Capital One Stays Cheap After Beating JPMorgan in Tests

Capital One Beats JPMorgan in Stress Test
Capital One Financial Corp. signage is displayed at a bank branch in New York on Aug. 10, 2011. Bloomberg. The firm’s Tier 1 common capital ratio, a measure of a bank’s ability to withstand losses, would be almost a percentage point higher than JPMorgan’s in a severe economic slump, according to the Fed. Photographer: Guy Calaf/Bloomberg

Capital One Financial Corp. is among the cheapest U.S. bank stocks, even as Federal Reserve data show the company is better-equipped than JPMorgan Chase & Co. and Wells Fargo & Co. to withstand a severe economic slump.

Capital One’s projected price-to-earnings ratio for the next 12 months is 9.59, tied with JPMorgan for the lowest among firms in the KBW Bank Index that passed Fed stress tests this month, according to analysts’ estimates compiled by Bloomberg. The firm’s Tier 1 common capital ratio, a measure of its ability to absorb losses, would be almost a percentage point higher than JPMorgan’s in the most dire Fed test scenario.

“It’s been too cheap for a long time,” said Ralph Cole, a senior vice president of research at Portland, Oregon-based Ferguson Wellman Inc., which manages $2.9 billion including Capital One shares. “You want a growth story, and we think in the outer years it will be a growth story,” he said, citing takeovers that added low-cost deposits and millions of potential new customers for loans.

Chief Executive Officer Richard Fairbank spent more than $28 billion since 2005 to transform the firm into the sixth-biggest U.S. commercial lender by deposits, capped by this year’s purchase of ING Direct USA. Even so, more than half of revenue comes from credit cards, and Fairbank is expanding those assets with a $2.6 billion purchase from HSBC Holdings Plc. Analysts say the CEO must show he can control the added expenses and concentration risk, and raise profit without acquisitions.

Shares Advance

Capital One’s shares have advanced 35 percent this year through yesterday, compared with a 28 percent gain for the KBW Bank Index. That made the McLean, Virginia-based firm the third-best performer over the past 12 months in the 24-company index. The stock hasn’t traded this high since November 2007, before the worst of the credit crisis took hold. Back in 2006, a share of Capital One fetched almost $90.

Only Citigroup Inc. has a lower price-earnings ratio, at 9.33, and the New York-based lender didn’t pass the Fed’s stress tests.

Analysts surveyed by Bloomberg predict Capital One’s stock could reach $62 in 12 months, an 8.7 percent rise that would top projected returns for all of the 10 biggest U.S. lenders. A stake equal to almost 10 percent may hit the market in coming months. Those shares were given to ING Groep NV as part of Capital One’s $9.1 billion purchase of the Dutch firm’s online bank announced in June.

ING’s Overhang

“The ING shares are an issue and are keeping some investors on the sidelines,” said Sanjay Sakhrani, an analyst at KBW Inc., who said their concern isn’t the most important. “The biggest issue or risk is more along the lines of execution,” Sakhrani said. He has an “outperform” rating on the shares, meaning he expects the stock to return at least 15 percent over 12 months.

Fairbank has one of the industry’s biggest cushions against losses if the economy sours, according to results of the Fed’s stress tests. The firm’s Tier 1 common ratio, assuming the company took no steps to boost capital, would fall no lower than 7.2 percent in the Fed’s worst-case scenario, above the 5 percent threshold for a bank to be deemed sufficiently insulated from an economic shock.

That’s better than 6.3 percent for JPMorgan, the biggest U.S bank, and 6.6 percent for Wells Fargo, the largest home lender. Capital One’s Tier 1 leverage ratio, a measure of how much equity supports total assets, would fall to 6.2 percent, higher than New York-based JPMorgan’s 4.5 percent.

Of the four core measures examined by the Fed, only Capital One’s minimum total risk-based capital ratio of 10.7 percent was below JPMorgan’s 10.9 percent, the results show.

Dividend Difference

JPMorgan and Wells Fargo won Fed approval to increase dividends and share repurchases, pushing their ratios lower. Capital One’s ratios got a boost because the lender didn’t seek approval to return capital to shareholders this year, Tatiana Stead, a bank spokeswoman, said in an e-mailed statement.

As for growth, the acquisitions of ING Direct and HSBC’s credit-card portfolio are “vehicles to secure additional customers,” said KBW’s Sakhrani. The HSBC deal added about $30 billion of U.S. credit-card assets, while ING Direct came with about $83 billion of deposits. That boosted Capital One’s total deposits to about $211 billion and vaulted the company from eighth to sixth among U.S. banks.

Capital One can tap those funds to pitch more commercial, auto and credit-card lending to 34 million former HSBC and ING customers who lacked access to products that Capital One offers, Sakhrani said. The deposits, he said, give Capital One a cheaper source of funding that will widen net interest margins, the difference between what the bank pays for deposits and what it charges for loans.

Mobile Banking

Capital One, which completed the ING purchase in February, has told ING customers who are accustomed to depositing checks through the mail that they will be able to do that using a computer or mobile application starting in the next few months. Clients with ING checking accounts also can use automated teller machines at Capital One branches, broadening their access to fee-free ATMs.

“We can provide ING Direct’s current and potential customers with a far wider array of customer-friendly, value-enhancing banking products,” Fairbank, 61, said in a September investor presentation. The combined firm “enhances and sustains key sources of shareholder value over the long-term, including increased loan volumes, strong and sustainable returns and strong capital generation,” he said. Capital One declined to make the CEO available to comment for this story.

Credit-Card Concentration

For now, the company still relies on credit cards, whose “What’s in your wallet?” slogan has been ingrained on consumers through television ads and mailings. The combination of heavy promotion, consumer rewards and no annual fees have made Capital One the fifth-biggest U.S. credit-card issuer by purchases and contributed $2.3 billion of the company’s $3.1 billion of profit last year. The acquisition of the HSBC portfolio is scheduled for completion by mid-year, boosting assets by more than 14 percent.

Capital One’s stock looks more expensive measured by price-to-tangible book value, which stands at 1.7. That’s higher than the average of 1.3 for its peers, including 1.4 times tangible book value for JPMorgan.

Headwinds include a nationwide drop in revolving consumer debt to $2.95 billion in January, the first decrease since August, according to Fed data. The total of $801 billion is down from a September 2008 peak of $972 billion.

“Consumers have paid down debt and appropriately so,” Cole said. Still, the decline won’t last and when borrowing picks up again, Capital One will be one of the industry’s leaders, he said.

Fee Squeeze

Threats to revenue from “swipe fees” charged to merchants for each card purchase may also re-emerge. New U.S. laws have already crimped such fees on debit cards, and a federal anti-trust lawsuit by merchants against banks and payment networks over credit-card fees is scheduled for trial later this year, according to Daniel Furtado, an analyst at Jefferies Group Inc. A defeat could cut the $1.32 billion the firm reaped last year, according to its fourth-quarter supplement.

Then there’s the prospect of more dilution. Capital One sold $1.26 billion of shares this month to help fund the purchase of HSBC’s U.S. credit-card assets, which included co-branded and “private-label” cards issued by retailers. That followed a $2 billion sale in July to help cover part of the cost of acquiring ING Direct.

Raising Alarm

In addition, on Feb. 17, Capital One issued more than 54 million shares to ING in connection with the purchase, making the Amsterdam-based firm the largest shareholder with a stake of almost 10 percent, according to data compiled by Bloomberg.

Capital One shares slid as much as 8.2 percent on Jan. 20, a day after the firm said a 25 percent increase in noninterest expenses pushed down fourth-quarter profit. Management cited technology and infrastructure needed to handle the additional customers.

That alarmed investors and made them wary of unexpected costs related to the transactions, said David Knutson, a credit analyst in Chicago with Legal & General Investment Management.

“Fairbank did not do a very good job of preparing the market,” he said in a phone interview. A sluggish U.S. economy may weigh on card spending, Knutson said.

Among analysts, buy recommendations outweigh sell and hold ratings by 21 to 9. Furtado at Jefferies said the bank may be able to boost its 5-cent quarterly dividend or buy back stock in 2013, and he moved his price target to $72 from $50 in a March 19 report.

Earnings Ahead

Brian Foran, a senior bank analyst at Nomura Securities, predicts Capital One will earn $7 a share in 2013, more than the $6.87 consensus in Bloomberg’s survey of analysts. Foran assigns a “buy” rating with a $54 price target for the next 12 months.

Jerrold Senser, the CEO of Institutional Capital LLC and ICAP money manager Robert Stoll, who helps oversee $24 billion, purchased 7.4 million Capital One shares in the fourth quarter, making their firm the lender’s 13th-biggest owner with a 1.3 percent stake, according to Bloomberg data. Icap believes Capital One’s purchases will boost long-term profit, Stoll said.

“A good, focused operator like Capital One can take market share and you can take it organically, or you can buy it,” Stoll said. “With the ING and HSBC deals, we think they bought market share at a reasonable price.”

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