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Edited Transcript of COF earnings conference call or presentation 25-Apr-19 9:00pm GMT

Q1 2019 Capital One Financial Corp Earnings Call

MCLEAN Apr 29, 2019 (Thomson StreetEvents) -- Edited Transcript of Capital One Financial Corp earnings conference call or presentation Thursday, April 25, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jeff Norris

Capital One Financial Corporation - SVP of Global Finance

* Richard D. Fairbank

Capital One Financial Corporation - Founder, Chairman, CEO & President

* Richard Scott Blackley

Capital One Financial Corporation - CFO

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Conference Call Participants

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* Betsy Lynn Graseck

Morgan Stanley, Research Division - MD

* Christopher Charles Brendler

The Buckingham Research Group Incorporated - Analyst

* Christopher Roy Donat

Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research

* Donald James Fandetti

Wells Fargo Securities, LLC, Research Division - Senior Analyst

* Eric Edmund Wasserstrom

UBS Investment Bank, Research Division - MD & Consumer Finance Analyst

* Kevin James Barker

Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst

* Moshe Ari Orenbuch

Crédit Suisse AG, Research Division - MD and Equity Research Analyst

* Richard Barry Shane

JP Morgan Chase & Co, Research Division - Senior Equity Analyst

* Ryan Matthew Nash

Goldman Sachs Group Inc., Research Division - MD

* Sanjay Harkishin Sakhrani

Keefe, Bruyette, & Woods, Inc., Research Division - MD

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Presentation

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Operator [1]

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Welcome to the Capital One First Quarter 2019 Earnings Conference Call. (Operator Instructions) I would now like to turn the call over to Mr. Jeff Norris, Senior Vice President of Finance. Sir, you may begin.

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Jeff Norris, Capital One Financial Corporation - SVP of Global Finance [2]

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Thanks very much, Leanne, and welcome, everyone, to Capital One's First Quarter 2019 Earnings Conference Call. As usual, we are webcasting live over the Internet. To access the call on the Internet, please log onto Capital One's website at capitalone.com and follow the links from there. In addition to the press release and financials, we have included a presentation summarizing our first quarter 2019 results.

With me today are Mr. Richard Fairbank, Capital One's Chairman and Chief Executive Officer; and Mr. Scott Blackley, Capital One's Chief Financial Officer. Rich and Scott will walk you through this presentation. To access a copy of the presentation and 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 in the materials speak only as of the particular date or dates indicated in the materials.

Capital One does not undertake any obligation to update or revise any of this information whether as a result of new information, future events or otherwise. Numerous factors could cause our actual results to differ materially from those described in forward-looking statements. And for more information on these factors, please see the section titled Forward-looking Information in the earnings release presentation and the Risk Factors section in our annual and quarterly reports accessible at the Capital One website and filed with the SEC.

And now I'll turn the call over to Mr. Blackley. Scott?

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Richard Scott Blackley, Capital One Financial Corporation - CFO [3]

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Thanks, Jeff. I'll begin tonight with Slide 2. Capital One earned $1.4 billion or $2.86 per share in the first quarter. Net of adjusting items, earnings per share were $2.90. The only adjusting item we had in the quarter was $25 million of launch and integration cost associated with our Walmart partnership.

Slide 13 outlines the financial impacts of this adjusting item. Pre-provision GAAP earnings increased 18% on a linked-quarter basis and 2% year-over-year to $3.4 billion. Revenue of $7.1 billion was 1% higher than Q4 '18 and 3% higher than a year ago. Relative to the prior quarter, noninterest expense was down 11%, largely from a lack of Q4 seasonal spending.

Compared to the prior year, noninterest expense was higher by 3%, driven by increased marketing spend as operating expenses remained flat. Provision for credit losses increased 3% on a linked-quarter basis driven by an allowance build in the quarter. Charge-offs were relatively flat as there were modestly offsetting seasonal changes in our Auto and Domestic Card businesses.

On a year-over-year basis, provision costs were higher by 1% driven by a larger allowance build in the quarter, partially offset by lower charge-offs in our Domestic Card business. Let me take a moment to explain the quarterly movements in allowance across our businesses, which are detailed in Table 8 of our earnings supplement. Reserves in our commercial business increased by $55 million driven by the establishment of reserves related to a few specific credits and loan growth.

Our credit card business saw an allowance increase of $25 million driven by a build in International Card, partially offset by smaller lease in Domestic Card. In our consumer business, there was a build of $14 million, driven by growth and portfolio mix in our Auto business.

Turning to Slide 4. Net interest margin was 6.86%, down 7 basis points year-over-year. The strong growth in Capital One's 360 deposit products drove an increase in our average deposit costs, which was the key driver of the year-over-year decrease in our net interest margin.

We continue to expect deposit cost to be a headwind in NIM throughout 2019. I also want to provide a reminder about Q2 NIM seasonality. Recall that net interest margin declined by 27 basis points from Q1 to Q2 last year and around half of that decline was attributable to normal seasonal factors.

Turning to Slide 5. Our common equity Tier 1 capital ratio on a Basel III standardized basis was 11.9%. We continue to view our capital need to be around 11% CET1. We are keeping a close eye on how CECL will impact CCAR stress testing, which could impact our view of our future capital need. We continue to believe that we have sufficient capital and earnings power to support growth, the Walmart portfolio acquisition later this year, the phased-in impact of adopting CECL on January 1, 2020 as well as a 2019 CCAR capital distribution request that is meaningfully higher than 2018, of course, which is subject to regulatory approval.

Before I turn the call over to Rich, let me take a moment to update you on our Walmart partnership. We now expect the acquired portfolio will be in the low $8 billion range at closing. Adjusting for this portfolio size, we now expect the day 1 allowance build will be around $100 million.

Of course, the actual balances acquired and the day 1 allowance build will depend on the program performance between now and close. We continue to expect that in 2019 we will incur $225 million in onetime expenses to launch the new originations program and integrate the acquired portfolio. And that the overall Walmart partnership, inclusive of those costs, will have returns and resilience in line with our domestic credit card business.

And with that, I'll turn the call over to Rich. Rich?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [4]

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Thank you, Scott, and good evening. Slide 8 summarizes first quarter results for our credit card business. First quarter pretax income was up 7% from the prior year as the positive impacts of revenue growth and lower provision for credit losses were partially offset by higher noninterest expense. Credit card segment results and trends are largely driven by the performance of our Domestic Card business, which is shown on Slide 9.

In the first quarter, Domestic Card ending loan balances were up $2.5 billion or about 3% compared to the first quarter of last year. Average loans grew about 2%. Revenue increased 4% from the first quarter of 2018 driven by purchase volume growth and loan growth. Revenue margin increased 21 basis points to 16.15% for the quarter.

Noninterest expense was up about 6% compared to the prior year quarter. Operating expenses increased as we began to ramp up operational capabilities for a smooth Walmart conversion and launch later this year. The larger driver of increased noninterest expense was higher marketing.

For years we have worked tirelessly to build a franchise at the highest end of the marketplace, heavy spenders. Heavy spenders are hard to get, but exceptionally valuable to have. They are long-term annuities that pay off on the bottom line with strong interchange revenue, loan balances from occasional revolving, very low charge-offs and very low attrition.

They can't be bought with just marketing. They have to be earned with great products and exceptional customer experience, leading digital capabilities and a trusted brand. Great marketing then tells the story.

We are seeing accelerating traction growing our heavy spender franchise. Account originations have grown to record levels over the last 2 quarters. Led by heavy spenders, Domestic Card purchase volume growth was 8.3% from the prior year quarter or 10.3% if normalized for 2 fewer processing days in the fourth -- in the first quarter of 2019. Net interchange growth was 18% aided by a favorable rewards liability adjustment. Excluding that, net interchange growth was in line with purchase volume growth.

Notably, we've been able to grow our spender franchise without sacrificing revenue margin. Our growth has not just been with heavy spenders. In the first quarter, overall Branded Card account originations grew 16% year-over-year. Branded Card's exclude all private label and co-branded cards.

Loan growth is also picking up even as we continue to be cautious on credit lines. Domestic Card loan growth was 2.6% year-over-year, including 4% growth in Branded Card loans, offset by some shrinkage in partnerships.

Strong credit performance continue to be a driver of Domestic Card results in the first quarter. The charge-off rate for the quarter was down -- excuse me, was 5.04%, down 22 basis points from the first quarter of 2018. Growth Math continues to be a good guy. Credit performance on the loans booked during our growth surge in 2014, 2015 and 2016 continued to improve year-over-year and drove the year-over-year improvement in the overall Domestic Card charge-off rate.

Pulling up in the first quarter competition in the credit card marketplace was relatively stable and rational and our Domestic Card business delivered strong results and gained momentum.

Slide 10 summarizes first quarter results for our Consumer Banking business. Both ending loans and average loans decreased about 21% compared to the prior year quarter driven by the home loans portfolio sale in 2018. Ending loans in our Auto business were up 3% year-over-year. Auto originations declined and loan growth decelerated as competitive intensity in auto increased in the quarter.

Ending deposits in the consumer bank were up 6% versus the prior year quarter, with a 38 basis point increase in average deposit interest rate. We're making digital banking easy with our award-winning mobile banking experience. Powered by the rollout of our national banking strategy, our strongest deposit growth is in Capital One 360 products, driving a product mix shift toward higher rate deposit products.

Over the past year, the changing product mix, rising interest rates and increasing competition have put upward pressure on deposit rates. Looking ahead, we expect further increases in average deposit interest rate as faster growth in higher rate deposits continue to change our product mix.

Consumer Banking revenue increased about 3% from the first quarter of last year. Growth in auto loans and retail deposits was partially offset by the revenue reduction from the home loans portfolio sale. Noninterest expense was essentially flat compared to the prior year quarter. Provision for credit losses was also essentially flat from the first quarter of 2018.

The auto charge-off rate improved modestly compared to the prior year quarter and we had a modest allowance build in the first quarter. Better-than-expected auction values continue to support strong auto credit.

Over the longer-term, we continue to expect that the auto charge-off rate will increase gradually as the cycle plays out.

Moving to Slide 11. I'll discuss our Commercial Banking business. First quarter ending loan balances were up 8% year-over-year. Growth in average loans was 10%. Linked-quarter growth was more modest, with ending loans up about 1% and average loans up about 3%.

Commercial bank ending deposits were down 9% from the prior year. Over the past year, commercial deposit customers have rotated out of deposits and into higher-yielding investments in the rising interest rate environment. First quarter revenue was down 2% from the prior year quarter driven by lower average deposit balances.

The revenue benefit of higher average loan balances was offset by lower loan margins. Noninterest expense was up 3% compared to the prior year quarter as we continue to invest in technology and other business initiatives.

Provision for credit losses increased compared to the first quarter of 2018 when we actually posted a net benefit from credit performance because of an unusually large allowance release. This year, we posted an allowance build in the first quarter driven by loan growth and the establishment of reserves related to a few specific credits.

The credit performance of our Commercial Banking business remains strong. The charge-off rate for the quarter was 0.08%. The commercial bank criticized performing loan rate for the quarter was 2.9%, and the criticized nonperforming loan rate was 0.5%.

Pulling up, increasing competition from nonbanks continues to drive less favorable terms in the commercial lending marketplace. We're keeping a watchful eye on market conditions and staying disciplined in our underwriting and origination choices.

In the first quarter, Capital One continue to post solid results as we invest to grow and to drive our digital transformation. Compared to the first quarter of 2018, revenue, noninterest expense, pre-provision earnings and earnings per share all increased. Provision for credit losses was essentially flat.

First quarter marketing expense declined from the unusually elevated level in the fourth quarter, but was up compared to the prior year quarter. Our marketing investments are building our momentum and creating great value. In our Domestic Card business, marketing is strengthening our heavy spender franchise and driving strong year-over-year growth in new accounts, purchase volume and net interchange revenue.

In our Consumer Banking business, our national advertising, brand and compelling digital customer experience enabled us to post strong retail deposit growth without being the industry price leader.

Turning to 2019. Marketing will, as always, depend on our continuous assessment of opportunities in the competitive marketplace. With the momentum we have, we expect full year marketing for 2019 to be modestly higher than in full year 2018, with more normal seasonal patterns than the exaggerated patterns we saw last year.

In closing tonight, I'd like to pull up and provide some context on our digital transformation and the impact we expected to have on key aspects of our longer-term financial performance. When we try to envision the future of banking, we don't start with how banking works or what other banks are doing. We look at how technology is changing our lives.

Just look at the technology and applications you use everyday. What is common to all of them is they provide you with instant solutions customized for you. What powers that? Tech companies that are built on a modern technology stack, leveraging the power of Big Data and machine learning in real-time.

Banking is headed to the same destination. Consumers will demand it. Technology competition will necessitate it. The challenge is banks aren't built to deliver those capabilities. What we're doing at Capital One is building a technology company that does banking instead of a bank that just uses technology. Our transformation stands on the shoulders of everything we have built in our 25-year journey at Capital One. While we didn't use the term back then, we were an original fintech. It is striking that our battle cry at the founding of our company was to build a tech company that does banking.

The reason that we declared the same battle cry 6 years ago is that we realized that the world has changed so much that we needed to yet, again, build sweepingly new infrastructure and capabilities from the ground up. We are now 6 years into this latest technology transformation.

Our progress is accelerating. We've hired thousands of engineers and built a scale engineering organization. We have deeply embedded designers, data scientists and product managers into our business. We work in agile. We harness the power of highly flexible APIs and micro services to deliver and deploy software.

We have embraced the public cloud and are well on our way to migrating our applications and data to the cloud. We are now considered one of the most cloud forward companies in the world.

Our technology transformation is motivated by many things beyond cost. Faster to market, better products, better customer experience, better risk management, more effective operations, more growth. We are already seeing significant benefits across the company.

But an important beneficiary will be the economics of our business. Digital productivity gains are driving operating leverage. Since our journey began, operating efficiency ratio has improved by 400 basis points even as we have continued to invest in our transformation.

We are operating today with one foot in the legacy data center environment and one foot in the cloud as we work to complete our cloud journey. As we migrate an increasing percentage of our applications and data to the cloud, we will have all those costs and at the same time, until we fully exit our data centers, we also bear the significant legacy cost as well.

We expect to complete the exit of our data centers by the end of 2020, which should generate significant cost and efficiency improvement opportunities beginning in 2021. Until then, we'll continue to drive for operating efficiency improvement even with the elevated cost of straddling both environments.

We expect to achieve modest improvements in full year operating efficiency ratio net of adjustments in both 2019 and 2020.

Adjusting items in 2019 include onetime Walmart launch and integration expenses. We expect full year operating efficiency ratio net of adjustments to improve to 42% in 2021 powered by the exit of our data centers, continuing technology innovation and Walmart, and we expect this operating efficiency improvement to drive significant improvement in total efficiency ratio by 2021 as well.

The improvements in efficiency are but one of many benefits we will enjoy from our technology transformation. We are well positioned to succeed in a rapidly changing marketplace and create long-term shareholder value.

Now Scott and I would be happy to answer your questions.

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Jeff Norris, Capital One Financial Corporation - SVP of Global Finance [5]

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Thank you, Rich. We'll now start the Q&A session. (Operator Instructions) Leanne, let's start the Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Eric Wasserstrom with UBS.

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Eric Edmund Wasserstrom, UBS Investment Bank, Research Division - MD & Consumer Finance Analyst [2]

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Great. Rich, in -- just a follow-up on the marketing commentary. You last quarter you signaled that you're focusing on acquiring accounts, but keeping lines low in anticipation of maybe some potential change in the credit environment, but would give you the flexibility to increase lines at a future date. Is that still the strategy or is there any change to that approach?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [3]

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So Eric, we are being cautious on lines, but let me tell you about how that works. It means that we want to see more validation before extending more line. And in fact with every passing month, we are seeing increasing validation in the performance of recent vintages and this augurs well for more line extensions over time.

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Eric Edmund Wasserstrom, UBS Investment Bank, Research Division - MD & Consumer Finance Analyst [4]

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Great. And maybe just to follow up on that. We've seen some information of data that points to some weakening in credit in kind of mid-FICO, modestly better than median income cohorts. Are you seeing anything like that? Or just more broadly, are you seeing any particular subpopulations where there is evidence of deteriorating asset quality?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [5]

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Eric, a thing that we noticed and we've seen this in that we were kind of on the lookout for it, but we have now with the benefit of hindsight seen some degradation of performance of consumers for a given FICO score. This isn't a Capital One thing. In fact, it isn't even an industry origination thing. This is really a -- we can see this all the way just sort of looking at bureau data. And the reason that we sort of hypothesize this is, well, let me tell you, our hypothesis for this modest effect, but I think it's important to note is that given the -- how long derogatory data stays on the credit bureaus. The derogatory data from the great recession has over the last few years been rolling off. And so our hypothesis has been, and one of the reasons for our own conservatism has been, we may be looking at data that might not paint the full picture of a consumers sort of credit history.

So we've been on the lookout for that. We have seen the effect sort of by FICO score. Different people could have a different hypothesis for the effect. Now in terms of what we do, we build comprehensive credit models that are far beyond sort of just a snapshot of bureau score. And so I think we feel very good about our credit, the recent vintages, the performance effect, my comment earlier about validation with respect to performance making us more comfortable with some line increases is indicative of that same point. But the part of the context for our caution has been not only sort of how deep we are in the cycle, but also the -- this is the time period when there is sort of less information than there once was on the bureau and we all need to be careful consumers of that information as we make our credit decisions.

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Operator [6]

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And we'll take our next question from Sanjay Sakhrani with KBW.

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Sanjay Harkishin Sakhrani, Keefe, Bruyette, & Woods, Inc., Research Division - MD [7]

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Appreciate the color on the cloud migration and the cost reductions from closing the data centers. I guess 2 questions on that. One, Rich, can you just talk about what competitive advantage it gives you from moving to the cloud and sort of the functionality there? And then secondly, on the 42% in 2021, is it fair to assume that there could be an expansion that's more greater than normal in the future because you get more leverage off of that? Maybe, Scott, you could address that.

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [8]

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So we've talked for years about the benefits of going to the cloud and I think there are many benefits. And ironically, the costs are not really at the top of the list. Our -- what we hypothesized and we are finding is that things are faster, the scalability is much greater, the time it takes to provision a hardware and software environment is much faster.

The ability to scale up and down basically on demand. The ability to tap into the world's innovation that is going on in that segment and also benefits in security and reliability. And along the way, there are economic benefits as well. So it's a pretty compelling case. The big issue and the issue that all American corporations face is not, gee, on paper is are there a lot of benefits from going to the cloud. The big question is how on earth are we going to get there from here? And that requires confronting really for most companies decades and decades of heritage in terms of who they are, the talent, the infrastructure, the way the company works, culture. And it is -- the big issue is the journey. And therefore the big news for Capital One is that we are announcing that we have line of sight to the completion of that journey. Now that's not the completion of our entire tech transformation in the sense, we will probably always be in a tech transformation because the world is in one. But it's a very important milestone for Capital One to arrive at this destination.

But it's really a story of journey and that is -- that's what American companies are really going to have to confront each of them in their own way as they decide what they want to be when they grow up from a technology point of view.

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Richard Scott Blackley, Capital One Financial Corporation - CFO [9]

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With respect to the 42% could you just explain your question, again, when you said will that expand?

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Sanjay Harkishin Sakhrani, Keefe, Bruyette, & Woods, Inc., Research Division - MD [10]

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Yes, I guess, is there more leverageability of that 42% because you're moving to the cloud. And you're not as physical data center intensive?

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Richard Scott Blackley, Capital One Financial Corporation - CFO [11]

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Well, I think the full year run rate benefits of getting out of the straddle and being fully on the cloud are reflected in the 42 number. I think from there -- we have always said basically the more we transform comprehensively into a digital company, the more benefits that can accrue over time in terms of the economics of the business.

With respect to the -- I think the number reflects the full benefit of getting out of the data centers and being in 1 environment and not 2. I think the longer journey of Capital One is going to continue to be one where we drive -- continue to drive our customers to digital and drive our company to digital. And the many benefits that I've cited, one of which is economics, should continue to manifest themselves.

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Operator [12]

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And we'll take our next question from Don Fandetti with Wells Fargo.

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Donald James Fandetti, Wells Fargo Securities, LLC, Research Division - Senior Analyst [13]

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Scott, you had mentioned that the targeted capital return will be meaningfully higher in 2019. Can you elaborate a little bit on that in terms of your priorities, buybacks, dividends? And if you can maybe sort of better quantify where that payout ratio target might go?

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Richard Scott Blackley, Capital One Financial Corporation - CFO [14]

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Yes, Don. Thanks for the question. We're closing out Q1 at around 11.9% CET1. So we're in a position where we're above our 11% capital need. And I would expect that we're going to accrete more capital in Q2 because as you may recall, we've already completed our 2018 CCAR share repurchase program. So I would -- we're not going to be in a position of distributing more capital before we get Fed approval on our 2019 plan. I'm not going to comment on CCAR at this point. I just don't want to get ahead of the Fed release, so I'm not going to give you any more details about that. I'll just say in general and I'm going to reiterate some of the points that I made in my talking points, but we are in a really good position, I believe, to fund organic growth, to fund the Walmart acquisition. We've got the first phase of CECL coming in 2020, which we're going to need to support through capital.

And then taking all those things and looking at the earnings power that we have and our capital position today, I feel pretty good that we're going to be able to have a distribution -- a capital distribution that is quite higher than what we had last year in our CCAR plan.

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Donald James Fandetti, Wells Fargo Securities, LLC, Research Division - Senior Analyst [15]

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Okay. And lastly, it looks like the delinquency rate on a year-over-year basis on Domestic Cards is sort of creeping up a little bit each month. Can you talk a little bit about your expectations going forward?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [16]

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Yes. So Don, our -- let me start with our credit losses. Our losses are still improving on a year-over-year basis. While as you point out, our delinquencies were about 4% higher than the year ago quarter. There is some idiosyncratic drivers of that increase. For example, we changed loss recognition timing for the Cabela's portfolio to align with Capital One practices back in October of 2018.

This had only a slight effect to our overall credit metrics, but it impacts the year-over-year delinquency comparison by a few percentage points, interestingly. First quarter may also have some effects from government shutdown, including delays to some tax refund payments, which contribute to the seasonal movements in our credit metrics this time of year.

So I wouldn't read too much into delinquencies in this slightly noisy quarter. Pulling up, our unique Growth Math dynamics have been the dominant driver of our credit performance for some time. First driving our card losses up and then down. And Growth Math continues to be a good guy. Of course, our credit is also impacted by the economy, the competitive cycle, our growth choices and other industry effects.

So we would expect a little normalization in terms of overall card industry performance over time. So going forward, we'll have a couple of offsetting drivers of card credit, Growth Math that will continue to be a good guy and industry normalization that will likely pull in the other direction.

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Operator [17]

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And we'll take our next question from Ryan Nash with Goldman Sachs.

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Ryan Matthew Nash, Goldman Sachs Group Inc., Research Division - MD [18]

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Rich, on the 42% efficiency target. I mean clearly that has 2 sides to the equation in terms of expenses and revenues. So can you maybe size for us how big the cost component of that is, just given the fact that the revenue environment could end up being different, better or worse, relative to what you're expecting, and -- as of today? And then, I guess, secondly, given that marketing historically has run somewhere between 600 and 800 basis points of efficiency, is it safe to say that we'll be looking at an efficiency ratio below 50% over time?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [19]

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So Ryan, we don't -- what we try to do in doing this 42, I mean, we can always create point estimates. The one thing we know about point estimates in our business, and by the way, our investors have all experienced this. Point estimates, the only thing you know is they're not going to be exactly that with respect to a particular metric like revenue. So what we did is go through a matrix of outcomes of different revenues, thinking through what -- how the cost associated with different revenue outcomes.

And sort of the way we think of it is, if you take away the -- what I'm calling good guys that are coming in 2021, our story really is and this was kind of in our guidance, our general guidance we've been giving over the last couple of years, that the combination of revenue growth and continuing to drive on the cost digital productivity gain general side, that will drive gradual improvement in operating efficiency.

So the -- our -- but the other primary point we're making here is, on top of what we think is a gradual improvement that will come from all the things that we do on the revenue and cost side, we're pointing out a few specific good guys that happen to align themselves around the full year 2021. And those good guys are the -- of course, the exit of our data centers by the end of 2020, which should drive significant savings beginning in 2021.

Some technology innovation that will enable some specific -- some efficiency gains and then the benefits from the Walmart partnership. Now that also lines up around 2021 because of the revenue sharing structure that we -- in our deal with Walmart. And as you recall, the revenue sharing is less over the first year of the deal, and then it steps up to the full revenue share thereafter. So there is kind of a coincidence of where several things sort of align themselves around 2021. So if I pull way up to your question, while we don't know the -- we'll see how the -- where the revenue and all the metrics that drive operating efficiency where they go over time, I just think a lot of planets align and a lot of things that are (inaudible) I must use the word baking in the oven, things that are kind of really in the work, where we are able to do something. It's a little out of character for Capital One to give such a specific number several years out in the future. But that would be the context behind that, Ryan. I'm sorry, he asked the question on the marketing side.

So I'm not -- we're not giving a specific number with respect to total efficiency ratio. And that is because marketing, of course, is very driven by the context that we find ourselves in over time and the opportunity to really generate great business when we get there. And that's not a thing that we're going to guide ourselves to several years out in the future.

But the -- but I think our other point was that the significant -- that the operating efficiency improvement to 42 will -- we expect that this improvement will drive significant improvement in total efficiency ratio by 2021 as well.

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Operator [20]

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And we'll take our next question from Chris Brendler with Buckingham.

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Christopher Charles Brendler, The Buckingham Research Group Incorporated - Analyst [21]

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So I just had a question on the card business. Really nice acceleration in noninterest income this quarter, up to 13%. Is there anything to call out there? And then related, while it looks like sub-prime mix in the card business ticked up a tiny bit, don't want to make a big deal out of it. Just want to know if it's leads more macro or is it a decision on the enrolling side?

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Richard Scott Blackley, Capital One Financial Corporation - CFO [22]

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Yes, Chris. It's Scott. A couple of things there. So one, on interchange, Rich mentioned that we had an adjustment to our rewards liability, that was about $51 million. And so just some context there. Every quarter we update our estimates of the cost of honoring our card awards. And that estimate always considers changes in consumer redemption patterns and then any updates that happen in terms of terms and conditions.

So we usually see some level of adjustment here every quarter, sometimes it's an increase; sometimes it's a decrease. This quarter it was $51 million release.

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Christopher Charles Brendler, The Buckingham Research Group Incorporated - Analyst [23]

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Got you. And then on the service fee side there, is it -- it's coming down quite a bit still. Is that a conscious decision?

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Richard Scott Blackley, Capital One Financial Corporation - CFO [24]

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On the service fees, a few things there. On a year-over-year basis, a couple of things. One, there were a few small ticket, one-timer benefits in Q1 '18. And then on an ongoing basis, we have exited a number of the subscale businesses that impact that line item as well. So I think that -- most of that is in the Q1 2018 number, but not in the 2019 number. So I would say that the $353 million of service charge and fee income for Q1 is a pretty clean quarter.

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [25]

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Chris, with respect to sub-prime mix. Our sub-prime asset mix of 34% is flat year-over-year and sort of in line with our historical portfolio mix of around 1/3 plus or minus. It is up slightly quarter-over-quarter in line with seasonal trends. And in all these numbers there is always rounding because these are integers.

So I think the takeaway that you really should have is, there is a lot of news with respect to the sub-prime mix.

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Operator [26]

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And we'll take our next question from Rick Shane with JPMorgan.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [27]

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Rich, I think implicitly when you're talking about account growth, you're bifurcating between heavy spenders and traditional revolvers. Our assumption is that for the heavy spenders that you have to be pretty competitive in terms of line limit. Is that the right way to be thinking about it? And if that's the case, when you look at the traditional revolvers, do you think that most of the accounts that you're -- you have added, do have the potential to grow the line limits over time?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [28]

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Yes. So I'm glad you asked that question because there on many dimensions the heavy spenders side of the business is so different from the revolver side of the business, but certainly one of them is credit line. So let me start with heavy spenders.

We -- our lines are very competitive, very comparable to the leading players at the top of the market on the spenders side. So there is not a low line strategy with respect to heavy spenders.

On the revolver side, we have always been very conservative probably relative to industry practices with respect to credit line. And looking for more validation over time, I think we've raised the bar with respect to validation recently and that's why we've been talking more caution on credit lines.

Now let me talk now about the surge of growth that we've had along -- that complements to the surge of marketing that we have had. This is growth that is across the credit spectrum. It's actually more upmarket shifted than usual. And that's kind of -- to my points earlier, we're especially getting traction at the top of the market.

And the way that all of those accounts will play out is very consistent with how spender business is booked. It's expensive to book. It's a great annuity. It grows over time, et cetera. The still because of the whole portfolio of what we're booking, there's lots of revolver business in there. And it's very -- and it’s all -- pretty much all business that we are looking to build lines with and as we are getting the validations that's what we are doing.

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Operator [29]

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And we'll take our next question from Betsy Graseck with Morgan Stanley.

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Betsy Lynn Graseck, Morgan Stanley, Research Division - MD [30]

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Two questions, just starting off, one, on the cloud. I've heard that the cloud can help deliver much more efficient marketing programs and drive much better efficiency in the marketing itself. So I'm just wondering if you're experiencing that as well. And if that's something that we could either expect to drive better revenues per marketing dollar invested with use of this tool or potentially even -- we talked a little bit earlier about driving down the budget, but that's a TBD kind of question. So I'm just wondering if you're seeing that same kind of marketing efficiency improvement that others are.

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [31]

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So when you say marketing efficiency improvements that others are, I think there are a lot of folks not leveraging the cloud at the moment. And maybe they're enjoying marketing efficiency improvements, too. I think there is a lot of things going on in the world of marketing and there is quite an impact that's coming from the major tech companies who are driving a lot of the digital marketing channels and the choices they make to -- in the walled garden of their information, how much they either provide turnkey services for other banks -- for other companies or provide data to facilitate company's own choices.

So I think the whole world is getting more capable and more efficient with respect to digital marketing. There is one of the -- what I mentioned earlier that it's kind of easy to write down on a piece of paper what you'd love to do with technology. And the whole problem is how do you get there from here. And marketing is a classic example.

The -- we know the world is exploding in terms of data. Big Data and the ability to leverage more and more information to not only make better decisions, but to make a more customized on a micro, really down to the segment of one. The elephant in the room is, how do you mobilize massive Big Data in real-time?

And I think for most American companies, if given enough time, they can do a lot with data. The challenge of when Big Data meets real-time, that's where modern technology really separates itself from classical technology. So marketing is on the list of one of the many things that we are driving improvements and look forward to driving more improvements with over time. But I don't want to set an expectation that you'll -- as we fully go in the cloud, you'll suddenly see a huge improvement in our marketing efficiency because frankly, with most of the marketing that we do, we're basically in the cloud with respect to the marketing that we're doing.

So that's a journey that has been ongoing and we look forward to more progress.

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Betsy Lynn Graseck, Morgan Stanley, Research Division - MD [32]

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Okay. And then just separately on Walmart. I know you've talked about the kind of products that you'll be launching when that comes over on the consumer side. I'm wondering, is there anything that you're working with or planning on doing with them on the business side in B2B or the supplier side of their business model? Or is it going to be fully on consumer? Just help us understand if there's -- how broad that relationship could be?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [33]

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Betsy, at this point our relationship with Walmart is consumer credit card.

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Operator [34]

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And we'll take our next question from Kevin Barker with Piper Jaffray.

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Kevin James Barker, Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst [35]

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In regards to some of the marketing spend that happened, ramped up quite a bit in the fourth quarter would've expected a little bit better growth metrics here in the first quarter versus what we've seen last year. Can you just talk about what your expectation is for growth? And I believe some of your comments about some of the upmarket customers that you're starting to get traction with as we move through the next couple of quarters?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [36]

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So Kevin, the one thing that I've said for probably those who have been following Capital One for many, many, many years, I have said all along, changes in marketing levels, don't expect them to, in coincident periods or in immediately adjacent periods, show dramatic effects on -- especially on metrics like loans.

So let me just talk a little bit about what's happening with respect to Capital One. So a reason that we have -- we don't spend money in marketing just to spend it. One of the comments that I made in the earlier remarks is you can't buy your way to lots of growth just by spending money, and especially at the top of the marketplace with spenders.

This is about earning it and for years we have been putting in place -- we've been very committed to building a spender business and investing in the customer experience, the digital experience, the products and the brand to be in a position where along all of those dimensions we're seeing tremendous progress.

And what sort of has happened in recent quarters is the alignment of a lot of progress on this -- with our spender business and traction with customers and our brand with noncustomers, combined with an actual opportunity that we see in the marketplace. So on the spenders side of the business, you see a lot of our marketing is directed at the spenders side of the business and we've had really tremendous traction there, as I mentioned. And how that shows up is in significant growth of new accounts. And those accounts are annuities that have great economics over time and the spenders ramp their purchases really literally for years.

It doesn't move the loan growth needle a lot just by the basic numbers of how many heavy spenders there are. And the fact that -- basically, it's a numbers thing. So the loan growth is dominated by what happens on the revolver side of the business. And let me comment about that.

Other than the capability, which always exists for any bank to do line increases. And I've often call that a coiled spring and it's a great opportunity for companies to take advantage of it when they want. It's -- the ultimate way to really drive growth is through new account origination. That's the prerequisite for loan and revenue growth on the revolver side.

As these customers mature, we gradually increase credit lines, which translates into loan and revenue growth. And we -- my point has been that we've had really strong account growth. We are getting with every passing month more validation on the credit performance of the vintages. And all of this puts us in a position to capitalize on the -- to turn the account growth into loan growth and revenue growth over time.

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Operator [37]

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And we'll take our next question from Moshe Orenbuch with Crédit Suisse.

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Moshe Ari Orenbuch, Crédit Suisse AG, Research Division - MD and Equity Research Analyst [38]

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Most of my questions have been asked and answered. But Rich, I was struck commentary about deposit cost growth and growth of the online deposits. And maybe you could talk a little bit about the strategy there because getting more online deposits at higher costs and hurting margin isn't really in and of itself a strategy. What's the plan there and how does that benefit the company shareholders?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [39]

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So the first order for any company is -- for any bank is the need to fund the company. And of course, that's -- like there's a lot of different ways to fund the company. Capital One is in a -- I love the position Capital One is in where our strongest and biggest funding sources on the consumer side because that's where, I think, through recessions. And if you look at how the Fed rates various types of deposits. If you look at the opportunity to have resilient funding and pricing over time, the top of my list is consumer deposits.

So building a -- we already are a national bank in our asset businesses. And we were a local bank in our funding businesses. And then we acquired a national direct bank. So building out a national bank is fundamentally central to the success of Capital One.

Now the way most banks over time, I think, envision how they're going to grow their deposit business is they do it through acquisitions. That's not acquisitions of other banks. While we have done bank acquisitions in the past and they've been important part of the strategic and funding migration of our company from a monoline specialty finance company, our future is going to be driven by organic growth of this national bank and that's different from what most players have done.

Now one way to grow deposits is to get on the league tables and have the highest price. And that certainly -- there is nothing wrong with doing that. What we're trying to do, Moshe, in a world where they're -- all of banking is centered around 1 of 2 poles, either people have a branch on every corner with quite low rate deposits or they have a direct bank and are paying -- at the high end for deposits. And our goal is not only to build a national bank but to work backwards from where retail banking is going to go, which I believe is toward thin physical distribution and great digital capabilities and attractive products for consumers. So we're basically trying to figure out where the market is going to go and just go build that. How will that manifest itself for Capital One and for our financials? Again, very importantly the funding of the company, but over time, increasingly building our company as a franchise, much of it through cross-sell to our own very large customer base and to not chase the hard-earned money that's available out there, but in fact really build long-term relationships. And end up as really a -- the one bank that is really a hybrid of the direct bank on the one side and the branch in every corner bank on the other side. And we've seen a lot of traction early on with this, but what we're flagging to investors is -- there are a number of reasons that we expect our deposit cost to go up. The competition, most banks are saying that anyway. But in our particular case, the mix effects of this journey and the sort of natural things that happened on the way to building this hybrid bank will be accompanied by higher average deposit costs.

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Moshe Ari Orenbuch, Crédit Suisse AG, Research Division - MD and Equity Research Analyst [40]

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And what are the products that you think you'd be able to sell the bank -- the online bank customers?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [41]

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So basically, Moshe, we -- between what is available -- so first of all, let's talk about capabilities for a second. One of the great challenges for a bank is, while most of the world has concluded in -- I find people that are not close to banking, of course, assume well, of course, banks are going to be digital, they'll probably be entirely digital.

I've come to really respect the importance of and power of some physical presence. But the challenge that any bank that doesn't have a branch on every corner needs to confront if you're going to build a deposit franchise is how to -- is having a full suite of banking capabilities that you can actually pull off online or on your phone as opposed to having some of them.

And so we have taken the whole set of activities that can be done in banking. And the vast majority of -- virtually all of them and sloped by importance, we have put these online and many of them, but not all of them on mobile, because we don't want to clutter mobile like a NASCAR uniform with every possible banking feature.

But on little cat feet over time, we have really build out a full banking capability that you don't need to have the local physical distribution. Now we're going to have some physical distribution, and we're locating that physical distribution in iconic locations, so it has particular reach and salience. But with this strategy, we hope to capture some of the best of both worlds from the world of direct banking and of local banking.

But what it has taken in the years that we've taken prior to rolling out our national bank has been, of course, taking the various tech platforms from the banks that we bought, putting them all together and putting that capability on the cloud, integrated and on the cloud, building a -- building out broad-based banking capabilities digitally. Building a great and now, J.D. Power award-winning for 2 years in a row banking capability, online banking capability. And importantly, also Moshe, a credible consistency in our retail bank experience locally.

The other thing that we have done is been on the leading end of branch rationalization, which is very important to the overall economics of this thin physical presence model.

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Operator [42]

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And our final question tonight comes from Christ Donat with Sandler O'Neill.

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Christopher Roy Donat, Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research [43]

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Just wanted to follow up on the data center migration and thinking about the journey you've been on starting 6 years ago, and then taking another couple of years to get to the end. I'm just curious, if you -- whatever, if you had to do it over again, do you think you could've shortened that path? Because it seems to me this might be a competitive advantage that anyone else out there is going to have to take, it's a decade process roughly. Just wondering what your thoughts are. If you could have done it in less time or if that's just how long it takes to redo the -- like, what you talked early about the systems and personnel and infrastructure?

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Richard D. Fairbank, Capital One Financial Corporation - Founder, Chairman, CEO & President [44]

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Chris, so we're -- one thing I said is that, well, I denominate our journey into 2 -- denominated in 2 ways. One is the recent journey, which is the 6 years. We completed 6 years. We're in our seventh for this technology transformation. Importantly, it stands on the shoulders of Capital One itself and the heritage of what we've built with the talent model. The whole information-based strategy, the data, the analytics, the technology that went into the whole founding of the company and sort of who we are.

So what is striking, and I appreciate your question, is that on those shoulders, this journey we're already 6 years in and we're looking ahead to getting out of our data centers 2 years. Essentially, 8 years after beginning the tech transformation at Capital One, which is a bit of an advantage starting place. I think there are lots of things we've learned along the way, but I think, if we did it over, the journey is really would be the same because it's a journey that -- it's a talent journey. It's a -- transforming how software is built.

It's a journey that requires confronting the way that we work and this would be true for any American company that takes this on. Confronting how the company works, how people works both on the tech side and across the company. We have -- to take on the entangled infrastructure that exists at large banks, including our own, is a very, very daunting task.

And to set out to rebuild that, not from the top of the tech stack, but really from the bottom, that is a tough undertaking. And it is -- I don't think the path could be much shorter than what we've done. But that's why I say, the real news isn't the destination, the news is the journey. And we have been all in on this journey. And we're in year 7 now. And by the way, our -- the last thing I would say is while I -- we wouldn't change too much, the one thing that we absolutely would choose to do is do this, because we are absolutely compelled by the opportunity here. And we can feel the accelerating progress on just about every dimension if you were inside this company, you could feel acceleration on what's happening with the customer experience, what's happening in risk management, what's happening with the dynamism of the company, the speed to market, the products, the -- how customers are feeling about Capital One. The pace of digital adoption by our customers, the momentum around transforming how sort of the operations work, the success in partnerships. I think our tech transformation was central to winning the Walmart deal.

And our momentum in the sense of possibility in building a national bank. And finally, the economic -- the acceleration of sort of economic opportunity that we've talked about on this call.

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Jeff Norris, Capital One Financial Corporation - SVP of Global Finance [45]

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Thanks, everyone, for joining us on this conference call today and thank you for your interest in Capital One. Remember, Investor Relations team will be here this evening to answer any further questions you may have. Have a great night.

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Operator [46]

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And that does conclude today's conference. Thank you for your participation. You may now disconnect.