Up 50%, Capital One Stock Still Has 20% Upside

Capital One stock (NYSE: COF) lost more than 58% – dropping from $103 at the end of 2019 to around $43 in late March – then spiked around 53% to around $66 now. Despite the recent rally, the stock remains 36% below the level at the beginning of the year.

This can be attributed to 2 factors:  The Covid-19 outbreak and economic slowdown meant that market expectations for 2020 and the near-term consumer demand plummeted. As the company derives most of its revenues from the credit card business, it could suffer losses due to lower consumer demand and an expected spike in loan default rates. The multi-billion-dollar Fed stimulus provided a floor, and the stock recovery owes much to that.

But this isn’t the end of the story for Capital One’s stock

Trefis estimates Capital One’s valuation to be around $78 per share – around 20% above the current market price – based on an upcoming trigger explained below and one risk factor.

The trigger is an improved trajectory for Capital One’s revenues over the second half of the year. We expect the company to report $27.5 billion in revenues for 2020 – around 4% lower than the figure for 2019. Our forecast stems from our belief that the economy is likely to open up in Q3. The easing of lockdown restrictions in most of the world is likely to help consumer demand, resulting in higher card loans and growth in transaction volume – the credit card business constitutes around 64% of the company’s total revenues. This, in turn, would benefit the revenue trajectory over the coming months. On the flip side, net income for the year is expected to take a hit due to build-up in provision for credit losses, reducing the EPS figure to -$2.17 for FY2020.

Thereafter, Capital One’s revenues are expected to improve to $28.2 billion in FY2021, mainly driven by growth in outstanding loans. Further, the net income margin is likely to improve as compared to the previous year due to a decline in provisions for credit losses, leading to an EPS of $7.20 for FY2021. 

Finally, how much should the market pay per dollar of Capital One’s earnings? Well, to earn close to $7.20 per year from a bank, you’d have to deposit about $785 in a saving account today, so around 110x the desired earnings. At Capital One’s current share price of roughly $66, we are talking about a P/E multiple of just above 9x. And we think a figure closer to 11x will be appropriate.

That said, consumer finance is a risky business right now. Growth looks less promising, and near-term prospects are less than rosy. What’s behind that? 

Capital One has a huge portfolio of outstanding loans – around $247 billion in FY2019 out of which close to $114 billion were in credit card loans alone. The economic slowdown is likely to hurt the financial health of many customers, exposing the company to potential loan defaults.

As a result, Capital One has increased its provisions for loan losses to around $9.7 billion by Q2 2020– more than three times the year-ago period, leading to a huge spike in the total expenses figure for the year. If the economic condition continues to deteriorate, this figure could further spike in the subsequent months. 

The same trend is visible across Capital One’s peer – American Express. Its revenues are likely to suffer in FY2020 due to lower consumer spending. Further, its net income margin is likely to suffer due to a jump in provisions for credit losses in anticipation of loan defaults. This would explain why American Express’ stock currently has a stock price of over $96 but looks slated for an EPS of around $6.66 in FY2021.

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