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Now that a number of banks have taken their lumps with bad commercial loans, investors are casting a cautious eye on consumer credit as the slowing economy continues to yield signs of deterioration. Analysts are homing in on some of the stronger pure-play consumer finance companies, betting that their niche focus and expertise will give them an edge in tougher times.




Household International

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Capital One Financial

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are cropping up on a number of top-pick lists based on their focused markets, solid balance sheets and growth prospects.

These are "data-driven companies that are managed on a very granular level," says David Berry, analyst at

Keefe Bruyette & Woods

. Consumer-lending margins tend to be solid, especially compared with those in commercial lending. "At Providian, in particular, the margins are quite wide, because they purposely play a down market," says Berry, referring to Providian's pursuit of customers with less-than-sterling credit histories. (He rates Providian buy and his firm has no underwriting relationship with the company.)

Providian balances that risk by limiting the size of its credit lines and charging customers a premium rate, in some cases as high as 23.99%. At 8.5%, Providian's loss rate, reflecting unrepaid loans that must be written off, more than doubled that of conservative lender



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last year. But the risk-rate tradeoff means that in the latest quarter, Providian's net interest margin was 13.13%, compared with MBNA's 7.22%.

"The charge-off rate is a little more than double MBNA's, but the bottom line is that the return is probably more than double that of MBNA," says Berry. "Obviously

Providian makes that up on the revenue side. They know what they are getting into and they are priced appropriately for it." The stock currently trades at about 14 times estimated 2001 earnings but is expected to see earnings per share grow by about 24% in the year ahead, on top of last year's 44% growth in per-share earnings.

The focused approach of these consumer finance companies "has allowed them to grow with above-average profitability, while some of the other issuers have had trouble growing their credit card businesses," says Berry.

Indeed, the need for a specialized focus was apparent in


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recent decision

to review its credit card portfolio as the increasingly competitive business demands specialized attention, and usually sizable marketing costs.

Balancing Act
Credit card stocks' yearlong rally

Analyst Michael Hughes of

Merrill Lynch

highlighted Household International in a recent research note, saying it has tended to be "in the shadow of the faster-growing Capital One and Providian" but has nonetheless reaped the benefits of both internal growth and increased market share. Hughes stressed Household's stable returns as well as earnings-per-share growth of 15% and return on equity of 22% to 23%, which he said have a "high likelihood of continuing" over two to three years.

The stock trades at about 13 times earnings with a 15% growth rate, compared with regional banks under Merrill Lynch coverage, says Hughes, which trade at about 14 times 2001 estimated EPS with growth at about 8% to 9%.

Capital One, which has garnered positive mention for similar growth, is also one of Hughes' picks. The company reported 45% loan growth in the fourth quarter while also managing to keep a tight lid on expenses. But at nearly 19 times earnings, it is hardly cheap.

Despite some of the jitters, analysts are quick to point out that deterioration on the consumer credit side will not likely be as severe as that seen in commercial and industrial loans. A

Goldman Sachs note about consumer credit trends certainly got the financial sector feeling nervous Tuesday.

But Berry notes that the risks of consumer lending are spread more thinly. "The credit card business is really relatively small loans made to millions and millions of consumers," he says, which is different from commercial lending, where "one


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can ruin your whole day."

Providian and Capital One have also been very conservative with loan-loss provisions, says Berry. In many cases, the analyst points out, they have added more to their loan-loss reserves than they take out for charge-offs. In the latest year, for instance, Providian set aside $2.2 billion for loan losses, well above the $1.8 billion it reported in net credit losses.

Says Hughes: "Clearly consumer credit is going to deteriorate, but it's not enough to derail" the earnings growth at these companies.