Capital One’s Strong Q2, Improved Outlook Justify A $117 Price Estimate

by Trefis Team
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Late last week Capital One (NYSE:COF) reported a better-than-expected EPS figure for the second quarter of the year, with the card-focused banking giant making the most of upbeat economic conditions to report a jump in revenues even as its loan losses fell sharply. The period also saw Capital One finally getting rid of the mortgage portfolio it had built after the downturn primarily through acquisitions (especially of ING Direct USA in 2012). One-time gains linked to this disposal helped boost the bank’s profits for the quarter further.

The 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. While this will have a positive impact on Capital One’s profits over subsequent quarters, we also expect the bank’s increased focus on card and mobile-based payment solutions to drive growth in the long run. Additionally, Capital One remains strongly capitalized, and its conservative capital plan for 2018 indicates that it might be saving up for a big-ticket acquisition in the near future. Taking all this into account, we believe that the bank’s shares are worth $117 as we detail in our interactive dashboard for Capital One. This represents an upside of nearly 20% to Capital One’s current share price.

See our full analysis for Capital One

Reduction In Card Charge-Offs Is Great News

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 2012-15, 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 dip in Q2 2018, as shown in the chart below. The low card losses, in turn, helped Capital One set aside less than $1.3 billion in loan provisions for Q2 – the lowest figure since Q3 2015. Given that upbeat economic conditions and seasonal factors are likely to keep consumer spending elevated for the rest of the year at least, even as repayments keep charge-off rates lower, Capital One profits in 2018 should see a sizable jump compared to the figure for 2017.

Declining Net Interest Margin (NIM) Is A Concern, But It Is An Industry-Wide Trend

The rate hikes implemented by the Fed have helped the interest rate environment in the country to recover steadily from the record low levels seen over 2014-15. However, a flattening of the yield curve over recent quarters has had a negative impact on net interest margins across the U.S. banking industry.

This issue has been especially present for Capital One, as it was accompanied by a notable increase in the bank’s deposit base due to the growing popularity of its online account offerings. The relatively higher interest yields offered by Capital One for online deposits have drawn in a lot of funds for the bank – something that will continue to weigh on the net interest margin in the near future, but will prove to be an invaluable source of cheap funding for the bank’s lending business in the long run.

In any case, we expect Capital One to more than make up for lower interest margin figures over coming months thanks to strong growth in its loan portfolio. While a bulk of this growth is likely to be organic, Capital One could also witness a strong boost in net interest revenues if it manages to win the Wal-Mart card business from Synchrony.

Based on Capital One’s Q2 2018 results, we expect the bank to report EPS of $10.64 for full-year 2018. Taken together with a P/E ratio of 11, this works out to a price estimate of $117 for Capital One’s stock, which is about 20% ahead of the current market price.

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