Buy on Capital One Financial Corp. (NYSE: COF) following 4Q results. Average loans again declined sequentially, as consumers turned cautious on spending, saved more and paid off loan balances. The loan loss provision fell sharply as high pandemic-related charge-offs have yet to materialize. The program began on August 1, 2019. The deal replaces an existing agreement between Walmart and Synchrony Financial. In 4Q19, COF acquired Walmart’s $9 billion credit card portfolio from Synchrony for an undisclosed amount. Management noted that charge-offs in the Walmart portfolio were better than in its current portfolio, suggesting that overall credit quality will benefit from the purchase. We believe the company is well positioned for the long term in the credit card space, while acknowledging the potential for near-term earnings volatility due to an uncertain consumer credit quality environment.
Results in the current period exclude legal reserve activity and cybersecurity incident expenses totaling $0.06 per share, while including a $0.10 equity investment gains. Net revenues declined 1% to $7.3 billion. Average loans held for investment fell 1% sequentially in 4Q20, to $247.7 billion, with a declines of 2% in credit cards and 1% in commercial banking outweighing a gain of 1% in consumer banking.Net charge-offs were $856 million (1.38% of average loans) in 4Q20, down from $1.68 billion (2.60%) in 4Q19. The provision for credit losses fell sharply to $264 million. Provisions in the first half, however, totaled $9.7 billion, in anticipation of customers facing repayment difficulties due to coronavirus containment efforts. For all of 2020, revenues were down 1%, to $28.5 billion, while EPS fell to $5.79 from $12.09. In 4Q19, the company acquired Walmart’s $9 billion credit card portfolio from Synchrony Financial for an undisclosed amount. In September 2017, the company acquired the credit card assets of retailer Cabela’s, adding $5.7 billion. In December 2015, Capital One acquired about $8.5 billion of healthcare-related loans from GE Capital, including GE’s Healthcare Financial Services business, for a 6% premium to the par value of receivables as of June 30, 2015.
EARNINGS & GROWTH ANALYSIS
Average loans were down 4%, year-over-year, in 4Q20, as consumers became more cautious on spending and paid down debt. This should moderate a bit in 2021 and we look for low single digit growth in average loans for the year. Marketing expenses were pared back in mid-2020 but rose substantially in 4Q. On the 4Q earnings call, management mentioned seeing many opportunities in the card space so we anticipate marketing costs to ramp up in 2021. Credit quality is often a big swing factor for Capital One, and 2020 highlighted this. After a $5.4 billion loss provision in 1Q, the company added $4.2 billion in 2Q, building substantial reserves. The loss provision was sharply lower in 3Q and 4Q as the high credit defaults expected earlier in the pandemic did not materialize. We look for net charge-offs to rise a bit later in 2021, but not nearly as high as during the 2008-2009 financial crisis.
We view the purchase of Walmart’s $9 billion credit card portfolio from Synchrony Financial as a positive. Management has noted that charge-offs in the Walmart portfolio are better than in its existing portfolio, suggesting that overall credit quality is likely to benefit from the purchase. Given a much improved credit quality environment, we are raising our 2021 EPS estimate to $11.87 from $8.75, while initiating a $14.10 forecast for 2022.
FINANCIAL STRENGTH & DIVIDEND
The Fed did institute a requirement that dividends not exceed the average quarterly level of earnings over the past four quarters. Given that requirement, management reduced its quarterly dividend to $0.10 per share as of 3Q20. We look for dividends to total $1.10 in 2021, and $1.60 in 2022.
In January 2021, directors authorized a $7.5 billion repurchase program.
MANAGEMENT & RISKS
Capital One’s founder, Richard D. Fairbank, has been the company’s CEO since its initial public offering in 1994 and its chairman since 1995. R. Scott Blackley, the CFO, is retiring as of March 31, 2021. Capital One is a domestic bank that derives nearly 80% of its earnings from lending. As such, its results are levered to general U.S. economic conditions, primarily related to employment, consumer spending, and debt leverage. The actions of the Consumer Financial Protection Bureau (CFPB) also bear watching, as Capital One’s presence in subprime consumer lending could come under increased scrutiny.
In July 2019, the company announced a data breach involving the personal information of 100 million U.S. and 6 million Canadian card applicants and customers in its credit card business. The company estimated that it would cost $100-$150 million to deal with the incident; however, it had cybersecurity insurance coverage of up to $400 million and recorded only $22 million of related expenses in 3Q and $16 million in 4Q. Data breaches are expected to remain a risk for credit card companies, with cybersecurity as a substantial ongoing cost.
Ranked by assets and deposits, Capital One is one of the largest banks in the U.S., with top-tier national businesses in credit card and auto lending and a retail and commercial banking presence in the New York, Metro D.C., and the Louisiana/Texas markets. Capital One’s mix of loans is about 42% card loans, 28% consumer loans, and 30% commercial loans.
The shares trade at only 9-times our forecast for 2021, for which we still include elevated loan loss provisions. Peer comparisons are difficult for Capital One because the major U.S. card issuers (Citi, Bank of America, JPMorgan Chase) tend to be global financial services firms whose businesses extend well beyond consumer finance.
COF’s valuation tends to be low relative to banks, which we believe reflects the company’s historical roots as a credit card lender, with high margins but also inherently higher credit loss rates. COF’s current portfolio is 42% credit card. High net charge-offs, feared in recent quarters due to pandemic-related job losses, have yet to materialize, although we expect more pressure latter in 2021 as stimulus measures and forbearance programs run off.