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Capital One: An Investment Opportunity for Value Investors

Investment thesis

The earnings season officially kicks off on Tuesday with some major banks, including Wells Fargo, The Citigroup and Bank of America expected to report their third-quarter financial results. All eyes are on the banking and finance sector stocks as investors and analysts are expecting to gauge the effects of interest rate cuts on banks.


Capital One Financial Corp. (NYSE:COF) shares have declined 2% overall in the last 12 months. As seen in the chart below, the shares were very volatile at times, especially when earnings results were released.

Source: Reuters

The company will report its third-quarter earnings results on October 25, and shares will likely become more volatile as this date approaches.

Shares are currently trading at a discount to fair value, and an earnings miss might push the shares further into undervalued territory. The company has a strong balance sheet and a high-quality loan portfolio and is strategically investing in improving its online presence. The long-term outlook for interest rates is also attractive, making Capital One a strong buy opportunity.

Company profile and business strategy

Capital One is a diversified financial services company serving retail consumers, small and medium enterprises and other large-scale commercial clients. The company operates under four business segments: Credit Card, Consumer Banking, Commercial Banking and Other. Capital One provides various products and services under each of these segments.

Business segment

Products and services

Credit card

Domestic consumer cards, small business card lending, international card lending in Canada and the United Kingdom

Consumer banking

Branch-based lending, savings deposits, auto lending, consumer home loans

Commercial banking

Lending, deposit collecting, and treasury management services to business clients



Source: Company filings

As of the second quarter, the credit card segment dominated company revenue.

Source: Company filings

The primary business strategy of Capital One, as confirmed by the management in the second-quarter earnings call, is to improve the technical aspects of the business and move forward as a tech-friendly financial institution. To achieve this objective, the company is investing in enhancing its digital capabilities.

Capital One plans to acquire companies on a strategic basis as well. The company has executed 55 deals since 2010. The acquisition of HSBC's U.S. credit card business in 2011 and ING Direct in the same year stand out as the most noteworthy transactions.

Source: Reuters

In the second-quarter earnings call, the management confirmed that the company would be willing to allocate funds to execute more such transactions if opportunities become available.

Distributing wealth to shareholders has remained one of the primary business objectives of the company for an extended period, and the rich history of dividends is proof of this.

Source: Company filings

The share repurchase program is another strategy in place to increase the total return of investors.

Industry analysis

As the credit card segment has accounted for over 50% of company revenue in each year of the last decade, consumer spending habits in the U.S. can materially impact Capital One's earnings. Since plummeting during the financial crisis in 2008, consumer spending has increased steadily to reach new highs in 2019. This has helped Capital One and will continue to be a driver of revenue as there are no signs of a significant slowdown in spending.

The declining interest rate environment is an obstacle for banks and other lenders to expand their net interest margins (NIMs). The Federal Open Market Committee (FOMC) decided to cut the Fed funds rate by 25 basis points in July and September, which has now pulled the target range back to 1.75% to 2%.

Declining rates are already affecting financial institutions negatively, and the net interest margins are compressing.

Source: Reuters

As illustrated above, Reuters analysts predict an expansion of NIMs in the next two years based on expectations for higher base rates in the future, as depicted from the below dot plot released by the Federal Reserve.

Source: The Federal Reserve/Reuters

Policymakers in the U.S. project economic growth to resume as trade war-related fears subside, which supports the case for higher policy rates in the future. Therefore, the macro-level outlook for U.S. lenders in the next couple of years is positive.

A key trend in the banking industry is the capital spending toward improving technological capabilities. A survey conducted by Deloitte in 2018 revealed that 61% of financial institutions in the country have either fully deployed digital initiatives or are planning to do so in the next 12 months. As an early investor of the digital space, Capital One would be in an excellent position from a competitive perspective.

Overall, the long-term industry outlook is positive for Capital One, and the company is well-positioned to grow revenue and earnings.

Financial performance

Total revenue increased at double-digit rates from 2009 to 2013 but has slowed since then. This growth was primarily driven by the two major acquisitions completed in 2011, which were discussed earlier.

Source: Company filings

The favorable macro-economic conditions helped the company in the last decade as well.

For the second quarter 2019, the company reported a net interest margin of 6.8%, an improvement from the 6.66% reported in the corresponding period last year. However, this trend might not be sustainable in the upcoming quarters as the macro-economic environment is not supportive of margin expansion in the short-term.

The loan portfolio of Capital One is of high quality, which is evident from the flat net charge-offs rate. In the second-quarter earnings call, the management commented that the robust loan portfolio will likely survive the headwinds in an economic downturn as well.

Source: Investor presentation

Capital One has sufficient liquidity as well, which is evident from the improving Common Equity Tier 1 Capital Ratio, which has consistently been higher than the 4.5% recommended by the Basel III Accord.

Source: Investor presentation

The balance sheet of the company is robust, and the loan portfolio is of high quality. These characteristics will help if the U.S. economy enters a recessionary period, which is one of the most significant risks for banks and financial institutions at present.

Growth opportunities and risks

Capital One has invested in improving its operations and IT systems in a bid to address the digital banking requirements of clients. As per the comments made by the company CEO in the second-quarter earnings call, these investments have boosted the ability of the company to measure and forecast consumer credit quality trends and customer behavior, resulting in better credit performance and lower customer acquisition costs. The company will reap the benefits of these investments in the future as well. Although profit margins will compress in the short-term due to these capital expenditures, in the long run, the company would benefit from its data analysis capabilities.

Source: Company filings

Capital One made profits during the financial crisis as well. The below table illustrates the net income of the company from 2006 to 2010.

Financial Year

Net Income (millions)

2006

$1,809.15

2007

$1,570.33

2008

$(-46)

2009

$884

2010

$2,743



Source: Company filings

Even though the company could not earn a profit in 2008, the financial performance of Capital One during the recessionary period was superior to that of its peers. For instance, according to Morningstar data, Capital One's charge-offs peaked at 5.9% during the crisis, in comparison to the average charge-offs of 8% for its peers, which indicates the quality of the company's loan portfolio. Eric Compton, the Morningstar analyst covering the company, further believes that Capital One was one of the first financial institutions to warn against the risks of subprime lending and had eventually cut back on such loans just before the crisis. These are all positive signs for investors, especially considering the World Bank's weak economic growth expectations for the U.S. in the next couple of years. The company has the experience to navigate unfavorable macro-economic conditions, which could prove to be a value driver.

Capital One has competitive advantages stemming from its massive cardholder base that is spread across the country. According to company filings, there were 45 million cardholders in the U.S. at the end of the second quarter. According to the Nilson Report, Capital One was the 5th largest credit card issuer in the U.S. by purchase volume in 2018.

Source: The Nilson Report

The wide reach and acceptance of Capital One cards will help the company retain its customer base for an extended period, which adds a degree of stability to the company's revenue and earnings.

Growth will be slow but steady in the next few years, and the benefits of capital investments will start flowing into the company in these years. The mature nature of the business makes Capital One an attractive consideration for value investors, though perhaps not for growth investors.

Dividend safety analysis

The dividend distributions from Capital One date back to 1996, and the current annual payout of $1.60 per share yields 1.8% at the current average market price of $88.84. The payout ratio is 14.75, which is an indication that Capital One can boost its shareholder distributions in the future.

Dividends have been covered by free cash flow since 2009, which is a promising sign for income investors. This cash coverage provides a cushion for Capital One to honor its commitment to distribute wealth to investors efficiently.

Source: Company filings

Even though the prospects for dividend investors are attractive, the company will likely cut its dividends to save cash if the U.S. economy enters a recession. The company did this during the financial crisis of 2008, when it reduced its quarterly dividend from 37 cents to 5 cents per share.

Valuation

Capital One is mostly followed by income investors, which prompted my decision to use a dividend discount model to derive the fair value of the shares.

According to data from Reuters, the company has made a net profit of $5.485 billion in the trailing twelve months, paid out $759 million as dividends and repurchased common stock worth $1.276 billion. Consequently, the company had retained earnings of $3.45 billion in this period.

A major assumption in this model is that Capital One will eventually distribute all of its accumulated earnings to shareholders. Under the premise of a mid-point required retention ratio of 12.5%, the excess retained earnings per share comes to $5.88.

Source: Author's calculations

When this is added to the current annual dividend per share of $1.60, the adjusted dividend comes to $7.48 per share.

A cost of capital assumption of 9.5% and a perpetual growth rate of 2% results in an intrinsic value of $101.69 per share, which represents an upside of 14.5% from the market price of around $88.61 as of today, Oct. 15 2019.

Wall Street analysts have a consensus target price estimate of $104 per share and a buy recommendation for Capital One.

Source: Reuters

Conclusion

Capital One will grow at modest rates in the future, and the market price does not reflect the present value of expected future dividends accurately. Even if the company grows at low single-digit rates for many years, dividend distributions are likely to remain steady or improve. Shares are undervalued to the intrinsic value calculated using a dividend discount model.

Disclosure: I do not own any stocks mentioned in this article.

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This article first appeared on GuruFocus.