CAPITAL ONE FINANCIAL CORP quarterly report, Q3 FY2012

Capital One Financial Corporation — Q3 2012 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2012. Capital One is a diversified financial-services company operating Credit Card, Consumer Banking and Commercial Banking businesses. Results include ING Direct from February 17 and HSBC’s U.S. card business from May 1, making year-over-year comparisons materially affected by acquisitions.

Financial performance and condition

Metric	Q3 2012	Q3 2011	Nine months 2012	Nine months 2011
Total net revenue	$5.782 billion	$4.154 billion	$15.772 billion	$12.229 billion
Net interest income	$4.646 billion	$3.283 billion	$12.061 billion	$9.559 billion
Provision for credit losses	$1.014 billion	$622 million	$3.264 billion	$1.499 billion
Non-interest expense	$3.045 billion	$2.297 billion	$8.691 billion	$6.714 billion
Net income	$1.178 billion	$813 million	$2.674 billion	$2.740 billion
Diluted EPS	$2.01	$1.77	$4.75	$5.95

Margins: Q3 net interest margin was 6.97%, down 43 basis points year over year; nine-month margin was 6.50%, down 78 basis points. Total net revenue margin was 8.67% in Q3 versus 9.36%.
Cash flow, nine months: Operating activities provided $8.133 billion; investing activities used $11.141 billion; financing activities provided $3.139 billion. Cash and cash equivalents increased $131 million to $5.969 billion. Acquisition-related cash flows were significant.
Balance sheet at September 30: Total assets were $301.989 billion, loans held for investment $203.132 billion, deposits $213.255 billion, borrowings $38.377 billion and stockholders’ equity $39.672 billion. Since year-end 2011, assets rose 47%, loans 49% and deposits 66%, primarily reflecting the acquisitions.
Liquidity and capital: Liquidity reserves were $51.575 billion, up from $35.835 billion at year-end. Preliminary Basel I ratios were 10.7% Tier 1 common, 12.7% Tier 1 risk-based and 15.0% total risk-based capital. The tangible common equity ratio was 8.2%.
Credit: Q3 net charge-offs were $887 million, a 1.75% rate, versus a 2.52% rate a year earlier; the rate excluding certain acquired loans was 2.18%. The 30+ day delinquency rate was 2.92% at quarter-end versus 3.95% at year-end 2011. Allowance for loan and lease losses was $5.154 billion, or 2.54% of loans, compared with $4.250 billion and 3.13% at year-end.

Material changes and drivers

Q3 revenue rose 39% year over year, while net income increased 45%; nine-month revenue rose 29%, but net income declined 2% and diluted EPS fell 20%.
The ING Direct acquisition added approximately $84.4 billion of deposits and $40.4 billion of loans at acquisition. HSBC added approximately 27 million active accounts and $27.8 billion of card receivables designated held for investment.
Acquisition accounting and one-time items materially affect results. The $594 million ING Direct bargain-purchase gain was recorded in Q1. HSBC card loans with existing revolving privileges generated a $1.3 billion provision in the first nine months, including $107 million in Q3. Acquisition-related premium amortization reduced net interest income by $133 million in Q3 and $267 million year to date.
Credit quality metrics are affected by acquired loans accounted for using expected cash flows: the acquisition-date credit mark absorbs expected losses, and those loans generally are not classified as delinquent or nonperforming. The filing therefore also presents adjusted credit measures.
Q3 segment net income was $741 million in Credit Card, $376 million in Consumer Banking and $228 million in Commercial Banking. Commercial Banking benefited from improving credit trends and allowance releases; Credit Card year-to-date earnings were pressured by HSBC-related credit provisions and acquisition expenses.

Outlook, risks and unusual items

Management expected full-year 2013 average loans to decline modestly from Q3 2012 levels, including approximately $11 billion of expected loan run-off, partly offset by growth in Domestic Card, Auto and Commercial Banking. Management cited weak consumer demand and intensifying competition in some lending businesses.
Management expected average quarterly non-interest expense, excluding marketing, through 2013 to be approximately equal to Q3 2012, and 2013 marketing expense of approximately $1.5 billion. It expected to exceed an internal 8% Basel III Tier 1 common ratio target in 2013; this estimate depends on future rules and assumptions.
Management projected Domestic Card revenue-margin reductions, including about 50 basis points by Q4 2013 from customer-practice changes, and additional reductions from payment-protection run-off and portfolio mix. It expected higher Domestic Card charge-off rates in Q4 2012 as acquired-loan credit marks cease covering future losses.
Hurricane Sandy was a subsequent event. Loans in Connecticut, New Jersey and New York totaled $36.442 billion at September 30, including $16.609 billion in commercial loans. The company had not completed its loss assessment and said the impact was too early to estimate; it highlighted commercial real-estate exposure in affected areas.
Mortgage representation-and-warranty reserves were $919 million. The company estimated approximately $1.7 billion of reasonably possible losses beyond the reserve, while noting actual losses could exceed its estimates. Other reasonably possible litigation losses were estimated at approximately $150 million, excluding specified mortgage matters.
Other notable matters include a $349 million year-to-date mortgage repurchase-loss provision, a $60 million civil penalty related to cross-sell activities, approximately $114 million of expected customer refunds, and $98 million of legal costs related to interchange and other litigation. A SEC investigation concerning auto-loan loss reserves for certain 2007 quarters remained ongoing.
After quarter-end, Capital One merged ING Bank, fsb into CONA on November 1 and issued $1.0 billion of senior notes on November 6. The filing describes integration, credit, interest-rate, regulatory, legal, funding and economic risks; forward-looking expectations are not guarantees.

Investor verification priorities

Assess earnings quality by separating recurring results from the ING Direct bargain gain, acquisition accounting, HSBC allowance build, purchase-accounting amortization, refunds, penalties and legal costs.
Review acquired-loan accounting and credit metrics both including and excluding loans carried based on expected cash flows; verify the assumptions underlying credit marks and allowance adequacy.
Track loan run-off, organic growth, card revenue margins, charge-offs and delinquencies as acquisition-related comparability effects diminish.
Evaluate mortgage representation-and-warranty exposure, litigation developments and the gap between the $919 million reserve and management’s estimated $1.7 billion of reasonably possible additional losses.
Monitor Sandy-related credit performance, particularly commercial real estate, and confirm management’s subsequent loss assessment.
Confirm capital ratios after final regulatory calculations and assess progress toward Basel III requirements alongside liquidity, funding maturities and integration costs.