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Thesis:
Capital One Financial (NYSE:COF) stock is down roughly 46% from all-time highs as rising rates, inflation, and broader macroeconomic fears continue to plague the market. Amid significant headwinds, Capital One has still produced solid financial results. At current price levels, inflation-fueled fears have made Capital One’s stock a discounted, value play worth consideration.
(Note: Financial data is sourced from ycharts.com unless cited otherwise.)
Macroeconomic impact on Capital One:
Rate hikes, rampant inflation, consumer weakness, war, and supply chain disruptions have all plagued the markets immediately following the disastrous Covid-19 pandemic. It’s important to analyze how these headwinds have already affected Capital One, and what to expect moving forward.
What happened:
Government stimulus and lenient payment policies on debt put a lot of discretionary capital in consumer pockets. Interest rates were on the floor and consumers felt comfortable spending to their heart’s desire. This got the inflation snowball rolling, as an influx in spending spikes demand and thus, the prices of consumer goods. Simultaneously, the Russian-Ukrainian conflict got the ball rolling on global supply chain disruptions. China’s inability to contain Covid-19 has also been a massive contributor to supply chain disruptions. The perfect storm was brewing, as U.S. consumers were incessantly spending at historically low rates, and global supply chain disruptions were reducing the supply of produce, oil, computer components, auto parts, etc. In the blink of an eye, the U.S. was facing 40-year high inflation and the Fed began hiking rates exceptionally quick. With rates up ~1,500% the market was left with a defeated consumer and lingering inflation.
Effect on Capital One:
Higher rates promote interest income growth on existing and new balances, as Capital One extends hikes to consumers. However, the shortfalls have a far greater weight on the company. Capital One has seen liquidity tank, higher charge offs, higher provisions for credit losses, reduced CET1, and a higher efficiency ratio. The abrupt transition to a high-rate market hit Capital One hard:
- 3Q22 Liquidity reserves of $92.8B. 3Q21 reserves were $123.393B.
- 3Q22 Net charge offs of $931mm. 3Q21 net charge offs were $426mm.
- 3Q22 Provisions for losses were $1.665B. 3Q21 provisions were ($344mm).
- 3Q22 CET1 was 12.2%. 3Q21 CET1 was 13.8%.
- 3Q22 Efficiency ratio was 56.21%. 3Q21 efficiency ratio was 53.46%.
- 3Q22 EPS of $4.20. 3Q21 EPS of $6.78.
- Capital One stock price is down roughly 44% from 3Q21 to 3Q22.
What to expect moving forward:
As inflation, higher rates, and consumer weakness lingers, Capital One will likely continue to see declines in operational and bottom-line figures. The Fed plans to taper rate hikes, and last month’s CPI report came back better than expected. Should the market stay on this trajectory, the worst may be behind us. Capital One’s net charge offs, provisions for losses, and CET1 ratio are key items to monitor moving forward. Liquidity and capital tier ratios must be in line to ensure financial stability, while net charge offs take a direct shot at bottom line figures. I expect further declines from Capital One, but do believe the bottom is near. I’d like to note these expectations are contingent on tapered rate hikes and improving CPI reports.
Rate hikes and inflation will likely persist through 2024:
Additional rate hikes are still on the horizon; however, I do believe we are getting close to a peak Federal Funds Rate. Powell signaled toward tapering rate hikes moving forward, though he maintained his stance on further hikes to stave off inflation. The next Fed meeting is on December 14th, with expectations of a 50-basis point hike. This would take the target rate to 4.25% – 4.75%. Goldman Sachs is predicting that the target rate will peak at 5% – 5.25% in May of 2023. The U.S. hasn’t seen a Federal Funds Rate north of 5.25% in over 20 years, with the most recent 5% period spanning 2006 – 2007 lasting almost exactly one year. Rates were cut to the floor before spiking to 2.5% in 2019 for a 6-month span. The Covid-19 pandemic led to another prompt cut to the floor. The rate hikes seen in 2022 are the most aggressive single-year hikes since the 80’s. Considering the macroeconomic landscape now differs from the higher rate market in 2007, it’s hard to say how long rates will stay high. The rates were high in 2007 before the housing crisis, which led to the rate cuts. Today, the Fed is rushing to hike rates to compensate for inflation. I do believe rates will peak in the low to mid 5% levels in 2023 and remain at those levels through 2023. We may see rate cuts at the end of 2023, but I think we’ll likely be in a high-rate market until 2024.
Inflation will likely persist well through 2023, granted it will hopefully improve progressively. October’s CPI report came in 20-basis points lower than expected, pegging inflation at 7.7%. As rates stay elevated, we can expect CPI reports to continue to improve. November’s CPI report should come out around December 10th – 15th, which will provide better insight into the trajectory of inflation. A big variable to consider is the fact that U.S. inflation is tied to global economics. The Russian-Ukrainian war, China’s inability to contain Covid-19, and global supply chain issues are all contributors to the inflation crisis in the U.S. Economic instability across the globe will delay the stabilization of U.S. inflation, regardless of interest rates. I expect inflation to continue to improve, albeit rather slowly.
While this information isn’t good news for Capital One or its investors, the company’s recent performance makes me confident it will be able to weather the storm.
Positive takeaways from Capital One in uncertain market:
It is clear that macroeconomic headwinds have taken a toll on Capital One; however, the company has produced some impressive results. Average loans held for investment increased $14.1 billion to $300.2 billion, representing a 4.9% increase. Average total deposits increased $6 billion to $311.9 billion, representing a 1.96% increase. Considering the state of the economy, loan and deposit growth is nice to see. Revenue growth has also been strong, as 3Q22 is up 12.45% on a YoY basis. Capital One’s net charge off rate for 3Q22 came in at 2.25%, up roughly 50% from 3Q21; however, considering rates are up roughly 1,500% during the same time frame, I find Capital One’s charge off rate to be acceptable.
Capital One is a value play at current price levels:
Capital One is trading well below its average valuation multiples:
- Average P/E is 12.5. Current P/E is 4.63.
- Average P/FCF is 6. Current P/FCF is 3.98.
- Average P/BV is 0.9. Current P/BV is 0.7.
- Average P/TBV is 1.2. Current P/TBV is 0.98.
Based on averages, one could say that Capital One is roughly 20% – 50% undervalued. I am particularly attracted to the fact that Capital One is trading below its tangible book value. Theoretically, an investor would be guaranteed a 2% return at current price levels if Capital One liquidated. I don’t find many investments with a rapport like Capital One trading under tangible book value.
As I address above, rate and inflation headwinds are likely to linger for some time. I’ve calculated the amount of net income that has been lost for every 25-basis point rate hike, as well as the spike in net charge offs. For every 25-basis point hike in rates, Capital One’s net income falls 3.03% and net charge offs increase by 3.33%. Rates are expected to reach a range of 5% – 5.25%, translating to five more 25-basis point hikes. I’d like to mention that hikes are coming in the form of 50 – 75-basis point hikes; however, I’m breaking it down by 25-basis points. Using this data, I’m forecasting net income to fall an additional ~15% and net charge offs to rise by 16.67% when rates hopefully peak in the low 5% range.
Net income is down ~45% on a YoY quarterly basis, while the stock is down ~44% for the same time frame. Should this pattern continue, Capital One’s stock has another 15% to drop as rates rise, translating to a price of $79.5 per share. I’m going to lay out some forecasted post-rate hike figures, assuming two more 50-basis point hikes and one 25-basis point hike.
- *4Q22 net income: $1.592B. *1Q23 net income: $1.497B. *2Q23 net income: $1.452B.
- *2Q23 TTM net income of $6.235B. *2Q23 TTM EPS of $16.33. *P/E of 5.72.
I’d like to note that I didn’t apply this to free cash flow or address the net charge off rate. Free cash flow has actually grown on a YoY quarterly basis, while the net charge off rate would come to ~2.63% with rates in the low 5% range. I’m using net income and earnings because the market generally follows earnings more than free cash flow. Also, the stock price movements have been directly correlated with the fall in net income.
My point with this data is that Capital One is still trading well below its average valuation multiples with significantly reduced earnings figures. Also, at lower prices, Capital One becomes more attractive as it will be trading further below book and tangible book value. A very modest fair value for Capital One would to be trading at 7 times forward EPS estimates of $16.33, translating to a price per share of $114.31. Again, I find that to be extremely modest and still points to 21% upside after accounting for higher rates, charge off rates, and lower net income. You’d also be buying a discounted book. I am generally bullish on Capital One. However, I do believe shares will decline more. I am comfortable buying at current price levels, but anything below $85 per share is a strong buy in my opinion.
Risk factors to monitor:
The primary risk factors to consider with a Capital One investment are addressed in my ‘rate hikes and inflation will likely persist through 2024’ paragraph above. Higher interest rates and inflation don’t mix well with corporate bottom lines. While higher rates promote better net interest income, they also spike defaults; a double-edged sword for Capital One and its investors.
Another risk factor to monitor is going to be Capital One’s CET1 ratio. This ratio measures Capital One’s capital against its risk weighted assets. The CET1 ratio was put in place following the housing crisis to ensure that banks can withstand financial distress. According to the Federal Reserve, Capital One has a minimum CET1 ratio requirement of 7.0. Capital One’s CET1 ratio of 12.2% is 74.3% higher than the requirement; however, it has also fallen more than 10% from a year ago. There’s currently no room for concern here, but it’s an extremely important ratio to monitor to ensure Capital One can withstand continued headwinds.
Capital One’s liquidity reserves and liquidity coverage ratio should be monitored as well. Sufficient liquidity coverage is imperative, as it measures an institution’s ability to cover cash outflows and short-term financial obligations. Capital One currently has liquid reserves of $92.8B and a liquidity coverage ratio of 139%. The coverage ratio is fine and has only come down 4% from 3Q21; however, liquid reserves have fallen 25% from $124.393B in 3Q21. Something to note is that Capital One has seen liquid reserves fall substantially, while its coverage ratio has remained quite stable. The only way this is possible is by altering short-term obligations. Capital One’s financial statements reflect a ~$6B reduction in the non-current portion of long-term debt with ~$3B in new debt issuance, indicating Capital One has financed new debt. This isn’t a big problem, but financing new debt in a high-rate market is never ideal. This should be monitored to make sure Capital One doesn’t make a habit of financing new debt to maintain sufficient liquidity coverage.
I am ultimately bullish on Capital One and believe it’s a great value play, even at current price levels. I am inherently a long-term investor and don’t mind watching a stock fall 15% from my purchase price if I firmly believe long-term results will be superior to market averages. That said, I do believe there is roughly 15% – 20% downside potential at current price levels. My analysis above breaks down why.
Conclusion:
In conclusion, Capital One’s stock is one with tremendous deep value. After accounting for future bottom-line shortfalls based on past data, Capital One would still be trading well below its historical average valuation multiples. The company is also trading under book and tangible book value, offering a great deal of value to prospective investors. Aside from some likely setbacks in the near future, Capital One stock appears to be a great long-term investment in the financial services industry for almost any portfolio. While I’m bullish on Capital One at current price levels, I recommend initiating a position at price levels below $85 per share.
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