DBRS Comments on Capital One Financial Corporation’s 4Q12 Earnings; Senior at BBB (high)

DBRS, Inc. (DBRS) has today commented on the 4Q12 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 $843 million in the quarter compared to $1.2 billion in the prior quarter and $407 million a year ago. Capital One’s results reflect the continuing, albeit diminishing, impact of purchase accounting items, as well as anticipated seasonal impacts. On an underlying basis, Capital One’s legacy businesses demonstrated acceptable growth in volumes despite the difficult operating environment including the impact of Hurricane Sandy. Overall, interest earning assets grew 3.5% quarter-over-quarter (QoQ) to $280.1 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. Moreover, DBRS sees Capital One’s results as demonstrating the solid and resilient earnings ability of the franchise and the Company’s solid risk management capabilities.

Total net revenues were 3% lower QoQ at $5.6 billion reflecting higher revenue suppression, which is returning to more normalized levels. DBRS notes that revenue suppression was below trend in 3Q12 benefiting from the purchase accounting mark on delinquent loans acquired from HSBC. Nonetheless, net interest income declined 2.5% from the prior quarter, as margin compression more than offset growth in average interest earning assets. Specifically, the net interest margin (NIM) declined 45 basis points (bps) to 6.52% reflecting a higher proportion of lower yielding cash and investment securities held by the Company in anticipation of the redemption of its high coupon trust preferred securities, as well as the revenue suppression discussed above. In DBRS’s view, Capital One’s pre-provision earnings capacity remains solid, and is more than sufficient to absorb the cost of credit and generate capital. For the quarter, provision expense was 49% of pre-provision earnings.

For the quarter, non-interest expenses were higher QoQ primarily due to higher marketing and operating expenses. On a linked quarter basis, marketing expense was 24% higher at $393 million reflecting seasonal patterns, as well as heightened competition in acquiring new customers. Operating expenses were 5% higher QoQ at $2.9 billion driven by higher professional services expense and modestly higher integration costs. Growth in operating expenses and the modest reduction in revenues resulted in the Company’s efficiency ratio increasing to 57.9% compared to 52.7% in the prior quarter.

Despite the uneven economy and the impact of Hurricane Sandy, Capital One generated solid loan growth across most businesses, as well as in billed business volumes. Within the Domestic Card segment, loans grew 3% QoQ despite anticipated run-off of HSBC credit card loans and installment loans. Purchase volumes, excluding HSBC, outpaced many of its peers, expanding 9% reflecting good customer brand loyalty and share of customer wallet. In Consumer Banking, Auto Finance loans grew 3% to $27.1 billion demonstrating the progress achieved to date by Capital One to grow in a highly competitive market. Meanwhile, the Commercial Banking loan portfolio expanded 4% in the quarter to $38.8 billion, as Capital One continues to see good demand in its local markets.

Credit metrics increased in the quarter across most lending portfolios, but remain manageable. Specifically, company-wide net charge-offs (NCOs) increased 51 bps sequentially, but were 43 bps lower year-over-year at 2.26%. At year-end 2012, 30-day plus delinquencies were 42 bps higher on a linked-quarter basis at 2.65%, but 182 bps lower than at year-end 2011. Within the $83.1 billion Domestic Card portfolio, NCOs were 131 bps higher at 4.35% primarily due to seasonality and diminishing benefits from credit marks on the acquired HSBC U.S. card portfolio. NCOs in the Auto Finance portfolio rose 45 bps QoQ to 2.24%, largely reflecting seasonality. The $38.8 billion Commercial Banking portfolio continues to perform well with a very low 10 bps of NCOs in the quarter. Overall, the provision for credit losses totaled $1.2 billion, a 14% increase QoQ reflecting a more normalized charge-off environment and run-off of the HSBC purchase accounting mark. With loan loss reserves totaling $5.2 billion, or 2.50% of total loans held for investment, DBRS views reserve coverage ratios as acceptable, especially given the Company’ pre-provision earnings generation.

From DBRS’s perspective, Capital One’s balance sheet strength remains sound supported by its well-managed funding profile and solid capital levels. The Company’s substantial deposit base underpinned by its local branch network and leading national direct banking franchise is the foundation of the funding profile. At December 31, 2012, deposits stood at $212.5 billion, a slight reduction QoQ. Growth in lending assets resulted in a modest increase in the Company’s loan-to-deposit ratio to 96.9% compared to 95.3% in 3Q12. Capital strengthened in the quarter reflecting solid earnings retention partially offset by higher risk-weighted assets from loan growth. Positively, Capital One’s Basel I Tier 1 common ratio improved 30 bps QoQ to 11.0% at year-end 2012. In DBRS’s view the quality of capital has improved with the repayment of $3.6 billion of trust preferred securities, which was completed on January 2, 2013. Given the resumption of the Company’s solid organic capital generation following the completion of the two sizeable acquisitions, DBRS sees Capital One as well-placed to meet forthcoming regulatory capital requirements. To this end, 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.

[Amended on May the 23rd, 2014 to remove unnecessary disclosures.]