Description

Introduction:

Capital One (COF) is the sixth largest bank by deposits in the United States. It has the largest market share in the Washington, DC MSA with >18% of total deposits, the #1 position in New Orleans, and top 10 positions in Houston and New York City. The company is also the largest direct online bank in the country, having grown through its 2012 acquisition of ING Direct and is over 3x the size of its closest competitor. The company is most well-known for its credit card business, but it also has a large national auto lending operation and expanding middle-market commercial lending operations. Many people don't even realize the company is a bank. Before the financial crisis, Capital One began its transformation from a monoline card company to a diversified bank through its acquisitions of Hibernia Bank and North Fork Bank in 2005 and 2006, respectively. It purchased Chevy Chase Bank in 2009.

Capital One has proven itself to be a prudent underwriter of risk. Even though its credit card business caters mainly to low-prime and high-quality subprime borrowers, it did not have a loss (excluding goodwill impairment charge in 2008) for even one year during the financial crisis. While its peers were salvaging their balance sheets, Capital One was in a position to make two transformative acquisitions at great prices. ING Direct (closed Feb 2012) stabilized its funding sources and gave it greater access to low cost deposits, and the HSBC private label credit card business (closed May 2012) provides another great platform for growth. Even after doubling the size of its balance sheets with these acquisitions, Capital One has already met its assumed Basel III Tier I Capital requirement of 8%, with the 2Q13 ratio estimated at 8.3% (including OCI). This means that Capital One will be able to return nearly all of its earnings each year to shareholders in the form of dividends and share buybacks, assuming regulators grant permission for this. Likely, regulators will allow Capital One to return only some portion of excess capital (beginning this quarter with a $1bn buyback), but we believe it will be at the high-end of what other banks are able to distribute over the next few years. At its current price, the company could theoretically reduce the share count by 10% each year and pay its $0.30 quarterly dividend (1.8% yield).

The ING Direct acquisition had a transformative effect on the company’s balance sheet, adding $40bn in loans and $85bn in deposits at the acquisition date. The loans are largely in run-off mode as Capital One does not intend to be in the residential real estate in any material way. ING Direct (now rebranded Capital One 360) was acquired for its seven million customers, deposit base, market position and technology capabilities. The HSBC card acquisition brought in $27.8bn in credit card receivables, made up of 21 retail partnerships, co-branded partnerships with GM and AFL-CIO and bank cards. Capital One is now the 3^rd largest provider of retail branded cards after GE and Citi.  

Valuation:

We look at cash earnings from continuing operations to assess the earnings power of the business. Our definition of cash earnings adds back intangibles amortization and merger-related expenses and excludes the bargain purchase gain associated with the ING acquisition in 2012. “Discontinued operations” refers to the GreenPoint Mortgage unit of North Fork Bank, which was acquired in December 2006 and shut down August 2007. Losses are due primarily to reps & warranty expense. At some point these will stop: charges, net of tax benefits, were $197m for the six month period to 6/30/13, $217m in 2012, and $106m in 2011. Cumulative losses since the operation was deemed discontinued have been $2.1bn.

Since Capital One is a bank, earnings can be highly variable due to the level of provisions. Just focusing on continuing operations, Capital One earned $18.96 per share in pre-tax pre-provision cash earnings for the TTM period ended 6/30/13. The company earned $8.69 per share in net cash earnings for the TTM period ended 6/30/13 (excluding the effect of the Best Buy portfolio of $0.37 annualized). 2012 actual results were $6.96 but this only includes ING Direct and HSBC results from the date acquired. One can run a number of scenarios for provisions and then taxes based on estimates for what “normalized” provisions look like. We think, given the current mix of loans, a normalized through-the-cycle provision should be ~2.5% of loans. The loan composition at 6/30/13 was comprised of: 41% credit card; 15% auto; 20% home loan (intentionally shrinking); 10% multi-family (a potential new platform for growth with recent Beech Street acquisition); 11% C&I and 3% other. Capital One has de-emphasized the subprime customer over recent years. In addition, ING Direct has an above-average income customer base that Capital One can cross-sell to. Over the cycle, it does not take heroic assumptions to see Capital One earning, on average ~$7.50-8.00 per share. If share repurchases are aggressive enough, this number could move quite a bit higher. This assumes Capital One is, in effect, “over-earning” right now due to below normal provisions.

Note the above mix of loans includes securitized loans put back on the balance sheet as a result of FAS 166 and 167. For historical comparisons, one needs to use the “managed” rather than the reported results, which the company included prior to the 1/10/10 new accounting rule adoption. Basically, the consolidation of the VIEs increased interest income, interest expense and provisions, and decreased non-interest income; non-interest expense stayed the same, as did net earnings.

Sale of Best Buy Portfolio:

The market did not like this one. The sell side was all in a tizzy because such an event was not in their models, so you can imagine the reaction. Back in 2011, Capital One, who at that time had recently announced the HSBC acquisition, stated that its ideal partner for this business would be one that was (1) growing; (2) possesses a loyal customer base; and (3) integrated the card program as part of how it delivers value to its customers. The type of partner Capital One didn’t want was one which (1) did not have a successful retail proposition on its own; (2) looked at the card partnership as a profit center; (3) thought of cards as a way of generating incremental buying dollars right now without regard for credit risk. What kind of partner do you think Best Buy would have been? We believe Best Buy would have been closer to the non-ideal partner than the ideal. Rich Fairbank did too. He has mentioned that they placed very little premium on this business when purchasing the portfolio, and that he hoped they could keep the business but they did not see eye-to-eye on what the partnership would look like, so they made the decision to walk away. Judging by the market reaction, walking away from bad, potentially unprofitable business is not a good idea, but we think the best quality in a banker is the ability to say no. Even though the Best Buy portfolio was 25% of the receivables purchased, when Capital One couldn’t get an attractive return for the assets tied up and the risk taken on in the business, it walked away. For a bank that plays a little further out on the risk curve than the average bank, this discipline and willingness to walk away demonstrates a way of thinking about risk-reward and return on investment that is missing from much of the pack.

Warrants:

Whoever at the Treasury came up with the idea of TARP warrants deserves your gratitude. And whoever insists on pricing these things based on Black-Scholes also deserves your gratitude. If you like Capital One, you will love the warrants, which expire December 2018. The strike is set at $42.13 and may be adjusted based on dividends – although it doesn’t appear they will get over the $0.50 quarterly threshold, at least not soon – and share repurchases (open up the Prospectus and play with Excel for the adjustments). These don’t trade a lot of volume but the last trade was at $28.08. Compare this to the price of COF at $67.62, which means that an investor has to pay an upfront interest premium of $2.59 (just over 6% of the $42.13 strike) for the right to exercise this warrant 63 months from now. This is very cheap – especially in light of the fact that management wants to buy back a lot of stock.

Risks:

1) Capital One is a bank and is thus highly regulated. In the current environment there is some regulatory hostility to banks, especially toward the bigger banks, although Capital One is not a TBTF institution. Fee income was negatively affected as a result of CARD Act provisions, and the new capital standards for banks with over $250bn in assets take into account OCI in assessing capital adequacy – this may affect how big banks manage their securities portfolios. With all regulated institutions, investors run the risk of value-harming regulations being introduced, but there appears to be clarity (for the most part) on the bank regulations moving forward, and, in Capital One’s case, the CARD Act had more of an impact on operations than will anything under Dodd-Frank.

2) The banking cycle has a magnetic rhythm to it – bankers just can’t keep themselves from doing the stupid things others do. Capital One is better than most, as demonstrated in the most recent cycle when its worst year was in 2009 when it earned $0.74 in GAAP EPS and $1.53 in continuing cash earnings, but it, like other well-run banks cannot resist participating in folly along with its peers. Banking is a forgivable business:  you will make good money as long as you don’t do anything too stupid.

3) Provisions are running a little below normal right now, as delinquencies and charge-offs are also below normal. The offset of this is that the bank is under-earning in net interest income – let’s call it a wash.

4) Mortgage portfolio inherited from ING and earlier banks are in run-off. Investors – according to recent Barclays’ conference poll – are concerned about when balance sheet growth will resume, which would continue to temper excitement for the stock. The actual risk here is that expenses don’t match a shrinking balance sheet and a loss of efficiency shows up in the financial results.

Conclusion:

Capital One is well-positioned for growth and return of capital. It has national scale lending through its credit card and auto lending platforms, local scale banking with leading deposit market share and now direct national banking reach. It is competitive in the markets it operates in and earns good returns. The market is offering investors the opportunity to purchase a high quality company at ~8x normalized cash earnings. In Capital One, we are buying a pretty good business at a low multiple of earnings when the company is planning to undertake major share repurchases. Over time we expect a re-pricing of the multiple to 10-12x earnings (which will become clearer as intangibles are amortized down) with fewer shares outstanding. 

Catalyst