Increase In Card Provisions, One-Time Costs Drag Down Capital One’s Q2 Results

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COF: Capital One Financial logo
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Capital One Financial

Capital One (NYSE:COF) reported a disappointing Q2 performance after market close on Thursday, July 23, as the card-focused banking giant struggled to grow revenues in yet another slow quarter even as one-time charges eroded profits for the period. ((Q2 2015 Earnings Press Release, Capital One Press Releases, Apr 27 2015)) While the seasonal card business sees weak activity levels over the second quarter of the year, the top line remained under pressure from shrinking net interest margin figures. As a result, total revenues were only marginally better than the figure for the previous quarter. To make things worse, Capital One incurred a $147 million restructuring cost related to its employee benefit plan and also had to set aside $78 million to cover additional customer redressals linked to its U.K. Payment Protection Insurance (PPI) misgivings – taking quarterly non-interest expenses to above $3.3 billion for the first time in the bank’s history.

Capital One’s net interest margin woes will come to an end early next year once the Fed hikes benchmark rates, and the one-time charges are unlikely to affect the bank’s results in the future – so neither of the factors that weighed on the performance this quarter are long-term concerns. However, we believe that the worse-than-expected provision figure of $1.1 billion this quarter hints at a downside to Capital One’s long-term value, as it may be the result of relaxed lending criteria.

We have revised our price estimate for the Capital One’s stock downwards from $91 to $89 to factor in the higher provision costs. The new estimate is slightly ahead of the current market price.

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Strong Growth In Card, Auto Loans Unable To Nullify Impact Of Shrinking Interest Margins

Over the 2012-2013 period, Capital One allowed parts of its credit card and home loan portfolio to run off to ensure that the loans acquired from HSBC and ING respectively which do not meet 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. Since then, the loan base has grown steadily each quarter to reach an all-time high of $209.7 billion at the end of Q2 2015. Card loans grew at a strong 7% quarter-on-quarter to reach $87.2 billion, while auto loans witnessed a 3% growth to reach $40 billion. Notably, the only loan category that continues to witness a steady decline 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 ten quarters:

Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015
Net Interest Margin 6.71% 6.83% 6.89% 6.73% 6.62% 6.55% 6.69% 6.81% 6.57% 6.56%
Net Interest Income $4.57 bil $4.55 bil $4.56 bil $4.42 bil $4.35 bil $4.32 bil $4.50 bil $4.66 bil $4.58 bil $4.54 bil

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%. The trend was short-lived though, as the NIM figure fell for two consecutive quarters to settle at 6.56% this time around. As a direct result, the net interest income fell from $4.66 billion in Q4 2014 to $4.54 billion in Q2 2015.

Interest margins are likely to improve early next year once the Federal Reserve raises 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 Nudge Lower, But Higher Provisions May Mean Poorer Loan Quality

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, which shot up from 3.22% in Q3 2012 to 4.32% in Q4 2012. This is because credit card loans by the erstwhile HSBC unit were not given out on the stringent terms that Capital One employs. Improving economic conditions over subsequent quarters helped the figure improve to 2.88% by Q3 2014. However, the trend reversed sharply over the next two quarters to reach 3.48% in Q1 2015. Although the figure decreased to 3.35% in Q2 2015, the elevated charge-off levels forced Capital One to set aside $1.1 billion in total loan provisions this quarter.

Capital One’s total loan provisions average $1 billion over the last four quarters, compared to an average of $800 million over the previous six quarters. Based on the trends seen over the last three quarters, we believe that Capital One’s aggressive loan growth policy has been accompanied by a weaker loan portfolio. This 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 – something that you can understand by making changes to the chart below.

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