Capital One: Strong Loan Growth, Improving Interest Margins Support $85 Price Estimate

Earlier this week, Capital One (NYSE:COF) reported better-than-expected performance figures for the fourth quarter of the year, as increased spending over the holiday season and a notable improvement in interest margins helped the bank churn out record revenues for the period. ^[1] Net interest revenues were at an unprecedented level of almost $5 billion – boosted by the addition of GE’s healthcare unit and strong organic growth in card balances. Card interchange fees also reached an all-time high of $617 million, allowing Capital One to report total revenues just shy of $6.2 billion.

The revenue gains did not reflect on the bottom line, though, as Capital One’s loan provisions jumped almost 25% compared to Q3 2015 as well as Q4 2014 to reach almost $1.4 billion. Also, seasonally higher marketing costs and one-time costs related to the integration of GE healthcare had a negative impact on pre-tax profits. Investors cheered the overall positive results for the last quarter, though, by sending Capital One’s shares 5% higher on Wednesday, January 27.

A key strength that Capital One has demonstrated over the years is its willingness to grow inorganically through big-ticket acquisitions, and its ability to effectively integrate the acquired business units. This, coupled with the potential gains the bank will realize on its strong loan portfolio as the Fed continues to raise benchmark interest rates, lends support to our $85 price estimate for Capital One’s stock. This figure is roughly 35% ahead of the current market price.

See our full analysis for Capital One

Loan Growth, Rising Interest Margins Should Drive Profits 

Strong demand for commercial and auto loans over recent years has primarily been responsible for growth in Capital One’s loan portfolio over recent years. Also, the bank has done well to achieve a steady increase in credit card balances – something that received a boost in Q4 due to seasonally higher consumer spending. As Capital One also added GE healthcare’s $8.3 billion portfolio of commercial loans in December, its total loan base reached an all-time high of $230 billion at the end of 2015. The deal helped commercial loans increase to more than $63 billion – an increase of more than 20% compared to Q3 2015 and Q4 2014 – while card loans grew by 7% quarter-on-quarter and 12% year-on-year to reach $96 billion. As has been seen over each of the last several quarters, Capital One reported a sequential increase in loans across categories except for home loans – indicating that the bank is still running off its mortgage portfolio.

After being particularly depressed over the first two quarters of the year, Capital One witnessed a sizable increase in its net interest margin (NIM) figure over the second half. The table below summarizes Capital One’s reported NIM as well as net interest income figures for each of the last twelve quarters:

As seen here, the bank’s NIM remained largely below 6.6% over the first half of 2014 and 2015 as a result of the low interest rate environment. Notably, credit card loans (which attract the highest interest yield) see the most growth in the second half of the year, because of which the NIM figure is usually uptick for Capital One in Q3 and Q4 – a trend that is evident in 2014 and 2015. The higher NIM figure in Q4 2015 allowed Capital One to report record net interest revenues of $4.96 billion.

Notably, the impact of the Fed’s interest rate hike last December would take a couple of months to reflect in Capital One’s net interest figure. This should help results for Q1 2016, even as subsequent increases in the benchmark rate continue to boost revenues in the near future.

Expect Improvements On The Cost Front In 2016

Capital One enjoys one of the best operating margins in the country’s banking industry thanks to the significant share of card lending operations in its business model. While being an important source of value for the bank, the relatively low-cost structure for the card unit provides Capital One more leeway in its plans to target new customers by increasing marketing spend. The bank usually reports the highest marketing costs for a year in the fourth quarter – something that was true for Q4 2015. At the same time, the bank incurred a $20 million one-time cost related to the GE healthcare acquisition, and also increased spending on infrastructure and technology to expand its retail banking capabilities. Taking all this account, Capital One did well to marginally reduce its expense-to-revenue ratio year-on-year.

Notably, Capital One’s workforce strength fell from 46,000 at the end of 2014 to 45,400 now. This indicates that the bank is working on cutting costs – the positive impact of which should be visible in results over coming quarters.

Weak Energy Industry Could Trigger Sizable Loan Losses

Capital One’s commercial lending business has grown rapidly over recent years to grow from under $30 billion in early 2011 to $63 billion now. And over this period, it has been a major driver of profits because of the low charge-off rates associated with these loans. The bank, however, has been slowly increasing provisions for loans handed out to clients in the oil & gas industry since early 2015 in response to the low oil prices. These provisions jumped in Q4 2015, with roughly one-third of the $604 in provisions for commercial loans now being set aside to cover oil & gas loans even though these loans are responsible for less than 5% of the commercial lending portfolio.

According to the bank’s Q4 earnings call, it has roughly $3.1 billion in loans to companies in the oil & gas industry. Roughly half of these loans are in the exploration and production (E&P) sector – the one hit hardest by sliding oil prices. Considering that the bank has just $190 million in loan loss provisions to cover them, it could potentially lose $1-1.5 billion if oil prices do not recover in the near future. You can make changes to the chart below to understand how an increase in commercial loan provisions impacts Capital One’s total value.

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1. Capital One Reports Fourth Quarter 2015 Net Income of $920 million, or $1.58 per share, Capital One Press Releases, Jan 26 2016 [↩]