Capital One Benefiting From Rising Card Usage

In a recent article titled Why The Dip In Credit Card Activity For Q1 Is Not A Cause For Concern, we explained how a seemingly weak Q1 performance by the cards division at the country’s biggest banks does not undermine the strong potential that exists for the business in the near future. Capital One’s (NYSE:COF) exceptionally strong results for the second quarter, which were announced late last week, helped reinforce our views as healthy growth in credit card balances and card payment volumes drove the strong earnings. The bank also benefited from the cost synergies created as a part of its acquisition of HSBC’s U.S. card business and ING Direct, while improving credit quality helped keep loan provisions low. As a direct result of all these factors, Capital One reported net earnings of just under $1.2 billion for Q2 2014 – the highest quarterly figure since the $1.4 billion seen in Q1 2012 (a figure that was boosted in that quarter by a one-time bargain purchase gain of $594 million).

Given that the low interest environment has squeezed Capital One’s net interest margin figure from 7.4% in late 2011 to 6.55% this quarter, the bank’s efforts are commendable – especially since net interest revenues are responsible for almost 80% of its total revenues on an average. The better-than-expected card usage volumes coupled with the fact that Capital One recorded a growth in its credit card loan portfolio earlier than its target of the second half of 2014, we have updated our price estimate for the bank’s stock from $81 to $86.

See our full analysis for Capital One

Net Interest Margins Likely To Remain Under Pressure

As we pointed out earlier, around 80% of Capital One’s total revenues in a given quarter are generated in the form of net interest margins on credit card balances as well as consumer (mortgage, auto and other retail credit) and commercial loans – making its business model extremely sensitive to interest rates. This is why the biggest concern among investors about its performance in recent quarters has been the sequential decline in its net interest margin (NIM). Due to the extended low interest rate environment, safe investment options with reasonably high rates of return have been difficult to come by, which has squeezed margins.

The table below summarizes Capital One’s reported net NIM figures for each quarter since early 2011:

As seen here, the bank’s NIM fell from 7.4% to almost 6.5% between Q1 2011 and Q2 2014. It should be noted that the fluctuations in this figure in 2012 were due to Capital One’s big-ticket acquisitions that changed the proportion of various loans in its portfolio. While the NIM normalized over subsequent quarters as the bank integrated the acquired units, the figure showed a rapid decline from late 2013. This has been due to lower interest income from variable sources, a steady growth in interest-bearing customer deposits and also because of actions undertaken by the bank to ensure regulatory liquidity requirements.

With the Fed initiating its tapering plan in January, the interest rate environment has begun showing signs of improvement over the last couple of months. As it is expected to take a few more months for the impact to spread across the economy, we believe the bank’s NIM figure will reverse its trend later this year. You can understand the partial impact of changes to net interest margins on the bank’s total value through the chart below, which represents Capital One’s NIM on its outstanding card balances.

Growing Loan Volumes, More Card Swipes Make Up Shortfall

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 shrank from an average size of $203 billion in Q3 2012 to under $191 billion in Q1 2014. While outstanding credit card and mortgage loans continued to fall, strong growth in commercial loans helped total loans reach almost $194 billion by Q1 2014. However, Q2 2014 saw credit card loans also grow from under $76 billion at the end of Q1 2014 to more than $79 billion now. In fact, all major loan types except for mortgages saw an increase in Q2 – largely cancelling out the negative impact of shrinking net interest margins on the top line.

At the same time, card usage volumes reached an all-time high of $56.5 billion for the quarter, representing a 19% growth quarter-on-quarter and an 11% growth year-on-year. This helped Capital One report record interchange fees of $535 million for the period – the first time the figure breached the $500-million mark. As we show in the chart below, we expect steady growth in charge volumes to be an important factor behind revenue gains for Capital One in the future.

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