Capital One Financial Corporation — 2011 Q2 Form 10-Q
Business context and reporting period. Capital One is a diversified financial services company with Credit Card, Consumer Banking and Commercial Banking segments. This unaudited filing covers the quarter and six months ended June 30, 2011; balance-sheet comparisons are to December 31, 2010. Amounts below are in U.S. dollars.
Financial performance and condition
- Quarterly earnings: Q2 net income was $911 million, or $1.97 per diluted share, versus $608 million, or $1.33 per diluted share, in Q2 2010. Income from continuing operations was $945 million, compared with $812 million.
- First-half earnings: Net income was $1.927 billion, versus $1.244 billion in the first half of 2010. Continuing-operations income was $1.977 billion, versus $1.532 billion.
- Revenue and margins: Q2 total revenue was $3.993 billion, up 2% year over year; net interest income was $3.136 billion, up 1%, and non-interest income was $857 million, up 6%. Net interest margin was 7.20%, up 11 basis points; revenue margin was 9.17%, up 23 basis points. First-half revenue was $8.075 billion, down 1%, and net interest income was $6.276 billion, down 1%.
- Credit costs and expenses: Q2 provision for loan and lease losses fell 53% to $343 million; first-half provision fell 60% to $877 million. Q2 non-interest expense increased 13% to $2.255 billion; first-half expense rose 15% to $4.417 billion, partly reflecting acquisition-related costs, legal fees and higher marketing. Q2 efficiency ratio was 56.47%, versus 51.23% a year earlier.
- Credit quality: Q2 net charge-off rate improved to 2.91% from 5.36% a year earlier; the 30-plus-day delinquency rate was 3.57% at June 30, down from 4.23% at year-end. The allowance was $4.488 billion, or 3.48% of loans, down from $5.628 billion, or 4.47%, at year-end. Management attributed the improvement to better credit trends and tighter underwriting.
- Business segments: Q2 continuing-operations income was $618 million for Credit Card, $287 million for Consumer Banking and $142 million for Commercial Banking. International Card reported a $24 million loss, including a U.K. payment-protection-insurance provision; Commercial Banking benefited from improved credit and recorded negative loan-loss provision.
- Balance sheet, funding and capital: Total assets were $199.8 billion; loans held for investment were $129.0 billion, up 2% from year-end, and deposits were $126.1 billion, up 3%. Other debt excluding securitized obligations was $17.9 billion; securitized debt was $19.9 billion. Liquidity reserves were $35.4 billion, including $6.6 billion cash and $28.8 billion unencumbered available-for-sale securities; the company had no undrawn committed securitization-conduit capacity. Tier 1 common equity ratio was 9.4% (8.8% at year-end), Tier 1 risk-based capital was 11.8% (11.6%), and total risk-based capital was 15.0% (16.8%). Banks were reported as well capitalized.
- Cash flows: For the first half, operating activities provided $4.361 billion, investing activities used $2.777 billion and financing activities used $190 million. Cash and cash equivalents ended at $6.643 billion, versus $5.199 billion a year earlier. These bank cash-flow figures reflect, among other items, loan and funding movements.
Material changes versus comparable periods
- Earnings growth substantially exceeded revenue growth, principally because of lower credit-loss provision and a sharp reduction in mortgage repurchase-loss provisions. Q2 2010 included a $404 million mortgage repurchase provision, compared with $37 million in Q2 2011; first-half amounts were $628 million and $81 million, respectively.
- Q2 total net charge-off rate fell 245 basis points year over year. The allowance declined by $1.1 billion during the first half as credit performance improved.
- Loan growth included the $3.7 billion Kohl’s portfolio acquired in April and the $1.4 billion HBC portfolio acquired in January. Excluding these additions, loans declined $2.1 billion in the first half, reflecting run-off, paydowns and charge-offs.
- Deposits increased while borrowings shifted: deposit growth supported the company’s strategy to rely more on lower-cost relationship funding. Securitized debt fell $7.1 billion from year-end, while other debt increased $3.0 billion.
- Consumer Banking income declined year over year, partly because Q1 2010 included a one-time $128 million pre-tax gain from deconsolidating mortgage trusts. Commercial Banking income improved markedly as provision needs fell.
Outlook, risks and unusual items
- Management outlook: Capital One expected modest year-over-year growth in ending loans in 2011, with full-year average loans comparable to 2010. It anticipated modest Credit Card loan growth in the second half, continued auto-loan growth offset largely by mortgage run-off, and modest growth in lower-risk commercial loans. Management expected auto charge-offs to rise in the second half due to seasonality, competition and used-vehicle auction prices; commercial credit results could remain volatile.
- ING Direct acquisition: The company agreed to acquire substantially all of ING Direct’s U.S. business for $6.2 billion cash plus approximately 55.9 million shares, subject to adjustments and approvals, with closing expected in late 2011 or early 2012. On July 19, 2011, it completed a senior-notes offering for approximately $3.0 billion and a 40-million-share forward sale intended to provide approximately $1.9 billion upon settlement. Proceeds and existing liquidity were expected to fund the cash consideration. Approval, financing, integration and execution remain risks.
- Mortgage repurchase exposure: The representation-and-warranty reserve was $869 million at June 30. Open repurchase claims totaled $1.746 billion in original loan principal, which is not an estimate of expected loss. Management said reasonably possible losses beyond the reserve, including specified litigation, could be as high as $1.1 billion; actual losses could exceed that estimate. Reserve adequacy depends on claims, litigation, loan performance, housing conditions and recoveries.
- Other legal and regulatory matters: Management estimated a $75 million to $225 million high end for reasonably possible losses across certain other litigation matters, excluding the mortgage matters discussed above. Disclosed proceedings include interchange-fee and credit-card-rate litigation, overdraft-fee litigation, a West Virginia Attorney General case, mortgage-related lawsuits, an SEC investigation focused largely on historical auto-loan loss reserves, and other matters. The filing states outcomes are uncertain. Dodd-Frank implementation and new consumer-finance oversight may increase costs or require business changes.
- Specific unusual items: Kohl’s revenue sharing reduced reported interest income by $215 million in Q2 and the first half; its loss-sharing arrangement reduced charge-offs by $42 million and the provision by $212 million in each period, with an expected reimbursement of about $170 million netted against the allowance. The U.K. PPI matter resulted in a $75 million reserve, including $52 million recorded as a revenue offset in Q2. The filing also identifies a $30 million Sony portfolio loss-sharing expense in Q2.
- Market and accounting risks: Management identified economic weakness, unemployment, interest rates, credit losses, deposit trends, competition, regulatory changes, acquisition integration, mortgage claims and operating or technology disruptions as factors that could affect results. Fair-value, loan-loss, tax, impairment and repurchase-reserve estimates involve substantial judgment.
Important facts for investors to verify
- Whether credit improvement and lower charge-offs persist, and whether the reduced allowance remains adequate as loan growth and portfolio mix change.
- The actual earnings contribution and credit performance of Kohl’s and HBC after accounting for revenue sharing, loss sharing and acquisition-related expenses.
- ING Direct closing conditions, final consideration, funding and share dilution, and progress integrating the business.
- Developments in mortgage repurchase claims and litigation, including whether losses exceed the $869 million reserve or management’s stated additional-loss estimate.
- The effect of regulatory changes, including debit interchange limits and consumer-finance rules, on fees, costs and business practices.