Capital One Financial (COF 1.62%) is an interesting bank stock right now. Not only is it a highly profitable business that trades for a discount to its book value, but it's also set to acquire fellow financial institution Discover (DFS +0.00%) in the not-too-distant future.
The Discover deal could result in cost synergies and network savings for Capital One, but the ownership of a payment network by a major U.S. bank creates some interesting possibilities for the future. Here's why Capital One has jumped to the top of my watch list and deserves a closer look right now.
NYSE: COF
Key Data Points
Capital One is an excellent business
Capital One's business is strong. Because of the credit-card-heavy nature of its business, as well as its focus on online and mobile banking, Capital One has an excellent cost structure. Its net interest margin of 6.7% is more than double what most other major U.S. banks produce.
Recent numbers look impressive. In the second quarter, the company's average credit card loans were up 8% year over year on strong purchase volume. The net charge-off rate has ticked up slightly but is still well covered by the bank's loan-loss reserves. Consumer deposits are up 7% over the past year, auto loan originations grew 18%, and income is growing faster than expenses.
In addition, the price is right. Even after its recent strong performance, Capital One trades for a discount to its book value.
The Discover deal could be a winner on several levels
There are some obvious benefits to the acquisition of Discover. For example, it makes Capital One's already impressive credit card business much larger, adding about 300 million Discover accounts. It also adds $87 billion in consumer deposits and about $20 billion in private student loans.
It's worth noting that most of Capital One and Discover's credit card products are complementary to each other, so there isn't as much overlap between the product portfolios as you might think. Just to name a couple of examples, Capital One offers several higher-end travel credit cards, while Discover doesn't, and Discover offers the popular cash-back cards with rotating 5% back categories, a product for which Capital One has no equivalent.
In addition, by moving some of its own transaction volumes onto Discover's payment network, Capital One will save on interchange fees (swipe fees). Management expects a total of $2.7 billion in synergies between expense and network savings by 2027.
The long-term potential is massive
Discover's payment network has long been a distant fourth place out of the four major payment networks, significantly behind Visa, Mastercard, and American Express. Just to put the size difference into perspective, Discover processed $225 billion in payment volume last year, less than 2% of Visa's volume.
But under Capital One's umbrella, there are some interesting long-term possibilities, and in the recent second-quarter earnings call, CEO Richard Fairbank said that "the combination of Capital One and Discover creates game-changing strategic opportunities," specifically calling out the benefits of scaling Discover's network.
I don't think Capital One's network will become anywhere near the size of Visa's or Mastercard's -- at least, not anytime soon. But if Capital One's management team can narrow the gap between Discover and its larger rivals, it could be a massive value-creation engine for the bank's investors.
According to Capital One's management, the latest expectation is for the acquisition to be completed "late this year or early next year." I can't wait to watch the combined company evolve over the coming years.
