Capital One Financial Corp (COF) 2003 Q3 法說會逐字稿

Good afternoon. My name is Amy and I will be your conference facilitator. At this time I would like to welcome everyone to Capital One's third 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 then the number one on your telephone key pad. If you would like to withdraw your question press star then the number two. Thank you. I would now like to turn the call over to Mr. Paul Paquin, Vice President, Investor Relations. Sir, you may begin.

Thank you very much, Amy. Welcome everyone to Capital One's third 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 on to Capital One's home page at www.capitalone.com and follow the links from there. This quarter we are introducing a new format. In addition to the press release and financials we have released a group of slides summarizing the third quarter results.

The prepared remarks presented by Rich Fairbank and Gary Perlin will walk you through these slides. To access a copy of the slide presentation for the purposes of following along please go to www.capitalone.com, click on investor and then click on financials. We are continually working to improve our communications with investors and we welcome any and all feedback you might have about this new format. The company generates earnings from its managed loan portfolio which includes both on balance sheet loans and securitized loans.

For this reason the company believes the managed financial measures and the related managed metrics useful to 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 principals. For more information please see the schedule entitled reconciliation of debt financial measures attached to the press release filed with the SEC on form 8(K) earlier today. The statements made in the course of this conference call that mention the company's or management's hopes, 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 SEC filings including but not limited to the company's most recently filed report on Form 10(Q) for the quarter ended June 30, 2003. Our Web site contains all of our SEC 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 would you ask only the more strategic questions. This will allow you to take advantage of senior managements availability.

The data questions and questions relating to the contribution of variables for the release data can be obtained at any time by calling investor relations. In fact the investor relations staff will be available after the 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. Gary Perlin, our Executive Vice President and Chief Financial Officer. At this time I will pass the call over to Mr. Fairbank for his remarks. Rich?

I thank you, Paul, and welcome everyone to our earnings call. I am going to give a business update and then turn it over to Gary for a financial update. If everyone could turn to slide four. This is a third quarter summary. Capital One had another solid quarter of earnings delivering EPS of $1.17.

In the quarter we grew managed outstandings by 6.5 billion with most of that growth in SuperPrime Card. Revenue margin declined 49 basis points consistent with a mixed shift upmarket and beyond U.S. Card. Risk also improved significantly in the quarter. Charge-offs fell 88 basis points which is the largest quarterly drop in our history. Delinquencies also fell 30 basis points and finally the allowance declined by $20 million. We will discuss that further. Now, there were a lot of metrics moving in the quarter and we are going to be talking about a lot of them over the course of this call.

There really are three stories that drive and explain just about everything. Portfolio growth, mix shift and improving credit. When we talk mix shift here we are talking about both the shift upmarket and also the continued diversification beyond our U.S. Card business. Now, let me give you just an example of how some of the metrics are driven by these three stories. Portfolio growth is, of course, associated with the metric of marketing growth in the quarter. But it also creates denominator effects in the credit metrics.

The mix shift is probably the most significant driver of the metrics, because the mix shift both upmarket and in diversifying to other businesses is driving lower margins, lower charge-offs and lower allowance. Improving credit, the third story, shows up, of course, in the credit metrics as evidenced by decline charge offs and delinquencies. But it's also driving lower allowance. So it turns out, for example, that lower allowance from the mix shift upmarket and the improving credit in the existing portfolio actually more than offsets the increase in allowance required by the reported loan growth of $3.8 billion. So Gary again will in a lot more detail discuss the reduction in the allowance.

What I want to do is go back and talk about the three big stories, portfolio growth, mix shift and improving credit. Let me start with portfolio growth and move now to slide number six. Here you see on slide six a time series both on loan growth and accounts and if you look at the fourth column you will see the quarterly growth versus the prior quarter. Loan growth was significant as we talked about before at $6.5 billion. The account growth was positive in the quarter, adding 621,000 net accounts to get our account level up to 46.4 million accounts. But still also the difference in the loan growth and the account growth is striking evidence of the mix shift upmarket going on at Capital One.

While the dollars of loans outstanding grew at 12.6% year to date, accounts actually shrank year to date. And this occurred because both superprime and non-card accounts have much higher average balances than our portfolio average. Now, as you all know we did not grow the portfolio materially in the first half of 2003 due to a couple of reasons. One is the natural seasonality in the business that causes all credit card issuers to be a little bit slow in the first half but also very much our growth was limited by the very tough credit card market.

And we've talked extensively to you about how we pulled back, sat on the side lines to some extent, readying products that would really work and be above hurdle rate in this environment. With the success in the upmarket card growth in the second half of the year we are now on track for loan growth of about 20% this year. The next slide itemizes where this growth is coming from. You can see that on this slide, the first column of course is the first half of the year we got the third quarter in the second column and if you look at the total there of the 6.5 billion in the third quarter, a full 5.2 of the 6 .5 is coming from the U.S. Card business. Now, this U.S. Card growth is coming from several places. The low fixed rate products that you see advertised on national television, our Miles One program that has been very successful.

Also you've probably seen some of our recent adds, we even mobilized Santa Clause to help us in those ads and the balanced stimulation programs that we've been doing at Capital One and very importantly this is balanced stimulation within the context of keeping credit lines at the same and therefore it tends to be particularly low risk kind of growth. So a lot of growth in the quarter in the U.S. Card business. The striking thing is, despite all that growth in the U.S. Card business you can see if you look at the year to date growth line that all of our business lines not only are growing but in fact all the business lines are growing faster than the U.S. Card business which is consistent with our story that we continue to diversify the company. So while the U.S. Card business is 9.3% loan growth for the year, year to date installment loans is already 30.7% growth to date. Auto finance at 14.5% is pretty striking given that that's after the sale of nearly $2 billion of auto loans in the year.

International is to date 23.1% growth. So obviously I think those are striking validations that the diversification of the company continues. The next slide, slide eight, I think is another way of looking at that momentum. When we think about our diversification businesses the way we look at it at Capital One is really four businesses, it really diversifying the company, auto, international, installment loans and our small business business. You will hear a little bit more about our small business business next week at our debt and equity conference.

You can see here that collectively, not even counting the small business business, the installment loans, international and auto, add up to nearly $20 billion at this point and now represent almost 30% of our loan portfolio, which is a significant share increase considering that the U.S. Card business is still growing through this period of time. Now up until recently the diversification has really been one of asset diversification and as many of you have reminded us, now, that's nice but in the end, true diversification is earnings diversification. As we fondly say internally, show me the money. And here's where a great story is happening in Capital One, you turn to slide nine. Diversification investments are really paying off.

Here we are showing the time series P&L for our auto finance and international business. I would remind you that our other diversification businesses, installment loans and small business, are contained inside the U.S. consumer segment. But even focusing just on these two, the auto finance and international, we can see if we look at the fourth column that to date this year these two businesses are turning a profit of $118 million, striking given that if you look to the left these businesses have lost considerable amounts of money as we have invested in getting to where we are. We expected over time these businesses will continue to grow both in assets and in profits at a faster pace than our U.S. consumer business and, therefore, the pace of diversification will continue.

This diversification and our move upmarket are the two drivers of what we call the overall mix change that continues in our portfolio. Turn to the next slide that kind of highlights a very important point that we've been reinforcing for some time. The mix change is causing a significant impact on some of our metrics, most notably revenue margins and charge-offs. Where we are going, our destination in a sense with these mix shifts is to do more upmarket credit cards, more products beyond credit cards and each of these tends to have lower revenue margins and lower charge-offs.

So, therefore, the journey on the way from one place to the other is associated with declining revenue margins and declining charge-offs. Now, the effect on margins is visible in slide 11. And here we are looking at revenue margin and you can see that the decline in our revenue margin has happened over a course of a number of quarters as the mix has shifted. This mix change is one of the key drivers of our charge-offs which leads me to the third big story, Capital One. Just to remind you our big story so far have been the growth story and the mix change. The third being the improving credit.

If we turn to slide 12, we can see pictorially the power of what's going on in the charge off story. In the month by month you all have watched our charge-offs plummeting to 5.75 in July, 5.34% in August and 5.24% in September. On a quarter over quarter basis, charge-offs fell from 6.32% in the second quarter to 5.44% in the third quarter. The significant decline in charge-offs is driven by several effects. Obviously there has been very strong performance of the loans across this company. Additionally we are now getting on the downhill side of the seasoning curve of sub prime loans that we've talked about for some number of quarters now.

Those loans that were booked in 2001 and 2002 are now enjoying getting on the other side of the spike in those curves. Also the decline in charge-offs is driven by the continued mix shift upmarket and into diversified businesses and finally, some of this dramatic decline is due to the denominator effect of significant growth in the quarter. The fact that the maturity of the improvement goes beyond the denominator effect can be sort of inferred on the next slide which shows nine month lag charge off rates. We're on slide 13. Our lag charge off rates have been declining for some time and are in fact lower now than they have been since the fourth quarter of 2000.

This is just another reflection of the impact of the mix shift going on at Capital One as well as, of course, the continued success of our underwriting. On slide 14 you can see the break down in the charge off trend for each of our major segments. U.S. consumer lending, auto and international. U.S. consumer lending segment which is, of course, primarily cards also includes installment loans and small business, is performing very well for the reasons that we've already talked about. International is relatively steady. I want to pause for a minute and talk about the auto finance business because it is up both in the quarter and also up over the period.

The third quarter increase over the second quarter increase is due to seasonality which you can see on the chart both for this year and for last year. The third quarter increase over a year ago quarter is due to really two effects, most significantly the denominator effect of slower growth. A year ago we were running at more of a doubling pace. Now we are growing at a rate of 14% year to date. But there is also a severity effect from the soft used car market. Each of these is somewhat offset by the mix shift that's going on internally upmarket in the auto finance business. But overall the charge off fixture at Capital One continues to be very positive.

Another way to look at this is looking at slide 15 which shows the delinquencies for the company. Delinquencies improved in the second quarter following 30 basis points to 4.65%. This decline in delinquencies is a key driver of the loss allowance calculation, thus contributed to the reduction of allowance in the quarter. Those really are the three big stories at Capital One, portfolio growth, mix shift and improving credit. These three stories are driving most of the financial metrics of the company. And with that I will turn it over to Gary who will talk about our financials.

Okay, thanks, Rich. Hello, everyone. Let me add my thanks for joining us on today's call. I'd like to underscore Rich's discussion of our business strategy with a brief financial picture. I will cover four primary areas. Key financial metrics, the loan loss allowance for the third quarter, Capital One's adoption of a new accounting standard and funding and balance sheet strength.

I will then hand the mic back to Rich who will conclude with some comments on the outlook for the fourth quarter of 2003. I am going to begin on slide 17 with a review of some of the quarter's key financial metrics. I would like to walk line by line through the top half of this slide which includes the principal elements of the income statement. Starting with revenue which increased as loan growth picked up. Next provisions declined, reflecting the lower third quarter charge-offs and a slightly lower allowance reflecting an improved loss outlook which I will talk about in a moment. Marketing expense increased with new product roll outs, particularly in SuperPrime Card.

Costs associated with setting up new accounts, achieving recoveries and with real estate consolidation at our Fredericksburg and Tampa sites drove an increase in operating expense. Net income after tax is $276.3 million which includes a $15 million charge related to the adoption of the new accounting standard FIN 46. This translates into earnings per share of $1.17 in the third quarter or what would have been $1.23 excluding the effect of the accounting change. With regard to the bottom half of slide 17, Rich has already addressed most of the asset growth and credit metrics so I will focus on two specific financial items of note for the third quarter.

The first relates to the line on slide 17, to the change in allowance which in fact is the only line on this particular part of the slide that reflects the reported income statement excluding securitized loans. Please move to slide 18 for an explanation of this somewhat counter intuitive move in the allowance. Again, for the quarter there was a negative build of $20 million in the allowance which follows a negative allowance build in the previous quarter of about $45 million. Some listeners may find it odd that the allowance is declining given the significant on balance sheet loan growth. That's why we thought it would be useful to remember how this allowance is determined. Allowance calculation is actually a very disciplined process that's applied consistently from quarter to quarter.

The process is largely formulaic and consistent with industry best practice as a means of estimating likely future principal losses for on balance sheet loans. There are three predominant factors that drive the allowance, first the aggregate level of reported or on balance sheet loans, the portfolio mix or the distribution of risk in that portfolio and lastly the actual credit performance and outlook. Now, during the first two quarters of 2003 we had significant declines in the allowance because of the improving credit performance in progress on the mix shift that Rich has described. During the first two quarters of 2003 there was no offsetting influence from growth in the portfolio because that growth was not particularly strong.

In the third quarter, however, the allowance is being affected significantly in both directions, first by the growth in the portfolio and then by the continued improvements in the credit metric. Looking again on slide 18 you see $3.8 billion of the growth in loans in this quarter are on balance sheet and, therefore, require an allowance. Taking alone, this statistic would have driven the allowance significantly higher. In this case, however, this effect has been more than offset slightly by the continuing credit improvement in mix shift. There has been a predominant growth in superprime assets and there has also been a strong credit performance in the entire existing portfolio.

Looking just at the reported loans, those which are on balance sheet, a 58 basis point decline in delinquencies. So two large effects, one that would push the allowance up, the other pushing it down on balance, there was a slight net decline in the allowance this quarter. What this tells us, of course, is that each quarter will reflect the moves that are driving the fundamentals of our business that could be affected by seasonal growth patterns, the timing of securitizations and the stability of credit quality. That covers the allowance. Now let's move on to the other income statement item I want to highlight which you'll see on slide 19.

Like many other corporations, we've adopted the new financial accounting standard number 46 this quarter because Capital One like many others use synthetic leases as a typical form of real estate financing for many of our office buildings. The result of this new financial accounting standards is to require that we bring both the buildings being financed and the associated debt on to our balance sheet which we accomplished in July. The net result of this and the difference in the recorded values between the 150 million or so of properties that were brought on to the balance sheet and the approximately $175 million worth of debt resulted in an after tax reduction in earnings of $15 million, or 6 cents per share. Finally I would like to cover funding and other indications of balance sheet strength.

As you can see on slide 20, during the third quarter we continued to experience extremely strong funding performance much as we have through the course of all of 2003. I would just like to mention a couple of items as highlights. Let me start with the $250 million of subordinated Triple B card asset backs. That $250 million was done in the form of a ten-year transaction, the longest Triple B that we have ever issued or that others have issued and quite large in size compared to that which we have done before. In fact there's been a significant increase in longer dated issuance across all of our funding instruments over the course of this quarter which is very important in terms of helping us improve our liquidity position and helping to us to manage interest rate risk.

As far as some of these longer dated issues go, the $600 million of unsecured senior bank debt was done at seven years. In fact as you look across the slide you'll see that we've actually been able to access all of our market channels at a very attractive level over the course of this quarter. We have found strong investor demand across all the channels. In fact all of the transactions we've done in the capital markets this quarter have either been up sized or executed inside price guidance. Speaking of price, if you move on to slide 21 you will see that at the same time the level of our funding has been increasing, we've also been able to achieve improvements in relative pricing as seen through the tightening of spreads.

Again on slide 21 we've just highlighted two or three of the most important metrics in terms of funding performance and you will see that spreads have tightened across all of our funding programs. The biggest gains are in the area of the subordinated Triple B asset backs and also in the unsecured debt. It may not be quite as obvious on this slide but the AAAs have also improved measurably over the course of the quarter. As a result of the funding success we've had over the last three months we've been able to maintain ample liquidity despite the rapid asset growth which has had to be financed during the quarter.

You can see this by turning to slide 22 where you can see on the left that we have maintained our very strong liquidity position even after funding our growth and comparing the level on the left part of the slide to the forthcoming debt maturities that we see over the course of the next 12 months which is the first bar on the right, you can see that our available liquidity is about 2.5 terms our term debt maturities over the next 12 months. One other thing I'd like to point out is that we've not only been able to maintain a healthy level of liquidity but you can also see on the left slide that we have aimed to try and create a much more cost-effective means of maintaining that liquidity through some composition changes.

What we did over the quarter was to use some of the cash on hand at the end of the second quarter to finance our growth and we've used the proceeds of many of our financings during the third quarter to pay down conduits which now makes them freshly available to finance future growth if necessary. The net effect of this is to reduce the amount of cash and securities on the balance sheet, increase the amount of available conduits and this has led to a much more cost effective way to have the level of liquidity that we feel is prudent to manage our business going forward. So in sum, our key financial metrics reflect sound business strategy and our funding and key balance sheet metrics have remain strong through the third quarter. With that, Rich, I would like to turn it back to you to offer an outlook for the fourth quarter.

Thank you very much, Gary. That's a real pleasure having you on board here at Capital One. I'd like to turn to slide 23 which is our final slide. As we move to Q&A I want to leave you with a few thoughts about the fourth quarter. We expect 2003 loan growth to come in at around 20% for the year. Revenue margins as we talked about will be lower, consistent with our mix shift upmarket and into diversified lending products.

A seasonal bump in charge-offs is likely, driven primarily by the seasonality of recoveries and finally we expect a positive allowance build driven by the seasonality of delinquencies, possible reduction of off balance sheet securitizations and a mix of growth that is not likely to be as extremely upmarket tilted as it happened to be in the third quarter. As a result of all these factors we still expect to report at least $4.55 EPS for the full year year. We continue to be highly confident in the future of Capital One and our business model. U.S. Card business continues to provide strong growth at attractive returns.

Our diversification businesses, auto, international, installment loans and small business are continuing to gain momentum positively contributing to our strong earnings performance. Our credit picture is expected to continue to improve as we diversify our business and shift our overall portfolio mix more upmarket. We remain focused on building the right levels of internal controls and governance to appropriately manage the risk associated with a company of our size and complexity. We maintain a strong working relationship with our federal and state banking regulators and have made great progress against the memorandum of understanding. We look forward to seeing many of you at our investor conference next week in New York to continue our dialogue about the Capital One story. With that I will turn it over to Paul.

Thank you very much, Rich. Amy, we will start the Q&A session now, if you would please do so.

Yes, sir. At this time I would like to remind everyone, in order to ask a question please press star then the number one on your telephone key pad. We will pause for just a moment to compile the Q&A roster. Your first question comes from Bob Napoli with Piper Jaffray.

Good afternoon. Just a brief question then a real question, I guess. I would like a little better definition of at least since we are starting to use the term at least more frequently, is 470 at least 455 in your definition, is 25% loan growth, at least 20, I don't know if you can narrow in what at least means? And with regards to auto finance, that seems to be on track if you add the $2 billion of growth that you had not sold, you are going to sell less, to become a much bigger part of your business, the credit trends there are not as favorable as they are at the other parts of the business. How comfortable are you and how big can auto finance get to be as a percentage of your business?

Okay, Bob. With respect to the definition of at least, I really want to avoid getting in the business of projecting ranges. I think that we continue to stand by our forecast that we made for the year of at least $4.55. With respect to 20 percent, does 25% loan growth mean, no, we really mean around 20%. Honestly in this marketplace I learned long ago that one cannot precisely forecast a loan growth. It depends on the nature of supply and demand at the moment that we do our originations but we believe that growth will be in the neighborhood of 20%. With respect to the auto finance business, the auto finance business is doing incredibly well. In fact, we have incredible amount of energy and excitement about the auto finance business. It's continuing to grow in both the sub prime and the superprime business lines. On balance sheet you are going to see going forward a more significant mix change upmarket because I think we are going to hold more of our origination on balance sheet as opposed to selling as much as maybe we did in the past as the economics continue to improve and our scale improves. So, therefore, I think you will see some mix shift upmarket. But the real point is, the originations, both sub prime and superprime, continue to be very strong. We will continue to do some selling of auto loans. We have a forward flow agreement on the sub prime side and we will continue to be opportunistic in our choice on the sales on the superprime side. It's attractive either way we look at it. The credit picture which is certainly the one that I think when you look at the picture it catches your eye, Bob. Actually I didn't give you the itemization but I will actually give you a striking itemization right now which is that of the charge off difference versus last year, the denominator affect is 121 basis points of the 80 some basis points, I think it's like 88 or something like that, basis points of increase in the charge-offs. So the denominator effect is more than 100% of the effect. The numerator effect relative to last year is actually a net positive. There is a worsening from severity and some positive impact of the going somewhat upmarket. But I really say somewhat upmarket because up until this quarter the vast majority of what we originated upmarket we sold, therefore there was a lot of upmarket originations but not as much of a portfolio shift. You are going to start seeing the effect of that portfolio shift going forward and that will continue to have in fact quite positive effects on the credit metrics going forward. The other big part, Bob, of the story in auto finance is profitability which is very strong and I want to remind folks that we took a very conservative approach of putting all of our securitizations on balance sheet, therefore, we had a lot of allowance build that led to losses over time and we've now been able to really hit our stride and grow the business and grow our earnings. So it's a very positive story.

Next question, please.

Your next question comes from Michael Hodes with Goldman Sachs.

Hi, good afternoon. Just focusing in on the managed loan growth expectation, it seems likes there's an implicit deceleration moving into the fourth quarter. I was wondering if you could elaborate on that. I think managed loan growth of around 20% equates to a sequential increase of somewhere between 4 and 4.5 billion. Is there somewhat of a slowing or less emphasis on SuperPrime Cards? Maybe you could just elaborate.

Michael, I think that the way we look at it is there will still be a very strong quarter of growth. I think a few planets aligned in the third quarter to lead to a very significant amount of upmarket growth that what you had is an aggressive marketing by Capital One of a variety of programs, competitors happened to back off right at that time which we sort of saw after the fact and also interest rates kind of surged upward right at that period of time and I think some customers stepped forward like they were going to a sale. It was their last chance to get in on the very low prices. I think our view is that we will continue to have strong growth upmarket and continue to have strong growth in all the other parts of our business where the net effect of a good solid quarters growth.

Okay. Should we expect, just given the move in interest rates, somewhat less emphasis on the 499 offer?

Yes.

Thanks.

Next question, please?

Your next question comes from Christina Clark with Banc of America Securities.

Hi, thanks a lot. I was wondering if you could elaborate a little bit more on the competitive environment right now in superprime and prime? Has it materially changed this quarter? I know you just commented a little bit on some of the competition backing away but you are obviously growing a lot faster than some of your bank competitors and I was wanted to see what you're seeing out there from them.

What we are seeing is most notably from Citibank and Bank One. Now I say most notably because they were the biggest aggressors, in a sense in the market place, so therefore changes with respect to Citibank and Bank One are more noticeable to us. Both of them seem to have pulled back pretty sharply on mailings. MBNA is mailing strongly still, Capital One though has moved into a position of being, by quite a significant margin, the number one mailer at least that we can see through our few months lag data through the summer. anecdotally it still, I think, feels like that at this point. But I don't want to paint a picture of anything other than a still very competitive marketplace. I think that we continue to make conservative assumptions and we continue to be very careful to originate products that will be resilient in a competitive marketplace.

Thanks a lot.

Thank you, Christina.

Next question, please.

Your next question comes from Chris Brendler with Legg Mason.

Good afternoon, hi. I'd like to follow up a little bit on the competitive environment. Can you give us any more detail, I'm surprised it hasn't been asked yet, but how much of the 499 made up of your growth seemed to be a pretty predominant part of your offers and then a more strategic philosophical question related to that is it seems like some of your bank competitors have at least tried to come close to your level of pricing there, but some of them are using floating rate offers, variable rate offerings. Can you just give any color or commentary on what we should expect or what your philosophical approach is to fixed rate versus variable rate, obviously your fixed rate cannot be fixed forever but how do customers respond and what is the attrition risk when you are using a variable rate offer versus a fixed rate offer? Thanks.

Okay. Thank you, Chris. First of all, 499 certainly was the most salient thing that Capital One did because in addition to being part of a lot of solicitations it was also plastered all over our television ads. The reality is actually the upmarket growth came from a variety of sources only one of which was 4.99% and there was very important contributions also from our Miles One program which I mentioned as well as balance stimulation. Quick comments on those, Miles One is really hitting its stride at Capital One. With the airlines going bankrupt or nearly so, with the changes that the airlines are doing to people's frequent flyer programs this is playing right into our hands with respect to our offering of any airline, no blackout periods. So that one is on a very positive roll right now. The balance stimulation programs which are really the essence of account management IBS, also has done very well and I think the reason also that it did particularly well during this period of time is that we see not only balanced growth from our new originations but also we've always found that being a fixed rate player in general our existing portfolio sees beneficial balance growth at times when rates were to move up. So all of those things work together. Now, with respect to fixed rate and floating rate offers. We have for years looked at the trade-off between those and we've been sort of struck by the sophistication of consumers in some ways of being able to see through one's attempt to pass the yield curve risk on to them and that we have found in general that it works better on all in all to do fixed rates and we like some of the long-term dynamics associated with that and then on the other side of it work to do the best we can to hedge that portfolio. There are certain shapes of the yield curve where it no longer is the wisest thing to really go out solely or predominantly with fixed rates and we continue to look at trying to optimize that choice. So I would not characterize Capital One as wedded entirely to fixed rates.

Next question, please.

Your next question comes from Mike Hughes with Merrill Lynch.

Thank you. Rich, you didn't say much about sub prime and I know you guys definitely had a superprime bias on this quarter. What kind of rough percentage of superprime originations will you expect over the next 12 months?

Mike, I can give you just a general, repeat sort of the general thing we've been saying for quite sometime. Last year we gave you with respect to a particular definition, it wasn't necessarily our definition, that we had used in the past but a definition of sub prime and our mix of sub prime and the closeness of that mix to the industry. We also have consistently said since then that half the margin, our growth will involve a lower rate of sub prime than the average within our portfolio such that there will be a gradual decline of sub prime in our portfolio. Not to be confused by the perception that a few have had that we are in fact walking away from the sub prime business or anything else. So I think that we continue to have the very same views that we have had all along, that the right move for Capital One is to do a balanced mix with one that on average will bring our sub prime mix down gradually on the portfolio. What happened in the quarter is that this gradual effect sort of got accelerated in the quarter by the very strong performance on the upmarket end of the business.

But does that mean dollars of marketing got shifted to super or does that mean that your response, et cetera, was so strong to super that it just worked the same dollar effort that you had planned at sub prime.

There's a little bit of everything. I think primarily it was just a superprime story in the quarter. And frankly, in that business more than most, we have found it's kind of about windows, when supply and demand are right we move. If you look back at the long history of Capital One there's been a lot of volatility in that growth. That's not an accident, that is really our moving at the right time with the markets. For this third quarter is the superprime story. But the overall story for Capital One continues to be the same story we've been saying for a number of quarters.

Next questions, please.

Your next question comes from Vincent Daniel with KBW.

Thanks, guys. I don't want to beat this sub prime horse, but if I take the fact that your provision is formulaic and if there's a continued mix shift you would actually lower the provision or, not provision as much in 4Q, but you are expecting an upward allowance pressure that would seem by definition that you expect the percentage of non-prime receivables to increase in the fourth quarter. Is that accurate or am I thinking too much?

Vince, I will take that. It's Gary. There are actually so many different contributing factors to the allowance that you really can't suggest that by looking for upward allowance pressure that that's all coming from something at the margin. In fact, the largest impact on the allowance is coming from the performance of the existing portfolio. And to the extent we've already enjoying a very significant improvement in the credit quality in the portfolio and perhaps it may be difficult to see moves of that kind again going forward, any growth in the portfolio across the credit spectrum is going to put some upward pressure on the allowance. Lastly, there has been also movements in the share of loans that are being securitized which will also change the overall aggregate balance of loans against which we need to allow. So I would look at the allowance pressure in the fourth quarter as really being more part of a long-term move in the credit metrics and some of the seasonality rather than the marginal shift that we may experience in new loans put on the books during the quarter.

Thank you.

Next question, please.

Your next question comes from Michael Cohen with CIBC World Market.

Hi, guys. Just wondering if you had, as you set loan growth targets and as you look out for 2004 and beyond if you maybe thought about a slower loan growth rate with a higher percentage of sub prime whereby your ROE might be faster than your loan growth. Can you comment on that where you would be building capital, obviously?

Mike, you are asking, are you suggesting that maybe we should grow slower and do more sub prime so in a sense grow the sub prime mix which therefore by the argument of the relatively higher profitability there in a sense build capital along the way, is that the suggestion? Michael, you may have hung up but I, I will respond to what I think is your question. Financially that would be, purely from a financial perspective and defined in terms of earnings and capital, that would be the better move. I think in terms of where we are trying to go as a company, how the company is going to be valued by virtually every constituency out there, and also in the end to leverage the opportunities that exist far beyond sub prime business. I think that strategy would not be in the best interest of our shareholders or, better put, the strategy that we are proposing I think in the long-term is going to be more in our shareholders interests and we feel very good about that. I appreciate the spirit of your question, though, that there still is a lot of positive things to say about the sub prime business and it is one of our hopes that some day folks will look back and when all the dust settles in the sub prime marketplace say that Capital One really did what it said and performed very effectively through that marketplace and hopefully we can build more credibility over time with all the markets with respect to our sub prime business, which we will continue to grow although at a lower rate.

Next question, please.

your next question comes from Ed Groshans with Moors and Cabot.

Good afternoon, or good evening. I want to take more of a systems approach here. I am a little confused as to some of the inconsistencies between what was been given out as guidance and the performance. Given how Capital One is consistently touted the IBS systems and it's technology, I am just wondering where the disconnect is. Specifically I had numerous conversations concerning higher provisionings in the third quarter and that actually came down, allowance building which went down, charge-offs I think the guidance was for low sixes and we're in the mid fives. If you could just address some of those issues, please?

Sure, Ed. Let me address that directly because I think you may be looking at two different aspects of things that drive the allowance. One is the growth that is incremental and the other is the performance of the credit that's already on the balance sheet. And, remember, that when we take a forward look at expected losses which are represented by the allowance against the on balance sheet loans, we are building that model based on the delinquencies that we are already experiencing. And so we always have to look forward based on the experience we've had and the experience of the last three months that we have experienced at Capital One and throughout the industry with declining delinquencies causes us to make forecasts going forward from this point on that suggest the likelihood of lower losses on our entire book of business. Now, truly at the margin we are also adding additional loans plus add 4 billion or $5 billion worth of loans of which maybe two or 3 billion may stay on balance sheet and the mix of that business will have an effect certainly on the allowance going forward but the impact of a very substantial improvement in the credit metrics on the $30 billion worth of loans already on the balance sheet, which really one can't speculate on until you experience it, is leading to the kind of experience we've had this quarter. When we said last quarter that we expect there might be some growth in the allowance that's because we saw growth in volume and that's what we've achieved. What we did not speculate on was what the delinquencies would do and now that we have experienced them we have to build those into the model going forward. So every quarter we have to use the formulaic approach and come up with what the accounting industry will agree is a fair estimate of losses going forward.

Next question, please.

Your next question comes from Moshe Orenbuch with CSFB.

Thanks. Just wondered if you could talk a little bit about the timing of revenue, either per account or per dollar of assets that you are adding. I noticed that the ending asset base was several percentage points higher than the average and maybe talk a little about if fees that would be generated from your new accounts.

Moshe, the timing of revenue, the general principle, this is my most significant guidance that I've given over the years consistently about revenue timing. Generally that which is sub prime tends to have very strong early, very strong pay back, quick pay back and strong profit and revenue characteristics right away. Those annuities decline over time sometimes as the charge off of the portfolio come to bear on the business. The upmarket stuff is the exact opposite. One tends to pay a high cost to originate the account, in some cases teaser rates are used, which we then have to go through that period of time, and they tend to be, therefore, back loaded and more long-term in their returns. We have consistently tried to manage the business to a balance of the more early return and the more later return types of businesses. Speaking specifically of fees, Moshe, the fees are not a strong part of the revenue structure in the very upmarket businesses. The net interest income is primarily the driver there and, but I think what we will see in this business is that we are booking business that has a strong revenue characteristics over a longer period of time at Capital One but we will see less immediate return from these than some of the other investments might have done.

Next questions, please.

You next question comes from Bruce Harting with Lehman Brothers.

Hi, if the deposit costs were expressed the same way as the other funding sources relative to LIBOR or treasuries and I'm trying to find that graph, but it's pretty late in the presentation, Page 21, would they be showing just as much typing as your other funding sources and then can you talk about if rates start to go back up which funding sources you will move toward or will you keep the same mix in terms of favoring securitization versus deposit funding? And given the continued low cost of funds on deposits, what are you finding out in the marketplace in terms of sensitivity and do you have any more room to lower your deposit funding costs? Thanks.

Well, thanks, Bruce. On the cost of deposits, certainly they have not had the kind of decrease in spreads that we've experienced with many of our capital market transactions simply for the reason that those spreads never actually moved up in the way that our capital market funding channels did. So throughout the course of this year and in fact through most of last year the level of deposits stayed relatively constant. The rollovers were constant. There was not a significant price impact on those deposits. So they have stayed relatively stable throughout this time period. Therefore, there's been less room for improvement other than the fact that the maturity of those deposits has been lengthening substantially. It's something we have done quite deliberately in order to try to again help manage interest rate risk to match the kinds of assets that we are adding to the balance sheet and so forth. By in large the deposits have been extremely stable both in terms of volume and rate and that is a level that obviously we would like to improve even further but we feel that the stability has been very welcome. In terms of what might happen overall to our funding mix should rates increase, it's really hard to pinpoint any change in the channel of funding that we would use. I think we would continue to use the full spectrum of our funding techniques regardless of where rates go. You'd find quite a lot of stability in the securitization level. In fact over the course of the last three or four years throughout the previous cycles of interest rates. So nothing in what we've seen thus far would suggest a major mix change because of interest rate movements, so we'll continue to try to maintain a good amount of liquidity, try and pick our spots on the curve, pick our spots in terms of the types of securities and pick our timing to try and get the best overall performance.

Thank you. Next question, please.

Your next question comes from Richard Shane with Jefferies.

Hi, guys. I'd like to sort of revisit the fourth quarter guidance a little bit. Obviously the gap between guidance and Street expectations is widening, particularly given the strength of this quarters results. Is there some event or, what's driving that widening gap, is it a function of there is some potential charge that is coming, is there an increase in marketing expenses? What are we missing?

Thanks, Rick. It's kind of hard for to us answer that question other than to say that with one quarter left you are getting more and more certain about the outcome and we continue to look at the obvious things that are out there in the course of the fourth quarter during which seasonality tends to have a lot of impact on the key metrics that drive the income and we simply feel that having stayed over the course of the year with an at least guidance, we are talking about at least 4.55. Unfortunately I haven't seen any estimates from the Street that start with at least and we are trying to give you a metric that we are willing to stick with over the course of the year, you are taking into account the major changes as we take a look at the fourth quarter and I take from your question and the others that we've received that you believe we are two low for a best guess. And hopefully by just repeating the items that might take us from what you might expect to what would be an at least number you will understand why we believe it is prudent to keep some room in there for the uncertainties that come along with any fourth quarter and that's the seasonal bump in charge-offs, it's the fact that the allowance build is going to be affected by seasonality and delinquencies. We've already experienced some major positive move in delinquencies that may not continue. We do expect asset growth over the course of the quarter and at the end of the year we will look back and say, we certainly met our at least target. If it is above that it is because some of these other things haven't occurred. But it is purely the fact that we have an at least philosophy about giving you guidance and we will try and explain to you the difference between where you might be at and what you think could happen if we got to the at least number. And we will try and keep you posted on what those things are as we see them happening.

Thank you. Next question, please. This will be the last question, if you would, please.

Your final question comes from Caren Mayer with Banc of America.

Hi, guys. Thank you. Gary, we are happy to have you on but I think that answer was maybe more confusing than the guidance. Paul, I just wanted to ask a question. I unfortunately disconnected myself at one point but I don't think you've addressed this. Looking at your other expenses, it was higher, I know you said higher salaries, you had some expenses for consolidating facilities, I didn't catch the third reason but as your mix shift changes we've been looking at your kind of expenses on a per account basis and maybe that's not the right way to look at it. Do you still have an expense dollar per account guidance for us or as your mix shift changes and you're having kind of higher balances for account, should we be thinking about that differently and then Gary, if I could just clarify from your last statement when you said if you do better than the at least, at least, you guys have provided that as a floor, you haven't told us at most, but when you said if you do better than the at least you don't mean better than 455, you're just saying if you come in way ahead of kind of whatever that guidance might imply. I just want to make sure that I understand that you still mean that to be anywhere above 455. Thanks.

Thanks, Caren I am going to take both of your questions. Let me start with the latter one first and I responding, you'll remember, to a question that asked why we are so low and I was simply trying to indicate that our at least number is lower than what we are hearing from many folks on the Street and I was simply trying to reconcile that, yes, 455 is a floor, it's an at least number that we feel comfortable with and I was just trying to give you some of the developments that might occur that would allow us to reach a higher number if they don't happen. If we don't see the seasonal effect on delinquencies, if we don't see the seasonal bump in charge-offs then clearly we would expect to see something above 455. So hopefully I have made that rather clear. As far as of the operating expenses go, you are absolutely right, Caren, I would like to thank you for noting that not only as we move upmarket and have higher average balances in our accounts but also the diversification into many other businesses. So that the cost of booking and managing an account, for example, in the auto finance business, is significantly different than that in the credit card business. So as we diversify our business both through the new business lines as well as going upmarket, the cost per account may become less insightful as a view on our overall expenses. But what we believe will occur, we've seen a modest increase in operating expenses this quarter. You correctly remember there were a number of one time occurrences. There had been some benefits in the first two quarters in the area of salaries and benefits that did not repeat. We've had the consolidation of some of our properties. We've also of course had to bear the cost of booking all these new accounts that have come in during the course of the third quarter. We would expect to see a modest increase in operating expenses again in the fourth quarter, again as we continue to consolidate, as we continue to book new assets. So we believe we will come in with just a modest increase in operating expenses and perhaps see costs per account stay around $80 through the next quarter. But going forward and taking you up on your offer to start looking for new metrics, certainly if we took a look at our overall level of cost against revenues and or assets we believe you would get a better measure of our efficiency, we think that as we get to scale in many of our businesses that we will show the benefit of the diversification strategy and in fact we hope that you will look at our business through the lens of different operating expenses ratios.

Thank you very much, Gary. At this point I would like to just pass it back to Rich for some final words.

I just want to say I appreciate all of you joining us today and we look forward to seeing you at our investor conference next week in New York. Thank you.

Thank you very much.

This concludes today's Capital One third quarter earnings conference call. You may now disconnect.