CAPITAL ONE FINANCE CORPORATION
Section I:
Security Analysis Report
Section II:
Earnings Model
Section III:
MS Powerpoint Presentation
CAPITAL ONE FINANCE CORPORATION:
EARNINGS, FINANCIAL STATEMENT,
AND VALUATION MODEL
BY: Ronald A. Garrick
KEY ASSUMPTIONS
Forecasting Variables:
1) Federal Funds Rate-
Used to Forecast:
Rationale:
Interest Expense
2003: Data from the annual report regarding average Federal Funds Rate.
2004: Conservative forecast of 1/4 point increase.
2) Provision for Loan Loss to Total Loans- Prov-Loan Loss
Forecast is for a modest reversal of trend in 2003 due to improving economic
conditions.
3) Interest Margin-
Interest Income
Expected continued down-trend due to high competition in prime and superprime lending segments.
4) Dividends-
Dividends
Earnings x Historical Payout Ratio.
5) Other Income-
Other Income
Primarily fee and service income. Growth should slow under improving
economic conditions. This is Represented by holding constant as percentage of
sales.
6)
Other Expense-
Other Expense
Primarily collections from delinquent accounts. Growth should slow during
times of economic improvement. Held constant to represent slowing growth.
7)
Debt & Equity-
L-T Debt &
Common Stock
Cash flow forecast justifies no increase in either category. However, slight
increase in debt forecast due to expectation that company remains in a growth
posture.
8)
Other Forecasts-
Other items
Reasonable assumptions based on historical data or trends.
SUMMARY OF RECOMMENDATION
Recommendation:
Underweight
Reasons for
recommendation:
1. Saturation in Capital One's target market will continue to apply pressure on
interest margins;
2. The relative attractiveness of value opportunities versus growth
opportunities;
3. Lack of justification for valuation above historical standards.
Catalysts:
1. Cyclicality of industry will positively affect earnings through reduction of loan
Losses (positive effect);
2. Increasing auto- and international lending will drive future earnings growth (positive
effect);
3. Interest rate environment continues to support depressed interest margins (negative
effect).
Target Price:
$61.46
COMPANY OVERVIEW
Capital One Finance Corporation is one of the top six credit card issuers in the U.S. and one of the leading providers of Visa and
Mastercard products in the world. As of September 30, 2003, the company handled 46.4 million customer accounts worth approximately $67.3
billion (COF Press Release- 29 Oct 2003).
This diversified financial company's primary operation is consumer lending with a focus on credit card lending. Auto loan financing and
international consumer lending comprise the remainder of the company's key operations. Capital One is organized into three distinct segments:
consumer lending, auto financing, and international finance. The company has several key subsidiaries charged with the execution of these
segments. Capital One, F.S.B provides consumer lending and deposit services and is responsible for the bulk of the company's domestic consumer
lending operations. Capital One Auto Finance Group handles auto loan services and has as its subsidiary Peoplefirst, Inc. to provide internet
services for the booking of on-line auto loans. Capital One Bank Plc (Europe) is responsible for all consumer loan services for the international
segment. Currently, international lending is focused on Canada and the United Kingdom, however, efforts are underway to broaden these services
throughout the whole of Europe.
Capital One Finance employs an information-based strategy (IBS) to match customer profiles with appropriate products and services. The
company has harnessed database technology to create a "mammoth" and comprehensive database system that provides highly customized product
offerings to customers and potential customers. Management describes this as a strategy of "mass customization" of consumer lending. This
highly integrated information technology system also provides the company with the capability to optimize marketing, responsiveness,
underwriting, risk management, and collections and recoveries. The collective capability of Capital One's information management system, or the
IBS, is the company's sustained competitive advantage. This competitive advantage allows the company to achieve a sense of focus on a customer
segment without having to actually focus on only one or a few segments. At the same time the company, through its information technology, can
compete at costs. This is important in an industry in which product differentiation is negligible.
ECONOMICS, CAPITAL MARKETS, and STYLE ANALYSIS
Economic Outlook:
The current economic landscape is forecast to be one of growth with low inflation. Actual GDP is expected to grow at a nominal
annualized rate of 4% to 4.5% during 2003 and 2004 (Goldman-Sachs Pocket Chartroom, CBO). The chart below shows the 2003 and projected
2004 nominal GDP growth:
Nominal GDP Growth
GDP Growth
8.0
6.0
4.0
2.0
0.0
2003 Q1 2003 Q2 2003 Q3 2003 Q4 2004 Q1 2004 Q2 2004 Q3 2004 Q4
Source: Goldman Sachs Pocket Chartroom September/October 2003; Congressional Budget Office.
Potential GDP is expected to grow at an annualized rate of 3.3%. This will represent a slight decrease in the GDP gap through 2004
(actual GDP = 4%). This slight decreasing of slack in the economy supports a potential decrease in unemployment during 2004 without the
concern of inflationary pressures. The GDP gap is expected to persist, however, so the unemployment rate is projected to drop only slightly before
stabilizing at around 6%. Inflation is expected to remain stable at about 2%.
Both fiscal and monetary policy is expected to be expansionary through 2004. Tax cuts and moderate increases in federal spending, led by
defense spending, are expected to lend support to GDP. The Federal Reserve is expected to stand still on interest rates possibly until 2005. There
are several key reasons to believe the fed will maintain an expansionary posture. First, concerns continue to linger regarding the possibility of
deflation as core inflation has yet to reverse its downward trend. Second, as evidenced earlier, the GDP gap is expected to persist which will keep
downward pressure on prices. Given the current projected potential and actual GDP numbers, it is not expected that the GDP gap will close
sufficiently to create inflationary pressures until 2005. The Federal Reserve's main concern is and will continue to be to avoid any possibility of
deflation. Therefore, interest rates are expected to remain stable at or near the current rates at least until the second half of 2004. A conservative
estimate for a 1/4 point interest rate increase is expected for late 2004.
It is concluded that the economy is in the early stages of recovery from a soft landing recession. The economic forecast is for the
economy to continue this recovery and move from its current state of low growth and low inflation to one of high growth with low inflation. It
will remain that way until actual GDP growth closes the gap with potential GDP and applies upward pressure on prices and ultimately interest
rates. It is expected that the high growth economic recovery will last about two years, at which time restrictive monetary policy may again be
necessary. Below is a summary of key economic projections for 2004:
GDP Growth
Potential GDP Growth
Unemployment Rate
4-4.5%
3.3%
6%
Inflation
Federal Funds Rate
2%
1.25%
Capital Markets Outlook:
The stock market's relative performance versus other investment assets is a function of stock market dividends, earnings growth, and
valuation measures. Dividend and earnings growth are driven by growth in corporate earnings, which is, primarily, a function of certain
macroeconomic factors. Most important among these economic factors are: GDP growth, interest rates, and inflation. As discussed earlier, it is
believed that these key economic variables are going to lend strength to equities. Earnings and dividends should feel positive effects from the
recovering economy. The chart below shows the estimated growth rate for the S&P 500 vs. GDP growth. One can see that, in general, high GDP
growth supports higher growth estimates for equities. Given the economic predictions, it is expected that the growth rate for the S&P 500 will
achieve growth at or above its historical mean. As such, we can expect dividend yields and earnings to grow commensurately providing impetus
to the recovering market.
Valuation Analysis:
VALUE APPROACH: The price-earnings and price-sales ratios are useful tools in assessing market valuations under a value approach.
As can be seen in the chart below, the P/E ratio has reversed its downward trend and appears to be heading back towards its historical mean. The
growth rate of earnings are crucial to the growth of P/E multiples. Though they have not begun to revert to the mean, they are expected to do so as
the recovery picks up steam. Given that earnings estimates are well below historical standards, one would expect a strong turnabout in the near
future. The market is undervalued according to its current P/E ratio.
The price/sales ratio is largely dependent on the expected performance of net margin. Using the charts below, we can see that net margin is at its
historical mean suggesting the possibility that price/sales, as a valuation measure, has somewhat equal upside and downside potential. Given the
expected state of the economy, however, it seems quite plausible that net margins will continue the upward trend lifting price/sales to or above
historical standards.
Using a valuation approach, it appears that the market is still the most attractive asset class. Although the performance of the
market in 2003 has absorbed a considerable amount of value in the market, there still appears to be considerable upside potential in equities.
GROWTH APPROACH: The growth approach uses price and earnings momentum to assess current trends. As the chart below shows, earnings
estimates for the S&P 500 are still being revised downward for FY 2003 and FY 2004, however, it appears that the momentum changed and
reversed in August. This is a bullish signal.
Using the price momentum index to assess the momentum of the S&P 500, we can see that the time-disparate moving averages are nearly
1 standard deviation apart. The market, according to this measure, is very near an overbought condition even though it appears to have slowed and
stabilized.
Using a growth approach we can also conclude that the market currently has enough upside potential to make equities attractive. S&P
earnings revisions appear to be following a typical cyclical trend. If this is the case, downward revisions should continue to slow until they
become positive. As this revision trend improves, the S&P 500 should also improve from a growth perspective.
Style Analysis:
The economic landscape plays a crucial role in determining which investment style is expected to outperform. The most important
economic factors to style analysis are business cycle phase (GDP), the monetary environment, and inflation. Each of these economic factors
has a unique relative impact on the prices of issues considered to be 'value' and those considered to be 'growth'.
The most comprehensive tool in analyzing those factors is the treasury yield curve. The current treasury yield curve is a steeply sloping,
normal yield curve. This type of yield curve is associated with an economic recovery phase generally characterized by high growth and low
inflation. Monetary policy in this situation can be restrictive or expansionary. In the context of the current economic situation, however, we know
that monetary policy is in a stable expansionary posture.
All three factors, as determined by economic and yield curve analysis, favor value equities. The rationale for this is as follows:
1. The economic recovery is expected to continue which will increase earnings for value and growth equities. Given the abundance of
earnings growth, however, there will be no reason to pay extremely high premiums for earnings growth. This, in a relative sense, favors value
equities.
Second, monetary policy is currently expansive and is expected to remain such until the recovery is sure to be sustainable. There are two
important points in favor of the value style here. Expansive monetary policy generally leads into a recovery, which we have determined
favors value. Also, value tends to outperform during times of rising interest rates due to the low duration of earnings streams. If the assumed
recovery occurs, interest rate hikes will follow which will benefit value investors.
Inflation, the third factor, favors growth equities in the near-term because they are expected to be stable and low. A shift toward value
equities is expected as the economy picks up momentum and inflation begins to pick up. Higher inflation will inflate profits, which, in a
relative sense, will benefit value issues.
One must also consider the capital market outlook when considering style. It is important to determine whether or not the market has
already priced in this economic data. Based on the valuation analysis for the market, it appears that the market is still undervalued with respect to
both value and growth. As such, neither approach seems relatively more attractive from a strict valuation perspective.
The value approach is the favorable investment style at this time due to the economic landscape and its neutral valuation relative
to growth.
Effect of Economic/Capital Markets Analysis on Industry and Stock:
The current recovery phase of the economy has and will continue to positively affect the financial sector and Capital One Financial
Corporation. Historically, cyclical industries have outperformed the market during economic recoveries due to their high degree of operating
leverage and sensitivity to the economy. During times of economic recovery, consumer and business spending increase leading to economic
expansion. This expansion must be financed leading to an increased demand for consumer and business loans. As the market begins to recover,
mergers, acquisitions, IPO's and other business growth activities begin to occur further fueling loan demand. Reduced unemployment and higher
corporate profit results in fewer loan delinquency rates in both consumer and business lending. The result is improved lending margins and
increased profitability for financial services providers that ultimately translate into strong stock performance.
The economic landscape currently favors value while the capital markets are currently favorable for both value and growth. The financial
sector and consumer finance industry are considered value industries as evident by steady and strong dividend yields, high fixed costs, low
margins, and historical cyclicality. Capital One is a maturing growth stock within a mature industry. As such, it is concluded that the
economic/capital market landscape is positive for both the industry and the stock.
INDUSTRY ANALYSIS
Capital One Financial Corporation is part of the consumer finance industry within the financial services sector. The industry and sector
are mature with cyclical sensitivity to the business cycle.
External Factors:
Certain external factors have affected or are expected to affect the consumer finance sector. Technology has changed the landscape of
consumer lending over the past decade. Integrated information systems have allowed consumer lending to move from a regional focus to one of
national and worldwide scope. With new technological innovations, it is increasingly possible to match consumers and lenders regardless of
where they are located. A result of this capability is the consolidation of financial services firms. Large, diversified and well-established firms
who have harnessed the power of information systems can compete at a distance and can achieve economies of scale that local and regional firms
cannot.
Demographic change is another important external factor that will affect the financials sector. The "graying" of America will result in an
increasingly aged population who will have changing financial needs. As the population ages, it is expected that demand for retirement planning,
estate planning, and insurance services will increase. On the other hand, it is possible that thrift-minded seniors will be eager to live within their
means which could have a negative effect on consumer spending and, of course, on consumer lending. The near-term outlook for demographic
effects on the industry is stable, however, as the baby boomers' financial needs change, so will the dynamics of demand for financial services.
Demand Analysis:
The demand for financial services is primarily the sum of the demand for business and consumer loans, home loans, and the demand for
insurance services. As the economic landscape becomes favorable for these drivers, the financials sector will observe and benefit from an increase
in demand for its products and services. Ultimately, demand for financial services is tied with GDP growth. For purposes of this analysis, we will
focus on the demand for consumer finance services. This is the most important driver for the diversified financials industry to which Capital One
Finance belongs.
The charts below show the relationship between GDP and revenues for the diversified financial services industry. As can be seen, there is
a strong cyclical correlation.
Profitability and Pricing:
Porter's Five Forces model gives important insights into profitability and pricing factors. Results of this analysis are summarized below:
Threats to Business
Analysis
Competition
Strength of Customers
Strength of Suppliers
Ease of Entry
Extremely high. The ability for a firm to gain and
Maintain market share is essential.
High. With a highly competitive market, the customer is
afforded high bargaining leverage due to the nature of
the product/service, there is little customer loyalty.
Low to medium. Most industry members achieve
Bargaining leverage due to their size and the resources they command. Allows firm to obtain inputs at competitive
costs.
Low due to economies of scale possessed by the major players
in each sub-industry.
Product Segmentation and
Substitutability
Extremeley high. Product differentiation difficult to
achieve due to nature of product and service. Nearly
all products are easily substituted. Places importance on current market share.
In examining and applying Porter's Five Forces to the sector, one can see that financials exhibit dominant characteristics of a mature
industry. Some key indicators are the strength of competition, which places high value on the ability to gain market share, and, barriers to entry,
which help to ensure the stability and predictability of the industry. Though it is a mature industry, it is important to note that the financial sector
and the consumer finance industry exhibit some characteristics of growth industries. The primary indicator of this is the amount of investments,
primarily mergers and acquisitions, which have taken place within the industry. Consequently, the industry has often been a net user of cash.
Both of these qualities are characteristic of growth industries.
INDUSTRY FINANCIAL ANALYSIS:
Dupont analysis for the financial sector reveals the following qualitative conclusions: First, interest expense is falling relative to earningsbefore-taxes (EBT) as shown by a number closer to 1. Second, return on equity is below its historical average. This is likely a cyclical effect as
ROE was below historical standards in the 1990/1991 recession (not shown) and the 2001/2002 recession. It is important to note that return on
equity fell further in the '90/'91 recession than it has in the most recent recession.
Cash flow analysis reveals that the sector has been using a substantial amount of cash for investments. The balance sheet shows that at
least part of this investment has been used toward acquisitions. Intangibles and plant and equipment have been increasing in proportion to the net
use of cash for investments. From the cash flow statement we can see that the financial sector has been consolidating using a combination of
internally generated cash and debt burden.
INDUSTRY VALUATION ANALYSIS:
From a value perspective, the financial sector is given a market-weight recommendation based on the following valuation factors:
1) Relative dividend yields vs. the S&P 500
2) Relative growth rate estimates vs. the S&P 500
3) Valuation Multiples
4) Factors affecting validity of historical valuation
Relative dividend yields are currently above historical standards (chart below). Growth rate estimates have been falling on an absolute
basis but have been rising relative to the S&P 500. As the economy begins to pick up economically, it is likely that growth rate estimates will
recover but the relative values will begin to revert to the mean as the rest of the S&P should recover at a faster pace than the financials industry.
Based on dividend yields and the expected growth rate it appears that topside potential, particularly relative to the S&P 500, may be limited.
Valuation measures also show limited top-side potential. The price-to-book and price-earnings ratios are both slightly above the mean on
a relative basis. From the chart below we can see that ROE is above its relative mean. As such, there is no reason to believe on the basis of ROE
performance, a key factor for the price-book ratio, that the price-to-book ratio should greatly exceed historical standards.
The price-earnings ratio is best related using EPS growth. As shown earlier, the estimated growth rate for the financial sector is well
above its historical mean. Should the growth rate fall relative to the S&P, the price-earnings ratio should also remain near its historical average.
S&P FINANCIALS SECTOR COMPOSITE ADJ (SP-40)
1993
1994
1995
1996
1997
1998
1999
2000
2001
Price
2002
44.2
2003
StockVal ®
2004
2005
0.85
0.80
0.76
HI
LO
ME
CU
0.72
0.68
0.81
0.48
0.65
0.76
0.64
0.60
0.56
0.52
10-29-1993
10-31-2003
0.48
PRICE / BOOK VALUE RELATIVE TO S&P 500 COMPOSITE ADJUSTED (SP5A) M-W td
3.6
3.3
3.0
HI
LO
ME
CU
2.7
2.4
3.4
1.4
2.5
2.3
2.1
1.8
1.5
10-29-1993
10-31-2003
1.2
PRICE / BOOK VALUE
There is some evidence in support of an expansion of historical valuations. This evidence appears when the relative performance of the
financials index is compared to the business cycle. In the 1990/1991 recession, GDP dropped to a low of 2.8%. The P/E and P/B ratios each fell
by 30% on a year-to-year basis. In the recession of 2001/2002, GDP growth slowed to 2% but the P/E and P/B ratios fell by 12% and 9%
respectively (stockval). From this evidence we can hypothesize that perhaps the financial sector, through geographic and product diversification,
has lost a considerable amount of cyclicality. If this is the case, the risk premium for financials should fall pushing valuation multiples higher. A
negative to this consideration is that the most recent recession is the only test case, which does not prove a trend. Further, something else unusual
occurred during the recent recession. Consumer spending was unusually strong. As shown earlier, consumer spending is an important driver in
the profitability of the financial sector.
The sector is a market-weight. Valuation multiples appear well-priced by historical standards, however, the cyclicality of the industry
makes it a reasonable bet during current economic conditions. There is also some reason to believe that valuation multiples may expand due to
reduced cyclicality, though the evidence here is not conclusive.
COMPANY ANALYSIS
Capital One Finance is one of the top six credit card issuers in the U.S. managing nearly $60 billion in consumer debt. Its primary industry group
is credit card services. Its closest competitors are American Express, Citigroup Financial, and MBNA. In comparison, with this peer group,
Capital One is the smallest in terms of sales and consumer loans managed, but Capital One is first in terms of sales and earnings growth. The chart
below shows Capital One's growth vs. its top competitors, the credit card services industry, and the market:
Growth
Capital One Financial
American
Express
Citigroup
MBNA
Industry
Market
12-Mo Rev Growth
6.4%
6.4%
(9.5%)
4.4%
40.8%
9.8%
12-Mo N.I. Growth
34.5%
27.2%
(7.4%)
24.2%
(83.4%)
7.3%
12-Mo EPS Growth
32.1%
30.4%
(7.1%)
25.6%
--
7.9%
12-Mo Div Growth
0.0%
6.3%
36.8%
15.4%
5.4%
14.6%
36-Mo Rev Growth
22.6%
1.7%
(4.8%)
11.4%
(3.4%)
4.6%
36-Mo N.I. Growth
32.0%
3.8%
5.6%
16.3%
--
(19.7%)
36-Mo EPS Growth
27.8%
5.0%
4.3%
15.6%
--
(22.2%)
36-Mo Div Growth
(1.9%)
2.1%
20.9%
12.1%
(3.5%)
(0.9%)
Source: Hoover's Online Database
Though not the largest credit card issuer, Capital One Finance is one of the fastest growing issuers in the U.S and has established a firm foothold
in the industry.
Growth Drivers/Catalysts:
There are two key growth drivers that support further growth of Capital One's earnings and share price. First, the cyclical nature of the
financial services industry is shared by COF, so the anticipated economic upswing should prove beneficial. The economic improvement is
expected to boost earnings growth due to improving consumer spending patterns, an expanding customer base, and improving credit quality. The
company's recent focus on moving credit quality up-scale will result in fewer charge-offs and delinquencies; this goal should become more
attainable as the economic environment improves. The cyclical nature of Capital One's business will provide a source of growth for earnings
and price per share.
Second, Capital One Finance is a young and growing concern in the auto financing and international lending segments of the market. Part
of the company's strategy is to become a full-spectrum lender in auto financing much as it has in the credit card industry. Given its informationbased strategy, Capital One appears poised to be able to successfully apply the lending principles it has used on credit card services to the autolending environment. This is an area of expected high growth for COF. Similarly, Capital One is continuing to test new markets around the globe.
Again, the firm's information-based strategy should find success on a global platform, which will provide further impetus to income growth.
Growth opportunities from product diversification (auto-lending and international) will drive future growth in earnings.
Company Management:
Given the unique environment for financial services firms, company management plays a crucial role in success or failure. The two main
reasons this is true is because of the sensitivity of a finance company's earnings to investment decisions and cost efficiencies. Management must
be competent enough to successfully execute the corporate strategy and deep enough to avoid losing its competitive edge in case of management
turnover.
The Chief Executive Officer of Capital One Finance, Richard D. Fairbank, is the founder, CEO, & chairman. It was Fairbank, along with
his vice chair, Nigel Morris, who developed the information-based strategy that gives Capital One its competitive advantage. Fairbank has led the
company to a slew of accolades and awards for innovation and growth and he has been named one of the nation's top executives. Given his
experience and his track record in growing Capital One to what it is today, it can be safely assumed that he has the expertise and leadership to
execute his information-based strategy in other areas of growth such as the auto-lending segment and international markets. He is helped in this
effort by his colleague and vice chair, Nigel Morris, who assisted him in founding and developing the company's current strategy. It appears that
Capital One, for the predictable future, has a competent and deep management team capable of maintaining the company's competitive position
within the industry (source: Hoover's On-line).
Risks/Concerns:
The key risk factors for Capital One Finance are the competitive and regulatory environments. The credit card industry appears to be
nearly saturated, particularly in the prime and superprime markets (Standard & Poors Stock Reports). This is because the recession had a
disproportionately adverse impact on the sub-prime segments forcing many lenders to tighten credit controls and focus on super-prime customers.
In the near-term this trend is expected to continue which will keep intense competitive pressure on Capital One's target market of super-prime
borrowers. However, should the economic recovery progress as expected, it is likely that this saturation will subside to normal levels.
Nonetheless, competition in the consumer lending industry is expected to remain very high maintaining current pressure on interest margins.
The regulatory environment appears stable for the credit card services industry, but the potential restriction of telemarketing solicitations
via the government's 'Do Not Call' list represents a threat to Capital One's marketing efforts. Most of Capital One's accounts are generated through
direct mail and direct telemarketing solicitations (Standard & Poors Stock Reports). Approval of the 'Do Not Call' list could have a material
adverse impact on Capital One's marketing efforts affecting its ability to generate and grow its managed accounts.
Based on financial projections (refer to financial analysis and attached earnings model), 2003 earnings for Capital One are projected
to come in slightly below the consensus estimates of $4.76 per share. It is expected, based on the earnings model, that Capital One Finance
will earn $4.67 per share. Earnings for are expected to be in the middle to upper range of current 2004 projections ($5.20-5.40) at $5.33 per
share. The company recently downgraded its earnings forecast for 2004 due to narrowing interest margins. This is consistent with the research
provided herein as the company's interest margin should remain thin due to intense competition within the prime and super-prime consumer
groups. Recent stock price movements may be reflecting these recent changes. The potential for Capital One to report earnings below 2003 and
2004 consensus estimates represents a risk to the current and future market price of Capital One's stock.
FINANCIAL STATEMENT ANALYSIS
The primary revenue drivers for Capital One Finance are Interest Income and Non-Interest Income. Interest income is a function of the company's
consumer lending activity (credit cards, auto, international), the current interest rate environment for consumers, consumer usage patterns of its
customers (i.e. attrition rate), marketing, and effectiveness of account management. As can be seen from the income statement, Capital One has
enjoyed robust revenue growth with a 5-year compound annual growth rate of 42%. Non-interest income is a collection of revenue earned
through servicing income on securitized loans, gains on securitization of loans, and various fees charged for account services. In general, noninterest income is partly a function of consumer lending activities and partly of consumer usage patterns and credit quality of the company's
managed loan portfolio. It is expected that as the credit quality of the portfolio increases, the fee and service income will decrease. This is
important to note considering COF's strategy of focusing on superprime consumers.
Nearly 60% of the firm's source of funding is from interest-bearing deposits. The cost of funding an important expense driver. Thus,
interest expense is directly related to the federal funds rate as this is the base for the interest expense that will be paid to acquire the needed funds.
In reviewing the income statement, it can be seen that interest expense has been growing at a healthy rate but, importantly, it has been growing at a
slower rate than interest income. Although interest expense has been growing, interest expense as a percentage of funds borrowed has been falling
showing the impact of falling rates on the company's expense line. Interest expense as a percentage of funds borrowed has fallen from 6.28% to
5.42% during the Fed's recent interest rate easing period. Given the current interest rate environment, this trend is expected to continue through
2003 and stabilize in 2004.
Allowance for loan losses is another key expense in determining Capital One's earnings. Allowance for loan losses is an estimate of
expense based on expected loan losses due to charge offs. This weighty expense is directly related to the credit quality of the company's loan
portfolio and general consumer trends in delinquencies and charge-offs. The recent recession has had an adverse impact on all three of these
factors and it is clear from the high rate of increase in the provision for loan losses. This trend is expected to slow in 2003 and reverse in 2004 as
the company's strategy of improving credit quality begins to take effect. Further, charge-off rates and delinquency rates are beginning to fall as
economic conditions improve. Nonetheless, it is expected that the ability for Capital One to expense less for loan loss reserves will provide the
primary source of earnings-per-share growth over the next couple of years.
Capital One's Return on Equity has been trending lower since 2000. The primary source of this drop can be found in the reduced leverage
of the company. COF's asset/equity ratio has dropped from 9.27x to 8.25x over the two-year period. The interpretation of this is that Capital
One's net loan (being the firm's largest asset) growth has slowed relative to equity growth. Provision for loan loss is a key determinant of the
company's net loans and, as shown earlier, this amount has been exceptionally high due to the recession. It is expected that this trend begin to
reverse in 2004 as the economy moves out of recession. Provision for loan losses should decrease pushing the company's net loans up relative to
equity. Given the magnitude of net loans on the balance sheet, this should increase leverage and begin to improve ROE. This effect, however,
will be somewhat tempered by the company's strategy of slowing overall loan growth to historical levels. The net result, however, is expected to
support and, stabilize Capital One's Return on Equity.
Cash Flow Analysis:
Capital One Finance has historically been a net provider of cash. Cash flow from operations has been consistently improving due to
steady net income growth. The company's largest expense, allowance for loan losses, is a non-cash charge that substantially reduces income but
not cash. Allowance for loan losses is expected to begin falling substantially in 2004 leading to higher positive cash flow from operations. Given
the nature of the company's business, they have had and will continue to have large negative investing cash flow. This is because increases in
consumer loans are booked as an investing activity. Likewise, financing cash flows are consistently positive because the sources of funds used in
the company's primary operations (i.e. interest-bearing deposits) are considered financing activities. Capital One has proven efficient at managing
its cash flows so that the company can support its consumer loan activity through internal cash flow and its typical sources of funds with little need
to raise cash through equity. It is expected coming out of the recession that Capital One should remain able to be a net provider of cash while
supporting its primary investing activities. As such, it is not expected that the company will require any significant increases in common stock
that would affect its earnings-per-share. Further, the company should provide sufficient cash to execute its growth strategy relating to autolending and international operations.
Summary of Financial Analysis, Sources of Growth, and Financial Projections:
Revenues:
Capital One should continue to enjoy healthy revenue growth but the rate will be slower than it has been historically. This
is due largely to the company's own efforts to reduce loan growth. Competition will also be a concern as low interest rates
saturate the prime and sub-prime markets.
Interest Expense:
Allowance for Loan
Loss:
Capital One will benefit from continued low interest rates, although interest
margins are expected to trend lower due to competition and Capital One's currently changing product mix. Nonetheless,
interest expense should be stable for the predictable future given the economic forecasts.
This should prove to be the key driver behind EPS growth as improving
economic conditions reduce delinquencies and charge-offs. An improvement in
the unemployment rate would further improve this parameter.
Summary of Key Financial Projections vs. Consensus Estimates:
Projected Value
Consensus
2003
2004
2003 2004
EPS
4.67
5.33
4.76
5.20-5.40
Earnings Growth
20.6% 13.9%
20.2% 9.2%-13.4
DPS
.12
.12
NG
ROE
18.72% 17.2%
NG
* See attached earnings model for further details of 2003, 2004 financial projections.
VALUATION ANALYSIS
The following factors are considered for valuation analysis:
1. Whether earnings growth is expected to improve or deteriorate;
2. Whether dividend growth and yields will increase;
3. Where current valuation multiples stand in relation to historical standards and what this means for the direction of the share price;
4. Whether there is justification for expansion/contraction of historical valuation multiples; and,
5. Whether technical analysis provides any signals for the outlook of the stock.
Earnings Growth:
Capital One's current growth-rate estimate is 15.5%, while its long-term growth rate (ROExRetention Rate) is currently 16.8%. Based on
the attached earnings model, the growth rate for 2003 and 2004 is 20.6% and 13.9%, respectively. In the near term, it is expected that Capital
One's growth estimates and its long-term growth rate will remain stable and low with a possibility of the growth trending even lower before
reversing its down-trend. There are two key reasons for these expectations. First, company management is intentionally slowing growth of its
managed loans account growth in order to maintain a stable and manageable growth. Second, Capital One's ROE should continue to trend lower
due to thin interest margins which are expected to continue through 2004. Since ROE is a determinant of growth, it will follow that growth rates
will slow along with ROE (unless the retention ratio increases, but it isn't expected to do so). While Capital One is expected to see healthy EPS
growth, it is expected to be stable at best through 2004 without the catalyst of rising rates (reduced competition in prime markets) to reduce pressure
on interest margins. This will apply downward pressure on Capital One's P/E ratio.
Dividend Growth/Yields:
Capital One's current dividend yield is .18%. Dividends-per-share for 1998 through 2002 were .11/share showing a non-existent growth
rate for dividends. Given the longevity of the no-growth trend in dividends, the trend is expected to continue for the foreseeable future. Dividend
growth is expected to remain flat and is not expected to provide a source of improved valuation.
Valuation:
The tables below show valuation results for Capital One Finance utilizing the relative and absolute value technique and the intrinsic value
technique. The aforementioned assumptions regarding earnings and dividend growth are factored into the forecasting model. The model is the
basis for the inputs to the intrinsic valuation (DDM valuation). Further, the same assumptions are used in selecting competitors that have similar
characteristics regarding earnings and dividend growth, ROE, financial condition, and product focus. Further details from the inputs of these
valuation models can be found in the attached financial statements model.
Absolute and Relative Value:Error! Not a valid link. Source: Capital One Finance Earnings
Capital One appears to be undervalued on an absolute basis using both Price-Book and Price-Earnings. Capital One is also undervalued Relative
to the S&P 500, the S&P Financials index, and its nearest competitors. It is also important to note that both the S&P 500 and the S&P Financials
(SP-40) indices are both slightly undervalued relative to historical standards. Using this table as a guideline, prices can be derived to aid in
valuation. The table below shows three possible pricing scenarios for Capital One. The first assumes mean reversion for Capital One Finance
relative to its benchmarks while holding all other factors (i.e. the benchmarks) constant. The second scenario, assumes reversion to the mean for
all parameters. That is, the table displays relevant prices for Capital One Finance in the instance that Capital One AND its bench marks return to
historical averages. The third scenario assumes that Capital One's P/E ratio will remain low relative to the benchmarks but the benchmarks
themselves will rise back to historical standards.
SCENARIO 1: COF's Parameters Revert to Mean; All Else is Constant.
S&P500
S&PFinancials
Relative P/E-Based Price
71.35
54.26
Avg. Target Price
62.81
SCENARIO 2: All Parameter's Revert to Mean.
S&P500
Relative P/E-Based Price
85.37
Avg. Target Price
73.60
S&PFinancials
61.82
SCENARIO 3: All Parameter's Revert to Mean.; COF held constant.
S&P500
S&PFinancials
Relative P/E-Based Price
61.46
42.50
Avg. Target Price
51.98
This report has established favorable conditions for the equity markets and a market-weight for the financials sector. It has also determined based
on earnings and dividend growth for Capital One Finance, that there is no current catalyst to justify an immediate recovery of historical valuation
multiples. Given these findings, it is expected that the S&P 500 multiples are likely to revert to the mean while the S&P Financials index and
Capital One will remain near current multiples. This scenario corresponds to selecting the relative P/E-based price of $61.46/share (scenario 3
S&P 500 value) and the relative P/E-based price of $54.26/share (scenario 1 S&P-Financials value). Using the mean of this price range, the
target price for Capital One Financial based on historical relative values is $57.86/share. Capital One's current market price of $56.50 is
fairly valued based on the relative value method.
Discounted Dividend Model with P/E-Based Terminal Value:
Error! Not a valid link.
With a current market price of $56.50/share, Capital One is slightly under-valued compared to its intrinsic value of $60.09. Due to the sensitivity
of the DDM, a margin of safety of 15% is applied. Capital One is well within this margin of safety leading to a finding of market-weight using
this model. The P/E-based terminal value used in this model was determined using Capital One's historical mean P/E ratio of 13.5 and applying a
premium of .25 to bring the expected P/E ratio to 13.75. The premium was added to account for the fact that Capital One has become a more
diversified firm than the historical averages reflect. This anticipated reduction in risk premium is expected to cause an expansion in the historical
P/E warranting the application of a terminal P/E value higher than the historical mean.
Technical Analysis:
Capital One Finance recently broke a strong up-trend that had been in existence since March of 2003. Having broken its trend, technical
traders will tend to remain bearish until the stock reaches its next probable resistance level around $45-50/share. This represents a potential 15%
decrease in the stock price. The chart below illustrates this:
(Insert StockVal Chart with Trendlines)
The impact of this bearish technical-sentiment is considered to be low due to the fact that institutional investors own approximately 87% of the
firm's stock (source: Wall Street Journal.com).
Another important technical measure is the Crossover Index. The crossover index (below) gives an inconclusive reading as the stock
appears to be neither currently overbought nor currently oversold. At present, there is no substantive sentiment in either direction from a technical
perspective.
RECOMMENDATION
Capital One Finance Corporation is given an underweight recommendation. The following are the key reasons for this recommendation:
1. Competitive pressures in the prime and superprime lending markets. These pressures are expected to continue through 2004 as low
interest rates continue to cause saturation of prime credit card markets. The result is low interest margins which will lead to results
below consensus expectations;
2. The relative attractiveness of value opportunities versus growth opportunities. Capital One represents a growth bet in a value
industry. The attractiveness of Capital One's expected growth will not warrant a premium due to an expected abundance of growth
opportunities in equity markets;
3. No catalyst to justify valuations in excess of historical standards. Capital One is currently valued fairly on a relative basis and based
on the Dividend Discount Model. There is no catalyst relating to earnings or dividend growth that warrants higher valuation
multiples.
Following are some reasons one might consider for an investment recommendation other than underweight:
1. Product diversification and growth of auto-lending and international lending segments. Growth in these areas reduces the risk of
an investment in Capital One. Further, it provides a new source of growth that has been relatively untapped by Capital One to this
point;
2. The firm's management has proven to have the experience necessary to efficiently execute the corporate strategy. This lends
support to prospective growth in new products;
3. Possible increase in dividends or share repurchases. The expected improved cash flow and the intentional slowing of account
growth could be evidence of a maturing company that will begin returning profits to the shareholders in the form of dividends or by
share repurchase programs. This would substantially improve the valuation of Capital One.
The pros to the underweight recommendation currently overwhelm the cons. The primary reason this is true is because of the relative levels of
certainty. It is believed with a high degree of certainty that the credit card lending market is over-saturated and that the current market favors
value opportunities over growth opportunities. On the other hand, it is fairly uncertain whether the auto and international lending segments will
meet with the same growth success as Capital One's credit card lending operations. Further, it is also very uncertain whether Capital One's
management will continue to aggressively pursue growth opportunities or whether they will begin to return profits to the shareholders. And, if
they do increase dividends, when will they do so? The uncertainty associated with 'cons' above reduces weight assigned them in the outcome of
the recommendation.
Valuation:
Dividend Discount Model
$60.09
Target Price:
$61.46
Relative Valuation Method
$57.86