Capital One Did Well To Grow Revenues Across Divisions In Q3, But It Will Have To Monitor Loan Losses Closely

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Capital One Financial

Capital One (NYSE:COF) reported better-than-expected performance figures for the third quarter after the market close on Tuesday, October 25, as an increase in revenues for its cornerstone card division helped mitigate the impact of higher loan provisions on its bottom line. ((Q3 2016 Earnings Press Release, Capital One Press Releases, Oct 25, 2016)) While an increase in card payment volumes and auto loan origination for the period led fee incomes higher, the interest income benefited from sharp loan growth. As a result, Capital One reported record quarterly revenues of nearly $6.5 billion for Q3 2016 – a 10% jump year-on-year.

The bottom line did not benefit from the revenue surge, though, and actually shrank 8% compared to Q3 2015. This was because Capital One set aside almost $1.6 billion in Q3 2016 to cover its bad loans – up 45% from the $1.1-billion figure a year ago. While an increase in loan provisions is in itself not a cause for concern (it is expected to accompany growth in a bank’s loan portfolio), it could have long-term repercussions if it is the result of relaxed lending criteria. Notably, card lenders have increased sub-prime card lending over recent years, because of which the quality of new card loans has been considerably lower than that of existing card loans. [1] If this trend continues, then it could have an adverse impact on the overall quality of loans in Capital One’s portfolio – making it vulnerable to huge losses if economic conditions change for the worse.

That said, a key strength that Capital One has demonstrated over the years is its willingness to grow inorganically through big-ticket acquisitions, and its ability to effectively integrate the acquired business units. This, coupled with the potential gains the bank will realize on its loan portfolio as the Fed resumes rate hikes, lends support to our $85 price estimate for Capital One’s stock. The price target is roughly 15% ahead of the current market price.

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COF_Ear_PBTDiff_16Q3

The table above summarizes the factors that aided Capital One’s pre-tax profit figure for Q3 2016 compared to the figures in Q3 2015 and Q2 2016. As seen here, the bank reported healthy growth in revenues across its Card, Commercial Banking, and Consumer Banking divisions y-on-y as well as q-on-q. Understandably, the revenue growth was accompanied by increased compensation expenses for the quarter. However, the compensation-to-revenue figure remained largely constant around 20% for each of these quarters. Interestingly, the y-on-y increase in non-compensation expenses can be attributed almost completely to the additional $63 million in legal provisions Capital One had to set aside in Q3 to cover customer redressals linked to the bank’s U.K. Payment Protection Insurance (PPI) misgivings. Despite the one-time charge, the bank’s total expense-to-revenue ratio improved from 53.6% in Q3 2015 and 52.7% in Q2 2016 to 52% in Q3 2016.

Capital One’s total loan portfolio grew 12% y-on-y from $213 billion at the end of Q3 2015 to over $238 billion now – partly thanks to the bank’s integration of GE’s healthcare business late last year which boosted the commercial lending portfolio. While the bank’s portfolio of auto loans saw the highest organic growth since Q3 2015 (14%), the card business saw the largest growth in absolute terms (~$8.8 billion). Moreover, card payment volumes for the quarter grew to a record high of $78 billion – something that helped card fees for the period.

An important factor behind elevated revenues for the quarter was an increase in the net interest margin (NIM) figure. The Fed’s decision to hold interest rates at near-zero levels since the economic downturn of 2008 resulted in NIM figures across banks to shrink almost every single quarter since late 2010. This was due to a combination of lower interest income from variable sources, a steady growth in interest-bearing customer deposits, and also stricter regulatory liquidity requirements. For most banks, the only saving grace has been the steady growth in interest-earnings assets (especially loans) over the period. As Capital One’s loan portfolio is heavy on credit card loans which attract high interest yields, a sizable increase in the loan portfolio for a quarter has a positive impact on the NIM figure – as was seen in Q3 2016.

COF_Ear_IntRevDiff_16Q3

The table above summarizes how changes in NIM and the interest-earning asset base affected Capital One’s net interest revenues (fully-taxable equivalent basis) in Q3 2016. The bank’s NIM figure for Q3 2016 was 6.79%, which was slightly ahead of the 6.73% in each of the two comparative periods. At the same time, average interest-earnings assets grew from $283 billion in Q3 2015 and $303 billion in Q2 2016 to over $310 billion in Q3 2016. Together, this helped interest revenues swell almost 11% y-on-y and roughly 4% q-on-q.

It must be remembered here that both the auto lending, as well as card lending industries, are witnessing a sharp increase in sub-prime loans over recent years, so the organic growth for these key units at Capital One would have come at the expense of quality. This is evident from the fact that Capital One’s card delinquency rates have jumped to almost 3.7% from below 3.2% in Q3 2015 and Q2 2016, even though the total charge-off rate has fallen. The higher delinquency rates will almost certainly lead to higher loan provisions over subsequent quarters too – weighing on results going forward.

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Notes:
  1. Subprime Credit Card Surge Pushing Up Missed Payments, The Wall Street Journal Blogs, Oct 24, 2016 []