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Morningstar | Our Capital One Estimates Likely Too Conservative as Company Realizes Benefits of Investments

After last quarter’s jump in marketing spending took investors by surprise, narrow-moat Capital One Financial appears to be on a path to realize the benefits of its sizable investments in marketing and technology. For the first quarter, the company earned $2.86 per diluted share, representing sequential growth of 15% and year-over-year growth of 9%. This growth in earnings happened despite Capital One’s commitment to marketing spending. During the quarter, Capital One’s marketing spending rose almost 25% from the previous year. Last quarter, we highlighted some of our concerns about slowing receivables growth as the company became more cautious on credit. During the quarter, period-end domestic credit card loans had seasonal declines of only 5.9% from the previous quarter. This marks a modest improvement from previous years. For now, we are comfortable with our forecast 2019 average card receivables growth exceeding 4%. However, the company’s commentary on achieving substantial operating leverage on its technology investments will force us to increase our fair value estimate. We expect to increase our fair value estimate by 10%-15% as we now believe our five-year forecast has probably been too conservative. We continue to believe Capital One is significantly undervalued by the market, and these results support this.

On only one other occasion of which we are aware has CEO Richard Fairbank offered anything closely resembling guidance. This quarter, Fairbank provided some insight into how much the company will save when it exits its existing data centers and completes its migration to Amazon Web Services. The company expects its operating expenses will now account for only 42% of revenue by 2021. To put this in perspective, in 2018, operating expenses were 45.3% of revenue. Had Capital One achieved management's forecast efficiency last year, pretax earnings would have increased by $900 million, or approximately 15%. Given that we anticipate Capital One will continue increasing revenue, this means the company should be able to increase GAAP earnings by at least $1.70 per share from improving efficiency. This suggests that consensus estimates, as well as our own forecast, have been too conservative. Starting in 2021, we intend to increase our earnings estimates by 8%-14% in each year. We have written extensively on Capital One’s early adoption of the cloud and migration to Amazon Web Services (see our 2018 Select piece, "Capital One: A Moat in Tech Vikings Can’t Surmount").

That said, it wasn’t all good news for Capital One. The company highlighted growing competition for deposits, which led to net interest margin compression of 7 basis points from the previous year. In total, deposit costs rose 12 basis points amid sequential growth in deposits of 1.7%. Also, management remarked that within its consumer bank, where the company is investing heavily to attract deposits, its cost of funding had risen by 38 basis points. Currently, interest-bearing deposits are on pace to grow by 6%-7%. Given the commentary on multiple bank earnings calls, we do not anticipate competition for new deposits to subside this year. Now, it will be on Capital One to keep these customers’ deposits by offering something other than a competitive interest rate. If the bank can’t do that, then Capital One’s extensive investment in cash rewards and cafes will have been wasted. So far, we are encouraged by what we see.