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.
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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|
|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|
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|
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.