Purchase volumes grew 4% from the second quarter of 2006. The deceleration in purchase volume growth resulted from slower retail sales trend and our exit of two retail partnership over the last couple quarters. These retail partnerships were transactor intensive with mutual agreement with our partners. We decided that the overall economics did not support continuing the relationships.

Revenue increased as a result of asset growth, the repricing of certain assets, changes to pricing and product terms, higher net interchange and a modest mix shift toward higher margin business. The completion of the final phases of the conversion to TSYS platform in the quarter drove several of these positive impacts.

During the conversion, we suspended many routine pricing and product term changes for the better part of the year. This pressured revenues during the conversion. In the second quarter we began to implement backlog of these actions that have been on hold. The example is the repricing of assets, whose match funding had expired in 2006.

Non-interest expense declined in the quarter, as we passed the peak of investment spending on the TSYS conversion. We also began to leverage the new infrastructure to streamline processes and reduce our cost structure as part of the broader cost initiative that Gary discussed earlier.

Charge-off and delinquency rates rose modestly from the second quarter of 2006. The increases resulted predominately from continued normalization of credit with the slowdown in loan growth also driving a modest denominator impact. Our shift to a more industry standard 25-day grace period resulted in a onetime 31 basis point reduction in charge-off rates this quarter, which cause the seasonally unusual decline in charge-off rates from the first quarter.

Looking forward, we expect that many of the second quarter trends will continue to drive US Card results through the second half of 2007. While we expect modest seasonal growth in loans in the second half of the year, we expect to end the year with the lower loan balances than at year end 2006. We expect steady growth in revenues to continue through the remainder of 2007, as many of the drivers of revenue growth in the quarter continue through the second half of the year.

Charge-off dollars continue to track with our expectations for normalization. But the decline in US Card loan balances is likely to push the charge-off rate higher due to the lower denominator. As a result, we expect charge-offs to continue their upward trend stabilizing around 5% at the end of 2007.

With a return of modest revenue growth, and continuing cost reductions, our US Card business is poised to sustain strong profitability despite the near term headwind of declining loans and normalizing charge-offs.

Turning to slide 10, I'll discuss our Global Financial Services or GFS segment.

Net income rose 62% from the second quarter of 2006 to $83 million. Year-over-year revenue growth resulted from the growth in managed loans and origination. Expenses increased over the same timeframe due to the same factors, as well as to the impact of the teaser's conversion in small business, and a similar platform conversion in installment lending.

Provision expense declined primarily due to a more stable outlook for UK credit. Charge-offs and delinquencies rose modestly from the prior year quarter. Our US businesses continued to experience the expected normalization of charge-offs from their very low 2006 level.

In the UK, we believe credit has stabilized driven by a flattening of insolvency and third-party debt management charge-offs. While this is welcome news, we remain cautious. Insolvency rates are still at historically high levels in the UK, and the overall level of indebtedness among UK consumers remains well above the levels, we see in the United States.

Managed loans grew 6% from the second quarter of 2006 to $27 billion. Our North American GFS businesses delivered strong low to mid teens loan growth from the year ago quarter. Our origination businesses posted even stronger growth. In contrast, our UK loan balance declined, as we continue to navigate the industry-wide challenges in that market. Overall our GFS businesses are on a solid trajectory, and they continue to drive diversification and growth of both loans and profit.

I'll discuss our Auto Finance growth on slide 11. Net income of $38 million was down significantly from last year's near record second quarter profit. The decline in net income resulted from the significant increase in provision expense, which increased by $108 million from the second quarter of last year, when our auto business charge-off rate reached its record low of 1.54%.

Credit results and outlook are the most significant story in our Auto business this quarter. Both charge-offs and delinquencies rose sharply from the very low levels, we saw in the second quarter of 2006. We continue to experience the credit impacts of two significant effects. The first is the ongoing normalization of charge-offs that we described in prior quarters.

We also continue experienced elevated losses in our recent dealer prime origination vintages. As we discussed last quarter, this increase in losses is primarily related to the transition from a judgmental underwriting approach to our first generation automated underwriting model for prime loans.

First generation model sometimes encounter blind spots that we can identify and correct in second and third generation models. We are now booking prime business under a second generation risk model. While we are optimistic that our model revisions have addressed the issue, charge-offs for the loans booked under the old model will remain elevated for several quarters, as these loans season.

Originations in the second quarter were $3 billion, a modest decline from the second quarter of last year. Based on elevated charge-offs and delinquencies, we pulled back dealer prime originations in the first half of 2007 by about $2 billion. This pull back was partially offset by strong growth in sub-prime origination.

Managed loans grew 18% in the second quarter of 2006. The loan growth resulted from ongoing originations as well as the addition of about $1.4 billion in prime loans from the North Fork auto portfolio.

After successful testing for several quarters, we launched our new dealer business model in the second quarter. We developed and tested an integrated approach, so that each of our dealers can now deal with one sales rep, one underwriter, one set of products across the credit risk spectrum, and one brand. We now implemented the dealer integrated program across nearly all of our 18,000 dealer relationships. We are aggressively driving toward a lower cost structure and we have moved to the new risk model for a dealer prime that I just discussed.

Initial results in terms of dealer satisfaction, loan originations and credit performance are promising, but it's still very early days.

Second quarter auto finance results reflect the challenges of credit normalization and our continuing efforts to expand in the prime market. Despite these challenges, we remain optimistic about the future growth and profitability of our auto business.

Turning to slide 12, I'll review our mortgage banking business. We call that mortgage banking is the legacy GreenPoint Mortgage business and does not include Capital One home loans, our direct-to-consumer origination business.

The secondary market challenges continue in the mortgage businesses, although trends have stabilized in the quarter.

Our mortgage banking business posted a modest profit for the quarter inline with our expectations that the business would breakeven for the last three quarters of 2007 after the net loss in the first quarter.

Net income growth in the quarter resulted primarily from a modest expansion of net gain on sale margin and a $16 million pretax increase in the value of our MSR. Our MSR stands at a still modest $316 million.

Origination volumes declined significantly and remained under pressure. The primary factor in lower volumes is our move to a tighter underwriting standard. The challenging interest rate environment and uncertain secondary market demand also contribute to the pressure on originations.

We added $688 million of fee loss to loans held for investment in the quarter. These loans have an average FICO of 700 and an arrange CLTV of 91%. The loans were originated to sell but the bid we received were below our assessment of the value of these loans. So, we decided to move the loan to our balance sheet rather than sell them into a distressed market.

The gain on sale margin rebounded slightly from the first quarter to 56 basis points. There are several moving pieces that underlie this modest improvement. About 75% of the loans that we sold in the second quarter were originated under the old underwriting standards in the first few months of the year. These loans generated a deeply discounted base gain on sale which was consistent with the held for sale warehouse evaluation adjustments that we made in the first quarter. We have now sold virtually all of these loans originated under the old underwriting guidelines. And the evaluation of any loans that remain has been adjusted to reflect current market condition.

About 25% of the loans we sold this quarter were originated under our new tighter underwriting standards. On average, these loans are generating a base gain on sale in the 80 basis point range. Overall, the base gain on sale for the quarter was 59 basis point and minor adjustments to the rep and warranty reserve, and the held for sale warehouse valuation only reduced net gain on sale by 3 basis points.

In the second quarter, we continue to streamline and reduce the cost structure of our mortgage banking business. We consolidated several branches and servicing facility, and we continue to aggressively manage expenses, as we right size this business for the reality of sharply lower volumes.

The year-to-date results of our mortgage banking business reflect the secondary market volume, and pricing risks of our originating sell business model. But our business model continues to mostly insulate us from the big longer-term risks in the mortgage market. We don't originate or hold sub-prime mortgages, if we don't securitize mortgage loans, we hold no equity residuals, and our MSR is still a very small fraction of our tangible equity. We continue to manage the mortgage banking business to minimize our exposure to longer-term risks, and to protect the P&L, while we write out this adverse part of the cycle.

I'll discuss our local banking business on slide 13. The slide shows actual result for 2007 quarters and the pro forma results for 2006 quarters. Net income of $133 million was up modestly from the first quarter. Revenues were essentially flat from the first quarter with modest gains in net interest income offsetting the decline in non-interest income. Non-interest income would have been flat, except for the gain on sale of Hibernia's Insurance Brokerage business we booked in the first quarter.

Total deposits were flat compared to the first quarter at $75 billion. Growth in commercial deposits was offset by modest declines in public funds, consumer and direct bank deposits. As expected in the current yield environment, our deposit mix continue to shift toward higher cost deposit. Despite the shift in deposit mix modest pricing adjustments enabled deposit net interest margin to hold steady in the quarter.

Loan balances grew modestly from the first quarter to $42 billion. Commercial and small business loans grew slightly offsetting the planned reduction in residential mortgages. The commercial real estate and multifamily loan portfolios were flat from the first quarter. Credit performance remained strong and stable with both charge-off rate, and non-performing loans, as a percentage of managed loans at just 19 basis points.

The biggest news in our local banking business in the second quarter is the continued progress on integration. We announced the transition to our new bank management team headed by Lynn Pike. Starting next month, Lynn will become the President of our local banking business, as John Kanas transitions to an advisory and customer relationship role. Lynn has built out her management team by selecting experienced executives from North Fork, Hibernia, Capital One, and carefully chosen external candidates.

Our most recent key hire is Mike Slocum. Mike was formally the head of Wachovia's real estate financial services, and he will be joining our banking team in August, as head of commercial banking. With Lynn quickly coming up to speed, and getting her team in place, the time was right for this transition.

I would like to pause for a moment, and thank John Kanas and John Bohlsen for all this they have done over the years to build the great North Fork franchise, and to integrate Capital One banking business, and also to hire and develop the next generation of great talents that lead our banking business going forward.

We look forward to their continuing advice and counsel and I thank them both for all their contributions to North Fork and Capital One. Beyond the transition of the leadership team, our integration efforts continued to be on track, integration efforts will accelerate later in the year with a deposit platform and brand conversions scheduled for the first quarter of 2008.

We remain on track to deliver the targeted North Fork synergies, although the sources will almost certainly change and realizing the full run rate synergies may spill over into 2009. In the second quarter, our local banking business continued to deliver solid results and to execute a successful integration.

Now, Gary and I will be happy to answer your questions. Jeff?

Jeff Norris

Thank you, Rich. We will now start the Q&A session. If you have any follow-up questions after the Q&A session, the Investor Relations staff will be available after the call. As a courtesy to other investors and analysts, who may wish to ask a question, please limit yourself to only one follow-up question. Katie, please start the Q&A session now.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we will take our first question from Laura Kaster, Sandler O'Neill.

Laura Kaster - Sandler O'Neill

Just two real quick questions, could you speak about the seasonality of the integration expenses for '08. I would assume that those would be more front-end loaded due to the brand change. And then second Gary, a question for you. Last quarter, I believe you said you expected the UK businesses to lose money and for the mortgage business to breakeven. Have those two outlooks changed at all. Thank you.

Gary Perlin

Hi Laura, a quick answer to your first question. Certainly the seasonality of the integration expense in 2008 will be front loaded because of the timing of the deposit platform conversion and the rebranding in the first half of the year, remember that exactly the opposite in 2007, you'll start to see those integration expenses ramping up in the second half of this year much more than in the first half of the year.

As far as the profitability outlook goes, our overall UK business is close to breakeven, actually the credit card business there is mildly profitable and with the better performance of credit there, we have some cautious optimism that we might continue to see a bit of better trajectory there. Although it's early to say and then the mortgage banking businesses as Rich said, our view was that we would breakeven over the last three quarters of this year. And given the assumptions that we have made about continuation of the current market environment and our strong strides in the area of cost management, we certainly expect to try and achieve those goals in the mortgage banking business as well.

Laura Kaster - Sandler O'Neill

Great, thank you.

Operator

And we'll take our next question from Craig Maurer, Calyon Securities.

Craig Maurer - Calyon Securities

Yeah. Good evening. My question is about marketing expenditures. I understand why they're down, those go against seasonal trends. If you could just talk about where you're spending that money these days, just for my own, looking at your TV ads it seems, I haven't seen much in the way of pure credit card marketing much these days. So if you can just address that a little. Thanks.

Gary Perlin

Yes. Thanks, Craig. The lion share of our marketing continues to be first of all if you look at total marketing expenditure they continue to be related to our credit card businesses. Our US Card business is a small business, and our Canadian and UK businesses mostly the marketing is pretty much as it has been. In terms of the direct one customer at a time marketing, the only slight change is that we pulled back a little bit in terms of the prime revolver segment.

We are always opportunistic Craig, every quarter on that. Our issues that we've with respect to the market clearing price of some of this highly re-priced business. And so, we recently have done a little bit less of that. Pretty much, though, all the other places, the marketing is continuing, the way it has been. There are lot of investment in transactor business continued the investment really across the credit segment just with the isolated avoidance of some parts of the prime revolver segment.

With respect to TV advertising, you actually make a good point there. I mean, I think in general Capital One will continue to leverage our very big credit card customer base to help finance the TV advertising. But we do have an imperative internally to do what we call stretch the brand. And you noticed across now multiple products and stretching across different customer segments, and in fact across distribution channels, you see an extension of our marketing.

So, things like advertising, home loans, advertising small business. These are part of our efforts to stretch the brand, because what we find, when we do customer research is that while it is credible to customers that they could buy products from us across any of our broad product array, they still tend to think about more as a credit card company.

Craig Maurer - Calyon Securities

Okay. If I could just ask one follow up. Regards to Texas and Louisiana and to help us think about your strategy for New York, and the tri-state area, how you using your cross sell ability to entice customers to bring their business to Capital One Bank. How are you using the credit card angle to try to get people to make that jump?

Gary Perlin

Craig one thing I really want to stress is there is very little effort right now to do a lot of cross selling vis-à-vis the bank and the rest of Capital One. We're so focused on making sure that we do a sure-footed integration. What we are really doing is putting in the infrastructural capability to be doing that.

But if I were to generalize that overtime the big opportunity that we see, one of the big opportunities we see from a cross selling opportunity is to drive a lot more retail volume into the North Fork franchise, which really hasn't done really any consumer marketing to speak of. And of course, we've 3 million customer accounts in New York for the sake of driving them into the branches, and a consumer brand, and a broad consumer nationally priced product line.

And to some extent the same story applies in Texas, the only difference is there has been more active marketing on the consumer side already in Texas. So again, I think, you are going to see the next several quarters, they are still going to be very focused on integration. But the infrastructure comes first, and then it's in a sense then back to business in terms of driving the sort of second generation of growth opportunities in the banking business.

Jeff Norris

Next question please?

Operator

And we will take our next question from Michael Cohen from [Nova] Capital.

Michael Cohen - Nova Capital

Hi. Thanks for taking my question. Can you talk about the process that you went through to convert from a manual underwriting process to the first generation and now second generation score card in auto. It would seem to me that generally speaking you wouldn't have, you wouldn't have adopted something on a wider scale without testing it. How does that fit with the sort of testing control DNA. And then I have a follow up question to that.

Gary Perlin

Michael, I appreciate the question because we are best in control, fanatical company. So this in the first time we've encountered the issues associated with converting from sort of a judgmental approach to a model base approach. Let me talk, first of all sort of conceptually about the challenges one face and then exactly what we did in the auto space.

It is, even if a judgmentally based underwriter is rich in data, which typically they aren't, but if they're rich in data. One can't, it's difficult to take their data and build models on it because it tends to have blind spots. Let me give you an extreme example. Let's say in an origination business, people always, they always excluded anybody who had a delinquency. Your data, the model that you build on that will have a blind spot in a sense did not calibrating that, in a sense any excluded variable judgmentally then gets difficult to calibrate into a model.

So, this is something that we've been very aware. So as we talk have about the auto business, the issue with Onyx was an entirely judgmentally based approach. Also very, fairly narrowly defined for a customer segment and of course we bought Onyx for the sake of trying to expand its business model in the prime space.

We felt that and early things validated this that expanding on the basis of the combined judgmental wisdom of the two institutions on this was something that did not look like it had promising results. So we felt the better decision and it was the better of the two was to put in our best approximation of a model and as quickly as possible sort of monitor and make adaptations to that.

The other issue, the other difference that one has in the auto business, you don't have in the credit card business, really it's an option to just turn volume off, because one has an whole franchise and so on. So in the card business, we would have done probably a more extreme sort of testing thing in the context of a ongoing franchise, this transition we knew would be involved some guesswork can be a little ugly. It turned out to be it was a little uglier and a little worse than we had expected, frankly Michael.

Michael Cohen - Nova Capital

Is that that have any implications or any of the goodwill associated with the Onyx purchase?

Gary Perlin

No, definitely not. I mean, we still are very bullish about the Onyx business. Let me go back to Onyx, Onyx was in a sense one of the last franchises of broad dealer relationships. This is a great sales force that we bought with very good and solid customer relationship.

The scalability, there were a number of scalability issues. One was the transition to a scalable automated model. There were sort of differences in the operating platforms and some of the branch-based approach that was used in Onyx as well. So, it's been a bit of a tricky transition, but a lot of the future success that we hope to have in the prime space comes from the foundation of the Onyx acquisition. So, we are very bullish about that.

Richard Fairbank

And Michael, the other thing I want to say is we are also very confident in terms of the rollouts we are doing with respect to the prime originations as well.

Jeff Norris

Next question, please.

Operator

We will take our next question from Meredith Whitney, CIBC World Markets.

Meredith Whitney - CIBC World Markets

Hi. Good afternoon. I wanted to ask a follow-up question what I thought was a very good question posed last quarter, which was, you guys clearly made people a lot of money in the 90's and over the last three years the stock has really been stuck in place. And the question on the last call was, how long do investors wait?

I am just curious as to what kind of conversations you've had with your top shareholders and your Board in terms of there is some good things about the company, but in terms of the tax rate, the provisions, some other issues, it's just hard to get excited about the underlying strength of the company with continued messiness through the quarters.

And if you could just direct me in terms of what type of sense of urgency you guys have to move the stock because obviously investors need the stock to go up for them to make money.

Richard Fairbank

Thank you, Meredith. We are very focused on making sure we deliver sure footedly for the sake of our investors. We have, right now, more larger than usual number of market-based challenges that we face, ranging from the mortgage marketplace of flat yield curve, the normalization of credit and challenges that we are very focused on.

Our way to make sure that our investors are well rewarded is to make sure that even as we have positioned the company for long-term continued success and I think we're very well positioned for that, that we make sure we are very focused on near-term execution and delivery. So, if you look at what we have been focusing on, you will see the very big efforts with respect to costs and, there's a tremendous momentum inside this company with respect to operating costs.

We have put a very big effort on the revenue side of the business to make sure that even as the card business backs off some of the least profitable investment opportunities in the US Card business that we create a steady solid revenue trajectory and you will see the manifestations of that going on in the quarter.

Additionally, we're also, and you can watch it in action now is taking advantage of the significant capital generation that happens in the company as you can see with the several times we've in fact accelerated repurchase activity.

So, around the company while, people are happy about the long-term position of the company and the prospects for long-term returns, we know thatour job, right now, is to make sure we deliver very effectively during this period of greater than usual market challenges, and also paying for the acquisitions that we've done.

And that is our focus and I think, Meredith, despite some of the noise associated with the data, I think if you look hard at the various metrics on this call, you will in fact see the manifestation of the really hard work that's going on and I think that our investors stand to be very well rewarded for that, although, I'm not going to predict the timing of that, because that's really the job of the investors.

Meredith Whitney - CIBC World Markets

Okay. So, for specifically this quarter, I guess the thing that confuses me most is why beat on lower tax rate, why not over provide as opposed to, in terms of on page 9, the charge-off rate is expected to go up to 5%, why not over reserve in a quarter like this as opposed to beat? It's confusing for me, it's confusing for investors, in terms if you want people to focus on the good of the story, I would think you would clear out that noise. And I was just curious as to what your top shareholders are saying?

Gary Perlin

Meredith, its Gary. I'm happy to take that one. I think if you take a look at the very first slide of the presentation today, you will see all the moving parts in front of you as clearly as we can possibly put them forward for you, coming all from very natural developments. So, restructuring charges coming from cost moves that we're making, recognizing all of the accounting requirements that we have as a public company, trying to make them as clear and obvious to you as possible.

And as Rich just said, if you simply do the simple math, you can take a look at the underlying strength of the company coming through certainly positioning us well for the future.

So, when I meet with investors, what I hear from them all the time is, please make sure that you're managing the company right, making the right decisions, being as transparent as you possibly can, being as (inaudible) as you possibly can and try and make it easy for us to recognize the value that you have got.

And certainly from an accounting standpoint, we do what's appropriate and trying to make sure you understand it. And from most of the investors I speak to that's what they appreciate.

Jeff Norris

Next question, please.

Operator

Thank you. We'll go next to Scott Valentin, Friedman Billings & Ramsey.

Scott Valentin - Friedman Billings & Ramsey

Thanks for taking my question. On the auto platform you mentioned the integration of entire platform resulting in driving some cost efficiencies. Can you talk about maybe the goals you have there, it was down, the costs include improved linked quarter. Just curious what you see driving that number down to over time.

Richard Fairbank

Scott, we have looked at not only our competitors overall costs, but we have on a segment-by-segment sort of credit segment adjusted basis looked at sort of best in class operating cost. And what we have targeted is that, if we want to really win in this highly consolidated competitive business, we need to be at the right cost level frankly in each of the segments of the business. And so, I'm not going to give you numbers, you can do your own calibrations of that.

But we are not going to rest until we are head-to-head in any segment we've got the right competitive cost. If you recall Scott, we showed a scale curve in our investor meeting earlier this year. We showed a scale curve that had every major players early cost. This was not adjusted by credit segment, but you could see Capital One was sort of out of line a bit. And we've been very focused on this and lot of the out of line comes not from not managing cost carefully. I think Dave Lawson has a long history of managing it very tightly.

It comes really from having four different platforms that we're putting together. So, there's a double significance to this pulling together of one platform, one credit policy, and the kind of single face to the dealer that it is both a move to pull from four different approaches to one, and get dealer penetration as a result. But it's also the thing that enabled the cost reduction.

And our costs, as the percentage of loans have declined from around 3.2% in the 04/05 period to 2.8% in the first quarter to 2.6% in the second quarter. We do expect it's got to be even lower by the end of the year, as we finish these things. And we believe that we're going to be head-to-head competitive on an ongoing basis with the major players in their segments.

Scott Valentin - Friedman Billings & Ramsey

Okay. One follow-up question, if I may. On credit card revenue margin, you had good improvement there. I was curious as to how much of that was due to re-pricing efforts versus maybe increased penalty fee income, you did cut the grace period by five days. I was just curious, if it had an impact on the revenue margin?

Gary Perlin

Scott, its Gary. I'll be happy to take that. The change to a 25 day grace period did not really have any material impact on the P&L. It did have a material impact on the charge-off rate, which is why Rich referred to it. What we did here in aligning our business practices with industry standard was to delay the cycle start time by five days. But it had no impact on the bottom-line because although we had lower charge-offs, we also could not release the allowance associated with it. So, there was no really no P&L impact from the 25 day grace.

So, the improvement in card margin was the result of a number of major developments, as Rich described with the re-pricing of some of the card assets to match up with funding some of those which had been kind of held in a queue waiting for the teasers conversion and some other moves with respect to customer pricing in line with our desire to make sure, we provide great value, but generate a reasonable return.

Jeff Norris

Next question, please.

Operator

We will take our next question from Chris Brendler with Stifel Nicolaus.

Chris Brendler - Stifel Nicolaus

Hi, thanks. Good afternoon. On the same topic, on the card margin, it typically declines in the second quarter. So, I think from a seasonal perspective, I'm thinking that, and Gary I think, we've talked about recently that I thought that the re-pricing initiative, why you started it maybe March, April, it really wouldn't have sort of a full run rate into the third quarter. So, is the outlook for the card margin to continue to expand from here, from the re-pricing initiatives? And then a related question is I'm very confused, in how you get to a 5% loss rate for the fourth quarter? There is on a year-over-year basis delinquencies are actually kind of flattish. There has been no real major move in the bankruptcy rate nationwide. So, what's causing the increase in losses that I already have modeled the receivables down a little bit. So, I'm not exactly sure what's causing you be so conservative on your last forecast for the card business?

Gary Perlin

Chris, its Gary. Why don’t I start off on the revenue conversation that we've been having and then I'll turn it back to Rich on the outlook for the charge-off rate. And yes, you're right a number of the revenue improvements started relatively early in the quarter, and then kind of feathered into throughout the quarter. So, you're seeing the benefit of many of those changes. And you should continue to see some upward trajectory to the card margin over the course of this year, as a lot of those moves will play through. And again in 2008, you will see the full year impact of some of those beneficial moves. So again, I think you've got it right that you are starting to see a movement that will be continuing in many quarters to come. And now I hand it over to Rich for the question on the charge-off rate outlook.

Richard Fairbank

Yes. Chris, our dollar losses that we forecast for the year and that are inherent in the guidance are coming in now six months into the year, almost exactly as we anticipated. The mix is a little different, because BK our bankruptcies are normalizing less quickly than we had expected. And that causes a lot of people we talked to, they say, this normalization isn't all that it's made out to be. But we have always talked about the substitution effect, where as it becomes more difficult for people to go bankrupt, they charge-off the old fashion way and there is a pent-up reservoir of people, who otherwise would have charged-off who, and we predicted a portion of these people going into the contractual charge-off this year. The contractuals are higher, the bankruptcies are lower, the overall effect is just about exactly the same. The reason for us that our, we are now guiding to a higher charge-off rate is really entirely a denominator effect, where our assets growth from the year, which we are seeing will be negative in the card business is lower than we had expected.

Chris Brendler - Stifel Nicolaus

Earlier I can be missing here is that may be you are talking about significant decline in loans, like billions of dollars decline in receivables? Other the impression would be a slight decline, I think that you said at a recent conference.

Gary Perlin

Chris, its Gary. I mean the slight decline is what you might see from quarter to quarter, I think the bigger move is looking at a sort of a year-on-year basis, but couple of points that might help you to get to our understanding of the outlook. The first thing is, remember that the starting point here in the second quarter, although we printed a charge-off rate of about 3% and 3.25%, as I indicated there is a big impact from the change to the 25-day grace period. Without that change and frankly without some debt sales that happen from time to time, the charge-off rate this quarter would have been more like 4.25%. So the move from here to the fourth quarter is not nearly as big as it might otherwise appear.

Remember as well, the fourth quarter is always our seasonally highest quarter for charge- offs. And again, depending on what's going on, in the denominator and the mix of the business, people all along have been asking us what does normalization mean and if you go back to the charge-off rates we were seeing in our card business before the change in the bankruptcy, it will always be about 4.7%, 4.8%.

So, we're getting back to normal, but we're getting there with a relatively different mix of business, a little best balance sheet intensive, therefore a smaller denominator that 4.7%, 4.8% can easily turn into 4.9 or 5.0 and it would be certainly within our minds very much a normalization. So that's the outlook.

Jeff Norris

Next question, please.

Operator

We'll go next to Bob Napoli, Piper Jaffray.

Bob Napoli - Piper Jaffray

Thank you. Within the credit card business, the mix shift that you're reducing the prime, you said less balance sheet intensive, is that and the margins going up. So, it sounds like you're doing more sub-prime, is that Gary, you're going back into some of the sectors that's in subprime that you had gone out of -- and you were successful in the past?

Richard Fairbank

Bob, it's really, I mean in the subprime space there is a great consistency to what we've done frankly for a long period of time. I mean, we haven't flow a little bit, but generally we're going after the most northern part, if you will of the subprime space.

So, there is not a lot of sort of strategy change in the subprime space. The implicit slight mix shift really comes from what's happening on the prime side, where I mean, we've a good solid profit story, but we're just being very disciplined about the choices that we make on what turns out to be the most asset intensive part of all the origination choices. I just want to pull up for a second here that it is the thing that most drives people growth in assets relates to their choice about balance transfer base origination, and that is the thing we've our foot the most off of the gas pedal.

So again, good solid opportunities, we continue to pursue in pretty much all other aspects of the credit card business. But there is that implicit sort of mix shift that comes from little bit less prime. But I wouldn't get too hung up about this. I mean, these are opportunistic choices we make at the line of scrimmage every quarter. It's not like we don't do any prime revolver business. These just happened to be asset sensitive choices. So, we end up in the situation, where we end up looking forward for the rest of the year at a reduction on a year-over-year basis in terms of the assets, while still the revenues and the purchase volume continue to move forward.

Bob Napoli - Piper Jaffray

Thanks. And then your mortgage business, just over the last week two relatively big players GE and CIT have announced they are getting out of that business. The industry literally is a mess in many regards. I just wondered if you have any updated thought on the importance of mortgage business to Capital One, and the growth strategy, if it is still something, do you deem important to the company?

Richard Fairbank

Bob, in the middle of sort of a battle one doesn't tend to think as much about long-term exactly what you're going to do after the battle. This is a very tough time in the business. What we're doing is being incredibly focused to stabilize the business along a number of dimensions most importantly probably on the cost dimension, but also very much on the underwriting side basis, on the business in terms of the product mix, and in terms of liquidity strategies and things like this.

So, we actually feel very good about the traction that we're getting on those dimensions. And in a sense the stabilization was a small yes, if you will in the middle of this difficult environment. We still have more work to do in terms of long term mortgage strategy. Obviously, we know this is a volatile business and so on. We do have, there are a very solid franchise with respect to GreenPoint, is a very talented people with great relationship and a great credibility and brand in the capital markets.

And this is a franchise, that I think has real potential in the long-term, but right now it's really more about the delivery, against set of challenges in the short-term. And the other thing that's I think really striking is the Capital One home loans business in the mid stuff sort of problems all over the industry. Capital One home loans, is growing, which is again our originating sell business. This is a business that has a full credit spectrum business. It's all internet-based and so on.

This business is in fact in the face of growing and growing profits if you can imagine over the course of this year. So we've got some good anchor tenants that we can work with in the middle of, but right now it's about near term delivery.

Jeff Norris

Next question, please.

Operator

We will go next to Moshe Orenbuch, Credit Suisse.

Moshe Orenbuch - Credit Suisse

Great. Rich, I was wondering if you could kind of characterize your decision to accelerate the share repurchase into 2007. What caused that and maybe follow up after, if you do that.

Richard Fairbank

Moshe, I think, I've been saying for a number of quarters, I want to make sure that our shareholders are be well served in a difficult times of market conditions and challenges for investors in this company over the last couple years. One of the important leverages that we have Moshe, to make sure our investors get paid is in fact returning capital. And we've have seized in a sense the opportunities that we find in front of us even though they don't massively move the needle every little bit helps, and we certainly seize that opportunity along with making important moves along other dimensions like cost and revenue.

Moshe Orenbuch - Credit Suisse

I guess, I'm truck by, this will be the first time I think in the company's history that you had a year-over-year decline in the credit card receivables given that you're generating capital in a high 20's rate. It would seem to me that you could probably be very, very close to the point at which you're thinking about not just completing that share repurchase, but also instituting a dividend. I wonder if you have any thoughts on that respect.

Richard Fairbank

Moshe, as we talk about for sometime, we know that we've moved and credit card is sort of leading the way in a sense move to a case, where our company is not on the targeted growth rate that we were in the past. And we therefore moved from capital mutual into a situation of substantial capital generation.

And we've flagged our intent to return capital to shareholders. As we've said, the form in which it comes, in the form of buybacks or dividends is something that we continue to discuss, and right now of course we're primarily doing the or entirely doing the share repurchase pursuant to the North Fork acquisition.

In the latter part of this year, and early into next year, as we look ahead to the other side of that, I think we'll have a lot to say to the marketplace about our capital strategy. And I'll leave it at that at this point.

Jeff Norris

Next question?

Operator

Actually, we have no further questions at this time. I'm going to turn the conference back over to Mr. Jeff Norris.

Jeff Norris

Thanks very much, Katie. Well, thank you all for joining us on this conference call today, and thank you for your continuing interest in Capital One. Remember the investor relation staff will be here this evening to answer any further questions you may have. Have a good evening.

Operator

We thank you for your participation on today's call. That will conclude our conference call. Have a great night. And you may now disconnect.

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