Capital One Financial Corp (COF) 2003 Q2 法說會逐字稿

Good afternoon. My name is Matthew and I will be your conference facilitator. At this time, I would like to welcome everyone to the Capital One Financial Corporation second quarter earnings conference call. All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer period. If you would like to ask a question during this time, simply press star and then the number one on your telephone keypad. We ask that you limit your questions to one each time you enter the question queue. If you would like to withdraw your question, press star and the number two. Thank you.

I would now like to turn the call over to Mr. Paul Paquin, Vice President of Investor Relations. Sir, you may begin.

Thank you very much, Matthew. Welcome, everyone to Capital One's second quarter 2003 earnings conference call.

As usual, we are webcasting live over the Internet. For those of you who would like access to the call on the Internet, please log to on to Capital One's home page at www.capitalone.com and follow the links from there.

The company generates earnings from its managed portfolio which includes both on balance sheet loans and off balance sheet loans. For this reason, the company believes that the managed financial measures and related managed metrics to be useful for shareholders. In compliance with Regulation G of the Securities and Exchange Commission, the company is providing a numerical reconciliation of managed financial measures to comparable measures calculated on a reported basis, using generally accepted accounting principles. For more information, please see the schedule entitled, "reconciliation of debt financial measures" attached to the press release filed with the S.E.C. earlier today.

The statements made in the course of this conference call that mentions the company's or management's hopes and intentions, beliefs expectations or projections of the future are forward-looking statements. It is important to note that the company's actual results could differ materially from the results projected in our forward-looking statements.

Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in the company's S.E.C. filings, including but not limited to the company's report on form 10-Q for the quarter ended March 31, 2003. Our web site contains all of the S.E.C. filings as well as our monthly asset backed securitization performance data. To access this information, please go to www.capitalone.com, click on investors and then click on financials.

In order to take advantage of the limited time available to ask questions of senior management, during this call, we would appreciate if you would ask only the most strategic questions. This will allow you to take advantage of senior management's availability.

The data questions and questions relating to contributions of various variables made to the reported data can be obtained at any time by calling the investor relations department. In fact, the investors relations staff will be available after this conference call this evening to answer any and all of your questions.

With me today on the conference call is Mr. Richard Fairbank, our Chairman and Chief Executive Officer, and Mr. David Lawson, our Senior Vice President and Chief Financial Officer.

At this time, I will pass the call over to Mr. Fairbank.

Thank you, Paul and thanks to all of you for joining us on our call this afternoon.

In the second quarter, we continued to deliver great results. Earnings for the quarter were $286.8m, or $1.23 per share, up 34% from the second quarter of 2002. We are very pleased with our strong financial performance.

For the full year, we continue to expect to report earnings per share of at least $4.55. I'll speak more about our guidance for the year in a few moments.

There are four major themes I would like to touch on in my remarks this afternoon. First, our success in driving earnings growth in our auto lending and international segments. Second, the gradual shift up market in all of our business lines. Third, our strong and improving credit performance and outlook and fourth the timing of our projected asset growth of 15% to 20% this year and its impact on our earnings guidance.

The increase in our second quarter earnings over the comparable period last year was driven principally by the success of our diversification strategy. Earnings from our auto and international segments increased by $63m over the same period a year ago.

Products and geographic diversification has been part of the Capital One story for many years. We believe this diversification reduces our concentration risk from a credit and earnings perspective and allows us to take advantage of growth opportunities in markets that are less saturated and growing more quickly.

What is different about our diversification story today is that it is now an unfolding story of earnings diversification rather than simply asset diversification. For years we have been patiently investing in the growth of our non-U.S. card business. In fact, even after subtracting the $1.3b in auto loans sold in the second quarter as part of our ongoing practice of selling automobile loans, our auto segment ended the quarter with $7.4b in loans or 12% of our managed portfolio.

International loans now comprise $6.1b, or 10% of our portfolio. Over the past year, both of these segments grew faster than our domestic card business.

As our second quarter results made clear, our investments in building these businesses are beginning to pay off. The earnings from these two business segments along with our success in small business and installment loans, which are included in the U.S. lending segment, are now making significant contributions to our bottom line. More importantly, we expect this trend to continue.

We also continue the gradual shift up market in all of our business lines, including U.S. cards. As you know, for some have been targeting our new originations with a greater emphasis on prime and super prime growth than on sub prime. This does not mean that we are abandoning the sub prime market.

In fact, we continue to emphasize our sub prime business and it is performing very well. With the experience we have gained over the years and the credit policies that we have developed through years of testing with our information-based strategy, we believe that our sub prime business will continue to yield very attractive risk-adjusted returns.

Our emphasis on prime and super prime originations has had and will continue to have an effect on some of our performance metrics, including the number of accounts, which we expect to be generally flat, credit performance, which I will discuss in a moment; and most notably, margin.

In the second quarter our managed revenue margin was 14.85%, an 85 basis point decline from the first quarter. 52 basis points of this decline was due to a $2.4b increase in our liquidity portfolio resulting from a very successful quarter in the funding market. Dave will provide more color on this later.

The remaining reduction in revenue margin was driven by our continuing shift up market as well as favorable delinquency trends which results in less late and over limit fee income offset in part by a seasonal uptick in interchange. As we shift our portfolio to higher quality assets, we would expect revenue margins to gradually decrease.

Credit quality continues to improve. The managed charge off rate declined 15 basis points to 6.32%, and 30-day delinquencies declined slightly to 4.95% at the end of the quarter. On a nine-month lag basis, the charge off number was 6.84%, and the delinquency rate, on a 6-month lag basis, was 5.03%. On a lag basis, both chargeoffs and delinquencies also are down from the previous quarter, another strong indication of real improvement in our credit performance.

Looking forward, we expect continued improvement in the credit outlook for the second half of the year with the third quarter to be slightly lower than the fourth due to seasonal effects. As you know, in the second quarter we began to release monthly data on managed chargeoffs and delinquencies Due to the importance investors place on these key metrics we intend to continue to release this information monthly in the future.

Our managed loans grew by $1.5b in the second quarter, after taking into account the sale of $1.3b in auto loans as part of an ongoing program of auto loan sales.

Competition in the U.S. credit card industry continues to be intense, particularly in the prime and super prime markets. As you know, many of our competitors have been offering 0% introductory rates for extended periods of time, up to 18 months.

It is in just such a challenging environment that our information-based strategy is a truly competitive advantage. We target only the most profitable customers in the prime and super prime markets we carefully design customized products and targeting strategies for each micro segment.

For example, we crafted, tested and recently rolled out our new 4.99% fixed rate product in the super prime market with our targeting capabilities we are confident that we will be able to grow profitably in the U.S. super prime card segment for foreseeable future.

We continue to target managed loan growth of 15% to 20% for the full year. This growth will come from new innovations such as our 4.99% product and also from the historically higher seasonal loan growth in the second half of the year and also our expectations that we will retain on the balance sheet a higher proportion of our auto loans in the second half of the year.

Of course, with this higher growth, we expect to spend more in marketing and to build our allowance for loan losses in the second half of the year, especially in the fourth quarter. As a result, we are sticking with our current earnings guidance of at least $4.55 per share for the full year.

At this time, I will pass it over to Dave Lawson for his remarks. Dave?

Thank you, Rich. Thanks again to all of you who are participating today.

I'll begin with a few words about operating costs. Operating expense declined $51m during the second quarter primarily driven by lower salaries and benefits. As a result, cost per account declined by $3 to $76. During the second half of this year, we expect cost per account to fluctuate around $80 which includes the cost of closing the Fredericksburg, Virginia site.

During the second quarter, we continued to strengthen our balance sheet for a remarkable string of funding successes draw increasing strength. With market interest rates at 45-year lows, our debt spreads seeing significant tightening, we took the opportunity to prefund growth and further augment our strong liquidity base.

We have raised approximately $5b since early April through diverse series of asset-backed and unsecured transactions. All of these transactions were upsized significantly and we saw improved pricing relative to launch indications reflecting extremely strong investor demand for our debt.

We began the quarter with a $1.2b AAA rated U.S. card securitization which was upsized by $700m and generated the lowest effective fixed rate cost after swap we've ever achieved on a card deal. Later in the quarter, we executed over $800m of single A and BBB rated subordinated U.S. card securitization including almost $500m of BBB rated issues. Our stockpile of subordinated securities from Capital One master trust is sufficient to support our growth and refinancing needs through the end of this year and we have met our expected BBB needs well into 2004.

We also securitized $1.1b of auto loans in a transaction that was upsized almost $400m and priced at an attractive spread relative to competitor benchmarks and last week, we priced a $500m euro securitization over our UK card portfolio with 57 investors from 13 countries participating. We further diversified our funding and capital through two unsecured debt transactions out of Capital One Bank.

In May, we issued $600m, five-year senior note deal that generated $1.8b in investor orders, shortly after launch and priced near the tightest spread in two years. A month later, we issued a $500m ten year subordinated debt transaction that was upsized by $250m. The subordinated deal qualifies for tier two regulatory capital treatment.

While our regulatory capital ratios already exceed well-capitalized standards prior to this transaction, we took advantage of the opportunities to book inexpensive regulatory capital and lock in ten-year liquidities. The investor reception for these unsecured transactions in what is traditionally our most credit sensitive market provides especially compelling evidence of our strong funding access.

Finally, we increased funding diversification not only with unsecured issues but also through the growing deposit base. Outstanding deposits increased by $1.3b during the quarter and are expected to pass a $20b mark in July. Deposits now represent 27% of our total funding and continue to be a source of low cost stable financing with original maturities now greater than three years.

Reflecting on our funding successes, total liquidity jumped to nearly $15b, including $8.5b of cash, and liquid investments and more than $6b of available credit facilities and conduits. Our liquidity is now approximately three times our turn debt refinancing needs over the next 12 months.

We also enhanced our strong capital position during the quarter. The ratio of capital to managed assets at 8.3% was unchanged from last quarter's record and this ratio excludes the benefits of our recent subordinated debt issue. Our regulatory risk-based capital ratios, after application of sub prime guidance once filed with our regulators are expected to show an increase to approximately 13.5% at our thrift and 15% at Capital One Bank, far above the 10% regulatory well-capitalized requirement. The subordinated debt transaction drove this significant increase in regulatory capitals at the bank.

Our allowance per loan losses declined by $47m during the quarter, entirely reflecting lower reported loan balances resulting from our increased securitization activity and improved credit performance. As a share of reported loans, the allowance was unchanged during the quarter at 5.92%.

In many ways, the second quarter epitomized an approach to financial management that mirrors the conservative philosophy pervasive across all of our business activities. In our lending activities, we build buffers against economic uncertainty through industry low credit lines to higher loss customers and underwriting that requires new loans on all of our businesses to be profitable even under a severe recession.

Similarly, we build buffers into our balance sheet to ensure we can meet both our financial obligations and growth obligations in extreme scenarios. The second quarter reflected this philosophy. We locked in over $6b of low-cost funding including deposits, built our stockpile of subordinated asset-backed securitizations, increased funding diversifications and significantly enhanced our record levels of liquidity and capital.

To maximize our liquidity position, our investment portfolio is comprised of extremely liquid, triple A securities and some cash equivalent. Building the liquidity portfolio lowered pretax earnings by $6m during the quarter. We believe this is cheap insurance for such valuable balance sheet protection. Our balance sheet has never been more solid and we intend to maintain our strong financial position in the future.

Now, back to Rich.

Thank you, Dave.

Before we close, I'd like to mention just two of the new executive appointments we made during the past quarter. The appointment of these two individuals each of whom will be working closely with the investment community, clearly demonstrates the strength of this company and the invigorating opportunities that lie before us.

We recently named Steve Lenehan as Senior Vice President and Treasurer of the company, a position that he has filled in fact, if not in name for sometime now. Steve has been instrumental in working with you to successfully meet the company's funding needs as we have grown and the appointment is very well deserved.

At the beginning of May, we announced that Gary Perlin has agreed to join the company as Executive Vice President and Chief Financial Officer. Gary will be officially joining us at the end of the month.

For the past ten years Gary has been with the World Bank most recently serving as its CFO with the responsibility for the overall financial management of the bank and its balance sheet of over $200b. Before that, Gary was the Senior Vice President of Finance and Treasury for Fannie Mae, another exceptional financial organization. Gary is with us today and will say a word to you in a moment.

Before I turn the microphone over to him, I just want to say how pleased and excited we are that a person of Gary's caliber and experience has chosen to join Capital One.

Gary?

Thanks, Rich and good afternoon, everyone. Let me briefly echo Rich's comments and say that I'm pleased and excited to be joining the management team of Capital One. This is an exciting company with lots of promise and I hope to add demonstrable value over time.

That's about all I am going to say today. I'm not fully on board yet and need a bit more time to come up the learning curve. Let me just say, thanks for your welcome and I look forward to seeing you very soon, starting with the south side analysts in New York this Friday and the debt and equity investors at our conference in October. Thanks, Rich.

Thank you, Gary. As I reflect on my 15 years in running this business, I feel that Capital One is in as powerful position to succeed as at any time in its history.

In our U.S. card business, we anticipate robust and profitable growth across all market segments even in super prime where the competition has been fierce in the first half of the year. We have taken steps to further strengthen our balance sheet and liquidity position with capital and liquidity at all-time high levels. Chargeoffs are stable and declining as we shift our portfolio up market. Allowance and reserve levels remain appropriately conservative.

Our diversification businesses, auto, international, installment loans and small business lending are getting traction where it really matters. They are contributing significantly to the earnings growth of the company.

Our operating costs remain among the lowest in the industry and we have a strong, experienced and highly energetic management team score card and highly energized management team, we are well positioned to continue to deliver strong earnings performance in the future.

With that, I will turn it over to Paul for the Q&A. Paul?

Thank you, Rich. If I could start the Q&A now, Matthew?

Certainly, at this time I would like to remind everyone, if you would like to ask a question, please press star and then the number one on your telephone keypad. We ask you to limit your questions to one each time you enter the question queue and we'll pause for just a moment to compile the Q&A roster.

Your first question is from Ken Posner with Morgan Stanley.

Hi, Rich. I'm wondering if you could talk a little bit about the new 4.99% credit card. As I understand it, that card is being marketed as a fixed rate for life and if that's the case, it would seem to me you need to fund it further out on the curve. So I'm just having trouble understanding how you would make any money or have a positive return on the card, even if credit losses were close to zero?

Thank you, Ken.

Yes, we did notice the comment in "American Banker" today, and I want to start by saying I think it is extremely plausible and reasonable that someone on the outside looking in could say, gosh, this is great deal for consumers but how in the world is Capital One going to make any money?

First thing I want to say is that we are not marketing it as a fixed rate for life. We very sincerely take the issue of fixed rate and the consumers' expectation of that. We take it seriously and so we do not plan to flippantly change the rate on consumers. On the other hand, we very importantly know that there is the flexibility to change rates and that includes the circumstances under which the consumers themselves have their circumstances change, as well as circumstances that can happen over the longer run course of our portfolio. So, I do want to stress that there are some people out there who market with the pledge "fixed rate for life", that is not a term that we use. But we certainly do, nonetheless take our fixed rate marketing very seriously.

An interesting thing, Ken, I now have over ten years of experience in being challenged by a lot of folks with respect to the rates that we are marketing, because Capital One has more or less been the low price leader in the industry for that period of time. We have particular experience in the area of fixed rate marketing where we are in our seventh or maybe even eighth year, with respect to doing low fixed rates, typically the lowest fixed rate in the nation and we have learned an awful lot about fixed rate marketing.

One thing we find is that a fixed rate marketing is a wonderful antidote to heavy teaser rate marketing that exists out there because consumers, over time, wear of the high maintenance aspects and continuing to be weary of teasers. There is a whole segment out there who we carefully target who love to get a low fixed rate and no nonsense type of product, which is what we market. But we have gained a lot of experience which we are leveraging in this product offering.

Let me talk to you, Ken, about the keys to making this thing work. First of all, it's all about selective targeting. Although there are lots of prime and super prime customers out there we selectively go after the ones, for this product that are going to respond, that will have very low losses and those who will stick around and that is certainly a subset of the whole super prime marketplace out there. That targeting allows us to avoid the inefficiencies that I think plague a lot of our competitors.

Also, though, it's not just about targeting. The account management expertise we have developed to selectively build balances and do customized marketing is very important, it's an important part of this product. Lower operations costs than we've had in the past. In fact we have a low price marketer for years but now we have a weapon we've never had before, which is close to the industry's lowest operations cost and that's an important weapon here.

We are also powered now by something new, which is our brand advertising, which not only sort of provides general positive impact for Capital One, the brand will, in fact, be featuring precisely this offering and therefore provides particular benefit in the marketing to our super prime marketplace.

At the end of the day, though, the most important thing about this is that we're able to generate very low losses and we pass those on to consumers in the form of lower prices.

So, this is not just something we pulled out of thin air. This is the result of very extensive testing, and really what you see here, Ken, in the end is the triumph of customized marketing and the irony here is in 199e. I remember as we were rolling out our balance transfer product and a major competitor challenged us and in a big interview in "American Banker" and said it is mathematically impossible that Capital One can be making money. From that interview to today, we have continued to succeed by selectively leveraging our information based strategy to deliver the right product to the right customer.

Thank you very much. Next question, please.

Your next question is from Bruce Harting from Lehman Brothers.

Can you just help with the guidance, the first half numbers, well above the implied second half number, and maybe embellish a little bit on the expectations for higher marketing spend and reserving in the second half? Thanks and how we get to that? Thanks.

Yes. It's a funny thing, while the company is really sort of settling in to an equilibrium, the interesting thing is this year we'll feel like a tale of two halves in a sense, to investors.

The first half characterized by very modest growth and a lot of earnings power by lower marketing because there's been less growth opportunity and also the significant relief on the loan loss allowance side.

The second half is going to be a very different kind of thing because it will be characterized by our taking advantage of significant growth opportunities that we have. Therefore, there will be the marketing levels will be significantly higher in the second half and also where we got relief on the loan loss allowance side in the first half, we will, in fact, be needing to significantly build the loan loss allowance in the second half as we put significant outstandings on the books, particularly in the fourth quarter.

The net effect is that the year will look very much like the year we envisioned when we embarked on this year. It's just that it's turned out to be a little bit more of a tale of two halves than we had probably originally had in mind.

The nice thing is we will leave '03 very nicely positioned for continuing success and earnings growth in '04.

Thank you very much. Next question, please.

Your next question is from Bob Napoli from U.S. Bancorp.

Good afternoon. Just wondering, Rich, if you can elaborate more on the operating expense line and the significant decline that you have this quarter and then your outlook for the cost per account moving up significantly later in the year and was there anything unusual in those numbers and what caused the big decline on the comp line?

There actually weren't any major unusual items. As you would expect, we continually we were looking at reserves and allowances and having studies completed that the basis from which we accrue costs, and occasionally we go back and have new studies and true those up and some of those sort of things. But basically, our benefit costs are running less than what we anticipated that they would run in the first half of the year, and that allowed our costs to stay down.

We do anticipate we'll have higher spend, as you might imagine, with the higher growth in the second half of the year. Operationally, you do have to spend more to execute on the higher growth that we'll have in the second half of the year, and the growth leads the revenue generation.

Thank you. Next question, please.

Your next question is from Caren Mayer, with Banc of America Securities.

Hey there. A couple of questions, really, I will make it one, Paul.

But topic related to the margin which is -- I mean it looks like you guys took advantage of the funding markets to go ahead and lock in some very low-cost funding which is sitting in liquidity. As that unwinds should we see the margins start to creep back up to the 9% range or is it really the function of the fact that you will be having more loans at teaser and low range that will keep that margin compressed? I do understand the rest of the revenue yield that you talked about, relates also to the mixed change and less late fee and over limit fee income.

Caren, the first point I want to make about a margin, I think the best margin to focus on is revenue margin, because it really covers all the revenues of Capital One.

I want to go back to what we said in the prepared remarks that the revenue margin we see gradually declining over time as we move up market and also as we move increasingly into other products which on average have lower revenue margins than the average of our credit card business.

What happens in the third and fourth quarter is that, we have not decided exactly what to do about the liquidity portfolio, the timing of any changes that we would put into that. That would have some impact on the one quarter to the next on what happens to margin but I think the best thing to focus on is in general the margin is going to gradually go down over time, as we continue our move up market.

Next question, please.

Your next question is from Robert Hottensen with Goldman Sachs.

Hi, Rich. You sold $1.3b of auto loans. I'm curious, what are the market conditions and mixed profile loan sales opportunistic and looking ahead, what would be the conditions in the second half, which would make, you know the production more attractive to retain?

Robert, good question. This is Dave Lawson. I will respond to that.

We really have two types of auto loan sales and one type is a more opportunistic type which has been the sales of our super prime loans and the other type, our sub prime loans are really sold on a contractual flow through basis. In the second half of the year, we anticipate the continuation of the sale of the sub prime loans on a flow through basis and actually those will increase somewhat in the second half, over the first half of the year, as it was in a ramp up stage in the first half of the year.

In the second half of the year, at this stage, we plan on holding most of our super prime loans. Obviously, we'll continue to look at the market and look at the growth that we'll experience in our other businesses and make a line of scrimmage call as we move through the second half of the year. But at this stage, we anticipate holding most of those loans.

Next question, please.

Your next question is from Eric Wasserstrom with UBS.

Thank you. Dave, in terms of the funding, you talked a lot about the prefunding you did in this quarter and the low absolute costs but how are the spreads relative to your own historical experience over time, do they remain wide or have they narrowed some?

Yes, Eric, the spreads have actually come in and they're really comparable. A good example would be the unsecured senior debt that we issued just in the last six weeks or so.

It was a spread of 10 to 15 basis points, which were two-year lows so that was a year before the MOU, we executed the ten-year sub debt, again, if you look at where that was, and is today, it's 60 basis points below the current market.

Mm-hmm.

So the spreads that we're seeing today are now at all-time lows.

And then some of the lower quality traunches, is that also true?

Yes. The, well, the BBB traunches have come in and they are comparable to what they were a little before the MOU.

Next question, please.

Your next question is from Reilly Tierney with Fox-Pitt, Kelton.

Hi, guys.

Hi.

I know you were planning on trying to accelerate loan growth in the second half of the year to get the to the 15% you need to close to $9b in the next two quarters and I would have to think that you need account growth to start picking up. But you spent $270m this quarter. You have another quarter of negative account growth.

What do you expect the trajectory of marketing spending to be going in the next two quarters and what do you have in mind specifically to start turning this thing around?

Okay.

Reilly, first of all, while it may seem paradoxical we would expect basically flattish account growth for the foreseeable future and that's because most of the things that are growing the most have high balance per account. That's our up market credit card business, our auto business and installment loans. So, really in some sense, it's by coincidence the trend towards higher balance per account is offsetting the otherwise increased growth that's going on in the company and leads to not a lot of account growth. So we feel pretty strongly about that.

But on the on the other hand, I want to be careful about the phrase, "turn this thing around". If you look at our pattern in the past, Capital One has typically been back loaded in the year in terms of our growth.

I think this is a little bit more extreme than sometimes, but what we have here is we have three different effects going on. You have the natural seasonal effect that lead to several billion dollars of growth anyway. You have the super prime auto portfolio coming on to the books and you have just by the timing of it, our rolling out of a response to the marketplace that has become a lot more competitive.

Typically the way our growth works, it's of two types. Either we come out with some innovation to start out with, or we see an effect in the marketplace, gather back in, particularly if there's a very competitive response in the marketplace. We tend to pull in our horns a little bit, very extensively test, combine lots of different test cells and ready a series of responses to that and what you have here is more of the pulling in the horns in the first half of the year, and the rolling out of how we respond to that in the second half of the year.

These things all add up to the really sort of striking difference between a large outstanding growth number in the second half after what looks like a pretty anemic first half. It's really part of something that is much more sort of continuous in terms of its trajectory, in terms of the underlining marketing dynamics.

Through it all, there will be a significant increase in marketing to support the higher growth in the second half of the year.

Next question, please.

Your next question is from Joel Houck with Wachovia Securities.

Thanks. Rich, I was wondering if you could comment strategically how the company has evolved over the last several years. The numbers have moved around quite a bit but the risk-adjusted margin which is 17% in 2000 has come down about 300 basis points a year. It's now sitting around 9%. Are we going to see that stabilize or do you expect that to go even lower going forward?

Joel, it is probably challenging to sometimes follow the metrics of Capital One. What we try to do is try to be very clear where our destination is and help you with the journey.

One thing that we have done is been out on a couple of destinations we tried to be very clear about. One destination set out many years ago was diversifying beyond the card business. For a while, that led to fairly sizable losses in our other businesses. The nice thing is finally we're getting some earnings out of that.

And the other thing which has been even more striking on the metrics has been this move up market and certainly both of them together, particularly contribute to striking effects on the margin, the most effected things have been impacts on revenue margins, risk-adjusted margin in general has a little bit of a nice offset to it, in the sense of when one moves up market, you get some corresponding benefits from some charge offs even as your revenue margin goes down.

I think the overall characterization, I would say of Capital One is that the earnings octane of the company, that showed itself in a 30% and 40%-type earnings per share growth in the past, even as we were financing unprofitable diversification will have pound-for-pound lower octane in the sense that the kind of earnings trajectories that you see at Capital One.

Now we do this by design, not by accident because we believe we're building a more robust, stronger and more valued company in the process.

Next question, please.

The next question is from David Hochstim from Bear Stearns.

One question and one clarification. Is there a way to reconcile the segment net income with total net income?

And then the clarification is, I just wonder when you're calling up on -- I didn't understand the answer to Ken's question about the 4.99% product. I wonder if you could give us an idea of what the appropriate funding rate would be for those balances and what kind of ROA could there be if you assume 20 basis points of loss and no marginal cost to service the account, would it still reach the average for the company?

Well, I'll respond to the first question regarding the segment reporting.

We have the three segments and then we actually have other costs to help offset the house, other revenue sources and costs that are held at the top of the house, including, in some of our lines of business, like home equity and liquidity portfolio, and CRS that are not included in the segments. They are too small as individual businesses and so they are all included as an "other" category and the combination of those four categories the three segments plus the other category produced the consolidated results.

David, first of all, I want to say that the economics of our 4.99% product will not reach the average profitability of the company overall. The company is a blend of up market, super prime, prime and sub prime businesses and so on, and I don't want to create any illusion that this offering will be the average for the company.

The key thing to us is that we very carefully look at the results of all of our test cells and make sure to our satisfaction level that this product will exceed the hurdle rate of the company, even with a recession scenario and based on the specific results that we see from these tests and from tests and rollouts like it.

While it sounds like you still need a little convincing on this, we are very comfortable that the economics of this product which is introduced on a targeted and selective basis to customers with spectacularly low chargeoffs will, in fact, be able to exceed hurdle rates.

Do not forget that revenue does not end with just 4.99%. There's a lot of interchanges, a lot of cross sell products, there's a lot of account management opportunities along the way which we have honed for years in the building of our low fixed rate product.

I think one of things that partly causes people to not be able to make ends meet is they forget to overlay the fact that we're building a customer relationship and this customer relationship is a dynamic one, with respect to balances, revenues and so on. Again, we are happy to declare that through person and the senior management of this company, we are comfortable this product will exceed from everything we can gather from our data, is an above hurdle rate return for Capital One, and as such, I think it represents an opportunity to really gain some share in a great place in the market.

Next question, please.

Your next question is from Steven Wharton with Loomis Sayles.

Hi, Rich, I had a question about core earnings power. You reported $1.23, and as I try to figure out what the run rate quarterly earnings is going forward, I tend to want to take out reserve releases which brings me down to $1.04. You know based on your guidance it sounds like the releases of the fee and the finance reserve and the loan loss reserve may be coming to an end.

Then when I look at the consensus estimates, especially for 2004, at about 5.30, I guess I'm trying to get a better understanding of where the growth you anticipate coming from as we head into next year, whether it's increasing margins, further declines on loss rates or, you know very rapid loan growth. Can you just maybe elaborate on that?

Okay. We're trying to reconcile your math with our own, but in any event, it's very clear that an important contributor to the earnings power in the first half of the year was what happened with loan loss allowance and secondarily with fee and finance charge reserve that where there was relief in contrast to the normal significant building that one had to do with it.

What happens is in many ways, we're in a situation from a bottom line point of view or over time a nice offset that happens when we shift out of the mode. You're correct in some sense, the second half is not about releasing reserves but more of building them, but what we're doing in the second half of the year is creating the growth that will generate the revenues that will power a lot of the earnings growth for next year.

So, we're going to pay the price a little bit in terms of what it takes in the short term to build the reserves a long way, but it is very much -- and this is no different from past years, it is very much the earnings power that comes from the growth that sets up the following year.

Also, I do want to stress again that the charge off trajectory of the company, we expect to continue in general to gradually go down. The same way I've been saying in general the macro trend for Capital One is the revenue margin will go down, so too, charge offs will gradually go down.

From an earnings point of view, not only does charge offs going down make you have less charge offs to state the obvious, it means in general that you get some relief on the loan loss allowance side, not necessarily by reduced loan loss allowance, but certainly by the forward-looking aspects that better charge offs tend to be preceded by better delinquencies and those better delinquencies tend to show up in the form of some relief in the loan loss allowance relative to what you would have otherwise had.

It all adds up, for us, into something that gives us a lot of confidence in the earnings power of the company going forward, even though the individual metrics seem to be bouncing around a bit.

Next question, please.

The next question is from Matthew Park with AJ Edwards.

Good afternoon. Just one more crack at the guidance that you have provided. Are you saying that because of the increased reserves, the reserving requirements that you are looking to deliver about $2 for the outlook this year, or is there some other things that's going on? Thanks.

Matthew, what we are saying is that we don't see any reason to move off of the at least $4.55 guidance. Frankly, as we look at the rest of the year, first thing I want to stress is that despite my, hopefully eloquent speech about the significant growth that we are anticipating, this will always be a line of scrimmage call for Capital One.

So, we will continue to watch the markets, watch response rates and so on. But if the growth goes like we anticipate, that will certainly require both higher marketing and higher loan loss allowance builds such that the "at least $4.55 guidance" would be very appropriate.

On the other hand, if the growth opportunities turn out to be less robust, as is always our case, we are not just going to bull headedly say, no, Rich said on the call we are going to do it and by gosh, we're going to do it. We could go less significantly and in that case market and saving allowance would go to the bottom line and put upward pressure on the number.

But all in all, we like our chances for the growth that we have in mind, and I think you can see, therefore, why the $4.55, at least $4.55 guidance for us seems like the right one to stick with.

Thank you. Next question, please.

Next question is from Ed Groshans with Moores & Co.

Hi everybody, I just had a question. In previous discussions I was under the impression that the auto portfolio will stay at $7.7b, it shrank a little bit here and then going forward it seems like you are going to grow that again and hold it on balance sheet.

I was wondering what's changed in the environment or what's changed in the thinking? I was under the impression there was some pressure from external sources that was limiting the amount of auto that was going to be held.

This is Dave Lawson, I will respond to that. Actually, we have breathing room, as you remember the initial growth guidance that we entered the year and we had modified that guidance somewhat. So we actually do have growth capacity and that capacity would allow us to retain the super prime loans and will originate during the second half of the year. So we would actually hold those loans rather than sell them, and the numbers would then be somewhat higher than what you had just mentioned.

One result of that, you will see it in the auto finance chargeoffs will also be reduced. We actually sold $1.5b in '02 and thus far in '03, we've sold $1.3b in auto loans.

I want to say two things, first of all, on the auto portfolio, we have a very nice problem to have, very much like the baseball manager that has two all-star third basemen.

We have a situation where we've developed a sales market in super prime that is very attractive; on the other hand, the reality is the attractiveness to us is growing right before our eyes as we get a lot more scale in the business, the operating costs are going down pretty dramatically and the funding costs, as we take advantage of all the things Dave talked about is also really enhancing margins in the business.

So we will continue to choose between our all-star third basemen over time, but I think for the second half of the year, we'll certainly probably be doing more of the super prime on balance sheet.

I want to state the obvious, in case people do not know this, Dave Lawson who has been answering the auto finance questions does know something about the business. He, in fact, prior to our plucking him out to run our financial function, Dave has not only run our auto finance business, he ran the company that we acquired years ago and all the success you see in auto finance is due to Mr. Lawson here.

Next question, please.

Your next question is from Mike Hughes with Merrill Lynch.

Hi. Are you guys going to securitize at all in the third quarter and part two, how are you going to fund the 4.99% card?

Yes, Mike, we'll continue to access the market as we need to and we clearly we have the capacity as we said with the subordinate pieces to get out there and fund this 4.99% card in the market.

The debt funding would be significantly driven by securitization.

Next question, please.

Your next question is from Rich Shane with Jefferies & Company.

Hi, when we sort of look at the first half of the year, we see that you guys were shifting up market and by your own admission the market was highly competitive and, frankly, rather flat asset growth and I would attribute to you guys choosing not to buy share as reflected in decreased marketing expense. Now we're basically looking at the same competitive environment and you're coming out and saying that you want to significantly accelerate growth in that prime, highly competitive market. What is shifting in the environment that causes you to sort of have elected in the first half of the year not to go after that growth and in the second half of the year, you are going after that growth?

Thank you, Rick. That's a great provocative question.

I think little has changed in the market, to be honest with you. While I think some have declared or sensed a slight easing of the market and probably if anything the evidence we see is a little bit of easing in the market. Frankly, that is not why we are changing. What has changed is our own offerings and the innovations that we have come out with.

Again, what happened, to go back to this thing and there's a pattern that many times before Capital One. While we set goals in every business unit for what they hope it achieves over the year, it's all about watching the marketplace and make line of scrimmage calls and as we watch the marketplace with some concern, certainly last year as it got more competitive, this year it has been raging in terms of its competition. We've seen pressure on response rates. We've seen some of the things that we would have traditionally seen do very well not do as well as we would like. So we have done less of them.

So what we did, despite the market having expectations of higher growth, notice that we in the first couple of quarters, frankly, delivered, we under delivered growth to the market, relative to their expectations. That's because we don't choose our growth targets based on what Wall Street expects. Even when those expectations have come from us, we choose growth targets based on opportunity and we did not see as robust an opportunity in the first half of the year.

Meanwhile, though, our folks scrambled incredibly hard to figure out how to respond to the marketplace in every market area we have happened to talk about super prime, the very, very, top end of super prime, is what we're talking about here. But collectively across the company and with respect to super prime in particular, it just so happens that we have developed responses to the marketplace that we are ready to roll out with.

In fact, we've already rolled out with them and our philosophy is to -- we believe markets are all about windows of opportunity. Markets open, opportunities open, opportunities close when we see opportunities we tend to move aggressively but we also tend to assume that particular opportunities don't last that long, therefore we're planning the next response. This particular time, we are rolling out with something that will be pretty aggressively marketed and we'll watch it at the line of scrimmage and we'll go from there.

Thank you. Next call, please.

Next question is from Michael Freudenstein with JP Morgan.

Good afternoon. Just wanted to clarify something you said, Rich, which was I think you said as far as your charge off guidance goes, that third quarter would be down and then the fourth quarter would be up and I guess seasonably speaking, given that you are expecting bigger growth in the fourth quarter. I wasn't sure I understood that. Could you explain that and tell us if you're sticking with the guidance of low sixes by year end?

Okay. I'm glad you asked that, Michael because it does seem odd. Wait a minute, we should get a great denominator effect in the fourth quarter.

Let me say there's nothing really actually odd about the fourth quarter number, what is a little odd, as we look at our projections is the third quarter number, which is definitely headed down and what happens in the fourth quarter there is a seasonal uptick that commonly happens in the fourth quarter and interesting is our study of seasonality is based on years of experience, even though the fourth quarter tends to be the highest growth quarter of the company. So what happens is, the real seasonality is almost bigger than you would otherwise think it tends to be masked by loan growth also offsettingly on the denominator.

The thing that's happening, though, is that the improvements in delinquencies that you've seen in the first half of the year are continuing to make their way into better charge offs in the second half of the year but we happen to believe from before we sit at the moment is the fourth and the third quarters, as it happens, will be lower than the fourth quarter. This is only for seasonality reasons. It is not a precursor of an increase to come because, in fact, we have already said for '04, we would see generally declining charge offs.

Thank you. We'll take one more question, if you will, please. And I'd like to remind the audience that investor relations staff will be here later this evening and we'll stay as long as you have questions. Thank you.

Your final question, then, is from Moshe Orenbuch with CS First Boston.

Thanks. I was wondering if you could talk a little bit about what you are seeing in the sub prime market? Is there in the competitive landscape out there, is there anyone else stepping in? Is that something that you are watching and looking towards, as the economy improves and taking a larger role in it at some point down the road?

Yes, thank you, Moshe.

One would think from all one reads in the "American Banker" about the sub prime marketplace that this would be the easiest pickings that somebody could do because there would be nobody there. As we walk in those woods that we expect to be vacant, we find lots of company there, which is an interesting observation. So the first thing I want to say is the sub prime marketplace is not dramatically better in terms of strong response rates or dramatic evidence of the exit of people from that marketplace.

Here's the thing that is dramatically different, Moshe, and that is the reduction in the thing that we feared would wreck the sub prime marketplace, companies running around offering a very high line to what we felt was customers who could not handle it. Our concern was that even if we didn't do that, that what spoil the marketplace in a sense and we would lose the ability to market our lower line products.

The devastation of the sub prime marketplace has, I think, significantly rationalized the type of offerings there and in making this market more sensible, I think it has a chance to be much more resilient in the long-term and to continue to be successful for us.

In the meantime, we continue to just set sub prime limits on our sub prime growth. We even in sub prime have moved up market even within sub prime and that's partly affecting the metrics you see. But what we like, Moshe, is that sub prime is able to continue to grow appropriately at this point and the market, in some sense isn't going anywhere. So I think in the long run, it represents a significant and enduring opportunity for us and it's on the bull's-eye for the power of IBS really works.

Dave you would like to comment for a minute on the auto sub prime marketplace as well.

Sure, Rich. As you know, in the auto sub prime arena, one of the major competitors pulled back. However, we've seen a number of competitors step up to capture some of that market share, including ourselves and we may very well be the leader of any of those companies stepping up.

However, one attribute of each of the companies that's stepping up is they are all moving up market also. So, we do find that as we move up market in the sub prime arena in auto, it is becoming increasingly competitive. So, it's much the same dynamic that Rich talked about we're seeing in the auto, but our advantage is we garner our business from three different channels in the auto business, both the indirect channels, the direct mail channel and the Internet channel which helps us avoid some of that competition.

Thank you very much, ladies and gentlemen. As I said, we will be here later this evening. So please give us a call. Thank you.

Thank you.

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