Capital One Lags Estimates

Capital One Financial Corp’s. (COF - Analyst Report) second-quarter 2012 adjusted earnings of $1.26 per share were lower than the Zacks Consensus Estimate of $1.35. This excluded the impact stemming from the acquisition of HSBC Holdings plc’s (HBC - Analyst Report) credit card business, which was completed in May, this year.

Higher net interest income, better asset quality and robust capital ratios were the positives for the quarter. However, the declining non-interest income and escalating operating costs were the dampeners.

Considering the impact of the abovementioned acquisition on the company’s financials and other non-recurring charges, net income came in at $92 million or 16 cents per share compared with $1.4 billion or $2.72 per share in the prior quarter.

Performance in Detail

Capital One’s total revenue for the reported quarter stood at $5.06 billion, rising 2.4% sequentially. However, total revenue was below the Zacks Consensus Estimate of $5.75 billion.

Net interest income for the quarter grew 17.2% from the previous quarter to $4.00 billion. The growth was fuelled by increases in average interest-earning assets. However, it was partially offset by certain charges related to the ING Groep NV (ING - Snapshot Report) and HSBC acquisitions.

Net interest margin in the quarter fell 16 basis points (bps) sequentially to 6.04%. The drop primarily resulted from reduced asset yields, partially mitigated by positive changes in the funding mix

Non-interest income declined 30.7% from $1.52 million in the prior quarter to $1.05 billion in the reported quarter. The absence of bargain purchase gain pertaining to the acquisition of ING Direct and lower other non-interest income was the reasons behind the decline.

Capital One’s operating expenses increased 25.5% sequentially to $3.14 billion. The rise was mainly due to higher salaries and benefits, marketing expenses, merger related expenses, along with occupancy costs as well as other miscellaneous expenditure.

The managed efficiency ratio increased to 62.16% from 50.74% in the prior quarter. The hike in efficiency ratio indicates deterioration in profitability.

Credit Quality

Capital One’s credit quality showed significant improvement during the quarter. Net charge-off rate declined from 2.04% in the prior quarter and 2.91% in the prior-year quarter to 1.53%. Moreover, the 30-plus day performing delinquency rate declined 17 bps sequentially and 84 bps year over year to 2.06%. However, allowance, as a percentage of reported loans held for investment, came in at 2.47% compared with 2.34% in the previous quarter and 3.48% in the year-ago quarter.

Further, provision for credit losses increased 192.7% sequentially to $1.68 billion. The rise was mainly due to allowances bought over by the acquisition of HSBC’s credit card business.

Capital and Profitability Ratios

The company’s capital and profitability ratios continued to elevate during the quarter. Tangible common equity (TCE) ratio for the reported quarter was 7.4%, down from 8.2% in the prior quarter and 7.9% in the prior-year quarter.

As of June 30, 2012, tier 1 risk-based capital ratio came in at 11.6% as against 13.9% in the prior quarter and 11.8% in the prior-year quarter. The company’s tangible book value per share was $35.67 as of June 30, 2012 compared with $39.37 as of March 31, 2012 and $31.94 as of June 30, 2011.

Other Developments

Concurrent with the earnings release Capital One announced that the Office of the Comptroller of the Currency (OCC) and the Consumer Financial Protection Bureau (CFPB) has penalized it for issues related to cross-sell activities in its domestic card business. The company has agreed to pay $210 million to resolve the issues.

Peer Performance

Discover Financial Services (DFS - Analyst Report) posted its second-quarter results, with earnings surpassing the Zacks Consensus Estimate. The decline in profits resulted from lower reserve releases, which offset revenue growth and higher interest income. Results were also affected by higher expenses and a decline in the pre-tax income from the Direct Banking segment.

Our Viewpoint

We anticipate continued synergies from Capital One’s geographic diversification. Just as ING Direct was accretive to the company’s financials, we anticipate the acquisition of HSBC’s U.S. credit card business will boost its top line and improve its market position in terms of deposits and assets. Also, a increase in loan demand will boost earnings growth in the near future.

However, rising operating expenses and its commercial real estate exposure will be the negatives.

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