Sunday, July 21, 2013

Why Capital One Financial is a strong buy

One of the best performing parts of the financial sector since the economic recovery began over four years ago are credit card companies. It is not hard to see why, since just about every factor one can think of that leads to more people using credit cards is at or near all-time highs. Let's first take a look at E-Commerce spending. As shown below, online spending has nearly doubled since the recovery began and is at all-time highs. People use their credit cards to make purchases, mainly to Amazon or EBay, then they receive their product. The online merchants that sell the goods end up paying a small percentage to the credit card companies as a fee when that person buys from them using a card. The fee is generally 1.5 percent to 3 percent of the transaction. Surcharges can’t exceed 4 percent of the purchase price.

Credit cards are mostly used on retail and discretionary items. Looking at XRT the retail sector SPRR ETF, it is up nearly 30% this year along with XLY the consumer discretionary sector SPDR ETF up 25.5%, both outperforming the overall market, up 18.6%. Consumers spending on mid to high in items in both sectors proves that the economy is strengthening.

In the US, there are 4 major credit card companies: Discover, American Express, Visa, MasterCard. They have thrived and are all trading at all-time highs, with forecasts out to next year reaping in more and more profits from fees as consumers spend more. Below is a YTD chart of the four companies

Today we are going to look at one of the largest credit card issuers in the US, Capital One Finanical. Recently in seeing how the Federal Reserve is becoming more hawkish on the possibility to increase rates due to the thriving economy, the main companies who will directly benefit are financial services.

Capital One Financial (via Google Finance) is a diversified financial services holding company with banking and non-banking subsidiaries which offer an array of financial products and services to consumers, small businesses and commercial clients through branches, the Internet and other distribution channels. As of December 31, 2012, the Company's principal subsidiaries included Capital One Bank (USA), National Association (COBN), which offers credit and debit card products, other lending products and deposit products, and Capital One, National Association (CONA), which offers a spectrum of banking products and financial services to consumers, small businesses and commercial clients. On February 17, 2012, the Company acquired ING Direct business in the United States (ING Direct) from ING Groep N.V., ING Bank N.V., ING Direct N.V. and ING Direct Bancorp.

On Thursday, July 18th, they released their second quarter 2013 earnings report. Net profit rose to $1.1 billion or $1.87 per share from $92 million or $0.16 a share a year earlier. Analysts expected $1.72 a share. This is the second quarter in a row they have beat earnings estimates.  Main takeaways from the report:

-Net interest income from credit cards up 19% to $2.8 billion

-Provision for credit losses were $762 million, down 55% from a year earlier

-Net interest income (non-credit cards) up 14% to $4.55 billion

-Net interest margin rose to 6.83% in the second quarter from 6.04% a year earlier

-Net charge off rate, percentage of loans written off as unrecoverable, fell to 2.03% from 2.2% in the previous quarter.

-Purchase volume was up 12% year-over-year. Ex-acquired card loans up 9%, which is above industry average.

-Passed the Federal Reserve's stress test in March, said this month they plan they plan to buy back up to $1 billion in shares after completing the sale of its best Buy Co, Inc portfolio in Q3.

-One of the top 10 US banks by deposits with over 1,000 branches.

-Stock is up 27% since their last quarterly report in April.

In 2013, they expect $11.5 billion in runoff (reduction in loan portfolio), $9.5 billion for mortgages, $2 billion in domestic card; in 2014 they expect $8 billion in runoff with $7 billion from mortgage and $1 billion in domestic card.

They expect to raise their payout ratio next year largely from stock repurchases, they believe that their shares are attractive and flexibility in repurchases is consistent with regulatory push for higher capital.
Comparing Capital One's Price to Earnings ratio with others in their industry, it is well below its competitors and below the industry average of 15.98

 I performed a discounted cash flow analysis and came up with a price target of $74.27, which is 7.42% above Friday, July 19th's close.

Please reply for any comments, questions, concerns or send them to my Twitter @Peter_Eller10