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Capital One, Little Credit

Peter Eavis

The cracks are reappearing in the Capital One (COF Quote) story.

For the past two years, Capital One has done a fair job of proving its critics, including this column, wrong. The racy credit card lender managed to post a whopping 34% increase in earnings in 2004, and its stock is up a massive 160% from February 2003, giving the company a current market worth of $19 billion. The huge amounts spent on sports sponsorship, TV advertising and other forms of marketing could even give the impression that Capital One has now established itself as a permanent heavyweight in the U.S. financial services industry.

But anyone taking an honest look at Capital One's fourth-quarter earnings would see that its growth-at-all-costs strategy never went away and is starting to come undone. Capital One has managed to do well since 2001 because it's been taking full advantage of the easiest credit environment in U.S. history. Now, as the advantages of that easy-money boom dissipate, the company's shortcomings are becoming sorely apparent.

Tuesday, Capital One stock fell $1.22 to $77.32. A company spokeswoman didn't respond to a call requesting comment.

At its current price, Capital One trades at 11.2 times the $6.92 that analysts expect in earnings for 2005. That doesn't look at all expensive, meaning that earnings disappointments might not cause the stock to collapse. Even though the fourth quarter's 77 cents in per-share earnings were well below the consensus estimate of 99 cents, and even though the earnings got a dubious boost from a substantially lower tax rate, the stock didn't totally crater. Instead, it slid 6.5% in the three days following the Jan. 19 earnings release, and then rose.

However, the fourth-quarter numbers suggest it will be hard for Capital One to earn the $6.92 that Wall Street expects this year. As a result, if the company ended up making, say, $5.50 instead, it would be trading at 14 times earnings, which is a pricey multiple for a company as unpredictable as Capital One.

So what was so distressing about the fourth quarter? Even Capital One bulls couldn't quite get over the size of marketing spending in the quarter. Capital One spent $511 million in the fourth quarter alone on marketing -- a sum even CEO Richard Fairbank labeled "eye-popping." In the year-earlier fourth quarter, Capital One spent $317 million. Nor did the 2004 quarter's big spend translate into strong loan or new accounts growth. Bill Ryan, analyst at New York brokerage Portales Partners, says that each net new account costs "an incredible $379." (Portales rates Capital One a sell, and Portales doesn't do investment banking.)

One has to assume the marketing spending was defensive, since the company didn't warn that it was coming. Perhaps in the latter part of 2004, it felt pressure from Citigroup (C Quote) and J.P. Morgan Chase (JPM Quote) and spent like crazy to snatch customers. Of course, marketing spending will dip in the first quarter from the fourth, and it's possible that accounts growth will be higher than expected. However, if Capital One is being forced to massively up marketing spending for most of 2005, it will make the $6.92 consensus estimate almost impossible to achieve.

Even if conditions in the credit card market stayed like they are today, Capital One would clearly get clobbered by its rivals. But conditions are likely to get worse on other fronts.

First, Capital One is going to feel gradually more pressure from regulators to rein in the use of penalty fees. One massive advantage under which Capital One has operated is that it is regulated by the Federal Reserve, which has taken a more lenient stance on late and overlimit fees than another federal banking regulator, the Office of the Comptroller of the Currency.

However, over time, it's fair to assume that the Fed will tighten standards as well, especially as larger banks are softening their penalty-fee practices. One thing the OCC really wants to limit is a credit card borrower's outstanding principal increasing even after minimum payments are made because the lender has slapped on high penalty fees. This is called negative amortization. Asked on the conference call how Capital One might respond to pressure from regulators to limit negative amortization, CFO Gary Perlin said that "we believe our minimum payment practices are very appropriate and that we are in compliance with" regulatory guidance. However, on the call, Perlin conspicuously didn't supply data showing how many of its accounts were in negative amortization.

The regulatory angle could also hamper another reputed part of Capital One's strategy, which is to buy a bank. The company wants to do this to diversify and gain cheaper and more stable funding, but if it did so, it might come under strong pressure from the OCC and the Fed if substantial amounts of its loans are experiencing negative amortization. Even if regulators did smile on a bank purchase, Capital One needs a higher price-to-earnings multiple to make most bank acquisitions accretive to earnings.

And Capital One won't have a chance of getting its multiple higher if even a whiff of credit worries return. To be sure, Capital One's numbers show almost no sign of credit problems, and the company's earnings have been hugely boosted by skimpier bad-loan reserving. However, Portales' Ryan notes that fourth-quarter numbers showed a small increase in charge-offs leading to a surprisingly large $110 million addition to reserves, which was a big contributor to the earnings shortfall.