Capital One Financial Corporation (COF) — Q2 2014 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2014. Capital One is a diversified financial services company, with Credit Card, Consumer Banking and Commercial Banking segments. Dollar amounts are in U.S. dollars.
Financial performance and condition
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Total net revenue | $5.47 billion | $5.64 billion | $10.84 billion | $11.19 billion |
| Net interest income | $4.32 billion | $4.55 billion | $8.67 billion | $9.12 billion |
| Provision for credit losses | $704 million | $762 million | $1.44 billion | $1.65 billion |
| Income from continuing operations, net of tax | $1.20 billion | $1.23 billion | $2.33 billion | $2.36 billion |
| Net income | $1.19 billion | $1.11 billion | $2.35 billion | $2.16 billion |
| Diluted earnings per share | $2.04 | $1.85 | $4.00 | $3.62 |
| Net interest margin | 6.55% | 6.83% | 6.59% | 6.78% |
- Profitability and margins: Q2 net income rose 8% year over year despite a 3% decline in revenue and a 5% decline in net interest income. The lower credit-loss provision and mortgage representation-and-warranty benefit helped offset lower lending income. Q2 return on average assets was 1.63%; return on average common equity was 11.09%. The efficiency ratio was 54.48%, up 95 basis points year over year.
- Cash flow: For the first six months, operating activities provided $4.92 billion, investing activities used $3.87 billion and financing activities used $612 million. Cash and cash equivalents ended the period at $6.73 billion. The filing’s bank cash-flow figures reflect substantial loan, securities and funding activity.
- Balance sheet and funding: At June 30, total assets were $298.3 billion, loans held for investment were $198.5 billion, deposits were $205.9 billion and stockholders’ equity was $43.8 billion. Other debt was $29.1 billion and securitized debt obligations were $10.0 billion. Total short- and long-term borrowings were $39.1 billion.
- Liquidity: Disclosed liquidity reserves were $77.3 billion, up from $69.7 billion at year-end 2013. Customer deposits were the company’s largest funding source. Short-term borrowings declined to $10.5 billion from $16.2 billion at year-end.
- Capital: The June 30 common equity Tier 1 ratio was 12.72% under the Basel III Standardized Approach with transition provisions; the December 31, 2013 Tier 1 common ratio was 12.19% under Basel I. These measures are not directly comparable because the calculation methods differ. The fully phased-in Basel III standardized estimate was 11.6%.
- Credit quality: Q2 net charge-offs were $812 million, with a 1.67% net charge-off rate, compared with $969 million and 2.03% a year earlier. The 30+ day delinquency rate was 2.53% at June 30, down from 2.96% at year-end. The allowance for loan and lease losses was $4.0 billion, or 2.01% of loans, down from $4.3 billion, or 2.19%, at year-end.
Material changes and segment results
Year-over-year comparisons reflect, among other factors, the September 2013 sale of the Best Buy card portfolio, acquired-loan run-off and the adoption of a new affordable-housing investment accounting method, with prior periods recast. The Best Buy sale and acquired card-loan run-off reduced average credit card assets and interest income; commercial and auto lending grew.
| Segment | Q2 2014 revenue | Q2 2014 net income | Year-over-year net income |
|---|---|---|---|
| Credit Card | $3.30 billion | $668 million | Down 7% |
| Consumer Banking | $1.60 billion | $334 million | Down 25% |
| Commercial Banking | $545 million | $171 million | Down 6% |
| Other | $22 million | $31 million | Compared with a $117 million loss |
- Credit Card earnings fell as revenue declined following the portfolio sale and acquired-loan run-off; lower credit provisions and expenses partly offset the impact. Purchase volume increased 11% to $56.4 billion.
- Consumer Banking earnings declined amid higher credit provisions and margin pressure. Auto originations grew 19% in Q2, while auto credit losses rose from low levels.
- Commercial Banking loans grew 7% from year-end to $48.3 billion, led by commercial and industrial and commercial real estate lending. Revenue growth was offset by spread compression, higher expenses and a shift from prior-year allowance releases to provisions.
- Other improved primarily from lower funding costs, higher net interest income and the absence of a 2013 charge on redemption of trust preferred securities.
Outlook, risks and unusual items
- Guidance: Management maintained its expectation for 2014 pre-provision earnings of approximately $10 billion, excluding non-recurring items. It expects higher revenue to offset higher expenses versus initial expectations, increased marketing in the second half of 2014 and pre-provision earnings growth in 2015. The 2015 full-year efficiency ratio was expected to be 53%–54%, excluding non-recurring items.
- Capital returns: Management expected to maintain a quarterly common dividend of $0.30 per share, subject to Board approval. The Board authorized up to $2.5 billion of buybacks through Q1 2015; approximately $1 billion had been repurchased through Q2.
- Credit outlook: Management said allowance releases were less likely going forward as lending growth resumed and charge-offs were below historical averages. It expected auto losses to rise gradually from recent lows, continuing pressure on auto margins and returns, and approximately $6 billion of home-loan run-off during 2014. Commercial credit performance was expected to remain strong, though competition could moderate growth.
- Mortgage representation and warranties: The reserve declined to $1.012 billion from $1.172 billion at year-end; the first-half provision was a $51 million benefit, driven mainly by legal developments. Management estimated approximately $2.5 billion of reasonably possible future losses beyond the recorded reserve. It cautioned that actual losses could exceed both the reserve and this estimate, and that adverse legal outcomes could materially affect results or cash flows in a period.
- Other contingencies: Management estimated reasonably possible future losses of approximately $250 million for certain other litigation matters where an estimate was possible; this excludes the mortgage litigation exposures discussed above. A $169 million U.K. cross-sell reserve remained in place; management cited uncertainty about claim volumes and possible further reserve additions.
- Market and regulatory risks: Interest rates, consumer credit performance, competition, deposit growth, access to funding, regulation, litigation, operational and technology disruptions, and marketing effectiveness could affect results. A 200-basis-point rate increase was estimated to raise projected 12-month net interest income by 4.4%; a 50-basis-point decrease was estimated to reduce it by 1.9%. Management stated both interest-rate sensitivity measures were within policy limits.
- Unusual accounting and presentation: The company adopted proportional amortization for qualified affordable-housing investments retrospectively. The filing reports a $1.1 billion liability for unfunded commitments to these investments, expected to be paid from 2014 to 2017. Acquired loans are accounted for based on expected cash flows and may not be classified as delinquent or nonperforming in the same way as other loans; the company provides adjusted credit metrics excluding their effect.
Important facts for investors to verify
- Whether revenue and net interest income stabilize as card balances recover from portfolio-sale effects and commercial and auto loans grow.
- Whether auto-loan growth remains profitable as competition compresses yields and credit losses rise from recent lows.
- Whether mortgage repurchase claims and litigation remain within the $1.012 billion reserve and management’s $2.5 billion estimate of reasonably possible additional losses.
- How the Basel III capital ratios evolve as transition provisions phase in and risk-weighted assets are recalculated.
- Whether the stated 2014 earnings outlook, 2015 efficiency target, dividend and authorized buybacks are achieved; these are forward-looking expectations, not guarantees.
- Cash-flow and funding trends alongside the disclosed liquidity reserve, including reliance on deposits, secured borrowing capacity and securitization markets.