COF Looks Ready to Ride Out a Recession

Updated from 3:32 p.m. on Jan. 22.

Capital One (COF - commentary - Cramer's Take) reported EPS from continuing operations of 85 cents vs. an average Street estimate of 63 cents and vs. a $1.14 EPS last year.

Management basically preannounced earnings and loss provisions earlier this month, so there is nothing really worth talking about in earnings. Nobody seems to care about any company's fourth-quarter results anyway; they are all worried about the future abyss.

With that in mind, Rich Fairbank, Capital One's CEO, decided to just talk about how the company is prepared for 2008 and the recession: "We are managing as if a recession is here."

The fourth-quarter 2007 net income after tax was up 55% from a year ago, revenue rose 27%, and expenses were down 10%, overcoming a 65% increase in the loss provision. Management sees charge-off normalization and economic weakening together with a pullback from the prime revolver market causing the charge-off rate to go to the mid-six percentile in the first half. The revenue margin at 20% has peaked and will move down to the high teens throughout 2008.

There have been policy adjustments to fewer fees and more flexibility to waive them. Fairbank said that that was related to research that found some people get angry at the company. I believe that it is political pressure from Congress. A move to 25 days to pay the monthly card bill means that the monthly charge-off rate could get to 7%. Strategies from dealing with the last two recessions are low credit lines, slowing growth and ramping up collections early.

Auto results are unacceptable to management, though clearly better than what AmeriCredit (ACF - commentary - Cramer's Take) reported in its fourth quarter. The managed 30-day delinquency is 7.84%, with 4% losses. Capital One is scaling back its dealer network to the ones that do the most business with them and have better performance.

The company is exiting near prime, which is the last segment it has moved into but performance there has not been good, so management has no desire to penetrate it during a recession. The company is also exiting the bottom 25% of subprime. FICO scores are already up 70 points vs. two years ago and 30 from last year. Pricing has improved as have credit metrics on new loans. Originations were down 25% in December. Management expects to pull back more in 2008.

Global financial services is seeing economic strength in Canada, and the U.K. credit experience is better, though card loans there fell 7%. Managed loans were up 9% in the quarter. Small business rose 12% ,and installment loans rose 17%

Local banking is helped by Capital One's footprint in Texas, Louisiana and Long Island, N.Y., where real estate is not a huge issue yet. Real estate losses are increasing from a low level. New Jersey construction loans are 1% of the total book. Management is being aggressive on deposit growth.

Capital One will manage to the high end of a 5.5% to 6.0% tangible-capital-to-assets ratio. There will be no share repurchases until the company is back at the high end of this range.

Management still sees the efficiency ratio declining after a blip up in the quarter and anticipates $200 million in lower expenses this year. (Residual merger saves have to be part of this.) The loan-loss reserve as a percentage of 30-day delinquencies is as follows:

• U.S. card, 109%;
• auto, 46% (cars can be repossessed, meaning lower needed reserves);
• global financial services, 187%;
• local banking, 94%; and
• Greenpoint, 276%.

Liquidity is $12 billion in cash equivalents, $11 billlon of three-year term conduits and $6 billion of Federal Home Loan Bank capacity. Management says that it can tap the capital markets throughout 2008 but could limit issuance to only AAA-rated asset-backed securities for a year. In the fourth quarter, Capital One did $1 billion in card securitizations from AAA to BBB and one prime and one subprime auto deal.

No EPS guidance will be given, but management will give guidance on loan and deposit growth in the low single digits, revenue growth also in the low single digits, cost management to a mid-40s efficiency ratio and capital management at the top of its range. The wild card is credit, where the company is giving no specific guidance.

Capital One is mildly liability-sensitive, so it will have some interest rate wind its back.

Asked about the shape of the recession, Fairbank said that this reminds him of 1990 to 1991, when the credit card and other lending markets went into the tank before the general economy went into recession. He said that Capital One has pretty good reliability on its own loss projections out for six months. He added, "After that it's anybody's call." Capital One's credit card experience in markets where the biggest gains in home price appreciation are reversing is about the same as its auto experience. The losses are turning up among all groups, with mortgage holders not any worse than the rest of the populations there, a comment I have heard from others.

OK, economic momentum is not positive, but Capital One is the consumer lender I feel best about in any recession, and the stock is extremely cheap. I see the company coming out relatively well on the other side as management has been doing all of the right things.

COF Preview: Credit Outlook Is Key

Capital One (COF - commentary - Cramer's Take) has been hit by the subprime, then the consumer, then the general financial crises.

Fourth-quarter EPS is expected to be 63 cents vs. $1.14 last year, and full-year 2007 EPS is expected to come in at $4.07, down from $7.67 last year. The average EPS estimate for 2008 is $6.14, within a wide $5.00 to $7.15 range.

Unfortunately, a company cannot make an attempt at a sort of a deck-clearing kitchen-sink write-off in this environment without investors thinking the worst and taking the stock down even more. The stock is now $40, down from $65 when the fourth quarter started.

In early January, Capital One announced that fourth-quarter EPS was to be around 60 cents, or about 85 cents without a loss from Greenpoint, rather than the nearly $1.55 that was previously expected. The primary reason is a $1.9 billion loan-loss provision vs. the $1.3 billion one that was expected. The differential is basically all a reserve build of $650 million.

Using one analyst's near consensus $6.20 EPS estimate for 2008, a 3.6% managed charge-off rate at December's end grows to 4.4% at the end of 2008, with card charge-offs going from a 5.4% fourth-quarter 2007 average to 6.5%. Charge-offs reached a peak of 6.6% in the last recession. Auto charge-offs go from 4.04% in December to 6.5% for 2008.

This is at least a decent attempt to clear the decks by a very risk-averse management with one of the best credit records in cards since I started following them in 1993 as a sub of Signet Bancorp.

OK, the last recession was not a normal one, and it somewhat bypassed the consumer. If I add 2% to loan losses across the board and draconically assume all is provisioned for through the income statement (instead of letting the reserve fall as less is provided than is written off, which would be sensible at a recession bottom), I have roughly $6.50 of losses, or no income in the year 2008. This is, in my opinion, an absolute kitchen-sink type charge-off. Then, assuming a draconian 10% return on equity for 2009 ($6.42 per share) and an absurd 5% EPS growth rate, the stock is worth $69. A 12% return on equity ($7.70) and 5% growth imply $83, a 55% gain.

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At the time of publication, Thomas was long Capital One.