2 Steps Capital One Financial Corp. (COF) Needs to Take

Since I worked for a bank, I’m always looking for ways financial institutions can improve their results. This is why even though Capital One Financial Corp. (NYSE:COF) just reported a 60% increase in EPS, I think the company can do better. Shares trade for a forward P/E ratio of about 8, and I think investors can benefit from two decisions the company could make in the next year. One of these improvements has been all but promised by Capital One, the other is so obvious it should be smacking management in the face.

Capital One Financial Corp. (NYSE:COF)A Different Kind of Bank
Though Capital One is a big bank, they are somewhat a unique breed because of the company’s huge credit card division. In the last few years, the bank’s acquisition of ING’s deposits and HSBC’s U.S. division have changed the company for the better. While the credit card business has been challenging for the last several years, as the economy and employment picture improves, Capital One should benefit.

If you look at Capital One’s major competition, you have to include companies like JPMorgan Chase & Co. (NYSE:JPM), Bank of America Corp (NYSE:BAC), and Wells Fargo & Company (NYSE:WFC). Each of these institutions is battling for deposit dollars. JPMorgan and Bank of America in particular, are very involved in the credit card business as well. On the one hand, you have JPMorgan and Wells Fargo as seemingly strong banks with good dividends. On the other hand, you have Capital One and Bank of America, which both have had troubles, and pay relatively minuscule dividends.

Competition Crushing Growth
Through acquisitions and organic growth, Capital One saw an increase of over 66% in average total deposits. By comparison, Bank of America’s deposit growth was the next strongest at 11%. Though JPMorgan and Wells Fargo saw good deposit growth of 10% and 7.39%, neither comes close to Capital One’s results.

When it comes to lending, the story is much the same. Capital One saw 51% growth in average loans. By comparison, Wells Fargo grew average loans by just 2.42%. With Bank of America seeing a 16% decrease in consumer real estate loans, and JPMorgan reporting average loans down 5%, Capital One’s performance obliterated their competition.

What Can They Do Better?
The first change Capital One should make has been telegraphed by CEO Richard Fairbank as he said, “we expect to return to a meaningful dividend in 2013.” Given that the company generated $825 million in net income in the current quarter, we can only guess what that dividend might be. Even if the company only used 25% of net income on a dividend, with 585 million shares outstanding, this $206 million would equate to a $0.35 quarterly payout. A $1.40 annual rate would give investors a current yield of about 2.67%. This is in line with JPMorgan’s 2.5% yield, and Wells Fargo’s 2.86% yield. Whether this will be the actual number is anyone’s guess, but we have to assume “meaningful” means something much better than the current yield of 0.40%.

The second change the company should make is to leverage their deposit gathering capabilities to reduce or eliminate the need to borrow funds. In the current quarter, Capital One reported a net interest margin of 6.52%. Relative to JPMorgan at 2.4%, Bank of America at 2.35%, and Wells Fargo at 3.56%, Capital One’s margin is a big advantage.

Capital One reported their interest bearing deposits interest rate was 0.72%. At the same time, the company paid 1.87% on their “other borrowings” and 2.95% on their long-term debt. This makes no sense. If the company offered a higher rate on their interest bearing deposits, they could likely attract more than enough deposits to avoid debt financing. Even if their average interest rate rose to 1%, this would give depositors a 38.89% increase in their average rate, and cut the company’s borrowing costs significantly. Since the company’s average borrowings were over $44 billion, this is not an insignificant opportunity.

Unseen Value
It’s easy enough for investors to cast aside Capital One with their tiny yield today, but this story could change quickly. Of the banks we’ve looked at, Wells Fargo seems to offer the best combination of growth and income. Wells offers a yield of 2.8%, combined with expected EPS growth of 9.33% in the next few years. With shares selling for less than 10 times projected earnings, this seems like a good deal. By comparison, JPMorgan seems much less attractive with a lower yield (2.5%) and lower expected growth (6.45%).

Investors looking for a turnaround story might buy Bank of America. The company’s 18.76% expected growth in earnings would seem much better than Capital One’s expected growth rate of 8.23%. Both companies have similar yields, and Bank of America is more well known. The problem with this theory is Bank of America’s net interest margin of 2.35% is almost 64% less than Capital One. Bank of America will have to perform significantly better just to report the same earnings because of this handicap.

We already know that Capital One’s dividend should increase significantly this year. The bank’s superior net interest margin means they can offer higher rates to depositors and steal significant dollars from the competition if they make that choice. The company’s famous tag line is, “what’s in your wallet?” The answer might be, “profits from Capital One’s stock” if management makes these two decisions.

The article 2 Steps This Company Needs to Take originally appeared on Fool.com and is written by Chad Henage.

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