Capital One Financial: Pessimistic Valuation Creates Opportunity (COF)

As we enter 2023, Mr. Market has become very short-term oriented. Most actual business analysts that are looking at Capital One Financial (NYSE:COF), or most of the other bigger banks, would agree that they are deeply undervalued relative to intrinsic value. However, because earnings might temporarily decline due to a weakening economy and normalizing credit losses, few analysts are willing to pound the table as this one writing might be. Capital One is a very good business in a strong competitive position. The earnings power of the enterprise is very robust and the company trades at a price implying substantial losses, as opposed to the strong profits that are likely even in a recessionary scenario. This brings opportunity to the long-term investor willing to stomach short-term pain for the long-term gain.

The last time I wrote about Capital One Financial was in July of 2020, during the heart of lockdowns and the Covid-19 pandemic-driven hysteria, which I’d encourage you to peruse as it provides some context to how mild the current economic crisis is relative to what was transpiring then. What a nightmare it was. Almost immediately, economic activity plunged with virtually no warning. There was zero clarity in terms of when the economy would be allowed to actually recover, or what that would even look like given the unprecedented actions of having the global economy lockdown. The crisis occurred shortly after the very important CECL accounting change was instituted in the very beginning of 2020, which required banks to reserve for total expected losses on the life of the loans, inclusive of periods of time when the economy is in a recession or challenged. Doing this upfront would reduce short-term income and frontload loss provisioning. Expectations of course can change, but by definition, future loss provisioning will be less than it would have been under the prior accounting regime, leading to less volatility in earnings all else being even. When you look at the valuation’s banks trade at though when there is any sign of potential economic crisis, it feels as though Wall Street never got this memo. It is one thing to trade at low multiples at peak earnings, especially if the company is likely to lose money or make very little in a recession due to increased provisioning, but it is a whole other thing to have the multiples reduced dramatically going into what are likely to be trough earnings, which are still going to be quite good. I’d argue the bigger banks have become much more like regulated utilities in that they aren’t capable of earnings the 30% ROTCE’s, but they also are far less risky than they have ever been. Utilities trade at double the valuation, if not more depending on the bank.

2022 saw one of the most aggressive interest rate expansions in U.S. history, which combined with strong loan growth, led to a large increase in preprovision net revenue for the banking industry. This improvement was offset by more normalized reserve provisioning, in comparison to the sugar-high stimulus credit environment of 2021, when credit performance had never been better. Normalized credit has been expected for several years, even before the pandemic, as credit had outperformed expectations time and time again, mostly due to much more conservative loan underwriting. To be clear, we are still far below even 2019 delinquencies and defaults in most cases, which was still a very good credit year for the industry. Unlike most of the last 13 years since the Financial Crisis, banks have higher rates providing a tailwind to their revenues, which obviously is a big deal for companies that make most of their money on net interest income, like Capital One does with its mostly low-cost deposit base. These positive attributes are quite obvious to behold, but still the stocks trade at ridiculous prices as though we are in another 2008. It doesn’t make sense, so you can either be paralyzed by fear, or take advantage of the irrational pessimism.

To make the case for the attractiveness of COF, let’s take a look at the 3^rd quarter income statement. Total net revenue increased 7% sequentially to $8.8B. Total non-interest expense increased 8% to $4.9B. Pre-provision earnings increased 6% to $3.9B, which is the biggest indicator of the underlying earnings power of the franchise. Upon some long-expected credit normalization, the provision for credit losses increased by $584MM to $1.7B, consisting of $931MM of net charge-offs and a $734MM reserve build. The net interest margin increased by 26 basis points to a very healthy 6.8%. So, there you have robust revenue growth aided by strong spending, higher rates, and loan growth, slightly offset by inflationary costs and higher loan loss provisioning. Net income was $1.7B, or $4.20 per diluted common share. If the economy weakens, COF can reduce spending on things like marketing and headcount, while the bottom line would remain profitable even if loan loss provisions doubled in a given quarter from these currently strong levels.

COF ended the 3^rd quarter with a Tier 1 capital ratio under the standardized approach of 12.2%, which is comfortably their ultimate target of around 11%. Period-end loans held for investment increased $7.6B, or 3%, to $303.9B. Period-end total deposits increased by $9.3B to $317.2B. Remember, a big part of my investment thesis is that the impact of CECL accounting is not being given proper credit at current valuations, so it is important to assess what types of reserves are currently on the books to be able to deal with that potential recessionary scenario. COF ended Q3 with a whopping $12.209B allowance for credit losses. The allowance coverage ratios for Credit Card, Consumer Banking, and Commercial Banking, are 6.87%, 2.6%, and 1.45%, respectively. To put these numbers in perspective, at 12/31/2020, the allowance coverage ratios were 10.46%, 3.94%, and 2.19%, respectively. The current economic environment is nothing like what we saw during the lockdowns, or the uncertainty we faced with the fastest rising unemployment rate and steepest drop in GDP we’ve seen in many decades. Even if COF had to get back to those allowance coverage ratios though, it could be done within a few quarters, while remaining profitable over a 4-quarter period. Just like recessionary scenarios are part of CECL reserves during non-recessionary times, a recovery period has to be factored into reserves during recessionary times. The longer the actual credit losses are delayed, the less they ultimately will likely end up being, while the company can keep refining its underwriting to adjust to market conditions. For instance, COF is reducing its auto lending to adjust to near-term market conditions upon declining used car prices. COF is more of a subprime lender in the space, so they are a bit more susceptible to where credit degradation is being seen most clearly. They can now adjust while maintaining amply reserved and focusing on collections.

Many seem to forget that credit losses are function of both defaults and recoveries. Naturally credit card lending has the highest loss reserve and the highest interest rates associated with it. There is currently a lot of hysteria about auto lending, but even if defaults were to increase significantly, losses can be managed via relatively quick repossessions and at least decent recoveries upon the sale of the vehicle. In addition, the banks gained valuable experience during lockdowns in terms of working out solutions for people that couldn’t make their payments. Certainly, those deferment programs were bolstered by government stimulus, but it provided very valuable data and expertise to the banks that I think could be leveraged in a period of future stress. Most importantly, credit losses are largely a function of unemployment rates and underwriting. Underwriting has been very strong since 2008. Unemployment remains persistently low despite the Federal Reserve’s best efforts to overturn the applecart. As long as people have jobs, they are unlikely to give up the keys to their house, or car, and they will usually try to at least make the minimum payments on their credit card. It’s ironic in some ways as stocks have been selling off on good jobs data, including the banks, yet low unemployment is the most important factor in reducing credit losses. I get that the fear is it means more rate hikes, ultimately causing a recession, but a recession seems to be baked into the share prices already, while very little credit is being given to the benefits of higher rates.

At a recent price of $93.98, COF trades at 4.7x its TTM earnings of $20.29 and 5.8x its expected forward earnings. Shares outstanding have dropped from 541.8MM at the end of 2015, to 384.6MM at the end of Q3. COF has earned $14.84 per share just over the last three quarters despite a more normalized credit environment, and loan loss provisioning in anticipation of a more challenging economic forecast. The stock yields roughly 2.55% and the tangible book value per share of $81.38, already reflects a significant impact from rising rates reducing the value of the assets on the balance sheet, as tangible book value per share stood at $99.74 at the end of 2021. COF has a proven track record of generating a double-digit ROTCE over the cycle and I think it is well poised to continue doing so. Long-term investors should take advantage of the discount currently being offered. For more conservative investors, a cheaper price can be manufactured from the sale of a put option. For instance, the January 2024, $80 put option is selling for around $8.00 per share. If COF stock trades above $80 at expiration, the put would yield a return of around 11%. Your worst-case scenario is if the stock trades below $80 at expiration, you’d end up owning COF at a breakeven price of $72.00 per share.