Capital One’s Results For Seasonally Slow Q1 Marred By Interest Margin Pressure

Capital One (NYSE:COF) reported a mixed performance for the first quarter of the year late last week, with the card-focused bank posting a better-than-expected net income figure for the period despite falling short on revenue expectations. ^[1] While the seasonal nature of the card business makes the first quarter of each year a weak period for card lenders, the top line also saw additional pressure from shrinking net interest margin figures. Capital One’s total revenues fell roughly 3% compared to the previous quarter, although the strong growth in loan portfolio year-on-year helped revenues jump 5% compared to the year-ago period. There was also a significant reduction in fee-based revenues as service charges fell 8% compared to Q1 2014 and 5.5% compared to Q4 2014. Also, as loan provisions for Q1 2015 ($935 million) were considerably higher than those for Q1 2014 ($735 million), there was a 3% reduction in pre-tax profits for Capital One compared to the figure last year.

We believe that Capital One’s lukewarm performance for the period was largely the result of macro-economic factors that are beyond its control. That said, the bank 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 maintain our $91 price estimate for the Capital One’s stock, which is about 15% ahead of the current market price.

See our full analysis for Capital One

Growing Loan Volumes Mitigate Lower Net Interest Margins To An Extent

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 this period, because of which its total loan portfolio shrank in size from $203 billion in Q3 2012 to under $193 billion in Q1 2014 despite strong growth in commercial and auto lending. The loan base grew steadily to cross $208 billion by the end of Q4 2014 before shrinking to slightly below $204 billion this quarter – something that can be attributed to the increase in loan prepayments in the first quarter of a year. Notably, the only loan category that has seen a steady decline over the last two years is retail mortgages, indicating that Capital One is still running-off this portfolio.

The bank faced headwinds in terms of shrinking net interest margin (NIM) figures, though, as this figure fell sharply after trending upwards for the last two quarters. The table below summarizes Capital One’s reported NIM as well as net interest income figures for each of the last nine 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 over the second half of 2014 by improving its NIM figure by 26 basis points to bring it to 6.81% for  Q4 2014 – allowing it to report the highest quarterly net interest income figure in its history. The trend was short-lived though, as the NIM figure fell to 6.57% this time around.

The pressure on interest margins are unlikely to be alleviated till the end of this year – which is when the Federal Reserve is expected to raise benchmark interest rates from their current record-low levels. You can understand the partial impact of changes in interest margins on Capital One’s share price by making changes to the chart below which captures the net interest yield on the bank’s commercial loans.

Charge-Off Rates May Indicate

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 figure increased further to 3.48% in Q1 2015. 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 and Q1 2015 aren’t necessarily something to worry about. But it may also be indicative of a relaxation in the bank’s lending criteria over recent quarters, as Capital One aggressively pursues growth in lending operations. After all, economic conditions across the country have only improved over recent quarters. A weaker loan portfolio can potentially result in millions in additional loan-related losses in the long run and presents a notable downside to Capital One’s share price. While it is too early to ascertain the cause of the higher charge-offs, the reason will likely become evident over subsequent months.

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1. Q1 2015 Earnings Press Release, Capital One Press Releases, Apr 27 2015 [↩]