Capital One Financial Corporation (NYSE:COF) Q4 2022 Earnings Call Transcript

Capital One Financial Corporation (NYSE:COF) Q4 2022 Earnings Call Transcript January 24, 2023

Operator: Good day, and thank you for standing by. Welcome to the Fourth Quarter 2022 Capital One Financial Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Jeff Norris, Senior Vice President of Finance. Please go ahead.

Jeff Norris: Thank you very much, Victor. And welcome everybody to Capital One’s fourth quarter 2022 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 2022 results. With me this evening are Mr. Richard Fairbank, Capital One’s Chairman and Chief Executive Officer; and Mr. Andrew Young, Capital One’s Chief Financial Officer. Rich and Andrew will walk you through the presentation. To access a copy of the presentation and the press release, please go to Capital One’s website, click on Investors and click on Quarterly Earnings Release.

Please note that this presentation may contain forward-looking statements. Information regarding Capital One’s financial performance and any forward-looking statements contained in today’s discussion and the materials speak only as of the particular date or dates indicated in the materials. Capital One does not undertake any obligation to update or revise any of this information, whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. For more information on these factors, please see the section titled, Forward-Looking Information in the earnings release presentation and the Risk Factors section in our annual and quarterly reports, which are accessible at Capital One’s website and filed with the SEC.

With that, I’ll turn the call over to Mr. Young. Andrew?

Andrew Young: Thanks, Jeff, and good afternoon, everyone. I’ll start on slide 3 of tonight’s presentation. In the fourth quarter, Capital One earned $1.2 billion or $3.03 per diluted common share. For the full year, Capital One earned $7.4 billion or $17.91 per share. Included in the results for the fourth quarter were two adjusting items, which collectively benefited pretax earnings by $105 million. Net of these adjustments, fourth quarter earnings per share were $2.82 and full year earnings performance share were $17.71. On a linked quarter basis, period-end loans grew 3% and average loans grew 2%, driven by growth in our domestic car business. This loan growth coupled with net interest margin expansion drove revenue up 3% on a linked quarter basis.

Noninterest expense grew 3% in the linked quarter, driven by an increase in marketing expenses while operating expenses were largely flat. Net of the adjustments I mentioned earlier, operating expenses were up 2.4%. Provision in the quarter — provision expense in the quarter was $2.4 billion, driven by net charge-offs of $1.4 billion and an allowance build of about $1 billion. Turning to slide 4, I will cover the changes in our allowance in greater detail. The $1 billion increase in allowance in the fourth quarter brings our total company year-end allowance balance up to $13.2 billion, increasing the total company coverage ratio by 22 basis points to 4.24%. I’ll cover the changes in allowance and coverage ratio by segment on slide 5. In our Domestic Card business, the allowance balance increased by $795 million, bringing our coverage ratio to 6.97%.

Three things put upward pressure on our card allowance. The first factor was the continued credit normalization in our portfolio. The second factor was a modestly worse economic outlook than our assumption a quarter ago. And finally, we built allowance for the loan growth in the quarter. The impact of the fourth quarter loan growth on the allowance is more muted than typical loan growth given the seasonal nature of these balances. These three factors were modestly offset by a release in our qualitative factors. In our Consumer Banking segment, the allowance balance increased by $129 million, driving a 20 basis-point increase in coverage to 2.8%. The build was primarily driven by continued credit normalization in our auto business, including lower recovery rates.

The second factor also putting upward pressure on our allowance is the impact of a modestly worse economic outlook. These two factors were modestly offset by a release in our qualitative factors. And finally, in our Commercial business, the allowance increased $73 million, resulting in a 9 basis-point increase in coverage to 1.54%. This was largely driven by reserve builds for our office portfolio. Turning to page 6, I’ll discuss liquidity. You can see our preliminary average liquidity coverage ratio during the fourth quarter was 143%, well above the 100% regulatory requirement. Total liquidity reserves increased by $14 billion to $107 billion. Strong consumer deposit growth throughout the quarter drove cash balances higher and allowed us to pay down prior FHLB borrowings.

Capital One Financial Corporation (NYSE:COF) Q4 2022 Earnings Call Transcript

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Turning to page 7, I’ll cover our net interest margin. Our net interest margin was 6.84% in the fourth quarter, 24 basis points higher than the year-ago quarter and 4 basis points higher than the prior quarter. The 4 basis-point linked quarter increase in NIM was driven by higher asset yields and a balance sheet mix shift towards car loans. This impact was mostly offset by higher deposit and wholesale funding costs. Turning to slide 8, I will end by discussing our capital position. Our common equity Tier 1 capital ratio was 12.5% at the end of the fourth quarter, up about 30 basis points relative to last quarter. The $1.2 billion of net income in the quarter was partially offset by growth in risk-weighted assets, dividends and share repurchases.

We repurchased approximately $150 million of common stock in the quarter, bringing the repurchases for the full year to $4.8 billion. We continue to estimate that our longer term CET1 capital need is around 11%. With that, I will turn the call over to Rich. Rich?

Richard Fairbank: Thank you, Andrew, and welcome, everybody. I’ll begin on slide 10 with fourth quarter results in our Credit Card business. Year-over-year growth in purchase volume and loans, coupled with strong revenue margin drove an increase in revenue compared to the fourth quarter of 2021. Credit Card segment results are largely a function of our domestic card results and trends, which are shown on slide 11. In the fourth quarter, strong year-over-year growth in every top line metric continued in our Domestic Card business. Purchase volume for the fourth quarter was up 9% from the fourth quarter of 2021. Ending loan balances increased $22.9 billion or about 21% year-over-year. Ending loans grew 8% from the sequential quarter.

And revenue was up 19% year-over-year, driven by the growth in purchase volume and loans as well as strong revenue margin. Both the charge-off rate and the delinquency rate continued to normalize and were below pre-pandemic levels. The domestic card charge-off rate for the quarter was 3.2%, up 173 basis points year-over-year. The 30-plus delinquency rate at quarter-end was 3.43%, 121 basis points above the prior year. On a linked quarter basis, the charge-off rate was up 102 basis points and the delinquency rate was up 46 basis points. Noninterest expense was up 12% from the fourth quarter of 2021, which includes an increase in marketing. Total company marketing expense was about $1.1 billion in the quarter. Our choice in domestic card marketing are the biggest driver of total company marketing.

In our Domestic Card business, we continue to lean into marketing to drive resilient growth. We’re keeping a close eye on competitor actions and potential marketplace risks. We’re seeing the success of our marketing and strong growth in domestic card new accounts, purchase volume and loans across our card business and strong momentum in our decade-long focus on heavy spenders at the top of the marketplace continues. Slide 12 shows fourth quarter results for our Consumer Banking business. In the fourth quarter, we continued to see the effects of our choice to pull back on auto growth in response to competitive pricing dynamics that have pressured industry margins. Auto originations declined 32% year-over-year and 20% from the linked quarter.

Driven by the decline in auto originations, Consumer Banking loan growth continued to be slower than previous quarters. Fourth quarter ending loans grew 3% compared to the year ago quarter. On a linked-quarter basis, ending loans were down 2%. Fourth quarter ending deposits in the Consumer Bank were up 6% year-over-year, and up 5% over the sequential quarter. Average deposits were up 4% year-over-year and up 3% from the sequential quarter. Our digital-first national direct banking strategy continues to get good traction. Consumer Banking revenue was up 10% year-over-year as growth in auto loans and deposits was partially offset by the year-over-year decline in auto margins. Noninterest expense was up 13% compared to the fourth quarter of 2021, driven by investments in the digital capabilities of our auto and retail banking businesses and marketing for our national digital bank.

The auto charge-off rate and delinquency rate continued to normalize in the fourth quarter. The charge-off rate for the fourth quarter was 1.66%, up 108 basis points year-over-year. The 30-plus delinquency rate was 5.62%, up 130 basis points year-over-year. On a linked quarter basis, the charge-off rate was up 61 basis points, and the 30-plus delinquency rate was up 77 basis points. Slide 13 shows fourth quarter results for our Commercial Banking business. Compared to the linked quarter, fourth quarter ending loan balances were down 1% and average loans were flat. Ending deposits were down 1% from the linked quarter. Average deposits grew 7%. Fourth quarter revenue was down 23% from the linked quarter. The decline was primarily driven by an internal funds transfer pricing impact that was offset by an equivalent increase in the other category and was therefore neutral to the Company.

Excluding this impact, fourth quarter commercial revenue would have been down about 6% quarter-over-quarter and up 2% year-over-year. Noninterest expense was up 2% from the linked quarter. The Commercial Banking annualized charge-off rate was 6 basis points. The criticized performing loan rate increased 74 basis points from the linked quarter to 6.71%, and the criticized nonperforming loan rate was up 17 basis points from the linked quarter to 0.74%. In closing, we continue to drive strong growth in card revenue, purchase volume and loans in the fourth quarter. Loan growth in our Consumer Banking business was slower compared to previous quarters as we continued to pull back on auto originations. Consumer deposits grew. And in our Commercial Banking business, ending loans and deposits were roughly flat compared to the linked quarter.

Charge-off rates and delinquency rates continue to normalize across our business and were below pre-pandemic levels. Total company operating expense net of adjustments was up 2.4% from the linked quarter. Our annual operating efficiency ratio for full year 2022 was 44.5% net of adjustments, a 15 basis points improvement from full year 2021. And we expect that the full year 2023 annual operating efficiency ratio net of adjustments will be roughly flat to modestly down compared to 2022. Pulling way up, we continue to see opportunities for resilient asset growth that can deliver sustained revenue annuities. We continue to closely monitor and assess competitive dynamics and economic uncertainty. Powered by our modern digital technology, we’re continuously improving our proprietary underwriting, marketing and product capabilities.

We’re focusing on efficiency improvement and we’re managing capital prudently. As a result of our investments to transform our technology and to drive resilient growth, we’re in a strong position to deliver compelling long-term shareholder value and thrive in a broad range of possible economic scenarios. And now, we’ll be happy to answer your questions. Jeff?

Jeff Norris: Thank you, Rich. We’ll now start the Q&A session. As a courtesy to our other investors and analysts who might wish to ask a question, please limit yourself to one question plus a single follow-up. If you have any follow-up questions after the Q&A session, Investor Relations team will be available after the call. Victor, please start the Q&A.

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Q&A Session

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Operator: Thank you. One moment for our first question. Our first question comes from line of Mihir Bhatia from Bank of America.

Mihir Bhatia: I wanted to ask about just the vintage seasoning or growth math as you talk — as I think we’ve talked about in the past. We’ve added a lot of loans here in last year. And as these loans season, I was just trying to — wonder if you could maybe talk about just how you see that flowing through into your loss rates and what that does to your delinquency and loss goes here over the next 12 to 24 months? Thank you.

Richard Fairbank: Yes. Thank you. Let me just start with a reminder of what we mean by growth math. As a general rule of thumb, losses on new loans tend to ramp up over a couple of years and then peak and then gradually come down. When we accelerate growth and especially when those new loans are added to a seasoned back book with low losses, it can increase the overall level of losses of a portfolio. We grew rapidly — for example, just looking back at when we talk a lot about growth math, we grew rapidly in 2014, 2015 and 2016, and had a particularly visible growth math effect in the wake of that growth. At that time, the large front book was adding to a back book that was unusually seasoned because it had survived the Great Recession.

Given our recent rate of growth, I think it’s likely we’ll see some growth math effect again over the next few years. But I think the general normalization trend will be the bigger driver of our credit trajectory. One other thing that’s different about growth math going forward is CECL. Under the CECL accounting regime, the allowance impact of new growth are pulled forward significantly. We haven’t seen this effect for most of the pandemic, even as we have accelerated our growth because of the offsetting favorable factors in our allowance. But as our growth continues, a portion of our allowance builds going forward are intended to support that growth.

Mihir Bhatia: Okay. Thanks. And then just maybe on your reserve. Just trying to understand just some of the assumptions underlying the reserves. Maybe you could just talk about what you’re assuming for unemployment whether you have a recession built into the short term. Any additional color you can help us with there? Thank you.

Andrew Young: Sure Mihir. As I said in the past, we are largely consumers of economic assumptions. In this particular case for unemployment, we are assuming something that’s a little modestly higher than consensus estimates for where we will land in the fourth quarter. I think consensus is somewhere around 4.8. We’re — our baseline forecast gets up to around 5% in the fourth quarter. But it’s important to note there’s a lot of other things that go into the calculation of the reserve, things like unemployment — sorry, changes in the unemployment rate, inflation, home prices, wages, all of those factors matter as well, but our unemployment assumption is to be around 4% in the fourth quarter — sorry, around 5% in the fourth quarter.

Operator: And our next question comes from the line of Ashish Sharma with Capital One.

Jeff Norris: Hey Victor, I don’t think that’s right.

Ryan Nash: Was that intended for me, Jeff?

Jeff Norris: Hey Ryan, why you don’t go ahead.

Ryan Nash: So Rich, maybe I can ask Mihir’s — one of Mihir’s questions in a slightly different manner. So, competitors in the industry are talking about reaching pre-pandemic loss levels by year-end or maybe even overshooting those levels. Can you maybe just talk a little bit about how you think about the pace of normalization or maybe even overshooting those? And maybe just talk a little bit about normalization versus parts of the portfolio if you’re actually seeing any deterioration. Thanks. And I have a follow-up.

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