In a time of economic uncertainty and significant personal deleveraging, it may be hard to be bullish on a company that derives 60% of revenues from credit card loans and 30% from consumer loans. However, on the back of the February Comprehensive Capital Analysis and Review (CCAR), which stress tests and reviews capital plans of the 19 largest U.S. bank holding companies, and strong credit metrics, we feel Capital One (NYSE: COF) is a cut above the rest as do hedge fund managers Eddie Lampert, John Paulson, Andreas Halvorsen, and John Horseman.
In February, COF reported strong credit metrics with declines in both net charge-offs (NCOs) and delinquencies for US cards. Net charge-offs refer to debts that are determined to be uncollectible and thus written off. Delinquencies recognized if a cardholder has not made the minimum payment 30 days after the payment was due. US Card NCOs decreased to 3.84% from 4.08% in January. US card delinquencies decreased to 3.62%. We view this data favorably as a part of a longer term trend of improving consumer credit.
The big news surrounding COF is its recent completion of a $1.25 billion capital raise for the HSBC USA card business transaction. Now that the ING Direct and HSBC transactions are complete, COF will focus its attention on managing the integration costs and executing its plans to increase infrastructure. Previously, there was some uncertainty regarding the amount and source of the financing. Now the main uncertainty that remains surround ING Group (NYSE: ING) selling its 9.7% stake in COF (worth an estimated $3 billion). Once there is more visibility on that issue, the overhang on the stock should be eliminated.
Our thoughts surrounding the deals are positive. ING Direct will add approximately $200 billion in deposits to COF, making it one of the largest depositories in the US. The strong depository franchise mitigates our concerns regarding COF’s sensitivity to lower spending and weakening credit. The HSBC acquisition will add approximately $30 billion of credit card receivables, increasing the existing US card portfolio by over 50%.
The decline in interest rates since the announcement of both deals has proved favorable: the fair value of ING Direct assets has appreciated since the announcement last June now that loans are delivering yields above prevailing market rates as has the HSBC Card portfolio since the announcement last August. On the HSBC portfolio, COF expects to take a $710 million markup and a $900 million credit mark down on delinquent loans. On the ING Direct portfolio, COF expects to take a mark down of $429 million, notably lower than management’s initial guidance of $1.7 billion. In our view, the ING Direct and HSBC card acquisitions will be the largest driver of earnings and will allow management some flexibility in managing expense ratios.
From a valuation standpoint, we find COF attractive, trading at ~7.9x 2013 earnings. This is below American Express (NYSE: AXP), which trades at ~11.8x, Discover Financial Services (NYSE: DFS) which trades at ~9.1x, and the larger bank group which trades at ~10.2x. AXP, DFS and COF had minimum Tier 1 Common capital ratios above the 5% minimum—COF reported 7.8%. However, the effect of Basel II/III post-mergers is yet to be determined. COF assumed approximately $2.5 billion of non-agency RMBS from ING. Basel III capital requirements may force COF to increase its risk weighted credit card assets, which will be a major determinant as to whether COF will be in a position to return cash to shareholders. However, we are optimistic that earnings accretion from the two deals will put COF in a good position to do so. AXP and DFS announced share repurchase plans, neither of which the Fed had objections to: AXP plans share repurchases of up to $4 billion in 2012 and plans to raise its quarterly dividend up 11%. DFS announced a new share repurchase program of up to $2 billion. Though COF shares up 30% YTD, we see potential for additional capital appreciation if management executes appropriately with regards to a smooth integration of ING Direct and HSBC Card operations, increasing loan growth, and focusing on customer retention.