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All Signs Are Go at Capital One

Fourth-quarter data show little evidence of a recessionary pullback.

Capital One

(COF) - Get Capital One Financial Corporation Report

bulls can breathe a sigh of relief now that the dynamic credit card lender has reported fourth-quarter earnings showing little evidence of recession-inflicted damage.

Earnings in the fourth quarter rose 31% from a year ago to 80 cents a share, in line with analyst expectations. As expected, losses from bad loans did jump, to 4.42% in the fourth quarter from 3.92% in the preceding period. But past-due loans actually dropped from the third-quarter level, indicating that the weak economy may start taking less of a toll on Capital One's credit quality.

Loan growth remained prodigious, with average loans rising 57% from a year earlier to $41.4 billion.

One weak spot was the decline in the profit margin on its loans, mainly due to an increase in the use of low teaser rates, a marketing tactic that Capital One has been unenthusiastic about in the past, and more lending to people with top-notch credit. The margin fell to 8.68% in the fourth quarter, from 9.27% in the third period. And despite many calls for greater disclosure in the post-


environment, Capital One execs repeatedly refused analysts' requests on a conference call Tuesday evening for a breakdown of their loan portfolio according to the creditworthiness of its borrowers. Capital One lends to people with excellent, good and poor credit quality.

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With the stock trading at 15 times analysts' forecast 2002 earnings of $3.50, Capital One stock should be poised to move higher. If the company hits that $3.50 number, it will post 20% growth. If the stock were to trade at 20 times $3.50, it would move 30% higher, to $70. But 15 isn't necessarily a low multiple in the financial sector. The bottom line is that Capital One will have to hold down delinquencies and boost margins to get its 20 multiple.

Investors have become spoiled by Capital One's enviable performance. They want to feel comfortable that the company's amazing trifecta -- strong loan growth, fat margins and low bad-loan numbers -- will continue to come in each quarter.

So far, Capital One appears to be doing that. The delinquency rate fell to 4.95% in the fourth quarter from 5.2% in the preceding period. But that could be a function of the massive growth in the loan portfolio. A fast-growing portfolio can artificially hold down the delinquency ratio, as problem loans take time to filter into the delinquency bucket. But the decline in the delinquency ratio is also a function of Capital One's shift in recent months to the superprime, or most creditworthy, sector.

If it carries on with this emphasis on superprime, Capital One is unlikely to experience serious credit problems. But then, the big question is whether it can post 20% earnings growth by focusing on these lower-yielding loans. That might be difficult if it continues to make heavy use of teaser rates to gain customers. A Capital One exec said on the call that the company is using teaser rates on borrowers of varying credit quality, including the least creditworthy group, the so-called subprime borrowers. Capital One bulls often argue that the company can cut its hefty marketing expense to meet earnings numbers, but an increasing use of teaser rates suggests the landscape is extremely competitive, and the lender needs to spend all the marketing dollars it can.

The stock, which rose 2.4% Tuesday to $53.55, is more or less flat for the year.

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.