Don't Say I Didn't Warn You About This Stock

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Back in November I listed "5 Companies That I'm Betting Against in 2012" and warned against a potential slowdown in all five companies. Today, just three weeks into 2012, marks the first time I can point and say, "See, I told you so!"

In November I warned that even with housing sentiment coming off of its multi-decade lows, that weakness in that sector would likely translate into weakness in Capital One Financial's (NYSE: COF  ) bottom line. Last night Capital One proved me partially correct.

In spite of loan balances rising 7.9% over the year-ago period, Capital One dismally missed Wall Street's profit expectations. For the fourth quarter, the company posted a profit of $0.88 on $4.1 billion in revenue, a 2.5% decline over Q4 2010. What might seem like another strong quarter looks like a rotten egg next to Wall Street's projections for a profit of $1.52.

The headline EPS missed wasn't the only red-flag, either; expenses at the bank were through the roof. Non-interest income expenses rose unexpected by 25% during the quarter to $2.62 billion. Although many were one-time items, Capital One's management team really didn't offer answer-seeking analysts a good reason during its conference call why expenses rose so dramatically and went on to say that expenses could remain high for quite some time.

Loan-loss reserves also rose during the quarter. Capital One blamed the rise in domestic credit charge-offs on the seasonality of the fourth-quarter and its recent increase in loans undertaken. To some extent, I will give the company some leeway with its increased-loan-balance argument, but it didn't shock me one bit to discover that its home loan business witnessed a 37-basis-point jump in charge-offs and its automotive financing division, despite seeing strong loan growth, also saw a rise in net charge-offs.

Capital One would like you to think that the credit quality of its customers is improving, but I'm seeing the exact opposite. With such an extraordinary amount of its revenue reliant on its credit card division, I don't think it would take much of a swoon in housing to really spike Capital One's loan-loss reserves and put the bank in a bind.

Recent data from homebuilders would suggest that a turnaround may be at hand, but even then I find myself skeptical. Recent reports from Lennar (NYSE: LEN  ) , KB Home (NYSE: KBH  ) , and Toll Brothers (NYSE: TOL  ) showed net order growth of 20%, 38%, and 8%, respectively. Even one of my least favorite indicators, the U.S. Homebuilders Sentiment Index, was propelled to a new four-and-a-half-year high at 25. Still, that all reversed yesterday when data showed that housing starts in December fell 4.1% versus an expected gain of 0.6%. The entire housing sector is nowhere near a bottom yet by my estimation.

This brings me back to my main premise, which is that a decline in the housing sector will cause the credit quality in many of Capital One's consumers to head south in a hurry. Capital One is way too exposed to the credit market for my comfort and I feel we may have seen just the tip of the iceberg in terms of bad news for this bank in 2012, which is why I'm maintaining my CAPScall of underperform on the bank.

What's your take on Capital One's miss? Is the company worth a gamble, or are its ties to the credit market simply too great to ignore? Share your thoughts in the comments section below and consider adding Capital One Financial to your free and personalized Watchlist so you can keep track of the latest news with the company.

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Fool contributor Sean Williams has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy that believes its readers come first.

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  • Report this Comment On January 21, 2012, at 11:19 AM, spunky42 wrote:

    I really don't follow your argument on COF at all. I too was blindsided by the expense increases and I think management did a poor job of explaining and forecasting these expense increases. Nonetheless, I see no relationship whatsoever with the COF numbers and the housing market. I also think analysts did a very poor job of anticipating what was happening in the numbers.

    1. Banks have been considered poor investments for a number of reasons. One of those reasons is that no one could evision growth for the forseeable future. Yet COF and some others demonstrated very good growth, especially towards the end of the fourth quarter. Unfortunately, when this occurs, you must recognize virtually all associated expenses and virtually zero revenue. This aspect of accounting alone probably cost COF $300-$400 million in profit for the fourth quarter. The profit from this growth will start to show in the 1st quarter of 2012.

    2. COF began 2011 with 25,000 employees. They ended with more than 30,000. Some of this was caused by a few small acquisitions, but they added 1,000 employees in the 4th quarter alone. If the ING and HSBC deals close as expected shortly, COF will have some 41,000 employees. That is a 65% increase in a little more than one year. This does not include millions of new customers and their accounts. Obviously, you don't just absorb all of that without a tremendous investment in people and infrastructure. That is where much of the increase in operating expense came from and again, it is case where all the expenses occur before any revenue is generated. Why analysts and management did such a poor job of predicting/explaining this I haven't a clue.

    3. You never avoid losses and delinquencies in any lending business. You don't even want to. The levels at COF now are very acceptable and will fluctuate from time to time, but they are back to levels considered attractive recession or not.

    4. The numbers in 2012 will be difficult to predict and complex to analyze with all that is planned to happen. The average investor and probably analysts will not be able to figure it out. I do believe in the next 6-9 months when the dust starts to settle, that people will see a path to extremely good profit growth at COF providing they get the required regulatory approvals. I would not even be surprised if much of the expenditures done in the fourth quarter weren't to help regulators become more comfortable that COF has in place the wherewithall to pull off these acquisitions.

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