When they are fulfilled, be prepared against them; when they are strong,avoid them
--Sun Tsu, The Art of War
With spending and credit card borrowing down, financial companies may face strong headwinds in providing investors with earnings growth, as demand for credit services may not grow for a while. Recent declines in the average household debt in U.S. families may carry the potential to boost worldwide economic recovery through the increase of consumption, but only if the U.S. consumer starts spending again. By defaulting on mortgages and credit cards, U.S. families were able to shed a large amount of their debt when commercial banks forgave $118 billion in household consumer debt in 2010. Will the U.S. consumer now be willing, or even able, to increase their credit card borrowing?
Although acquiring new loans has been difficult due to a more cautious approach to banking, some forms of debt, like auto and student loans, have begun to grow in recent years – a sign that consumers may be ready to begin spending more. On the other hand, there are several factors that could impair consumer spending, such as the inability of some U.S. families to eliminate their debt due to stricter bankruptcy rules; further, the weak demand for labor leaves many consumers with no expendable income. If an improvement to the employment situation does not happen soon, I believe the cautious tone will continue and consumers will maintain their current state of austerity. Consumer confidence is cyclical, so while it is just a matter of time before improvements are seen, some consumer finance related companies may remain under pressure. The Credit Card Act of 2009 appears to be having an impact as well. Even if consumers may be willing to charge credit cards, if they are unable to because they don't have a card, it could mean growth pressures for the industry. A recent turnaround within the health of the credit card industry could help companies deal with federally imposed regulations meant to reduce or limit the amount of fees that financial institutions can charge on their customers. These regulations also serve to place restrictions on how much a company can increase its interest rates, which could have the negative result of a decline in net interest yield. Slight changes in a credit card company’s net interest yield can cause the stock price to drop significantly. While the health may have improved, the patient is far from being cured. With the federal deficit actually increasing in momentum, including a record-setting $222.5 billion deficit for the month of February, it is clear that finance companies will face increasing competition from the government for borrowing.
I expect that this will increase the cost of borrowing/cost of funds squeezing the margins and growth. The Federal Reserve is scheduled to stop purchasing Treasury debt on June 30th. Some of the largest players appear to believe this will cause interest rates to rise. Pimpco's flagship, the Pimco Total Return Fund, recently announced that they sold the last of their government-related debt. Several of the bigger players in the consumer credit space include these companies that may have a challenge in delivering increasing investor returns. Here are some companies that an investor may look at if the consumer spending space doesn't perform well in the next quarter:
MasterCard Incorporated (NYSE:MA), the $32.44 billion transaction processing and related services, makes money every time a consumer uses a MasterCard labeled credit card or debit card. If consumers are spending less and or using cash or alternative payment methods such as PayPal, it would be expected to have a direct impact on the top and bottom line. MasterCard also faces regulatory risk. Recently, Congress enacted legislation that would allow the Federal Reserve to have some controls over the debit card industry. Following that legislation, the Federal Reserve enacted rules that would considerably limit the fees for processing debit card transactions with merchants. This has set up an ongoing legal battle between banking groups and retailing groups. For MasterCard stock to gain 10% from its current value, the company has to grow over $3 billion in market capitalization. A way that an investor may capitalize if MasterCard is unable to grow 10% within the next four months is by selling the July 2011 $275 strike call options for approximately $7.20 each. MasterCard stock would have to increase to over $282 by option expiration in July for this strategy to lose money.
Visa Incorporated (NYSE:V), the larger twin and competitor of MasterCard, faces much of the same headwinds as MasterCard. Unlike MasterCard, however, Visa has a greater exposure with the current legal battle being waged between banking groups and retailers. This is because Visa derives a greater percentage of revenue from debit card fees then does MasterCard. Visa has a slightly lower PE ratio at 16.75 than does MasterCard with a PE ratio of 17.68. The lower PE ratio and greater uncertainty of the impact of the regulatory and judicial environment tends to make Visa more difficult to trade. While I believe it's riskier to short than MasterCard, a way that an investor may profit from a lack of growth is by selling the September $90 strike call options for approximately $1.05 each.
Capital One Financial Corp. (NYSE:COF), the $22.6 billion "What's in your wallet?" credit card issuer/consumer finance company, has experienced a lot of volatility as well as an increasing stock price. COF has a book value of over $58 per share while the stock closed just slightly under $50 per share at the time of writing. COF has as of late been building investor confidence. The recent pay increase for Richard Fairbank, Chief Executive Officer, shows an admirable level of confidence; not many financially stressed companies would double their CEO’s pay to $14.9 million over the course of 2010. According to the Wall Street Journal, some funds have been increasing their stake in Capital One, including Waddell & Reed Core investment fund, which has increased their stake in COF by about 50% in the last year. Institutional money currently makes up over 85% of investors. Having a high percentage of institutional investors can become a risk factor in itself. When big elephants decide it is time to leave, it may have a rather large impact on the price. The recent large earnings and revenue growth may set up investors for disappointment and price depreciation if COF is unable to continue with their recent results. COF has a relatively small short interest being reported in the last filing. An investor who believes COF will not increase by over 10% before the June options expiration date could look towards selling the June $55 strike price call options for approximately 1.15 each.
Discover Financial Services (NYSE:DFS) is an $11.9 billion consumer finance company. For consumers, this company is best known for their "Discover Card" credit card, but they are also a merchant processing company much like MasterCard and Visa; DFS also offers a debit card. As a result of the multi-faceted nature of DFS, they have faced a considerable amount of regulatory headwinds lately. DFS is under pressure from the Federal Reserve debit card fee limitations as well as the recently enacted Credit Card Act of 2009. The stock could also be affected by how regulations and movements of interest rates impact net interest yields, and slight changes in Discover’s net interest yield may cause the stock price to drop significantly. DFS currently has a PE ratio of about 17.8. DFS options have almost no real volume and this makes trading options especially difficult. If an investor believes that the stock will decline, a short position could be applied. Currently less than 2% of the float is shorted, which implies a low level of confidence that the stock will depreciate in value.
American Express Company (NYSE:AXP) is a $53.2 billion consumer/business finance company. Much like DFS, AXP is a card issuer and merchant processing company. AXP currently has a dividend yield of 1.6% and a PE ratio of about 13.2. Also like DFS, AXP faces regulatory burdens and risks from both merchant processing and card issuance. An investor who believes that AXP will not grow at least 10% before the July options expiration date may look at selling the July $50 strike call options for about $.87 each.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in V, MA, COF, DFS, AXP over the next 72 hours.