Capital One Financial: In A Strong Market, But For How Long?

| About: Capital One (COF)

By Joseph Hogue, CFA

Capital One Financial (NYSE:COF) reports earnings after market close on the 19th with consensus estimates coming in at $1.54 per share, down 13.0% from the most recent quarter but still up 1.3% over the same quarter a year earlier. Despite the unimpressive quarterly earnings, per share net income for the year has increased by 24.6% over the prior four quarters.

The company focuses primarily on consumer and commercial lending through three segments: credit cards, commercial banking, and consumer banking with the card segment amounting to almost half (48.9%) of total loans. Geographic exposure through banking includes the United States, the United Kingdom, and Canada but extends across the globe through card lending.

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Charge-off rates within domestic credit have been decreasing over the last 18 months, from more than 8 percent during third quarter 2010 to around 4 percent last year. The delinquency rate, a measure of future charge offs, has also been decreasing and may signal better times ahead.

Though retail sales over the holidays were generally weak, it does appear that the consumer is gradually coming back. Lack of real income growth held sales back to an increase of just 0.1% in December and 0.4% in November. Despite a generally weak environment, consumer credit increased to $20.4 billion last year, the highest level since 2009. Non-revolving credit surged by 10.7% on an annualized basis and revolving credit grew by 8.5% annualized over the month. While this makes for a particularly bullish case going into quarterly earnings, the outlook for the rest of the year may be slower. Consumers have had to cut back on savings to fuel consumption but cannot do this for an extended period.

Tightening underwriting standards over the last few years have cleaned up much of the bad loans and credit quality that led us into the crisis. Continued high unemployment and a week housing market will limit growth in consumer expenditures over the next year but should improve in the second half of the year.

The regulatory environment is one of the biggest risks to the financials but may moderate depending on the outcome of November's elections. Detailed in a previous article, many of the provisions in the Dodd-Frank bill may still be adjusted. While this is assumed, the market may not be pricing in the positive effects of those unknown adjustments.

Capital One has already reported to the Securities and Exchange Commission that it will be exiting its hedge fund and private-equity exposure in compliance with the Volcker Rule. Bloomberg reported last year that the bank will restructure about $150 million in funds but should not have a material effect on business.

The heat map above shows fundamentals versus peers in the financials sector. Capital One is relatively well positioned compared to financials in general but not as strong versus its main competitor in the card space, Discover Financial Services (NYSE:DFS). Discover shows higher profitability measures like return-on-equity and is less volatility with a beta of 1.38 versus COF. Discover also pays a higher dividend yield but is more expensive on a book value basis.

The shares have increased 5.9% since our last report in November where we detailed each business segment. The company has outperformed the general market and the Select SPDR Financials (NYSEARCA:XLF) over the last year but much of this is from strong performance since the beginning of the month.

A price-to-earnings between 7-9 times trailing earnings is more common for the sector and the shares may return to this range over the next year. A trailing P/E of eight would put the shares at just over $60 for an increase of 23.0% over the current price. The recent trends in consumer credit may help drive quarterly numbers but could weaken in near quarters.

Though the company has fairly strong fundamentals, it is still subject to high volatility due to regulatory and litigation risk in the year to come. The stock may be appropriate for investors with medium-high risk tolerances and time horizons of greater than a few years. Investors needing constant income and lower risk may still look to purchase the shares but should do so with a less aggressive strategy. Covered call writing and portfolio insurance may help mitigate near term risk in the general market.

Disclosure: I am long XLF.

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