Quick Thoughts – COF: A Reassuring Voice on US Consumer Credit

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Howard Mason

203.901.1635

January 27, 2016

Quick Thoughts – COF: A Reassuring Voice on US Consumer Credit

Credit – Lower Energy a Net Positive for Consumer Credit

With the Dallas Fed reporting over the last few days on deterioration in the Texas economy across both manufacturing (where the production index fell to a contractionary minus-10 in January from plus-13 in December after improving through the fourth quarter) and services (where the revenue index fell to 10 in January from 15 in December suggesting slowing growth in activity), Capital One’s earnings call on Tuesday evening was timely not only for the view into the company but also for the read-through to credit conditions more generally.

COF has ~7% of its North America card and auto loans in Texas (although CEO Rich Fairbank, presenting a finer-grained analysis, indicated that ~5% were in energy-dependent regions including Houston, North Dakota, and Canada’s Alberta province) and, as a card lender, has access to important leading indicators of credit quality including purchase volumes, payment rates, and delinquency rolls. It was reassuring, then, that the company re-affirmed guidance for the 2016 loss ratio in North America card at ~4% and indicated that low energy prices, while creating stress in energy-dependent geographies, would likely be a “net positive” for consumer credit. Management added that there had been delinquency “upticks” in energy-dependent geographies but that, on a national view, core drivers of consumer credit quality – employment, home prices, and confidence – remained supportive despite volatility in the financial markets.

As to commercial credit quality, $190mm of the present $604mm loan loss allowance for the commercial bank is allocated to E&P and OFS[1] borrowers (and represents 6.1% of balances of $3.1bn). Given year-to-date declines in the oil price, it would have been $50mm higher if established today. Tax-effected, this increment represents 6 cents/share and would have reduced reported EPS, net of adjusting items including those related to the closing on December 1 of the GE Healthcare portfolio acquisition, from $1.67 to consensus of $1.61.

Interchange Risk with Large Merchants

We have not heard COF comment as explicitly on interchange risk as it did yesterday.

For context, net interchange increased 11% in FY2015 against growth in purchase volume of 21% as the industry continues to upgrade rewards offerings for transactors and extend rewards offerings to high-end revolvers. Our thesis has been that the balance-of-power in payments is shifting to merchants from issuers (with the transition to digital payments and given the merchant payments consortium, MCX) and that gross interchange rates, having increased over the last decade, will begin to decline. While not endorsing this view, CEO Rich Fairbank commented on the need to monitor interchange risk as “a few of the larger merchants have negotiated lower interchange … and also we’re watching the evolving digital marketplace for payment alternatives and any impact there on interchange or disintermediation”.

Outlook and Valuation

We expect COF to maintain the 2015 return on tangible equity of 12-13% generating a price-target of $90 (as ~1.3x tangible book value/share of $58). There are puts-and-calls on this profitability with rising provisions across all businesses and a headwind in the consumer bank from declining auto-margins as the business normalizes from high post-GFC returns and with a mix-shift to prime as COF becomes more cautious in sub-prime (with sub-prime originations falling in Q4 after being flat for several quarters). Against that, card returns have been suppressed by the front-loading of costs as COF returned to growth beginning 2014H2 and this affect will anniversary. Furthermore, the mix-shift to card in the overall portfolio will tend to lift returns as, in 2015 for example, domestic card grew 13% while the overall portfolio, excluding GE Healthcare, grew 6%.

Finally, COF guided to some improvement in the efficiency ratio in both 2016 and 2017 from a base-level of 54.3% in 2015, and positive operating leverage in card as digital investments increase productivity in servicing and infrastructure and as card-industry loan growth improves (currently running about 5% year-on-year). These comments on efficiency will reassure investors concerned that strategic commitment to digital innovation is over-riding expense discipline.

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, BAC, WFC, and GS.

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