Capital One's Weak Results Set Up Buying Opportunity

NEW YORK (TheStreet) -- Capital One (COF) disappointed with a relatively weak fourth-quarter earnings report, sending the shares down over 5% on Friday, but the company is focused on a great business -- credit cards -- and its stock trades at a low multiple to peers, setting up what could be a nice entry point for investors.

The company is based in McLean, Va., and tends to be lumped in with regional banks, as it has an extensive east-coast branch network. However, Capital One is a major credit card lender that has a much stronger net interest margin than the nation's large regional banks.  The company's net interest margin -- the difference between the average yield on loans and investments and the average cost for deposits and borrowings -- was 6.73% during the fourth quarter, while all the major regional banks have margins well below 4%.

Capital One's shares dropped over 5% on Friday to $72.48.  Following Thursday's market close, the company reported fourth-quarter earnings available to common shareholders of $859 million, or $1.45 a share, down from $1.099 billion, or $1.86 a share, the previous quarter, but up from $825 million, or $1.41 a share, a year earlier.  The fourth-quarter earnings came in considerably lower than the consensus estimate of $1.57 a share among analysts polled by Thomson Reuters.

A major factor in the sequential earnings decline was an increase in marketing expenses to $427 million in the fourth quarter from $299 million the previous quarter and $393 million a year earlier. 

Investors were not placated by Capital One's return to loan growth. Average domestic credit card loans rose 1% during the quarter, to $70.368 billion, although they were down 13% from a year earlier, as the company wound down the riskier part of the U.S. credit card portfolio it purchased during 2012 from HSBC (HSBC), while in September completing the sale of its $6 billion portfolio of  Best Buy (BBY) credit card accounts to Citigroup (C).

The company did post solid growth in average commercial loans, rising 4% sequentially and 15% year-over-year to $43.359 billion in the fourth quarter.

Capital One plans to continue keeping its marketing efforts, and expenses, at an elevated level.  CFO Steve Crawford during the company's earnings conference call on Thursday said the company's outlook for 2014 was for pre-provision net revenue re-provision net revenue -- that is, revenue less expenses but excluding additions to loan loss reserves -- to total about $9.8 billion, "with a reasonable margin for error," declining from about $10 billion during 2014.

"After adjusting 2013 revenues for the loss of Best Buy, which contributed a little over $630 million in revenues, this year we expect very modest revenue growth in 2014," Crawford added.

So investors may be underwhelmed by the short-term earnings outlook for the company.  But what about for the long haul?

Capital One's shares trade for 9.9 times the consensus 2015 EPS estimate of $7.32. Among the 24 component stocks of the KBW Bank Indez (I:BKX), only Bank of America (BAC) and JPMorgan Chase (JPM) trade at lower forward P/E multiples, and Bank of America is a much weaker earnings performer, while JPMorgan's shares continue to be held back by regulatory and headline risk.

Capital One's 2013 return on average tangible common equity (ROTCE) was 14.98% during 2013, according to Thomson Reuters Bank Insight.  Bank of America's ROTCE during 2013 was 7.94%, while JPMorgan's ROTCE -- lowered because of the company's third-quarter net loss, as it set aside provisions to help cover its $17.5 billion in fourth-quarter mortgage-backed securities settlements -- was 11.92%.

"We remain positive on COF as the company works toward a full peer bank multiple, which we believe is in the 12.0x-13.0x range," wrote UBS analyst Matthew Howlett in a note to clients on Monday. 

That's the key for investors.  Following Capital One's major acquisitions during 2012, with higher-than-expected credit expenses from the HSBC card portfolio, the shares have dragged peers.  But with greater earnings potential, based on the higher margin credit card business that performed so well when compared to most other loan types in the wake of the real estate meltdown of 2008, as well as strong growth in coveted commercial loans, the company could see its stock valuation come up to peer levels, assuming it doesn't plan on another transformative acquisition over the near term.

Based on Capital One's fourth-quarter results and 2014 outlook, Howlett reiterated his "buy rating," lowered his price target for the shares to $85 from $87, while lowering his 2014 EPS estimate to $6.65 from $7.15 and his 2015 EPS estimate to $7.43 from $7.74. 

Howlett wrote that his investment case for Capital One is "predicated on its post balance sheet transformation earnings model, which should be in full swing by 2H14. We believe the U.S. card book can grow by $4B (6%) in 2015, while the commercial and auto books can grow at mid-double digit rates. Factoring in expense and capital management, we expect the earnings growth rate to be in 10%+ 2015-2017."

Capital One's shares were up 0.9% in early trading Tuesday, to $72.79.

This chart shows the performance of Capital One's stock against the KBW Bank Index and the S&P 500 since the end of 2011:

COF Chart data by YCharts


Interested in more onCapital One? See TheStreet Ratings' report card for this stock.

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-- Written by Philip van Doorn in Jupiter, Fla.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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