Capital One Turns In Better-Than-Expected Earnings

| About: Capital One (COF)
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Capital One Financial Corp. (NYSE:COF) reported third quarter 2011 earnings from continuing operations of $1.88 per share, handsomely beating the Zacks Consensus Estimate of $1.70. Though this compares unfavorably with $2.04 per share earned in the prior quarter, it surpassed earnings of $1.79 per share recorded in the year-ago quarter.

Better-than-expected results for the quarter were primarily aided by increased revenues. Though the company’s capital and profitability ratios showed improvement, its asset quality showed mixed results. However, increase in operating expenses and higher provision for loan and lease losses were the downsides.

Additionally during the quarter, Capital One announced an agreement to acquire HSBC Holdings Plc’s (HBC) U.S. credit card business for $32.7 billion. The deal, which is expected to be completed in the second quarter of 2012, will bring long-term benefits for the company.

Furthermore, during the second quarter Capital One announced 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 $865 million, down 8.5% from $945 million in the prior quarter but up 5.7% from $818 million in the year-ago quarter. Adjusting the loss from discontinued operations, Capital One’s net income came in at $813 million or $1.77 per share, compared with $911 million or $1.97 per share in the previous quarter and $803 million or $1.76 per share in the year-ago quarter.

Total revenue for the reported quarter stood at $4.15 billion, up 4.0% sequentially and 3.4% year over year. The growth was mainly driven by higher net interest income. Total revenue also topped the Zacks Consensus Estimate of $4.04 billion.

Net interest income upped 4.7% sequentially and 5.6% year over year to $3.28 billion. Similarly, non-interest income also rose 1.6% sequentially but fell 4.0% year over year to $871 million.

Net interest margin (NYSE:NIM) improved 19 basis points (bps) sequentially and 18 bps year over year to 7.39%. The rise was attributable to the increase in earning asset yields, partially offset by higher cost of funds.

Capital One’s operating expenses for the reported quarter climbed 1.9% sequentially and 15.1% year over year to $2.30 billion mainly due to rise in salaries and associate benefits expenses.

The managed efficiency ratio improved to 55.30% from 56.47% in the prior quarter. The increase in efficiency ratio indicates deterioration in profitability.

Credit Quality

Capital One’s credit quality was a mixed bag during the quarter. Allowance, as a percentage of reported loans held for investment, slipped 19 bps sequentially to 3.29%. Also, the net charge-off rate dropped 39 bps sequentially to 2.52%, as a continued improvement in credit led to charge-off improvements across all business segments.

However, the 30-plus day performing delinquency rate also scaled up 23 bps sequentially to 3.13%. Similarly, provision for loan and lease losses increased 81.3% sequentially but declined 28.3% year over year to $622 million.

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 8.3% from 7.9% in the prior quarter. Also, Tier 1 risk-based capital ratio rose 60 bps sequentially to 12.4%.

The company’s tangible book value per share was $33.82 as of September 30, 2011 compared with $32.20 as of June 30, 2011.

Peer Performance

One of the close peers of Capital One, Discover Financial Services (NYSE:DFS) posted a solid third quarter, reporting earnings substantially ahead of the Zacks Consensus Estimate. The surge in profits was driven by strong sales volume complemented by lower interest expense, reduced provision for loan losses and delinquency rates based on improved credit quality.

The profit was also boosted by the escalated income from both direct banking and payment services business. However, these were partially offset by increased operating and tax expenses.

Our Viewpoint

We anticipate continued synergies from the company’s geographic diversification. Additionally, the resilience shown by almost all its businesses will continue to support its financials. The upcoming acquisitions of ING and HSBC units will also improve the company’s position in terms of deposits and assets, as well as be significantly accretive to its financials.

However, rising operating expenses and the company’s commercial real estate exposure will remain dampeners. Moreover, a weak loan demand, along with the impact of the new financial reform law, will suppress earnings in the near future.

Capital One currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Also, considering the fundamentals, we maintain a long-term Neutral” recommendation on the shares.