COF: Revenue Growth Trumps Rising Credit Costs
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
February 2, 2016
COF: Revenue Growth Trumps Rising Credit Costs
Despite generating a return-on-tangible equity of 13% in 2015, with consensus calling for 14% in 2016, COF is now trading at below 1.2x tangible book value of $54/share. This price is discounting either a meaningful earnings miss in 2016 and/or a negative balance sheet event. While there is some risk to earnings from above-consensus provisions, we see revenue-upside and expense-flexibility as mitigating and expect the firm to deliver in-line EPS of $7.75 in 2016.
The revenue-upside arises because of strong long growth, of 12% year-on-year for 2015Q4, in the card business, and our assumption of expense-flexibility rests on comments by CFO Steve Crawford that operating leverage is a way to maintain return on capital in the face of rising credit costs. Below are the numbers.
Revenue: Consensus is calling for 2016 net revenues of ~$25.2bn representing a yield of 10.7% on our forecast of average loan balances of $236bn vs. the reported yield of 11.2% in 2015; we expect the yield to remain closer to flat for a 2016 revenue estimate of $26.2bn. The reason is declining revenue yields in the consumer bank, driven largely by intensifying competition in the auto business, will be offset by a firm-wide mix-shift to card (comprising 42% of the portfolio, growing at 12%, and generating a net revenue margin of ~17%) from consumer banking (comprising 30% of the portfolio, showing no growth, and generating a revenue margin of ~6%).
The largest books within the consumer banking portfolio are auto-loans at ~60% and home-loans at ~35% and both will be flat-to-down in 2016. In the case of auto-loans, fourth quarter originations were down 8% over the year-ago quarter as COF responds to intensifying competition and, in the case of home loans, balances were down 16% as legacy business continues to run-off.
Credit Provisions: The credit provision in any given year consists of net credit losses plus any build in the allowance for loan losses (which, in turn, is based on a 12-month look-forward on net credit losses). Management made the estimation easier by providing guidance on the net loss ratio in the domestic card business, the key driver of credit despite commercial energy exposure, for 2017 as well as 2016:
~4% in 2016 and “low-4’s” in 2017 as low gas prices are likely a “net positive” for the consumer notwithstanding an uptick in delinquencies in energy-dependent locations (such as Dallas, North Dakota, and Canada’s Alberta province) where COF has ~5% of its portfolio. The 30-day delinquency ratio, as a leading indicator of credit quality, supports this benign outlook and stands at 3.39% for the domestic card portfolio as a whole, up only 12bps from the year-ago quarter; the increase is due more to seasoning effects on recent vintages than stress in energy-related geographies.
Given our forecast for loan growth, and assuming losses on the commercial book of just over $250mm in 2016 largely driven by energy, this puts net credit losses at $5.1bn for 2016 and $5.9bn for 2017 (Exhibit 1) and equates to a 2016 provision expense, given current reserves of $5.1bn, of $5.9bn. The estimate for commercial losses is consistent with COF having established reserves of $190mm against its $3.1bn oil-related portfolio (two-thirds E&P and one-third OFS) and disclosing that this amount would have been $50mm higher had it been established when the quarter was reported and oil at $30/bbl versus at year-end when oil prices were 20% higher.
Exhibit 1: Revenue Yields and Credit Losses at COF
Source: SSR Analysis
Expenses: An investor concern around expenses has been that management is so committed to investing in “digital transformation” that near-term results will be adversely impacted. To some extent, this view is supported by the lack of operating leverage, on an adjusted basis, in 2015 as expenses increased the same 5% as revenue even with the firm generating a full-year adjusted efficiency ratio of 54.3% versus a target of 55%. However, COF has looked to provide reassurance with CFO Steve Crawford commenting that “[strategic investment] cannot be an excuse for not having reasonable financial performance in the interim … as credit becomes more of a challenge in the income statement, the way you maintain your return on capital is by having operating leverage”. The message was reinforced on the last quarterly call with management repeating an expectation for some improvement in the adjusted efficiency ratio in 2016 (driven by the back-half) and more improvement in 2017. We assume a 2016 efficiency ratio of 53.1% generating non-interest expenses of $13.9bn which, given our above-consensus forecast for revenue, represents expense growth of 9%.
The Appendix integrates these assumptions into our core model which suggests COF can meet consensus EPS expectations for 2016 and 2017 despite rising credit costs. Assuming the firm maintains current leverage (with a standard CET1 ratio of 11.1% corresponding to over 8% on an advanced basis), the net payout ratio sustains at ~80% so that the firm buys back ~5% of outstanding stock each year and the return on tangible equity increases from 13% in 2015 to 14% in 2016 and 2017. This is consistent with a valuation multiple of 1.6x end-2016 tangible book value/share of $57 hence a target price of $90.
Quick Note on Auto Lending
There are media reports of a “bubble” and comparisons by regulators to the housing debacle with Comptroller of the Currency Thomas Curry remarking that auto lending, “reminds me of what happened in mortgage-backed securities in the run up to the crisis.” Concerns are triggered by a run-up on auto-loan originations since the financial crisis particularly for weaker credits: in 2015Q3, for example, auto-loan originations reached over $150bn of which ~one-third was to sub-prime borrowers (Exhibit 2). However, the asset class is not conducive to a bubble: cars are a depreciating asset and are purchased for utility not speculation; indeed, for a sub-prime borrower, car-ownership tends to improve credit by broadening the opportunity for employment.
Exhibit 2: Auto Loan Originations by Credit Score
Source: New York Fed
Furthermore, unlike houses, cars can be repossessed quickly (typically within 60-days of delinquency) and quickly sold at auction. The key driver of recovery rates is used car prices and these are holding up with the Mannheim index near all-time highs (Exhibit 3). COF underwrites assuming a meaningful pull-back from these levels and, in any event, is reducing its originations which were down 8% in 2015Q4 over the prior year. The delinquency rate is flat year-on-year (6.7% vs. 6.6%) and the net loss ratio down slightly at 2.1%. We expect a net loss ratio of 2.0% for FY2016 (vs. 1.7% for FY2015) and have incorporated this into our model. Finally, the discussion would not be complete without mention of COF’s taxi-medallion portfolio, which is stressed as Uber competes with medallion-owners particularly in dispatch (rather than hail) markets, but is <$1bn and, at this point, we assume well-reserved.
Exhibit 3: Mannheim Used Vehicle Value Index
Appendix: COF Model
Source: Capital IQ, SSR Analysis
Source: Capital IQ, SSR Analysis
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- http://fortune.com/2015/11/20/subprime-car-loans/ ↑