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Is Capital One Financial a Buy?

By Dave Kovaleski – Jul 28, 2020 at 7:00AM

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The bank and credit card issuer had a net loss in Q2 and will likely reduce its dividend.

It's been a tough year for banks in general and Capital One Financial (COF 2.09%) in particular. The company has had two straight quarters of net losses during the COVID-19-fueled recession and is likely to reduce its dividend for the third quarter.

Is this a case of the bank hitting bottom and becoming a good buy on the dip? Or will Capital One continue to struggle over the next few quarters, making it a stock to avoid for the time being? Let's take a look.

At a loss

Capital One reported a net loss of $918 million, or $2.21 per share, in the second quarter, down from a $1.6 billion net gain, or $3.24 per diluted share, in the second quarter of 2019. This was its second straight quarter with a net loss, following a net loss of $1.3 billion in the first quarter of this year.

Capital One is one of the largest credit card issuers in the U.S., ranking among the top four in market share. The credit card business is its largest source of revenue, accounting for about 64% of its income. The company also has smaller consumer banking and commercial banking arms. In the second quarter, credit card revenue was down about 8% to $4.2 billion. The other business lines also had revenue drops, but not as steep. In a recession with historically high unemployment, credit card issuers like Capital One face stiff challenges as people don't have the money to charge expenses. Purchase volumes were down 15.7% in the quarter, year over year.

A woman looking at her phone and a credit card.

Image source: Getty Images.

Capital One has done a good job managing expenses, which were basically flat in the quarter due to marketing cutbacks. But the much bigger issue for Capital One is its provision for credit losses. Credit card loans have higher default and delinquency rates than typical bank loans because during hard times, people tend to give them lower priority than mortgages, car payments, and other types of loans. Thus, that requires money to be set aside for potential credit losses, which has been a huge drag on earnings and taken Capital One into net loss territory.

The bank allocated a $4.2 billion provision for credit losses -- including a $2.7 billion reserve build due to the economic struggles related to the pandemic. The reserve build sets aside $1.7 billion for credit card losses, $668 million for auto loan losses, and $330 million for commercial loan losses. This was up 68% from the second quarter of last year, but down from the $5.4 billion set aside in the first quarter of 2020.

Dividend reduction

The hardships of the last two quarters mean that Capital One will likely reduce its quarterly dividend from the current $0.40 per share to $0.10 per share in the third quarter, pending approval by the board. The move is in line with the Federal Reserve's formula for dividends that is based on a bank's income. The market responded positively to that, up about 4% since the earnings call on July 21.

The good news is that Capital One has good liquidity and is well-capitalized to navigate the tough times. Its common equity tier 1 ratio -- or core capital compared to risk-weighted assets, which is a measure of a company's ability to withstand shocks -- went up 10 basis points to 12.4% year over year, above the Federal Reserve's capital requirement of 10.1%. Liquidity is also strong, as the amount of cash, cash equivalents, and securities increased to $149 billion. The liquidity coverage ratio went up to 146% in the second quarter, well above the 100% requirement.

Going forward, it comes down to the provision of credit allowance, as CFO Richard Scott Blackley said on the second-quarter earnings call:

With the allowance from here, it's really going to depend on some of the major drivers of our reserve build in the quarter ... If the economic outlook and forecasts get worse, then that would lead to an allowance build. And then on the other side of that, all else being equal, if we did see more stimulus, that would be a positive to the allowance, and we could see an offset to the potential effects of the economic scenario that we built the allowance on this quarter.

That's just too much uncertainty to warrant a buy right now. It might be better to wait a few quarters to see how these factors Blackley discussed play out.

Dave Kovaleski has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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