Wednesday, January 27, 2010

Capital One Financial (COF)

Falling Reserves to Drive Earnings

•Capital One reported 4Q EPS from continuing ops of $0.89 (CS: $0.46, FC: $0.45). The earnings beat was supported by a $0.60 reserve bleed versus our expectation for none. While positive revenue and credit quality trends continued throughout 4Q, the outlook was less promising. Falling revenue margins in the card business, challenged commercial banking earnings, and overall higher expense levels will likely suppress preprovision earnings in the coming years. Coupled with continued portfolio shrinkage, investors may reassess “normalized” earnings projections.

■We are reducing our 2010 and 2011 EPS estimates to $1.10 and $3.00 (from $1.95 and $3.55), respectively. Our estimates factor in $1.75 and $1.45 of reserve bleed. We are lowering our target to $36 (from $38) which represents 1.7x year-end 2010 tangible book value per share.

■Revenue outlook weak. Revenues totaled $4.4Bn, 3% ahead of our forecast as stronger revenues in the card business was partially offset by weaker than expected consumer banking results. Margins in the domestic card unit held steady at 17% supported by lower revenue suppression and better funding costs. Management guided to a mid-15% revenue yield in 2010 as some of the effects of the recent repricing initiatives

■ Reserve drawdown concentrated in card business. The allowance declined $386mn -- $439mn release in Card, $42mn drawdown in Consumer Banking, and $115mn build in Commercial Banking. The allowance now stands at 4.56% of onbalance sheet loans, an 11 bp decline from September. Managed credit losses totaled $2.2Bn, 2% higher q/q and in line with our forecast. Card losses were flat from 3Q at 9.6%; 30+ delinquencies increased 34 bps to 5.87%. Domestic card losses are expected to approach 11.0% in 1Q10. Commercial losses increased 149bps q/q to 2.91% driven primarily by small-ticket CRE as the company wrote-down a portfolio of small ticket CRE NPLs transferred to held-for-sale. Our revised model assumes $9.1Bn of losses in 2010 and $7.2Bn in 2011, representing 6.9% and 5.5% of average loans.

■ Portfolio shrinkage to continue. Managed loans declined $4.3Bn (3%) sequentially. The domestic card portfolio declined 3%, a majority of which was due to the run-off of the installment loan portfolio. This stood at $7.0Bn at year-end and is projected to decline an additional $3.0Bn in 2010. Consumer banking loans shrank 6% q/q to $38.2Bn driven by auto and mortgage balances. Management guided towards an additional $1.0Bn and $2.5Bn of portfolio run-off within these loan books, respectively. The commercial loan portfolio declined 1%. This is expected to grow modestly in 2010. While some on the earnings conference call were hopeful for some growth in card balances in 2010, we expect the card portfolio to decline, albeit more modestly.

■ Higher operating expenses. Operating expenses totaled $1.95Bn, 8% higher sequentially. Marketing spend totaled $188mn, $84 million more than 3Q results. Expect increased marketing efforts throughout 2010. Our revised estimates assume expenses to rise remain elevated, increasing 2% from full year 2009. This translates to a 46.6% efficiency ratio in 2010 versus 43.5% in 2009.

■ FAS 166/167 impact still looming. Capital One will add $4.3Bn to the allowance, with a corresponding $3.1Bn hit to retained earnings. This represents a 25% reduction to book value. Pro-forma, the TCE ratio will decline to 4.8% from 6.3% at the end of December. The incremental risk-weighted assets will be phased in starting mid-2010. The TCE ratio will likely improve during Q1 as a result of loan shrinkage.

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