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Capital One to Test Fed's 'Too Big To Fail' Cred

In December, the Federal Reserve approved PNC Financial Services' $3.6 billion acquisition of the Royal Bank of Canada's (RBC - Get Report) U.S. credit card operations, giving the first meaningful insight into how "too big to fail" may impact M&A.

The ability for PNC to add assets signals to Valentin of FBR that similar sized banks like BB&T (BBT - Get Report) and SunTrust (STI - Get Report) with modest trading operations can still pass Fed M&A tests.

However, Capital One's ING Direct acquisition is of a completely different scale than previously approved deals. The acquisition would make the McLean, Va., -based lender the fifth largest bank in the U.S. boosting from its No. 8 spot.

With ING, Capital One is trying to add liquid deposits and an online presence, which will grow its assets, while providing the liquidity to complete a $2.6 deal to buy a private label credit card portfolio from HSBC (HBC). Those deals are expected to be a boost to Capital One's earnings, while providing a strategic entry into higher yielding assets. Both moves could one day be considered opportunistic acquisitions as European banking conglomerates sell U.S. assets to bolster their capital.

In doing diligence on its "systemically important" decision, the Federal Reserve has held three public hearings on the proposed merger and has taken comment from advocacy groups like the National Community Reinvestment Coalition.

Five of the Federal Reserve board governors will need to approve Capital One's acquisition for it to be approved. The Federal Reserve can also approve the deal subject to divestiture, lending and hiring conditions.

Capital One has said that the move will increase the flow of credit to U.S. banking customers, while also committing to investment in hiring and low-income lending. In fourth quarter earnings, Capital One Chief Executive Richard D. Fairbank said that the "game changing" deal is on track and is expected to close in early 2012.

In January, Capital One missed its fourth-quarter earnings per share estimates of $1.56 among analyst polled by Thomson Reuters, on rising noninterest expenses. Net earnings of $407 million, or 88 cents a share, declined from $697 million, or $1.54 a share, a year earlier.

Another major factor in Capital One's earnings decline was the absence of a significant release of loan losses during the fourth quarter. The company's fourth-quarter bottom line saw only a $30 million boost from a reduction in loan loss reserves, while reserve releases totaled $208 million the previous quarter.

In reaction the banks' earnings, Guggenheim Securities analyst Marty Mosby reiterated his neutral rating on Capital One, saying that his rating "has been based on COF's earnings transition to a lower base, as we expected loan loss reserve release to run out."

Mosby expects "that once COF resumes earnings per share growth, which we expect following the completion of the ING Direct and HSBC Credit Card portfolio acquisitions, stock price appreciation should return."

Capital One said that the sharp increase in fourth-quarter noninterest expenses was "primarily due to a seasonal ramp in marketing expenses and an increase in operating expenses," which included roughly $90 million in litigation expenses and $40 million in asset write downs. The fourth-quarter expense spike also included items related to the company's coming ING Direct purchase.

Capital One expects to leverage its improved liquidity in a subsequent deal to purchase HSBC's U.S. credit card portfolio for a premium of $2.6 billion during the second quarter, while raising between $750 million and $1.25 billion in common equity through a public offering of shares.

Nevertheless, Capital One reported that its total loan balances had increased 5% sequentially and 8% year-over-year, to $135.9 billion as of Dec. 31, with credit card balances and commercial loans growing 6% and 14% respectively, compared with 2010.

Analysts give Capital One a price target of $56.86 and expect the bank to earn profits of $3 bilion on sales of $19.7 billion, according to consensus estimates compiled by Bloomberg. Both Sakhrani of KBW and Valentin of FBR give the bank an "outperform" rating, with $62 and $60 price targets, respectively.

Interested in more on Capital One? See TheStreet Ratings' report card for this stock.

-- Written by Antoine Gara in New York
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