Stocks For Dad
TMF Ralegh's Stock For
Dad
Capital One Financial Corporation <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: COF)") else Response.Write("(NYSE: COF)") end if %>
2980 Fairview Park Dr., Ste. 1300
Falls Church, VA 22042-4525
(703) 205 - 1000
Company
Snapshot
Dear Dad,
Hey, hope you're having a fun Father's Day and that you've had a chance to
get out on the golf course, even as cold as it's been up north this spring.
I've got a little present for you -- it's an investing idea. I've been looking
at CAPITAL ONE FINANCIAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: COF)") else Response.Write("(NYSE: COF)") end if %>. Well, actually, I've bought
some shares, but I don't want that to unduly influence you.
What we're looking for: As usual, Dad, I'm looking for above-market earnings
growth without above-average risk. That's why I like to pick around the sectors
that the market at large has shunned. This time, we're looking at credit
card lenders, which have come down on fears that consumer defaults and
slow-payments will accelerate. Notable blow-ups in the sector include
ADVANTA <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ADVNA)") else Response.Write("(Nasdaq: ADVNA)") end if %>, which fell from $40 to around $21 per share
in mid-March when it announced it was going to bulk up on its reserves and
take a "big bath" to get its house in order. During the time that it was
showing amazing earnings growth, then, it was really overstating profits.
Capital One never took that big bath and was reserving properly all along.
Capital One did come
down, though, when it announced that its customers were borrowing more
responsibly, meaning the company was earning less over-limit charges and
late fees. Interesting how Capital One got into this position -- I'll tell
you why.
Capital One is the oldest continually operating credit card business in the
country, but they don't really think of themselves as just a credit card
issuer. Their information-based strategy, launched in 1988, makes them a
marketing information company: "Our proprietary information-based strategy
is the cornerstone of our success." The company's multi-terabyte database
is constantly mined for "what ifs" and for credit quality red flags. Since
you've always told me about the value of knowing your customers, I think
you'd like this company, as they know their customers (and potential customers)
better than any financial institution in the world. For more information
on the company's information technologies spending, I direct you to an excellent
ComputerWorld
article,
"Customer 'Data Mining' Pays Off," by Gary Anthes.
Financials
I know you love financials, Dad, so here's a light review of some financial
arcana. Among the four companies from a peer group that I selected, Capital
One has shown the best risk reward profile as to its reserves, valuation
of its stock, and forward-looking growth prospects. Only Advanta, which
took the hit last quarter
and had its forward earnings estimates devastated, has a lower price-to-book
and higher reserves for credit losses.
Compared to other industry stalwarts, MBNA <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KRB)") else Response.Write("(NYSE: KRB)") end if %> and FIRST
USA <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FUS)") else Response.Write("(NYSE: FUS)") end if %> (the valuation of which is locked in place by virtue
of its merger agreement
with BANC ONE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %>), the price to assets and price to book
ratio on Capital One is much more reasonable. While MBNA trades at 6.9 times
book value and 1.71 times its gross loans and receivables, and First USA
trades at 5.2 times book and 138% of loans and receivables on the balance
sheet, I see better value at Capital One, which is priced at 2.8 times book
value and 62% of gross loans and receivables. I also like Capital One's more
conservative credit loss reserves of 3.4% of loans and receivables, which
compare to 2.5% at First USA and only 1.9% at MBNA. Finally, in banking parlance,
the company's leverage ratio is much better than MBNA's and just about the
same as First USA's (which, remember, is carrying a much higher valuation
than our baby).
What We're Hoping For: We've picked another stock here that we'd like to
return 15% or more per year over the next five years. According to the analysts
that cover the sector, that's about the market growth rate over the coming
half-decade, and I feel pretty comfortable that Capital One will match that.
I think the company can do this because of its intelligent spending on marketing
and dissection of customer preference. There is also a larger societal trend
toward the digitization of money, which hasn't quite played out yet and is
nowhere near as mature in other countries as it is here. We also have a
consolidating banking sector, which lends price support to Capital One's
stock because there are many bank Chairs and CEOs out there that would love
to trade their equity for Capital One's.
Multiples to Forward Earnings Estimates
1998 EPS Estimate Multiple
Capital One $3.19 10.1
First USA $2.80 17.6
MBNA $2.10 15.9
Advanta $2.98 9.8
Yeah, Dad, Advanta looks cheap, and is possible a pretty good buy here, but
I like Capital One's smooth earnings growth, borne of better knowledge of
customers and a lack of desire to reach for the marginal customer, better
than Advanta. The other valuations in the group don't really excite me all
that much, either.
What to Look out For: Though we could take a temporary hit on the value of
our shares, I believe that the downside on Capital One is much less than
for other companies in the sector. The company's reserves for credit losses
are adequate and prudent. In a slower-growth environment or a more competitive
environment, its risk management strategies and customer selection will enable
it to weather a storm better than others. If consumers reign in credit, though,
the company is somewhat more vulnerable to slackening fee income, which greatly
outweighs its net interest income. The company falls in the right spot, though,
between looking dangerously cheap and looking like we might be paying too
much for growth. I'm comfortable with the level of risk we assume here for
a first-rate financial services company.
Love, your son and friend,
Dale
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