COF: Guidance Conservative; Reiterate 2015 EPS of $7.70 and $90 Price Target
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
January 29, 2014
COF: Guidance Conservative; Reiterate 2015 EPS of $7.70 and $90 Price Target
- We view COF’s guidance for 2014 pre-provision earnings (PPE) of $9.8bn as conservative and reiterate our 2015 EPS estimate of $7.70 (versus consensus of $7.33) and our price target of $90. Consensus appears to discount a flat net interest margin (“NIM”) while we expect rising short rates (with the forward-market indicating 6-month Libor at 1.4% for mid-2015 versus ~0.35% today) to lift the NIM by at least 20 basis points; each 10 basis point increase in NIM lifts EPS by ~35 cents.
- Regardless, COF is mispriced. Even 2015 consensus estimates represent a 16% return on current tangible book value (“TBV”) of $46.2/share which is consistent in our valuation framework with a TBV multiple of 1.7x (see Exhibit). Given we do not expect a falling return, we apply this to end-2014 TBV/share of $50 for a valuation of $85 representing 20% upside from today’s close.
- CEO remarks that NPV-at-origination is as good as it has been for a long time bode well for forward earnings power (and explain the increased guidance for marketing spend).
- A risk to the thesis is that capital is trapped by the CCAR process in which case returns will decline. COF appears over-capitalized already by $6bn (CET1 ratio of 10.9% under Basel 3 versus the expected target of 8% on ~$225bn of risk-weighted assets) but there is uncertainty: COF will transition to the “advanced” approach (versus the above numbers under the “standard” approach) and, in any event, the Fed has discretion based on its stress-test analysis.
- Our model assumes the total payout ratio, across dividends and buyback, rises to 70% in 2014 and 90% in 2015 versus 25% in 2013; even so, COF is de-levering on an accounting basis (given our assumption of a flat balance sheet over the next two years).
- Strategically, COF is well-positioned, given its private-label card business and data-analytics capabilities, to support merchants as they look to take advantage of mobile payments to integrate payments with marketing through personalized and targeted e-coupon businesses. We see the potential for COF to replicate the funded portion of ADS’ business model and to become a key partner of merchant members of the MCX consortium.
Exhibit: Bank Valuations are driven by Forward Return on Tangible Equity
COF has issued overly conservative guidance for 2014 and we disagree with the analyst response of lowering 2015 estimates; we are reiterating our 2015 EPS estimate of $7.70 (versus consensus of $7.33). We believe guidance and consensus are anchored to spot interest rates while the proper benchmark is forward rates; the forward market is indicating 6-month Libor will increase from the current 0.35% to 1.4% by mid-2015 and we expect the net interest margin (“NIM”) at COF to rise by at least 20 basis points; all other things being equal, each 10 basis point increase in NIM is worth 35 cents/share in EPS.
Even if we are wrong 2015 consensus still implies a near-16% return on current tangible book value (“TBV”) of $46.2/share which, in our valuation framework, is consistent with a 1.7x multiple. Given we do not expect a declining ROE, we apply this to projected end-2014 TBV/share of $50 for a valuation of $85. A risk to our thesis is that capital is trapped by the CCAR process in which case returns may decline; we are assuming the payout ratio, across dividends and buyback, rises to 70% and 90% in 2014 and 2015 respectively (versus 25% in 2013) and note that this does not increase accounting leverage.
Management has stated they will be seeking Fed permission for a payout ratio well in excess of 50% but noted that the transition to the “advanced” approach under Basel 3 (versus the standard approach where the firm has excess capital of over $6bn given a CET1 ratio of 10.9% against the expected target of 8% on ~$225bn of risk-weighted assets) and the Fed’s discretion based on stress-tests creates risk and uncertainty in the CCAR process. The results, expected in March, for COF will therefore be highly significant.
COF Guidance Seems Conservative
Since 2013Q4 results, and guidance for 2014 pre-provision earnings (“PPE”) to be flat at $9.8bn, 2015 EPS estimates for COF have fallen by just over a dime to $7.35; this is consistent, in our model (see Appendix), with a net interest margin that is flat with the 2013 result of 6.75%. The 2014 guidance is consistent with the net interest margin (“NIM”) being down 10 basis points to 6.65%.
Given the forward markets are suggesting 6-month Libor (“6ML”) will increase from today’s level of 35 basis points to 1.4% by mid-2015, we would be surprised if NIM does not move meaningfully higher from today (with history suggesting that banks capture about half of the increase in short rates in the net interest margin provided the curve does not also flatten). This rule-of-thumb may not apply to COF since about one-half of its deposits are through the online channel and this may prove to be more rate-sensitive than branch deposits (although COF argues that its customers are increasingly turning to the online channel for its convenience rather than rate alone). Regardless, even if NIM is just 10 basis points higher, 2015 EPS at COF will be close to $7.70 all other things being equal.
Granted, 2015 EPS at COF is exquisitely sensitive to pricing. As indicated, a 10 basis point increase in NIM lifts EPS by ~35 cents, and a 10 basis point increase in the net loss ratio reduces EPS ~50 cents (taking into account the need to build reserves to maintain reserve-coverage). Indeed, increasing the reserve coverage ratio from the assumed 1.05 to 1.1 (versus 1.09 in 2013) reduces EPS by 25 cents and the coverage ratio, albeit trending down, is difficult to predict within this margin of error. Our experience is that investors can over-react to this EPS sensitivity so that recent disappointment creates an entry point.
Stock is Mispriced Even under Consensus Estimates
We believe that, even if a renormalizing rate environment does not, through NIM, lift COF earnings above consensus, the stock is meaningfully mispriced and maintain our target of $90 for end-2014. Specifically, consensus EPS in 2015 represents a near 16% return on current tangible book value (“TBV”) of $46.2/share corresponding, in our valuation framework, to a 1.7X multiple of tangible book (see Exhibit 1). With returns expected to improve even under (conservative in our view) consensus, we can apply this multiple to end-2014 TBV of $50/share for a price target of $85 representing 20% upside from today’s close. In practice, given we believe 2015 EPS will be nearer $7.70, we believe a $90 price-target is defensible.
Exhibit 1: Bank Valuations are driven by Forward Return on Tangible Equity
Apparent Modeling Assumptions behind Consensus
Below, we summarize the model assumptions, beyond the NIM discussed above, that are consistent with consensus EPS estimates with commentary on where they appear conservative. The full model is included in the Appendix and available in electronic form on request:
PPE: COF guided to PPE of $9.8bn in 2014 which is consistent with a 15 basis point decline in NIM to 6.65%, flat service charges, and 5% growth in interchange; all three of these assumptions seem conservative particularly given the CEO’s remark that he sees NPV-at-origination opportunities as good today as they have been in a long time (presumably among the low-balance and transactor-segments since COF has tilted its marketing away from high-balance revolvers); we model 2014 PPE at $$10.1bn rising to $10.9bn in 2015 with a 10 basis point increase in NIM.
Non-Interest Expense: COF guided to $10.5bn of expenses in 2014 excluding marketing and one-time items, and we have adopted this guidance and assumed a further decline of $500mm in 2015 as the company continues to exploit digital channels and to reduce third-party spending. We set 2014 marketing at $1.45bn up $80mm from 2013 and increase it again by $100mm in 2015.
Credit Provision: We assume the 2014 net loss ratio is flat to 2013 at 2.0% and rises slightly in 2015 to 2.05% with the auto loss ratio increasing as we emerge from a period of strong used-car prices and the card loss ratio decreasing given legacy tight underwriting in the industry (which has a 3-year lagged effect on credit performance) and an improving employment picture. We assume the year-end reserve coverage ratio (i.e. reserves to past-12 month credit losses) falls to 1.05 in 2014, and stays flat at that level in 2015, from 1.09 in 2013.
Capital Management: COF is exceedingly capital-generative particularly over the next 2 years when, with run-off of legacy portfolios and a focus on the transactor segment in card, we do not expect material growth in the balance sheet (1-2% loan growth in 2014 and 5% in 2015) and flat-to-down non-loan assets. Furthermore, it appears to have significant excess capital (over $6bn on risk-weighted assets of ~$225bn) already with a CET1 ratio under Basel 3 of ~10.9% versus the expected target of 8%; there is some uncertainty because these numbers are under the standard approach while COF will also be subject to the advanced approach and, in any event, the Fed has discretion based on stress-test analysis. All that said, management is sufficiently confident to say it will be looking for approval for a payout ratio well above 50% in the current CCAR round. Our model suggests the firm will not increase accounting leverage even if the payout, across dividend and buyback, is 70% in 2014 and 90% in 2015.
APPENDIX: COF MODEL