Capital One Financial Corporation (COF) — Q2 2019 Form 10-Q
Reporting period: Three and six months ended June 30, 2019. Capital One is a diversified financial services company operating primarily in Credit Card, Consumer Banking and Commercial Banking.
Financial performance and condition
| Metric | Q2 2019 | Q2 2018 | Change |
|---|---|---|---|
| Total net revenue | $7.124 billion | $7.192 billion | Down 1% |
| Net interest income | $5.746 billion | $5.551 billion | Up 4% |
| Non-interest income | $1.378 billion | $1.641 billion | Down 16% |
| Provision for credit losses | $1.342 billion | $1.276 billion | Up 5% |
| Non-interest expense | $3.779 billion | $3.424 billion | Up 10% |
| Net income | $1.625 billion | $1.906 billion | Down 15% |
| Diluted EPS | $3.24 | $3.71 | Down 13% |
| Net interest margin | 6.80% | 6.66% | Up 14 bps |
| Efficiency ratio | 53.05% | 47.61% | Higher by 544 bps |
For the first six months, revenue was $14.207 billion (up 1%), net income was $3.037 billion (down 7%) and diluted EPS was $6.10 (down 4%). The effective tax rate was 19.3% in Q2 versus 23.1% a year earlier.
Q2 earnings fell despite higher net interest income, mainly because prior-year home-loan sale gains did not recur and marketing and operating expenses rose. Management cited continued technology and infrastructure investment and Walmart partnership costs. Interchange income benefited from higher card purchase volume and updated rewards cost estimates. Purchase volume grew 10% to $106.9 billion.
Cash flow, liquidity and balance sheet: Six-month operating cash flow was $9.107 billion, investing cash flow was negative $125 million, and financing cash flow was negative $6.650 billion. Cash, cash equivalents and restricted cash ended at $15.821 billion, up $2.332 billion from the start of the period. At June 30, total assets were $373.6 billion, loans held for investment were $244.5 billion, deposits were $254.5 billion and stockholders’ equity was $55.8 billion. Total borrowings were $49.2 billion, down from $58.9 billion at year-end, largely reflecting repayment of short-term FHLB advances. Liquidity reserves were $99.5 billion, and the average Q2 liquidity coverage ratio exceeded the 100% regulatory requirement.
Capital and credit: The company’s common equity Tier 1 ratio was 12.3%, up from 11.2% at year-end; total capital was 16.2%. The allowance for loan and lease losses was $7.133 billion, or 2.92% of loans. Q2 net charge-offs were $1.508 billion and the net charge-off rate was 2.48%, up 6 bps year over year. The 30-plus-day delinquency rate was 3.35%, down from 3.84% at year-end. Commercial Banking earnings declined to $157 million from $217 million in Q2 2018, while allowance builds and some isolated credit deterioration were noted in commercial lending.
Material changes and business developments
- In Q2, Capital One exited several small card partnership portfolios, selling about $900 million of receivables and transferring about $100 million to loans held for sale. The transactions generated a $49 million gain and a $68 million allowance release.
- Loans held for investment declined $1.4 billion from year-end to $244.5 billion, mainly due to seasonal card paydowns and portfolio sales, partly offset by commercial, card and auto growth.
- Deposits increased $4.8 billion from year-end, while total borrowings declined $9.7 billion. Common equity increased 9% to $51.4 billion.
- Capital One expects to launch its new Walmart U.S. cobrand and private-label card program and close on the existing receivables portfolio in late Q3 or early Q4 2019.
- The company adopted the new lease standard in Q1, recording a $1.9 billion lease liability and $1.6 billion right-of-use asset; management reported no material impact from the adoption.
Outlook, risks and contingencies
- Management expects deposit-mix changes to weigh on net interest margin during 2019. Full-year marketing expense is expected to be modestly higher than 2018, with a more normal seasonal pattern.
- Management expects modest improvement in the adjusted operating efficiency ratio in 2019 and 2020, and targets 42% in 2021; it expects this to drive a significant improvement in the total efficiency ratio by 2021.
- Consumer Banking expects faster growth in higher-rate deposit products to continue changing its mix and expects the annual auto charge-off rate to increase gradually as the credit cycle progresses.
- Cybersecurity incident: Announced July 29, 2019, after the quarter-end. Unauthorized access occurred March 22–23 and affected approximately 100 million people in the U.S. and 6 million in Canada. Capital One reported that no card account numbers or login credentials were compromised, but some Social Security numbers and secured-card bank account numbers were accessed. The investigation remained ongoing. The company estimated $100–$150 million of incremental 2019 costs, expected to be separately reported as an adjusting item. Cyber insurance has a $10 million deductible and $400 million coverage limit, subject to exclusions; the timing and amount of any recovery may differ from costs. Litigation had begun, and losses could not be reasonably estimated.
- For disclosed litigation matters where an estimate was possible, management estimated approximately $1.1 billion of reasonably possible future losses beyond reserves; actual losses could exceed this estimate. The U.K. payment protection insurance reserve was $71 million, with approximately $100 million of reasonably possible losses beyond the reserve.
- Capital One’s 2019 CCAR plan received no objection from the Federal Reserve. The board authorized up to $2.2 billion of share repurchases from Q3 2019 through Q2 2020 and expected to maintain the $0.40 quarterly common dividend, subject to board approval.
- CECL adoption is planned for January 1, 2020. Management expects it to increase credit-loss reserves, but the amount will depend on portfolio characteristics and economic and loss forecasts at adoption.
Most important facts for investors to verify
- Whether card credit losses or commercial credit deterioration accelerate, and how allowance levels and charge-offs change.
- Whether higher funding costs and deposit-mix shifts pressure net interest margin and deposit growth.
- Whether expense growth, including technology, marketing and Walmart-related costs, is consistent with the efficiency targets.
- The final scope, costs, insurance recoveries, litigation exposure and reputational impact of the cybersecurity incident.
- The actual timing and financial contribution of the Walmart program and portfolio acquisition.
- The CECL transition’s impact on reserves, earnings and regulatory capital, and the resolution or evolution of significant legal contingencies.