We are upgrading our recommendation on Capital One Financial Corp. (COF) to Outperform. The company’s third quarter earnings were substantially ahead of the Zacks Consensus Estimate, driven primarily by higher-than-expected revenue and almost stable expenses. However, an increase in provisions and a decrease in average deposits were on the downsides.
 
We think that the full repayment of the bailout money and the warrants sell-off by the Treasury department will help Capital One get back investors’ confidence. Also, the company is now free from government interventions and pay restrictions on its key executives. Restrictions on pay rules as a result of absorbing government money were a major competitive disadvantage for the company in retaining talented employees.
 
As part of its transformation to banking, Capital One acquired Chevy Chase Bank in February 2009. Chevy Chase’s large retail presence in the Washington D.C. region will further expand Capital One’s operational reach in these lucrative markets. This acquisition will support its earnings growth going forward.
 
Disciplined expense management is another major strength of Capital One. The expense management initiatives have significantly helped the company in offsetting rising credit losses and driving shareholder value in the recent years.
 
However, credit quality continues to deteriorate and remains a significant threat to profitability in the upcoming quarters. Capital One’s significant exposure to commercial real estate will remain a drag on its earnings, driven by a decrease in collateral values, specifically in its construction portfolio. Given the stressed economic conditions, we expect this weakening trend to continue.
 
We expect new loan originations to reduce due to weakening demand from credit-worthy borrowers. As a result, a decline in managed loans in the near future is expected. Additionally, we expect loan growth to face headwinds due to stiff competition as banks compete for high-yielding loans.
 
We anticipate continued synergies from the company’s geographic diversification, strategic expansions and expense management initiatives. The repayment of the bailout money also bode well for investors. Hence, we have upgraded the recommendation to Outperform.
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