Updated valuation may outweigh headwinds (NYSE:COF)

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Thesis

I believe Capital One Financial Corp. (NYSE: COF) will fuel long-term earnings growth by continuing to digitize its business model. By moving away from physical branches, Capital One has the ability to eliminate maintenance capital expenditure (CAPEX). This can not only increase free cash flow, but also allow management to focus on their marketing strategy while maintaining a competitive cost structure. I think if Capital One can combine its digital business model with the ability to add new major retailers to its mix of brand partnerships, the growth will be exemplary.

Capital One is currently 25% off the highs and trading at the all-time low of its futures price/earnings (P/E) channel, in my view. While I think there are legitimate reasons for Capital One to be trading at historically low valuation levels (which I’ll get to later), this can also be a good time for investors.

context

I’ve covered Capital One in the past, so I’ll link to my previous article to cover the company’s more in-depth background, but I’ll list a few highlights below:

  • Compared to more traditional banks, Capital One has a limited number of physical branches.
  • The main segment is credit cards, which account for 40% of the company’s total loans and 62% of its total revenue.
  • The company is also involved in personal and business banking, with auto loans making up the majority on the consumer side.
  • Capital One recently won co-branded credit cards with BJ’s Wholesale Club (BJ) and Walmart (WMT).

Capital One Walmart Rewards® Card

Capital one

Thesis support

Digitization and cost structure

In recent years, Capital One has reduced the number of branches it operates from 700 to 500. By reducing the number of branches it operates, Capital One has been able to control operating costs while increasing total loans:

Growth in loans relative to OPEX (excluding marketing)

Created by author using data from COF 10-K

Even though their physical footprint is shrinking, which has helped reduce OPEX as a % of sales by around 300 basis points, loan growth achieved through heavy use of online deposits has increased by 25% in 6 years.

By controlling the cost structure, Capital One has also been able to keep maintenance CAPEX constant since 2015. Over the past 6 years, Capital One has increased operating cash flow by $2.2 billion, while maintenance CAPEX only increased by $166 million. This contributed to their high free cash flow yield shown below: (the table below includes cash acquisitions (growth CAPEX) in the free cash flow formula).

Free movement of capital

Created by author using data from COF 10-K

Capital One’s management of cost structure is also evident in the efficiency ratio.

  • Efficiency report: non-interest expense/income.

Over the past decade, Capital One’s efficiency ratio has averaged below 55%, while its peer group typically ranges between 55-60%. Capital One typically spends more on the marketing department than its peers, but I think that helps fuel the growth of their digital repositories. Marketing spend is also not vital to day-to-day operations, meaning it can reduce spending in this area during times of uncertainty (as seen in 2020).

Not only has the growth of digital deposits contributed to loan growth while containing the cost structure, but it is also a source of protection for Capital One, in my opinion. This protection takes the form of customer diversification. I believe that their focus on digitizing their business model allows them to expand nationally and reach a wider range of customers, not limiting them to a specific demographic close to branches. These benefits are similar to those of a large bank operating an extensive interstate branch network without the associated costs. Below are the geographic breakdowns of loans for the credit card and personal banking segments:

Geographic distribution CC

COF 10-K

Geographical distribution CB

COF 10-K

Brand Agreement Drivers

Capital One’s largest business segment is credit cards, which account for 62% of total revenue. One of the ways Capital One has sought to expand this business segment is through co-branded deals. They were able to complete the Walmart co-branded credit card deal in August 2019 and the BJ wholesale deal earlier this year. In my view, pursuing co-branded cards with massive retail brands will be a key way for Capital One to grow its revenue.

Competitive advantages

I believe investing in companies with sustainable competitive advantages is the key to long-term success. Capital One operates in a highly competitive industry, but in my opinion, they have created efficiencies in their business model that I believe protect them from competition and help them in their future growth.

  • The digitization of the banking business may continue to lead to higher efficiency ratios compared to peers.
  • A higher efficiency ratio (operating margins) leads to the ability to invest more in marketing/technology.
  • Geographical diversification of loans can reduce the economic cyclicality of certain regions.
  • Not big enough to be globally consistently important avoiding the heaviest regulatory requirements (still required to participate in Fed stress tests)

Evaluation

I think Capital One is currently trading at the bottom of its historical P/E channel:

PE term COF

Koyfin

Although I think there are reasons why Capital One is currently trading at this level (I will highlight them later) and there were reasons in the past for it to be trading at levels

Les cercles représentent lorsque les actions sont négociées <6,5x NTM PE

TradingView

Based on Capital One’s business breakdown and competitor valuations, I also believe Capital One is trading at a discount to its peers:

Comp.  Implicit P/E

Created by the author using data from Koyfin

Risks – Why is the valuation depressed?

  1. Current inflationary environment: With high inflation and suppressed real wage growth, Capital One could see credit card loan balances rise. As the Federal Reserve looks to raise interest rates to fight inflation, Capital One could also see loan yields rise. While both of these are positives for Capital One, the tail risk lies in reducing consumer spending and credit losses and expectations around them (credit loss allowances). Customers with FICO scores

Full-time employees: Real median usual weekly earnings: Paid workers: 16 years and older

Fred

Inflation risk mitigation: I think Capital One’s balance sheet is well capitalized and conservatively positioned for the current environment. Capital One’s long-term CET1 ratio is 11.7%, while its average provision for credit loss ratios (as a % of loans held for investment) is 3.4%. Currently, their CET1 and claims provision ratios are 13.1% and 4.12% respectively.

Funding ratios

Created by author using data from COF 10-K

2. Industry competition: Although I think Capital One holds many competitive advantages, they still operate in a competitive industry. With co-branded card offerings being an important area for growth, in my view, these offerings could be withdrawn due to competing card issuers.

Competition attenuator: Capital One’s current cost structure may give it a competitive advantage when building a set of co-branded cards. With a higher efficiency rate than the competition, they may be able to offer a cushion that competitors might not otherwise be able to afford.

Forecasts

After reviewing the valuation and projecting 5-year earnings, I created bearish, base, and bullish price targets for Capital One.

Model Highlights

Created by author using data from COF 10-K

Price targets

Created by the author using data from Koyfin

(Returns are based on PV share price of $134, excluding dividends)

Summary

Given current valuation levels and long-term growth prospects, I think Capital One presents an attractive investment opportunity. As they continue to digitize their business model, which could lead to reductions in maintenance CAPEX and increases in their efficiency ratio, Capital One will in my view continue to generate strong free cash flow. With this free cash flow, I believe they will be able to continue to return capital to shareholders through dividends and share buybacks. With stocks trading below 7x NTM EPS, I think this may present an opportunity for long-term shareholders.

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