Of course, the stock has rebounded to $73 over the last several days, but the dichotomy between the company's outlook and the stock price remains evident. Capital One is one of the cheapest non-cyclical names in the S&P 500 index right now. With such a meager valuation (around 9 times forward 12-month earnings) one might think the growth outlook for the company was murky. However, when I look at what they are doing, and at the expansion possibilities they have over the next several years and beyond, I can't help but me completely baffled by the market's recent distaste for the stock. Whenever this happens, I just sit back and hit the "buy" button.
As most of you probably know, Capital One made a name for itself in the consumer lending business via direct mail and media advertising. For the next leg of growth, COF management has decided it could leverage its brand awareness by expanding into retail banking and owning bricks and mortar branches as a new distribution network for its products. Capital One bought Hibernia Bank last year, entering the Louisiana and Texas markets. This year they announced plans to acquire New York based North Fork Bank. The deal is expected to close prior to year-end.
Since announcing the North Fork deal, COF shares have fallen 20% from their closing high of $90 per share. There are many reasons why investors could be concerned, but none of them really warrant the kind of price cut we've seen, in my view. Let's go through the list of possible negatives for Capital One.
1) Mergers often go bad
Investors often get spooked by growth-via-acquisition strategies because so many mergers have failed to deliver the promises made by management at the time the deals were announced. Capital One has grown internally in the past, so it is true that they are new to the acquisition game. That said, combining a direct marketing plan with a branch distribution makes a lot of sense given Capital One's high brand awareness. COF management has delivered for investors over the last decade since its IPO, so I would be hesitant to write them off without any evidence that they have lost their ability to boost shareholder value.
2) Flat or inverted yield curves hurt bank margins
There is no doubt that bank net interest margins are being squeezed heavily by the current inverted yield curve. While this will impact profits short-term, long term investors looking to play the Capital One growth story over the next 305 years should be unconcerned. Yield curves signal potential for a recession, and rarely persist for an extended period of time. The yield curve will eventually revert back to a normal shape, which will serve as a boost to overall company profits.
3) Hibernia was based in New Orleans
Investors got really nervous when Hurricane Katrina came through and closed many of Hibernia's branches, just as the merger was about to be approved. Capital One renegotiated the purchase price lower and the company has not seen any negative effects from having a major presence in an area of the Gulf Coast that remains desolate in many areas. If the rebuilding of New Orleans eventually becomes a major priority, Capital One should be able to reap the benefits.
4) North Fork has a sizeable mortgage business
The acquisition of North Fork has many people nervous because it gets Capital One into the mortgage business. With all of the talk of a housing bubble ready to collapse, investors are likely worried about the fallout it will have on Capital One's business. There will likely be some effect, as there will be with most banks, but as long as interest rates do not spike to above-normal levels, I would not expect an outright housing collapse. Capital One has a very diverse business, and mortgages still represent a fairly small portion of the total for the company. Much of this concern has already been priced into the stock.
Now I can't refute any of these bearish arguments outright. The only thing I can do is look at the track record of Capital One's management, look at the strategy they are undertaking, consider the expansion opportunities left even after these two bank deals are digested, and determine if the company's growth outlook for the next 3 to 5 years warrants a P/E ratio of 9 times earnings.
When the North Fork deal was first announced, COF presented a model to investors that showed an EPS target of $10 per share in 2008, the first full year after the integration, was possible. If they hit that number, we're looking at only 7 times post-merger earnings power at current prices.
Given that Capital One's expansion into retail banking will have only encompassed three states out of fifty by 2007, the growth opportunities for COF remain bright. There is no reason to doubt the company can deliver double digit earnings growth for the rest of the decade and perhaps beyond. And if they ever decide to sell COF outright, the stock trades at a price-to-book ratio of 1.4, whereas recent bank deals have been priced at 2.0 to 3.0 times book. All in all, a single digit multiple for COF, at this stage in their growth track, seems like one of the best large cap bargains around in the domestic equity market.