NEW YORK ( TheStreet) -- Heading into third-quarter earnings season, it's clear that the market is undervaluing some credit card lenders.
Over the past five years, as the U.S. banking industry has recovered from the credit crisis, lenders with the sharpest focus on credit card lending have fared quite well, with outstanding returns on equity. But their price-to-forward earnings don't reflect their earnings strength, setting up a golden opportunity for long-term investors.
Capital One (COF) had a rocky road earlier this year, with the stock sinking in the wake of higher-than-expected costs tied to its purchases of HSBC's U.S. credit card portfolio, as well as an overall decline in credit card receivables. Part of this decline reflects the company's decision to move away from private-label card lending, including the sale of a $7 billion portfolio of Best Buy (BBY) loans to Citigroup (C).
But the company had a good second quarter, with a return on average tangible common equity (ROTCE) of 17.87%, according to Thomson Reuters Bank Insight.Another challenge for Capital One is a rise in expenses, with KBW analyst Sanjay Sakhrani on Thursday estimating the company's third-quarter efficiency ratio will rise to 54% from 53.4% the previous quarter and 51.8% a year earlier. The efficiency ratio is, essentially, the number of pennies of overhead expenses for each dollar of revenue. But Sakhrani rates Capital One "outperform," with a $79 price target and lists the company as his favorite pick among the credit card lenders and payment processors he covers. The analyst estimates the company will post third-quarter earnings of $1.78 a share, declining from $1.87 the previous quarter and $2.01 a year earlier. Despite the expected decline in earnings, Capital One remains very attractive because the stock at Thursday's closing price of $68.78 traded for 10.1 times the consensus 2014 EPS estimate of $6.82, among analysts polled by Thomson Reuters. That's a low forward P/E for a company with an ROTCE close to 18%. Discover Financial Services (DFS) is a highflier, showing an annual growth rate of 12% for average credit card loans held on the balance sheet during August, and achieving an industry-leading efficiency ratio of 40.29% for the 12-month period ended June 30.
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