Capital One Will Need To Keep Loan Losses In Check To Benefit From Improving Interest Rates

The last quarter of 2016 turned out to be a soft period for Capital One (NYSE:COF), as an increase in operating expenses as well as in loan provisions for the period erased revenue gains from the Fed’s rate hike in December – making the bank fall short of investor expectations last week. ^[1] Although the bank’s total fee revenues fell to the lowest level in 2 years due to an unusually low “other income” figure, net interest revenues crossed $5.4 billion for the first time in the bank’s history. This, coupled with seasonally elevated card fees, helped Capital One post record revenue figures.

In any case, we do not see the low fee revenues for Q4 as a sign of weakness, as it was entirely due to a reduction in non-recurring revenues. At the same time, there were two factors behind the elevated operating expenses: seasonally higher marketing expenses, and one-time costs of $134 million, which should not be a problem in subsequent quarters. Taking all this into account, the only thing that stands out as bad in Capital One’s results for the quarter was the jump in loan provisions. Capital One set aside $1.75 billion in Q4 2016 to cover its bad loans. The bank has reported higher loan provisions on only one occasion in the past – at the peak of the economic downturn in Q4 2008. Given the strong economic conditions over recent quarters, the elevated provision figure points at a focus on below-average quality loans in its portfolio. 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. ^[2] 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 $92 price estimate for Capital One’s stock. The price target is slightly ahead of the current market price.

See our full analysis for Capital One

The table above summarizes the factors that aided Capital One’s pre-tax profit figure for Q4 2016 compared to the figures in Q4 2015 and Q3 2016. As seen here, the bank reported healthy growth in revenues for its Card and Commercial Banking divisions. Revenues for its Consumer Banking operations fell due to lower fee income as well as due to a one-time loss related to its “Other” operating division. The overall improvement in revenues came at the price of higher operating revenues, though, as compensation as well as other operating expenses increased at a faster rate that revenues. While a big reason behind this was seasonally elevated marketing costs, results were also hurt by an additional $44 million in legal provisions which Capital One had to set aside in Q4 to cover customer redressals linked to the bank’s U.K. Payment Protection Insurance (PPI) misgivings. Besides this, the bank also incurred a $28 million impairment charge linked to intangible assets. Taking into account these non-recurring items, the bank’s total expense-to-revenue ratio (as adjusted) improved from 56.2% in Q4 2015 to 55.1% in Q4 2016.

Capital One Continues To Grow Its Loan Portfolio At A Steady Pace

Capital One’s total loan portfolio grew 7% y-o-y from just under $230 billion at the end of Q4 2015 to almost $246 billion now. The bank’s portfolio of auto loans continued to be the largest growing segment, with growth over the last year touching 15% (absolute growth of ~$6.4 billion). The card business saw the largest growth in absolute terms (~$9.8 billion) for y-o-y growth of 10%. The bank continued to run-off its mortgage portfolio – a trend witnessed since it acquired ING’s operations – with outstanding home loans shrinking 14% y-o-y to below $22 billion by the end of 2016. While card loans will remain Capital One’s primary growth driver in the future, we also expect mortgage loans to witness growth in the long run as the bank eventually finishes cleaning up its portfolio of acquired loans and reports organic growth in mortgage lending.

Loans Will Churn Out Profits As Interest Rates Increase

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. But with the Fed announcing only its second rate hike in December 2016, net interest margins saw an improvement across the industry. As Capital One’s loan portfolio is heavy on credit card loans which attract high interest yields, the bank benefited in particular from the rate hike.

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 Q4 2016. The bank’s NIM figure improved 6 basis points to 6.85% in Q4 2016 from 6.79% in each of the two comparative periods. At the same time, average interest-earnings assets grew from $292 billion in Q4 2015 and $311 billion in Q3 2016 to almost $318 billion in Q4 2016. Together, this helped interest revenues swell almost 10% y-o-y and roughly 3% sequentially.

Lenient Lending Policies Weighing On Profits

It should be noted 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 may have come at the expense of quality. This is evident from the fact that Capital One’s total charge-off rate swelled from around 2% over recent quarters to almost 2.5% in Q4 2016. And things aren’t going to be much better in Q1 2017, as overall delinquency rates have jumped to almost 3.3% from around 3% in Q4 2015 and Q3 2016. While increased charge-off rates forced the bank to considerably increase loan provisions in Q4, the bank is likely to raise loan provisions again over subsequent quarters. This is a worrying trend, considering the fact that the overall improvement in economic conditions have helped the large banks reduce loan provisions in Q4. Capital One seems to have relaxed its lending standards too much in its quest to grow its loan base, and this will become a serious cause for concern unless the bank addresses the issue at the earliest. You can see how an increase in card loan provisions impacts our estimate for Capital One’s share price by modifying the chart below.

View Interactive Institutional Research (Powered by Trefis):
Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap
More Trefis Research

1. Q4 2016 Earnings Press Release, Capital One Press Releases, Jan 24, 2017 [↩]
2. Subprime Credit Card Surge Pushing Up Missed Payments, The Wall Street Journal Blogs, Oct 24, 2016 [↩]