Capital One Financial Corporation — Q3 2013 Form 10-Q
Reporting period: Three and nine months ended September 30, 2013; balance-sheet comparisons are generally against December 31, 2012. Capital One is a diversified financial services holding company operating Credit Card, Consumer Banking and Commercial Banking businesses. Amounts are in U.S. dollars; financial figures are generally in millions unless stated otherwise.
Financial performance and condition
| Metric | Q3 2013 | Q3 2012 | Nine months 2013 | Nine months 2012 |
|---|---|---|---|---|
| Total net revenue | $5,651 | $5,782 | $16,840 | $15,772 |
| Net interest income | $4,560 | $4,646 | $13,683 | $12,061 |
| Provision for credit losses | $849 | $1,014 | $2,496 | $3,264 |
| Non-interest expense | $3,147 | $3,045 | $9,234 | $8,691 |
| Net income | $1,117 | $1,178 | $3,300 | $2,674 |
| Diluted earnings per share | $1.86 | $2.01 | $5.51 | $4.75 |
- Q3 net income fell 5% year over year; nine-month net income rose 23%. The nine-month comparison benefited substantially from the absence of the $1.2 billion provision to establish an allowance on acquired credit-card loans in 2012, partly offset by the absence of the $594 million ING Direct bargain-purchase gain recorded in 2012.
- Q3 net interest margin was 6.89%, down 8 basis points year over year; the nine-month margin was 6.82%, up 32 basis points. The year-to-date improvement reflected lower funding costs, including the shift toward deposits and redemption of $3.65 billion of trust preferred securities.
- At September 30, total assets were $289.9 billion, loans held for investment $191.8 billion, deposits $206.8 billion, total borrowings $31.8 billion, and stockholders’ equity $41.8 billion. Since year-end 2012, loans fell 7%, deposits 3%, borrowings 36%, and assets 7%.
- The allowance for loan and lease losses was $4.3 billion, down from $5.2 billion at year-end; coverage was 2.26%, versus 2.50%. The decline reflected lower loan balances, a better credit outlook and a $289 million allowance reduction related to the Best Buy portfolio sale.
- Credit indicators were mixed: the overall 30+ day delinquency rate improved to 2.88% from 3.09%, while the Q3 net charge-off rate increased to 1.92% from 1.75% year over year. Management attributed much of the reported charge-off-rate increase to acquisition accounting and the lag in recognizing acquired-loan charge-offs. Acquired loans accounted for on expected cash flows can also affect reported credit metrics.
- Nine-month cash flows: operating activities provided $15.3 billion, investing activities provided $2.9 billion, and financing activities used $23.5 billion. Cash and cash equivalents declined $5.3 billion to $5.7 billion.
- Liquidity reserves were $54.5 billion, down from $61.2 billion at year-end. Regulatory capital ratios under Basel I were 12.74% Tier 1 common, 13.13% Tier 1 risk-based and 15.28% total risk-based; management said the banks exceeded applicable “well capitalized” thresholds.
Material changes and business segments
- Capital One completed the sale of its Best Buy private-label and co-branded card portfolio to Citibank on September 6, receiving $6.4 billion. The sale reduced loans held for investment and contributed to a $289 million allowance release.
- Credit Card earned $694 million in Q3, down from $741 million, and $2.1 billion for the first nine months, up from $1.0 billion. The Q3 decline reflected portfolio run-off, the sale and $101 million of added litigation reserves; year-to-date results benefited from acquisition-related comparison items and higher purchase volume.
- Consumer Banking earned $345 million in Q3, down from $376 million, and $1.2 billion year to date, up from $1.0 billion. Auto lending grew, while acquired home-loan balances ran off.
- Commercial Banking earned $174 million in Q3, down from $228 million, and $567 million year to date, down from $666 million. Loan and deposit growth lifted revenue, but reduced allowance releases and higher credit-loss provisions weighed on earnings.
- In Q3, Capital One transferred $18.3 billion of securities from available-for-sale to held-to-maturity, citing reduced AOCI volatility and potential Basel III capital effects. The transferred securities had $1.5 billion of pre-tax unrealized losses. Nine-month other comprehensive loss was $1.6 billion, largely associated with investment-security valuation changes as interest rates rose.
- Beech Street Capital, a multifamily commercial real-estate loan originator and servicer, was acquired on November 1, 2013, after quarter-end.
Outlook, risks and unusual items
- Management expected 2013 average interest-earning assets and average loan balances to decline. It projected approximately $11 billion of operating expenses and $10 billion of pre-provision net revenue for 2013; estimates exclude specified non-recurring items, including Q3 litigation expense, certain expected restructuring costs and the Beech Street acquisition’s impact.
- For 2014, management expected approximately $5 billion of portfolio run-off—$1 billion in card loans and $4 billion in home loans—and operating expenses of approximately $10.5 billion, excluding potential non-recurring items. Domestic Card loan growth was expected to remain muted, with growth resuming around the second half of 2014. Management expected auto finance losses to rise gradually and yields to decline from unusually high levels; competition could pressure pricing and margins.
- The company began a $1 billion share-repurchase program after the portfolio sale, repurchasing $256 million during Q3, and expected to complete the authorization by year-end. The Board declared a $0.30 quarterly common dividend in October. Any 2014 capital distributions remain subject to regulatory approval; management noted Federal Reserve stress-test estimates could constrain distributions more than the company’s own estimates.
- Mortgage representation-and-warranty reserves totaled $1.145 billion at September 30, up from $899 million at year-end. Management estimated reasonably possible additional losses beyond the reserve of approximately $2.5 billion, while warning actual losses could exceed estimates. Other litigation matters had estimated reasonably possible future losses of approximately $250 million, excluding the specified mortgage-related proceedings.
- Other notable exposures include a $154 million U.K. payment-protection-insurance reserve, potential effects of evolving capital and liquidity rules, interest-rate and credit risks, and acquisition integration and competition risks. Management identified loan-loss reserves, fair value, representation-and-warranty reserves, rewards reserves and income taxes among its critical accounting estimates.
Most important facts for investors to verify
- Whether reported credit-loss trends continue to improve, including charge-offs and delinquencies, and how acquired-loan accounting affects comparisons.
- The adequacy of the $4.3 billion loan-loss allowance and the $1.145 billion mortgage representation-and-warranty reserve, including the potential $2.5 billion of additional reasonably possible mortgage losses.
- Whether the portfolio sale, loan run-off and growth in auto and commercial lending produce the expected revenue, credit costs and margins.
- Progress against 2013 and 2014 expense, pre-provision revenue and portfolio run-off expectations, including the impact of Beech Street and restructuring costs.
- The effect of securities valuation losses, Basel III implementation and regulatory stress testing on capital, liquidity and shareholder distributions.
- Developments in interchange, payment-protection, mortgage repurchase and other litigation, and any changes to related reserves or contingencies.