Time for Margin Expansion at Capital One

We believe that Capital One’s rising charge-offs should not be viewed as indications of danger or the next lending debacle. Rather, the charge-offs should be considered necessary investments in building a high-quality, seasoned book of profitable credit card holders. Unlike other consumer loans, charge-offs on credit card holders typically happen early in the relationship. In addition, it is unlikely that any bank will be able to match the credit quality on credit card originations from before 2014, because credit lending standards were much higher after the financial crisis. In fact, it would be more surprising to us if credit card losses hadn’t risen over the past few years. When looking for value creation in credit card issuers, we believe investors need to spend less time looking at the quarter-to-quarter income statements, which are noisy, and more time studying the balance sheet, as the assets being created are long-lived and will generate returns many quarters into the future.

On top of this, the market has seen aggressive lending in auto finance. Though industrywide total growth in auto lending isn’t unprecedented, auto lenders have increasingly been willing to lend for longer periods, resulting in higher risk. Since 2013, Capital One’s auto loan portfolio (21% of total loans) has grown at nearly a 15% average annual rate. While this elevated growth rate gives us concern, management has said that it has avoided longer-duration auto loans, and we have found no evidence that Capital One has lowered underwriting standards. In addition, Capital One has shown a willingness to be tactically conservative when others have extended loan terms and been aggressive when others have pulled back from the market.

Higher Losses From Growth in Private Label, Market Share Since 2014, Capital One has expanded credit card receivables at a compound annual growth rate of 9.6%. To put this in perspective, total U.S. revolving credit has grown at a 7.1% CAGR the past three years. Capital One's growth is elevated, and anytime we see higher growth rates, it gives us some concern and requires investigation.

We believe this growth has come from its expanding private-label business and market share gains in rewards cards, not changes in underwriting. Specifically, we observe that American Express AXP has some of the weakest credit card growth. This is partly due to losses on the partnership side, but some of this is attributable to share stolen by JPMorgan JPM and Capital One. Capital One has been able to modestly gain share through its steady approach to investing in marketing to develop its brand, technology spending, where we consider it a leader among banks, and opportunistic underwriting. In contrast, JPMorgan has offered aggressive bonuses (including 100,000 rewards points and a $300 travel credit) as it rolled out its Sapphire Reserve premium card. American Express members are some of the highest-quality credits, in contrast to the subprime customers Capital One has historically targeted.

FICO scores on Capital One’s total domestic portfolio have dipped over the past four years. In 2013, 69% of the company’s portfolio had a FICO score greater than 660, but the percentage fell to 63% in 2016. Today, it stands at 66%. This decline almost perfectly corresponds with Capital One’s opportunistic growth in private label. Store-brand credit cards have higher losses but substantially higher interest rates. We speculate that private label is driving much of the recent rise in charge-offs as Capital One’s charge-off behavior more closely resembles rival private-label issuers Synchrony SYF and Alliance Data Systems ADS than the card portfolios of banks more focused on rewards-based credit cards.

Capital One and its peers have experienced higher charge-offs to accompany this growth. Bears will point to Capital One’s 2016 and 2017 charge-offs and claim that underwriting has become lax and higher credit losses will eat all of the company’s credit card loan growth. However, management says Capital One’s increasing charge-offs are the result of the tendency for new card holders to have higher credit losses. The company’s charge-offs have become increasingly correlated with the other major private-label issuers, Synchrony and Alliance Data Systems, suggesting to us that Capital One has derived much of its recent growth from private-label credit cards.

Accepting Near-Term Losses for Long-Term Share Gains The first time we heard CEO Richard Fairbank use the phrase "growth math," we thought it was a euphemism invented by a management team who wanted to put a positive spin on weaker performance. Basically, growth math is the upward pressure on credit losses attributable to portfolio growth derived from new card holders. Capital One claims that its rising charge-offs aren't the result of aggressive underwriting, but just simply healthy growth. Unlike other consumer loans, credit card charge-offs peak within the first 48 months of origination and materially decline thereafter. Therefore, a credit card portfolio weighted toward newer originations should have higher charge-off rates than a credit card portfolio that isn't growing. In addition, winning new credit card holders from rivals without lowering standards is some of the healthiest growth a consumer lender can realize. This is a much better sign than growth derived from card holders increasing their monthly balances, signaling a decline in the health of the consumer, which we have not seen so far.

For 2017, Capital One charged off 4.99% of its domestic credit card loans, an increase of 83 basis points from the previous year. This made some investors nervous, but we believe it gives patient investors an opportunity. Capital One has implored analysts to look at its trust securitizations. Capital One no longer securitizes the receivables of new credit card holders, but it does have securitized receivables for cards issued before 2014. The idea is that the charge-off rate on these older securitizations should be a good proxy for charge-offs on Capital One’s seasoned credit card portfolio. In 2017, the charge-off rate on its mature securitized portfolio was 2.22%. In comparison, the 2017 charge-off rate on Capital One’s entire domestic credit card receivables was 4.99%, 277 basis points higher than the mature portfolio. We remind investors that Capital One’s securitized portfolio has minimal exposure to private-label credit cards. We believe Capital One’s charge-offs will still decline substantially but will never match the performance of Capital One’s legacy portfolio. Nevertheless, this would still support management’s argument that the recent rise in charge-offs is not caused by lower credit quality but simply healthy growth.

However, just because charge-offs on newer credit cards are materially higher, that doesn’t necessarily mean losses on newer vintages will decline over time, especially if underwriting standards have slipped. We cannot use Capital One’s trust documents to verify newer vintages because the company no longer securitizes new credit card loans and doesn’t provide disclosure on individual vintages. However, we pulled the trust documents for issuers that continue to securitize receivables: American Express and Alliance Data Systems.

The trust documents of American Express, which mostly issues higher-quality rewards cards, displays the best indication of growth math. Charge-offs most often peak in the first 36 months and decline thereafter. This is because credit card issuers have less information on new card holders and have the most difficulty assessing risk. As time goes on, issuers gather more data and can adjust interest rates and weed out less profitable card holders. The charge-off behavior on some vintages is greatly accentuated by economic disturbances, but for the most part, charge-offs decline over time, leaving American Express with a high-quality book of loans. It would appear that it takes only two to three years to season a general-purpose credit card portfolio, suggesting that Capital One is close to realizing substantially lower credit losses since growth has modestly decelerated.

When we look at the charge-off behavior of Alliance Data Systems and other private-label providers, we get a more muddled picture. Generally, a private-label credit card is not a card holder’s primary credit card, and these cards have higher charge-offs. Often, people just forget about these cards. With private-label cards, late fees are a significant contributor to portfolio yields. When we look at Alliance Data Systems’ charge-off rates by vintage, with a few exceptions charge-offs increase and stay high throughout the first four years of a private-label vintage. Nevertheless, we do know that on vintages older than four years, charge-off rates are substantially lower. In 2017, Alliance Data’s total charge-off rate on its securitized master trust was 7.66%, and the charge-off rate on originations before 2013 was 5.38%. This suggests to us that it takes somewhere between four and six years for losses to moderate.

Credit Losses to Drop in 2018, but Long Term Comparable With 2017 We think Capital One's credit card charge-offs will continue dropping throughout 2018. However, because the portfolio is now more weighted toward private-label cards, which have higher credit losses, we anticipate that charge-offs will be higher than in previous cycles. We estimate that Capital One's private-label business accounts for approximately 20% of total credit card receivables. Before Capital One's acquisition of HSBC's card business, Kohl's was the only significant retail relationship the company had. Historically, Capital One has seen a normalized midcycle charge-off rate of around 4.5%. With its expansion in private label, we think normalized charge-offs should be 4.75%-5%, comparable to or modestly below 2017's credit losses.

In 2012, Capital One acquired HSBC’s domestic credit card business, which was heavily weighted toward private-label credit cards. We don’t believe investors appreciate how much of Capital One’s growth in credit cards over the past five years resulted from private-label and co-branded cards. Given that the initial outsize growth in private-label cards started six years ago and that it takes around four to six years for private-label credit losses to season, it makes sense to us that growth math is beginning to subside in 2018. As this happens, Capital One’s charge-offs should fall, which is what we saw in the first quarter. However, investors should not expect credit card losses to return to levels seen before 2015.

Declining Increases in Delinquencies Give Reasons for Confidence To achieve significant earnings growth and operating leverage, Capital One does not need charge-offs to decline substantially. Rather, credit losses just need to stabilize, which we think is happening. Once charge-offs stabilize, Capital One won't need to build additional reserves. Delinquencies are the best forward indicator of reserve builds and future charge-offs. For Capital One, the year-over-year change in delinquencies has trended downward significantly over the past year. We think the initial surge in delinquencies throughout 2016 is partly attributable to the changing loan mix, as Capital One's performance has become increasingly influenced by private-label cards.

In reference to its delayed growth in earnings as credit cards have grown, Fairbank has described Capital One as a “coiled spring” of earnings potential. We believe 2018 is the year energy is released from Capital One’s tightly wound coil and the company sees substantial earnings growth. We now forecast that Capital One will increase pretax earnings by almost 15%. That said, our 2018 estimate still assumes that total provisions remain in line with 2017, despite a sequential and year-over-year decline in credit provisions of 13% and 16%, respectively, during the first quarter. Capital One’s allowances for domestic credit cards are 3.2 times total credit cards delinquent 90 or more days. Capital One’s delinquency rate is a seasonal number, and it’s the highest reserve/delinquencies ratio for the first quarter since at least 2010. This suggests to us that provisions will continue to be low and reserves may even be released, which would make our 2019 earnings estimate of $10.28 per share conservative.

Auto Loans Not a Crisis but Suggest Lower Margins Though we are increasingly confident that credit cards will provide a significant tailwind for Capital One in 2018, we are more cautious on auto lending. Over the past five years, Capital One has increased auto loans at a compound annual growth rate of nearly 15%. In comparison, total U.S. motor vehicle loans have grown at an annual rate of 6.6%. This is in contrast to personal income, which has grown only 3% on average. Auto loan growth across the industry is concerning to us. We believe the industry's elevated growth indicates that auto credit supply is high and margins on auto loans will be lower in the future. Though some investors link auto loans to the next catastrophe, we've really only seen one financial institution that's been increasingly willing to extend credit to consumers with lower credit scores for extended periods. Within subprime auto lending, terms and spreads have been decreasing, but we believe lending standards are still better than they were before the 2008-09 financial crisis. The outlier is GM Financial. Though General Motors' GM captive finance company continues to grow at an impressive clip, much of the abnormal growth is related to its acquisition of AmeriCredit and creating an exclusive captive finance arm for its dealers.

Recently, we have seen mixed signals from auto lenders. In general, when reviewing the securitizations of the largest auto lenders and the captive finance companies of the largest manufacturers, we have seen steady annual percentage rates, FICO scores that don’t raise any alarms, and stable loan/value ratios. Other than elevated growth across the entire auto finance industry, there aren’t any significant red flags except for one metric: loan duration. We do know that auto lenders have been willing to make loans for longer periods. This is the primary term that lenders have been willing to loosen for prime borrowers.

When it comes to loan quality and loss modeling, Capital One management has said it assumes lower prices for used cars in the future. That said, the company no longer securitizes auto loans. Thus, we cannot independently verify that Capital One’s auto loan terms have changed or to what extent. Close competitor Ally Financial ALLY is the clearest example we have of increasing loan durations and possibly the best comparison. In 2014, 2% of Ally’s total retail loan originations were more than 76 months. In 2017, that number jumped to 14%. Though Ally is a reasonable comparison, there’s no indication that Capital One has increased the number of months it’s willing to lend on an auto loan. Management has said it has avoided increasing the length of loans.

There's Always Somebody Willing to Push the Envelope Throughout 2017, Capital One mentioned aggressive underwriting that was driven by one player in particular. This one player was almost certainly Santander Consumer SC, a company we don't cover but have been monitoring as a competitive peer for auto loans. Because we do not take anything any management team says as fact, we have sought to find other companies that have been underwriting auto loans without requiring documentation and determine whether the practice has been curtailed. Thus far, we can only find one. In Santander Consumer's 2015 10-K filing, we came across this language, which we found interesting:

“In early 2015, we increased our origination volume of loans to borrowers with limited credit experience, such as those with less than 36 months of credit history or less than four trade lines. For these borrowers, many of whom do not have a FICO score, other factors such as the LexisNexis risk view score, loan-to-value ratio, and payment-to-income ratio are utilized to assign an internal credit score.”

It definitely appears that Santander Consumer let credit quality slip, and it had a ripple effect on the entire auto loan industry. However, this aggressive push by one player was met with a quick rebuke and rationalization as Santander Consumer’s auto charge-offs increased rapidly. We continue to worry about lending standards today and the quality of existing loans throughout the industry, however. Some lenders either greatly decelerated originations or tightened terms within the past year. Capital One has responded to this pullback by its competitors by increasing originations. While this may be attributable to holding lending terms steady, we’d like to highlight how good Capital One has been at spotting competitors pulling away from the market and opportunistically capitalizing on growth opportunities. During periods when Santander Consumer was accelerating loan growth, Capital One was walking away. Conversely, when Santander Consumer backed away from auto lending in 2016 and 2017, Capital One filled the void. We believe this demonstrates the value of Capital One’s investment in technology and its data-oriented approach to consumer lending.

Prime Segments of Market Appear to Be Getting Competitive Based mostly on comments in earnings calls and Ally's loan origination numbers, it would appear that prime lending is one of the more crowded areas of auto lending. While this is a negative for Capital One, it does appear there has been rationalization by some borrowers in prime auto lending, specifically shorter lending terms.

Given Capital One’s routine lending discipline, we don’t believe increasing competition in prime auto lending represents a huge risk for the company. The only risk we see arising from auto lending is that Capital One will slow originations and margins will moderate. This is something we have seen in recent periods, as year-over-year auto originations have fallen 4.5%-5% the past two quarters. We believe this speaks to the Capital One’s culture and supports of our Exemplary stewardship rating.

In 2017, the Manheim Used Vehicle Value Index surged to record levels, in part because hurricane damage caused a reduction in auto fleets. We suspect this has aided Capital One’s recoveries in auto and probably artificially boosted the company’s performance. We cannot imagine that auto lenders will benefit from this tailwind forever, and we don’t anticipate charge-offs in auto will remain this benign.

Last quarter, Capital One’s recoveries were 49.3% of gross charge-offs, the highest since 2011. We think this partly masks some of the competitive issues happening in auto lending. Gross charge-off rates are approaching 2011 levels, which were still elevated from the 2008-09 crisis. We do believe Capital One is writing good loans, but given the significant growth throughout the industry, we have to assume lower margins on auto lending going forward.

During Capital One’s first-quarter earnings call, Fairbank suggested that auto charge-offs will rise gradually. While we agree that this is the case, we believe credit loss provisions will be more volatile and reserve builds in auto allowances are in Capital One’s future. We think it’s extremely difficult to make quarterly loss projections in the current environment because used-auto prices have been so strong, partly because of hurricanes. Damage from Irma and Harvey probably destroyed a few months’ worth of auto inventory, giving a significant, albeit temporary, boost to used-car prices and helping to explain the Manheim index’s recent performance.

At the end of the first quarter, Capital One’s auto allowances were 4.1 times nonperforming auto loans. Going back to at least 2010, this is the lowest first-quarter allowance to nonperforming loans coverage rate. The last few quarters have produced similar coverage rates, and we have to assume this is because recoveries on defaulted auto loans have been so high. We think higher reserve builds in auto are in Capital One’s future as used-car prices weaken.

Previously, we projected that auto loans would grow at a rate of about 4% annually over the next five years and charge-offs would peak at 2.25% and decline to 1.75%. In light of our expectation for sustained rational competition in prime, we’ve trimmed our forecast for loan growth to 2.5%-3% from 4%. In addition, we now expect auto charge-offs will be 2%-3% for the next five years. Though we worry about used-car prices, we do not see this turning into a debacle. It appears to us that when terms in auto got aggressive, they quickly corrected, especially at noncaptive auto lenders.

Lower Losses Ahead, but Overall Growth May Be Next Issue Overall, we think Capital One and some of its peers are cheap because ever since 2008, investors have been relentlessly focused on predicting the next banking crisis. Banks, possibly driven by regulators and overly anxious investors, have been the opposite of complacent. Generally speaking, the key drivers of the last crisis should not cause the next crisis. Given the extent of the scrutiny endured by banks, it is doubtful that credit cards or auto loans will result in disaster for Capital One.

As growth moderates, we are more worried about what drives receivables growth for Capital One, rather than where credit losses are going, and we believe shareholders will benefit from capital returns. Beyond 2019, we think Capital One’s growth in credit cards will mostly resemble the growth of the economy. Currently, we anticipate only a small benefit from higher interest rates. For now, we believe Capital One’s stock is inexpensive and shareholders should benefit from significant share repurchases in the years to come. Capital One just sold off its mortgage operations, which will provide significant ammo to return capital while remaining in the good graces of regulators.

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