Company Description:
Capital One Financial Corporation, incorporated on July 21, 1994, is a diversified financial services company, which markets a variety of financial products and services through its banking and non-banking subsidiaries. The Company has four operating segments: U.S. Card, Auto Finance, Global Financial Services and Banking. The U.S. Card segment consists of domestic consumer credit card activities. The Auto Finance segment consists of automobile and other motor vehicle financing activities. The Global Financial Services segment consists of international lending activities, small business lending, installment loans, home loans, healthcare financing and other diversified activities. The Banking segment consists of local banking operations, which includes consumer, small business and commercial deposits and lending conducted within the Company's branch network. On
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Annual Report Highlights (latest report is for the period ending
Overview
As of December 31, 2006, we had $85.8 billion in deposits and $146.2 billion in managed loans outstanding. We are among the largest issuers of Visa and MasterCard credit cards in the United States based on managed credit card loans outstanding, and we are the 11th largest depository institution in the United States.
We offer our products throughout the
Important factors underlying the growth of our lending and deposit activities include strategic acquisitions, industry dynamics, including the level of competition, and our customer oriented business strategies and brand.
Capital One is one of the largest financial services franchises in the
Auto Finance Segment. We purchase retail installment contracts, secured by automobiles or other motor vehicles, through dealer networks throughout the
Global Financial Services Segment. The Global Financial Services segment consists of international (UK and Canada) lending, small business lending, installment loans, home loans, healthcare finance and other consumer financial service activities, extending Capital One’s national scale lending franchise and providing geographic diversification. In our international businesses, we utilize the methodologies and approaches similar to those we use in the
Banking Segment. The Banking segment represents the results of the legacy
Acquisition of
On
Competition
As a marketer of credit card, consumer and commercial financial products and services, we face intense competition in all aspects of our business from numerous bank and non-bank providers of financial services.
Our industry has experienced substantial consolidation and may continue to do so; this consolidation continues to create competitors who are larger and have more resources than we do. In addition, such consolidated and/or larger competitors may have a more diversified product and customer base, operational efficiencies and more versatile technology platforms than we do.
Each of our financial products is marketed to specific consumer populations across the credit spectrum. The terms of each product are actively managed to achieve a balance between risk and expected performance.
We compete with international, national, regional and local issuers of Visa and MasterCard credit cards, as well as with American Express, Discover Card and, to a certain extent, smart cards and debit cards. In general, customers are attracted to credit card issuers largely on the basis of price, credit limit and other product features, and customer loyalty is often limited.
We compete with national and state banks for deposits, commercial loans and trust accounts and with savings and loan associations and credit unions for loans and deposits.
In motor vehicle finance, we face competition from banks and non-bank lenders who provide financing for dealer-originated loans. We also face competition from a small, but growing number of online automobile finance providers.
We believe that we are able to compete effectively in both our current and new markets.
As of
Risk Factors
- We Face Intense Competition in All of Our Markets
- We May Experience Increased Delinquencies and Credit Losses
- We Face Risk of Interest Rate Fluctuations
- We May Fail To Realize All of the Anticipated Benefits of our Mergers with Hibernia Corporation and North Fork Bancorporation
- We Face Risk From Economic Downturns
- We Face Risk Related to the Strength of our Operational, Technological and Organizational Infrastructure
- The Credit Card Industry Faces Increased Litigation Risks Relating to Industry Structure
- We Face the Risk of a Complex and Changing Regulatory and Legal Environment
- We Face the Risk of Fluctuations in Our Expenses and Other Costs that May Hurt Our Financial Results
- Reputational Risk and Social Factors May Impact our Results
- We May Face Limited Availability of Financing, Variation in Our Funding Costs and Uncertainty in Our Securitization Financing
Management Summary
The following discussion provides a summary of 2006 results compared to 2005.
Net income increased 33% to $2.4 billion for the year ended
Diluted earnings per share were $7.62 for the full year, which included a $0.32 dilutive impact from the
Revenue growth was fueled by managed loan growth in the Auto Finance and Global Financial Services segments and a full year of
Non-interest expense increased $1.2 billion in 2006 driven by increases in operating expense. The increase in operating expense was driven primarily by a full year of Hibernia’s results which contributed $951.3 million (which includes integration costs and costs to support the branch expansion efforts) of the overall increase, the one month impact of the North Fork acquisition which added $97.4 million of operating expense, and increased costs for infrastructure investments, including the conversion of the Company’s cardholder transaction and account processing platform. Although operating expenses increased for the year, operating expense as a percentage of average managed assets continued to decline, reflecting the Company’s improved operating efficiency. The Company’s return on managed assets of 1.69% is consistent with prior years and reflects the sustainability and diversification of the Company’s earnings stream.
Managed loans as of
In 2006, the Company made additional progress to become a diversified financial services company. The successful integration of
As a result of the corporate strategies and banking acquisitions, the Company’s debt ratings were upgraded during 2006. Moody’s raised its rating to A2 and A3 at the Bank and the Corporation respectively. Two Standard & Poor upgrades now have the Company rated A- at the Bank entities and BBB+ at the Corporation.
During the fourth quarter, the Company entered agreements and established the price with third parties to sell $1.5 billion of CONA’s residential mortgage portfolio and $4.2 billion of North Fork Bank’s mortgage portfolio as part of a balance sheet downsizing related to the acquisition of
Business Outlook
This business outlook section summarizes the Company’s expectations for earnings for 2007, and its primary goals and strategies for continued growth. The statements contained in this section are based on management’s current expectations and do not take into account any acquisitions that might occur during the year.
Expected Earnings
The Company expects to deliver diluted earnings per share between $7.40 and $7.80 in 2007. This guidance includes the expected impact of about $140 million in intangibles amortization and about $100 million of integration expenses both related to the acquisitions of both
Inclusive in this guidance is the assumption that unsecured credit in the
The Company’s 2007 results will also be impacted by the targeted $275 million pre-tax in net synergies, consistent with the announcement of the deal in March 2006. The Company now expects the full run-rate synergies will be realized later in 2008, and there is a reduced level of opportunity to achieve cost and revenue synergies in 2007. This is partially a result of the impact of the expected yield curve environment on near-term balance sheet synergies. It also results from the scheduling of the conversion to a single deposit platform and brand in the first quarter of 2008. This timing is driven by the interest of a smooth and effective integration.
The share count used to translate the Company’s expected GAAP NIAT to earnings per share assumes the beginning of the previously announced $3 billion in share buy-backs in the second quarter of 2007. The Company previously announced its intention to execute $3 billion in share buy-backs, split evenly between the second half of 2007 and the first half of 2008. The Company now expects to start the program in the second quarter of 2007, and increase the expected portion of the share buy-back, which will occur in 2007, to approximately $2.25 billion.
Specific factors likely to affect the Company’s 2007 earnings are the portion of its loan portfolio it holds in higher credit quality assets, the level of off-balance sheet securitizations, changes in consumer payment behavior, the amount of and quality of deposits it generates, the competitive, legal, regulatory and reputational environment, the level of investments, growth in its businesses, and the health of the economy and its labor markets.
The Company’s U.S. Card segment consisted of $53.6 billion of managed
Revenue margin for the U.S. Card business was down 122 basis points from 2005 driven by two product strategy changes and one-time effects. For several years, the Company has focused on marketing products that build long- term customer loyalty, including rewards cards. These products have relatively high acquisition costs, build balances relatively slowly, and have thinner revenue margins. However, they have low charge-off rates, and tend to stay around for many years. Rewards accounts also bring credit leverage, resulting in sustained profitability while enhancing the Company’s brand and creating enduring customer relationships.
Another significant part of the U.S. Card’s product strategy has been the Company’s shift upmarket within the subprime portion of its U.S. Card business to include more products with no annual fees and competitive rates. The Company believes the payoff in this strategy results in lower servicing costs, lower credit costs, and lower attrition rates.
The Company believes these changes made over the last several years position the U.S. Card business to deliver sustainable bottom-line returns through low credit losses, long-term customer relationships, diversified revenue streams, and improving operating efficiency.
Auto Finance Segment Outlook
The Company’s Auto Finance segment consisted of $21.8 billion of managed
The Company believes that its strong risk management skills, increasing operating scale, full credit spectrum product offerings and multi-channel marketing approach will enable it to continue to increase market share in the Auto Finance industry.
Global Financial Services Segment Outlook
The Global Financial Services segment consisted of $27.0 billion of managed loans as of
The Company expects continued loan, credit and profit pressure from a deteriorating credit environment in its
Banking Segment Outlook
Deposits in the Banking segment increased $170.8 million to $35.3 billion in the fourth quarter and continued to grow in Texas and parts of Louisiana that were not significantly disrupted by the Gulf Coast hurricanes of 2005. Growth in these areas is partially offset by the run off of deposits in the hurricane-impacted areas since customers continue to use these funds for rebuilding and recovery efforts in the hurricane-impacted
Managed loans in the Banking segment grew modestly in the fourth quarter, but that loan growth was more than offset by $1.5 billion in mortgage sales which were part of the Company’s balance sheet downsizing in conjunction with the
The Company believes the integration of
Financial Highlights:
Revenue Growth (1-yr): 20.5%
Revenue Growth (10-yr average): 26.8%
Net Income Growth (1-yr): 33.5%
Net Income Growth (9-yr average): 32.9%
Earnings-Per-Share Growth (1-yr): 13.2%
Earnings-Per-Share (9-yr average): 25.8%
Net Profit Margin (current): 18.3%
Net Profit Margin (5-yr average): 16.0%
Return On Equity (current): 9.5%
Return On Equity (5-yr average): 18.7%
Valuation:
Given that this is a financial services firm, it’s impossible to do a discounted cash flow analysis I typically rely on in my valuation of stocks, so I have to largely rely on Morningstar’s valuation, my assessment of the financial information that is available to me (and that part of it that actually makes any sense), and looking at comparative P/E ratios. So here are the results that I have from this ad-hoc assortment of resources:
- Morningstar values this company at almost twice the current market price of $62/share basing their decision largely on the fact that this is a wide-moat company with a highly recognizable brand name led by a high-quality management team (CEO Richard Fairbank has been at the helm of the company since 1994).
- Current P/E of 9.4 is at an almost 20% discount to the 5-yr average P/E of 11.3.
- Company has posted positive revenue net income growth (at least) for the past nine years and this growth has been rather impressive (see above at Financial Highlights).
- Since it’s impossible to value the company using DCF analysis, I’ve attempted using the model by substituting the latest free cash flow figure for net income and my result was similar to Morningstar’s valuation (well over $100/share). And that is assuming that Capital One’s long term growth will be at 7%, which seems to be rather conservative when you consider that it’s been growing at double digits during the past nine years.
Pros:
- Capital One’s brand commands wide recognition among consumers, which gives it an edge over competition.
- Company has a deep knowledge of consumer behavior from operating in different consumer segments and can use that knowledge to successfully cross-sell its products.
- Interest rate will most likely come back up in 2008 and consumer finance companies such as COF typically benefit from such trends.
- Capital One has shown a history of consistently high growth rates in both, revenue and net income, during the past decade and there is no reason to believe that it will do significantly worse than that in the next ten years (which is what current market valuation of the stock seems to assume).
- Some of the largest institutional shareholders of the company are renowned mutual funds such as Dodge & Cox Stock and Vanguard Windsor II.
Cons:
- Company has relatively little experience in the acquisition field and might not be most efficient at integrating companies it buys.
- Capital One is subject to adverse effects of the possible economic slow down as its results would suffer from higher levels of debt defaults.
Final Decision:
Capital One seems to be a good company available at a bargain price with a high upside potential. There are a few things that I’m concerned about though: 1) The company typically doesn’t do well in bear markets and it’s possible that we are about to have one on our hands fairly soon; 2) Although the upside potential is significant, it is not clear when it will be realized: 1 year? 2? 5? 3) It is also not clear if the company has already hit it’s bottom or will decrease further before starting the climb back up. As you can see my concerns are not related to the quality of the company, but rather to market timing. Since market timing is something no prudent investor should try to succeed at, according to value investors such as Benjamin Graham and Warren Buffett, the question should be whether to buy this company at all, not whether to buy it now or wait to see if it will go down a little more. So, even though I’m still hesitant, I am willing to put this company at the top of my consideration list and unless the pool of potential candidates to take place in my portfolio will be crowded by companies I’m much more confident about, Capital One is likely to be one of my final picks.
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