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Morningstar | Capital One Continues to Benefit From Solid Underwriting and Technology Initiatives

Narrow-moat Capital One turned in a fine second quarter that aligns well with our thesis that it is a well-run bank materially undervalued by the market. Capital One outperformed our conservative expectations, earning $3.37 per share, 4.6% growth from the previous year. On a GAAP basis, earnings per share declined 13%, but this was almost entirely driven by last year’s divestiture of the company's home loan portfolio. Capital One’s improvement in adjusted earnings were driven by lower provisions that declined 21% from the previous year. This is an example of management’s “growth math” playing out. Capital One grew credit card receivables by only 2.2% from the previous year, limiting the company’s credit losses. This slower growth has enabled the company to realize substantial operating leverage and may suggest it is achieving normalized credit losses.

We think Capital One will continue to benefit from its willingness to incur near-term expenses for long-term gains. For now, we’ll be maintaining our fair value estimate of $133 per share, about a 45% premium to the current share price. For investors looking for a high-quality company and willing to endure the company’s ongoing investments that may limit near-term margins, we think Capital One remains an excellent choice.

The company’s branded card portfolio grew 4.7% from the prior year, about 250 basis points faster than the rest of the domestic portfolio. It appears Capital One is exercising the greatest caution in its private label portfolios which have higher credit losses. We would expect receivables growth to accelerate once Capital One onboards the Walmart portfolio. Meanwhile, Capital One’s purchase volume grew by 9.8% from the previous year. Purchase volume to average receivables was 96.3% for the quarter, the highest number we have calculated going back more than 8 years. We think purchase volume to card receivables is an important metric because it demonstrates that the company’s growth hasn’t been achieved by increasing existing balances, but rather finding new customers that are spending, just not holding balances. Eventually, these customers will hold balances, generating interest income. It also suggests to us the company might have the opportunity to increase existing balances. Most importantly, it demonstrates to us that Capital One is pursuing sustainable growth.

Meanwhile, Capital One continues to reiterate it intends to realize $800 million in savings in 2021, as a result of closing its redundant data center facilities. From an operational standpoint, Capital One has been operating two different banks in parallel. In its 10-K, we know that Fidelity is Capital One’s core processing provider. We expect Capital One to lessen its reliance on Fidelity and other software vendors.

In addition, we are interested in seeing what impact, if any, Capital One’s cloud migration has on its relationship with Total Systems Services (TSYS), which processes card payments on behalf of Capital One using IBM mainframes. Furthermore, Walmart is also a TSYS customer. We are intrigued at what IP could come out of this and how the ongoing relationship between issuers, acquirers and merchants will evolve.

Finally, Capital One grew consumer deposits by 5% from the prior-year quarter. Investors should anticipate this to be a headwind over the next year. That said, it does appear that the company has been able to modestly lower rates on its 360 money market account which has been the biggest source of deposit growth. Also, recent promotional activity targeting deposits doesn’t appear as aggressive as it was in 2018. Despite the recent slowdown, we think the slower promotional activity will be short lived and investors should anticipate increased promotional activity once the company onboards Walmart.