Does Capital One Bank Live Up to its Name?

While the rest of the market heads towards a correction, the financial sector has held up extraordinarily well.

And one name that’s caught our eye is Capital One Financial (COF).

Unlike most traditional banks, Capital One focuses more on lending services, specifically credit cards.

That gives it a different exposure to rising interest rates, which benefits the company.

You see, financial service companies like Capital One make more money as interest rates rise because the rate they pay depositors rises at a slower rate then the rate they charge borrowers.

After we pulled the top searches for financial services companies amongst financial pros, two names floated to the top: Capital One and Ally Financial (ALLY).

Both offer fantastic values but for different reasons.

That’s why today’s newsletter covers Capital One with tomorrow’s looking at Ally Financial.

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Capital One Financial’s Business

Capital One offers financial services through three main segments: 

• Credit cards (62% of net revenues)
• Consumer banking (27% of net revenues)
• Commercial banking (11% of net revenues)

The heavy reliance on credit cards for income exposes the company to consumer purchase behavior as well as interest rates.

Financial services companies rely on streamlined operations, timely payments, and low defaults.

Capital One has been able to drop its allowance for credit losses considerably over the past year, adding to earnings. Yet, levels are still above pre-pandemic levels, leaving room for additional releases.

A good chunk of that has come from higher auto values that allow the company to reclaim and resell cars at better prices.

As we mentioned at the beginning, higher interest rates benefit the net interest margin for lenders.

That’s helped drive an additional $600 million in Q4 net interest income YoY.

Capital One has captured steady topline growth over the last five years of 2.8% compounded annually driven by steady low growth and opportunistic acquisitions.

It’s worth noting that although buy now pay later has increased in popularity, it has yet to take away any meaningful market share from Capital One.

Financials

While Capital One struggled with declining net income from 2014 to 2017, the company turned things around, driving substantial growth in 2018. That faltered in 2019 and 2020 only to make a huge comeback in the last 12 months.

Free cash flow has consistently landed north of $10 billion since 2016 and above $33 per share in the last two years. With shares trading at $150, that’s roughly 5x free cash flow.

While Capital One was forced to cut its quarterly dividend by 75% in 2020, they restored it in Q1 of 2021. Since then, management has hiked it by 50% and announced a special dividend of $0.60 per share.

For 2022, the board allocated $5 billion in share buybacks or around $11 per share in total value.

Valuation

As we mentioned in the beginning of the newsletter, Capital One’s valuation is outstanding compared to the financial services sector and the company’s own 5-year average.

With a P/E ratio of 5.6x, Capital One comes in at nearly half the price of the rest of the sector. Even with the expected P/E ratio set to rise to 7.6x net year, that’s still more than 35% below the sector average.

Don’t take the higher forward P/E ratio as a bad thing. A confluence of factors helped Capital One, like many financial institutions, bring in huge revenues without a proportional jump in expenses.

That’s expected to contractnext year yet still deliver solid earnings.

We can also see this in the incredible price to cash flow ratio rising slightly from 5x to 6x. But again, that’s expected across the entire industry.

When we compare Capital One to its historical average, we find it trading at a relative discount based on earnings and cash flow. The one area that it’s a bit more expensive in is the price to book. However, both the trailing and forward looking price to book ratios are below the industry average.

Our Opinion – 8/10

Capital One’s focus on credit cards and lending exposes it to interest rate changes more than larger financial institutions like Citigroup, which has a more diverse income structure.

That’s perfect for an environment where rising rates boost the company’s bottom line.

And with consumer spending continuing at an unprecedented pace, we expect management to keep returning cash back to shareholders.