CAPITAL ONE FINANCIAL CORP quarterly report, Q3 FY2011

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Capital One Financial Corporation — Q3 2011 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2011; balance-sheet comparisons are primarily against December 31, 2010. Capital One is a diversified financial-services holding company operating Credit Card, Consumer Banking and Commercial Banking businesses. Unless otherwise stated, amounts are in U.S. dollars.

Financial performance

  • Q3 revenue: $4.154 billion, up 3% year over year. Net interest income was $3.283 billion, up 6%; non-interest income was $871 million, down 4%.
  • Q3 earnings: Income from continuing operations was $865 million; net income was $813 million, or $1.77 per diluted share, versus $803 million, or $1.76 per diluted share, in Q3 2010. Net income was below Q2 2011’s $911 million.
  • Nine-month results: Revenue was $12.229 billion versus $12.209 billion; continuing-operations income was $2.842 billion versus $2.349 billion; net income was $2.740 billion versus $2.046 billion. Diluted EPS was $5.95 versus $4.49.
  • Margins and efficiency: Q3 net interest margin was 7.39%, up 18 basis points year over year; revenue margin was 9.35%. The efficiency ratio was 55.30%, compared with 49.70% a year earlier. For the nine months, net interest margin was 7.28%, up 15 basis points, while the efficiency ratio was 54.90%, compared with 47.86%.
  • Credit costs: Q3 provision for loan and lease losses was $622 million, down 28%; nine-month provision was $1.499 billion, down 51%. Net charge-off rates were 2.52% for Q3 and 3.02% for the nine months, versus 4.82% and 5.41%, respectively, in 2010.
  • Expenses: Q3 non-interest expense increased 15% to $2.297 billion; nine-month expense increased 15% to $6.714 billion. The filing attributes increases to acquisition integration, marketing and contingent payments.
  • Cash flow: For the first nine months, operating activities provided $5.916 billion, investing activities used $3.149 billion and financing activities used $1.658 billion. Cash and cash equivalents ended the period at $6.358 billion, up from $5.249 billion at year-end 2010.

Balance sheet, funding and capital

  • Total assets were $200.148 billion; total loans held for investment were $129.952 billion, up 3% from year-end. Total deposits were $128.318 billion, up 5%; stockholders’ equity was $29.378 billion, up 11%.
  • Total borrowings, including securitized debt, were $34.315 billion, down from $41.796 billion. Securitized debt declined to $17.120 billion from $26.915 billion; other debt was $17.195 billion, up from $14.881 billion.
  • Liquidity reserves totaled $35.908 billion, including $6.358 billion of cash and $29.550 billion of unencumbered available-for-sale securities. Brokered deposits were $14.4 billion, or 11% of deposits.
  • At September 30, the Basel I Tier 1 risk-based capital ratio was 12.4%, Tier 1 common equity ratio was 10.0% (a non-GAAP measure), total risk-based capital ratio was 15.4%, and tangible common equity ratio was 8.3% (non-GAAP). The company’s estimate of its Basel III Tier 1 common ratio was 10.1%, based on a framework not yet implemented and subject to change.
  • Capital One issued approximately $3.0 billion of senior notes in Q3. Its 40 million-share offering was subject to forward-sale agreements; the company had not yet received proceeds as of the filing and expected approximately $1.9 billion upon settlement.

Material changes and segment performance

  • Management attributed improved year-to-date earnings mainly to lower credit costs and a substantially smaller provision for legacy mortgage repurchase claims. Higher operating costs and marketing partly offset these gains.
  • Credit Card: Q3 segment net income was $663 million, up 5%; nine-month income was $1.924 billion, up 14%. Purchase volume rose 29% in Q3. The Q3 result included an approximately $83 million revenue benefit from revised estimates of recoveries on previously uncollectible finance charges and fees.
  • Consumer Banking: Q3 net income was $190 million, up 9%; nine-month income was $692 million, down 12%. Auto originations increased 40% in Q3 and 60% for the nine months; growth was partly offset by the runoff of legacy home loans.
  • Commercial Banking: Q3 net income was $145 million versus $39 million; nine-month income was $435 million versus $67 million. Improved credit quality led to negative provision expense of $10 million in Q3 and $43 million for the nine months.
  • Loans grew through the HBC and Kohl’s card portfolio acquisitions, auto finance, commercial lending and revolving card balances. Excluding the HBC and Kohl’s additions, loans declined 1% over the first nine months.

Outlook, unusual items and risks

  • Management expected modest year-over-year growth in ending loan balances in 2011, with average loan balances broadly comparable to 2010. It expected seasonal Domestic Card loan growth in Q4, continued strong auto originations but seasonal increases in auto charge-offs, and modest Commercial Banking loan growth. Management said commercial credit performance had improved but quarterly charge-offs and nonperforming loans could remain variable.
  • The pending ING Direct acquisition was expected to close in late 2011 or early 2012 for $6.2 billion in cash and approximately 55.9 million shares, subject to approvals and other conditions. The HSBC U.S. card-business acquisition was expected to close in Q2 2012; its estimated premium was $2.6 billion. Management outlined a planned $1.25 billion capital raise related to HSBC and expected a Tier 1 common ratio in the mid-9% range at the end of Q2 2012, inclusive of that raise.
  • ING-related pay-fixed/receive-floating swaps had approximately $23.8 billion notional. They were economic hedges, not designated for hedge accounting; Q3 included a $266 million mark-to-market loss. A $239 million gain on sales of approximately $6.4 billion of securities largely offset that loss. Further fair-value changes could affect earnings until the swaps are terminated.
  • Mortgage representation-and-warranty reserve was $892 million, versus $816 million at year-end 2010. Open repurchase requests were about $1.9 billion of original loan principal. Management estimated reasonably possible losses beyond the reserve could be as high as $1.5 billion; actual losses could exceed that estimate. The reserve and estimate depend on claims, litigation outcomes, loan performance, collateral recoveries and housing and employment conditions.
  • Other notable items include a $52 million after-tax Q3 discontinued-operations loss related to the closed GreenPoint mortgage business, and a $52 million Q2 provision for anticipated U.K. payment-protection-insurance refunds. The filing also reports a $98 million tax benefit for the first nine months from deferred-tax-asset valuation allowance release and resolution of tax matters.
  • Management cited economic uncertainty, including elevated U.S. unemployment, the European debt crisis and market volatility. Risks include acquisition approvals, integration and execution, credit deterioration, mortgage claims and litigation, interest-rate and market movements, funding access, regulatory changes and cost control. The filing states disclosure controls were effective as of September 30, 2011 and reports no material Q3 change in internal control over financial reporting.

Key facts for investors to verify

  • Whether and when the ING Direct and HSBC transactions close, their final consideration and capital impact, and whether anticipated benefits and integration plans are achieved.
  • How the $1.5 billion upper-end estimate of reasonably possible additional mortgage representation-and-warranty losses compares with subsequent claims, settlements and litigation outcomes.
  • Whether credit-quality improvement persists as management expected seasonal patterns to return, and how allowance releases and the 3.29% allowance-to-loans ratio perform through a weaker economy.
  • The recurring earnings impact of acquisition-related costs, higher marketing and the $83 million finance-charge-and-fee reserve methodology change; distinguish these items from underlying operating trends.
  • Settlement of the equity forward-sale agreements, the resulting share issuance and proceeds, and the conditional redemption terms on the 2011 notes if ING Direct does not close by June 30, 2012.
  • Developments in disclosed litigation and regulatory matters, including mortgage repurchase cases, card interest-rate and overdraft claims, interchange litigation and the SEC investigation concerning auto-finance loan-loss reserves.