Upside and Downside Scenario for Capital One

Capital One (NYSE:COF) is one of the largest banks in the United States, whose banking and non-banking subsidiaries market a variety of financial products and services. It competes with JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C) and American Express (NYSE:AXP) in the credit card business.

Capital One benefits from an increase in retail spending if the economic recovery continues in the US, and it presents upside for financial firms like Capital One whose profits are directly linked to consumer spending. Capital One also reported a decline in delinquencies for the month of November 2010 which would also boost its stock price. However, recently passed regulations like the 12 cents limit per debit card transaction enforced by Federal Reserve last month could potentially limit its upside.

We explore upside and downside scenarios to Capital One’s credit card unit, which we estimate accounts for 41% of the $50.53 Trefis price estimate for Capital One’s stock which is about 4% above the current market price.

10% Upside – Fall in Delinquencies

Capital One’s US credit card 30-days delinquency rates which are an indicator of future credit card losses fell from 4.45% in October to 4.26% in November last year signaling that the consumers are recovering from the stress of the financial crisis ^[1]. However, the annualized net charge-off rate for US credit cards rose marginally from 7.26% in October to 7.56% in November. The charge-off rate is the percentage of credit card debts that the company believes it will never recover. A lower delinquency rate would result in a lower charge-off rate in the future.

A decline in delinquencies will have a direct impact on the provisions for losses which are expressed as a percent of total outstanding loans. Provisions for losses increased dramatically from 7.8% in 2007 to 16% in 2008 because of the credit crisis but recovered back to 10.6% during 2009 and 7.5% in 2010 as the banks have become more conservative in their lending standards and are avoiding making loans where the risks of default are high. We expect the provision for losses to further decline to 6.5% by 2012.

There is a 10% upside to our price estimate for Capital One if the provisions for losses declined to 5% by 2012 due to falling delinquencies and stricter lending requirement which as a result of regulatory changes.

3% Downside – Interchange fee limit on debit card transactions

A key revenue stream for credit card companies like Capital One stems from the commission charged to merchants in a card transaction by the card-issuing bank, otherwise known as the interchange fee. The Durbin Amendment, enacted in July 2010, granted the Fed the power to control the levels of this fee. In December last year, the Fed enforced one such limit – 12 cents per debit card transaction. This limit could represent a loss of $13 billion in revenues for banks issuing debit cards, as per a report by CardHub.com ^[2].

We wrote two articles recently that discussed the potential impact of the Durbin Amendment on banks and card issuers. (See Impact of Durbin Interchange Amendment on JP Morgan, Bank of America and Cap on Debit Card Interchange Fee is a Positive for American Express)

We estimate that Capital One’s interchange fees will decline to about 0.4% by 2013 from its current level of 0.5% due to the regulatory changes but there is a 3% downside to our price estimate for Capital One’s stock if the interchange fee decline to about 0.2% by 2013.

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Notes:

1. Capital One credit card delinquencies fall in November, Reuters [↩]
2. Interchange Fee Study, CardHub [↩]