Capital One Financial Corp (COF, Financial) is a diversified financial services holding company, providing banking and non-banking financial products and services to consumers, small businesses and commercial clients through more than 1000 branches, the internet and other distribution channels. COF now serves more than 45 million customer accounts across New York, Louisiana, Texas, Maryland, Virginia, New Jersey and the District of Columbia. COF is also developing a growing presence in Europe and Canada and operates the largest online direct banking platform in the United States. COF’s flagship products and services include bank lending, treasury management and depository services, credit and debit card products, auto loans and mortgage loans.
The business is divided into three business segments: Credit Card, Consumer Banking and Commercial Banking. There is also an “other segment,” which includes the management of its corporate investment portfolio and the asset/liability management services of its centralized Corporate Treasury group.
The first and largest segment is the credit card segment. This accounts for 61% of total company revenues and reflects its domestic consumer and small business card lending activities and the international card lending activities in Canada and the United Kingdom. Consumer banking provides branch-based lending and deposit gathering activities for consumers and small businesses, national deposit gathering, national auto lending and consumer home loan lending and servicing activities and accounts for 29% of company revenues. Commercial banking contributes to the remaining 10% of company revenues and reflects its lending, deposit gathering and treasury management services to commercial real estate and commercial and industrial customers. These are customers that typically include companies with annual revenues between $10 million to $1 billion.
As of December 2014, COF had $308 billion in assets, loans of $204 billion, deposits of $206 billion, and shareholder equity of $45 billion. Based on deposits, COF is now one of the 10 largest banks in the United States. They have 46,000 employees, or “associates,” as they prefer to call them. The company continues to expand its market with the 2013 acquisitions of Beech Street Capital, a privately-held, national originator and servicer of Federal National Mortgage Association “Fannie Mae,” the Federal Home Loan Mortgage Corporation “Freddie Mac” and Federal Housing Authority “FHA” multifamily commercial real estate loans.
Financial highlights
Like all big banks, COF hit a wall during the recession/financial crisis of 2008-2009 with a substantial hit to earnings and increased concern about its loan portfolio quality. COF weathered the storm much better than most other banks, however, and rebounded quicker and more forcefully than most of its larger counterparts. Loan loss provisions and charge-offs remain acceptable and the all-important “Tier 1” ratio, a measure of equity to assets, remains at a strong 12.5%. COF reported net income of $1.2 billion ($2.00 per diluted common share) on total net revenue of $5.6 billion for the first quarter of 2015. In comparison, COF reported net income of $1.2 billion ($1.96 per diluted common share) on total net revenue of $5.4 billion for the first quarter of 2014. The market expects EPS of $7.70 in 2015 and $8.08 in 2016. The average return on equity for COF during the last 10 years was approximately 9%, with returns on assets averaging 1.3%. The company has maintained moderate charge-off rates of 2.8% over the last 10 years and holds an efficiency ratio (operating costs/net revenues) of 31%. COF continues to successfully grow its deposit base and holds a cash position (cash/assets) of 2.4% and a total liquidity ratio (cash+marketable securities) of 22%. COF's Board also recently authorized the repurchase of up to $2.5 billion of shares of common stock to begin in the second quarter of 2015 through the end of the second quarter of 2016. The Board also authorized an increase in the quarterly dividend from the current level of $0.30 per share to $0.40 per share.
Valuation
Below we use a market-based price multiple approach to value COF. This approach requires assessing the distributional properties of various relative value measures based on the current market price of the company's stock. These measures include equity multiples such as the firm's P/EPS, P/SPS, P/FCFPS and P/BVPS using 15 years of data. Means, medians, and ranges for each multiple were reviewed with the aim of identify at what values observed multiples tend to revert to normal levels. This is known as weighted mean reversion in the multiples. These multiples are then applied against corresponding estimates of the firm's average EPS, SPS, FCFPS and BVPS for the next 10 years. Because each multiple produces a different estimate of the company's value, to derive a fair value estimate based on a weighted average of the 4 valuations, an optimization procedure has to be run that assigns optimal weights to each multiple based on its historical effectiveness in predicting stock value. Figures 1 and 2 below present historical multiplier values with target points of reversion.
Figure 1: Historical multipliers and target points of reversion
Figure 2: Target multipliers, per share projections, and optimization weights
Based on our experiences with the industry we then decided to overweight earnings as it has been a particularly effective predictor of company value. Applying the weights shown above we derived a weighted-average fair value estimate for COF of $103.00.
Conclusion
We continue to be impressed by the conservative nature of COF’s lending activities and relatively low charge-off rates during the financial crisis. They suffered far lighter losses than much of the competition and were strategically well placed over the next five years to undertake some major acquisition activities and divest its less profitable holdings (e.g. the Best Buy credit card portfolio). Overall, we think that COF has boosted its asset quality since 2009 and will likely see a decline in loan and lease losses. As its public image continues to improve and consumer and corporate confidence in the banking sector strengthens, we think that COF is developing into one of the most solid and valuable brands in the industry. That being said, based on our valuation model above, the firm is only offering a margin-of-safety of 15%. For a financial service firm in a mid-cycle environment we typically want to see a margin-of-safety of 35%. We would recommend looking for a reasonable pull-back in the company’s stock before making an investment.
