By now, Capital One’s (NYSE:COF) Q3 loss stemming from the closure of their GreenPoint mortgage unit has been fairly well documented. So rather than beat the dead mortgage horse for another bank, let’s review the results from their auto lending and credit card units. The fact that Auto Lending has gone from a net profit of nearly $100M in Q2 of ’06 to a loss of nearly $4 million in Q3 of ’07 hasn’t gotten enough attention, nor has some of the problems within their credit card unit.
First, let’s quickly review some of the high level data from Q3 (see conference call transcript):
- A loss of $81.6 million vs. a profit of $587.8 million a year ago, due to an $898 million charge from the closure of GreenPoint.
- Operating earnings of $2.09/share if you excluded the costs related to the closure of GreenPoint.
- Capital One wrote off a total of $1.03 billion of loans or 2.86% of total managed loans, down from 2.92% in Q3 of ’06. Capital One estimates that it will write down $1.2 billion worth of loans in Q4. Total managed loan write-offs for 2008 is expected to hit $4.9 billion.
- Total revenue was $3.774 billion for the quarter vs. 3.056 billion in Q3 of ’06.
- Capital One still expects earnings of $5.00/share for 2008, down from their initial estimate of $7.15/share.
- Capital One executed $477.5 million worth of share buybacks in Q3 and they completed the $1.5 billion accelerated share buyback program they launched in April.
Now, the results from their Auto Lending and Credit Card segments:
Auto Lending: COF’s auto lending segment has been in decline for some time and reported a net loss (as I predicted in September) of $3.8 million. After recording $95.1 million in net income in Q2 of ’06, the unit has generally trended downwards typically generating net income of $30-$40m per quarter. If we look at credit quality metrics over that time period we see that loans that are 30+ days delinquent have risen by 57% and net charge offs have increased by 131%. The losses come despite the fact that COF increased total loan originations and revenue; if the unit continues to lose money it’s a clear indication of a need for higher credit standards.
COF can “spin” this situation as a change from a time period with historical low delinquency rates, but credit quality is still deteriorating, the unit is losing money and will probably continue to do so or the next 2-3 quarters.
Thinking about the larger economy, the performance of COF’s auto lending unit could be an indicator of weakness in auto lending space overall, particularly in the subprime segment. I wouldn’t be surprised to see auto lending follow the same trend as mortgages: problems in the subprime segment are followed by problems within the prime segment. If people are losing their homes, it’s just a matter of time before some of them lose their cars as well.
The big question is: what measures is COF taking to rectify this situation?
Credit Cards: The story with this unit is rather simple, COF is (at the moment) able to grow the business faster than the rate of delinquencies and losses, so net income continues to grow, with net income increasing 33% YoY. With respect to credit quality Q3 delinquencies increased 3.29% to 4.43%, roughly 35.6% on a YoY basis and charge-offs increased by 25%, moving from 3.30% to 4.13%. In Q4 the company expects the charge-off rate for credit cards to hit 5.25%. However, it’s worth noting that a combination of policy changes, moving from a 30 day to 25 day grace period, a changed fee structure, etc, “goosed” these numbers a bit.
Thinking about the future of Capital One’s credit card business I have some concerns due to their increased “courting” of the subprime credit card market. Subprime Mortgages and Auto Loans are already hurting the company’s bottom line, so I’m not particularly confident about their ability to successfully evaluate subprime credit card customers. Mortgages, Auto Loans and Credit Cards could easily turn into a “subprime triple whammy” for COF.
Another item I find troubling is that their new policies and fees and made it harder for some of their customers to pay their credit card bills on time, as it indicates that many of their customers are struggling to hold on. It’s not uncommon for delinquencies from new financial pressures to be a lagging indicator, so I wouldn’t be surprised if the changes to the COF credit card agreements continue to increase the delinquency and charge-off rate in future quarters. Another scenario stemming from the changes to agreements and fees (especially if it’s enough to cause defaults) is that other customers may simply stop using the cards all together, cancel the accounts, etc. Finally, their plan to offer fewer teaser rate cards may back-fire as it may result in them winning fewer prime customers who can easily get teaser rate cards from other banks.
Overall I’m not bearish on Capital One, if they can continue to diversify their business, develop the retail banking segment and avoid the pitfalls of the subprime market they can continue to grow the company. I also think their new found focus to return more earnings to shareholders in the form of dividends and share buybacks is a good move as well. However, the company has some significant short-medium pitfalls to overcome, which are likely to put significant downside pressure on the stock for the next 2-4 quarters.
Disclosure: the Author doesn’t own a position in Capital One
Capital One: “Capital One reports Q3 Earnings” – Q3 Earnings Report, October 18, 2007
Seeking Alpha: “Capital One Financial Q3 2007 Earnings Call Transcript”, October 18, 2007