Credit card company Capital One Financial (COF 0.66%) has seen its stock price surge more than 63% year to date, and it's one of the top gainers in the financials sector. In the second quarter, the company soundly beat analysts' expectations on both earnings and revenue, generating $7.62 earnings per share (EPS) after the consensus for the quarter was only $4.54.
Despite the big run-up in its stock price, I still see plenty of reasons to remain bullish on the company and believe there's further upside. Here are five reasons in particular.
1. Signs of loan growth
There was some noise in the second quarter, but period-end loan balances grew 3% from the sequential first quarter, and were down 1% on a year-over-year basis. Meanwhile, average loan balances grew 1% from the sequential quarter and were down 3% from the second quarter of 2020. These numbers, however, included moving $4.1 billion of loans held for investment to loans held for sale during the quarter. If the $4.1 billion had not been moved, period-end loan balances would have grown 4.3%, which is pretty good considering loan growth has been muted across the industry. On the loan front, the consumer has shown more signs of bouncing back than commercial customers, which is more beneficial for a credit card company like Capital One.
In particular, domestic credit card period-end loan balances grew 5% from the sequential quarter, which is ahead of typical seasonal growth of 2%. Purchase volume, which is spending on Capital One cards that results in interchange fees for the company, jumped 23% from the first quarter of the year and is 48% higher year over year. As a result, fee income in the domestic card division grew by similar amounts. But historically high payment rates by customers on existing loans continue to offset the growth.
Capital One's consumer banking division saw very solid growth in the current environment, with period-end balances growing 6% from the first quarter of the year and up 12% from the second quarter of 2020. Auto loan originations came in very strong, up 47% from the sequential quarter and 56% year over year.
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2. Superb credit
High payment rates may be a headwind to loan growth, but it's a huge tailwind to credit, which helps out companies like Capital One because they do not need to allocate as much capital to cover credit losses. In the second quarter, Capital One released $1.7 billion previously stored away for credit losses back into earnings, which resulted in a nearly $1.2 billion boost to profits.
Following the release, Capital One still has enough money set aside to cover loan losses equivalent to 5% of total loans, which includes an 8.78% coverage ratio specifically for the credit card book. Despite this solid coverage amount, net charge-offs (NCOs, debt unlikely to be collected and a good indicator of actual losses) for the domestic credit card portfolio, a main driver of the total credit card book, ended the second quarter at 2.28%. Meanwhile, the 30-day credit card delinquency rate at the end of the quarter was only 1.68%. Credit card loans tend to have higher default rates, so these are really strong numbers.
In the consumer banking division, overall NCOs were -0.06%, meaning the bank actually recovered debt initially thought to be a loss. Auto loan charge offs were -0.12%. Capital One's CEO Rich Fairbank called these NCO levels "unusual," while saying that overall credit in the quarter was "strikingly strong."
3. Making up for lost dividends
Capital One was one of the few large banks that had to cut its quarterly dividend -- from $0.40 to $0.10 -- in 2020 due to the pandemic. But the company has said that the only reason it felt it needed to do this was because of restrictions imposed by the Federal Reserve on capital returns in 2020.
With those restrictions now removed, management has not only raised the quarterly dividend back to $0.40, but also said that the company is planning to make up the lost dividend amount during the quarters it was reduced by paying a special dividend of $0.60 in the third quarter. Management also said it is planning to raise the company's regular $0.40 quarterly common dividend by 50% to $0.60 in the third quarter. The forward dividend yield at $0.60 is still only about 1.5% at the company's current share price, but the actions show that the company could have indeed maintained its dividend during 2020 had it not been for the Fed's restrictions. It also shows that Capital One is committed to returning capital to shareholders and that the company has a strong overall capital position.
4. A very strong capital position
All large banks must hold regulatory capital for unexpected losses. The amount of capital each bank needs to hold is largely determined by the Fed's annual stress testing exercise. A key capital ratio investors and regulators focus on is the common equity tier 1 (CET1) ratio, which is a measure of a bank's core capital expressed as a percentage of risk-weighted assets such as loans. Following stress testing in 2020, Capital One's required CET1 ratio was 10.1%. But following this year's stress testing, the bank performed better and that number got reduced to 7%, which is the floor for any large bank. At the end of the second quarter, Capital One had a CET1 ratio of 14.5%, which means it's currently holding roughly double the capital required by regulators.
Now, management said that its required CET1 ratio can move around quite a bit year to year, so the company still plans to maintain a target CET1 ratio of 11%. But even so, it still has lots of excess capital that it can return to shareholders through share repurchases and dividends, use to fund loan growth, reinvest in the business for things like technology initiatives, or use for acquisitions. The 11% target still leaves a lot of excess capital, and if the bank continues to perform like this in future stress testing exercises, the internal CET1 target could come down over time.
5. Undervalued compared to competitors
Whether you value Capital One on a price-to-tangible book basis, which looks at a bank's market price compared to the value of its physical equity, or on a price-to-earnings basis, Capital One is valued lower than several of its competitors. I am sure there is good reason for the disparity, and you'll want to study the other companies to see why the market has assigned them a higher valuation. But if a company that is valued lower than competitors looks to be in a strong position like Capital One, at the very least it usually indicates upside.
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