Improved Focus On Cards, Better Cost Management Could Help Capital One Shares Scale $110

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COF: Capital One Financial logo
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Capital One Financial

Capital One (NYSE:COF) has come a long way from being a monoline consumer lending company at the turn of the century to become one of the largest bank holding companies in the country today. Pioneering the use of analytics to understand consumer spending patterns and come up with products and offers suited to their requirements, Capital One has steadily grown its credit card business over the years. At the same time, the bank has also been on the lookout for acquisition opportunities – expanding its retail banking offerings through several big-ticket acquisitions between 2005 and 2012. The extent of change in the bank’s business model over the last decade can be understood by the fact that its average loan portfolio swelled from $41 billion in 2005 to just under $200 billion in 2014.

Although the proportion of credit card loans in this portfolio shrunk from 65% to 40% over the same period, the card business remains the cornerstone of Capital One’s business model. Our analysis shows that credit cards are responsible for almost 60% of the $91 price estimate for Capital One’s stock. In this article, we detail how an increased focus on cards in the long run coupled with improved operating efficiency could push Capital One’s share value above the $110 mark.

See our full analysis for Capital One

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Capital One Has Diversified Its Operations Over The Years…

COF_Loans

As seen in the chart above, Capital One’s loan portfolio has grown five-fold over the last 10 years. The abrupt jumps on several occasions are a result of the bank’s various acquisitions. Notably, the bank’s consumer lending arm saw the biggest jump in 2012 after Capital One acquired ING Direct. The bank followed this up by adding HSBC’s U.S. card business to its own the same year. Over recent years,  Capital One has kept itself busy paring down the acquired loan portfolio (both card loans and consumer loans) to ensure that it gets rid of low quality and strategically redundant loans. As a result, only the commercial lending portfolio has seen positive growth between 2012 and 2014.

… But This Hasn’t Helped Operating Performance Much Over Recent Years

COF_HistoricalFigures

The current low interest environment has had a negative impact on revenues for the banking sector as a whole over recent years. As is clearly seen in the chart above, this has affected revenues for Capital One across all operating divisions. Moreover, the bank has also had to contend with lower profitability in the card business in the wake of stricter regulations. This is why Capital One’s pre-tax income figure fell sharply in 2014 compared to 2013 despite a notable improvement in card usage year-on-year.

Long-Term Revenue, Profit Distributions Likely To Remain Mostly Unchanged

COF_Estimates_Base

The charts above capture our estimates for Capital One’s revenue as well as pre-tax income figures. You will notice the fact that the revenue as well as profit contribution from credit card loans is well above the proportion of these loans in the bank’s loan portfolio. This is because credit card loans enjoy a much higher net interest margin (~13%) compared to consumer loans (~8%) and commercial loans (less than 4%).

Our base case scenario relies on the above detailed growth in revenues and pre-tax incomes for Capital One – helping us arrive at a $91 price estimate for its shares.

There Is Considerable Upside To A More Card-Oriented Business Model

COF_Estimates_Alt

If Capital One chooses to increase its focus on its card business and pursues a more aggressive growth strategy for the division in the future, then the shares could be worth more than $110. This represents a 20% upside to our base case scenario and is a good 30% ahead of the current market price for Capital One’s shares. The revenue and pre-tax distribution in this case are as detailed above.

There are three key drivers which are responsible for this price difference in the alternative scenario:

  • Outstanding credit card balances: Capital One’s outstanding card balances have remained around $80 billion over 2012-2014, with any organic growth over the period being nullified by run-offs as well as the outright sale of certain acquired loan portfolios. We assume 4% annual growth in these balances in our base case, but given Capital One’s history of growing through acquisitions, this figure could easily touch 7% per annum in the future.

  • Card purchase volumes: With regulations limiting the amount of fees card lenders can charge cardholders since the economic downturn of 2008, the only way lenders can benefit from higher non-interest card revenues is through an increase in card usage. As card issuers earns a fee every time a card is swiped at a merchant, an increase in card purchase volumes would translate into higher revenues. Purchase volumes for cards issued by Capital One have jumped 11% in each of the last two years, and we estimate an average annual growth of 6% in our base case. Aided by the faster growth in card balances for our alternative case, though, purchase volumes could grow at a higher rate of around 8% each year.

  • Card division expense as % of revenue: Non-interest expenses for Capital One’s card business have hovered around 52% of the division’s total revenues over the 2012-2014 period. With these expenses likely to grow at a slower rate than revenues in the long run, we estimate a reduction in this metric to about 50% in our base case. Notably, this represents an increase in non-interest expenses from $7 billion in 2014 to around $9.2 billion by the end of our forecast period. The alternative scenario will definitely entail higher expenses in dollar terms as the faster growth in card base will include higher employee as well as marketing costs. But expressed in terms of revenues, this figure will fall to around 46% over the same period. It should be noted that this still represents a substantial increase in non-interest expenses from $9.2 billion to $10.4 billion at the end of the forecast period between the base case and the alternative case.

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