COF: Revenue Upside from Mix-Shift to Card

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Howard Mason

203.901.1635

hmason@ssrllc.com

April 28, 2016

COF: Revenue Upside from Mix-Shift to Card

  • This note updates our call of Feb 2, 2016 on COF to reiterate the thesis that the market is under-discounting the impact on 2017 revenue-growth from a portfolio mix-shift to the high revenue-margin card book (which will offset the impact from declining margins in the auto-lending book), and over-discounting the risk of credit and expense headwinds.
  • We note that in reporting Tuesday management stood by guidance for: (i) a net loss ratio in the domestic card book of ~4% for FY2016 and “low-4s” for FY2017 despite the Q1 provision increase; and (ii) an improving efficiency ratio in FY2016 and FY2017 despite the expense headwinds of branch-optimization and rising FDIC fees.
  • In 2017, we expect average card-loans to grow ~14% while the non-card book (including the declining home-loan book within the consumer bank) grows only ~2%. Given the revenue-margin on card loans at 16%+ is ~double that on the non-card book, this mix-shift tend to lift the revenue-margin at the consolidated level. This effect will offset declines in the revenue-margin at the segment-level in 2017 so that the consolidated result is stable even assuming margin erosion in the card book as well as in the auto-book within the consumer bank (Chart 1).

Chart 1: COF – Segment Revenue Margins (i.e. revenue as a percentage of average loans)

Source: Company Reports, SSR Estimates

  • As a result, we expect COF to beat 2017 revenue-estimates by ~$300mm providing flexibility to absorb higher-than-expected credit and non-interest expenses and still meet consensus eps. In practice, we believe there is upside to our 2017 revenue estimate because it assumes a meaningful decline in the revenue-margin in the card book whereas rising rates will likely provide a tailwind (notwithstanding management commentary that deposit betas may be higher than initially thought because of structural factors, presumably the aggressive online pricing of the GE spinouts in the form SYF and GS Bank). The net result of our model is a stable-to-rising tangible ROE of 13.4% in 2017 which supports a multiple of 1.5x tangible book (of $56.5/share by end-2017) and hence a price target of $85 representing ~15% upside from today.

Overview

Beyond the 2016Q1 eps miss ($1.84 vs. $1.91), investor concerns for COF include deteriorating credit metrics, the potential for declining revenue-margins in auto-lending, and the expense of branch-optimization and rising FDIC fees. Given our confidence in management guidance for a domestic card loss ratio of ~4% in 2016 and “low 4s” for 2017 and the commitment to improving the efficiency ratio in 2016 and 2017 despite expense headwinds, we view these concerns as over-discounted.

The reason is that strong card loan growth will translate to above-consensus revenue providing a buffer to absorb credit and expense headwinds. Specifically, we expect COF to beat revenue-consensus by ~$300mm in 2017 as the consolidated revenue-margin stabilizes on growth in average loan balances of ~7%. The balance growth is, in turn, is driven by the card loan portfolio that we expect to grow ~14% on an average basis while the remainder of the firm-wide portfolio (so including the declining home loan book within consumer banking) grows at ~2%. The result is a mix-shift to the high revenue-margin card book from the relatively lower revenue-margin, non-card book so that the consolidated revenue-margin remains stable even as segment revenue-margins decline (Chart 1).

Chart 1: COF – Segment Revenue Margins (i.e. revenue as a percentage of average loans)

Source: Company Reports, SSR Estimates

While strong revenue may support an eps beat, we allow for it to be absorbed into above-consensus reserve-builds and expense-estimates. Specifically, we assume an increase in the reserve-to-loan ratio to 2.7% by end-2017, from 2.38% today, corresponding to a reserve build of ~$750mm for the balance of 2016 and of ~$1bn in 2017; the decline in the run-rate from a reserve build of ~$350mm in 2016Q1 allows for normalization of provisioning for energy-related exposures which contributed $139mm to the Q1 build. Our expense-estimates, while conservative relative to consensus, are consistent with management guidance for an improving efficiency ratio in 2016 and 2017.

The net result for 2017 relative to 2016 is a stable ROA at 1.2% and tangible ROE at 13%+ that we believe justifies a 1.5x multiple of tangible book (of $56.5 by end-2016) for a price-target of $85 representing ~15% upside from today. A combination of strong loan growth, and the fact that COF has returned excess capital to shareholders (so that the CET1 ratio under the standard approach has declined to 11.1% from 12.5% at end-2014 and now corresponds to a number that management has not disclosed but is “above” the minimum target of 8% under the advanced approach), means the payout ratio will decline from ~75% in 2015 to ~50% in 2017. Still, this allows for a buyback of ~$1bn in 2017 vs. $2bn+ in 2015 (Chart 2).

Chart 2: COF – Returns and Capital

Source: Company Reports, SSR Estimates

Risks

We see upside risk to the above eps, and particularly, revenue estimates given no allowance is made for expansion of the net interest margin which is held steady at 6.75% of 2016Q1 through end-2017. Both the loan mix-shift to card and rising rates, despite management’s remarks on the Q1 call that deposit betas may be higher than initial estimates (presumably given the presence of firms like SYF and now GS Bank that are competing aggressively for deposits on price in the online channel), generate upside potential. With expected average assets of ~$365bn and average diluted shares of ~500mm, each 10bps of margin expansion adds ~50c to 2017 eps. More generally, we believe our assumption for a decline in the card revenue-margin to 16.3% in 2017 from 16.7% in 2016Q1 may prove conservative.

©2016, 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, BAC, WFC, and GS.

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