A few days ago, I lamented the fact that some commentators were throwing the baby out with the bathwater when it came to bank earnings. There are some institutions that I am certainly not enamored with. However, I believe a trifecta of circumstances creates the "perfect storm" in reverse for a few select financials. For these companies, I believe the following three points are key:
- Rising interest rates and a steepening yield curve will benefit asset-sensitive banks.
- Valuations are low and current earnings may be understated due to amortization of core deposits.
- A strengthening macro picture, combined with a healthy consumer, will lead to loan growth.
Investors might be smart to take a look at institutions of this sort while their stock (both literally and metaphorically) is being held down by broader sector-level concerns.
Wells Fargo (WFC) is one of my favorites (read my recent article here). Capital One (COF) is quickly becoming another. While you can read my full thoughts here, I'll summarize the salient points briefly:
- Much or the market seems to continue to perceive Capital One as a company focused on high-balance revolvers. In reality, it has shifted its card focus to low-balance revolvers and high-dollar transactors; it has also established strong positions in other critical areas like direct/digital banking.
- Capital One has a very strong capital position under Basel III advanced and is in good position to significantly ramp up shareholder returns.
- GAAP accounting is understating the bank's true earnings power; the stock trades at less than 10x TTM non-GAAP earnings. (See below for a reconciliation of GAAP to non-GAAP. Link to full deck here.)
Capital One's fourth quarter results contained few surprises, demonstrating continued progress on several fronts. Earnings slightly missed expectations in a seasonally weak fourth quarter due to higher marketing expense and increased provisions; the management guided for higher marketing expense to continue through 2014 as they take advantage of opportunities in specific segments of the market. Planned runoff and the full-quarter impact of the divestiture of the Best Buy portfolio obscured growth in commercial and auto, as well as strong purchase volume (up 8% y/y) in general purpose credit cards. As expected, revenue growth in 2014 will be modest as planned runoff continues to offset growth.
The Wells Fargo conference call earlier this week suggested an improving consumer and increasing potential for loan growth. Capital One CEO Richard Fairbank made similar comments during the conference call:
... we're seeing strong underlying loan growth in many segments, including transactors and revolvers other than high-balance revolvers. New account originations are growing, and we're seeing more opportunities to increase lines for existing customers, which should improve the trajectory of both loan growth and purchase volume growth over time.
Charge-offs will continue to increase over time off cyclical lows, but a continued focus on the upper end of the market will mitigate some of that impact.
The charge-off rates were reasonable and don't really concern me. The one issue to keep an eye on is marketing spend; one analyst on the call (Moshe Orenbuch with Credit Suisse) asked the management how investors should think about the effectiveness of marketing, and what metrics to watch. The response was interesting:
... I can appreciate that there is no one single metric that you can look at that has a direct link. There are a number of ones that are very important over time. The most important thing to us is the creation of value. [ ... ] we measure the net present value of every initiative to generate more business, either be it something with existing accounts or the origination of new accounts. And when we look at our net present value per -- not kind of -- total projected net present value created in a year of originations, what we're projecting, sort of, these days is as high as I've seen in total over versus -- you'd have to go back a long time to see numbers quite as high as this. Now I mean, they're not going to massively show up in metrics tomorrow. A lot of what we're originating is, frankly, more things that are -- that build value in the long term, that have lower attrition, low credit losses and build balances over time.
Definitely something to watch over time.
Perhaps the most immediate thing investors should look for, however, is the regulatory decision on capital returns. Capital One requested authorization for share repurchases that would result in a total payout ratio "well above" the industry norm of 50%.
For the sake of conservatism, we'll assume next year's earnings will come in at $6.75 on a GAAP basis. (This is well below the average analyst estimate for 2014 and well below my estimate as well.) The definition of "significantly" is up for debate, but let's just call it 60%. We already know Capital One will be paying out $1.20 per share in dividends, so that leaves $2.85 on a per-share basis for buybacks. That works out to nearly 4% of the shares outstanding, which will be immediately accretive given that shares continue to be undervalued.
Given all of the above, Capital One shares continue to look attractive to me (and, for risk-tolerant investors, the warrants are even more so). Share price returns in 2014 may be more moderate than those of 2013, but management continues to execute on a sound strategy and the economic backdrop is favorable.
Disclaimer: This is solely my opinion, not an investment recommendation or solicitation, and may not represent the views of my employer(s), associates, or other related parties. No guarantees made to accuracy or completeness. I am long the companies mentioned in the disclosure and may change my position at any time without notification. Please see the full disclaimer in my profile, and do your own due diligence before making any investment.
Additional disclosure: I am long both COF warrants and WFC warrants.