Description

Introduction

The relationship between interest rates and market valuations has been a widely discussed topic over the past year. As the Fed has cut interest rates, capital has flowed into higher yielding equities, so that equity risk premiums would correspondingly adjust.

However, valuations have not evenly increased across all sectors. Banks, in particular, have seen their multiples trade below historical averages, implying that the equity risk premium for banks has meaningfully widened.

This is in spite of the fact that banks are less risky than they have been in decades. Basel capital requirements and routine stress tests administered by the Federal Reserve have added a new margin of safety which did not exist prior to the Great Recession. We believe that in this circumstance, there is a large market dislocation causing bank stocks to trade substantially below intrinsic value.

In addition to this dislocation, today’s backdrop makes investing in bank stocks particularly attractive. A strong macro environment evidenced by solid GDP growth, tax cuts, a Trump Administration that is focused on deregulating financial services, and rising interest rates (and net interest margins).

In the short-term, investors are concerned about rising charge-offs and movements in the yield curve that might impact net interest margins, but we believe there is a large margin of safety given the historically wide equity risk premium and the fundamentals described above.    

Company Overview

Capital One’s business is relatively simple. It makes loans in three main segments: credit cards, auto loans and commercial lending (composed of commercial real estate and C&I loans).

The company’s goal has been to make loans in sectors where it has the ability to gain scale quickly and become one of the top lenders in those areas. Hence, on the consumer side, Capital One has focused on credit cards and auto loans and on the commercial side in real estate and healthcare, for example.   

Unlike some of the other banks, Capital One does not earn trading fees or investment banking revenue. The primary sources of revenue come from interest income on loans, interchange fees, and service charges.

Capital One is also different from the other lenders because the bank has exposure to subprime credit card and auto customers.

These loans are very profitable for the company and earn the company very high returns on capital. Capital One is often perceived as a lower quality bank because of its exposure to subprime credit, but data indicates that these asset classes on a macro level held up during the financial crisis (particularly auto loans).

In fact, during the Great Recession, when Capital One was even less diversified than it is today (more credit card exposure), the company still did not lose money (excluding non-cash goodwill impairments) unlike many of its competitor banks. We believe this is a testament to the company’s ability to manage risk effectively.

Market Overview

Capital One’s two main markets are credit cards and auto loans. The top 5 credit card lenders are JP Morgan, Citi, Capital One, Bank of America and Synchrony Financial and account for 70% market share (in that order). The top 8 lenders account for 95% of the market. The participants are all generally viewed as highly sophisticated lenders who take a disciplined approach to growth. Capital One is ranked #1 in <660 FICO loans. This is a market that remains relatively underpenetrated and has room to grow compared to historical levels.

In addition, credit card transaction volume is growing 3.5x the rate of GDP (or 8% per annum) indicating that the company still has a long growth runway for high margin interchange revenue.

Capital One’s auto lending book is currently $54bn of loans outstanding in a $1.2 trillion industry, indicating that the company only has 4.4% market share and substantial room to grow.

Over the past two years, Capital One has grown its credit card portfolio at a 9% CAGR and auto loan book at a 13.5% CAGR (almost 16% over the last 5 years).   

Accelerating EPS Growth

Over the past two years, as Capital One has meaningfully grown its consumer lending portfolio, it has had to significantly increase its provision for loan losses. This is because as the company wins new business, it is required to build reserves upfront, while recognizing the revenues and charge-offs over the life of the loan.

Over the past three years, Capital One has built up $3.2bn dollars in reserves cumulatively for growth. This has been a drag on Capital One’s EPS growth over the past several years but will reverse as the company’s growth moderates (which they expect will occur in the coming two years). With this information, one can see the potential for a significant increase in Capital One’s EPS over the coming years, in addition to potential EPS growth from market share gains and share repurchases.

Over these past three years, the company has seen its efficiency ratio improved by 320 basis points. With its continued investment in technology, management believes there is still room for the company to further improve its efficiency.

Margin of Safety   

Capital One is likely to earn $10 in EPS in 2018. If the company does not earn any net income for two years because another recession hits, its effective earnings multiple is 11.5x. We believe that this implies too large an equity risk premium for this business and a large margin of safety if there is a recession, a contraction in net interest margin, or a spike in charge-offs.

Valuation

Given where interest rates are and assuming we are in the later part of the cycle, we think that at least a 14x P/E multiple is appropriate for Capital One given its risk profile,history of prudent underwriting, and EPS growth potential. 14x earnings implies Capital One is worth approximately 50% more than where it trades today—around $140 versus the current share price of $94.

Catalyst

- Growth math produces a significant increase in EPS.

- A multiple re-rating occurs after investors witness the quality and durability of the company's earnings stream.

- Share buybacks.