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Capital One Financial Corp.’s (NYSE:COF) second quarter 2011 earnings from continuing operations of $2.04 per share were substantially ahead of the Zacks Consensus Estimate of $1.67. Though this compared unfavorably with $2.04 in the prior quarter, it surpassed $1.78 recorded in the year-ago quarter.

Better-than-expected results for the quarter were primarily aided by increased revenues and a lower provision for loan losses ensuing from an improved credit performance. Additionally, the company’s capital and profitability ratios also improved. However, an increase in operating expenses was a downside.

Additionally during the quarter, Capital One announced an agreement to acquire ING Direct USA, the online banking unit of Amsterdam-based ING Groep NV (NYSE:ING), in a stock-cum-cash transaction valued at $9.0 billion. The acquisition is expected to close late this year or early next year.

Quarter in Detail

Capital One’s net income from continuing operations was $945 million, down 8.4% from $1,032 million in the prior quarter but up 16.4% from $812 million in the year-ago quarter. Adjusting the loss from discontinued operations, Capital One’s net income came in at $911 million, or $1.97 per share, compared with $1,016 million, or $2.21 per share, in the previous quarter and $608 million, or $1.33 per share, in the year-ago quarter.

Total revenue for the reported quarter stood at $3.99 billion, down 2.2% sequentially but up 2.3% year over year.

Net interest income slipped 0.1% sequentially but inched up 1.3% year over year to $3.14 billion. Similarly, non-interest income also declined 9.0% sequentially but rose 6.2% year over year to $857 million.

Net interest margin (NYSE:NIM) decreased 4 basis points (bps) sequentially but improved 11 bps on a year-over-year basis to 7.20%. The sequential drop was due to a 15 basis point fall in earning asset yields, partially offset by a 13 basis point improvement in cost of funds.

Capital One’s operating expenses for the reported quarter climbed 2.1% sequentially and 8.4% year over year to $1.93 billion. The increase was mainly due to a rise in salaries and associate benefits expenses.

The managed efficiency ratio deteriorated to 56.47% from 52.96% in the prior quarter and 51.23% in the prior-year quarter. The increase in efficiency ratio indicates deterioration in profitability.

Credit Quality

Capital One’s credit quality continued to improve during the quarter. Allowance, as a percentage of reported loans held for investment, fell 60 bps sequentially to 3.48%. Also, the net charge-off rate dropped 75 bps sequentially to 2.91%, as a continued improvement in credit led to charge-off improvements across all business segments. The 30-plus day performing delinquency rate also fell 17 bps sequentially to 2.9%.

Similarly, provision for loan and lease losses declined 35.8% sequentially and 52.6% year over year to $534 million. The decrease was driven by lower charge-offs in the reported quarter.

Capital and Profitability Ratios

Capital One’s capital and profitability ratios continued to enhance during the quarter. Tangible common equity (TCE) ratio for the quarter improved to 7.9% from 7.3% in the prior quarter and 7.1% in the year-ago quarter. Also, Tier 1 risk-based capital ratio rose 70 bps sequentially to 11.6%.

The company’s tangible book value per share was $32.33 as of June 30, 2011 compared with $29.70 as of March 31, 2011 and $24.89 as of June 30, 2010.

Peer Performance

One of the close peers of Capital One, Discover financial Services (NYSE:DFS) posted a solid second quarter, reporting earnings substantially ahead of the Zacks Consensus Estimate, driven by a lower loan loss provision and higher transaction and credit card sales volumes, which also drove the loan loss reserve release growth. In addition, higher consumer spending and merchant acceptance also contributed to the substantial expansion of income across the direct banking and payment services segments.

Our Viewpoint

We anticipate continued synergies from Capital One’s geographic diversification. Additionally, the resilience of almost all its businesses will continue to support the company’s financials. Further, we believe with the addition of ING Direct USA, the combined company will create a valuable banking franchise to take advantages of a large number of branch banking in attractive high-growth markets and an online banking franchise with a national reach. However, its commercial real estate exposure will remain a drag. Also, a weak loan demand and the impact of the financial reform law will restrict earnings in the near future.

Capital One currently retains a Zacks #2 Rank, which translates into a short-term ‘Buy’ rating. However, considering the fundamentals, we maintain a long-term “Neutral” recommendation on the shares.

Source: Capital One Beats Estimates on Lower Loan Loss Provisions