Capital One Lowered to Neutral

Based on the financial impact of the recently implemented Credit Card Act, we have lowered our long-term recommendation on Capital One Financial Corporation (COF) to “Neutral” from “Outperform”.

Capital One’s second quarter 2010 earnings of $1.78 per share were significantly ahead of the Zacks Consensus Estimate of 88 cents and the prior-year quarter’s net loss of 64 cents.

Results improved over the prior-year quarter due to a lower provision for loan losses due to improved credit performance and increased revenues. However, an increase in operating expenses was the downside.

Capital One has selectively diversified into other areas of consumer banking by focusing on the healthiest businesses while largely avoiding less resilient ventures such as mortgages. Also, many of its strategic decisions over the last few years have braced it against the economic meltdown.

Capital One’s disciplined expense management is also one of the positive catalysts. The strategy has helped the company to offset increasing credit losses and enhance shareholders’ value over the last few quarters. During the six months ended June 30, 2010, operating expenses (excluding marketing expenses) were $2.2 billion, down 10% compared with $2.0 billion in the corresponding period of 2009. We expect the expense reduction to continue as Capital One completes the integration of Chevy Chase Bank. In February 2009, the company had completed its acquisition of all of the shares of Chevy Chase Bank F.S.B. and certain of its subsidiaries.

Although the market conditions are expected to stabilize in the next few quarters, we believe that any recovery in the credit card business will be marred by implementation of the Credit CARD Act in the U.S. and other restrictive regulatory measures in the U.K. and the European Union. Capital One expects its quarterly Domestic Card revenue margin to decline to about 15% by the end of 2010 or early 2011.

Though credit quality improved during the second quarter of 2010, we believe that it will remain under pressure. The company believes that the rate of net charge-offs and nonperforming loans is likely to fluctuate over the next few quarters due to continuing economic uncertainty.

We anticipate continued synergies from Capital One’s geographic diversification and expense management initiatives. Additionally, the resilience of almost all of its businesses will continue to support the company’s financials. However, its commercial real estate exposure, a weakening demand for new loans and the enactment of new financial reform law will restrict earnings in the near future.

Capital One’s shares currently retain a Zacks #3 Rank. This translates into a short-term ‘Hold’ rating and indicates no directional pressure on the shares over the near term.

CAPITAL ONE FIN (COF): Free Stock Analysis Report

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