FOOL CONFERENCE CALL SYNOPSIS*
By Dale Wettlaufer (TMF Ralegh)

Capital One Financial
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2980 Fairview Park Dr., Ste. 1300
Falls Church, VA 22042-4525
(703) 205-1000
http://www.capital1.com

ALEXANDRIA, Va., (July 20, 1997)/FOOLWIRE/ --- On July 15, 1997, Capital One Financial reported second quarter, fiscal 1997, earnings results. On the conference call to discuss the quarter's results were Richard Fairbank, Chair and CEO; Nigel Morris, President and COO; James Zinn, CFO.

EARNINGS. On May 14, we indicated in our 10-Q for the first quarter that we did not expect to hit the $0.66 consensus EPS estimate for Q2. Instead, we indicated that we expected earnings per share to be in the mid-$0.50 per share range. Actual earnings for the quarter were $0.58 per share, slightly better than we expected. This result is up from $0.57 per share we earned in Q2 1996, but down from $0.63 from Q1 1997. Our earnings were effected by higher than expected competition, which reduced response rates and increased attrition in the balance transfer segment, and by lower than expected delinquencies, which reduced late and over-limit fees. In response to these challenges, we have taken a number of steps to improve our financial performance and have revised our earnings targets for the rest of the year.

DELINQUENCIES. Delinquencies this year are lower and have stayed lower longer than we expected. The reported delinquency rate for the second quarter was 6.33%, compared with 6.41% in the previous quarter. Although this 8 basis point decline in encouraging, we still expect higher delinquency rates in the second half of the year, as seasonal patterns suggest. If we see a moderation in delinquency rates that is greater than what we would expect from the seasonal patterns, than we would expect to see some moderation in our charge-off rate. Charge-offs increased in the quarter 54 basis points, to 6.38%, from 5.84% in the first quarter.

ACCOUNT ORIGINATIONS. We again had a very successful quarter in new account origination. We grew by 673,000 net new accounts in Q2, bringing total accounts to 9.8 million. This was the second-largest quarterly growth in accounts ever by Capital One, and represented a 30% annualized rate of growth. This growth is significantly fueled by the success of the second generation mass customized credit card products, which we target to specialty niches. While there are many variations, as a general rule these products tend to have lower credit lines and lower balances, but higher returns than balance transfer originations. The account growth, even without significant corresponding loan growth, is really a key engine to fuel our future profit growth because of the dynamics of profits that are driven by accounts, rather than by balances, primarily in the second generation products.

We increase our managed loans by $130 million, to $12.7 billion at June 30, 1997. The loan growth was somewhat lower than we had anticipated at the beginning of the quarter, due to greater than expected mailing intensity by the industry in the second quarter. This led us at the line of scrimmage to reduce our balance transfer mailings and to shift our mix more toward lower balance, more profitable second generation products. The competitive intensity also led to somewhat higher balance attrition than expected.

NET INTEREST MARGIN, EXPENSE LEVELS. Our net interest margin declined to 8.30% from 8.83% in the previous quarter. This was in part caused by the addition of some low introductory rate balance transfer loans that replaced the increased attrition of higher priced loans resulting from the higher mail solicitation volume that we infer is going on.

Marketing expenses for the quarter were $45 million, compared with $54 million last quarter and $43 million in the year-ago quarter. We continue to see strong growth opportunities, particularly in second generation products, despite the intense competitive environment. We expect that our total marketing expense this year will be very close to the roughly $200 million level for 1995.

CREDIT QUALITY. The big question we're all asking now is, "has the industry turned the corner on credit risk?" As you can imagine, this question has generated quite a lot of heat here at Capital One, and out bottom line is that we're just not sure yet. It is difficult to point to any major change in consumer behavior or in the economy that would halt the rise in delinquencies or charge-offs. Early estimates for mail volumes for the second quarter, which is the best proxy for industry supply, suggests that volume increases continue unabated. Our May and June attrition rates are consistent with high levels of industry mailings for that period. Despite the bank's willingness to supply credit, the consumer continues to rein in their willingness to take on new debt. May growth in consumer credit was only a seasonally adjusted 2.9%, and consumer installment debt was up only 6% from last year. VISA outstandings fell $6 billion in the first quarter, and only 2.5 million VISA accounts were added over that time period. Additionally, the Weather Vein debt service burden remains flat at 17.1% in the first quarter of 1997. Industry delinquency rates edged up in the first quarter, from 6.83% to 6.88%. This is VISA-only data, as MasterCard has not yet reported. VISA chare-offs increased much more dramatically from 5.71% to a record 6.31%.

Turning to our situation, with only $130 million in loan growth this quarter, our 30-day delinquency rate actually declined for the first time in eight quarter, by 8 basis points, from 6.41% to 6.33%. While we had anticipated, based on seasonal patterns from previous years, that the second quarter delinquency rate would be the most benign of the year, the depth and the length of the delinquency reduction exceeded our internal estimates. We've seen this effect through all products through June, a time of the year when delinquency rates often begin to increase, but the positive effect seems to be more pronounced in certain second generation products.

Though lower delinquency rates, versus projections, lead to short-tern earnings pressures, we've never met lower delinquencies that we've not liked. Lower delinquencies today portend very well for charge-offs tomorrow. However, I do want to throw out a few words of warning in making one-on-one extrapolations. We've been noticing the relationship between delinquencies and charge-offs has been changing over the last two or three years for the industry. Delinquency rates are rising at a lesser rate than charge-offs. There are several potential explanations. Increasing bankruptcies (20% of industry bankruptcies do not come from delinquent accounts), more debt collection activities, and perhaps higher late and over-limit fee rates could cause careless, but low-risk, customers to be more diligent than in the past, thus suggesting that delinquencies are not having a proportional impact on charge-offs.

Our charge-off rate increased along with expectations for the second quarter, from 5.84% to 6.38%. We are seeing increasing bankruptcy pressure. Bankruptcy as a percentage of our charge-offs has increased from the high 30% range to the low 40% range. As we look into the third quarter and the remainder of the year, we continue to anticipate rising delinquency from emerging seasonal effects and from the increasing shift to second generation products. We are also projecting that our charge-off rates will continue to increase. Both measures will be significantly impacted by the degree of asset growth that we elect to undertake.

OPERATIONS. On the operational front, we are seeing our recovery efforts show great progress, and our collection departments are improving all the time in efficiency and effectiveness. Our information based strategy (IBS) platform allows us to surgically re-price our portfolio to absorb risk. In the third quarter, we will continue to implement time and tested risk-based pricing programs. Additionally, we have increased our late and over-limit fees to $25 on large portions of our portfolio, effective July 1. Since virtually the time of the spin-offs from Signet in 1994, we have been investing in our infrastructure to allow us to pursue our rapid account growth rates and our development in new businesses outside of the U.S. credit card business. We have developed a modular, flexible, and high quality platform. The investment is beginning to pay off in areas beyond flexibility and service. It's beginning to show up in productivity and efficiency. In 1997 so far, we've added more than 1.2 million accounts - 537,000 in Q1 and 673,000 in Q2. In the last quarter, our headcount was flat to down, and our operating expense actually fell from $159 million to $157 million. Therefore, our cost to service an account has fallen by 9% over the last quarter. IBS is now being deployed across all parts of our operating infrastructure to maximize profit per account and to manage expenses. We do feel good that our focus on infrastructure and process management is yielding strong returns.

JAMES ZINN, CFO. Net interest margin dropped 53 basis points from a very high 8.83% in Q1, which is generally speaking our highest quarter on margins. The majority of this decline was expected, as the first quarter benefited from $900 million in re-pricings. The actual outstanding balances on file decreased. The second quarter decrease was primarily impacted by the level of underlying growth and introductory rate balance transfer business, and then to a lesser extent, to declining late fees and attrition of some of the loans at different price points generally adverse to the margin throughout the file. In the second quarter, we did re-price $800 million of introductory rate loans. Our outlook for the margin is that it will stay in the low 8% range during the remainder of the year, based on current growth assumptions, as we'll re-price $700 million this quarter and about $400 million in the final quarter of the year.

NON-INTEREST INCOME. Our non-interest income grew by $12 million in the quarter to $169 million. This growth rate in absolute dollars is favorable, but a little bit less than it has been in prior quarters. The category includes annual membership fees, interchange, over-limit fees (which were down), cross-sell income, other fees collect. The annual increase rate we're at, which is about 30%, continues to reflect out new product initiatives and further application of our strategies. This revenue category represents about 5% of our average earning assets, a level which we expect to be steady, if not upward. The positive trend will continue as we focus on fee-oriented products and then as the non-interest income line begins to see the incremental impact of both this new account growth and the pick-up from the application of Statement #125, which we now find the amounts of which to be material and which will requite recognition in the second half of the year.

BALANCE SHEET. We maintained our on-balance sheet allowance at $118.5 million. This caused a slight decrease of the on-balance sheet allowance versus the loans, to 3.27%, down 10 basis points from the first quarter, but up from 2.73% at the end of the year. Our allowance remains very strong, on a percentage basis, in comparison to others in the industry. Finally, our capital to managed asset ratio remains strong at just over 6%, and on a reported basis, at 14.91%. Our board approved a two million share general stock buyback to offset the impact of shares to be issued under our dividend reinvestment, associate stock purchase, and options plans.

EARNINGS GUIDANCE. We are projecting earnings for the full year to be up 5 to 10% over the $2.30 EPS we reported last year. Our earnings estimates are particularly sensitive to the pattern of delinquencies, as we have talked about. We assume a return to increasing delinquencies. If delinquencies do not increase, it will put more pressure on short-term earnings but should significantly benefit us next year. We are disappointed that we are not going to be able to deliver earnings growth of 20% this year. The challenges of the credit environment, compounded by the timing difference between revenues in the form of late and over-limit fees and charge-offs, have caused us to be unable to achieve our original earnings target for this year. We do take some comfort in the fact that, in the face of a very tough environment, we continue to see earnings growth and we continue to uncover new and exciting growth opportunities.

We expect to continue the strong growth in the very profitable second generation mass customized products with pricing and credit line structures designed to withstand turbulent markets. While we will continue to focus on second generation opportunities, we will continue to pursue opportunistic growth in balance transfer solicitations, as well. This will be quite dependent upon market conditions, particularly with respect to supply at the time. We will also continue to maintain our quiet pursuit of expansion beyond the credit card business into other industries, both financial and non-financial, where we continue to see promising opportunities. As always, the strategy at Capital One remains consistent.

The outlook for 1998 is significantly dependent on the credit and competitive conditions in the industry that develop over the next six months. As the industry outlook solidifies, we will be able to discuss the earnings outlook for 1998.

QUESTION AND ANSWER SESSION. The fundamental challenge that we and everyone else in the industry faces is the increasing rise in charge-offs. The steady rise that we've seen for a number of quarters now puts significant pressure on earnings that requires very significant increases in revenues and/or significant reductions in expenses. What we saw this quarter was a moderation in delinquencies, and therefore, a moderation in late fees and over-limit fees that was a much more significant moderation than we had expected. Give the transformation of Capital One, moreso than any other credit card company, from first generation to second generation products, we are particularly sensitive to situations where delinquencies are lower than expected, because that means in the short term our revenues will be lower than expected, and that is the most significant dynamic in our second quarter results. The late fees show up in our net interest margin and the over-limit fees show up in the non-interest income account. Collectively, they fell well short of what had expected, and to the extent that delinquencies continue to be more favorable than we expect, we will in the short term continue to carry this burden of having the revenues shortfall strike earlier than the reduction in charge-offs.

With respect to the number of accounts not leading to higher asset growth, again I really want to stress that the nature of second generation products is that they generate virtually no assets to speak of in the quarter of booking, because you book an account with a relatively small credit limit and the nature of the balance ramp within those accounts tends to be the slow traditional way instead of booking a big balance all at once, which we've always seen in the balance transfer business. That's not to say that we didn't book any balance transfers at all. We did continue moderate growth in the balance transfer business, which was essentially offset by higher than expected attrition. The trading of an introductory rate asset for a higher-priced asset is another thing that put pressure on our margins. As we look forward to rest of the year, a big question that looms is "will the delinquency trend continue or not?" We are hoping with great passion that the moderation in delinquencies continues, although this will be the thing that puts the most pressure on us for the second half of the year. Not knowing which way that delinquency situation will evolve, we are taking the more prudent scenario, which is that delinquencies will increase at least moderately. You still have the situation which we project conservatively that charge-offs will continue to rise, particularly in the third quarter, but also in the fourth quarter, remembering the historical patterns that seasonal delinquency easing does not necessarily translate 1-for-1 into dramatically better charge-offs at the end of the year. All told, that is what gives us our more cautious outlook for the rest of the year.

We see ourselves beginning to move the needle on expenses. In the last two or three years, we've invested tremendously in voice-response units, imaging, technology, new systems and human talent. Right now, we feel that we're really on par with the best of the industry in terms of the way we manage our infrastructure. With that infrastructure now in place, we're able to drive hard for productivity gains, really moving the efficiency needle, and at the same time not in any way sacrificing flexibility and entrepreneurism. As we look forward, we are looking for continued gains in efficiency and productivity and we're being very careful to make sure that we don't in any way undermine the franchise. We're really proud of what we've done here.

More and more credit card issuers are chasing the same customers. The fact that the overall demand has not expanded and outstandings growth is slowing is consistent with more mailing, if you believe that it's the same people who are going from issuer A to issuer B. I think that's what we're seeing. The vast proportion of the mailings that are going on that we from our mail monitor databases are balance transfer-oriented. I think we're seeing a lot of issuers are taking the benefit of the FASB 125 gains and coming into the market during the second quarter. I think that's impacted our attrition rates.

On the FASB 125 gain projected for the second half, we have done preliminary calculations. I will say it will be a significant component of revenue in the second half of the year, in the low double-digits. We continue to conduct a dialogue on the changes that occur on those assets. We'll probably have some more disclosure in the 10-Q.

The absolute dollar amounts of late and over-limit fees were down from the first quarter, and our expectation is that we're going to see a tick up with those in the second half of the year. We are for certain products increasing that fee amount from a $20 to a $25 level, in-step with some of our competitors. As a percentage of revenue, it was consistent with the first quarter, to slightly down, given the similarity of all the numbers.

We have hypothesized that there is inevitably should be a relationship between higher fees and attrition. We have not, in anything that we can infer from our data, seen much of a relationship. One of the reasons that this part of the pricing structure is the one that is being increased is both that it tends to be a form of risk-based pricing but also tends to be the component in the pricing structure that tends to have much more inertia associated with it. We're still assuming that there's going to be some effect; we're kind of surprised that we have not specifically observed it to date.

The people who are taking away balances are issuers that have fees just like ours. The industry is moving to $20 to $25 being down the fairway, and many credit card issuers are now in the high $20s, actually. The people who are doing the most mailing are taking the balances away.

With FASB 125, the inclusion of late fees was determined over the last several weeks to have to be included in this calculation - this is through deliberations we've had with our accounting firm as well as their conversations with the Financial Accounting Standards Board. As we go to pick those amounts up and as they represent a significant portion of our future cash stream on securitizations, they tip the scale and we need to go ahead and book the amounts. We did not have any impact on our results in the second quarter or the first half of the year.

There was no addition to income from increased recoveries, or sales to do date, from previously charged-off receivables. We do continue to explore the topic somewhat actively internally, though we haven't formed a conclusion on when and if we might be interested in that. We do consider that to be among the options as we look out over the remainder of the year.

The plan for the second half of the year is for FASB 125 gains to enhance net income. As we look at the incremental income from FASB 125 for the second half of the year, we remain opportunistic as to how we'll use that income either in the results that we have targeted for ourselves, in the 5-10% EPS growth range, or the potential to build reserves elsewhere in the company. I think it's fair to say that the gain will be in the 30-35 basis points range of on-balance sheet loans over a full year, which shows a lower level of dependency on that income in our expected results. We'll decide how we use it as we progress through the second half of the year.

We're seeing the sale of charged-off accounts in the industry. We're seeing very large and capable recovery shops that are now buying this paper and doing a pretty good job of delivering on it, from what we can see. We are going through the process of looking at whether or not it's worth more to us or to somebody else, and of course, if we can sell those assets for more than they're worth to us, then of course it's good business for our shareholders, and we're in the process of thinking about that.

Growth rates for VISA receivables over the last twelve months: June 95-96, 22%; September 95-96, 18%; December 95-96, 14%; March 96-97, 11%.

The growth in accounts for the quarter was not matched by growth in assets because of the characteristics of second generation products, which are getting the bulk of our marketing dollars at this point. These have substantially lower credit lines than balance transfer-based products. The percentage of revenues that comes from the net interest margin, particularly from the paying of an APR, is a dramatically lower percentage on those products than you have in the high asset products. We get the bulk of our revenue from late fees, over-limit fees, and annual fees and cross-selling revenues, and the wonderful thing is, that the intensity of fee revenue means that the company doesn't need a big asset to generate that, and therefore, we can limit the overall asset exposure the company has as we solicit into the headwinds of a very challenging credit environment. Again, what we're able to do is generate primarily fee-based revenues from these accounts. Therefore, counting up the account is really the key measure for the second generation products, as opposed to the asset growth, which is the key measure for essentially any player in the balance transfer business.

The key driving assumptions to square account growth and increases in pricing of fees are a continued ramp in charge-offs not being offset higher levels of revenues from late and over-limit fees, as we had projected earlier in the year when we had the same pricing levels that we are re-pricing to now, but a later and lower trajectory with respect to those delinquencies. Also, we have revised our assumptions about attrition as we have gone away from our early hope that the attrition patterns in the third and fourth quarters of last year, which followed in a very strong correlation with the reduction in supply, as we are seeing the return of supply and attrition levels to the greater intensity of the past couple years, we have revised those assumptions and that also takes its toll on earnings for the second half of the year.

The non-balance transfer products accounted for the overwhelming majority of account additions in the quarter.

Since attrition is a very important baked-in phenomenon to any portfolio of any balance transfer assets, we start each quarter by spotting ourselves a significant level of attrition that needs to be made up through asset originations of all types. Any player that is in a transformation, as we have been over the last couple years, towards second generation., low balance products away from as much intensity on the higher-balance balance transfer business, will tend to see this disconnect between account growth and asset growth.

There was a slight different between the provision for loan losses and the level of charge-offs. That was really a by-product of securitization and held-for-sale accounting. Whenever we post accounts as available-for-sale as we did in the quarter, we actually take the charge-offs on those a bit in advance so that the reversal of that provision last quarter is what's causing the difference, and you will not see the beak-apart from us on the relationship of charge-offs and provisions over time.

We have focus groups scheduled in the very near future across all of our segments. At this point, the key thing to do is to handicap consumer behavior in a price and non-reprice mode and continue to watch the patterns over time. Right now, the phenomenon is early. We don't see a lot of impact so far, but that is not to say that over time we won't see a greater impact on consumer behavior. This has to do with handicapping the direct impact of a fee change versus another group having no fee change. While we haven't seen that effect in our recent tests, that's not to say that there isn't some larger secular trend going on with consumers in general as they become more sensitive and knowledgeable about how to use credit card products and therefore change their patterns of delinquency. There's also a lot of transformation going on in the collections industry. At Capital One, for example, we're constantly balancing the nature and amount of energy spent in collection against various buckets of delinquencies, trying to figure out what is the optimal way to collect. Any of those changes can have consequences on the relationships between delinquency levels in one bucket versus another. Again, we try to monitor that as best we can. All of these things can have some modest changes. I think, though, if we continue to see level delinquencies for some time in the future that that will really transcend the usual very dramatic effects that happen at this time with the ending of seasonality.

Expectations for securitization for the quarter are for one deal per quarter of $500-550 million, more along the lines of our historical trend of transactions. The driver to the recognition of incremental income in the rest of the year is not so much the incremental deals we may do but the picking up from here into early 1998 the accounting result from applying FASB 125. It's our going into that accounting that will carry this into the second half and into early 1998, not the incremental deals. That'll be taken from existing securitizations as we substitute receivables from there, as well.

* A Fool conference call synopsis represents an effort to highlight the salient points of a conference call and should not be taken as an authoritative accounting or transcription of the entire event. Note: Statements made by a company other than historical information may constitute forward-looking statements for which the company can claim protection under the Safe Harbor Act. Please consult the company's filings with the SEC for information on risk factors which might cause actual results to differ materially from the information contained in these forward-looking statements.