Capital One’s Q4 Results Saw Headwinds, But Its Shares Still Look Underpriced

Capital One (NYSE:COF) reported a worse-than-expected EPS figure for the fourth quarter despite meeting revenue expectations, as unusually high marketing expenses for the period hurt the bottom line. Notably, the bank’s reported EPS figure was well ahead of expectations due to a one-time accounting gain, but adjusting the earnings for this gain puts the spotlight on the elevated costs for the period. While the card industry is highly competitive, the substantial increase in marketing costs for Capital One indicates that it had to put in considerably higher effort in the seasonally upbeat Q4 2018 to grow its top line. This trend can be explained by the rapid growth in popularity of non-card payment services, which has forced card issuers to dole out higher rewards to attract and retain customers.

As we have pointed out over recent months, current economic conditions in the U.S. are perfectly suited for companies like Capital One, which rely primarily on short-term consumer credit to make money. A strong outlook for the economy helps individuals take on card debt, while extremely low unemployment levels reduce the risks associated with the additional debt for lenders. This will have a positive impact on Capital One’s profits over subsequent quarters. While Capital One will continue to be affected by industry-wide headwinds in the future, we believe that the company will likely aim for a stronger foothold in the evolving payment industry through a big-ticket acquisition at some point. Its conservative capital plan for the current Fed stress test cycle lends support to this possibility. Due to these factors, we maintain our price estimate of  $100 for the bank’s shares, as we detail in our interactive dashboard for Capital One. This represents an upside of 25% to Capital One’s current share price.

See our full analysis for Capital One

Capital One Could Actually Make Less Money If Interest Rates Increase

The rate hikes implemented by the Fed have helped the interest rate environment in the country recover steadily from the record low levels seen over 2014-15. However, Capital One hasn’t benefited from this over recent quarters, as is evident from the charts below. This is primarily because roughly 80% of Capital One’s loan portfolio constitutes of credit card, auto and retail loans – the interest yields on which are often fixed. This results in the total interest income growing at a very small rate from the Fed’s interest rate hikes. On the other hand, rising interest rates require the bank to raise interest yields on deposits so that they remain competitive, which in turn increases interest expenses at a much faster rate. The net effect is a shrinking net interest margin (NIM) figure.

That said, it should be noted that the card-focused strategy means that Capital One’s NIM figure is already much higher than that of its peers. To put things in perspective, Capital One’s NIM figure for Q4 2018 was 6.96%, while the average for the U.S. banking industry was less than 3.4%. Although we expect Capital One’ net interest income figure to remain under pressure in 2019, it should trend higher once the Fed is through with its rate hike process thanks to its swelling asset base.

Controlled Charge-Off Rates Will Have A Positive Impact On The Bottom Line

As we have pointed out on several instances in the past, the steady increase in card charge-off rates in 2017 was expected, as the figure for the industry had been hovering at a 20-year low of under 3% over 2015-16. The card industry as a whole benefited from a recovery in credit market conditions over 2012-2015, which helped banks reverse some of the loan provisions they had set aside immediately after the downturn. At the same time, card lenders like Capital One relaxed their lending standards to make the most of the situation – considerably expanding their sub-prime card lending activity.

However, the notable improvement in market conditions and outlook over recent months helped the charge-off figure fall considerably in 2018 compared to 2017. Capital One’s card charge-off rate for Q4 2018 was 4.61% – a figure that was higher than the 4.15% reported in Q3 2018 due to seasonal trends, but well below the 4.99% level seen in Q4 2017. This helped provisions fall year-on-year – allowing the bottom line to benefit from the increase in card revenues for the period.

We forecast Capital One to report EPS of over $11 for full-year 2019. Taken together with a forward P/E ratio of 9, this works out to a price estimate of $100 for Capital One’s stock, which is about 25% ahead of the current market price.

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