Capital One (COF 2.72%) made huge news earlier this year when it announced plans to acquire Discover Financial Services. The deal would make Capital One the largest credit card lender in the U.S., but it faces regulatory scrutiny before approval.
The company also faces rising charge-offs from its credit card customers as delinquencies rise above pre-pandemic levels. If you're thinking of scooping up Capital One stock today, consider this first.
Capital One's big splash
Capital One is the fourth-largest credit card company in the U.S. today, trailing JPMorgan Chase, American Express, and Citigroup. The company works with payment processors, like Visa and Mastercard, to provide customers with branded debit and credit cards.
Its primary revenue source is interchange fees from those processors. The company took in $1.1 billion in interchange fees in the first quarter. It also earns revenue from interest that it charges on its card and benefits as interest rates rise. In Q1, Capital One raked in $7.5 billion in net interest income.
NYSE: COF
Key Data Points
By acquiring Discover Financial Services, Capital One could become the largest credit card lender in the U.S. Not only that, it would also give Capital One Discover's payment networks, including the Discover Network, Diners Club, and Pulse debit network.
By owning a payment network, Capital One becomes more like American Express, which issues cards to customers, processes payments through its own network, and holds on to those card loans for interest income. This would allow Capital One to create a closed-loop payment network and boost its earnings as it saves on the fees that Visa or Mastercard would usually collect.
Capital One's deal for Discover faces an uphill battle
The potential Capital One-Discover deal would make Capital One a compelling stock to buy right now. However, the deal faces an uphill battle as regulators debate the deal on antitrust merits.
Capital One management argues that that deal would boost Discover's payment network and create a better competitor against Visa and Mastercard. Regulators have previously criticized the duopoly held by the two payment processors.
Opponents of the deal say that it would consolidate the credit card market and could limit customers' choices. Senator Elizabeth Warren (D-Mass.) and others have asked the Office of the Comptroller of the Currency and the Federal Reserve to block the deal.
The Federal Reserve and Office of the Comptroller of the Currency announced they would extend the public comment period on the deal to July 24, 2024. Capital One management anticipates the deal will be completed at the end of this year or early next year.
Image source: Getty Images.
Keep an eye on the consumer
Another factor to consider is Capital One's credit metrics. Consumer credit card debt has exploded in recent years and is now over $1.1 trillion. Capital One's customer base tends to be on the lower end of the credit spectrum. These customers face ultra-high interest rates on credit cards and could be vulnerable in an economic downturn.
In the first quarter, Capital One's net charge-off rate was 3.3%, up from 2.2% just one year earlier. Based on its credit card loans only, Capital One's net charge-off rate was 5.9%, up from 4.1% in the same quarter last year.
Capital One currently has $11.3 billion in allowance for credit losses, which is like a safety net it has to account for losses. Based on its $144 billion loan portfolio, this provides it with an allowance coverage ratio of 7.85%, showing it has a decent buffer to absorb losses. However, if charge-offs continue rising, Capital One may have to set aside more funds to account for those potential losses.
Is it a buy?
Capital One's potential acquisition of Discover could be huge and would make it a compelling investment today. However, it remains unclear whether regulators will approve the deal by the end of this year. The company also faces the prospect of a weakening consumer, as evidenced by its rising net charge-offs.
The stock is priced at 1.23 times its tangible book value, above its 10-year average of 1.17, and doesn't appear to reflect some of the risks the company faces. For that reason, I think investors are better off waiting to buy the stock until more details on the approval (or denial) of its acquisition emerge.
