Capital One Financial Corporation — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012. Capital One is a diversified financial-services company operating Credit Card, Consumer Banking and Commercial Banking businesses. Results include ING Direct from February 17 and HSBC’s U.S. card business from May 1, making year-over-year comparisons materially affected by acquisitions.
Financial performance and condition
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Total net revenue | $5.782 billion | $4.154 billion | $15.772 billion | $12.229 billion |
| Net interest income | $4.646 billion | $3.283 billion | $12.061 billion | $9.559 billion |
| Provision for credit losses | $1.014 billion | $622 million | $3.264 billion | $1.499 billion |
| Non-interest expense | $3.045 billion | $2.297 billion | $8.691 billion | $6.714 billion |
| Net income | $1.178 billion | $813 million | $2.674 billion | $2.740 billion |
| Diluted EPS | $2.01 | $1.77 | $4.75 | $5.95 |
- Margins: Q3 net interest margin was 6.97%, down 43 basis points year over year; nine-month margin was 6.50%, down 78 basis points. Total net revenue margin was 8.67% in Q3 versus 9.36%.
- Cash flow, nine months: Operating activities provided $8.133 billion; investing activities used $11.141 billion; financing activities provided $3.139 billion. Cash and cash equivalents increased $131 million to $5.969 billion. Acquisition-related cash flows were significant.
- Balance sheet at September 30: Total assets were $301.989 billion, loans held for investment $203.132 billion, deposits $213.255 billion, borrowings $38.377 billion and stockholders’ equity $39.672 billion. Since year-end 2011, assets rose 47%, loans 49% and deposits 66%, primarily reflecting the acquisitions.
- Liquidity and capital: Liquidity reserves were $51.575 billion, up from $35.835 billion at year-end. Preliminary Basel I ratios were 10.7% Tier 1 common, 12.7% Tier 1 risk-based and 15.0% total risk-based capital. The tangible common equity ratio was 8.2%.
- Credit: Q3 net charge-offs were $887 million, a 1.75% rate, versus a 2.52% rate a year earlier; the rate excluding certain acquired loans was 2.18%. The 30+ day delinquency rate was 2.92% at quarter-end versus 3.95% at year-end 2011. Allowance for loan and lease losses was $5.154 billion, or 2.54% of loans, compared with $4.250 billion and 3.13% at year-end.
Material changes and drivers
- Q3 revenue rose 39% year over year, while net income increased 45%; nine-month revenue rose 29%, but net income declined 2% and diluted EPS fell 20%.
- The ING Direct acquisition added approximately $84.4 billion of deposits and $40.4 billion of loans at acquisition. HSBC added approximately 27 million active accounts and $27.8 billion of card receivables designated held for investment.
- Acquisition accounting and one-time items materially affect results. The $594 million ING Direct bargain-purchase gain was recorded in Q1. HSBC card loans with existing revolving privileges generated a $1.3 billion provision in the first nine months, including $107 million in Q3. Acquisition-related premium amortization reduced net interest income by $133 million in Q3 and $267 million year to date.
- Credit quality metrics are affected by acquired loans accounted for using expected cash flows: the acquisition-date credit mark absorbs expected losses, and those loans generally are not classified as delinquent or nonperforming. The filing therefore also presents adjusted credit measures.
- Q3 segment net income was $741 million in Credit Card, $376 million in Consumer Banking and $228 million in Commercial Banking. Commercial Banking benefited from improving credit trends and allowance releases; Credit Card year-to-date earnings were pressured by HSBC-related credit provisions and acquisition expenses.
Outlook, risks and unusual items
- Management expected full-year 2013 average loans to decline modestly from Q3 2012 levels, including approximately $11 billion of expected loan run-off, partly offset by growth in Domestic Card, Auto and Commercial Banking. Management cited weak consumer demand and intensifying competition in some lending businesses.
- Management expected average quarterly non-interest expense, excluding marketing, through 2013 to be approximately equal to Q3 2012, and 2013 marketing expense of approximately $1.5 billion. It expected to exceed an internal 8% Basel III Tier 1 common ratio target in 2013; this estimate depends on future rules and assumptions.
- Management projected Domestic Card revenue-margin reductions, including about 50 basis points by Q4 2013 from customer-practice changes, and additional reductions from payment-protection run-off and portfolio mix. It expected higher Domestic Card charge-off rates in Q4 2012 as acquired-loan credit marks cease covering future losses.
- Hurricane Sandy was a subsequent event. Loans in Connecticut, New Jersey and New York totaled $36.442 billion at September 30, including $16.609 billion in commercial loans. The company had not completed its loss assessment and said the impact was too early to estimate; it highlighted commercial real-estate exposure in affected areas.
- Mortgage representation-and-warranty reserves were $919 million. The company estimated approximately $1.7 billion of reasonably possible losses beyond the reserve, while noting actual losses could exceed its estimates. Other reasonably possible litigation losses were estimated at approximately $150 million, excluding specified mortgage matters.
- Other notable matters include a $349 million year-to-date mortgage repurchase-loss provision, a $60 million civil penalty related to cross-sell activities, approximately $114 million of expected customer refunds, and $98 million of legal costs related to interchange and other litigation. A SEC investigation concerning auto-loan loss reserves for certain 2007 quarters remained ongoing.
- After quarter-end, Capital One merged ING Bank, fsb into CONA on November 1 and issued $1.0 billion of senior notes on November 6. The filing describes integration, credit, interest-rate, regulatory, legal, funding and economic risks; forward-looking expectations are not guarantees.
Investor verification priorities
- Assess earnings quality by separating recurring results from the ING Direct bargain gain, acquisition accounting, HSBC allowance build, purchase-accounting amortization, refunds, penalties and legal costs.
- Review acquired-loan accounting and credit metrics both including and excluding loans carried based on expected cash flows; verify the assumptions underlying credit marks and allowance adequacy.
- Track loan run-off, organic growth, card revenue margins, charge-offs and delinquencies as acquisition-related comparability effects diminish.
- Evaluate mortgage representation-and-warranty exposure, litigation developments and the gap between the $919 million reserve and management’s estimated $1.7 billion of reasonably possible additional losses.
- Monitor Sandy-related credit performance, particularly commercial real estate, and confirm management’s subsequent loss assessment.
- Confirm capital ratios after final regulatory calculations and assess progress toward Basel III requirements alongside liquidity, funding maturities and integration costs.