What's in Your Wallet? Maybe It Should Be Capital One

With its highly visible ad campaigns featuring a traveling Alec Baldwin or anachronistic Vikings pillaging the modern world,  Capital One Financial (COF) has become a recognizable financial brand in U.S. households. While the popular perception is that Capital One is primarily a credit card company, we think its balance sheet looks more similar to a bank's, with lower-cost deposit funding and a diversified loan portfolio. We would point to Capital One's growth in commercial and consumer automotive lending as it replaces stagnant credit card receivables growth as evidence of that claim. With typical bank multiples at 11-12 times forward earnings, Capital One currently trades at 10.4 times our 2013 earnings forecast and  less than 1 times book value, still a significant discount to our fair value estimate.

Capital One's Strong Franchise Contributes to Its Low-Cost Funding
We prefer to invest in banks with strong deposit bases, in part because deposits are an exceptionally low-cost form of funding and help produce excess returns year after year. That's one reason we're impressed by CapOne, which through bold acquisitions into traditional and nontraditional banking markets, has become the seventh-largest bank by deposits in the United States. These acquisitions have also helped Capital One enter more traditional commercial and consumer lines of banking and benefit from its lower-cost funding. With the acquisition of Hibernia in 2005, Capital One acquired $3 billion of noninterest-bearing deposits and established itself as the largest bank in Louisiana. When it acquired North Fork Bancorporation in 2006, Capital One gained a strong eighth deposit position in the New York metro area along with $8 billion of non-interest-bearing deposits and is currently the sixth-largest deposit gatherer in the New York metro area. In 2012, Capital One acquired ING Direct's U.S. operations, at the time the 15th-largest U.S. bank, and added 7 million customers and $80 billion in deposits. With national reach making it the largest online-only banking platform, this deal provided Capital One with significantly lower-cost funding than competitors using other funding methods, including securitizations, to fund its lending operations. We also think this acquisition will help reduce Capital One's need for high-cost branches in order to attract additional low-cost funding.

Capital One has always had a strong market presence near its headquarters in McLean, Va., outside Washington, D.C. Before making major acquisitions in 2006, Capital One had the fifth-largest deposit base in the D.C. metro area. Currently, it is the second-largest deposit taker in the metro area.

Cheap Deposits Will Fund Growth in Commercial and Auto Loans
With the domestic auto industry recovering and on track to produce more than 15 million vehicles in 2013, we are optimistic that this will have a positive impact on the automotive lending business. We expect CapOne to benefit disproportionately, as its deposits cost the bank just 62 basis points on average (compared with 132 basis points for the largest U.S. auto lender, Ally Financial). This is a valuable competitive advantage that will be difficult for other competitors to replicate. CapOne has already proved its strength in this business--it is the third-largest automotive lender in the U.S. and has shown impressive growth over the past two years. We're pleased that this growth has come with low credit costs and that nonperforming auto loans have averaged only 0.49% of total auto loans over the past five quarters.

CapOne has also benefited from strong growth in commercial lending and will continue to do so, in our opinion. Its strength in this business is rooted in its acquisitions of North Fork and Hibernia, in which Capital One also acquired the commercial lending operations. Total commercial and commercial real estate lending now makes up 20.4% of total loans, and the bank has demonstrated strong growth over the past two years. Furthermore, total nonperforming commercial loans represent only 1.02% of total commercial loans, which demonstrates that Capital One's solid underwriting standards have not slipped in the face of double-digit growth.

Capital One's growth in the automotive and commercial segments will be partially offset by management's decision to allow the portfolio of home mortgages, especially those acquired in the ING Direct acquisition, to run off. Given that mortgages are generally lower-yield, we think this is a good move for Capital One and will help it to manage the pressure on its net interest margin.

Capital One Performs Like a Quality Regional Bank, but Isn't Valued Like One
We think that the market overweights Capital One's history and incorrectly views the company as a credit card bank. We believe this has created an opportunity for value-conscious investors, as Capital One is now more similar to a high-quality regional bank than the credit card bank it once was. To demonstrate, we have compared Capital One with two excellent regional banks, U.S. Bancorp and PNC Financial Services Group.

Capital One has consistently lower nonperforming loans/total loans compared with U.S. Bancorp and PNC over the past three years. In addition, loan quality has consistently improved over the past three years at Capital One.

Capital One continues to have a stronger net interest margin than peers. Obviously, part of the reason for the much higher margin is Capital One's larger credit card portfolio with its double-digit yields. However, the asset mix has changed significantly since 2011, beginning with the acquisition of ING Direct and its mortgage portfolio in the first quarter of 2012. This was followed by the second-quarter 2012 acquisition of HSBC's nearly $30 billion credit card portfolio, which made Capital One among the top five credit card issuers in the world. While Capital One sold $7 billion or 23% of Best Buy card receivables from that portfolio to Citigroup, it retained the higher-end transactional cards that did not have high rolling balances, such as Neiman Marcus or Saks Fifth Avenue. All the while, Capital One has been focused on expanding its automotive and commercial lending segments. Despite these significant changes and events, net interest margin remains very strong compared with peers.

Net Interest Margin Still Quite Strong Compared With Other Regionals

Source: Thomson Reuters/BankInsight, Morningstar

We also prefer to invest in banks with lower cost operations than peers, and we find that CapOne operates almost as efficiently as best-of-breed peer U.S. Bancorp. One meaningful measure of cost controls and profitability is a bank's efficiency ratio. Generally, the efficiency ratio is the ratio of costs needed to generate $1 of revenue (an efficiency ratio of 60% means the company spent $0.60 to generate $1 of revenue). In general, a lower efficiency ratio signifies a company with a lower cost structure, which is often a competitive advantage in terms of pricing and can help banks to earn outsize returns compared with less-efficient peers. Capital One has demonstrated efficiency comparable to similar-size regional banks.

Efficiency Ratio Is Comparable With Similar-Size Peer Banks

Source: Thomson Reuters/BankInsight, Morningstar

The acquisition of ING Direct in 2012 was very attractive for Capital One for a couple of reasons. ING Direct was the largest online bank in the U.S. at the time. But when it was combined with Capital One's legacy national direct bank, the third-largest in directly originated deposits in the U.S. at the time, Capital One became the leading digital bank in the U.S., providing it with a number of advantages. The bank acquired millions of early-adopter digital customers (usually younger, urban, and upwardly mobile customers) without the expense of physical branches.

Given its better overall asset quality, stronger margins, and low costs, we think Capital One has the characteristics of a strong regional bank rather than a credit card company. However, the market does not appear to value it the same as a regional bank; Capital One still trades at a discount to similar high-quality regional banks.