COF - Capital One Financial

[cmattporter]

Please Comment

 

Matt

[rranjan]

Care to put your thoughts first? I noticed you created few more threads without putting anything to get started. I think putting your thoughts first is better way to kick start a discussion.

[Myth465]

Ya I believe you are supposed to post a thesis first and then others comment.....

[cmattporter]

COF... Ok their non diluted book value is around 60$(Not taken into consideration that they have a relatively high Goodwill). Trading around 53 isn't bad either. EPS for past four years is like... 6.8, 1.78, 1.24, and 6.8. Now I expect 08 and 09 to have bad years so i disregard the 1.7&1.2.

 

For the first Q of 2011 EPS is around 2.25 while last years Q1 was at 1.25... so they must be getting the ball rolllings.

 

They just bought Chevy Chase Bank which has the biggest presence as a bank in the DC area, me being from around that area, defiantly has the place dominated . If you think about it the counties in and around DC are loaded with money, I'm talking WASP status. Now COF has an extremely good place to start their banking industry, BUT they have never been in the banking industry so what to think...?

 

P/E ratio is at 7.5

 

They want to acquire ING Direct

 

Net profit margin for 2010- 18.2%

Net profit margin for Q1 2011- 25.3%

 

Let me finish up by saying if the Q2 EPS for 2011 results are good COF must be doing something right.

[HJ]

I recently accumulated a small position in Capital One, and would look to buy more if it gets cheaper.  I'd like to put my thoughts out there for critique.  Quantitatively, the stock trades at a small premium to tangible book, 5x trailing 12 month earnings, high single digits multiples of forward earning.  I think they can do ROE (tangible) in the high teens to better in the next several years, if US doesn't fall into a severe recession ala 2009.  Qualitatively here are the thoughts:

 

1. Through this cycle, one lesson learned about consumer finance is that under duress, a guy will give up his mortgage, but will keep his car payments and credit card payments, and in that order (perhaps with money saved from mortgage payments).  I'd argue that in hindsight, auto lending and credit card lending are structurally better businesses than mortgages because of the absence of government.  Without Fannie and Freddie, who in their right mind would ever lend money for 30 years, even if it's secured?  If a borrower is 40 year old, are you really looking for him to pay mortgages till he's 70?  Capital One focuses on those 2 forms of consumer finance among the large cap financials.  The recent consumer protection law did structurally changed the economics of their business somewhat, but I think it's still better than mortgage lending by magnitudes.  As it relates to mistakes made in the past, I'd also rather take the headline risks associated with their collection efforts than those associated with mortgage put backs or robosigning (their mortgage put back risk related to Greenpoint is a lot smaller than others).  There are questions raised about the average credit quality of their borrowers compared with Amex, Discover, and the credit card divisions of JPM and Citi, (they are better than BofA's card subsidiary, MBNA) but it speaks to volumes how credit card lending is structurally better, when you consider that Capital One's card division actually made money in '08 and '09. 

 

2. Looking at the big strategic things that management has done over the years, they've done most things right in building the company up from a small specialty lender to where they are today.  They got hurt buying Hibernia and North Folk Bank (which came with Greenpoint Mortgage, ugh!) at too high a premium, and at the wrong point of the cycle.  But the motivation to buy them was defensive in nature, stems from the management's fear of shut down of the securitization market in 98 and 02, and wanting to be funded with retail deposits.  When you are running balance sheet as big as theirs, having stable funding was the right thing to do.  They just got blind sighted by all the bad things that came with the acquisition.  It's still a knock against the management, just not as big a knock if they had made the decision purely on expansion ambitions.

 

3. The 2 pending acquisitions of ING direct and HSBC card division are offensive in nature, and are the trades that everybody in banking would like to do today, namely pick up assets from European banks in retreat.  If the US doesn't fall back into a severe recession next couple of years, they would have turned out to be good transactions.  And it distinguishes the bank from its peers in actually having places to put their internally generated capital in the next couple of years.  In structuring those 2 deals, the management was also smart in prefunding the equity pieces of the deal.  And if those 2 deals get turned down by the regulators, they've already pre-sold a decent chunk of equity at 50.  To be over-capitalized in this environment is not a bad thing.

 

4. All these large cap financials are hated today, and further, in a world driven by macro fear, these large cap financials are used as hedging instruments, which gives rises to opportunity.  Looking at the short interest history of COF, BAC, JPM, GS, why does it make sense today that on a dollar value basis, they all have about the same dollar amount of shorts?  If one's trying to hedge the interconnection with Europe, should it be the opposite?  I'm very bothered by this one, since I fear that there's something that I'm not seeing.

 

From a numbers perspective, if the 2 acquisition gets approved by the regulators, then their ROTangibleE will be sustained in the high teens at a minimum, (management claims that return on capital for those 2 acquisitions are in the 20's, and post acquisition, that'll be more than 1/3 of their business).  If they don't get approved, I'd look for the management to do  the right things, in paying out a more meaningful dividend, which they've already started to do right before the crisis, but was pulled back when it hit.

 

TARP warrants available.

 

[PlanMaestro]

I recently accumulated a small position in Capital One, and would look to buy more if it gets cheaper.  I'd like to put my thoughts out there for critique.  Quantitatively, the stock trades at a small premium to tangible book, 5x trailing 12 month earnings, high single digits multiples of forward earning.  I think they can do ROE (tangible) in the high teens to better in the next several years, if US doesn't fall into a severe recession ala 2009.  Qualitatively here are the thoughts:

 

I do not like credit cards. But if you have them as part of your portfolio, Capital One is one of the strongest .

 

Credit ratios look very strong since they do not have much of the real credit killers in this cycle: land/construction/development and housing mortgages.

 

30-89 and charge-offs/provisions are always going to be high because of their concentration in unsecured consumer lending, but that is compensated with a ridiculously high NIM (8%). So you have to compare those ratios to pre-2008 numbers because peer comparison is not going to help.

 

They also have been increasing their deposit funding. This environment, with lack of lending activity, but flooded w/ deposits is perfect for them.

 

In terms of other risks, they are prime candidates for even further regulation. But I have to give you that w/o mortgages and C&D they are most probably be one of the first to recover as they have been showing.

 

 

[PlanMaestro]

3. The 2 pending acquisitions of ING direct and HSBC card division are offensive in nature, and are the trades that everybody in banking would like to do today, namely pick up assets from European banks in retreat.  If the US doesn't fall back into a severe recession next couple of years, they would have turned out to be good transactions.  And it distinguishes the bank from its peers in actually having places to put their internally generated capital in the next couple of years.  In structuring those 2 deals, the management was also smart in prefunding the equity pieces of the deal.  And if those 2 deals get turned down by the regulators, they've already pre-sold a decent chunk of equity at 50.  To be over-capitalized in this environment is not a bad thing.

 

Have you run the number on those acquisitions? I love the strategic sense  (specially ING Direct) but I do not know if they paid too much.

[HJ]

the nature of the mortgage business is that lenders are usually lending around the 7-8 year duration. That's because of refis and people moving and old mortgages being paid off. So banks, practically speaking don't have to worry about the 40 year old guy paying until he is 70. And as you know banks can sell their mortgages in the securitization markets so they actually can choose what paper to hold.

 

Underwriting something assuming you can refi, isn't that the problem with the teaser rate ARM mortgages?  I think statistics is something like 5-6% of the loans would refi purely due to people moving and simple payoffs.  If you assume 5-6% CPR and run out a 30 year loan, you still end up with 12-15 year duration.  To get to 7-8 yr, you need to assume 20% CPR.  I doubt that will be the experience for a 30 year mortgage today taken out at sub 4% APR.  When you assume refi on that mortgage, you are assuming 1) the guy still has a job 5-10 year down the road, and 2) the real estate value hasn't gone down much, since mortgages don't amortize much in the first 5 years.  Further, you lent him money on a fixed rate prepayable basis.  30 year fixed rate prepayable mortgage is a uniquely American phenomena, which arguably wouldn't exist without Fannie and Freddie.  The private market simply can't compete on that basis, and when they thought they could post 2000, look at how it turned out.  That's the reason today, they are 90% of the market.  Some members of congress want to shut them down, but they really couldn't do it without seriously damaging the underlying mortgage / real estate market. 

 

The auto business is another one that has structurally changed to their favor, namely, the scaling down of GMAC and Chrysler Financial.  It's a booming business today when vendor financing no longer dominate the market as much as it did pre crisis.

 

They did acquire a couple of banks, and by extension got into the mortgage business, but the rationale was to get funded with retail deposits rather than whole sale funding, not necessarily turning themselves into more of a traditional mortgage bank.  That rationale is still valid for as big a balance sheet as they run.  Even American Express turned themselves into a bank in the crisis.  They have since shut down Greenpoint, and mortgages isn't the business they chose to emphasize on.  It's a needed service to keep their retail deposits. 

 

BAC and C are probably all fine investments, but they are both much more of a P/B recovery play, and carry with them different risk / return prospects.  I'm just arguing Capital One's core business going forward arguably have better risk / reward characteristics, and the market is priced for it.  All credit card related plays (AXP, DFS) are trading at modest premium to tangible book compared with the money center banks.  A side note, you can't tell me MA and V would go to the sky yet COF doesn't deserve a premium to book.

[PlanMaestro]

BAC and C are probably all fine investments, but they are both much more of a P/B recovery play, and carry with them different risk / return prospects.  I'm just arguing Capital One's core business going forward arguably have better risk / reward characteristics, and the market is priced for it.

 

Good point on auto loans.

[HJ]

3. The 2 pending acquisitions of ING direct and HSBC card division are offensive in nature, and are the trades that everybody in banking would like to do today, namely pick up assets from European banks in retreat.  If the US doesn't fall back into a severe recession next couple of years, they would have turned out to be good transactions.  And it distinguishes the bank from its peers in actually having places to put their internally generated capital in the next couple of years.  In structuring those 2 deals, the management was also smart in prefunding the equity pieces of the deal.  And if those 2 deals get turned down by the regulators, they've already pre-sold a decent chunk of equity at 50.  To be over-capitalized in this environment is not a bad thing.

 

Have you run the number on those acquisitions? I love the strategic sense  (specially ING Direct) but I do not know if they paid too much.

 

They are buying the ING direct book at 1x tangible book.  In one of the 8-K filings, the ING direct balance sheet was disclosed, nothing dramatically funky.  2 things to note 1) they are taking a 4% credit mark on the mortgage portfolio prior to closing, where 40% of the portfolio are originated post 2007.  That's the big risk in the transaction, particularly if US falls into a big recession ala 2009.  And 2) A portion of the Alt-A mortgage portfolio from ING Direct  benefits from Dutch government guarantee, and that was supposed to be either assigned to Capital One or pre-funded with cash before closing.  So you can argue ING Direct is substantially under levered / over capitalized at this point.  Management claims return on capital is above 20%.  I think that assumes over time, deposit will be used to fund their credit card business.  You can really sort of make that return on capital number look any way you want, given the NIM they run on the core credit card portfolio.  If that mortgage book doesn't blow up, I do think you can achieve the 20% number over time. 

 

For half of the transaction, ING took 10% of Capital One Stock, and the other half of the transaction has already been funded, with equity (secondary done at 50) and debt just before the European headline struck.  So if it doesn't close, Capital One would be very over-capitalized.

 

The other thing that's unclear at this point is what the ultimate economics will be of direct banking.  Remember, no real estate costs of branch opening.  Time will tell.  But the risk in my mind continues to be the mortgage portfolio, is this 4% credit mark enough? 

 

[HJ]

 

30-89 and charge-offs/provisions are always going to be high because of their concentration in unsecured consumer lending, but that is compensated with a ridiculously high NIM (8%). So you have to compare those ratios to pre-2008 numbers because peer comparison is not going to help.

 

 

I'm postulating that the 8% NIM will be structurally higher compared with the assets of a typical regional bank.  The proper comp is really AXP and DFS, but I don't have a lot of confidence in the student loan side of DFS (the term and condition in that business is quite crazy with all the deferment options, and it's sort of like a lifetime of indenture for the borrower as well, offset by the fact that that loan is not dischargeable in bankruptcy.  Those structures were also the product of a once upon a time quasi governmental organization, Sallie Mae).  As for AXP, it's a premium business, and perfectly good.  Dating back to the mid 90's, COF has grown book value at a higher rate, and has a clearer growth path at the present time, which it's not priced for.

 

Now the issue may well be, as you mentioned, that the NIM is too high, and therefore not sustainable in the long term from regulatory standpoint.  But the Card Act was just recently passed 2 years ago, and has been in implementation for the past year (USB announced a $75MM earnings impact in one of those quarters), most of the impact is already reflected in the number this past year.  The next round of re-regulation is probably outside of "forecast horizon".

 

Can I ask you why you don't invest in Credit Card companies in general? 

 

[HJ]

i don't see the qualitative aspects of COF selling where they are (premium to c and bac) as enough compensation, when you can get bak at like 1/4 of book and around 1/2 tangible book. And to compare COF to ma and v after COF has systematically and deliberately diversified away from being a pure credit card company seems a stretch. not to mention that v and ma are really transaction processors and take no credit risk. Like I said you will do well if the financials do well. But, if indeed the financials start to come around, it is really hard to see C and BAC not do way better over the long term, not in business performance, but in stock performance, simply by virtue of the price you are paying for the asset.

 

I really haven't dug into the BofA or C situation as much as I probably should.  So don't have a educated opinion as to a relative valuation.  But just from a birds eye's view, the investment banking side of their businesses seem to be extremely difficult to get a handle on.  Even before the most recent round of European turmoil, even the mighty Goldman hasn't consistently traded above tangible book since '08.  There's some serious headwinds in that business from implementing Volker, etc.  With the retreat of shadow banking system, Wall street may very well just evolve into a bunch of hedge funds / PE funds and a bunch of boutique advisory firms, and the commercial banks.  I fear there may well be a lot of value destruction that has yet to occur on that side of the business, and so have mostly avoided there.  In the late 70's, very few Harvard grads wants jobs on Wall Street.  Will we be revisiting that environment?

 

One note on Citi, is the idea of them being this great emerging market bank.  I don't know the details there, but what does a former convertible arb guy know about running an emerging market bank?  By lineage, isn't that the franchise that almost bankrupted Citi in the late 80's?  Was Citi competing with the likes of China Construction Bank in Hong Kong for those corporate loans?  Does anybody have confidence on how that lending book really look like?  Just think it's a very hard exercise to put a franchise value on all the various geographic locales piece by piece (and I sort of think you need to do that to properly put a number if you want to treat it as an emerging market bank). 

 

The comment on Visa and MA was not trying to say they are comps, but just to say that for V and MA to be traded  as the growth stock that they are, it's hard to imagine that their biggest clients (the likes of Citicards, JPM Cards, MBNA and COF ) have businesses that should be valued below tangible book.  Their clients have to do at least reasonably well for them to have consistent growth. 

[vinod1]

 

30-89 and charge-offs/provisions are always going to be high because of their concentration in unsecured consumer lending, but that is compensated with a ridiculously high NIM (8%). So you have to compare those ratios to pre-2008 numbers because peer comparison is not going to help.

 

 

I'm postulating that the 8% NIM will be structurally higher compared with the assets of a typical regional bank.  The proper comp is really AXP and DFS, but I don't have a lot of confidence in the student loan side of DFS (the term and condition in that business is quite crazy with all the deferment options, and it's sort of like a lifetime of indenture for the borrower as well, offset by the fact that that loan is not dischargeable in bankruptcy.  Those structures were also the product of a once upon a time quasi governmental organization, Sallie Mae).  As for AXP, it's a premium business, and perfectly good.  Dating back to the mid 90's, COF has grown book value at a higher rate, and has a clearer growth path at the present time, which it's not priced for.

 

Now the issue may well be, as you mentioned, that the NIM is too high, and therefore not sustainable in the long term from regulatory standpoint.  But the Card Act was just recently passed 2 years ago, and has been in implementation for the past year (USB announced a $75MM earnings impact in one of those quarters), most of the impact is already reflected in the number this past year.  The next round of re-regulation is probably outside of "forecast horizon".

 

Can I ask you why you don't invest in Credit Card companies in general?

 

The NIM is high just because of the nature of the credit card business. The charge offs are going to be in the 5% range, so you need a high NIM to be profitable. The charge offs on many of other kinds of loans in general in the banking industry is in the 0.25%-1% range. So you need to look at risk adjusted margin i.e. margin after charge offs.

 

I like the credit card business a lot, especially before the CARD act. It is just a license to print money as long as you dont do anything stupid. You can generate very good ROE in the range of 15-20% if you just stick to taking deposits and lending out via credit cards and dont do anything else. But companies cannot just stick to only just this and they keep diversifing into various other activities. That said, COF comes the closest to the business model that I would like to invest in the financial services industry. Which business would let you change the price of the product after it has been sold with impunity? The business before the CARD act is a dream but it is not so bad after it either. There is not a whole lot of tail risk in this line of business. The dispersion of losses is 3x at a max compared to your normal losses unlike the 10-20x in other lines of business of the banking industry.

 

I am watching COF very closely and have BAC and C.

 

Vinod

[vinod1]

 

BAC and C are probably all fine investments, but they are both much more of a P/B recovery play, and carry with them different risk / return prospects.  I'm just arguing Capital One's core business going forward arguably have better risk / reward characteristics, and the market is priced for it.  All credit card related plays (AXP, DFS) are trading at modest premium to tangible book compared with the money center banks.  A side note, you can't tell me MA and V would go to the sky yet COF doesn't deserve a premium to book.

 

Agreed. COF has a very different risk/reward profile compared to C/BAC. Must less risk of a wipeout. Just not sure if COF has a better risk/reward profile in the stock itself. With warrants COF is very compelling.

 

Vinod

[Blue61180]

New to Board. 

 

Any thoughts on Citi A warrants? $106.1 Strike, 1/04 2019 expiration date,  cost per warrant .33

 

2012: Current assets of "Citi Core" 1.6 trillion ROA .08: Market cap 80 billion: div pay out .01

2018 : Current  2012 assets grow 25% over 7 years  to 2 trillion. ROA improves to .012: Eps $8 with a dividend payout of 35%

 

If C can get to these numbers in 2018.  Does the 106.10 strike seem reasonable

 

 

 

[PlanMaestro]

Capital One’s Deal for ING Direct Still in Limbo

 

http://dealbook.nytimes.com/2012/02/13/capital-ones-deal-for-ing-direct-still-in-limbo/?smid=tw-nytimesdealbook&seid=auto

 

But it is unclear whether the repeated delays may also indicate dissent among the Fed’s governors. Capital One needs support from a majority of the five governors to obtain approval.

[Packer16]

This firm has a cheap TARP warrant and has just increased the dividend which will allow the strike price declines to begin.  The stock is modestly undervalued but the warrant is really cheap.

 

Packer

[dcollon]

Packer,

 

Would you be willing to share some more details on the warrants?  I have some of the specifics (expiration, strike, etc..), but I'm not aware of the dividend hurdle rate. 

 

If you don't mind what is the upside you ultimately see with the warrants over time.

 

Thanks in advance

[HJ]

Not yet.  They raised dividend to raised to 0.30 per quarter, but my recollection was that the hurdle was set at 0.375 per quarter.  The next order of business on that front for them would be to institute a buy back program.  So we are still maybe 1 - 1.5 years away from a dividend raise to go above the hurdle.

[racemize]

Not yet.  They raised dividend to raised to 0.30 per quarter, but my recollection was that the hurdle was set at 0.375 per quarter.  The next order of business on that front for them would be to institute a buy back program.  So we are still maybe 1 - 1.5 years away from a dividend raise to go above the hurdle.

 

I agree--I had it at 0.38 (perhaps I rounded).

 

Dcollon, I have a spreadsheet for most of the warrants I posted elsewhere that will let you see the required growth rates/other information.  You may find it useful:

https://docs.google.com/spreadsheet/ccc?key=0AhTPR9eP5nWedEF1SGVLdllJTnBMSDMzM3lYZ2d0SlE&usp=sharing

[Packer16]

You are correct on the dividend.  The SP will not decline for 3 years but the aggregate by expiration should be about $1.00.  This will provide a nice boost and an IRR of about 30.2% assuming a 10% BV growth, a 1.1x BV fair value and 20% payout.

 

Packer

[dcollon]

Race,

 

Thanks for the link.  I will definitely be helpful.

 

Packer,

 

Thanks for the comments on valuation/upside.

 

 

[LC]

Anyone have the Tarp prospectus link saved? I'd be glad to post the summary statistics for group reference in return...otherwise my hunt through the EDGAR jungle begins! Where is my machete...

[PlanMaestro]

Anyone have the Tarp prospectus link saved? I'd be glad to post the summary statistics for group reference in return...otherwise my hunt through the EDGAR jungle begins! Where is my machete...

 

http://www.sec.gov/Archives/edgar/data/927628/000119312509247252/d424b5.htm

 

12,657,960 warrants

Strike $42.13

Expiration November 14, 2018

Dividend Adjustment $0.375

 

[Packer16]

Attached is my latest COF and other TARP warrant relative value worksheet to show why I think the COF warrants are cheap.  I have to give credit for the base spreadsheet to another poster on this board.

 

Packer

TARP_Warrants_0211.xls