Here’s Why Capital One Is Worth $79

by Trefis Team
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Capital One (NYSE:COF) has long since outgrown its roots of being a monoline consumer lending company. A pioneer in the use of analytics to understand consumer spending patterns and offer products suited to their preferences, Capital One became one of the biggest credit card lenders in the country before turning to the retail banking industry through a series of acquisitions between 2005 and 2008. And despite the boost to its consumer lending portfolio (mortgages, auto and other retail loans) from the acquisition of ING Direct in late 2011, the credit card business continues to remain the most important source of value for Capital One.

We believe that Capital One’s shares have an intrinsic value of $79, two-thirds of which comes from its credit card business. A simple justification for the huge share of the credit card business is that the interest margins for credit card loans are roughly double those of its other consumer loans. While we have pointed out on numerous occasions the significant downside risk that exists to Capital One’s value from rising card charge-off rates (see Rising Card Charge-Off Rates Are A Major Source Of Concern For Capital One), the steady improvement in these figures over recent quarters is one of the most important factors behind our optimism, which values the bank’s shares roughly 15% ahead of the current market price.

Additionally, Capital One has been acquiring companies over the last few years to beef up almost every aspect of its business – from its trademark analytics unit to commercial real estate. The mix of organic growth and acquisitions is a good strategy for long-term sustainability.

See our full analysis for Capital One

Capital One Is Tracking Its Loan Portfolio Closely

The most important thing about Capital One’s growth strategy is that the bank is very clear about the risks it wants to add to as well as avoid in terms of its balance sheet. This is demonstrated by the chart below, which highlights the changes in Capital One’s average loan balances for each quarter over the last two years and is based on information provided by the bank in its quarterly filings.

(in $ mil) Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013
Credit Card:
Domestic credit card 51,889 53,868 53,668 54,403 54,131 71,468 80,502 80,718 74,714 69,966 69,947
International credit card 8,697 8,823 8,703 8,361 8,301 8,194 8,154 8,372 8,238 7,980 7,782
Total Credit Card 60,586 62,691 62,371 62,764 62,432 79,662 88,656 89,090 82,952 77,946 77,729
Consumer Banking:
Automobile 18,025 18,753 19,757 21,101 22,582 24,487 25,923 26,881 27,477 28,677 30,157
Home Loan 11,960 11,534 11,126 10,683 29,502 48,966 47,262 45,250 43,023 40,532 37,852
Retail Banking 4,251 4,154 3,979 4,007 4,179 4,153 4,086 3,967 3,786 3,721 3,655
Total consumer 34,236 34,441 34,862 35,791 56,263 77,606 77,271 76,098 74,286 72,930 71,644
Commercial Banking:
Commercial real-estate 13,579 13,859 14,291 14,920 15,514 15,838 16,654 17,005 17,454 18,084 19,047
Commercial/industrial 14,630 14,993 15,726 16,376 17,038 18,001 18,817 19,344 19,949 20,332 21,491
Small-ticket CRE 1,818 1,726 1,598 1,547 1,480 1,388 1,296 1,249 1,173 1,096 1,038
Total commercial 30,027 30,578 31,615 32,843 34,032 35,227 36,767 37,598 38,576 39,512 41,576
Other Loans 228 206 195 183 173 137 162 158 183 174 166
Total Loans 125,077 127,916 129,043 131,581 152,900 192,632 202,856 202,944 195,997 190,562 191,135

Capital One has been very selective about the areas in which it wants to grow over the mentioned period – more specifically after it acquired ING Direct and HSBC’s credit card business. The ING Direct deal led to an exponential jump in home loans that are a part of the bank’s portfolio, whereas the HSBC deal resulted in a near 50% increase in the bank’s credit card loans.

But the bank allowed its home loan and credit card portfolios to run off over the last few quarters, to ensure that the loans that do not meet its risk-return criteria are eliminated from its balance sheet. In fact, Capital One sold its Best Buy card portfolio to Citigroup (NYSE:C) earlier this year (see Citi Snaps Up Capital One’s Best Buy Credit Card Portfolio) to get rid of the strategically redundant loans.

At the same time, the bank has focused considerably on its automobile and commercial lending businesses – as can be seen from the healthy growth in these loans over the period. As a result, card loans, consumer loans and commercial loans make up Capital One’s loan portfolio in the ratio of roughly 40:40:20 – something we believe will be maintained over subsequent quarters, once the bank is done with its current loan-paring phase.

.. And Improving Credit Quality Should Give Its Bottom Line A Steady Boost

The table below summarizes the credit card charge-off rates for Capital One in the last eleven quarters. The data has been compiled using figures reported by individual banks as a part of their quarterly announcements.

Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013
6.13% 5.06% 4.23% 4.30% 4.14% 3.13% 3.22% 4.32% 4.45% 4.36% 3.78%

As a part of its Q3 2012 earnings release, Capital One gave investors a heads up about higher charge-off figures in the future, holding the less stringent lending practices by the acquired HSBC (NYSE:HBC) card business responsible for an overall reduction in the quality of its loan portfolio. ((Q3 2012 Earnings Press Release, Capital One Press Releases, Oct 18 2012)) This began to show in the bank’s performance figures over subsequent quarters, with card loan charge-offs jumping from just above 3% in Q2 2012 to almost 4.5% in Q1 2013.

But this figure has shown a marked decline over the last two quarters to fall to under 3.8% last quarter. As lower charge-off figures require the bank to set aside lower provisions to cover these losses over subsequent quarters, this points to a significant potential upside to the bank’s stock.

To put things in perspective: if Capital One is forced to set aside 3% of its loan size as provisions each year in the future, instead of the almost-4% figure we forecast, the bank’s share price will gain nearly 10% over our current estimate of $79 to reach above $87.

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