As the Federal Reserve grew fearful of plunging the U.S. economy into a recession as it aggressively raised interest rates to bring down inflation, many companies exposed to the economic cycle underperformed with Capital One (NYSE: COF) a particularly poor performance, down 44% from last year. With company earnings set to decline from unsustainable levels, stocks are pricing in a much worse scenario than I think, which makes them extremely attractive.
Capital One is one of the nation’s leading credit card lenders, and because credit card debt is unsecured, losses can be greater than on car or home loans, which is also why interest rates on credit cards are so much higher. This raised fears that its financial performance could deteriorate significantly if the economy slowed further. These alarm bells rang even louder after the company second quarter results when it provisioned a gross amount of $1.1 billion for credit losses. Taking into account write-offs of $850 million, this was a net increase of more than $200 million in the provision for credit losses. This also represents an increase in provisions of $408 million. As you can see below, construction has been focused on consumer and commercial banking units.
Amid worries about credit losses, it was seemingly lost that despite this build, Capital One was earning $4.96 per share, or about $2 billion. Increased losses reduce profitability, but do not lead to company-wide financial losses. Now, a bear could argue that just as we saw a sequential increase in credit allocations in the second quarter, we could see further increases over the next few quarters until profitability is eroded more dramatically. This argument may seem even more compelling given that in August, the delinquency rate on Capital One’s credit card portfolio was 2.76%, up from 1.79% a year ago. I think more context is needed.
There is no doubt that credit losses and delinquencies are increasing, in part because delinquencies in 2021 were extremely low. In 2020 and 2021, we have adopted several economic recovery programs such as the CARES Act and US rescue plan, which sent many Americans several thousand dollars in checks. With so much money coming from the government, consumers were able to easily pay their bills – as we’ll see later, many even paid off their debts. These checks do not recur, it is natural that the unpaid increase.
That’s why I like to watch the results of end of 2019, before COVID-related distortions. At the time, we thought the economy was doing well with an unemployment rate of 3.5%. At that time, delinquencies on credit cards were 3.93%. So while chargebacks have increased over the past year to 2.76%, they are still well below 2019 levels. I think credit card chargebacks are best described as normalizing. from unsustainable levels rather than actually deteriorating.
Importantly, Capital One always assumed that delinquencies would rise again. From a credit loss adequacy perspective, I think it’s helpful to see how its provisions have sweat over time, which I think will bring some comfort to investors. Currently, defaults are performing better than in Q4 2019, but looking at PCL as a percentage of total loans, Capital One reserves more today than in 2019. 0.45% on credit cards, 0.07% on consumer loans. banking and 0.18% in commercial banking. This means that credit quality may continue to erode before Capital One needs to significantly increase its credit loss reserves. As such, I would expect reserves in Q3 and Q4 to be similar or slightly higher than Q2, but not to spiral ever higher. The COF has been conservative and cautious in its allocation policy, never assuming that the ideal conditions of 2021 would persist forever.
It is also important to note that while the focus is on the fact that credit losses are negative, there are also positives that will contribute to earning power. Despite high inflation, Capital One is showing considerable cost control with non-interest expenses up just 1%, driven entirely by a 9% increase in marketing spend. All other expenses actually decreased by 1%. The company is also growing its loan portfolio, which should increase interest income. Credit card loan growth was 20% year over year to $121 billion. This outpaced the 9% growth in consumer bank loan growth, with auto loans down 20%.
Today, some may argue that such rapid growth in credit card lending is actually a harbinger that consumers are desperately strained by high inflation, forcing them to borrow and heralding a coming wave of payment defaults. Yes, credit card debt is increasing, but when you look credit card debt to incomethe picture is much less concerning.
Just when COVID hit and unemployment plunged, credit card debt to income rose, but then when stimulus checks were sent out and people were rehired, it started to plunge, falling 15% from December 2019 levels. Although it has increased, we are still 8% below the pre-COVID norm. That means consumers could borrow about $70 billion more on their credit cards just to get back to where we were in Q4 2019, a time when we were happy with the economy and consumer credit. As with chargebacks, credit card balances are returning to pre-COVID levels rather than deteriorating alarmingly.
While consumer credit losses have raised such concerns, it is notable that we are seeing improvement from commercial banking, where loans rose 9% to $94 billion. “Contested Loans” were down 0.5% quarter-over-quarter and 2.60% year-over-year to 5.99%. These are loans that regulators have expressed concern over, usually due to excessive leverage ratios. The fact that these are falling actually indicates that fewer loans are at risk of loss.
Due to a larger loan portfolio and higher interest rates, Capital One’s net interest margin increased to $6.4 billion from $5.7 billion a year ago . The COF has cash reserves of $93 billion, including more than $21 billion in cash and cash equivalents. Since the end of the second quarter, the Federal Reserve has raised interest rates twice by 0.75%, and its “dot plotpoints to 1.25% additional increases in the fourth quarter. These increases will directly increase the income that COF is able to generate on its liquid assets. At the same time, COF held its deposits at $254 billion quarter-over-quarter, although it only increased its average. interest rate of 9bp at 0.38%.
As the rate hikes continue, the COF will increase what it pays on deposits to keep them, but it only has to increase them by a fraction. Relative to the current rate in the second quarter, higher starting interest rates could generate an additional $1.25 billion to $1.75 billion of pretax earnings power in 2023, according to the Fed’s projection of 4.6%.
First-half earnings were $10.61, down sharply from $14.65 when it overstated its true earnings power as fiscal stimulus artificially suppressed credit losses. The question is where the income goes in the future. At Q2 pace, COF has around $19.75 of earnings power. The increased net interest margin is worth about $2.85 of additional earning power. Even if COF were to reserve 1% net of its loan portfolio, a 25% increase in allocations would reduce EPS by $5.61. On the net, that still provides Capital One with around $16.50-$17 in earnings in 2023, giving the stock a sub-6x multiple.
Additionally, Capital One has been aggressively repurchasing stock, repurchasing $2 billion of stock in the second quarter and $4.4 billion year-to-date. Over the past twelve months, the company has reduced the number of its shares by 13% to 392.6 million. Last August, the company also increased its dividend by 50% to $0.60. Due to its large share buybacks and loan growth, the company’s Tier 1 capital ratio fell from 14.4% to 12.1%. Over the long term, management is targeting a capital ratio of 11%.
As a result, I expect COF to continue to repurchase shares, albeit at a slower pace, especially since it might choose to keep its capital ratio a little above target given economic uncertainty. I also expect buybacks to focus on dividend growth and consider a hike before mid-2023 unlikely. Still, even if COF chose to return only half of its profits to shareholders, it would be possible to buy back about $2.3 billion worth of stock or an additional 6% of outstanding stock, and that’s probably at the bottom. of the scale of what management will do. .
The shares are now trading at just 1.1 times the tangible book value of $87.84. The book value including goodwill is $125. With the company comfortably over $15 in earning power and a better consumer credit outlook than many fear, stocks are a bargain below $100. As the sustainability of its earnings power is best appreciated over the coming quarters, I think the stock would merit a 10x earnings multiple, recognizing that the cyclicality of credit card lending will structurally keep Capital One’s weaker than less cyclical companies. This still indicates a stock price of $150, an increase of 50%. Even at 8x earnings, it would only trade at book value in the $120s, up more than 25% from here. COF is one of the most exciting opportunities I see in the market today.