COF – Revenue Margin and Mix Shift to Card

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Howard Mason

hmason@ssrllc.com

Ocotber 24, 2015

Re: COF – Revenue Margin and Mix Shift to Card

  • We expect positive revisions to 2017 eps estimates for COF from $8.60 to $8.80 given the mix-shift to card (where average balances are growing 10%+ versus 5%- for non-card) and where the revenue-margin at just under 17% is more than double that for non-card (chart below). CEO Richard Fairbank indicated last December that “what we are originating now [in card]… its revenue margin is pretty similar to our existing book” and we expect the mix-shift benefit, along with a lift from home-equity run-off, to overcome headwinds to firm-wide revenue margin (drag from payment protection, compression in auto and commercial).
  • Specifically, assuming a flat card margin, consensus seems to call for a sharp decline in non-card margins to 6.6% in 2017 from 7.1% in 2015; we allow for a less severe decline to 6.7%.
  • COF earnings are highly-sensitive to the revenue margin so that our 2017 eps estimate of 20c above consensus corresponds to just an incremental 6bps on net revenue margin on a base of 11.1%.

Chart: COF – Segment Revenue Margins (Implied Consensus)

Source: Company Reports

  • We assume no operating leverage (because of investment in compliance and digital capabilities) and negative credit leverage (e.g. because allowance-builds are front-loaded). We align with consensus in that stock buyback will lift eps by ~5% requiring the net payout ratio to increase to 80% in 2017 (from nearer 60% in 2015 and 2016). This reflects over-capitalization at COF with a CET1 ratio (standard, transitional) at 12% versus the regulatory minimum of 8%.
  • Some of the excess will be absorbed by increased risk intensity (e.g. risk assets up 9% in 2015 vs. 6% for GAAP assets) given a shift to loans from securities and given parallel run which the firm entered at the beginning of the year, and some by migration to a fully-phased advanced approach. Nonetheless, we estimate COF has 150bps of excess capital and will utilize 50bps of this excess in 2016 to hold the net payout ratio at ~60% and a further 25bps in 2017 raising the payout ratio to 80%.
  • Credit, particularly the dynamics for the loan-loss allowance, is a wild card for COF earnings. As CFO Steven Crawford commented in June “the best person in consumer credit would tell you that beyond six months it’s hard [to forecast the allowance] and even minor changes in the loss rates have a big impact on provision”. We model an increase in the allowance, as a proportion of gross loans, to 2.5% in 2017 from 2.3% today as loan growth moves towards a more steady-state after the sharp increase in 2015 (when the ratio increased 25bps); along with estimates for rising loss ratios, in line with management guidance for card, this means that growth in credit provisions will slow to around 10% from 30% in 2015.
  • The base investment case for COF is that projected (tangible) return-on-equity of 13.5% merits a 1.5x multiple of end-2016 tangible book of $61/share for a valuation of just over $90, or ~10.5x consensus estimates for 2017 eps of $8.60. We expect valuation upside from this $90 target with positive revisions as the portfolio mix-shifts to card lifting estimates for profitability.

Overview

We expect positive revisions to 2017 eps estimates for COF as the portfolio mix-shifts to card (with average card loans likely to grow over the next 2 years at 10%+ versus 5%- for non-card) lifting firm-wide revenue margin which, at a segment level, is more than double in card than non-card (Exhibit 1). A key assumption is that the card-segment margin remains stable despite the small drag from payment protection whose contribution (~25bps for FY2015) is guided to zero by FQ22016. The longer-term effect is the economics of new vintages versus the back book, and CEO Richard Fairbank indicated last December that “what we are originating now … its revenue margin is pretty similar to our existing book”. We also assume the margin-benefit of mix-shift to card is not drowned by margin-compression in the auto- and commercial portfolios albeit offset by home-equity run-off.

Exhibit 1: COF – Segment Revenue Margins

Source: Company Reports

The earnings model is highly sensitive to the revenue margin with each change of 5bps worth just over 15 cents in 2017 eps (on a base of $8.60). Consensus appears to be forecasting the firm-wide revenue margin flat at 11.10% and we allow a lift of 6bps in 2017, after the payment protection affect is run through in 2016, for the card mix-shift generating 2017 eps of $8.80 up 20 cents from consensus (Exhibit 2 – next page). We assume no operating leverage (because of investments in compliance and digital capabilities) and negative credit leverage (e.g. because allowance-builds are front-loaded).

Exhibit 2: COF – Earnings and Returns

Source: Company Reports, Capital IQ, SSR Analysis

Capital and Leverage

While negative credit leverage tends to reduce the return-on-assets, the key driver of the decline in tangible return-on-equity from ~15% in 2015 to ~13.5% in 2017 is deleveraging of the GAAP balance-sheet as the ratio of tangible equity to assets increases to 8.9% from 8.4%. This is despite the fact COF is over-capitalized on the risk balance-sheet with a CET1 ratio of 12% (standard, transitional), versus the regulatory minimum of 8%, that is modeled to fall to just under 11% by 2017 (Exhibit 3). The reason for the different dynamics is that risk assets are increasing faster than GAAP assets: 9% in 2015 (period-end) versus 6%. In part, this is because loan growth at 8% is outpacing non-loan growth and in part it is because regulators are increasing risk-intensity likely related to Capital One’s entry to parallel run at the beginning of the year.

Exhibit 3: COF – Balance Sheet and Payout

Source: Company Reports, Capital IQ, SSR Analysis

The glide-path of the CET1 ratio is a key variable for the net payout ratio and, hence, the stock count which consensus calls for contributing over 5% to eps growth in 2016 and 2017. The ratio will decline as COF moves from a standard, transitional computation to the advanced fully-phased approach but there likely remains excess capital of at least 100bps even allowing for a 50bps buffer over the minimum requirement of 8%. We note that, in its self-reported mid-year stress test, COF computed a 2.5% decline in the (standard) CET1 ratio from actual to stressed-minimum consistent (since the formal stress test conducted by regulators uses the standard, not advanced, approach) with the estimate of a 1.5% excess.

We expect management to utilize 50bps of this excess in 2016 to hold the net payout ratio at ~60% and increase risk-leverage by a further 25bps in 2017 thereby raising the payout ratio to 80%. In each year, we allow for $0.5bn negative marks on the securities portfolio to flow to CET1 capital other comprehensive income (OCI) as required in the fully-phased (but not transitional) basis. Finally, while management has indicated a prioritization for capital-return for share repurchase (because of its flexibility) over dividends, we assume annual dividend increases in line with the past two years.

Credit and Allowance-Build

Credit, particularly the dynamics for the loan-loss allowance, is a wild card for any COF earnings model. As CFO Steven Crawford commented in June “the best person in consumer credit would tell you that beyond six months it’s hard [to forecast the allowance] and even minor changes in the loss rates have a big impact on provision”. The firm’s methodology is to model the allowance in line with 24-month forward loss estimates but it remains subject to a wide and irreducible error bands. This matters because the stock can over-react to negative provision-surprises, as when the second quarter results were released on July 23rd, when related to seasoning effects (including the front-loading of allowances on fresh vintages) rather than providing a signal on over-the-life loan economics or changes in the ambient credit environment. We model an increase in the allowance, as a proportion of gross loans, to 2.5% in 2017 from 2.3% today as loan growth moves towards a more steady-state after the sharp increase in 2015 (when the ratio increased 25bps); along with estimates for rising loss ratios, in line with management guidance for card, this means that growth in credit provisions will slow to around 10% from 30% in 2015.

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, C, BAC, WFC, and GS.

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