COF: Capital Generation and Digital Opportunity in Payments Can Drive 25% Upside

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

December 2, 2013

COF: Capital Generation and Digital Opportunity in Payments Can Drive 25% Upside

  • We expect COF to generate 2015 EPS of $7.70 (20 cents above consensus) as the payout ratio rises to ~80% corresponding to a 2015 buyback amount of $2.5 billion and reducing the average share count by 3-4%; even with this payout ratio, the bank will end 2015 with an equity/assets ratio of 14.8% versus 14.4% today.
  • COF has signaled its intent to increase the payout ratio from the current level of just under 30% to “well in excess of” 50% and believes it has this flexibility given its estimate that the Tier 1 common equity ratio (calculated under the Basel 3 advanced approach methodology) is in the range of “low-to-mid” 8% versus the target of 8%.
  • At the same time, management has cautioned Fed estimates of capital adequacy under stress scenarios may differ from its own with particular uncertainty arising because it has not yet entered into “parallel run” calculations. It follows the results of this year’s CCAR process, expected to be announced in March 2014, will be an important litmus test.
  • Along with our expectation that the earnings multiple rises from the current 10x to 12x with more visibility into the potential for margin lift as the yield curve re-normalizes and for growth of the private-label card business as merchants respond to the shift to mobile payments by expanding their proprietary card programs (to enable e-coupons while controlling payments data and to reduce card acceptance costs), our 2015 EPS estimate generates a one-year price target of $92 representing 25% upside from today.
  • Even after the sale this September to C of the $6 billion Best Buy card portfolio, COF has a larger private-label card portfolio than ADS and so is #3 behind GE and C (see Exhibit); unlike GE and C, it has a specific focus on using information-based capabilities to design e-coupon programs so as to create marketing advantage for merchant partners.
  • We see COF as a natural partner for MCX which will be looking to make credit at point-of-sale available through its mobile wallet and has indicated a preference for working directly with issuers rather than provisioning into the wallet Visa/MasterCard products. Kohl’s, one of Capital One’s major private-label partners, joined MCX this July coincident with MCX’s announcement that it had selected FIS as a transaction-processing partner.

Exhibit: Private Label Credit Cards at end-2012

Source: Nilson. Excludes impact of sale of $6bn Best Buy portfolio to C in Sep 2013

Investment Conclusion

At $7.46, the 2015 consensus EPS estimate for COF is about 20 cents too low; we expect nearer $7.70 representing ~10% growth driven by a $2.5 billion stock buyback reducing average diluted shares by 3-4%. Furthermore, we expect the earnings multiple to expand from the current 10x to 12x with more visibility into margin expansion as the yield curve renormalizes and into the potential for COF to leverage its private-label platform to partner with merchants around e-couponing as mobile payments gain share. Combined, these assumptions give us a one-year price-target of $92 representing over 25% upside.

While CEO, Richard Fairbank, has described the rate of capital generation at COF as “breathtaking” and has repeatedly emphasized his commitment to raising the payout ratio (across dividends and buyback) to “well in excess of” the prevailing average for banks, a key risk to our thesis is that this aspiration will be impeded by the CCAR process. Even under our assumptions (that the payout ratio rises to 63% in 2014 and 78% in 2015), COF will continue to build capital so that the equity/assets ratio increases towards 15% from the current 14.4%; however, the CCAR process involves stress-testing and is less certain at COF since the bank is not yet in a parallel run for the “advanced approach” assessment that will ultimately be applied. As such, the results of this year’s CCAR process, expected to be announced in March 2014, are an important litmus test.

2015 EPS Estimates

Compared to the early 2000’s, when it exploited the mail channel to grow credit-card loans at over 20% annually, COF has matured: we expect normalized growth in loans of 4-6% and in card spend of 8-10% as the firm gains share including through leveraging it private-label platform to partner with merchants (an increasingly important distribution channel for payments products as the transition to mobile payments gathers momentum – see our note of November 4th entitled “Winners and Losers in Mobile Payments”).

Given our expectation for normalized ROE of 10-12%, these assumptions are consistent with a normalized payout ratio of 50% compared with just below 30% this year. Over the next 2-3 years, loan growth will be below-normal given run-off in acquired portfolios and cyclical factors (consumers are saving and companies have cash-on-hand) and so closer to 1-3% allowing for a payout ratio of closer to 80%. It is a payout ratio at this level that supports our above-consensus EPS estimate in 2015 by reducing the stock count 3-4%. Other aspects of the model (see Exhibit 1) are:

  • Revenue yield constant aside from a slight lift in net interest margin in 2015 as the yield curve re-normalizes. In practice, the margin-lift could be substantially greater given card loans are variable-rate with the result that COF is asset-sensitive; every 10 basis points lift to net interest margin increases 2015 EPS by 25 cents.
  • Non-interest expenses run at $12.1bn in 2014 and $12.3bn in 2015 consistent with guidance for run-rate expenses of $10.5bn and assuming marketing rises modestly from the 2013 level of $1.5bn.
  • Net loss ratio rises slightly from 2.1% in 2013 to 2.2% in 2014 and 2015 as used-car prices weaken (affecting collections in the auto business) but losses otherwise remain flat given tight underwriting standards at both industry and company level since 2008. There are reserve builds of $300 million and $330 million in 2014 and 2015 respectively so that the reserve/loan ratio increases from the current 2.3% to 2.5% in 2015.
  • Dividend increases to 35 cents/share in 2014Q2 and 40 cents/share in 2015Q2

Exhibit 1: Earnings Model for Capital One

Source: Company Reports, SNL, SSR Analysis

Payout Ratio

The normalized payout ratio of 50% described above, and potential for an ~80% payout ratio in 2015 given below-normal loan growth, make two crucial assumptions: that COF is adequately capitalized at present and that the firm does not deploy capital into acquisitions. The second of these is more assured than the first: the CEO has emphasized that it is comfortable with the current strategic footprint and that returning excess capital to shareholders is a strategic priority; we see no reason to be skeptical given management is likely to face significant opportunity and challenge in leveraging the digital capabilities of ING across the organization, re-purposing existing branch infrastructure for a more digital approach to banking, and leveraging the private-label platform acquired from HSBC to partner digitally with merchants. We note that the CEO has been explicit about the priority of returning capital to shareholders: “we’ve to really get actively in the mode of distributing this capital or it’s going to be hard to contain”.

The first of the assumptions, around regulatory approval for the modeled payout ratio, is more conjectural. In the Q3 earnings call, CFO Stephen Crawford commented that COF expects “to request capital distribution in the upcoming CCAR process that, if approved, would result in a total payout ratio well above the industry norm of 50%” but cautioned that while COF believes it has substantial flexibility to return capital to shareholders while remaining well-capitalized there is a “real possibility that the Fed’s modeling under CCAR will result in lower ratios under stress”.

The regulatory uncertainty is compounded because while COF will migrate to the Basel 3 “advanced” approach (albeit no earlier than Q1 2016) it will not begin the parallel run which regulators follow with larger financial institutions until Q1 2015; the value of the parallel run is that it provides information for advanced-approaches institutions as to how their capital ratios will be calculated and what optimizations of the balance sheet can improve measured capital adequacy. All that said, COF is meaningfully better-capitalized than bank competitors (see Exhibit 2) with a Tier 1 common capital ratio in Q3 2013 of 12.7% using the Basel regime to which it is presently subject and estimates this ratio in the low-to-mid 8% range under the Basel 3 advanced approach (versus the regulatory target for the firm of 8%).

Exhibit 2: Tier 1 Common Capital Ratios under Basel 1 for Q3 2013

Source: Company Presentation

Given these data, it is hard to imagine COF will be required to hold more capital. However, the CCAR process gives the Fed wide discretion and the bank has explicitly warned that there were large differences between company estimates and Fed estimates for capital levels under stress and that, this year, these differences could be amplified because of methodological issues. In particular, the Fed will be using its own modeling assumptions and will be stress-testing both Basel 1 and standardized (but not advanced) Basel 3 capital ratios; COF estimates its standardized Basel 3 Tier 1 common equity ratio at 11.7%. Regardless, the results from this year’s CCAR process, expected to be announced in March 2014, will be an important event.

Mobile and the Private-Label Card Business

We believe the shift to mobile profoundly shifts the balance of power in the payments industry to merchants from issuers, and this is already affecting industry structure as issuers look to forge merchant partnerships so as to combine the in-store payments data available to merchants with the out-of-store data available to issuers and use the results to make personalized, targeted, and real-time consumer offers at point-of-sale (“e-coupons”) and hence drive customer loyalty, visit frequency, and ticket lift. While a lack of standards and muddied business cases have meant the only meaningful mobile payments program to date is at Starbucks (where mobile accounts for ~10% of US tender), we believe a tipping point has been reached as MCX and Isis begin to compete and as the carrier-control over embedding payment credentials in a secure element is by-passed with “host card emulation” (which essentially creates a virtual secure element in the cloud).

We expect merchants to take advantage of new-found leverage in the mobile payments value-chain to shift the payments mix to proprietary products so as to control and protect payments data and to reduce the costs of card acceptance; the first of these two goals is presently the more important for Starbucks and the second the more important for Target (whose proprietary cards now account for 14% of US tender). MCX has been explicit that its mobile solution will focus on ACH-enabled debit products and proprietary credit products, and we believe proprietary products (whether offered through the MCX consortium or through merchants individually) will gain share to account for near 11% of purchase volume on payment cards (whether physical or mobile) by 2018 versus 8% in 2012; this assumption equates to a 17% CAGR for these purchase volumes with a 13% CAGR on credit products (see Exhibit 3).

Exhibit 3: Purchase Volume by Payment Rails (excludes impact of bank closed-loops)

Source: Nilson, SSR Estimates

To achieve these payments mix-shift goals, merchants will need the support of partners who can provide credit at point-of-sale, and do this in the context of leveraging payments data to inform e-coupon and other pay-with-points-at-point-of-sale programs. COF is well-positioned to act in this role giving its heritage of information-based decision-making and, with the 2012 acquisition of HSBC’s US card portfolio, scale-able private-label card platform which gave COF a #3 position in the business behind GE and C (see Exhibit 4).

The data in Exhibit 4 do not take account of the sale to C in September 2013 of the $6 billion Best Buy portfolio acquired in the HSBC deal. We believe the reason is that the portfolio had more of the traits of an instalment program (large purchases bought on credit) rather than the more frequent interaction with customers (and associated payment data) characteristic of a more typical credit portfolio such as the program

COF runs in partnership with Kohls. Given the traits of the Best Buy portfolio, we do not view the sale as invalidating our positive view of the opportunity for COF in private label and its likely approach to use private-label relationships, along with information-based marketing capabilities, to leverage payments information so as to inform e-couponing and generate marketing advantage for merchant clients. We note CEO Richard Fairbank has stressed his interest in private-label as a growth business and, albeit in a different context, his belief that e-couponing can have a transformational impact on retailing.

The specific advantage to merchants of working with COF is that they can access the firm’s information-based capabilities without losing control of their data which can be managed contractually. In the case of Kohl’s, for example, the privacy policy allows Kohl’s and COF to share data with each other for marketing purposes, among others, but not third parties (see Exhibit 5). Of course, a risk to the strategy is the possibility of regulatory action on privacy.

Exhibit 4: Private Label Credit Cards at end-2012

Source: Nilson. Excludes impact of sale of $6bn Best Buy portfolio to C in Sep 2013

Exhibit 5: Merchants Retain Control of Data in a Private-Label Partnership

Source: Company website

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