Is It Safe? Credit Card Trouble at Capital One

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Capital One Financial ( COF) has been outrunning rivals for the past three months with a return of 92% versus 38% for the S&P 500 financial sector index. Even though it's outperforming and undervalued, the credit card company faces an uncertain future.

Since the start of the credit crisis, many have been expecting an avalanche of credit card defaults as consumers lose their jobs and struggle to repay loans. While that hasn't happened yet, Capital One warned earlier this week that charge-off rates were rising.

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Capital One's highly geared balance sheet makes it especially vulnerable to charge-offs, loans deemed uncollectable. With about six times more debt than equity and credit cards providing 62% of sales, even a moderate decrease in card revenue would hurt profits.

The McLean, Virginia-based company's charge-off rate rose 85 basis points in the past month to 9.4%. It's faring better than American Express ( AXP), which has a charge-off rate of 10%, but lags behind the 8.3% rate at Discover Financial Services ( DFS).

Charge-offs occur when credit card loans go unpaid for 180 days, leading the company to write down the loan and interest. On that basis, today's charge-offs came from accounts that became delinquent in mid-December, before huge increases in joblessness. The amount of uncollectable loans will likely rise as the defaults of more recently unemployed customers reach the 180-day mark.

Capital One swung to a first-quarter loss of $111.9 million from a year-earlier profit of $548.5 million. The results follow a $1.42 billion loss in the fourth quarter.

The company relies so heavily on credit card income that even in the best of times it would make a riskier investment than more diversified competitors. Bank of America ( BAC) and JPMorgan Chase ( JPM), for example, have large credit card businesses, but also collect revenue from consumer banking and money management.

Luckily, most of Capital One's financing comes from customer deposits that carry an exceptionally low yield. Standard and Poor's cut the company's credit rating to junk status, along with those of 17 other banks, which means it would have to pay a painfully high rate to borrow.

Capital One shares are cheaper than those of its competitors when you consider its price-to-book ratio of 0.39, compared with 1.56 for its competitors. Its profitability is very shaky, though, with a return on equity of negative 0.3% versus 24% for American Express.

Capital One has a "sell" rating from TheStreet.com Ratings, with a grade of D-plus. The stock is too dicey for a portfolio with any risk aversion, especially in a weak economy.

TSC Ratings provides exclusive stock, ETF and mutual fund ratings and commentary based on award-winning, proprietary tools. Its "safety first" approach to investing aims to reduce risk while seeking solid outperformance on a total return basis.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.