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Morningstar | On the Backs of Improving Credit Quality and Technology, Capital One Continues Its Momentum

As expected, narrow-moat Capital One continues to build on the momentum of recent quarters. For the third quarter, the bank generated earnings $2.99 per diluted share. After adjusting for a few one-time items that we actually believe to be nonrecurring (a rarity for us), normalized earnings per share was $3.44, 6.8% improvement from the previous quarter and a 42% increase from the previous year. Capital One booked a gain on a divested business, increased its legal reserves resulting from an OCC fine related to money laundering and took a loss on its investment portfolio as the company exchanged lower yielding securities for bonds with higher yields. The loss on its securities portfolio shouldn't concern investors too much as it'll provide a small lift to net interest margins going forward.

However, we’ll remind investors that Capital One is benefiting from significantly lower credit provisions which are providing a temporary boost to the bottom line. During the quarter, by our math, domestic credit card provisions were 3.8%; not since 2013 has Capital One seen third quarter provisions this low in its domestic credit card business. Though we don't expect a meaningful increase in credit provisions, investors shouldn't expect credit losses to be this low forever. For now, we’ll be maintaining our fair value estimate at $127 per share. We continue to believe Capital One is materially undervalued by the market and can’t come up with any reason why shares should have sold off with other banks in recent weeks.

During the call there was much talk about Walmart and technology. When it comes to technology, Capital One continues to be highly circumspect when discussing its strategy. However, CEO Richard Fairbank said when asked about what attracted Walmart on the digital side said, “I think it's really more the capabilities and possibly really the similarity of the journeys between the two (Capital One and Walmart).” In our recent select presentation, Capital One: A Moat in Tech Vikings Can’t Surmount, we made a strikingly similar observation saying that Capital One and Walmart appeared to be pursuing noticeably analogous strategies using open-source software. We would strongly encourage any investor trying to make sense of management’s hard-to-understand comments on technology and its “digital transformation” to read our report. Furthermore, we are aware of companies besides Walmart already using Capital One’s software which the company provides for free to anyone, suggesting to us Capital One will continue to win additional retail partners. This is a great cost saver for companies, as it means companies do not have to sign up for expensive software licenses. In addition, we’re not aware of any other bank that has embraced open-source software to this extent.

In addition, Capital One management’s comments on the possibility of buying Walmart’s portfolio to be interesting. Specifically, Fairbank said, “For us to agree to buy the (Walmart) back book, it needs to be at a price and at terms attractive to us, which will be determined through the negotiations over the next quarter or two.” This stands in contrast to Synchrony’s comments that any portfolio sale would be expected to generate a gain. More importantly, it suggests the decision isn’t entirely up to Synchrony. Given we aren’t convinced which option is better, our models assume Capital One purchases the portfolio at par from Synchrony. Also, this would require Capital One to hold more capital which could potentially limit Cap One’s ability to repurchase additional shares. Nevertheless, we think the benefits of holding additional capital are evident.

In third quarter, we’ll observe Capital One’s pretax income was up 21% which is impressive considering the company’s marketing expense jumped nearly 33% from the previous year. This increase in marketing investment is attributable to the launch of the Capital One Savor rewards card which offers better rewards for purchases on dining and groceries. It appears that as Capital One has started to benefit from improving margins as credit losses moderated, management has increased investment in marketing. Management stated investors should expect higher marketing expense in the fourth quarter as well. This shouldn’t concern investors too much and we like that management isn’t overly fixated on improving margins if there’s a good investment to be made.

Loan growth continues to slow, but still remains positive. For the quarter, domestic credit cards grew by 0.8% from the previous quarter. This is the slowest third-quarter growth in domestic cards in five years. We appreciated management’s comments that the easiest way for a credit card lender to achieve growth would be to increase credit limits and that the company went down the opposite path by dialing bank on initial limits. Despite this, Capital One is still seeing growth in credit card loans. Finally, we found management’s comments around commercial lending interesting, specifically the company mentioned competition from nonbank lenders who have adopted more aggressive structures and terms. This is not the first bank we heard this quarter mention this trend and we appreciate Capital One’s comments that the company is “watching it and obsessing about it.” For us, we’ll continue monitoring this trend and the impact it has on Capital One and the other banks we cover.