A Closer Look at Capital One

Capital One Financial (COF 0.44%) is a unique bank, with an innovative approach to branch-based banking and a credit-card-focused lending operation. In this week's Industry Focus: Financials show, host Jason Moser and Fool contributor Matt Frankel, CFP, take a closer look at how the business works and what investors need to know. Plus, hear why Matt has his eye on Simon Property Group (SPG 0.96%), while Jason thinks Target (TGT -0.36%) could be worth a look.

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This video was recorded on November 16, 2020.

Jason Moser: It's Monday, November 16th. I'm your host Jason Moser, and on this week's Financial show, we're going to be taking a closer look at a company that holds a pretty big share of the consumer credit card market, among other things. And joining me this week, it's Certified Financial Planner, Matt Frankel.

Matt, how's everything going?

Matt Frankel: Pretty good. It was a beautiful weekend down here in South Carolina. We were supposed to get a lot of rain from that tropical storm, but it just never happened. How is the weather up by you?

Moser: Yeah, you know, it's been really nice. It was actually a bit of a warm spell last week, got out and did a little yard work. I think I tidied up the yard and got everything, kind of, prepped for the Winter, because it's starting to cool down a little bit now this week, but a beautiful weekend, certainly. Got out of the house and was able to enjoy that good weather. And you know, I mean, Thanksgiving is just around the corner, it's November, it doesn't feel like November, so I guess a lot of people are still, you know, kind of happy about that. Not too cold up here yet.

Frankel: Yeah. I mean, South Carolina never gets that cold, I guess by your standards, but it's cooling off a little bit, it's definitely not a typical November yet.

Moser: Yeah, well, same here, but you know, it's just around the corner, I'm sure we'll get there eventually. [laughs]

Matt, we had one of our loyal and wonderful listeners, he reached out to us on Twitter recently and asked if we could dive into a specific company for one of our shows, and we thought today would be actually a really good day to do this. Now, we got a tweet from Carlos, @dj_los10, and Carlos asked, "Can you do a deep dive on Capital One on Monday's Financial show? Very interested to hear your opinion."

Well, Carlos, you know, we just kind of got through the crux of earnings season, so today is your lucky day, we're actually going to give you our opinion on Capital One. We're going to take a closer look at Capital One, understand the business, how it makes money, the market it's playing in, opportunities for investors, all that good stuff. I feel like I've got the man for the job right here with me, Matt, so I'm really going to be looking forward to hearing your take here.

So, let's just jump in. And first off, you know, with Capital One, it's understanding exactly what this business does, I think first and foremost, we see a lot of the commercials out there with Samuel L. Jackson, Jennifer Garner, they keep asking you that question over and over again, "What's in your wallet?" That's the Capital One we're talking about, right? But this is more than just a credit card company, isn't it?

Frankel: Yeah, well, technically they're a regional bank. As a consumer, you're probably more familiar with Capital One than I am, because they're in your area, but not mine.

Moser: They are. Yeah, McLean, Virginia; its home base is up here in McLean, Virginia.

Frankel: Funny story, I got my first Capital One credit card when I was in college, but I didn't know they were an actual physical bank until I first went to DC and saw a Capital One branch in -- I think there was a Capital One ATM in the airport. And I had no idea they were an actual physical bank until then.

Moser: Well, physical bank, but like many banks out there, they're starting to whittle back that physical presence too. They're definitely, and we'll get into this, but they're certainly trying to become more of a digital and virtual bank, as many are.

Frankel: Well, yes and no. They are scaling back their branch network to some degree, but Capital One, correct me if I'm wrong, they're the ones who are, like, opening cafes inside some of their branches. They are trying to really double down on the more high-traffic and valuable branches that people are actually going to, they're doubling down on those locations.

I remember reading the Capital One Cafe story a while ago. I don't know if there's a Capital One Cafe near you, but ...

Moser: I don't know, I've seen the commercials. I mean, it's interesting to me, I've seen those commercials and it always kind of makes me wonder, [laughs] it's almost like they're trying to be Starbucks and that third place. It's like, is a bank really where you want to go sit and just hang out? I don't know. I guess it doesn't resonate with me, but I also understand, I'm an old guy compared to a lot of these younger consumers they're pursuing, so maybe there's something there, I don't know.

Frankel: Maybe. I mean, they're definitely taking a more quality over quantity approach, they're not just scaling back like -- I mean, Bank of America is just closing down branches, Wells Fargo is just closing down branches, but they're really, like, doubling down on their core branches, I guess I'd say. But they are a branch-based bank, they're a regional bank. I know that the "Capital" in Capital One refers to DC. So, they are a regional bank, they have branches, if you're not in the DC area or some other major cities in the Northeast, you might not know that. In South Carolina, for example, we don't have Capital One branches.

So, they are unique in the sense that they are a lender, but all banks lend money, at the core of the banking business, you lend money, you take in deposits, you pay them at one interest rate, you charge another interest rate to your customers, it's when you're making out loans, and your profit is the difference. Where Capital One is really different is because they are primarily a credit card lender, that is not the case for most other banks. For example, I know Wells Fargo and Bank of America have mortgage loans, auto loans, they are not primarily a credit card lender. They all have credit card products, but for Capital One, just to kind of mention one of the numbers, they ended 2019 with almost half of their loan portfolio as credit cards. That's a pretty big makeup, and the rest. I mean, they have some auto loans, they have some commercial loans to businesses. But credit cards are their biggest single type of loan, and that can be a good or a bad thing, we'll get into that in just a minute, but they are a credit card heavy lender, which is the most unique thing about them.

I tell you that story, but I'm sure I'm not the only one who thinks that they are just a credit card company.

Moser: [laughs] Well, no, I mean, I think it's probably easy to think that, because that's really how as consumers, that's probably how we most identify with that brand is just through those commercials and understanding that they are aiming to hold a position in your actual wallet, whether it's physical or digital. But to your point there, in regard to that leverage to credit cards, to take that even one step further, looking through their 10-K. One thing, you search the word "mortgage," and really the only reason mortgage exists in that 10-K is in the form of how perhaps they have investment exposure in their assets regarding mortgage-backed securities and whatnot. I mean, this is not a mortgage banker.

I was looking at just how they make their money, and over the last year, it looked like credit cards were responsible for about 64% of net revenues with consumer banking making up about 26%, commercial banking making up about 10%. So, to your point, yeah, extremely levered to that credit card business.

Frankel: Yeah, credit cards are not only a big portion of their loan portfolio, but they are higher income. I mean, anyone who has a credit card in their wallet knows that the interest rate on it is a lot more than you're paying on your auto loan, for example. I don't know if you have a Capital One credit card, but I have a couple of them.

Moser: I don't, you know, I don't. I never have, and I guess I never will, I try to limit the number of cards, it's nothing against them, you know, it's not something I ever ended up with in my wallet. I mean, I've got the Amazon Prime Visa, and I've got an American Express card, and those two together take care of everything I need.

Frankel: That's true. I'm technically a small business owner, because I'm an independent contractor, so I have their business version of their credit card, the Spark Business is a fantastic business card, by the way. I've written about it for The Ascent, it's a really good product. And that's kind of the point, they've differentiated themselves through their credit card business. I mean, you don't get $128 billion of credit card loans on your books at the end of last year without having a good product. So, I mean, the Venture card, I'd say the Venture is their flagship credit card, and that has one of the best, a 2% flat reward rate, which is one of the best in the business. They have some really unique credit card products. They have one, I think, that's a newer product that's geared toward eating out, where it's designed for people who dine out and pays really good rewards on that. Their business credit cards are excellent, when you compare them to the perks and annual fees that the competition has. So, they've really done a great job of differentiating their credit card business.

And credit cards are a good and bad thing from an investor's point-of-view. I mentioned that they are very profitable if things are going well. Just to kind of name a couple of the statistics here, Capital One's net revenue margin on their credit card business is 15.8%. That means when you take the rate they're getting off their credit card loans and subtract the cost of that capital through deposits, you get 15.8%, that's a big spread. I mean, most banks are happy to get, like, 4%. So, that's a big differentiating factor.

Moser: Now, that's an interesting point that you make there in regard to that spread, because one thing you hear banks talk more and more about these days, particularly these days, it feels like is, access to that low- to no-cost deposit base, right? That base where we as consumers are depositing into that bank account and we're not getting any interest on it or we're getting virtually no interest on it, and that basically is free money for the bank to do whatever they want, that low- to no-cost deposit base. Is that something that Capital One benefits from or is it more because they're able to dictate terms on the card side more?

Frankel: Yeah, well, a little of both. And I'm really glad you brought up the deposit thing, because they are really good at getting deposits to cover their cost of capital, instead of having to borrow money, which is a more expensive way to do it. And that's especially true in 2020. They ended last year with almost dead-even, $266 billion in total loans, and $263 billion in deposits. Now, you know, in 2020 everyone has become a supersaver, apparently, we've talked about that before on the show. Their credit card loan portfolio dropped by about $17 billion, about $248 billion at the end of the third quarter. Their deposit base is now up to $306 billion. So, they've taken in a lot of deposits this year, and that's a really good model for a credit card lender.

If you can take in, I mean, we've talked at Synchrony on the show before if you remember.

Moser: Sure, yeah.

Frankel: Their deposit base was almost enough to cover their credit card portfolio, but not quite, they still had billions of dollars of capital from other sources. In Capital One's case, their deposit portfolio is enough to cover their entire lending operation, and they have some higher yield savings accounts, which let's face it, right now still are not very high yield. So, I think that I want to say I read that their cost, their average deposit pays something about 0.8% right now. So, when you have that and you have a credit card that's charging 16%, the challenge is giving credit cards to people who are going to be able to pay them back.

Moser: Yeah, that's a good point. And we're living in a time now where we've seen a lot of news recently with FICO scores, you know, they've adjusted how those FICO scores are tallied, and we've seen the average FICO score go up, which obviously opens up a bigger lending base, right, more people able to get cards and access to lending.

Frankel: It is. Some lenders are pumping the brakes on credit card lending right now, which is totally understandable given the uncertainty that's been going on. Most credit card lenders don't publish their specific approval guidelines, like, we want a 720 credit score and we want to see this much income and things like that. But in general, when times get tough, it becomes tougher to get a credit card. You know, where a lender might normally want, like, a 700 score, they might want a 740 now or something to that effect. So, that can have a little bit to do with why Capital One's credit card portfolio has dropped a little bit. But their core competency is credit card lending.

And I mean, it's a riskier type of lending, before the pandemic happened the net charge off rate in their loan portfolio was about 2.6%. That's elevated compared to other banks, most are well under 1% in normal times. In the credit card side of the portfolio, it was 4.3%, meaning that every $100 they loan out as credit card loans, they're not going to get back about $4.30 of it. But when you're making $15 on that $100 credit card loan, losing $4 is a reasonable cost of doing business. The problem is when you get the pandemic or a recession or any tough times like we're seeing in 2020. When unemployment spikes, people run into trouble paying their debts, and that 4.3% or 4% charge off rate can easily spike to the double-digits. We saw this in the financial crisis where most credit card lenders had peak default rates in the 10% to 12% range, that can make your profit margin disappear really quickly. So, it's a riskier form of lending, but it's higher profit when, one, it's done well, and two, when times are going well. So, it's a different animal.

I mentioned that the net revenue margin was 15.8% on their credit card business, the net interest margin, that's after paying everything, including losses and things like that, the net interest margin was almost 7% at the end of 2019. Most banks are happy with a net interest margin in the 3% ballpark, that's where Bank of America and JPMorgan Chase run. So, Capital One is, you know, twice as profitable; and that's not just their credit card business, that's the entire lending operation. So, that's a pretty impressive cost advantage.

Moser: What do you think about, you know, I saw back in September, I think, of last year, of 2019, they forged a new relationship with Walmart, they launched a credit card issuance program with Walmart. They're the exclusive issuer of Walmart's co-brand and private label credit card program here in the U.S. I mean, that's obviously, I mean that's a massive potential opportunity. When you see those exclusive types of relationships, I think it was, what, American Express had that with Costco for a while until that disappeared and went to Visa.

But you're seeing, with Capital One, I mean, this relationship with Walmart, on the one hand, it seems like a massive opportunity to get a lot of cards out there in consumers' hands, on the other, it also could be maybe a little bit more open to that risk of the sensitive consumer, right. When times get a little bit tougher that they may not, you know, have the resources to be able to pay back those bills, so that could be something ... you could see that working both ways, I think.

Frankel: Yeah, and I'm glad you brought up the Walmart thing, that was actually Synchrony's before it was Capital One's. If you remember, about a year ago, Synchrony stock just fell off a cliff and that was because they lost the Walmart account. They just couldn't agree on terms, so Capital One ended up getting it. And in a way it was actually, kind of, a sigh of relief for Synchrony, because Walmart, it wasn't the best credit quality portfolio. When you think of, say, like American Express, their clientele tends to skew toward the affluent, you know, upper middle class, the people who get American Express cards are generally the more capable and willing and able to pay their credit cards back. Capital One, and just general bank credit cards are a more middle-of-the-road consumer base, so when you get retail credit cards, they tend to be the riskier of all. That's why Synchrony cards generally charge, [laughs] like, 29%, 30% interest, because the store credit cards generally have a much higher net charge off rate than other ones.

So, it's something to keep an eye on, but at the same time getting co-branded deals like that is something I would like to see Capital One do better, and Walmart is definitely a step in the right direction. When you think of all these other credit card issuers, like, how many co-branding partnerships does American Express have? I can name Delta, I can name Hilton, I can name Marriott, you know, the list goes on, there's a lot of co-branded American Express cards. When you think of Capital One, most Capital One cards are just Capital One cards. So, I think co-branding is a big opportunity for them, so I think Walmart is a step in the right direction, but a step that needs to be taken with caution.

Moser: Yeah, and you get something like that with a Walmart, where it's going to be a little bit more of a, kind of, a recurring spend, a little bit more of a reliable and recurring spend. People shopping at a place like Walmart for all sorts of reasons, I mean, not to mention the fact that they hold, like, [laughs] a 50% share in the U.S. grocery markets. So, it's a very nice recurring spend model and just a massive customer base where you can certainly see the opportunity there. It made a lot of sense to me for them to jump in that.

So, at the end of the day, Capital One, this is a bank. I mean, Capital One itself, this is a holding company for a couple of subsidiaries, but this is a bank, it's beholden to these same types of obligations, ratios, requirements that all banks are required to maintain. The metrics for success for something like a Capital One, I'm assuming are very similar to your typical banks that we cover, whether it's a Wells Fargo or, you know, an American Express, for example.

Frankel: Yeah, for sure. I mean, all banks, including Capital One, have to submit to pretty stringent capital requirements these days. No. 2, banks put money in reserves to cover their potential losses, this is why bank earnings were terrible in the second quarter. For example, if you remember when Wells Fargo was putting aside $3 billion or $4 billion and other banks were doing the same. Capital One generally has a pretty high level of reserves. In normal times, they have more set aside for their losses than their net charge off ratio is. About 2.7% of their loan portfolio is just set aside to cover losses.

Moser: I mean that's the nature of the product that they're selling there, right. I mean, a credit card is far different than a mortgage. I mean, it seems like that that's going to be always the case even in the best of times, right?

Frankel: For sure. And right now, they have 6.5% of their entire loan portfolio set aside to cover losses, including 11% of their credit card portfolio. So, they can not collect 11% of their outstanding credit card loans and they have the money in the bank to cover it. So, that's pretty impressive. And worth mentioning, their net charge-off ratio actually went down in the third quarter, a lot of that has to do with stimulus, kind of, holding the economy up, things like that. And we'll see what happens now that Congress can't get its act together and agree on a stimulus bill.

But so, the net charge off ratio is actually about 3.5% right now, and they're setting aside enough for 11% in the credit card business. So, if this holds out, that's going to be a big reserve release too. So, it kind of works both ways, they set aside a ton of money, but then if losses don't happen, they get to give some of that back to investors. So, they're well-capitalized and well-prepared for losses, which is the short version of all that. [laughs]

Moser: Well, that's what you want to hear; I mean, that's definitely what you want to hear, particularly when you're tied to cards, as they are.

Let's talk a little bit about today's big headline. We were talking before taping regarding Moderna and the headline that came out this morning. Preliminary data from a Phase III trial shows that its coronavirus vaccine is more than 94% effective in preventing against COVID-19. I mean, this is something, CEO, Stephane Bancel, I hope I'm pronouncing her [his] (sic) name correctly, she [he] (sic) called a game changer. And to me, you know, we were talking about how the string of vaccine news has certainly been received very well by the real estate market. What about -- with a company like Capital One, why is the vaccine such a positive catalyst for a company like Capital One?

Frankel: Well, you want unemployment to return to normal as soon as possible, especially if you're a credit card lender. High unemployment means higher than average defaults. For the second and third quarter, banks and credit card companies have been really good about letting people suspend their payments if they want to, there's been some stimulus going on, things like that. So, we really haven't seen the effects play out yet. The ideal scenario is that the vaccine will be available, life will essentially return to normal, unemployment will normalize before we start seeing a giant wave of people running out of money to pay their bills. So, that's the big hope when you see this vaccine news. When it comes to banks and credit card heavy banks like Capital One, in general, you want the economy and life as we knew it to return, essentially, unemployment as we knew it to return, especially before people start running out of money.

You know, unemployment rate in the 4% to 5% ballpark would be great, great news for Capital One, and the sooner we get a vaccine, the sooner we're going to get there.

Moser: Yeah, that makes a lot of sense.

Frankel: Oh, and by the way, I looked up their co-branding partners; Capital One also partners with GM, they issue their credit card; Cabela's, if you're an outdoorsy person you know who that is; and Bass Pro Shops.

Moser: Bass Pro Shops. Well hey, listen, good go, brand relationships. And frankly, I think they do a tremendous job on just brand awareness. The commercials become a little redundant, but you remember them, you know, you remember them. [laughs]

Frankel: They do. I mean, Walmart's a big deal, and I'd like to see them pursue a few more big deals. I mean, the ones we were just talking about, like GM, Cabela's, and Bass, that's not a Delta, that's not a Costco, that's not, you know, Amazon. So, I'd like to see them pursue, like how Buffett likes to say, fire the elephant gun, like, pursue a big partnership and bring that into the fold. But Capital One, they put out great credit card products and I think that's a big opportunity they have going forward.

Moser: You know, one thing I noticed, and I guess it doesn't seem like you see this that often, particularly with a $40 billion bank, but Rich Fairbank, the CEO and the Chairman of the business, also the Founder of Capital One Bank. I think Rich is 69 years old maybe now, so I don't know how long he plans to remain at the helm there, but you just don't really often see a bank of this size still Founder-led. I mean, I feel like that's a reason for the success to this point. I mean, you have a $40 billion bank, you know, you get there with a vision, and it seems like Rich has always had one.

Frankel: You know, like I was saying, the credit card business is really profitable, but really hard to be good at, and he's clearly good at it. So, that's definitely part of the investment thesis there. And as you said, he's not getting any younger, so -- and Capital One is his baby, so I mean, I can name founder-led companies where the founder is there well into their 80s, but that doesn't mean that's going to happen in this case, so that's definitely something to be aware of.

Moser: So, you know, let's bring this down to the bottom-line here. And if you look at the way the stock has performed here over the last several years, I mean, it's not lighting the world on fire, right? I mean, the last five years have been just kind of, meh! You stretch it out over 10 years, you know, you've made money, it's nothing to write home about. It seems to me though, that they are in a position where you could see better days ahead. I don't know, am I looking at that right way or...?

Frankel: Yeah, I mean, well, no bank stocks have done that great in the past couple of years as a whole. I mean, interest rates were falling even before the pandemic started, and they've been one of the worst-hit parts of the pandemic. So, take that with a grain of salt, most bank stocks haven't done fantastic. There's money to be made, and over the long run they've done pretty well. I mean, just looking over the last 10 years, they've returned about 160% to investors. So, that's not great, but it's not terrible considering what they've gone through in the past year-and-a-half or so with falling rates and rising defaults and the pandemic coming on.

So, if you give them 10 good years, [laughs] then they're going to return a lot of money, but like I said, that's the risk of the credit card business, it's not a great business to be in during tough times, though. They're not a great recession stock.

Moser: Yeah, it feels like times [laughs] should, in theory, get better. I mean, I don't want to be, God! If it gets worse from here, then that really sucks. [laughs] So, let's hope things get better from here. But I mean, also, there's the potential signing on another meaningful cobrand partnership. You can see that that can really have a lasting impact for a business like this. And I think that as we see the finance space change so much with fintech and new offerings for younger consumers particularly, to start establishing credit, using credit and debit, it does seem like there are plenty of opportunities for a business like this. I'll put it to you that way.

Frankel: Yeah, for sure. There's definitely a lot of opportunities, a lot of directions they could go in. And the credit card business has been very innovative over the past, I'd say, you know, five years or so, especially that competition has never been higher, it's another big risk going forward, credit card competition keeps heating up. Like a 2% reward card would have been unheard of 10 years ago. So, that also increases the cost and things like that, so that's something to be aware of, there's a lot of competitive pressures in the space.

You know, American Express is really doing a great job of competing for the millennial business, which is a big deal to credit card issuers, there's just a lot of competition. Discover is another one doing a great job of marketing to the younger generation. So, it's a lot of competition there, and that's one thing to really keep in mind, even when times are good, it's a competitive business.

Moser: It's a very, very good point. Well, Matt, before we wrap it up this week, as most always, we want to give our listeners a stock to keep an eye on this coming week. So, what is your one to watch this week?

Frankel: I am watching Simon Property Group, ticker symbol is SPG. They are a Real Estate Investment Trust, they're the biggest mall Real Estate Investment Trust in the world. They just announced today a revised agreement to buy one of their rivals, Taubman Centers, another class A mall operator, and they're getting a 20% discount, they were under contract to buy Taubman before the pandemic, ended up backing out of the deal, Taubman sued them, they sued Taubman, it was going to be a big mess. They just announced today that all the litigation is resolved and they're buying Taubman now for 20% less than they originally were. They're scooping up a competitor, they're broadening their reach. And I've said before, when it comes to malls, it's Simon and everyone else, and this acquisition just really adds to that statement, so I'm a big fan.

Moser: Nice, good deal. Well, I'm going to be keeping an eye on Target, ticker for Target is TGT. They actually have earnings coming out on Wednesday. There are a number of different angles to this company now, which I find just a fascinating business and one where they've made so many interesting moves here in the last few years. I want to hear their perspective on the holiday season upcoming, but then there's also the Shipt angle. Remember they acquired Shipt several years ago for $550 million in cash, and that's something that has given them a presence in the shipping and fulfillment space. A little membership model there, and partnering with all sorts of different retailers out there. They recently announced this Ulta partnership, which I think is pretty fascinating.

And then, you know, speaking of cards, there's the Target RedCard, which they work in partnership with MasterCard and TD Bank. Penetration rates there for Target's RedCard, you know, it's kind of hovering in that 23% to 24% range, which, that's just basically talking about the percentage of revenue spent within the company, the purchases made within Target with that RedCard. But you know, it's always interesting to see how big retailers like that pull that lever of that card. And then, certainly, Target RedCard is something that keeps some of those customers loyal, I'd say, which is just interesting. But I mean, the business has done really well over the past several years and I'm interested to see what they have to say on Wednesday, so we'll be keeping an eye on that.

But Matt, I think that is going to do it for us this week. I appreciate you joining, as always; it was a lot of fun talking about Capital One.

Frankel: Of course. It's a fun company to dive into; they're a lot different than the other banks we follow, it's like if American Express and Bank of America had a child, it would be Capital One.

Moser: [laughs] Well, we're going to leave it right there, folks. Remember, you can always reach out to us on Twitter @MFIndustryFocus or drop us an email at [email protected].

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

Thanks, as always, to Tim Sparks for putting the show together for us. For Matt Frankel, I'm Jason Moser, thanks for listening and we'll see you next week.