Capital One Financial Corp. (COF, Financial) has been the exclusive issuer for Walmart (WMT, Financial) credit cards in the U.S. since 2018. However, last week, the discount retailer filed a lawsuit to end the partnership early, with the official argument that Capital One was not living up to the customer service standards stipulated in the contract.
“Unfortunately, Capital One was consistently unable to meet the customer-service standards required by the Contract,” Walmart claimed in the lawsuit. The alleged customer service standards violations include failure to provide replacement cards to customers within five days and not promptly posting transaction and payment information to cardholders’ accounts.
However, Capital One called the customer service issues “immaterial” and said they were resolved in line with the terms of the agreement, vowing to “vigorously defend” its contractual rights. The market does not seem worried about the potential loss of the Walmart deal either, as Capital One’s shares were mostly unchanged after the news broke.
The good news is that even if Walmart wins the lawsuit, the partnership accounted for only about 3% of Capital One’s net income for 2022, so that by itself would not have much of an impact. What is more concerning is what Walmart’s move reveals about the state of the consumer credit market, and the implications it could have for card issuers in general.
Digging for better terms
Capital One was quick to point out that Walmart’s lawsuit may have motivations that are entirely unrelated to customer service, even if alleged customer service failures can serve as a convenient excuse.
“Walmart’s lawsuit is an attempt to renegotiate the economic terms of the partnership it agreed to just a few years ago, or end the deal early,” a capital One spokesperson told Barron’s. “These servicing issues were immaterial and cured by Capital One pursuant to the terms of the agreement, without harm to customers, the program, or Walmart.”
Why would Walmart want to renegotiate the economic terms of the partnership? If this is indeed Walmart’s motive, it would most likely be because the company’s management believes it can either negotiate a more favorable deal with Capital One or get a better offer from a competitor due to the weakening in consumer credit card trends.
Credit card trends are worrying
The Walmart partnership may not be a big slice of Capital One’s revenue pie, but as of its most recent earnings report for the fourth quarter of 2022, approximately half of the company’s revenue comes from net interest income on its credit cards, so weakening consumer credit card trends could be a big problem.
Due to inflation and the weakening economy, consumer credit card balances in the U.S. have been rising at record rates. High employment levels and Covid lockdown savings can only mask these systemic problems for so long before their coverage runs out.
According to reports from TransUnion, total credit card debt reached a record $930.6 billion in the U.S. in the fourth quarter of 2022 following three months of record increases in credit card debt. This may seem like a positive for Capital One at first glance, but credit card debt has ballooned even faster than the official CPI inflation numbers, mostly because the majority of non-wealthy credit card users spend most of their money on housing, food and energy – three categories that have exploded in price at much faster rates than the overall CPI.
This means that as credit card balances and net interest income have risen, so have delinquencies. TransUnion expects credit card delinquencies to rise from 2.1% at the end of 2022 to 2.6% by the end of 2023. Since Capital One provides credit to customers with less-than-perfect credit scores, it is at a unique disadvantage in a declining economy compared to most other major card issuers.
In fact, Capital One is already feeling the net negative effects of credit card balances rising at an unsustainably rapid rate. The company booked charge-offs of $1.43 billion in the fourth quarter of 2022, up 171% from the year-ago quarter, while credit card net interest income was $4.53 billion, up just 5% from a year ago.
Too many unknowns limit outlook
From a valuation perspective, Capital One’s stock may look attractive at a price-earnings ratio of 5.35 and a price-book ratio of 0.69. However, Morningstar (MORN, Financial) analysts’ estimates peg the company’s future three-to-five-year earnings per share growth rate at 1% and its future three-to-five-year total revenue growth rate at 3.14%. Even if we were in a bull market, such sluggish growth rates would not likely lend themselves to multiple expansion for a mature company that investors expect profitability from.
I think the issue could be that despite the low price tag, there are just too many unknowns for Capital One’s outlook at the moment, resulting in analysts turning bearish on the stock. A declining economy and a struggling customer base do not make for a growing business; even if Capital One can charge more for late credit card payments, you cannot get money from people if they do not have any in the first place.
It does not seem likely Capital One will collapse or even need a bailout in the very near future. The CET1 capital ratio stood at 12.5% as of the end of the fourth quarter, while the stress capital buffer was 3.1% as of Oct. 1, 2022. The cash-debt ratio of 0.65 is incredible for a company in the credit services industry. However, the tides can turn quickly and unexpectedly in the financial sector, and Capital One’s main source of revenue is stacking up risks. I wasn't too worried about this before the Walmart issue, but when a major partnership starts suing for better terms because it smells blood in the water (i.e. Capital One's struggles in the current recessionary environment), I think the near-term is too risky.
