CAPITAL ONE FINANCIAL CORP quarterly report, Q2 FY2018

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Capital One Financial Corporation — Q2 2018 Form 10-Q

Reporting period: Three and six months ended June 30, 2018; comparisons are with the corresponding 2017 periods unless stated otherwise. Capital One is a diversified financial services company, with Credit Card, Consumer Banking and Commercial Banking segments.

Financial performance and condition

  • Revenue and earnings: Q2 total net revenue was $7.192 billion, up 7%; net income was $1.906 billion, up 84%, and diluted EPS was $3.71 versus $1.94. For the first six months, revenue was $14.101 billion, up 7%; net income was $3.252 billion, up 76%, and diluted EPS was $6.33 versus $3.49.
  • Key earnings drivers: Lower credit-loss provision, the gain on the consumer home-loan portfolio sale and higher net interest income lifted results. The $400 million sale-related net gain included a $46 million benefit for credit losses and was recorded in Other.
  • Interest income and margins: Q2 net interest income increased 1% to $5.551 billion; first-half net interest income increased 3% to $11.269 billion. Net interest margin fell to 6.66% in Q2 from 6.88%, and to 6.79% for the half from 6.88%, as higher funding costs partly offset higher asset yields and growth.
  • Credit costs and quality: Provision for credit losses was $1.276 billion in Q2, down 29%, and $2.950 billion for the first half, down 22%. The company cited allowance releases in domestic credit card and auto, improved credit trends, and unusually high prior-year oil-and-gas and taxi-medallion charge-offs. Q2 net charge-off rate was 2.42%, down 25 basis points year over year; the 30+ day delinquency rate was 3.05% at June 30, down from 3.48% at year-end.
  • Expenses and taxes: Q2 non-interest expense was essentially flat at $3.424 billion; first-half expense rose 2% to $6.997 billion, reflecting loan growth, technology and infrastructure investment, and restructuring, partly offset by lower fee assessments. The effective tax rate was 23.1% in Q2 and 21.5% for the first half, versus 29.7% and 29.1%, respectively, primarily due to the Tax Act’s lower federal rate.
  • Segment net income from continuing operations: Q2 Credit Card $923 million (versus $553 million), Consumer Banking $539 million (versus $276 million), Commercial Banking $242 million (versus $146 million), and Other $213 million (versus $72 million). The Other increase chiefly reflected the home-loan sale gain.
  • Balance sheet, funding and debt: At June 30, total assets were $363.989 billion, loans held for investment $236.124 billion, deposits $248.225 billion, borrowings $53.310 billion, and stockholders’ equity $49.926 billion. Loans held for investment fell 7% from year-end, mainly following the home-loan sale and seasonal card paydowns; deposits rose 2%. Long-term debt was $52.757 billion, down from $59.705 billion at year-end. Allowance for loan and lease losses was $7.368 billion, or 3.12% of loans.
  • Cash flow and liquidity: First-half operating cash flow was $5.687 billion, investing cash outflow $3.615 billion and financing cash outflow $3.128 billion. Cash, cash equivalents and restricted cash ended at $13.296 billion, down from $14.352 billion at the start of the year. Liquidity reserves were $98.860 billion; the second-quarter liquidity coverage ratio exceeded the 100% requirement.
  • Capital: Preliminary Basel III Standardized Approach common equity Tier 1 ratio was 11.1%, versus 10.3% at year-end; total capital ratio was 15.1%. The company reported that it and its banks exceeded applicable minimum capital requirements.

Material changes and notable items

  • Capital One sold the substantial majority of its consumer home-loan portfolio and related servicing in Q2, transferred the remaining $398 million portfolio to loans held for sale, and recorded the $400 million net gain. It had ceased new home-loan originations in Q4 2017.
  • Average domestic card purchase volume increased 17% in Q2 to $97.392 billion. Average credit-card loans grew year over year, partly reflecting the 2017 Cabela’s portfolio acquisition, while auto loans also grew.
  • The company’s first-half allowance decreased $134 million from year-end, while the allowance coverage ratio rose 17 basis points, largely because loan balances declined.
  • Higher interest rates increased deposit and other funding costs. Consumer Banking’s average deposit rate rose to 0.88% in Q2 from 0.59% a year earlier; management identified deposit costs as a continuing net-interest-margin headwind.
  • Adoption of hedge-accounting guidance led to a one-time transfer of $9.0 billion of held-to-maturity securities to available-for-sale. The filing also reports adoption of other accounting standards, including revenue recognition, with no material impact from that adoption.

Outlook, risks and contingencies

  • Outlook: Management expected a 2018 corporate annual effective tax rate around 20% before discrete items; 2018 operating efficiency, net of adjusting items, roughly flat with 2017; and higher 2018 marketing expense, with essentially all of the increase in the second half. Over the longer term, management expects gradual efficiency improvement, largely from digital productivity and operating efficiency.
  • Management expected continued increases in deposit costs from higher market rates and competition, and a gradual longer-term increase in the auto charge-off rate. Interest-rate sensitivity analysis estimated projected net interest income would be down 1.0% under a 150-basis-point decline scenario; economic value of equity was down 8.5% under a 200-basis-point increase scenario. These are model estimates, not forecasts.
  • The Board authorized up to $1.2 billion of common-stock repurchases from Q3 2018 through Q2 2019 and authorized a quarterly common dividend of $0.40 per share. The company repurchased approximately $1.0 billion under the prior program through Q2 2018.
  • On July 26, 2018, after quarter-end, Capital One announced a long-term Walmart credit-card program agreement. It is to become the exclusive U.S. issuer of Walmart’s private-label and co-branded cards beginning August 1, 2019.
  • Contingencies: The company estimated reasonably possible future litigation losses beyond recorded reserves at approximately $500 million, including mortgage representation-and-warranty matters; it cautioned that actual losses could exceed its estimates. The U.K. payment-protection-insurance reserve was $157 million, with approximately $100 million of reasonably possible future losses beyond the reserve. Capital One also disclosed investigations concerning anti-money-laundering controls and an open OCC consent order dated 2015. Management reported no material change in the risk factors from its 2017 Form 10-K.
  • Other stated risks include credit deterioration, deposit outflows or higher funding costs, interest-rate changes, regulation and litigation, competition, execution and technology risks, cybersecurity, and model and data reliability. The filing says the California Consumer Privacy Act was expected to take effect in 2020 and identifies new U.K. persistent-debt requirements due for implementation in 2018.

Important facts for investors to verify

  1. How much of the earnings increase is repeatable, given the $400 million home-loan sale gain and credit-loss allowance releases?
  2. Whether credit performance and reserve adequacy remain favorable as card and auto portfolios evolve, including the expected longer-term rise in auto charge-offs.
  3. How deposit-cost increases affect net interest margin, earnings and deposit growth.
  4. The eventual exposure from litigation, mortgage representation-and-warranty claims, U.K. PPI remediation and the anti-money-laundering matters.
  5. Whether the Walmart program agreement produces the expected business benefits when it begins in 2019, and how the announced repurchases affect capital and share count.