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gameguru (32.03)

Capital One: Two-Faced or a Single Coin?

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July 20, 2007 – Comments (0)

The market doesn't know what to make of Capital One. Is it a high-growth, high-risk, low-yield lender, or a low-growth, low-risk branch bank that should be offering a high yield? The answer is simultaneously both and neither, yet it's hybrid identity has the market pricing it as the worst of all possible financial institutions - expecting low-growth, high-risk, and low-yield. While it is certainly a low-yield stock, that's because Capital One has consistently been able to get higher returns on investment than it would through returning money via a dividend. (I would argue that at current prices, buybacks are a better use of any uninvested cash flow than dividends.) Ever since it got into trouble with regulators a few years ago for underfunding its loss reserves, it has been carefully increasing those reserves and also focusing on increasing credit quality. Coupled with the bank acquistions, the company is now lower-risk than ever, and yet it continues to exhibit nice growth rates.

Capital One's strategy has been to lend nationally (hence the broad and appealing "What's in Your Wallet" ad campaigns) and have added the capability to bank locally (hence the acquistions of Hibernia and North Fork). Customer psychology has long been geared to support this strategy, yet few banks explicitly play to it (Wachovia and UBS get it at least half right in some of their advertising).

Here are two articles (from the end of last year) by Emil Lee that have highlighted COF's "bank-local, lend-national" strategy:

Capital One's Capital Strategy

Capital One's Bright Future

So is it now simply two separate businesses? I don't think so - the deposits now held provide assets which can be applied to the lending business, either as capital or as additional loss reserves. They have been promising, and are now beginning to show, cost savings and (buzzword alert!) synergies from the bank acquistions. I expect that they'll be offering their bank customers credit cards and other lending options as well, and this may provide a lower-cost pool of credit customers.

Since my comments on the 2nd quarter numbers are now buried in a reply to a reply to a pitch, I thought I'd repost them here: 

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Capital One reported nice-looking 2nd quarter results today, although it was not exactly an apples-to-apples comparison with either the year-over-year or prior quarter period. Analysts had predicted earnings of $1.62 on $4.07B in revenue. On the positive side, the $1.89 earnings handily beat consensus estimates, and this was AFTER subtracting about $.15 in one-time charges related to the recent Hibernia and North Fork acquistions ($.35 in charges from restructuring, integration, and accelerated vesting of restricted stock, less roughly $.20 from reduced taxes and other savings). These earnings were achieved on revenues of $3.97B that didn't quite meet analyst expectations, meaning that COF is making serious headway on cost-cutting (they announced 2000 job cuts earlier in the quarter) and increasing margins. They announced expectations of another $.16 or so in charges for the rest of the year, and issued earnings guidance of $7-7.40. One lackluster spot was in the acquired banking mortgage segment (big surprise!), with originations down 44% since last year (but this could be a positive sign that they are not making new and risky loans in the midst of the sub-prime worries). Indeed, credit quality looks good, with net charge-offs dropping on both a year-over-year and quarterly basis, now standing at 2.5%.

Assuming the low end of yearly earnings guidance ($7) is achieved and applying an 11.3% discount rate, my pessimistic scenario (8% growth falling to 2% over 10 years, with no growth thereafter) yields a value of $100/share. A somewhat more optimistic scenario (11% growth falling to 5% over 10 years, terminal growth of 2%) gives a value of $121/share. At current prices ($75-78), I see a substantial margin of safety.

Perhaps the most positive indicator is that management appears to agree that the company is quite undervalued, buying back $1.75B worth of shares during the 2nd quarter, and announcing plans to complete another $1.25B in buybacks over the rest of the year.

I've been penalized in CAPS for my bullishness on COF so far, but I continue to see a bright outlook for this company. As long as it doesn't develop indigestion from its recent acquisitions, the market will eventually recognize the opportunity present in investing alongside this returns-focused management team.

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