Capital One Financial Corporation — Q1 2010 Form 10-Q
Reporting period: Three months ended March 31, 2010. Capital One is a diversified financial services company reporting Credit Card, Commercial Banking and Consumer Banking segments. Comparisons require caution: effective January 1, 2010, new consolidation rules brought most securitization trusts onto the balance sheet. Unless noted, the filing compares 2010 reported GAAP results with 2009 managed results; these bases are not fully comparable. The Chevy Chase Bank acquisition also means Q1 2010 includes a full quarter while Q1 2009 includes only a partial quarter.
Financial performance and position
- Earnings and revenue: Net income was $636.3 million, or $1.40 per diluted share, versus a $172.3 million loss available to common shareholders in Q1 2009. Continuing-operations income after tax was $719.5 million; discontinued operations recorded an $83.2 million loss. Total revenue was $4.29 billion, up $554.0 million (17%) from 2009 managed revenue of $3.74 billion.
- Interest income and margins: Net interest income was $3.23 billion, up 17% from $2.75 billion managed in Q1 2009. Net interest margin expanded to 7.10% from 5.89%, reflecting higher asset yields and lower funding costs. Non-interest income was $1.06 billion, up 8% from the managed comparison.
- Credit costs and expenses: Provision for loan and lease losses was $1.48 billion, down from $2.13 billion managed in Q1 2009. The allowance was $7.75 billion at March 31; its reported 5.96% coverage of loans reflects the newly consolidated loans. Non-interest expense was $1.85 billion, up 6% from $1.75 billion.
- Cash flow: Operating activities provided $2.02 billion and investing activities provided $6.14 billion; financing activities used $9.35 billion. Cash and cash equivalents fell $1.19 billion during the quarter to $7.50 billion. Changes in securitization accounting significantly affect cash-flow presentation and comparability.
- Balance sheet and funding: Total assets were $200.7 billion and total liabilities $176.3 billion at March 31. The January accounting adoption initially added about $41.9 billion of assets and $44.3 billion of securitized debt; on an adjusted basis, assets declined $10.8 billion from January 1. Loans were $130.1 billion, down 5% from $136.8 billion managed at year-end; deposits rose 2% to $117.8 billion. Securitized debt was $37.8 billion, versus $4.0 billion at year-end, primarily due to consolidation. Senior and subordinated notes totaled $9.1 billion and other borrowings $5.7 billion.
- Liquidity and capital: Liquidity reserves were $39.8 billion, including $7.5 billion cash, $26.9 billion unencumbered available-for-sale securities and $5.4 billion of undrawn committed securitization facilities. The company’s Tier 1 risk-based capital ratio was 9.57%, total capital ratio 16.90%, and tangible common equity ratio 5.5%. The Tier 1 ratio was 13.75% at year-end before the consolidation impact; the company elected a regulatory phase-in and said it expected to remain above well-capitalized minimums.
Material changes and credit trends
- Reported results improved substantially year over year, chiefly from higher net interest margin and lower provision expense. The comparison is affected by the consolidation change and Chevy Chase acquisition; it should not be read as a like-for-like GAAP comparison.
- Credit Card segment net income was $489.6 million versus $3.3 million; Consumer Banking net income was $305.4 million versus $25.3 million. Commercial Banking recorded a $49.5 million loss versus $17.9 million income, as commercial real-estate stress and credit deterioration drove higher provisions.
- The total net charge-off rate was 6.01%, up from 5.41% a year earlier but down from 6.33% in Q4 2009. The 30-plus-day performing delinquency rate was 4.22%, compared with 4.10% a year earlier and 4.73% at year-end. Nonperforming loans were 1.04% of loans, up from 0.94% at year-end; deterioration was concentrated in commercial real estate and mortgages.
- Capital One recorded a $127.6 million gain from selling interest-only mortgage bonds and deconsolidating related option-ARM trusts. It also recorded a $2.9 billion after-tax reduction to opening retained earnings on adoption of consolidation standards.
Outlook, risks and contingencies
- Management expected Domestic Card revenue margins to decline through the remainder of 2010 and into early 2011, to around 15% by year-end or early 2011, citing credit trends, promotional-rate mix and Credit CARD Act fee restrictions. Marketing expense was expected to rise toward more normal levels.
- Management expected total loans to decline about $7.0 billion from year-end 2009 to year-end 2010, with mid-single-digit percentage decline in ending balances and high-single-digit decline in average balances. It anticipated lower charge-offs and provision expense, potentially including further allowance releases, but expected lower pre-provision earnings into 2011.
- Commercial Banking expected modest portfolio growth, while nonperforming loans and charge-offs could remain elevated. Consumer Banking expected continued auto and mortgage runoff. Economic uncertainty, unemployment, housing and commercial property values, interest rates, funding access, regulation, competition and execution remain material risks.
- Mortgage representation-and-warranty exposure is significant and uncertain. Open repurchase requests covered about $1.2 billion of original loan principal. The reserve rose to $454 million from $238 million at year-end, including a $224 million quarterly expense largely reflecting updated litigation estimates. A separate U.S. Bank action seeks repurchase of a portfolio with about $1.8 billion original principal; this portfolio-wide claim was not reserved because management did not consider it probable and estimable. The company said it could not reasonably estimate total losses and reserves might prove inadequate.
- Other legal and regulatory matters include payment-protection-product class actions and inquiries, interchange-fee litigation, and a formal SEC investigation focused largely on auto-finance loan-loss reserve methods for certain 2007 quarters. The filing states outcomes and effects cannot presently be determined. Proposed financial reforms and Credit CARD Act requirements could affect revenue, costs and operations.
Most important facts for investors to verify
- Reconcile the GAAP and managed comparisons, particularly revenue, provision, loan balances and credit metrics, and isolate the effects of consolidation and Chevy Chase.
- Track credit performance by portfolio: charge-offs, delinquencies, nonperforming loans, commercial real-estate exposure and allowance adequacy.
- Assess the trajectory of card margins, fee income, marketing expense, loan runoff and management’s expected timing of earnings normalization.
- Monitor regulatory capital through the consolidation phase-in and confirm liquidity and deposit funding remain available at acceptable cost.
- Follow mortgage repurchase claims, litigation developments and reserve changes; the filing does not provide a clear estimate of ultimate exposure.
- Review the $127.6 million deconsolidation gain and other unusual items when assessing recurring earnings.