Concerns Over Increase In Capital One’s Q1 Loan Charge-Offs Are Overblown

Earlier this week Capital One (NYSE:COF) reported a worse-than-expected performance for the first quarter of the year as the impact of seasonally lower revenues on the bottom line were exacerbated by a sharp increase in loan provisions. ^[1] While the Fed’s rate hikes helped the card-focused bank report record net interest revenues just shy of $5.5 billion, an increase in domestic card charge-off rates from 4.16% a year ago to 5.14% in Q1 forced Capital One to set aside almost $2 billion in loan provisions for the quarter – the highest since the bank set aside $2.1 billion in provisions at the peak of the economic downturn in Q4 2008.

The sizable increase in card charge-off rates is not entirely unexpected, as the figure for the industry had been hovering at a 20-year low of under 3% over 2015-16. ^[2] In fact, signs of a normalization began to show in Q4 2016 when card charge-offs for the industry increased to 3.56%. The card industry as a whole benefited from a recovery in credit market conditions over 2012-15, and this helped banks reverse some of the loan provisions they had set aside immediately after the downturn. At the same time, card lenders relaxed their lending standards to make the most of the situation – considerably expanding their sub-prime card lending activity. ^[3] With the credit cycle returning to normal, the lower quality card balances are triggering losses – something that will lead to loan provisions remaining elevated over subsequent quarters.

As Capital One grew its card loan portfolio at a faster rate than the industry, it very likely has a larger proportion of low-quality card loans on its balance sheet. And this should keep its loan charge-off rates higher than that for the industry going forward. But we believe that the figure will level off soon. That said, Capital One should benefit considerably from the Fed’s ongoing rate hikes. The bank is also expected to capitalize on its strength of being able to grow inorganically through big-ticket acquisitions. Because of this, we stick to our $92 price estimate for Capital One’s stock which is about 10% 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 Q1 2017 compared to the figures in Q1 2016 and Q4 2016. The bank reported a notable increase in revenues across its operating divisions year-on-year. While revenues slid sequentially, this was primarily due to the fact that the last quarter is seasonally the best period for the card business. It should be noted that results for Q1 2017 were also negatively impacted by a $99-million increase in legal provisions to cover customer redressals linked to the bank’s U.K. Payment Protection Insurance (PPI) misgivings – up from $44 million in Q4 2016.

The increase in Capital One’s compensation expenses compared to both quarters can be attributed to a mix of seasonal factors and an increase in operating revenues. It should be mentioned that the 15% year-on-year increase in compensation expenses is more than the 10% revenue growth over the same period. But the bank did well to reduce non-compensation expenses enough to report an overall decrease in total costs (adjusting for one-time costs). This helped the bank’s total expense-to-revenue ratio (as adjusted) improve marginally from 51.8% in Q1 2016 to 51.6% in Q1 2017.

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1. Q1 2017 Earnings Press Release, Capital One Press Releases, Apr 25 2017 [↩]
2. Charge-Off Rate on Credit Card Loans, All Commercial Banks, St. Louis Fed Website [↩]
3. Subprime Credit Card Surge Pushing Up Missed Payments, The Wall Street Journal Blogs, Oct 24, 2016 [↩]