Trade of the Day: Capital One Financial (COF)

COF is beaten down, but it may not be out for the count yet

   

At first blush, Capital One Financial (NYSE:COF) isn’t a compelling buy, but value investors and short-term traders alike should take note of this stock despite disappointing Q4 earnings.

 Capital One a Dud?

On January 17, COF missed the consensus estimate from their Q4 earnings report and lowered their revenue guidance for FY 2013. Consequently, the stock has shed 18%. Financials in aggregate are up 8.5% YTD while COF, the sixth largest bank in the US, is down -12.3%.

Yet the recent selloff has also made COF one of the most undervalued names in the sector. With a book value per share (BVPS) of $68.10, the current price puts the stock at a mere 0.75x and only 7.5x the 2014 consensus estimate of $6.76, all while maintaining a return on equity of 10.64%. These cut-rate multiples are the kind of numbers that get value investors salivating. But the severe selling in the wake of the earnings report, going on five weeks now, is indicative of a fundamental shift in attitude towards the company.

So what is the long term outlook for COF?

Linked to an Improving Economy

If economic growth returns in earnest, COF could outpace other financial stocks given its current position in the back of the pack. Card delinquencies hit an 18-year low in Q3 of last year, indicating that consumers are cutting back on discretionary spending, cleaning up their credit records, and repairing personal balance sheets. While lower delinquencies mean fewer charge-offs and less bad debt for banks, it also means lower interest income from revolving credit. Yet COF has hinged its FY 2013 performance on a return to good old American “buy today, pay tomorrow” consumer leveraging.

Continued low rates will certainly help their cause. If credit costs begin to rise, however, COF could see tough sledding through the year. With 82% of its total loan portfolio in consumer loans (and 40% in domestic credit card receivables) and only 18% in commercial (nearly half in real estate), it is evident why so much centers on the strength of the American consumer.

Effects of Acquisitions

COF recently acquired ING Direct and HSBC’s US credit card portfolio. Additionally, COF announced that it is selling its portfolio of Best Buy (NYSE:BBY) retail credit cards to Citigroup (NYSE:C), worth approximately $7 billion. While COF management expects this sale to be earnings neutral, the acquisitions of ING Direct and HSBC cards should give COF more expense flexibility and growth potential once the acquisitions are completed. However, HSBC’s card portfolio contains higher charge-off rates since HSBC had less stringent credit terms than COF. So while the overall credit card portfolio will get a significant boost and see cost synergies, the increased overall charge off rate necessitated that COF set aside an additional $1.15 billion in provisions to cover loan losses – part of the reason for COF’s disappointing earnings announcement.

Increasing Total Payout Ratio for 2013

COF is not a high yielding stock: it currently has a dividend of only $0.20, or 0.4%. However, management reiterated in its earnings report that in spite of tempered revenue expectations for FY 2013 it still expected to raise its dividend “meaningfully.” Analysts are looking for an increase to $0.40 per share, double the current level. Additionally, analysts believe the company will begin to buy back shares towards the latter part of 2013 due to high capital accretion. This could bring COF’s total payout ratio to 16% for 2013 and 53% in 2014.

The Price Action

2 27 13 cof 300x159 Trade of the Day: Capital One Financial (COF)
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An increasing dividend totaling a 0.80% yield will most likely not be sufficient weight to balance rising provisions for loan losses, lower loan growth, high acquisition costs, or, most importantly, a fundamental shift in price action.

The chart at right shows the break in the 16-month uptrending channel that followed the January 17 earnings report. Following a meager attempt to retrace back to the trendline, the stock fell to break through the $55 support level. These two consecutive breaches of technical support indicate a reversal of COF’s long term trend – as well as a reversal of investor psychology towards the stock.

However, this reversal has occurred so quickly, taking out over $6 billion in market cap and turning a solid value stock into an outright bargain that the stock is primed for a sharp move back up.

2 27 13 cof 1yr 300x223 Trade of the Day: Capital One Financial (COF)
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In the one-year chart, the MACD and Stochastics have fallen near their current levels only twice and both times were followed by decisive rebounds. COF tends to see a lot of whipsaw action, often retracing moves abruptly to return to a mean trendline. Given these characteristics, it is likely that COF will rebound to the $55 resistance level.

Recommendation: Short-term, stock is overly beaten down. Look for a rebound to test resistance at previous support of $55.

Option Alternative: Expecting a short-term bounce we recommend the March $52.50 calls for $0.70 per share or less.

 

John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.


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