Capital One’s Q3 Earnings Miss Is Not A Cause For Concern

Capital One (NYSE:COF) announced its performance figures for the third quarter of the year after the market closed on Thursday, October 16, with the results missing expectations and sending its share price 2.6% lower in after-hours trading. ^[1] The main reason for the sell-off was an unexpected increase in Capital One’s loan provisions to almost $1 billion over Q3 2014 – a 17% increase compared to the year-ago period and a 41% jump sequentially. The higher provisions nullified the impact of strong quarter-on-quarter revenue growth on the bottom line even as operating expenses remained steady.

We believe that there are some very promising trends in Capital One’s results which cannot be overlooked in view of its long-term profitability. The bank’s net interest income increased for the first time after sliding for four consecutive quarters and almost touched $4.5 billion thanks to a marked improvement in its net interest margin (NIM). While the interest income was also aided by strong growth in auto, commercial and card loans for the period, fee-based income gained from the 13% year-on-year jump in credit card purchase volumes. Also, the increased provisions appear to primarily cover retail loans (and not the core card loan portfolio), as only retail loans saw an increase in charge-offs for the period. Although there was a small increase in delinquency rates for card loans, the company’s card and commercial loan portfolios reported a continued reduction in charge-off rates for the quarter.

We maintain our $85 price estimate for the bank’s stock, which is about 10% ahead of the current market price.

See our full analysis for Capital One

Net Interest Margin Figure Finally Improves

Capital One generates roughly 80% of its total revenues for any quarter 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). The table below summarizes Capital One’s reported NIM as well as net interest income figures for each of the last 7 quarters:

As seen here, the bank’s NIM fell from 6.89% in Q3 2013 to 6.55% in Q2 2014. 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. The bank bucked the trend in Q3 by improving its NIM figure by 14 basis points to bring it to 6.69%. This, coupled with the steady growth in its loan portfolio, helped the company’s net interest income reach the $4.5-billion level last seen in Q3 2013.

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.

Card Fees Improve As Purchase Volume Reaches Record High

Capital One reported an all-time high card usage volume of $57.5 billion for the quarter, representing a 2% growth quarter-on-quarter and a 13% growth year-on-year. This helped the bank’s interchange fees remain above the $500 million figure for a second consecutive quarter. The $523 million in interchange fees for the quarter are a 10% improvement compared to the $476 million the bank reported in Q3 2013 and slightly below the $535 million figure for the previous quarter. 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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1. Q3 2014 Capital One Financial Earnings Press Release, Capital One Press Releases, Oct 16 2014 [↩]