Capital One Financial is an interesting and undervalued bank

Ticker: COF

Author: Stock Analyst  Date: 2021/02/15

Capital One Financial is an American diversified financial holding, one of the top 10 largest banks in the country in terms of assets.

We rate Capital One Buy with a 12-month target price. at $ 138.9, which implies 18.6% upside potential.

  • Capital One is the fifth largest bank card issuer in the United States and also has the second largest car loan volume in the country.
  • Capital One survived the crisis of 2020 quite well, driven by a strong brand, an extensive customer base and a high degree of business digitalization.
  • The financial position of Capital One looks quite stable, with capital and liquidity ratios at high levels.
  • We expect Capital One to be one of the main beneficiaries of the recovery in consumer and business activity in the United States, given the bank's strong position in the credit card and consumer banking segment.
  • Capital One recently restored its quarterly dividend to pre-crisis levels and announced a share buyback program.

Issuer Description

Capital One Financial Corp. - American diversified financial holding, one of the top 10 largest banks in the country in terms of assets. The company offers a wide range of financial products to individuals and legal entities, specializing in credit cards and car loans. In addition to the US, Capital One does business in Canada and the UK.

The company's capitalization is $ 29.3 billion.The main large shareholders are investment funds Dodge & Cox (11.04%), Vanguard Group (7.54%), Fidelity Management & Research (4.85%), Capital World Investors (4 , 73%) and State Street Global Advisors (4.29%).

Capital One pioneered mass marketing of credit cards in the 1990s and remains one of the leaders in this segment today. Thus, the company is the fifth largest issuer of bank cards in the United States after American Express, JPMorgan Chase, Bank of America and Citigroup. Capital One issues its cards both independently and in partnership with other companies, such as Walmart. In addition, the bank ranks second in the United States in terms of car loans (after Ally Financial).

Capital One retail network has over 700 branches in the United States, but the company focuses on digital channels for the development and provision of financial services. In particular, for many years Capital One has been actively investing in the development of digital technologies and is considered the most technologically advanced bank in the country.

In particular, Capital One's operating infrastructure is now almost entirely migrated to the AWS cloud platform, minimizing the use of traditional data centers. With AWS, a company analyzes data using machine learning and artificial intelligence, so it can quickly create and deploy new products and services for customers.

Capital One's digital banking applications are considered the most advanced in the States. With their help, consumers not only receive a full range of banking services, including opening and closing accounts, making transactions, obtaining and servicing loans, but they can also monitor their credit rating in real time, as well as receive recommendations for improving it. Note that Capital One has partnerships with the largest US car dealers, while the Auto Navigator application provides the bank's customers with a convenient service for selecting a car and buying it on credit.

Capital One presents financial results for three main segments:

  • Credit Card - issue and service of credit cards in the USA, Canada and the UK; main clients are individuals and small businesses;
  • Consumer Banking - a wide range of banking services, including account maintenance and payments, lending and deposits, to individuals and small businesses; includes a car lending division;
  • Commercial Banking - banking services for medium-sized enterprises with annual revenues ranging from $ 20 million to $ 2 billion; it also includes a private banking division serving high-net-worth clients.

The credit card segment currently generates 62% of Capital One's revenues, consumer and corporate banking 27% and 11%, respectively. Geographically, over 90% of revenues come from operations in the United States, while operations in other countries (Canada and the UK) together account for only 8% of the bank's revenue.

Financial results

Capital One Financial recently released good results for the fourth quarter of 2020 and summed up the last year, which was extremely difficult for the entire industry, overshadowed by the coronavirus pandemic. Net profit in October - December jumped more than 2 times, to $ 2.44 million, or $ 5.29 per share. At the same time, the EPS indicator significantly surpassed the average forecast of Wall Street analysts at $ 2.85.

Capital One's quarterly revenue declined 1.2% year-on-year to $ 7.34 billion, but beat the consensus forecast of $ 6.90 billion. Net interest income fell 3.2% to $ 5.87 billion , against the background of a decrease in the volume of loans issued, as well as a decrease in the net interest margin by 90 basis points, to 6.05%, due to a general decrease in interest rates in the United States. Meanwhile, operating expenses decreased by 3.7% to $ 4.01 billion, which was facilitated, among other things, by measures to optimize costs, and the operating efficiency ratio (Cost / Income, C / I) improved by 1.39 p.p. , up to 54.64%.

Capital One's profit in the 4th quarter, in addition to the outrunning reduction in operating expenses, was supported by a reduction in the effective income tax rate (to 16.2% from 18.6% in the same period in 2019), as well as the release of provisions for possible losses on loans for the amount of $ 593 billion, which is due to improved forecasts for the outlook for the American and global economy. Nevertheless, the total volume of such reserves still remains at an increased level - $ 15.56 billion, or 6.19% of all loans issued, against $ 7.21 billion, or 2.71%, at the end of 2019.

Capital One's assets at the end of the IV quarter amounted to $ 421.6 billion, practically unchanged from the previous quarter. The volume of issued loans increased by 1.4%, to $ 251.6 billion, while in the segment of credit cards, the growth was 3.2%, to $ 107 billion, and the volume of car loans rose by 0.6%, to $ 65.8 billion. The volume of deposits remained approximately at the level of the III quarter - $ 305.4 billion. The capital adequacy ratio of the 1st level (Tier 1 Capital Ratio) was quite high 13.7%, having increased from 13% in the previous quarter and 12.2% at the end of 2019.

In general, we can say that Capital One survived the crisis of 2020 quite well, which was facilitated, among other things, by a significant margin of safety made in previous years. Thanks to a strong brand, an extensive customer base, and a high degree of digitalization of the business, the company managed to maintain revenues around the 2019 level, while improving operational efficiency. The sharp drop in profits was almost entirely due to the need to build up reserves for possible loan losses. Capital One's current financial position looks solid. The CET1 capital adequacy ratio of 13.7% is significantly above the regulatory minimum of 10%, and the liquidity coverage ratio (LCR) is a substantial 145%.

The current 2021 should be a watershed year for the American and global economy. According to the IMF, the US GDP will grow by 5.1% this year, after falling by 3.4% in 2020, and in the second half of the year, economic activity in the country is expected to reach the pre-crisis level. This will be facilitated primarily by the expansion of vaccination against coronavirus, which will gradually lift quarantine restrictions and return economic life to normal. Currently, about 28 million citizens have received at least one of the two prescribed vaccinations against coronavirus in the States, while President Joe Biden has promised that 300 million Americans will be vaccinated by the end of July.

Additional support for the recovery should be provided by the super-soft monetary policy of the Federal Reserve - the first steps to normalize it are expected no earlier than 2022. In addition, by mid-March, the United States should adopt a new stimulus package in the amount of $ 1.9 trillion, including, among other things, significant direct cash payments to the population. According to the statement of the new US Treasury Secretary Janet Yellen, this package will return the country's labor market to full employment by early next year.

We expect Capital One to be one of the main beneficiaries of the recovery in consumer and business activity in the United States, given the bank's strong position in the credit card and consumer banking segment. At the same time, due to the improved situation in the economy, we should expect a further release of reserves for possible loan losses, which will provide additional support for profit indicators. Below is our outlook for Capital One's financials.

Payments to shareholders

In recent years, Capital One has committed significant funds to shareholder payments. So, at the end of 2019, $ 2.23 billion was spent for these purposes (buyback volume - $ 1.48 billion, dividends - $ 753 million). Meanwhile, payments fell sharply in 2020, as the Fed imposed a ban on bank buybacks in the middle of the year, and also limited dividend payments due to the need to save capital by financial companies. As a result, Capital One spent only $ 388 million on share buybacks last year. Moreover, the company was forced to cut its quarterly dividend to just 10 cents per share for the second and third quarters, down from 40 cents per share in the first quarter.

However, at the end of December, after another round of stress tests, the regulator significantly eased the restrictions on payments to shareholders for US banks. Against this background, the management of Capital One raised the dividend for the 4th quarter to 40 cents per share, that is, to the pre-crisis level, and also announced a new share buyback program in the amount of $ 7.5 billion, $ 500 million of which is planned to be spent in the current quarter.

Valuation

We have valued Capital One using the comparative method based on our forecasted financial results for 2021. Our valuation is determined as the arithmetic mean of our P / E and P / BV multiples.

Our estimate of the fair value of Capital One over a 12-month horizon. is $63.7 billion, or $138.90 per common share. The upside potential is 18.6%, the recommendation is Buy.