Capital One’s strong quarter and progressing Discover integration are rewarded
Capital One Financial on Tuesday evening delivered better-than-expected third-quarter results, driven by stronger net interest income and credit performance. Revenue in the third quarter ended Sept. 30 increased 6.4% year over year to $16.34 billion, beating the $16.27 billion consensus estimate of analysts surveyed by LSEG. Adjusted earnings per share (EPS) increased 12% year over year to $6.69, beating the $5.50 estimate, LSEG data showed. COF YTD mountain Capital One YTD Capital One shares jumped about 4% in after-hours trading to $210 each. As of the close of Tuesday’s regular trading session, the stock was down nearly 17% year to date. Bottom line The top-line beat was driven by better-than-expected net interest income (NII), which was up about 4% quarter over quarter and exceeded the consensus estimate by $134 million, according to FactSet. Non-interest income dipped 1% quarter over quarter and missed analysts’ estimates by $30 million. However, net discount and interchange fees revenue increased 3.5% sequentially to $2.34 billion. This is a worthy callout because Capital One owns the Discover payment network, which allows it to capture more of the economics from card transactions rather than relying solely on third-party networks. The network’s continued growth is a positive indicator for the Discover integration story. Partially offsetting some of the top-line growth was a year-over-year increase in non-interest expense, which was our principal worry heading into the quarter. Higher expenses weighing on profits were part of the reason we sold a small amount of shares this afternoon, a trade that looks ill-timed given Capital One’s positive after-hours reaction. Expenses were a little high at $8.86 billion compared to the consensus estimate of $8.75 billion, according to FactSet. While expenses as a total were larger than expected, operating expenses would look a lot better if you back out $385 million worth of Discover and Brex integration spending as well as another $519 million of acquisition amortization expenses. A bright spot was marketing expense, which at $1.59 billion came in below analyst forecasts of around $1.71 billion, according to FactSet. This is a volatile figure quarter to quarter, and Capital One can always pull back marketing in times when the economic picture looks murky. But the bank likes to lean into marketing and media to drive new accounts in its domestic credit card and checking account business, meaning this figure will bounce around. Looking ahead to 2027, the company plans to “lean harder” into marketing, including ramping up spending on Discover and pursuing growth opportunities across its businesses. This is something to watch in the quarters ahead because, as we’ve pointed out, elevated expenses have limited the size of near-term earnings beats. “Our biggest competitors continue to invest heavily in marketing, and we need to be at the top of our game,” CEO Richard Fairbank said on the earnings call. Another part of the story we liked was the strong credit performance. This was actually a huge driver of the company’s earnings beat. Provisions for credit losses were $2.9 billion, well below analyst forecasts of around $3.6 billion. With net charge-offs of $3.12 billion, the $225 million allowance release provided a big boost to earnings. As for Discover integrations, management reiterated it is making good progress on the expected synergies. Fairbank said Capital One’s year-to-date results reflect about $1.8 billion of annualized combined synergies, which includes expense and network synergies. The target at the time the $35 billion Discover deal was announced in February 2024 was a combined $2.7 billion of synergies in 2027. Recall, the network synergies were always expected to be realized first as a function of moving debit volumes from Mastercard onto the Discover network. Expense synergies will become more apparent in 2027. One new wrinkle to the synergy story is that Fairbank expects Capital One to lose some interchange revenue if the proposed Visa and Mastercard swipe-fee settlement with merchants receives final court approval. He expects the lost revenue to roughly offset the remaining synergies from the Discover acquisition. As for buybacks, Capital One repurchased 12.6 million shares for $2.6 billion in the third quarter. That’s slightly below $2.7 billion worth of shares repurchased in the second quarter. Year to date, the company has repurchased $7.9 billion in stock and about $10 billion a year seems like the right cadence for them. Putting it all together, this was a good quarter for Capital One and one that likely does not warrant any additional sales on our part. We were pleased to see the revenue beat and the fee story continues its momentum. Credit risk is always an issue when oil prices spike; the bank’s performance in the quarter was a clear positive. We’ll keep monitoring the investment and expense story as competition in the credit card industry heats up. Capital One is looking to compete more aggressively with American Express for affluent, high-spending customers through its Venture X card, travel rewards, airport lounges and premium experiences. Trading at less than 9 times consensus 2027 earnings estimates, Capital One stock remains too cheap relative to its peers. We’re reiterating our hold-equivalent 2 rating and $255 price target. Credit commentary Credit was strong despite continued anxiety around high energy prices and interest rates. As mentioned, provisions for credit losses were less than expected, which is a good thing because those are funds Capital One sets aside to cover potential loan defaults; the higher the provisions, the weaker the credit-quality signal. The credit metrics include an allowance release for credit losses of about $225 million, which also boosted the company’s reported EPS. That’s the opposite of an allowance build, which means money set aside to cover potential future losses. The allowance release was primarily driven by its domestic card business, reflecting favorable credit performance. Consumer banking had a small allowance build of $41 million due to strong growth in its auto loan business. The domestic card charge-off rate for the third quarter was 3.98%. That’s down from 4.71% in the second quarter and 4.63% in the third quarter last year. Net charge-offs are also known as recovery rates. You want to see these decline because they refer to the amount of debt a bank has written off as uncollectible, minus any recoveries. Capital One’s charge-offs benefited from steady improvement in delinquencies compared to the first half of the year and strong recoveries performance. In consumer banking, the net charge-off rate was 1.63%, up from 1.48% in the second quarter and 1.58% in the third quarter last year. Commercial banking net charge-offs were zero in the third quarter, down from 0.53% in the second quarter and 0.21% in the third quarter last year. (Jim Cramer’s Charitable Trust is long COF. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. 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