Saturday, January 26, 2013

Capital One Financial's Results Weren't That Bad

We have all heard all we can possibly take on the subject of banks, loan quality, off balance sheet accounting and such matters over the last few years. I won’t attempt to add anything new to the discussion other than to make one key observation concerning Capital One Financial’s (NYSE: COF) recent results. Before I get to that I will summarize that I thought the recent results were okay and the stock still represents a good way to play a belief in a long awaited cyclical upturn in the credit cycle in the US.

Why the Market Hated the Results and I Didn’t

A quick look at the price chart will reveal that not everyone shares my rosy view! Indeed, the reason why the market hated them was a combination of three things.
  1. Some unexpected seasonality creeping into the results
  2. Normalization of revenue suppression (I will explain in plain English)
  3. The outlook for a decline in average loan volumes in 2013 as runoff is forecast to offset underlying loan growth
First, the unexpected seasonality appears to be more of an optical problem. COF’s business is always seasonal--more so than its rivals American Express (NYSE: AXP) and Discover Financial Services (NYSE: DFS)--however, it has been masked over the last few years by unusual cyclicality in the economy. This seemed to catch analysts cold, and COF’s management even mentioned the need to educate the analyst community over this issue.

Second, revenues decreased from the third quarter mainly due to a return to normal levels of revenue suppression, principally in the domestic card segment with loans acquired from HSBC (NYSE: HBC). Finance companies earn income fees and charges from credit card loans in line with contractual arrangements. Since not all of these monies will be paid (and more so when the economy is bad) the company has to reduce the level of expected income, and this reduction is called the suppression amount.

Now let’s say that a company acquires a lot of loans with a high suppression amount and then the economy gets better and concomitantly credit quality does too. This will result in a benefit when that suppression amount is reduced. Indeed COF saw a $70 million benefit in Q3, however, in Q4 that benefit reduced to $10 million. This helped reduce earnings from Q3 to Q4, but it is just a return to normalization. No need to panic. Indeed COF stated that there was no change in its long term estimates of recoverability.

The third issue is more problematic because this issue will face the credit industry in 2013. Essentially we are in a lower lending environment than pre-recession and runoff will challenge the ability of banks to replace those previous loans with new ones. It was a similar story to what many deduced with Wells Fargo's (NYSE: WFC) recent set of results. In WFC’s case it was about investors unfavorably comparing declining refinancing activity with the growth in the mortgage book.  You can read more on that here.

My point is the same for WFC and COF. Ultimately lending will follow the general economy. When the economy is on the up, everyone will want to lend. With regards to WFC the growth in deposits (which hurt the net interest margin) is actually a good thing because it could mean more lending in the future.

One Key Observation

Remember the great financial crisis? Remember how everyone hated the banks for their failure to manage risk? Well they were incompetent but investors need to remember one thing. When the economy is doing well asset quality tends to improve and banks want to lend. Movements in banks' balance sheets are as much about the pricing direction of the underlying assets as they are about credit risk. Investors wanted the banks to lend then because assets (housing etc) were doing well.

Now consider the current situation. If credit quality is improving, unemployment reducing, housing recovering and the economy is gradually improving than its time for the banks to start lending again and it is these notions that will ultimately decide the direction of the banking sector in 2013. Just as prior to 2008 we want the banks to lend but we don’t want off balance sheets leverage.

Where Next for Capital One?

On the negative side the outlook wasn’t great and no one likes to see earnings miss estimates, but on the positive side the reasons for the miss are as much about analyst expectations as they are about the underlying business.

On the positive side, if you share my bullish view on US credit expansion in 2013 and you look at the evaluations of the sector you can see that COF looks cheap on a historical basis. I know this is a busy chart but note how COF is lowly rated because it has a low RoE and vice versa for the other stocks.

data by YCharts

On a relative evaluation basis it rather suggests that DFS is the value in the sector, and AXP looks a little rich in relation to by stint of generating similar return on assets to DFS but having a higher price/book ratio.

Going forward, COF looks set to increase its dividend and provided you want exposure to the credit cycle this dip could be creating a decent entry point.

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