Capital One and the Invisible For-Sale Sign
By Peter Eavis
Senior Columnist
04/23/2003 05:42 PM EDT
Capital One (COF:NYSE) has to be putting itself on the block now.
For months now, the rumor mill has been saying that the racy credit card lender is trying to sell itself. But developments this week added much grist to that mill. First and foremost, Capital One reported low-quality first-quarter earnings that clearly showed the limitations of its new, slower-growth business model and displayed the need for new management.
Perhaps as a step in that direction, the company announced that Nigel Morris, its highly promotional president and COO, is leaving that post and sharply reducing his responsibilities within the company. The news of Morris' pullback comes just over a month after the resignation of Capital One's CFO David Willey amid allegations that he engaged in insider trading.
Detox, which has closely tracked the fate of Capital One, calculates that a discerning buyer would be ill-advised to pay more than $25 per share for the company. As usual, the market disagrees. Thursday, the stock rose 89 cents, or 2.3%, to $39.07, which is over 60% off recent lows.
Cheers
In the first quarter, Capital One made $1.35 per share, up 63% from the year-ago quarter. The earnings surpassed analysts' estimates by a whopping 32 cents, which led to a sharp rise in Capital One stock and cheers from Wall Street's bulls.
So how does the quarter show that Capital One may want to sell out? Well, in a series of exercises that would cause Jane Fonda to hang up her leotard in shame, the company stretched in more directions than one might think humanly possible to make its earnings number. Most important about these antics is that they can't be sustained for more than a couple of quarters, which implies the company is trying to project the impression of strong earnings to attract buyers. When asked if the company was being shopped, Capital One said it doesn't comment on market rumors about whether it is up for sale.
After a disastrous foray into subprime credit card loans, Capital One is retreating fast from that sector and is focusing now on chasing borrowers with good credit. However, the competition for these so-called prime and superprime customers is fierce, and Capital One currently has no visible competitive advantage in this segment of the market.
Bill Ryan, consumer finance analyst at New York-based Portales Partners, calculates that maneuvers that will be hard to repeat over time accounted for between 30% and 60% of first-quarter earnings. Here's how. First, by having the all-important marketing expense come in $58 million below guidance, Ryan says earnings benefited to the tune of 16 cents per share. And as Capital One concentrates on prime and superprime borrowers, it needs to be spending these marketing dollars. The company got a 2-cent boost to earnings from a cut in the tax rate. And by reducing its bad loan reserve by $85 million, Capital One's earnings benefited to the tune of 23 cents. Those three sources contributed 41 cents per share, but Ryan estimates Capital One may have gained an extra 43-cent boost to earnings from reducing another reserve, for fee revenue.
The Loan Book
Capital One says the reserve cut was appropriate, even though loans written off as uncollectible, or charge-offs, rose to 6.63% of loans in the first quarter, from 6.02% in the fourth quarter of last year. That's because the company sees charge-offs peaking. Supporting that assertion, loans more than 30 days past due fell to 5.72% in the first quarter, from 6.51% in the fourth quarter of 2002. The company confidently predicted that credit quality improvements would continue through 2003.
So what's not to like? When under pressure, lenders can make credit quality look a lot better than it really is by giving breaks to distressed borrowers so that their loans get classified as current, a practice heavily used at subprime lender Household International, for example. Given the levers that can be pulled, investors should demand at least two quarters' worth of credit-quality improvement before trusting any financial firm's pronouncements on bad loans.
If we take that leap of faith and assume charge-offs have peaked and earnings can benefit from one-off reserve reductions, we still need to look at the prospects for Capital One's underlying business. First, subprime could still hurt it. Skeptics like Ryan claim Capital One has relied on a penalty pricing model that takes inordinate fees from subprime borrowers. Ryan expects that new banking regulations designed to limit practices that lead to excessive fees will hurt the lender. Indeed, a sequential quarterly drop in fee income could be a sign that the bank rules are biting. Capital One denied this Monday, telling investors it was partly attributable to lower fees from merchants. As for the prime segments, the fact that Capital One cuts its loan growth guidance for 2003 from 20%-25% to 15%-20% shows the competitive pressures are bearing hard on the company.
Door Store
It's hard to underestimate the significance of Morris' departure. Along with CEO Richard Fairbank, he was an architect of Capital One's growth and wowed Wall Street for years with a delivery style more suited to a motivational speaker than a top executive at a federally insured bank. Capital One says Morris wants to spend more time with his family, but will continue to serve in some roles.
On the call, Fairbank said Morris would have no "engagement in the day-to-day operation" of the company. When an executive leaves or changes role for "family reasons," it often emerges later that he or she had other, not so edifying reasons for the shift. Morris was reportedly the point man for ongoing discussions with bank regulators over how to improve its internal controls. Who knows, maybe the regulators pressured the company to sideline Morris. After all, Capital One's internal controls are hardly considered to be the tightest in the lending industry.
When a faltering finance firm stretches for earnings and makes big changes in leadership, seasoned investors will often assume that the company in question wants to sell itself before things get too bad. Potential buyers will have even more of an idea of what's going on at Capital One. If we generously assume Capital One's true earnings power is around $3.50 per share, and it sells for a multiple of seven times earnings, it should be worth around $25. The go-go days are over for Capital One. It should take its $25 and run. |
