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Morningstar | With Improving Profitability, Healthy Capital Levels, Capital One Poised to Increase Capital Returns. See Updated Analyst Note from 20 Jul 2018

Narrow-moat Capital One had an excellent quarter driven by improving credit quality and continued growth that will force us to increase our 2018 earnings estimate to $12.54 per share. Previously, we projected GAAP earnings of $10.28 per share. However, we’d like to point out approximately $0.75 per share of our estimate increase is related to Capital One’s divestiture of its mortgage portfolio, which generated a one-time pretax gain of $400 million. In addition, in a normalized environment Capital One will not benefit from such consistent reserve releases. As we have said before, in recent years, as Capital One built reserves as a result of the company's exceptional growth, it had the impact of understating Capital One’s true earnings. Now, we’re seeing the opposite and reserve releases are giving a temporary boost to earnings. Though Capital One may continue to see reserve releases in 2019, we expect earnings to decline to $10.78 per share, which we regard as a more normalized level of profitability. We believe Capital One's improving fortunes will eventually lead to dividend increases and increased share repurchases. After making a few near-term adjustments to reflect this quarter's results, we’ll be increasing our fair value estimate to $127 per share from $123.

During the call, management was asked if the sale of its mortgage portfolio would allow the company to go back to regulators and ask for a top-up request so that Capital One can increase its capital return. Though CFO Scott Blackley was noncommittal, we would guess the company would be able to return more capital to shareholders. Currently, the company is approved to spend up to $1.2 billion on share repurchases, if we include dividends, Capital One is on pace to return about $1.9 billion-$2 billion in capital to shareholders in the next 12 months. This is about one third of what we estimate Capital One will earn this year. At the end of the second quarter, Capital One’s common equity Tier 1 capital stood at 11.1%, a 60-basis-point sequential improvement. We believe this leaves the door open for Capital One to increase its dividend or increase share repurchases. Given we believe shares are cheap, we would hope management would up its share repurchase.

For the second quarter, credit quality continued to improve. Something we have been expecting and outlined in our recent Select piece, "Capital One: Time for Margin Expansion." At the end of June, Domestic credit card delinquencies were 3.32%, which is a small increase from May, but still more than 30 basis points lower than the previous year. Auto performance continues to be better than what we’ve expected, and the company was even able to reverse auto allowances during the quarter. Within consumer banking, which is primarily just auto loans, Capital One recorded credit loss provisions of $118 million, this is a 56% decrease from the previous year. Though competition within auto appears to be increasing, competition within credit cards appears to have stabilized. Though we think it’ll be hard for credit quality within auto to get any better than it already is, there is still room for improvement within credit cards.

We’re impressed that Capital One has been able to maintain its recent level of growth. Domestic credit cards grew by 2.2% from the first quarter. This is a modest acceleration from the previous year which saw growth of 1.9%. In addition, it appeared much of this quarter’s growth in credit cards came from higher quality consumers. During the quarter, the percentage of Capital One’s cardholders with FICO scores greater than 660 went from 66% to 68%. In addition, this is a 4% increase since last June. We’ll be digging into this some more, since some of Capital One’s competitors seem to be aggressively growing balances within prime customers. Nevertheless, we still assume that Capital One’s growth within credit cards continues to moderate.

Finally, much has been made about reports Walmart is entertaining proposals from Capital One for its card portfolio which is currently held by Synchrony. The announcement will likely come in the next week to 10 days. During the call, when asked about what Capital One looks for in an ideal partner, CEO Richard Fairbank gave away very little in whether Capital One is the front runner for Walmart’s business. Our attempts to read the situation were made even more complicated with Bloomberg’s report that two senior Capital One managers involved in the bid were departing. Though we think Walmart could benefit from Capital One’s technological expertise, we suspect the business will remain at Synchrony. According to The Wall Street Journal, one of Walmart’s complaints with Synchrony was the acceptance rate of consumers. We can’t imagine that Capital One would be willing to accept a higher percentage of applicants than Synchrony already does. Given Walmart’s importance to Synchrony, we’ll speculate Capital One will be unsuccessful in stealing the company’s portfolio. We estimate that Walmart and Sam's Club account for about 20% of Synchrony's card portfolio. Unlike Capital One's more diversified card business, Synchrony is much more likely to pay up to retain the business.