Lower Costs, Provisions Help Capital One Overcome Shrinking Revenues

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Capital One Financial

Capital One (NYSE:COF) reported better-than-expected results for the first quarter of the year last week, as it mitigated the impact of shrinking net interest incomes on its results by cutting costs. [1] The card-focused bank also benefited from an improvement in the quality of its loans as it set aside the lowest amount of provisions this quarter ($735 million) than it has since the big-ticket acquisitions of ING Direct and HSBC’s (NYSE:HBC) U.S. card operations in mid-2012.

Capital One’s top line figures took a notable hit in Q1, as falling net interest incomes reduced total revenues by more than 3% compared to the previous quarter as well as the year-ago period. There was also a significant reduction in fee-based revenues as service charges and interchange fees declined quarter-on-quarter by 4% and 10% respectively. Fortunately, non-interest expenses fell below $3 billion for the first time in two years due to a sequential 9.5% reduction – salvaging the results for Capital One this time around.

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In view of the continued growth of Capital One’s commercial lending portfolio, improving provision figures for retail banking operations as well as the recently announced share repurchase plan (see Capital One’s $2.5 Billion Share Repurchase Plan Welcome News For Investors), we HAVE increased our price estimate for Capital One’s stock from $79 to $81, which  slightly ahead of the current market price.

See our full analysis for Capital One

Credit Card Charge-Offs Appear To Have Stabilized

One of the unwanted side-effects of Capital One’s acquisition of HSBC’s U.S. card business was a notable increase in charge-off rates for the bank’s credit card business. This is because credit card loans by the erstwhile HSBC unit were not given out on similarly stringent terms that Capital One employs. This was the inherent trade-off in the deal – while the acquisition boosted the credit card portfolio and also brought in cost synergies, the overall charge-off rate on loans (and hence the corresponding provisions) will remain higher than their historical levels. To put things in perspective, Capital One’s charge off figure shot up from 3.22% in Q3 2012 to 4.32% in Q4 2012, although the credit conditions in the country were fairly constant between these quarters.

Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014
6.13% 5.06% 4.23% 4.30% 4.14% 3.13% 3.22% 4.32% 4.45% 4.36% 3.78% 3.98% 4.02%

Since then, the charge off rates fell to a low of 3.78% in Q3 2013 before stabilizing around the 4%-mark over the last two quarters. Charge-offs for the bank’s international card business have done noticeably well – falling from above 5% in Q2 2013 to 4.17% now. This, coupled with a marked improvement in retail loan charge-offs (auto loans in particular), is what helped Capital One report its lowest provision figure in over two years.

Commercial Lending Operations Strengthen Loan Portfolio

Capital One has allowed parts of its credit card and home loan portfolio to run off over several quarters to ensure that acquired loans not meeting its risk-return criteria are eliminated from its balance sheet. The bank also sold several chunks of these loans over the period, with the biggest deal being the sale of its Best Buy card portfolio to Citigroup (NYSE:C) to get rid of strategically redundant loans (see Citi Snaps Up Capital One’s Best Buy Credit Card Portfolio). Because of this, Capital One’s total loan portfolio has shrunk from an average size of $196 billion in Q1 2013 to under $194 billion now.

But the commercial lending arm has continued to increase steadily over the years, with the bank growing the amount of commercial loans handed out from $39 billion at the end of Q1 2013 to more than $46 billion now – an 18% increase. This growth includes a 20% increase in Capital One’s commercial real estate as well as commercial & industrial lending over this one-year period.

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Notes:
  1. Q1 2014 Earnings Press Release, Capital One Press Releases, Apr 16 2014 []