Capital One’s Decision To Get Rid Of Its Remaining Mortgage Portfolio Is Good News For Investors

by Trefis Team
Capital One
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Earlier this week, Capital One (NYSE:COF) inked a deal to sell its portfolio of roughly $17 billion mortgage loans to DLJ Mortgage Capital, a subsidiary of Credit Suisse (NYSE:CS) in the U.S. The portfolio sale marks Capital One’s exit from the U.S. mortgage industry, with the bank having discontinued mortgage originations last November. We capture the impact of the portfolio sale on several key metrics for Capital One in our interactive dashboard for the card-focused banking giant, parts of which are summarized below.

We believe that the portfolio sale will have a negligible impact on our forecast for Capital One’s revenues and EPS for this year. However, the biggest gain for investors from the deal is that the funds generated from the deal will allow Capital One to reinstate is share repurchase program – resulting in a sizable increase in its payout ratio over subsequent quarters. We maintain our $107 price estimate for Capital One’s stock, which is about 15% ahead of the current market price

See our full analysis for Capital One

The U.S. Mortgage Industry Is Changing – Capital One’s Exit Only Reinforces This Fact

Stricter regulatory requirements, coupled with an overall slowdown in the mortgage industry since 2012, reduced the appeal of the once-lucrative mortgage business for banks. Non-banking financial institutions have quickly grown in size and numbers to fill in the gap left by the banks.

The mortgage division was never a strategic growth area for the bank. With the Fed’s ongoing rate hike over recent years driving mortgage rates higher, Capital One concluded late last year that it would no longer be able to keep up with the competition in a profitable manner – prompting an abrupt exit from mortgage originations. The bank had already been running off its mortgage portfolio since mid-2012, after the bank’s merger with ING Direct USA resulted in the mortgage portfolio swelling from around $10.5 billion at the end of 2011 to almost $50 billion in early 2012. The bank’s most recent quarterly filing with the SEC shows that it held just over $16.6 billion in mortgages at the end of Q1 2018 – roughly 35% of the mortgage portfolio’s size six years ago.

Understanding The Impact On 2018 Results, Share Price And Investor Payout

As we mentioned above, Capital One currently has a mortgage portfolio of $16.6 billion – which will be transferred to DLJ Mortgage Capital over coming months. Accordingly, Capital One’s loan portfolio will no longer have any mortgages in the near future. It should be noted that the charts below capture the average loan portfolio by category over a year (which is why the mortgage portfolio is not zero for 2018). As Capital One currently holds a mortgage portfolio of ~$17 billion (and will continue to hold it for a couple more months until the deal is closed), the average figure for full-year 2018 should be around $8 billion.

While a smaller loan portfolio will have a negative impact on Capital One’s net interest income for the year, the revenue loss will be partially mitigated by higher net interest yield for the bank’s remaining consumer loan portfolio (which will now consist entirely of high-interest yielding auto loans and personal loans). Factoring this in, the consumer lending interest income should fall ~8% from our original estimate of $6.67 billion to $6.14 billion.

However, taken together with estimated one-time gains of ~$150 million from the sale, the impact on total revenues should be substantially lower. We expect revenues for 2018 to be $28.7 billion now, instead of our original estimate of $29.1 billion.

Now the interest income from mortgages accrued almost completely to Capital One’s bottom line (because there are negligible operating expenses involved), so the loss of this revenue stream will hurt the bank’s net margin. At the same time, the one-time gain and the reduction in operating expenses related to the mortgage business will benefit the margin figure. Taking both these opposing factors into consideration, we expect the bank’s net margin to remain around the currently forecast level of 16%.

Finally, as we pointed out earlier, an increase in share repurchases will reduce the average outstanding shares for the year. The net impact of all these factors will be to increase Capital One’s EPS figure for 2018 slightly to $9.75 from our original estimate of $9.73.

Using the new EPS figure, and a forward P/E multiple of 11x (which we believe is appropriate for Capital One), we arrive at an estimate of $107 for Capital One’s shares – which is in line with our previous estimate.

But, as detailed in the chart below, the cash Capital One generates from the portfolio sale should help it increase share repurchases from our original estimate of $750 million to an expected $2.5 billion over the rest of the year. This will more than double our estimate for the bank’s effective payout ratio in 2018 from below 36% to almost 75%.

In case you disagree with any of our forecasts, feel free to modify them in our interactive model to come up with your own forecast for Capital One

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