Way to go Tom, spamming COF 2 days ago at $32. LMAO!!!!!
Misinformation, Weak Analysis, and Fear
Article date: 10/21/02
Thomas Brown
Director, bankstocks.com
tbrown@secondcurve.com
It should be no secret by now that I believe Capital One, at current prices, represents the single best investment opportunity I’ve seen in my investor/analyst lifetime. It is a great company with a fabulous earnings outlook, whose stock is trading under a massive cloud of investor fear.
Some numbers, for perspective: Capital One has grown its earnings per share at 28% annually since it came public in
1994. More impressive, the company’s earnings have grown at least 20% in each year since it came public, and its
return on equity has never failed to top 20%. That is a “true” record, by the way, that’s been achieved without the
exclusion of nonrecurring charges.
Until recently, Capital One’s P/E multiple had fluctuated between 10 times and 30 times forward earnings, with the
arithmetic average a little above 20 times. Today the stock trades at 6 times. That’s a key reason why I believe that now
is such a great time to own a piece of one of America’s great companies.
Such a low valuation on such a great company can only be caused by one thing: massive amounts of investor fear and
misunderstanding. This is certainly the case at Capital One today. If you doubt it, take a look at some of the negative
comments the sell-side has had about the company this week, following its third-quarter earnings report Tuesday night.
They are a mishmash of half-truths, misunderstandings, and wrong-headed analysis. Here’s a sample:
“In our opinion the ‘quality’ of earnings at COF has declined during the previous six months.” – Jeff Hopson, A.G.
Edwards.
It’s hard to imagine how this statement could be more untrue.
In the past six months, Capital One’s reported earnings per share have been both strong and
considerably better than any analyst expected. And yet during this same period, the company has built
its loan loss reserve by an incredible $660 million! To put that in perspective, the company reported
$2.05 in EPS the last two quarters, up 41% from the prior year, and built its reserve for loan losses by
$1.65 per share! In addition, the company’s earnings in the last six months also included $110 million
of nonrecurring charges, or the equivalent of another 30 cents per share.
That’s poor-quality earnings? In fact, it’s just the reverse! Capital One has always conservatively
stated its earnings, but it has never buried as much earnings as it has in the last six months. To claim
that the company’s earnings have been lower in quality is absurd.
“COF has implemented changes to slow loan growth to the 20-25% range, which will be made up of 25% growth in
prime and super-prime loans and 15% growth in sub-prime business. While we fully understand the change in the mix,
the realization is that COF’s business over the previous years has not been as successful as we had believed.
Management’s guidance for a risk adjusted margin in the 10% range throughout 2003 indicates to us that the sub-prime
loans underwritten using COF’s ‘Information-Based System’ [sic] are not performing as well as management had
previously expected.” –Jeff Hopson, A.G. Edwards
The numbers are right, but the conclusions Hopson reaches are way, way off base.
The fact that the company’s risk-adjusted margin is going to fall from 14.01% of receivables in the third
quarter of 2002 to 10% in 2003 doesn’t mean that Cap One’s prior business wasn’t as profitable as
previously thought. Instead, the margin decline is the result of the arithmetic that occurs when older
accounts start to season at the same time that overall loan growth slows, as well as the one-time
benefits included in the third-quarter number.
The portfolio dynamics that accompany such a mix shift can be complex, but they are hardly
impossible to understand or model. As analyst Howard Mason OF Sanford C. Bernstein has explained
well, Capital One’s superprime accounts are low-balance-per-account, early-pay, and late-cost, versus
its prime and subprime accounts, which are high-balance-per-account, later-pay and early-cost.
As the blend of those two types of accounts shifts in the loan portfolio, lots of metrics will temporarily
become distorted, including risk-adjusted margin and net chargeoffs.
Besides, even at 10%, Capital One’s risk-adjusted margin would continue to compare favorably to other
major card issuers such as MBNA (7.7%), Citi (6.9%) and JP Morgan Chase (6.8%). In the end,
Capital One’s business model remains the best in the business.
“In the current environment COF is achieving the earnings growth that investors expect, but is utilizing its financial
flexibility to do so.” – Jeff Hopson, A.G. Edwards
Just the opposite is true. Capital One has delivered earnings in the current environment that have been
considerable higher than investors have expected, and has strengthened its balance sheet at the same
time! The company not only hasn’t had to use its “financial flexibility” to make its numbers, it has
created more!
“Upside to our EPS estimate was mainly driven by a 42% sequential decline in marketing, better-than-expected credit
costs, and a better than expected NIM.” –Matt Vetto, Salomon Smith Barney
This is a terribly misleading statement. The “credit costs” that run through the income statement, and
affects EPS, is the loan loss provision—and Capital One’s loan loss provision in the third quarter was
considerably higher than anyone forecast, because of the massive reserve building (some would say
over-building) the company did in the quarter. In particular, managed net chargeoffs were $686 million
and Capital One added $370 million to the loan loss reserve.
In addition, Vetto fails to mention that the upside in earnings was achieved despite the massive reserve
building and the absorption of $110 million in nonrecurring expenses. Needless to say, he rates the
stock “underperform”.
“This multiple is also towards the low end of this stock’s historical valuations range, which we thing is reasonable under
the current circumstances.” –Matt Vetto, Salomon Smith Barney
I obviously don’t think the current P/E multiple is reasonable and I don’t believe it is sustainable, but
that’s just a difference of opinion. What is misleading is to state that Capital One’s trading toward the
low end of its historic range. As the chart below clearly shows, the current relative P/E is a record low!
“Our confidence in COF meeting its 2003 earnings target is limited to a significantly lower run rate in marketing
expenses in 2003.” –Joel Houck, Wachovia Securities
I believe Houck is saying that he has no confidence that Cap One will achieve his $4.54 earnings
forecast for next year without significantly cutting back on marketing.
He may be right, but I doubt it. Capital One’s management is guiding investors to earnings of at least
$4.55 with a marketing budget that will be 5% to 10% higher than 2002, not significantly lower, as this
analyst is predicting.
“This significant ramp in delinquencies (82 basis points) was higher than indicated in Capital One’s monthly master
trust data.” – Joel Houck, Wachovia Securities
Houck really hasn’t been paying close enough attention to Capital One! Third-quarter delinquencies
were higher in the total managed portfolio than in the master trust data because the mix of loans is
different, with the master trust having a meaningfully lower percentage of subprime accounts. It is the
seasoning of the significant number of subprime accounts booked last year that is driving both the
managed delinquencies rate and that of the trust data higher.
Again, the company has been saying for months that it is moving away from subprime, to prime and
superprime. As that happens, there will be temporary distortions of several of Cap One’s credit quality
and profitability metrics, simply because of the way the arithmetic works. The end of the world it ain’t.
Fear, misinformation and poor analysis are currently surrounding one of America’s great Companies: Capital One.
While painful for investors in the short run it does create a great buying opportunity because in the long run,
fundamentals win out!
bankstocks.com |
