Capital One Financial Corporation — Q2 2010 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2010. Unaudited. Capital One is a diversified financial services company focused on credit cards, consumer banking and commercial banking.
Key financial results
Dollars in billions unless otherwise noted. Comparisons with 2009 below generally use management’s managed-basis figures, which are more comparable to 2010 after the accounting change described below.
| Metric | Q2 2010 | Prior comparable period / change |
|---|---|---|
| Net interest income | $3.10 | $2.96 managed; up 5% |
| Non-interest income | $0.81 | $1.19 managed; down 32% |
| Total revenue | $3.90 | $4.15 managed; down 6% |
| Provision for loan and lease losses | $0.72 | $1.90 managed; down 62% |
| Income from continuing operations, net of tax | $0.81 | $0.23 |
| Net income | $0.61 | $0.22 |
| Net income available to common shareholders; diluted EPS | $0.61; $1.33 | Common loss of $0.28; diluted loss per share of $0.66 |
Q2 net income included a $1.0 billion reduction in the loan-loss allowance. Net income fell $28 million from Q1 2010, as lower revenue, higher expenses and a larger discontinued-operations loss outweighed lower provision expense. Q2 2010 discontinued operations recorded a $204 million after-tax loss, primarily tied to mortgage representation-and-warranty claims.
For the first six months, revenue was $8.19 billion, up 4% versus 2009 managed results; net interest income was $6.33 billion, up 11%; provision expense was $2.20 billion, down 46%; and net income was $1.24 billion versus $115 million. Six-month diluted EPS was $2.73 versus a loss of $1.11. The 2009 common-shareholder loss also reflected preferred-stock dividends and accretion.
- Margins and returns: Q2 net interest margin was 7.09%, up 90 basis points from 2009 managed; revenue margin was 8.94%, up 26 basis points; risk-adjusted margin was 5.01%, up 70 basis points. Return on average assets was 1.63% and return on average equity was 13.24%.
- Credit: Q2 net charge-off rate was 5.36%, down from 6.01% in Q1; 30+ day performing delinquency rate was 3.81%, down from 4.22%. Management said it believed charge-offs peaked in Q1, while noting rates remained elevated. Period-end nonperforming loans were $1.31 billion, or 1.03% of loans.
- Allowance: The allowance was $6.8 billion at June 30, 5.35% of reported loans, versus $8.4 billion at January 1 after the accounting adoption. It declined $1.6 billion during the first half, including the Q2 reduction noted above.
- Balance sheet and funding: Assets were $197.5 billion, liabilities $172.2 billion and stockholders’ equity $25.3 billion. Loans held for investment were $127.1 billion; deposits were $117.3 billion. Other debt was $15.0 billion and securitized debt obligations were $33.0 billion.
- Liquidity and cash flows: Liquidity reserves totaled $39.6 billion. For the six months, operating cash flow was $4.8 billion, investing cash flow $6.5 billion and financing cash flow negative $14.8 billion; cash and cash equivalents fell $3.5 billion to $5.2 billion.
- Capital: Company Tier 1 risk-based capital ratio was 9.93% at June 30, up from 9.6% at March 31; the tangible common equity-to-tangible managed assets ratio was 6.1%, up from 5.5%.
Business performance and material changes
- Credit Card: Q2 net income was $568 million versus $173 million. Lower credit-loss provision and stronger net interest margin more than offset lower non-interest income. Domestic Card revenue margin was 16.61%; management expected it to fall to around 15% by end-2010 or early 2011.
- Consumer Banking: Q2 net income was $305 million versus $81 million, reflecting improved credit performance, particularly in auto lending, and lower deposit funding costs. Loans continued to run off, while deposits grew.
- Commercial Banking: Q2 net income was $77 million versus $33 million. Commercial real estate conditions remained challenging, though management saw some stabilization in property values and increased lending activity.
- Loan portfolio: Loans declined 7% from year-end 2009, primarily from charge-offs and runoff in credit card, installment and mortgage portfolios. The filing’s period comparisons are affected by the 2010 consolidation change.
- Mortgage servicing rights: Fair value declined to $137 million from $240 million at year-end, reflecting portfolio runoff, valuation changes and sales; a Q2 sale of servicing rights generated a $14 million loss.
Outlook, unusual items and risks
- Accounting change: Effective January 1, 2010, new consolidation standards brought substantial securitization trusts onto the balance sheet. Capital One added about $41.9 billion of assets and $44.3 billion of related debt and recorded a $2.9 billion after-tax reduction to retained earnings, including a $4.3 billion increase to the allowance. This materially changed reported balance-sheet and income-statement presentation; historical 2010 and 2009 reported figures are not directly comparable.
- Outlook: Management expected loan balances to bottom over the next several quarters, stabilize and begin modest growth in 2011. It expected quarterly margins and pre-provision earnings to decline into 2011, with pre-provision earnings then beginning to grow during 2011. Allowance reductions were expected to continue over the remainder of 2010.
- Funding outlook: Securitized debt was expected to decline to approximately $23.9 billion by year-end 2010, about 51% below its January 1 level.
- Regulation: The Dodd-Frank Act was signed July 21, 2010. Management cited potential changes to capital, liquidity, fees, consumer regulation and business practices. Credit CARD Act fee requirements effective August 22, 2010 were expected to add pressure to card revenue.
- Mortgage claims and litigation: Representation-and-warranty reserves reached $853 million, up from $238 million at year-end, following a Q2 refinement that extended estimates, in most cases, over the full life of loans sold. The company said it could not determine a meaningful reasonably possible loss range above the reserve or assure that the reserve would be adequate. A separate portfolio-wide repurchase claim involving about 30,000 loans and $1.8 billion original principal was not reserved because it was not considered probable and estimable. Other matters include interchange-fee litigation, payment-protection claims, and an SEC investigation concerning auto-finance loan-loss reserves for certain 2007 quarters; loss ranges were not clear or estimable for these matters.
- Economic and execution risks: Management described recovery as fragile and modest at best. Key risks include unemployment and consumer credit trends, commercial real estate, mortgage repurchase exposure, changing regulation, funding access, and interest-rate and market movements.
Most important facts for investors to verify
- How much Q2 earnings depended on the $1.0 billion allowance reduction, and whether credit trends support further reserve releases.
- Whether charge-offs continue to fall from Q1 levels, particularly in credit cards, and whether delinquencies and nonperforming loans stabilize.
- Whether the $853 million mortgage representation-and-warranty reserve proves adequate, including outcomes in the U.S. Bank litigation and other claims.
- How the forecast declines in card margins, fee revenue and pre-provision earnings affect profitability through 2011, including the effects of the CARD Act and Dodd-Frank rules.
- Capital-ratio effects as the securitization-consolidation phase-in progresses through early 2011, and the sustainability of liquidity and deposit funding.
- Reported-versus-managed accounting reconciliations when comparing 2010 results with prior periods.