Capital One Financial Corporation (NYSE: COF) — Q1 2014 Form 10-Q
Reporting period: Three months ended March 31, 2014; balance-sheet comparisons are with December 31, 2013 unless stated otherwise. Capital One is a diversified financial services holding company with Credit Card, Consumer Banking and Commercial Banking segments. Amounts below are in U.S. dollars; financial figures are generally in millions unless indicated.
Financial performance and condition
- Revenue and earnings: Total net revenue was $5.37 billion, down 3% year over year. Net interest income fell 5% to $4.35 billion; non-interest income rose 4% to $1.02 billion. Income from continuing operations was $1.124 billion versus $1.134 billion; net income, including discontinued operations, was $1.154 billion versus $1.056 billion. Diluted EPS increased 11% to $1.96.
- Credit costs and expenses: Provision for credit losses decreased 17% to $735 million. Non-interest expense declined 2% to $2.932 billion. Pretax income from continuing operations rose 2% to $1.703 billion.
- Margins and returns: Net interest margin was 6.62%, down 9 basis points year over year; total net revenue margin was 8.18%, up 3 basis points. Efficiency ratio was 54.60%, compared with 53.88%. Return on average assets was 1.53%; return on average common equity was 10.53%.
- Cash flow: Operating activities provided $3.159 billion and investing activities provided $3.386 billion; financing activities used $6.654 billion. Cash and cash equivalents decreased $109 million during the quarter to $6.182 billion.
- Loans, deposits and debt: Period-end loans held for investment were $192.9 billion, down 2% from year-end; deposits were $208.3 billion, up 2%. Total assets were $290.5 billion and stockholders’ equity was $42.8 billion. Other debt was $20.3 billion, down from $30.4 billion; securitized debt was $9.8 billion.
- Credit quality: Net charge-offs were $931 million, and the charge-off rate improved to 1.92% from 2.20% year over year. The 30-plus-day delinquency rate declined to 2.51% from 2.96% at year-end. The allowance for loan and lease losses was $4.098 billion, or 2.12% of loans, versus $4.315 billion and 2.19% at year-end.
- Liquidity and capital: Liquidity reserves were $82.3 billion, up from $69.7 billion at year-end. The Basel III Standardized Approach common equity Tier 1 ratio was 12.98%; Tier 1 risk-based capital was 13.36%, total risk-based capital 15.42%, and Tier 1 leverage 10.42%. The filing estimates a fully phased-in Basel III Standardized CET1 ratio of 11.7%; the reported and estimated ratios use different transition assumptions.
Material changes and segment performance
- Net interest income declined mainly because average interest-earning assets and past-due fees were lower, reflecting the 2013 Best Buy portfolio sale and continued run-off of acquired card and home-loan portfolios. Lower funding costs partly offset the decline.
- Credit Card net income was $668 million, down 3%; lower revenue and a smaller loan portfolio were partly offset by lower credit provisions. Purchase volume increased 5% to $47.4 billion.
- Consumer Banking net income was $330 million, down 14%, primarily due to retail and auto margin pressure and home-loan run-off. Auto originations rose 25% to $4.7 billion; management noted increased competition and lower auto yields.
- Commercial Banking net income was $137 million, down 29%. Revenue grew 5% and loans grew 3% sequentially, but the segment moved from a $35 million provision benefit in Q1 2013 to a $40 million provision expense in Q1 2014, alongside higher operating expenses.
- Discontinued operations contributed $30 million after tax, compared with a $78 million loss in Q1 2013, primarily reflecting a release of mortgage representation-and-warranty reserves.
Outlook, commentary and key risks
- Management expected 2014 pre-provision earnings, excluding non-recurring items, of approximately $10 billion, with higher revenue expected to offset higher expenses. It projected approximately $1 billion of card-loan run-off and $5 billion of home-loan run-off.
- Management expected Domestic Card year-over-year growth to resume in the second half of 2014. It expected auto credit losses to rise gradually from historically low levels and continued pressure on retail deposit economics from low rates. It expected strong Commercial Banking credit performance, while noting competition could pressure loan pricing and originations.
- The Federal Reserve did not object to the company’s 2014 capital plan. The board authorized up to $2.5 billion of share repurchases through Q1 2015; timing and amount remain subject to market conditions, capital and retained earnings. Management expected to maintain the $0.30 quarterly common dividend, subject to board approval.
- Mortgage claims: The booked representation-and-warranty reserve was $1.128 billion. Management estimated approximately $2.5 billion of reasonably possible future losses beyond the reserve, down from $2.6 billion at year-end, and cautioned that actual losses could exceed both the reserve and estimate. Relevant matters include mortgage repurchase litigation and government investigations.
- For other litigation matters where a reasonably possible loss estimate was available, management estimated approximately $250 million in possible future losses, excluding the specified mortgage-related matters. The filing states estimates are uncertain and adverse outcomes could materially affect a particular period.
- Other exposures include a $123 million reserve for U.K. payment-protection-insurance complaints and a $1.1 billion liability for unfunded affordable-housing investment commitments expected to be paid during 2014–2018. The company also disclosed unconsolidated VIE maximum exposure to loss of $3.8 billion.
- Key risks include economic and credit deterioration, interest-rate changes, regulatory and capital-rule changes, competition, funding-market access, operational or technology disruption, and uncertainty around mortgage claims and litigation. Management identified loan-loss reserves, fair values, representation-and-warranty reserves, customer rewards and income taxes as critical estimates.
Important facts for investors to verify
- Whether the improvement in charge-offs and delinquencies persists, particularly as auto lending grows and management expects auto losses to rise.
- Whether card and home-loan run-off, margin pressure and the expected $10 billion pre-provision earnings target develop as management anticipated.
- The adequacy and evolution of the $1.128 billion mortgage reserve and the estimated $2.5 billion of additional reasonably possible losses, including litigation and claim developments.
- Capital and liquidity under fully phased-in Basel III and Advanced Approaches requirements; the filing notes the 12.98% transitional CET1 ratio is not directly comparable with the prior-year Basel I ratio.
- The execution, timing and effect of the authorized $2.5 billion repurchase program and the sustainability of dividends.
- Comparability effects: the Best Buy portfolio sale, acquired-loan accounting and the 2014 adoption of proportional amortization for affordable-housing investments. The accounting adoption reduced Q1 2013 net income by $10 million and year-end 2013 retained earnings by $112 million on a recast basis.