Capital One's ING Direct Acquisition Terms Are a Pleasant Surprise

| About: Capital One (COF)

After Thursday’s close, Capital One (NYSE:COF) announced the acquisition of ING Direct and the terms are favorable for Capital One shareholders. Capital One will be paying tangible book value after the mark-to-market of ING Direct’s balance sheet. The deal will be accretive to tangible book value and earnings immediately. Capital One claims the IRR is greater than 20%. In addition to the financial benefits, the operational and strategic benefits for Capital One are:

  1. substantially reduces risk on liability side of Capital One’s balance sheet,
  2. reduces future acquisition risk,
  3. puts capital to work in a low risk manner,
  4. fixes a mistake Capital One made 8 years ago by allowing ING Direct to become the leader in direct banking, and 5) makes sense because Capital One is the logical acquirer for the national direct banking footprint of ING Direct.

With ING Direct’s deposit base, this deal reduces Capital One’s funding risk. The $80 billion of ING Direct’s deposits will improve Capital One’s liquidity. Over time, Capital One should be able to let low spread mortgage assets from ING Direct mature and roll off the balance sheet. At the same time, Capital One will be able to pay off the rest of its risky wholesale funding. This consolidation and optimization will increase the overall company’s returns and make the Capital One franchise more valuable.

The ING Direct acquisition reduces the risk that Capital One does a large dilutive deal in the near-term. The memories of Capital One shareholders are haunted by visions of the Hibernia and North Fork acquisitions at large multiples of tangible book value. Some investors fear Capital One’s management team desire to be end-game players. At least in the short-term, this deal should help mitigate these fears. Plus, with the fix to Capital One’s liability structure, it takes pressure off management to acquire additional local banking franchises to gain access to deposit funding.

This acquisition is an attractive way for Capital One to put capital to work. Capital One is raising about $5 billion in common equity at 1.67x tangible book and investing it at 1x tangible book, which provides into $4 per share of tangible book value accretion. ING Direct was in growth mode, so its expense base may not have been completely leveraged, which provides opportunity to Capital One. Capital One can also test deposit pricing to see how sensitive ING Direct customers are to lower deposit rates. Overall, Capital One claims an IRR on the deal of greater than 20%.

Capital One fixes a mistake it made long ago by allowing ING Direct to become the leader in online direct banking. In 2002, if there was a financial services company well position to be the leader in online direct banking, it was Capital One. Capital One had been among the leaders in moving the credit card business into a national scale direct business. Plus, Capital One was scarred from the securitization markets closing in 1998 and 2001. Capital One’s leadership knew they needed deposit funding, and they made steps to move into online direct banking. However, they allowed ING Direct to capture a huge lead and were never able to catch-up. Maybe there were organizational distractions from the MOU in 2002 that prevented Capital One from being more aggressive. This acquisition fixes the mistake.

Capital One is the logical acquirer of ING Direct considering it is one of the few banks with scale in national consumer lending businesses like credit cards and auto loans. Of the possible acquirers of ING Direct, Capital One is probably the only company that would be willing to continue to invest in the online direct banking platform. Capital One’s management team uses a multi-period net present value framework for making investment decisions. Another way of saying this is: management looks at the lifetime return on investment rather than a short-term payback model. This leads to more rational long-term investments but can lead to lower margins in the short-term. Most other acquirers of ING Direct would immediately try to raise margins by milking the deposit base and allow price sensitive deposits to roll off. I bet Capital One will accept the lower margins and continue to grow the ING Direct platform.

Some investors and market commentators will point to the open question about the franchise value of ING Direct. Was ING Direct simply the best bid on the market for online deposits? The fact that Capital One was able to buy the ING Direct franchise for tangible book value implies there is no franchise value. However, I argue that there is franchise value to ING Direct that has not been realized yet. There could be franchise value if Capital One is able to cross-sell additional products into the ING Direct customer base or if the customer base is less price sensitive than many believe.

I’m surprised GE was not more aggressive in bidding for ING Direct. Given that GE’s percentage of wholesale funding is higher than Capital One’s, one could argue that GE had more to gain by acquiring ING Direct’s deposit base. Press reports point to GE’s unwillingness to acquire ING Direct’s mortgage assets. This may make sense.

Overall, Capital One shareholders will benefit from the ING Direct acquisition. The transaction has low financial risk, improves Capital One’s liability structure, and puts capital to work in an attractive way.

Disclosure: I am long COF.W.

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