What’s Behind The Recent Fall In Capital One’s Share Price?

Earlier this week Capital One (NYSE:COF) reported a much better-than-expected EPS figure for the first quarter of the year. However, investors were unhappy with the card-focused bank’s performance for the quarter, as they led its shares 5% lower on the next trading day. While Capital One’s overall results are strong for the seasonally slow first quarter, the single biggest concern raised by investors was the sequential 10 basis points reduction in its net interest margin (NIM) figure – something that dragged its total revenues below the consensus figure. This is in sharp contrast to the improving net interest margin figure across the banking industry thanks to the Fed’s rate hike process. We have summarized Capital One’s Q1 2018 earnings and also detailed the major takeaways from the announcement in our interactive dashboard for the company, the key parts of which are captured in the charts below.

We believe that the sell-off in Capital One’s shares was not warranted. Unlike other commercial banks, Capital One has a card-heavy portfolio of loans. This makes the bank’s loan portfolio more sensitive to the seasonal trend of people paying off their outstanding loan balances in the first quarter using additional cash in hand in the form of tax refunds and annual bonuses. While this had a clear impact on Capital One’s interest revenues for the quarter, strong growth in its deposit base resulted in a sharp increase in interest expenses – leading to the lower net interest margin. But a larger deposit base is a good thing for Capital One in the long run, as it is a cheap source of funds for its lending business. With the interest rate environment expected to improve over coming months, Capital One should be able to channel these funds into more profitable loans in subsequent quarter – boosting revenues and profits. Because of this, we stick to our price estimate of $107 for Capital One’s stock which is about 15% ahead of the current market price.

See our full analysis for Capital One

The Decline In Net Interest Margin (NIM) Is Temporary

The rate hikes implemented by the Fed have helped the interest rate environment in the country to recover steadily from the record low levels seen over 2014-15. However, as we pointed out earlier, Capital One has bucked this industry trend to report a decline in its NIM figure for two consecutive quarters now. At the same time, seasonal factors also led to a sequential decline in the bank’s total interest-earning assets. Taken together, this led to a reduction in Capital One’s total interest income from the record figure of $5.8 billion in the previous quarter to $5.7 billion in Q1 2018.

But we expect the trend to reverse in Q2, with the net interest margin and asset base increasing notably to help the bank post record net interest income figures.

Loan Provisions Sharply Lower Despite A Small Uptick In Card Charge-off Rate

Capital One set aside the lowest amount of cash to cover loan losses for the quarter since Q3 2016, although card charge-off rates were at the highest level seen over recent years (5.02%). The reason for this was the lower overall charge-off rate for the company, which fell sequentially from 2.89% to 2.59% thanks to a notable reduction in consumer and commercial loan charge-offs for the quarter.

As we have pointed out on several instances in the past, a steady increase in card charge-off rates is expected, as the figure for the industry had been hovering at a 20-year low of under 3% over 2015-16. In fact, signs of a normalization began to show in Q4 2016 when card charge-offs for the industry increased to 3.56%. The card industry as a whole benefited from a recovery in credit market conditions over 2012-15, and this helped banks reverse some of the loan provisions they had set aside immediately after the downturn. At the same time, card lenders relaxed their lending standards to make the most of the situation – considerably expanding their sub-prime card lending activity.

As Capital One grew its card loan portfolio at a faster rate than the industry, it very likely has a larger proportion of low-quality card loans on its balance sheet. And this should keep its loan charge-off rates higher than that for the industry going forward. But we believe that the figure will level off soon.

Seasonally Lower Card Purchase Volumes Weigh On Card Fees

The cards and payments industry witnesses considerable seasonal trends, with the first quarter being the slowest period and the fourth quarter (which includes the holiday season) being the strongest period. This is evident in the chart below that captures Capital One’s card purchase volume over the last five quarters. Although the purchase volume of $86.5 billion for Q1 2018 was 10% lower than the figure for the previous quarter, it was almost 5% higher than the figure a year ago. This led card fees for the quarter lower compared to Q4 2017.

Based on Capital One’s Q1 2018 results, we expect the bank to report EPS of $9.73 for full-year 2018. Taken together with a P/E ratio of 11 (which we believe is appropriate for the bank), this works out to a price estimate of $107 for Capital One’s stock, which is slightly ahead of the current market price.

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