Capital One Financial Corporation — Q2 2012 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2012. Capital One operates Credit Card, Consumer Banking and Commercial Banking businesses. Results were materially affected by the February ING Direct acquisition and the May 1 HSBC U.S. card acquisition; comparisons with 2011 therefore include different business perimeters.
Financial performance and position
| Metric | Q2 2012 | Six months 2012 |
|---|---|---|
| Net interest income | $4.001B, up 28% | $7.415B, up 18% |
| Non-interest income | $1.054B, up 23% | $2.575B, up 43% |
| Total net revenue | $5.055B, up 27% | $9.990B, up 24% |
| Provision for credit losses | $1.677B | $2.250B |
| Non-interest expense | $3.142B, up 39% | $5.646B, up 28% |
| Income from continuing operations, net of tax | $193M | $1.698B |
| Net income / net income available to common | $93M / $92M | $1.496B / $1.488B |
| Diluted EPS | $0.16 | $2.72 |
| Net interest margin | 6.04%, down 116 bps year over year | 6.24%, down 98 bps |
| Net charge-off rate | 1.53%, versus 2.91% a year earlier | 1.76%, versus 3.28% |
Net income available to common fell 90% in Q2 and 23% for the first half versus 2011. Q2 revenue growth reflected larger acquired and organic balances, but was outweighed by credit-loss provisioning, acquisition-related costs and other charges. First-half non-interest income included a $594M ING Direct bargain-purchase gain and $162M from a Visa share sale.
Balance sheet at June 30: Total assets were $296.6B; loans held for investment were $202.7B, up 49% from year-end 2011; deposits were $213.9B, up 67%; and stockholders’ equity was $37.2B. Allowance for loan and lease losses was $5.0B, or 2.47% of loans (3.08% excluding acquired loans accounted for on expected cash flows). Borrowings were $35.9B, including $13.6B of securitized debt and $22.3B of other debt.
Liquidity and capital: Liquidity reserves were $53.7B, including $47.7B of unencumbered available-for-sale securities and $6.0B cash and cash equivalents. Preliminary Basel I ratios were 9.9% Tier 1 common, 11.6% Tier 1 risk-based and 14.0% total risk-based; the Tier 1 common ratio was 11.9% at March 31. TCE ratio was 7.4%.
Cash flow, six months: Operating activities provided $3.152B, versus $4.361B in 2011; investing activities used $3.500B, versus $2.777B; financing activities provided $489M, versus using $190M. Cash and cash equivalents ended at $5.979B. Investing cash flows included $17.603B net cash paid for acquired companies.
Material changes and business segments
- ING Direct added approximately $40.4B of loans and $84.4B of deposits at acquisition. The HSBC card transaction added approximately 27 million active accounts and $27.8B of card receivables designated held for investment.
- Q2 Credit Card reported a $297M loss from continuing operations, versus $618M income a year earlier. The $1.2B HSBC-related allowance build was the main driver; reported card charge-off and delinquency measures also benefited from acquisition accounting and portfolio mix.
- Consumer Banking Q2 income rose to $438M from $287M, supported by ING Direct and auto-loan growth. Commercial Banking income rose to $228M from $159M, with stronger revenue and credit trends.
- Average loan balances and deposits expanded substantially with acquisitions, while net interest margin declined as lower asset yields and acquired-asset mix offset lower funding costs.
Outlook, risks and unusual items
- Management expected acquisition integration to require significant effort and believed the combined businesses could generate attractive results and capital. No specific consolidated earnings guidance was provided.
- Management expected HSBC portfolio runoff to offset growth elsewhere in Domestic Card, keeping balances relatively flat. It anticipated a higher Domestic Card charge-off rate in Q4 2012 and, over time, a combined-card charge-off rate 40–60 bps above Capital One’s stand-alone Domestic Card rate. HSBC customer-practice changes were expected to pressure card revenue margin over coming quarters.
- ING Direct home-loan runoff was expected to affect Consumer Banking loan volumes; management expected continued auto growth. Commercial Banking was expected to maintain strong, relatively steady performance during 2012.
- Q2 included $174M to establish an HSBC billed-fee reserve, $106M of HSBC merger-related expenses, $60M in civil penalties and $41M in expected customer refunds related to Domestic Card cross-sell settlements, $98M of legal costs related to interchange and other settlements, and a $180M mortgage repurchase provision. The HSBC allowance build was $1.2B.
- Mortgage representation-and-warranty reserves were $1.002B at June 30. The filing estimated a further $1.7B of reasonably possible future losses beyond the reserve; actual losses could exceed both the reserve and estimate. Management also estimated approximately $150M of reasonably possible losses for other specified litigation matters, excluding the mortgage matters already included in the $1.7B estimate.
- After quarter-end, bank subsidiaries entered into consent orders concerning payment-protection and credit-monitoring sales practices, Servicemembers Civil Relief Act compliance and third-party management. Required enterprise-wide compliance and risk-management enhancements could increase future expenses; the amount was uncertain. Proposed Basel III rules could also increase required capital if finalized.
- Other risks include acquisition integration and purchase-accounting estimates, credit deterioration, mortgage repurchase claims and litigation, regulatory actions, interest-rate and liquidity changes, and economic conditions. Management stated disclosure controls were effective as of June 30; it reported no material change in internal control over financial reporting apart from extending oversight to acquired HSBC operations.
Important facts for investors to verify
- How much of subsequent earnings and credit performance reflects acquired portfolios, purchase accounting, and one-time or transaction-related items.
- Whether HSBC allowance assumptions, acquired-loan cash-flow estimates and reported credit metrics remain appropriate as the portfolios season.
- Developments in mortgage repurchase litigation and claims, including adequacy of the $1.002B reserve and the $1.7B reasonably possible loss estimate.
- Progress and costs of acquisition integration and regulatory-mandated compliance enhancements.
- Capital and liquidity trends, including the effect of proposed regulatory capital rules and the evolution of deposits, borrowing maturities and liquidity reserves.