Capital One's Curious Valuation Seems To Be Predicting Tougher Times

 

Enlightened paranoia is a valuable asset when it comes to investing - if something looks too good to be true, it often pays to thoroughly reexamine your assumptions rather than just assume the market has it all wrong. That brings me to the curious case of Capital One (NYSE:COF). I understand concerns that charge-offs and delinquencies will get worse from here, but relative to a healthy labor market and conservative reserving, the valuation here seems to be pricing in some really tough times ahead.

Capital One came through the pandemic-driven downturn in better shape than I'd expected, and in better shape than management had expected given initial reserving decisions. The shares have risen around 90% since my last update - okay relative to large banks, about on par with American Express (AXP) and Discover (DFS), and better than Alliance Data (ADS) and Synchrony (SYF), but the shares have significantly underperformed large banks (by more than 20%) since August of 2021.

I find the valuation curious. Maybe I'm missing something, but even in the context of inflation and credit normalization, the valuation here is pretty appealing if Capital One can generate normalized core earnings growth in the neighborhood of 5%.

 

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Capital One's Curious Valuation Seems To Be Predicting Tougher Times

Slow Progress Not Getting The Job Done For Citigroup Shares

The year-to-date performance of the banking sector hasn’t been all that impressive, as the benefits of higher rates and loan growth seem to be largely priced into market expectations and investors don’t see any particularly exciting near-term drivers. Even against that backdrop, Citigroup (NYSE:C) has continued to deliver lackluster performance, with the year-to-date performance only slightly exceeding Wells Fargo (NYSE:WFC) and trailing the likes of JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC), PNC Financial Services Group (NYSE:PNC), and Capital One (NYSE:COF) (the latter arguably being its best/fairest peer comparison).

Although I think there is significant long-term value in Citi shares even if management falls short of its near-term/intermediate targets (something that the share price already seems to reflect as a given), it’s harder to make the case for near-term outperformance given the bank’s heavy reliance on cards (as opposed to business or mortgage loans) and the fact that a lot of the expense/efficiency benefits won’t show up until 2019 and 2020. Even so, I still believe patient shareholders can be rewarded here, and I think the shares are undervalued below $80.

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Slow Progress Not Getting The Job Done For Citigroup Shares

JPMorgan Benefiting From Calm Credit, A Strong Competitive Position, And Potential Catalysts

Among the larger banks, JPMorgan's (NYSE:JPM) post-election performance has been on the higher side of average (up about 25%), but the shares have been a standout (along with Bank of America (NYSE:BAC)) over the past year as the bank has been leveraging its strong market share and competitive positions as it waits for rates and economic conditions to improve.

Credit quality has been good and likely can't get much better, but loan demand can improve if the economy grows from here and higher rates should drive better spreads. What's more, JPMorgan and the rest of its large bank peers could be in place to benefit from a less stringent regulatory environment and a lower tax rate. While the shares look priced for a high single-digit return absent a meaningful reduction in the bank's tax rate, a meaningful reduction of the tax rate could drive a fair value into mid-to-high $80's.

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JPMorgan Benefiting From Calm Credit, A Strong Competitive Position, And Potential Catalysts

Seeking Alpha: JPMorgan's Steady Progress Not Fully Rewarded

It may be boring, but JPMorgan Chase's (NYSE:JPM) ability to deliver on the "blocking and tackling" issues identified by management continues to build value for long-term shareholders of this enormous financial institution. More specifically, JPMorgan's management has managed to reduce its GSIB buffer and make progress on cost reductions while simultaneously driving above-average loan growth.

These improvements have led me to adjust my revenue and earnings targets, as well as the company's risk premium, and those improvements support a higher fair value. JPMorgan definitely has a delicate balancing act to maintain between further reducing its buffers and costs and not alienating customers, not to mention balancing the risk of expanded credit and credit losses, and maintaining leading market share in multiple businesses without getting dragged into a race to the bottom on pricing.

JPMorgan appears to be handling this balancing act with considerable skill. Given that, as well as the higher fair value and a generally "meh" attitude towards banks over the past six months, I think JPMorgan is looking a little more interesting as a new buy.

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JPMorgan's Steady Progress Not Fully Rewarded

Seeking Alpha: Old Faithful Portfolio Recovery Associates Does It Again

The kind of performance Portfolio Recovery Associates (PRAA) delivers just doesn't get boring. Although debt recovery is not a well-liked business by any stretch, PRA has done a remarkable job of refining its model so as to identify only those who can pay their debts, and the extent to which those customers are likely to respond to particular collection methodologies. Moreover, PRA has done a very good job of adhering to above-average standards such that it is one of the preferred buyers in the market and a likely beneficiary of rule/regulatory changes that could push some competitors out of the market.

Still, it's not as though the shares are notably cheap. The valuation model I use is very sensitive to changes in inputs like collection rates and discount rates, but almost all of the results end up falling into a valuation range of about $150 to $175. Further consolidation in the debt collection space and/or continued outperformance on collections and collection efficiency could certainly make those estimates conservative, but it's hard to see enough margin of safety here for me to recommend new investors make big purchases at these prices.

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Old Faithful Portfolio Recovery Associates Does It Again

Seeking Alpha: Hancock Holding Needs To Marry Better Performance With Its Good Footprint

While speculating on where people are going to want to live in five, 10, or 20 years' time may be enjoyable as a thought-exercise, it's not really a good thesis for investing in any particular company. That said, I believe that Hancock Holding's (HBHC) footprint across the Gulf Coast states is an attractive one on balance, and one where ongoing population trends and the dynamics of the U.S. energy industry are likely to create an attractive operating environment.

Although Hancock's location may be good enough, the recent performance hasn't been. This bank has made something of a habit lately of missing expectations, with weak internal loan growth, higher than expected margin compression, and non-interest expenses weighing down results. A cost-cutting program and sizable share buyback offer some support, but it looks like the valuation here already presupposes better results in the coming years.

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Hancock Holding Needs To Marry Better Performance With Its Good Footprint

Investopedia: Core Growth At Wells Fargo Is Weak, But The Multiple Doesn't Look Demanding

During bull markets, investors typically prize growth more than anything and that would seem to explain a lot of the relative valuations I'm seeing in the banking sector these days. To wit, investors don't seem nearly as concerned about quality or long-term business prospects as the they do about the near-term growth and capital returns potential. That may be frustrating for Wells Fargo (NYSE:WFC) shareholders in the short term, but I think it does leave some long-term potential in the shares today.

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http://www.investopedia.com/stock-analysis/041213/core-growth-wells-fargo-weak-multiple-doesnt-look-demanding-wfc-jpm-bac-usb.aspx

Investopedia: Where Does A Bruised JPMorgan Go From Here?

Reputation is a delicate thing, and in less than one quarter JP Morgan (NYSE:JPM) has lost much of the luster it built during the credit crisis. While management has apparently acted quickly to mitigate the damage of a large bad trade, the slow pace of recovery in its core banking business makes it harder to take up the slack. Although investors can certainly find value in JP Morgan at current prices, risks remain from scandals like the LIBOR rigging and a potential worsening of credit conditions if the economy slows significantly

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http://stocks.investopedia.com/stock-analysis/2012/Where-Does-A-Bruised-JP-Morgan-Go-From-Here-JPM-C-USB-COF0716.aspx

Seeking Alpha: Steady As She Goes At Portfolio Recovery Associates

When it comes to buying charged-off debts and then trying to collect them, surprises are seldom ever a good thing. So it's probably just as well that Portfolio Recovery Associates (PRAA) offered few surprises this quarter. This company is always going to be controversial - the accounting is confusing for those unaccustomed to it, the IRS is investigating the company's tax calculation policies, there's more regulation and oversight coming, and it's an inherently difficult thing to collect on debt.

All of that said, PRAA is one of the best at what it does and there's more than enough room for the company to continue growing.

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Steady As She Goes At Portfolio Recovery Associates

Seeking Alpha: Unsavory Business And Murky Accounting Undervalue Portfolio Recovery

At the risk of climbing on a soapbox, isn't it interesting how people generally expect others to honor their obligations to them, but they get quite resentful when they are held to account on their own obligations? Portfolio Recovery Associates (Nasdaq: PRAA) is the largest publicly traded pure-play in a very unsavory business – debt collection. Not only does PRA have to contend with trying to get money from people who either cannot or do not want to pay, but the company is further burdened with an ever-shifting legal, legislative, and accounting environment. Perhaps it's little wonder then that these shares look quite cheap.

A Vital, But Disliked, Link In The Credit Chain
The availability of capital is predicated on the idea that lenders get their money back and/or can avail themselves of legal remedies to secure repayment. If borrowers are allowed to default and walk away too easily, the price of money shoots up and the availability drops. To that end, Portfolio Recovery occupies an important niche in the credit chain – PRAA buys up receivables that creditors could not not collect, takes the risk upon itself, and profits if it can be more successful in securing repayment.

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Unsavory Business And Murky Accounting Undervalue Portfolio Recovery

Seeking Alpha: JPMorgan Chase Has Value But Little Momentum

There may be plenty of apparent values in the banking sector these days, but investors aren't biting. Take the case of JPMorgan Chase (NYSE: JPM) – most analysts seem happy enough to crown them as the best-run major bank in America, but that didn't keep the stock from losing about 20% of its value in 2011. At least part of the problem here is timing and the absence of any real near-term momentum. Although there are plenty of long-term factors in the bank's favor, the list of what could go wrong in the short term is a fair bit longer than the list of things that could go right.

Good Capital … Or Is It?

Unlike major rivals like Citigroup (NYSE: C) and Bank Of America (NYSE: BAC), JPMorgan has been lauded for how it managed its credit exposures through the crisis and recovery. In terms of metrics like Tier 1 capital, JPMorgan does look to be reasonably well off and credit losses have been improving apace.

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JPMorgan Chase Has Value But Little Momentum

Investopedia: Discover Still A Little Underappreciated

Discover Financial Services (NYSE:DFS) is really no longer the plucky up-and-comer. It's getting to the point where merchant acceptance of the Discover card is much more common than not, and the company is certainly a viable alternative to American Express (NYSE:AXP) when it comes to closed-loop systems. That said, the company still lags MasterCard (NYSE:MA) and Visa (NYSE:V) meaningfully, and investors have to balance out the potential benefits of future growth and M&A with the credit risks inherent to the business model.

A Solid End to the Year 

Discover's fiscal fourth quarter results ended the year on a relatively strong note. Revenue rose 13% as reported, with net revenue rising almost 23% from the year-ago level. Although the company's net interest income and margin was a little sluggish, that had a lot to do with student loans that the company acquired. Other metrics were pretty solid; receivables were up about 1%, credit card loans were up 3% and card sales volume was up 8% from last year.

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http://stocks.investopedia.com/stock-analysis/2011/Discover-Still-A-Little-Underappreciated-DFS-AXP-MA-V1219.aspx

Investopedia: Can Capital One Get Real Value From ING Direct?

Capital One (NYSE:COF) has seemingly always been on the hunt for more loanable funds, and the company has taken a big swing with its acquisition of ING Groep's (NYSE:ING) ING Direct. While there is no question that this acquisition will give Capital One a much larger deposit base, it is not so obvious that the company will turn this into a value-additive deal. (For more on how this deal and others are valued, check out Analyzing An Acquisition Announcement.)


Terms of the Deal
Capital One agreed to pay $9 billion for ING's U.S. online banking operations, with $6.2 billion of that coming in the form of cash. With the remainder in stock, ING will be a major shareholder of Capital One. At close to 1 times tangible book value, it may not seem like Capital One is paying all that much, but investors should remember that ING was a highly motivated seller - divesting ING Direct was a requirement as part of the company's bailout.

What Capital One Is Getting
With this deal, Capital One adds about $80 billion in deposits to its franchise and returns to the mortgage business. While Capital One already had its own online bank, ING Direct is arguably the best-known operator of online savings accounts and may enjoy some brand value and distinction. Unfortunately for Capital One, the branch-free model at ING Direct is not quite as profitable as some might imagine and pre-provision earnings of $630 million is not a compelling return on capital. (To help you determine if this acquisition is going to be a success, read What Makes An M&A Deal Work?)

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http://stocks.investopedia.com/stock-analysis/2011/Can-Capital-One-Get-Real-Value-From-ING-Direct-ING-COF-HBC-ZION-AXP-DFS-PNC0622.aspx

Seeking Alpha: A First Glance At JPMorgan Earnings Is Somewhat Encouraging

JPMorgan (JPM) gets a lot of press for being one of the best-run large banks in the country, and that praise is well deserved up to a point. Like virtually every bank earnings report these days, there are certainly some areas of trouble and concern, but overall the results would seem to offer a strong validation for how CEO Jamie Dimon positioned the company both for the credit crisis and the recovery. 

Overall the company did report some upside in total revenue (around $500 million depending upon whose “average” estimate you use) and earnings were $0.12 ahead of average expectations. JPMorgan saw about a three-cent net benefit from special items, so overall profitability was solid. Details matter, though, and a large part of JPMorgan's outperformance was due to the investment banking operations.

I-Banking A-Ok
Investment banking was the only area to show sequential revenue growth and a clear area of strength for JPMorgan this quarter. Although banking fees were down a bit, trading was exceptionally strong this quarter – defying the expectation of generally weak trading results from big banks this quarter.


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A First Glance at JP Morgan Earnings Is Somewhat Encouraging

Seeking Alpha: Big Banks Winners And Losers In Q1

With the first quarter in the books and reporting about to start, it seems like a good time to consider what could be in store for some of the country's largest banks. Bank of America (BAC) and JPMorgan (JPM) will be among the first major banks to report, and their results and guidance will no doubt set the tone for this sector.

General Thoughts

On the positive side, the banking sector most likely saw ongoing improvements in credit and investors should expect lower provisions. That will mean that reserve releases will once again play a large role in the extent to which banks outperform published estimates, and while they may lead some commentators to carp about earnings quality, it is nevertheless better than the alternative.

Credit and debt markets have been strong, and that would seem to be a positive for those banks with larger holdings of securities as a percentage of earnings assets. On the above-average side sit JPMorgan, Citigroup (C), and Bank of America (all of which are also very active in trading), while U.S. Bancorp (USB), BB&T (BBT), and Wells Fargo (WFC) have relatively less exposure.

That said, the outlook for trading revenue does not look so strong and overall investment banking revenues could be a little iffy, as weak equity underwriting may limit upside to the healthy M&A market. That is not a major factor for U.S. Bancorp, BB&T, or PNC (PNC), but will be more significant for JPMorgan, Citi, and Bank of America.

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Big Banks Winners and Losers in Q1

Investopedia: Discover - A Cleaner Play On The Consumer Recovery

Sometimes it feels as though Congress and federal regulators are trying to bleed out major banks through dozens and dozens of regulatory papercuts. On top of that, there is still a lot of overheated rhetoric about the "evils" of large banks that hearken back to the populist movements of the late 19th century. That may all be an advantage for Discover Financial Services (NYSE:DFS), then, as this relatively purer play on credit cards may have fewer restraints on its day-to-day operations. 

A Solid Recovery Continues 

Like its banking cousins, Discover is continuing to benefit from a much-improved credit environment and that is funneling through to the bottom line. Growth was not necessarily all that impressive in its own right, though. Total revenue rose about 3% from last year (or about 4% sequentially), fueled by a 2% rise in net interest income (up 4% sequentially). Within that, card sales volume was up 7%, but credit card loans were down 3% while total loans rose on higher student loan numbers.

Credit was once again a good story. Write-offs dropped almost a full point sequentially and more than three points on a year-over-year basis. That fueled a lot of the outperformance this quarter, as the company reversed a year-ago loss and beat the average estimate by a wide margin.

Interestingly, fee income is going nowhere fast at Discover. That is interesting as Discover "under-fees" its customers relative to the likes of American Express (NYSE:AXP) or Capital One (NYSE:COF), and this would seem to be an opportunity for growth in the future. On the other hand, with regulators looking to hammer the fee income of companies ranging from AmEx to Mastercard (NYSE:MA) to US Bancorp (NYSE:USB) to Visa (NYSE:V), maybe Discover's low fee revenue is a point of positive differentiation.

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http://stocks.investopedia.com/stock-analysis/2011/Discover-A-Cleaner-Play-On-The-Consumer-Recovery-DFS-AXP-COF-MA-USB-V-VZ0324.aspx

Quick Thoughts On JPMorgan Earnings

All in all, JPMorgan (NYSE: JPM) reported pretty decent earnings this morning. The company beat the consensus number by $0.12, with about $0.06 of that coming from actual better-than-expected operating performance.

Net interest income was down about 3% sequentially (not so good), but investment banking was pretty strong (positive). The company also had a lot of shuffling of reserves - adding $2.1B in reserves to WaMu's credit book, adding $1.5B to litigation reserves, releasing $2B in reserves tied to credit cards, releasing $1.2B in reserves tied to the bank's core mortgage portfolio (its own mortgages, not WaMu's), and recognizing $1.2B in securities gains.

Non-performing assets were down 6% on a sequential basis (though still quite high at $16.6B), while consumer NPLs were down about 10% (and wholesale were up 6%).

So, bottom line(s):

- A good quarter, but not a blow-out

- Cards continue to recover nicely, and that should be good news for Citi (NYSE: C), Bank of America (NYSE: BAC), US Bancorp (NYSE: USB), American Express (NYSE: AXP), and Capital One (NYSE: COF). Interestingly, but not surprisingly, debtors are making sure they take care of their credit card bills, even while they default on their mortgage (after all, you can't spend a house, right?).

- Lower net interest income and higher losses/charge-offs in commercial real estate are bad news for regional banks. It wouldn't surprise me to see a little concern regarding banks like Comerica (NYSE: CMA), BB&T (NYSE: BBT), Zions (Nasdaq: ZION), Westamerica (Nasdaq: WABC) and so on.

- Loan growth is coming back and losses are getting better. The GSE put-back issue may be close to over (if the Bank of America deal is any indication), and there seems to be increasing clarity on the foreclosure litigation front.

- JPMorgan is moving on to the next phase and figuring out what to do with its capital. I would like to see them get more active internationally, but time will tell if Dimon agrees with me.

I would BUY JPMorgan shares today.

Disclosure: I own shares of JPMorgan and BB&T. 

Discover Shows A Better Credit Environment

Whether or not the recent news that recession "officially" ended a year ago has any meaning or not, it is hard to argue that improving consumer credit trends are not a positive for the economy. When reviewing Discover Financial Services' (NYSE:DFS) August quarter earnings announcement, there are definitely some encouraging signs of improvement.

The Quarter that Was
The number four credit card company - behind Mastercard (NYSE:MA), Visa (NYSE:V) and American Express (NYSE:AXP) - Discover, announced a solid earnings beat for its fiscal third quarter. Earnings were up 73% for the period, handily beating the consensus estimate. Transaction volume increased about 7% in the quarter, an interesting metric for both consumer spending and the company's relative market share. 


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http://stocks.investopedia.com/stock-analysis/2010/Discover-Shows-A-Better-Credit-Environment-DFS-MA-V-AXP-COF-USB-C0922.aspx

Another Solid Performance From PRAA

Portfolio Recovery Associates (Nasdaq: PRAA) is my second-longest held position, and the company has never really given me a good business-related reason to think about selling. The accounting here is admittedly a bit "advanced" and the stock probably is not right for everyone, but it is a business (debt collection) I really happen to like.

Revenue rose 31% this quarter to $93M - about 10% ahead of the hurdle laid out by the analysts. Net income, though, climbed 67% (to $19.5M), and the company's EPS of $1.14 handily beat the estimate of $0.93. Cash collections jumped 42% to $128M, while the company spent $87M on new paper (with a face value of $1.67B).

For the quarter, call center collections (the largest segment; about 42% of all collections) were up 9%, while the company's internal legal collections (an area of growth that the company is focusing on) were up 167% to $11M. For the quarter, 40.1% of cash collections were applied to amortization - down slightly from 40.3% last year, and still pretty high relative to the levels of a few years ago.

Looking out a bit, I do not see any reason to think that PRAA is going to be hurting for product. Major card issuers like US Bancorp (NYSE: USB), Wells Fargo (NYSE: WFC), Capital One (NYSE: COF), and JP Morgan (NYSE: JPM) have a lot of bad credit card paper on their books and they are eventually going to get rid of it - and it stands to reason that if the market leaders have this issue, so too does almost everyone else. So even though we keep reading about declining bad debt charge-offs, that needs to be seen in the context that the absolute levels are still quite high.

On top of that, management says that the purchasing environment is still relatively attractive. This, frankly, is my biggest fear - if the company cannot buy enough charged-off collections at a good price, the future growth of the company gets dicey.

Elsewhere, though, the company's dynamic scoring process still seems to be paying off in terms of enhanced productivity, and the expansion into more bankruptcy business should help. Bankruptcy business is not as lucrative in terms of the ratio of collections to purchase price, but it takes less work to get the money and it offers an annuity-like stream of cashflow.

There is a little external risk here as well. It seems like some states are looking to crack down harder on debt collection. I do not see this being a huge risk to PRAA, though. States generally acknowledge that businesses must be allowed to collect on bad debts, and it is really only the abusive collectors that are at risk. PRAA wisely chooses to avoid that route, so I think more regulation could actually force some companies out of business and reduce PRAA's competition for purchasing charged-off receivables.

PRAA has been on a pretty good tear lately and my old target of $74 does not offer much upside at all. I have not yet run the numbers on a new price target, but I cannot imagine that I will raise it enough that it would be a good idea to recommend others get in at these prices.

That, in turn, is going to lead to some deep thinking for myself - do I go ahead and cash in these shares (and pay the capital gains) and move into a more undervalued-idea, or do I sit tight and accept a lower expected return than I normally take? I always hate selling the stock of companies that are doing well (and have pretty much always done well), so it is not going to be a simple decision.

Disclosure - I own shares of JP Morgan and PRAA.

Wal-Mart's Sort-Of Foray Into Banking

Behold the wonders of the pithy headline. Reading the news over the past couple of days, you would think something big has happened - namely, that Wal-Mart (NYSE:WMT) is getting into the banking business and will begin making small business loans through its Sam's Club subsidiary. 

Not so fast. 

What Is Really Going On
When you look a little deeper, you see that Wal-Mart is actually partnering with Superior Financial Group, a non-bank lender, to offer Superior's financial services through its Sam's Club locations. In other words, by engaging in this move, Wal-Mart is as much a bank as having Verizon (NYSE:VZ) kiosks makes Wal-Mart a cell phone/telecommunications company. 


The full piece is at:
http://stocks.investopedia.com/stock-analysis/2010/Wal-Marts-Sort-Of-Foray-Into-Banking-WMT-VZ-COST-KEY-AXP-COF-WFC0712.aspx