Higher Provisions, Marketing Costs Weigh On Strong Q4 Operating Performance At Capital One

Capital One (NYSE:COF) reported a strong operating performance for Q4 2014 late last week, with the banking group capitalizing on increased card usage during the holiday season as well as healthy growth across its loan categories to churn out a record revenue figure. ((Capital One Reports Fourth Quarter 2014 Net Income of $999 million, or $1.73 per share, Capital One Press Releases, Jan 22 2015)) Notably, the bank also managed to increase its net interest margin figure for the second consecutive quarter – bucking the trend of a steady decline in interest margins that has been plaguing the banking sector each quarter for well over two years now. The top line also saw a one-time $41 million gain in the form of mortgage representation and warranty benefits from discontinued operations.

The improvement in revenues did not reflect in Capital One’s bottom-line figure, though, due to an increase in loan provisions for the period coupled with a sharp jump in marketing expenses. The bank set aside a little over $1.1 billion to cover loan losses for Q4 2014 – the highest since Q4 2012. Also, non-interest expenses increased by more than 10% quarter-on-quarter as marketing costs crossed $500 million for the first time in Capital One’s history. Compared to the $509 million in marketing marketing costs in Q4 2014, the bank reported a figure of $427 million in Q4 2013 and $392 million in Q3 2014. However, it should be noted that Capital One’s marketing expenses have historically been the highest for the last quarter of the year – so the sharp increase in these costs for the period is not something to worry about given the bank’s efforts to aggressively grow its loan offerings over recent years.

We believe that Capital One is well poised to gain considerably from an improvement in the interest rate environment when the Fed eventually hikes benchmark interest rates later this year. Consequently, we have increased our price estimate for the bank’s stock upwards from $85 to $89. The new estimate is about 15% ahead of the current market price.

See our full analysis for Capital One

Growing Loan Volumes, Higher Net Interest Margins, Increasing Swipes

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 in size from $203 billion in Q3 2012 to under $193 billion in Q1 2014. But the bank’s push in originating auto loans and a sharp increase in domestic credit card loans owing to strong holiday-season activity helped the total loan figure cross $208 billion by the end of Q4 2014.

Another positive in Capital One’s results for the quarter was the notable increase in net interest income. The table below summarizes Capital One’s reported NIM as well as net interest income figures for each of the last 8 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. But the bank bucked the industry trend in Q3 by improving its NIM figure by 14 basis points to bring it to 6.69%, and followed it up with another 12 basis point (0.12%) improvement in Q4 2014 – allowing it to report the highest quarterly net interest income figure in its history.

Finally, card usage volumes reached an all-time high of $63.5 billion for the quarter, representing a 10% growth quarter-on-quarter and a 17% growth year-on-year. This helped Capital One report an interchange fees in excess of $500 million for the third consecutive 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.

Higher Charge-Offs May Be A Bad Sign

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 the stringent terms that Capital One employs. To put things in perspective, Capital One’s card charge off rate 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. Improving economic conditions over subsequent quarters helped the figure improve to 2.88% in Q3 2014. However, the trend reversed sharply in Q4 as charge-off rates increased to 3.38% for the period. This in turn forced Capital One to hike its loan provisions from just under $1 billion in Q3 2014 to more than $1.1 billion in Q4 2014. The chart below represents Capital One’s card loan provisions, and you can see how changes to it impacts the bank’s share price.

The higher charge-off and loan provision figures for Q4 2014 aren’t really anything to worry about, as other card lenders such as Discover and American Express have also reported a similar trend as a part of their results for the quarter. But the thing that stands out in Capital One’s case is that charge-off rates have deteriorated across loan categories – something that was not seen in the performance figures of its larger peers. We believe that a cause for this could be a relaxation in the bank’s lending requirements over recent quarters, as Capital One aggressively pursues growth in lending operations. A weaker loan portfolio can potentially result in millions in additional loan-related losses in the long run – something that could present a notable downside to Capital One’s share price.

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