Higher Net Interest Margin, Increased Card Spending Helps Capital One Report Strong Q3 Results

Capital One (NYSE:COF) reported better-than-expected performance figures for the third quarter of the year after market close on Thursday, October 22, as an increase in interest revenues and lower operating expenses drove profits in what was otherwise a rather lukewarm period for the banking industry. ((Q3 2015 Earnings Press Release, Capital One Press Releases, Oct 22 2015)) The card-focused bank witnessed an uptick in card payment volumes for Q3, which along with higher interest revenues, helped the top line scale a record high of $5.9 billion. Although non-interest expenses were hurt by an additional $69 million in provisions to cover customer redressals linked to the bank’s U.K. Payment Protection Insurance (PPI) misgivings, employee-related expenses gained from a sequential reduction in total headcount.

With the last quarter of the year usually being the strongest period for Capital One from higher card usage volumes during the holiday season, we expect the bank to end the year on a high note. Also, Capital One is in a position to make handsome gains when the Fed hikes benchmark interest rates in the near future thanks to the sharp increase in loans across categories over recent quarters. Accordingly, we have revised our price estimate for Capital One’s stock upwards from $89 to $91. The new estimate is roughly 20% ahead of the current market price.

See our full analysis for Capital One

Growth In Loan Portfolio, Jump In Interest Margins Boosts Revenue 

Over 2012-2013, 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 $213.3 billion at the end of Q3 2015. Card loans grew by 3% quarter-on-quarter to cross the $90 billion mark, while auto loans also recorded a 3% growth to reach $41 billion. In fact, Capital One reported a sequential increase in loans across categories, except for home loans – indicating that Capital One is still running off its mortgage portfolio.

After being particularly depressed over the first two quarters of the year, Capital One witnessed a sizable increase in its net interest margin (NIM) figure over the third quarter. The table below summarizes Capital One’s reported NIM as well as net interest income figures for each of the last eleven 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%. The trend appears to be repeating again in Q3, as the NIM figure shot up to 6.73% after falling over Q1 and Q2. With loans continuing to grow, the higher NIM figure allowed Capital One to report record net interest revenues of $4.76 billion this time around.

Costs Hit By One-Time Charge, Operating Margins Remain Solid

Capital One enjoys one of the best operating margins in the country’s banking industry thanks to the significant share of card lending operations in its business model. While being an important source of value for the bank, the relatively low cost structure provides Capital One more leeway in its plans to target new customers by increasing marketing spend. The bank usually reports the highest marketing costs for a year in the fourth quarter, with the figure for the third quarter also being elevated compared to that of the first two quarters of the year. Taking the seasonal nature of Capital One’s expenses into account, and considering the fact that revenues were at a record high this time around, the bank did a good job of keeping total expenses in check in Q3 compared to Q2 2015. Although the non-interest expense figure suffered from a one-time cost of $69 million from PPI redressals in the U.K., total costs as adjusted for any non-recurring items remained largely unchanged compared to the previous quarter.

The adjusted cost figure of $3.1 billion for Q3 2015 represents a 3% increase compared to the $3 billion figure reported a year ago. But it should be noted that Capital One’s employee base swelled from 44,900 to 46,900 over the same period – an increase of roughly 4.5%. Considering this factor, the bank has done well to ensure that costs grow at a slower rate. This is clearly reflected in the fact that the efficiency ratio (the ratio of total expenses to total revenues) improved slightly from 52.9% in Q3 2014 to 52.8% in Q3 2015.

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