Thursday, March 26, 1998

Capital One Financial, Inc.
(NYSE: COF)
Phone: 703-205-1000
Website: http://www.capital1.com
Price (3/25/98): $76 1/2


HOW DID IT DOUBLE?

With the consumer economy rolling along strongly, it's no surprise to see a credit card company in the Daily Double. Capital One steps outside the boundaries of mere sector analysis, though, having handily outperformed its peers in the card industry. There are specific reasons why the company's stock is up 140% from its 52-week low.

Capital One reported earnings gains of 24% and 45% in the last two quarters of 1997. Though the company did include some gains in those earnings numbers to conform to Financial Account Standards Board Statement #125 (regarding the mark-up of certain residual assets from securitization of receivables), the company's earnings gains surprised analysts following the stock. A drop earlier in the year was responsible for some of the super-normal returns investors have achieved with Capital One, though.

In May, Capital One fell because of "problems" with customers paying off too much of their credit card debt. Since credit quality issues were at the center of some investors' concern over the industry, the fact that Capital One customers were acting more responsibly than the bulging mean of Americans spoke to the quality of the company's credit controls. At the low point, Capital One was trading at 12 times 1997 earnings estimates, which was far cheaper than the rest of the sector and excessively discounted the slowdown in earnings at the company.

In mid-June the company was trading in the low $30s and was valued comparably only with Advanta (Nasdaq: ADVNA), which was having real credit control problems -- a totally different issue than at Capital One:

Multiples to Forward Earnings Estimates 

 
              1998 EPS Est.   P/E Multiple 
 Capital One   $3.19            10.1 
 First USA     $2.80            17.6 
 MBNA          $2.10            15.9 
 Advanta       $2.98             9.8

At this point in the game, the forward look was very compelling, which we'll discuss in a moment.

BUSINESS DESCRIPTION

Capital One Financial was spun off from Signet Bank in 1995. It is one of the oldest credit card issuers in the U.S., with operations dating back to 1953.

Capital One's success has come through a very flexible approach to the credit card market. It was the first issuer to promote balance transfers at more desirable rates to lure new customers. Now most card issuers offer this program. Currently the company is focused on "second-generation" products, such as secured credit cards and cellular phone financing. It also focuses on the student credit card market.

These ventures allow it to charge higher average fees, while at the same time its loss rates have remained flat. The company has used a sophisticated database to market its products to target audiences and thinks of itself as an "information-based marketer" more than as a monoline financial services company. This proprietary database increases the company's marketing opportunities and helps it spot rising problems with customers' financial patterns.

FINANCIAL FACTS

Income Statement
12-month sales: $1,189.4 million
12-month income: $189.4 million
12-month EPS: $2.80
Profit Margin: 15.9%
Market Cap: $5,178.3 million

Balance Sheet
Total Loans: $4,861.7 million
Loan Loss Reserves: $183 million
Reserves as % of loans: 3.76%
Total Assets: $7,078.3 million
Shareholders' Equity: $893.2 million
Shareholders' to Assets: 12.6%

Ratios
Price-to-earnings: 27.3
Price-to-assets: 0.75

HOW COULD YOU HAVE FOUND THIS DOUBLE?

The company basically called its own shot. Management set a goal of 20% earnings growth for 1997 and then achieved it. If an investor had heeded the forecast, the relatively low PE could have attracted interest.

In the company's second quarter conference call, management talked about what lay ahead for the rest of the year. Of vital import, they spoke about their strategy of building earning assets with second-generation, secured credit card products. Having booked 673,000 new accounts in the quarter (an annual growth rate close to 30%), the company was headed for serious growth in earning assets, but it wouldn't happen immediately: "With respect to the number of accounts not leading to higher asset growth, again I really want to stress that the nature of second generation products is that they generate virtually no assets to speak of in the quarter of booking..."

With higher fees than other cards, the major push on secured cards would start to pay off after the slowdown in asset growth and pick up in the net charge-off rate in the second quarter. Return on equity was still a respectable 19.7% in Q2, but it exploded to 23.5% in Q3 and was an excellent 26.1% in Q4. The strategy of getting away from commoditized products such as balance transfer/teaser rate cards worked very well after the transition period in the middle of the year.

WHERE TO FROM HERE?

The company has once again predicted earnings growth of 20% for the coming year. However, this year the company sports a PE of 28 instead of in the low teens that it was at this time last year. The company will very likely have to outperform its expectations to gain another double.

If the company can continue to grow earning assets as quickly in the coming year, growth could be in the offing, but it'll have to be very strong to outperform the S&P 500. If an investor models 15% yearly growth in shareholders' equity over the coming three years, a 25% ROE at the end of those three years, and a multiple of 20 on year 2000 earnings, we're looking at 8.8% compound annual return (before dividends) over that period. Higher asset and capital growth at the company combined with share buybacks would increase that return. An investor could model a higher terminal value on 2000 earnings, but this calculation is our best guess.

Last fall more than 80 of the company's executives traded future cash bonuses for options exercisable only if the company's stock price reaches $84 within three years -- the fall of 2000. If the stock doesn't hit $84, these executives get nothing. The CEO and COO took options instead of salary for the next three years as well. Well, to be totally accurate, they do get a modest annual salary... $1.

While another quick double might not be in the cards, a Foolish investor might want to take the opportunity to ride on the backs of some highly motivated executives.

-- Dale Wettlaufer (TMF Ralegh) and Mark Weaver (MWEAV)


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