2016 presents some challenges for Capital One Financial (NYSE:COF). Due to a competitive card space, the current year is likely to result in higher operating and marketing costs. The majority of growth in COF's top-line revenues is likely to be consumed by rising expenses, resulting in limited net income growth.
Despite these issues, COF's shares represent a compelling opportunity given strong underlying trends amid growing macro fears. While the company is seeing some pressure on profitability in the auto business, it remains optimistic about continued loan growth and strong profitability in the card business.
Based on a number of indicators, such as consumer confidence, COF's management feels that the U.S. real economy looks strong. Indeed, there has been sustained improvement in labor markets. While the sharp decline in energy prices is certainly a headwind for some sectors, the drop in prices has also provided a direct benefit to consumers. At this point, the ultimate impact of global issues and low commodity prices is still unclear and COF is not seeing any indication of stress in the portfolio yet.
U.S. Card Loan Growth Beats Peers
There is an argument against COF that the company has material credit exposures that could pressure EPS in a recession. But the stock appears to be already discounting this risk amid little evidence of consumer deterioration. In Q4, COF's U.S. card loans grew faster than all major peers. The company's average domestic card loans grew 13% Y/Y to $88 billion. COF selectively pulled back in subprime auto lending given deteriorating risk-adjusted returns while continuing to focus on expanded prime lending.
CEO Richard Fairbank commented on the company's Q4 call that he continues to see "windows of opportunity." He believes that these opportunities exist more in the subprime space because of COF's fast growth in that segment. Mr. Fairbank was positive about card industry growth trends, noting that growth was only 1% in 2012-2013, then accelerated to 3% around mid-2014, and it has been over 4% in recent months.
In the commercial banking business, ending loan balances increased 24% Y/Y, including the acquisition of the GE Healthcare finance business and about $900 million from a short-term agency warehousing transaction that is already paid down. Excluding both the GE Healthcare loans and the agency warehouse transactions, loans grew about 6% Y/Y. While increasing competition is pressuring loan terms, COF is well positioned to benefit from growth opportunities in specialty industry verticals.
Another Strong Quarter
COF reported Q4 GAAP EPS of $1.58, below Street estimates of $1.61. However, after excluding one-time costs of $69 million and an estimated $12 million benefit from the GE Healthcare acquisition, the core EPS was $1.65, above consensus estimates of $1.61. The strong results were helped by growth in cards in what is typically a seasonally weak quarter. The window of opportunity for more card growth remains, and COF reiterated its card loss guidance for 2016 (4%) and said loss rates are likely to be in the low 4% range in 2017. Management also reaffirmed positive operating leverage for 2016.
COF's shares look attractive. Despite COF's better relative returns, the company is trading at 7x 2017 estimated EPS, a discount to the bank median multiple of ~9.5x (Source: Baird). COF's relative performance would be best in an extended low-rate environment, where the company can deliver better loan growth and capital return. Less volatility in results should help shares trade closer to high-quality bank peers.
With its leading industry growth, COF is taking share in the U.S. card business and its deposit funding structure should allow for sustainable to improving margins over time. Management has been upfront about timing issues associated with higher credit costs and associated operating expense increases. As the market better understands the growth impact and as COF's digital investments take hold, I believe the long-term earnings picture will become better understood and lift the multiple.
Capital One's card lending/spending continues to be among the strongest in the industry. The company continues to expect efficiency ratio improvement in 2016 largely due to better card revenue growth and productivity gains from digital investments, and believes that it will see further improvement in 2017. Historically, COF's expense discipline has led to better relative operating leverage even as the company expanded through acquisitions and asset purchases.
It's true that credit concerns are keeping some investors on the sidelines, but the stock appears to be already discounting this risk. With another strong quarter of growth and profitability, COF remains one of the best positioned card stocks among its peers. With the muted reserve build and rebound in interchange revenues, COF's material market share gains are a key positive relative to its card lending peers that ultimately should drive outsized top line and EPS growth.
I think the company's industry-leading growth is driving true value creation that should ultimately help the stock recover.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.