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Increasing Consumer Debt Will Provide Growth Opportunities For Capital One

About: Capital One Financial Corporation (COF)
by: Econ Alerts
Econ Alerts
Newsletter provider, research analyst, currencies, macro

Low interest rates and a slow-growing U.S. economy, make banking and finance stocks seem unattractive to some investors.

However, Capital One is unique as its main focus is credit cards and with increasing consumer debt, this will favor companies such as Capital One.

Capital One seems to be trading 10% below my valuation.

Investment thesis

Investing in banks and finance companies is increasingly becoming a tricky task, especially with the declining interest rate environment. The Federal Open Market Committee decided to cut the Fed Funds rate 3 times this year in a bid to provide a boost to the slowing U.S. economy. Low rates could turn out to be an obstacle for banks and finance companies to improve their net interest margins, which is the reason behind many investors staying on the sidelines without investing in bank stocks.

Capital One Financial (COF) is a unique financial services company with a focus on credit cards and shares have risen 14% in the last 12 months. However, the bulk of this gain came in the last 30 days since releasing its third-quarter earnings results.

Shares are trading at a discount to my intrinsic value estimate and the long history of dividend distributions makes Capital One an attractive investment for income investors.

Company profile and business strategy

Capital One is a diversified financial services company serving retail consumers, small and medium enterprises and other large-scale commercial clients. The company operates under four business segments: Credit Card, Consumer Banking, Commercial Banking and Other. Capital One provides various products and services under each of these segments.

Business segment

Products and services

Credit card

Domestic consumer cards, small business card lending, international card lending in Canada and the United Kingdom

Consumer banking

Branch-based lending, savings deposits, auto lending, consumer home loans

Commercial banking

Lending, deposit collecting, and treasury management services to business clients

Source: Company filings

The credit card segment is the leading contributor to company revenue and earnings.

The management, throughout the last few earnings conference calls, went on to highlight the need to evolve as a tech-friendly financial institution. This is to tackle the increasing demand for online financial services. The growth of concepts such as Fintech will fuel the demand for such services in the future, and the management wants to position Capital One as a leader in this space.

Inorganic growth has also been at the center of the company throughout its past. Capital One has executed a few deals to add more revenue streams to the company, to penetrate into new regions and product categories, and to improve the technological capabilities of the company.

Most recent acquisitions of Capital One

Source: Crunchbase

The company has executed 55 deals since 2010. The acquisition of HSBC’s U.S. credit card business in 2011 and ING Direct in the same year stand out as the most noteworthy transactions, and these two deals are continuing to create value for Capital One shareholders.

The management is looking for value-accretive opportunities on a continuous basis. In the future, the company might build on its acquisition spree to scale up and earn higher revenue and profits.

The interest rate environment and the macro outlook

The 3 rate cuts so far this year have painted a negative picture of the prospects of major banks and financial institutes. However, analysts believe that this pressure might turn out to be short term in nature, based on the belief that economic growth will resume its upward momentum once trade war-related fears subside.

Source: Federal Reserve Bank of St. Louis

The dot plot released by the Fed in September points to rising rates in the future, which is in line with the expectations of policymakers for the revival of economic growth in the country. If rates do rise in the future, as expected by FOMC participants, Capital One and other leading financial institutes would be in a good position to expand their net interest margins.

Source: CNBC

Consumer spending in the U.S., on the other hand, has risen to new highs in 2019. Higher than expected GDP growth in the country, over the last few years, is mainly responsible for this development.

Source: Trading Economics

If spending remains elevated, this would be a good thing for credit card issuers like Capital One.

Overall, the industry outlook for Capital One is challenging in the short term but would be supportive of growth in the long term.

Financial performance

The total revenue of the company has increased in each of the last 4 years, and the company is now much bigger than it was prior to the financial crisis in 2008. As highlighted in an earlier segment, timely, value accretive acquisitions have been at the center of this growth over the last decade.


Continuing its streak of earnings beats, Capital One reported an earnings surprise in the third quarter of 2019 as well, which boosted the share price. The company reported improving numbers for its deposits and advances as well; some of which are highlighted below.

  • Period-end loans held for investment increased $4.9 billion to $249.4 billion

  • Average loans held for investment increased $3.5 billion to $246.1 billion

  • Period-end total deposits increased $2.6 billion to $257.1 billion

  • Average total deposits increased $1.4 billion to $255.1 billion

However, as feared by many investors, net interest income and net interest margin have both entered a declining trend, which is evident from the below graph. It’s unlikely that this trend will reverse in the future, given the dovish stance of the Fed.

Source: Third-quarter earnings presentation

The loan portfolio of Capital One is of high quality, which is evident from the flat net charge-offs rate. In the third-quarter earnings conference call, the management commented that the robust loan portfolio will likely survive the headwinds in an economic downturn as well.

Source: Third-quarter earnings presentation

Capital One has sufficient liquidity as well, which is evident from the improving Common Equity Tier 1 Capital Ratio, which has consistently been higher than the 4.5% recommended by the Basel III Accord.

Source: Third-quarter earnings conference call

The loan portfolio of the company is of high quality and Capital One has sufficient liquidity as well. In this challenging macro-economic environment, the company will likely grow at low single-digit rates. There are growth opportunities for the credit card business segment, and the company is pursuing these opportunities aggressively.

Growth opportunities

Improving technological capabilities is at the center of the company’s growth strategy and the company has correctly identified the importance of addressing digital banking requirements of existing and potential clients. The demand for online banking solutions is on the rise and internet-based concepts such as Fintech and the Internet of Things (IoT) are fueling the demand for these products.

In addition, as per the comments made by the company CEO in the third-quarter earnings call, these investments have boosted the ability of the company to measure and forecast consumer credit quality trends and customer behavior, resulting in better credit performance and lower customer acquisition costs.

Capital expenditures remain elevated

The capital laid out by the company today will, however, provide returns in the long term. Therefore, in the short term, the company would have to avoid increasing the dividend payout to ensure sufficient liquidity to support these investments. Income investors should not be discouraged by this effort by the management as this would eventually secure the sustainability of the company’s earnings in the future, which would, in turn, translate to dividend growth.

Capital One has competitive advantages stemming from its massive cardholder base that is spread across the country. According to company filings, there were 45 million cardholders in the U.S. at the end of the second quarter. According to the Nilson Report, Capital One was the 5th largest credit card issuer in the U.S. by purchase volume in 2018.

Source: The Nilson Report

The wide reach and acceptance of Capital One cards will help the company retain its customer base for an extended period, which adds a degree of stability to the company’s revenue and earnings. The company will capitalize on these advantages over its peers to generate high single-digit to double-digit return on equity.


Consumer spending in the U.S., as highlighted in a previous segment, is still rising. This is a good sign for Capital One, but the possibility of a slowdown in economic growth paints a pessimistic view from this front. This would be the biggest risk for Capital One in the next 5 years.

Overall, the company will likely grow at a slow but steady pace in the next 5 years. Such growth would be sufficient to maintain or increase the dividend per share in this period, which would be a nice compensation for investors until shares reach their intrinsic value.

Dividend safety analysis

Capital One’s dividend policy dates back to 1996 and the company has consistently delivered on its promise to distribute wealth to shareholders. Since 2016, dividend per share has not grown but remained steady.

Source: GuruFocus

The company was forced to cut its dividend during the financial crisis, which is something investors need to be wary of. If the U.S. economy enters a recession and consumer spending declines drastically, there would be literally no choice for Capital One but to cut the dividend to save cash.

The positive news for investors is that the company is covering its dividend distributions with free cash flow. Even though dividend per share has not grown in the last 3 years, the company has improved its ability to earn free cash flow, which has now left room for future dividend growth.

Source: Company filings

The company is pursuing growth opportunities as well, which adds another layer of safety to the dividend at present. There are no warning signs for investors and the improving cash flow position provides the necessary safety for an income investor.


A stable dividend growth model was used to determine the intrinsic value of Capital One's shares. However, in building the model, I incorporated buybacks into consideration as well to provide a more conservative view from a valuation perspective.

According to data from Seeking Alpha, for the 12 months ended on September 30, Capital One earned $5.312 billion in adjusted net income and paid out $758 million as dividends. This implies a retained ratio of 85.7%. However, during the same period, the company spent $1.174 billion to repurchase common stock. The adjusted distributions figure results in a retained ratio of 63.6%.

It is assumed that the company needs to retain at least 13% of its earnings, which results in excess retained per share of $5.77.

Source: Author’s calculations

The other major assumptions used in this model are listed below.

  • A cost of capital of 8%

  • The perpetual growth rate of 1.5%

These assumptions lead to an intrinsic value estimate of $106.41 per share, which is 10% higher than the current market price of $98.10 on Monday.

Wall Street analysts have a median target price estimate of $106 at present, which is in line with the intrinsic value I calculated using a dividend discount model.



Capital One is a unique financial institution in that it generates the bulk of its earnings from the credit card segment. This makes consumer spending in the country one of the most important determinants of company profits. Despite the challenges from a macro-economic perspective, the company is positioning itself to deliver long-term value to its investors.

During the crisis period from 2006 to 2010, Capital One successfully earned profits in each fiscal year except for 2008, which is indicative of the prudent management of the company. This adds another layer of safety for investors. Shares are trading below my intrinsic value estimate and the dividend per share will grow in the future, as capital expenditures decline with the successful implementation of advanced technologies to support the demand for online banking requirements. Low single-digit revenue growth will also support dividend growth in the future. Capital One is a buy.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in COF over 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.