DBRS Comments on Capital One Financial Corporation’s 3Q12 Earnings; Senior at BBB (high)

DBRS, Inc. (DBRS) has today commented on the 3Q12 earnings of Capital One Financial Corporation (Capital One or the Company). DBRS rates Capital One at BBB (high). The trend on all ratings is Stable. Capital One reported net income of $1.2 billion in the third quarter compared to $93 million in 2Q12 and $813 million a year ago. DBRS considers the results as providing an early illustration of the solid earnings generation ability of the strengthened franchise following recent acquisitions, as well as demonstrating continued sound balance sheet management.

The absence of significant acquisition-related accounting items, a full quarter of the HSBC Card business, and good performance in Capital One’s legacy businesses were the primary drivers behind the improved quarter-on-quarter results. On an underlying basis, Capital One’s legacy businesses demonstrated solid volume growth despite the tepid economic recovery and strong credit performance. Overall, interest earning assets grew 2% QoQ to $270.7 billion, illustrating that the benefits of the Company’s acquisitions as well as its investments to grow certain parts of the Domestic Card, Auto Finance and commercial banking businesses are being realized.

Total net revenues were 14% higher QoQ at $5.8 billion reflecting the full-quarter impact of the HSBC credit card loans acquired in 2Q12 and a lower non-principal reserve build related to the HSBC acquisition. Revenues were negatively impacted by $133 million in acquisition premium amortization. DBRS notes that this item will become less of a headwind over the medium-term. Net interest income improved 16% from the prior quarter from margin expansion and growth in average interest earning assets. Specifically, the net interest margin (NIM) increased 93 basis points (bps) to 6.97% owing to the full-quarter impact of the higher yielding HSBC credit card loans and the associated reduction in cash. Further, the lower finance charge and fee reserve build related to the HSBC acquired loans supported NIM expansion.

Operating expenses were 3% lower QoQ largely due to lower charges for legal and regulatory settlements and unique items, partially offset by the full-quarter impact of the HSBC card business acquisition. On a linked quarter basis, marketing expense was 5% lower at $316 million, but still sufficient to support future growth in DBRS’s view. The solid cost containment and higher revenue generation drove the improvement in the Company’s efficiency ratio to 52.7% compared to 62.2% in the prior quarter.

Despite the weak economic environment, Capital One reported solid growth in loans across all businesses and in billed business volumes. Within the Domestic Card segment, loans were slightly lower quarter-on-quarter, as modest organic growth was more than offset by run-off of HSBC credit card loans and installment loans. Importantly, purchase volumes outpaced many of its peers, expanding 7% to $44.6 billion reflecting the benefit of the HSBC acquisition and good customer brand loyalty. In Consumer Banking, Auto Finance loans grew 5% to $26.4 billion illustrating the continued success of Capital One’s repositioning of the business. Meanwhile, the Commercial Banking loan portfolio expanded 3% in 3Q12 to $37.2 billion as Capital One continues to see good demand in its local markets.

While credit metrics in the legacy businesses increased slightly in the quarter reflecting seasonality, overall credit performance remains favorable demonstrating the sound risk management capabilities of Capital One. Within the loan book, excluding acquired loans, Company-wide net charge-offs (NCOs) increased 22 bps sequentially, but were 44 bps lower year-on-year at 2.18%. At September 30, 2012, 30-day plus delinquencies were 56 bps higher on a linked-quarter basis at 3.15%, but 10 bps lower than in 3Q11. Within the $89.0 billion Domestic Card portfolio, NCOs were 9 bps higher at 3.22%, but still 99 bps lower than a year ago a year ago. The modest increase primarily reflects a lower proportion of charge-offs in the HSBC U.S. credit card loans, which was absorbed by a credit mark, than in the previous quarter. NCOs in Consumer Banking rose 35 bps quarter-on-quarter to 0.83%, largely reflecting seasonality in the Auto Finance portfolio. The $37.2 billion Commercial Banking portfolio continues to perform well with no NCOs this quarter compared to 0.19% in the prior quarter. Provision for credit losses totaled $1.0 billion, a 40% reduction QoQ reflecting a substantially lower HSBC allowance build. Nonetheless, with loan loss reserves totaling $5.2 billion, or 3.11% of total loans, excluding acquired loans, DBRS views reserve coverage ratios as appropriate given the favorable credit performance.

As expected, post-completion of the acquisitions, Capital One’s solid capital generation ability was restored in the quarter. To this end, Capital One’s Basel I Tier 1 common ratio improved to 10.7% in 3Q12 from 9.9% at 2Q12. Meanwhile, the improvement in regulatory capital ratios also reflected solid earnings generation, as well as a corresponding reduction in the allowance for DTAs, which partially offset growth in risk-weighted assets. Specifically, acquired mortgage loan run-off was replaced with auto and commercial loans that carry a higher risk weighting. With several recent acquisitions completed, combined with the Company’s strong earnings generation ability, Capital One expects to build capital levels at a steady rate going forward. Indeed, based on its current interpretation of the Basel III capital rules, Capital One expects to meet assumed Basel III capital targets in 2013.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include company documents. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This is an unsolicited rating. This rating was not initiated at the request of the issuer or rated entity and did not include participation by the issuer or any related third party.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Michael Driscoll
Approver: Roger Lister
Initial Rating Date: 17 November 2005
Most Recent Rating Update: 12 September 2012

For additional information on this rating, please refer to the linking document under Related Research.