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Capital One Reaffirmed at Neutral

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We reiterate our long term ‘Neutral’ recommendation on Capital One Financial Corp. (COF - Free Report) to reflect continued synergies from its geographic diversification and the recent acquisitions – ING Direct USA from ING Groep NV (ING - Free Report) and U.S. credit card business from HSBC Holdings plc . However, the company’s second quarter adjusted earnings, excluding the impact of the acquisition of HSBC’s credit card business, were slightly below the Zacks Consensus Estimate.

Capital One’s second quarter results benefited from higher net interest income. Moreover, steady improvement in credit quality and capital as well as profitability ratios were among the positives. Nevertheless, enhanced non-interest expenses and reduced fee revenue more than offset the results.

Capital One remains fundamentally strong with respect to its credit card businesses. Though deposit market is becoming increasingly competitive, total customer deposits augmented nearly 70% year over year to $213.9 billion in the first half of 2012. Also, U.S. Card operations continue to deliver strong returns on a risk-adjusted basis, with continuous expansion in revenue.

Additionally, Capital One continues to grow inorganically. In the first six months of 2012, the company wrapped up two major deals that are expected to bolster the top line going forward. Moreover, HSBC’s U.S. credit card business deal is anticipated to create a valuable banking franchise, taking advantage of a large number of branch banking in attractive high-growth markets, while ING Direct USA would enable the creation of a large online banking franchise with a national reach.

Further, Capital One’s capital deployment activity through dividend payment reflects its capital strength. We expect the company to continue building capital, resulting in a better financial position that will help meet the Basel III requirements.

On the flip side, ever-increasing operating expenses remain a major concern for Capital One at this point. Though expense management initiatives have significantly aided in offsetting higher credit losses in the last few years, operating expense has been continuously increasing. We anticipate operating expenses to remain high over the next few quarters as the company has to integrate its latest acquisitions and will focus on organic growth through improvement of its loan portfolio and enhancement of new client base.

Moreover, despite progressions over the last few quarters, we expect credit quality to remain under pressure as the weak state of the economy is expected to persist for a while. Also, net charge-offs and nonperforming loans are expected to fluctuate over the next few quarters due to the continuing economic volatility and the recent acquisition of HSBC’s card unit.

Capital One currently retains a Zacks #3 Rank, which translates into a short-term Hold rating.

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