Valens Research – Weekly Equity Idea Highlight - 2019 02 06
COF trades well below peer multiple levels at 6.4x Uniform P/E (Fwd V/E') approaching trough valuations in 2009-2011. Their peers in the Consumer Finance (58% of their business) space averaged an 8x Fwd V/E', and in the Regional Bank (42% of their business) space average a 9x Fwd V/E', highlighting that they are trading at a discount. They also remain to be one of the few financial companies trading around book value, at 0.90x traditional P/B, even though their 17% ROE' is above community bank peer levels, highlighting how this is unjustified.COF has benefited over the past 10 years from consistently having stronger returns than most of their peers in the banking business, which is due to the high ROE' their credit card business generates, similar to AXP and DFS. Because of this, the company has consistently had much more robust Unlevered ROA'. Also, while this had been trending down in recent years due to higher competition in their lending business, for instance in the auto business, this has reversed recently. They had also benefited by falling leverage costs thanks to the interest rate environment, a trend has reverse, and is likely to continue due to rising interest rates.
At current valuations, the market is pricing in ROE' to fall from 13%-14% levels of the past two years, and this year, to 7% levels going forward. The market is expecting the trend around rising cost of leverage to continue, and also expecting the recent inflection in Unlevered ROA to reverse, and for COF to see falling profitability and rising costs. However, their trend around declining earnings power of their balance sheet appears to be shifting going forward, given the stabilizing and declining competition in their markets as alternative lenders have become less active, as can be seen significantly in the past year and a half plus.
Also, while the cost of borrowing is likely to continue to rise going forward, even if it does rise to 2%, levels seen in 2009-2010, this will not be a cause for concern after COF had transformed into a more balanced business with both Consumer Finance and Regional Banking arms. If they can improve unlevered ROA back to 2014-2015 levels, they would keep ROE' roughly flat going forward, not see it fall. If they can improve Unlevered ROA levels to 2010-2011 levels, they could even see ROE' recover back to the 20%+ levels they saw in those years, justifying incremental upside.
As mentioned before, the main reason for the declining unlevered ROA of the business until recently had been increased competition, and in several of their markets, new competitors who had appeared, for instance in subprime auto lending and in credit cards, are becoming less focused in the space. This has contributed to the recent rise in unlevered ROA', and it is likely to power ROE' to improve to 17% levels analysts are forecasting.
Capital One Financial is a financial services holding company. Through its subsidiaries, the company provides an array of financial products and services. The company's segments are: Credit Card, which consists of the company's domestic consumer and small business card lending, and international card businesses in Canada and the United Kingdom.; Consumer Banking, which consists of the company's deposit gathering and lending activities for consumers and small businesses, and national auto lending; and Commercial Banking, which consists of the company's lending, deposit gathering, capital markets and treasury management services to commercial real estate and commercial and industrial customers.
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