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Morningstar | Higher Expenses Mean Capital One's Winning Accounts and New Cardholders

Narrow-moat Capital One had an interesting fourth quarter that many will misinterpret, as we did initially. The company produced net revenue of $7 billion, flat with last year’s fourth quarter. The bottom line was more impressive as the bank generated normalized earnings per share of $1.87, about a 15% like-for-like improvement from last year. We were mildly disappointed by card receivables growth; domestic receivables grew only 2% from the previous year as Capital One’s tighter underwriting clearly signaled management’s caution. We’re lowering our fair value estimate to $119 per share from $127 as we take into account the lower-than-expected receivables growth. We believe Capital One is exceedingly cheap. The market seems to not realize that this quarter's higher marketing expenses mean the company is winning the deposits of new customers, securing new cardholders, and probably outperforming management's own expectations.

Many investors will decry Capital One’s $831 million in marketing expenses this quarter, a massive 81% or $371 million jump from the previous year. Initially, we had to recheck that number because it didn’t seem possible. No, Capital One isn't spending like mad to employ Samuel L. Jackson and Jennifer Garner. This quarter's earnings miss appears to be entirely driven by two offers: the $200-$1,000 cash bonus on new deposit accounts and the $500 signup bonus for the new Savor card. Based on the incredible growth in marketing expense, it appears Capital One had a terrific quarter in opening new deposit accounts and securing new cardholders. We estimate this cost Capital One at least $0.45 per share in earnings, almost accounting for this quarter’s miss. We’ll see how sticky these deposits are and how Capital One shifts its funding mix, but to us it looks like a shrewd investment. Investors should not discount the long-term benefits generated by these expenses.

We believe Capital One’s aggressive promotional offers for new deposit accounts are a bold move most companies wouldn't make out of fear of angering short-term-oriented analysts. But if it results in sticky deposits, we like it. To put this in perspective, during the quarter, Capital One’s interest-bearing deposits cost the company 1.36%, compared to 2.99% for securitized debt obligations and 3.86% for senior subordinated debt. Based on average balances, interest-bearing deposits accounted for about 80% of funding. Keeping interest rates fixed, had deposits accounted for 85% of interest-bearing funding, it would have decreased funding costs by approximately $75 million for the quarter. That might not seem like much, given the increase in expenses during the quarter, but if these result in loyal depositors, the one-time bonus will be dwarfed by the long-term savings of cheaper funding. It’s on Capital One now to keep these depositors in place and increase engagement through its digital offerings.

Though we were disappointed to see slower loan growth for the quarter, Capital One’s purchase volume was up 10.5% from the previous year. Per our math, purchase volume to average card balances has never been higher, as purchase volume was 93% of average balance. Some of this is attributable to Capital One targeting the spender segment, but a lot of this is a result of cautious underwriting. Eventually, some of these cardholders will hold balances and generate interest income; when that happens, Capital One will be in position to benefit.

During the call, management discussed the Walmart transition. The portfolio will be about $9 billion in receivables. As of this summer, Synchrony had Walmart card balances exceeding $10 billion. The declining size of the balances may suggest Synchrony has tightened underwriting since the announcement that Capital One would be taking the portfolio. We had anticipated Capital One would have to eliminate some of the weaker credits and reduce the size of the portfolio. Though Capital One will probably still have to rationalize the size of the portfolio, it may not be as drastic as we had initially expected. We are eager to see what IP Walmart and Capital One develop together. We’re looking to see what Walmart does with payments through closed-end networks. Rival Target has a popular private-label debit card with a closed-end network that enables it to sidestep fees paid to Visa and MasterCard.