Will Capital One’s consumer lending business survive the next recession? (NYSE:COF)
the Capital One Financial (COF) is highly dependent on the growth of the US economy, with a low level of delinquencies and cancellations of consumer loans. Fortunately, Capital One investors witnessed relatively low/declining credit write-downs of around $7 billion in 2017 and around $5.5-6 billion in 2018, using data from the top nine months as an approximation. In a worrying development of late, the company has seen an increase in chargebacks since September.
My bearish argument revolves around the rising odds of a recession in 2019-20, with sharply increased charges destroying Capital One’s earnings. Given a severe recession like that of 2007-2009, the company may be forced to raise additional capital or sell business units to cover losses and remain solvent, significantly diluting existing shareholder value from early 2019. .
Image source: Capital One TV ad
Capital One is among a select group in terms of size and concentration in the subprime consumer lending market, particularly unsecured credit cards. The company currently has $110 billion in credit card loans and another $60 billion in consumer auto/mortgage/personal loans. We’ve all seen the ads with Jennifer Garnier and others who provide quick and easy signature loans through mass media. During good economic times, the company is able to achieve strong levels of profitability as loan losses remain low.
On the other hand, the 2007-2009 recession nearly bankrupted the company, as credit losses increased. You can check out the chart and table below highlighting the correlation between credit card delinquencies and Capital One’s stock plunge from $84 per share in early 2007 to below $8 at the low of March 2009. The stock price “discounted” expanding radiation levels, trading well ahead of news on the ground. The Great Recession’s credit market woes peaked in late 2009 and early 2010, 6-9 months after the stock price bottomed out.
The chart above of credit card overdue and charge rates from 1989 to 2016 is from Wallethub using 2017 Federal Reserve data. By any measure, credit card delinquency rates have remained at record highs for a record length of time since 2013.
In total, Capital One’s credit card delinquency rate of 4% today is about one-third the rate of the last recession and lower than the industry’s 30-year long-term average of over 5%. . What if the next recession isn’t mild, as Wall Street analysts are predicting for 2020 as the consensus view right now? What if record debts all over the world, including in the United States, lead to a deep recession, even deeper than in 2007-2009? If we get this as our reality soon, Capital One will be in huge trouble dealing with such a monster, in my opinion.
Is the trading stock of lending companies starting to price in a recession?
Below are graphs of Capital One’s underperformance relative to its peers in banking, particularly high-risk, consumer-focused companies. Discover Financial (DFS) and American Express (AXP). The leading diversified banks in the United States, including JPMorgan Chase (JMP), Citibank (VS), Bank of America (BAC), and Wells Fargo (WFC) also began to fade from the return of the S&P 500 last year. Moreover, the SPDR Selected Financial Sector ETFs (XLF) was a significant laggard in 2018. Are delinquency issues coming for lenders?
The price rebound at the start of 2019 seems like a good technical area to sell Capital One shares, or even consider selling them short. You can see the general price resistance zone in the chart below. The $85-90 range seems like a formidable supply hurdle to overcome. At the very least, a retest of the $70 mid-zone just above the December low seems likely.
How big can loan losses be?
Clues to the poor quality of Capital One’s loan portfolio abound. Perhaps the biggest deal on my mind was the summer 2017 Federal Reserve stress test snub. All of the major US banks passed, but Capital One had to reapply and was the only company out of 34 banks not to increase their common dividend in June-July 2017. Again, after the results of the summer 2018 stress test, Capital One did not increase their $0.40. paying quarterly dividends, as other major banks have done. The company has “returned” capital to shareholders through share buybacks at high prices over the past few years. Nevertheless, the current dividend yield of 1.9% is below the average for the S&P 500 stock market, the average for the financial sector and well below the average rate of major banks.
According to the latest available balance sheet from the September 2018 10-Q filing, the company has one of the largest credit card loan portfolios in the country at $110 billion and one of the highest consumer loan percentages. raised from total assets to 50%. Compare Capital One’s 50% asset exposure to US consumer loans versus 80% for Discover, 35% for American Express, 12% for Citibank and less than 10% for JPMorgan Chase, Bank of America and Wells Fargo.
Capital One’s strong operating profit performance in 2018 was almost entirely a function of low and lower loan loss reserves taken, in addition to Trump’s tax law changes. You can take a look at the increase in Q3 earnings below, as write-offs have fallen significantly.
While mainstream analysts count 2018 earnings and leading margins as sustainable, Capital One’s stock price is beginning to look forward to the final stages of the credit cycle and an impending downturn. When this happens, loan losses will increase dramatically, and if past cycles are any guide, interest income will fall as interest rates fall. This double whammy typically produces a significant drop in earnings during a recession. It’s possible that all profits will be wiped out for a year or two, and the company will face charges that erode underlying shareholder value from the tangible book value of $35 billion today. The current stock price of $85 is equivalent to a market capitalization of $40 billion.
In 2010, at the end of the last recession, the company wrote off about 7% of the value of all loans. That’s well above today’s ultra-low 2% credit loss charge annualized in the September quarter, reported on a loan value of $240 billion. If we get a huge recession again, Capital One could write an “extra” $10 billion or $15 billion to its earnings per year. Given that 2018 earnings could peak at just under $6 billion, the drop in profitability and shareholder value is gigantic, given another major recession. While the current price of 0.8x book value seems cheap (1.2x tangible book value after subtracting $15 billion of goodwill and intangibles), the 2009 low price was only 0.15x book value. To say such a low valuation will never happen again is like someone saying in the depths of the financial panic a decade ago that the stock market would never recover or trade at valuations record similar to those of 2007 or 2000. FALSE. “Story does not repeat itself, but often rhymes“, is the famous quote from Mark Twain.
If you are looking to sell financial services, Capital One should be at the top of your prospect list to continue your research. My personal view is that we are headed for a severe downturn, either in terms of damage to the economy or over an extended period. Tightening of credit conditions, as evidenced by the almost inverted Treasury yield curve at the end of 2018; the appearance of a real trade war with China during the summer months; and a sharp drop in confidence and wealth caused by the 20% slump in the stock market in the just-ended 4th quarter – all signs of a slowing economy in the first half of 2019.
Depending on events on the ground, a slowing economy could easily tip into recession. Then the most overleveraged US economy in history, including sovereign debt, corporate debt, and consumer debt overall relative to economic output, could quickly turn into an economic fiasco. Don’t say it can’t happen. From my 30 years of trading experience, whenever we encounter three or more significant issues that weigh on wealth, production and confidence, we fall into a recession. Holding too much leverage before a recession is what turns a mild one into a deeper one.
Looking for Alpha Author Danielle DiMartino Booth wrote an interesting article last week on late-cycle credit card usage and how it relates to 2018 trends. It appears the November-December slump in Capital One stock has a lot of fundamental logic to support the sale. We have been waiting for a recession for a long time, almost 10 years after our current expansion. The clock is turning.
Please consult a registered financial advisor if you are considering a short Capital One position. The unique risks of short selling, including the potential for unlimited losses, are different from holding a long position only. Always sell a diversified basket of stocks to reduce the risk of one stock creating outsized losses.