Capital One: Still Charging, Still Cheap

Capital One Financial (NYSE:COF) is among the cheapest big bank stocks out there, and the second half of 2012 looks to be relatively clean following a rocky second quarter.

Back in December, I made Capital One my pick for InvestorPlace‘s Ten Best Stocks for 2012 contest, and the shares have returned 32% through Wednesday, which beats three of the “big four” U.S. banks — the exception being Bank of America (NYSE:BAC) which has returned 46% year-to-date. Rounding out the big four, Wells Fargo (NYSE:WFC) has gained 24% YTD, Citigroup (NYSE:C) is up 15% and JPMorgan Chase (NYSE:JPM) has returned 13%.

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Of course, Bank of America’s strong year-to-date performance follows a 58% decline — and Citigroup’s follows a 44% drop — during 2011, when Capital One had a flat return that compared rather well with a 25% decline for the KBW Bank Index. The index was up 21% through Tuesday’s close, with all but two of the 24 index components showing year-to-date gains.

JPMorgan has bounced back from a 20% decline — although the shares are down 7% since May 10, when the company’s “London Whale” scandal came to light. While second-quarter trading losses ended up totaling $4.4 billion, JPMorgan reported earnings of $5 billion, and the company now expects to restart its share repurchase program in 2013.

Wells Fargo fared relatively well during 2011, with shares declining 10%, and is among the best earnings performers among large U.S. banks, with returns on average assets ranging between 1.27% and 1.4% during the past four quarters, according to Thomson Reuters Bank Insight.

Looking at current valuations, Capital One still is one of the cheapest of the large banks, relative to earnings estimates. The shares trade for 8.2 times the consensus 2013 earnings estimate of $6.92, among analysts polled by Thomson Reuters. Among the 24 components of the KBW Bank Index, only two stocks have lower forward price-to-earnings ratios: Citigroup trades for 6.8 times 2013 EPS estimates of $4.54, while JPMorgan Chase trades for 7.3 times 2013 estimates for $5.23. BAC is more expensive, trading at 8.9 times 2013 EPS estimate of 92 cents.

Capital One had a messy second quarter, as the company completed its purchase of HSBC‘s (NYSE:HBC) $27.6 billion credit portfolio and reported “an expense of $174 million to establish a finance charge and fee reserve for estimated uncollectible billed finance charges and fees and loan premium amortization expense of $63 million.”

The company also was hit with $60 million in civil penalties related to credit card settlements with the Consumer Financial Protection Bureau and the Office of the Comptroller of the Currency, along with $150 million in refunds to the company’s credit card customers. The two regulators had accused Capital One of failing to properly monitor third-party vendors selling add-on credit protection and credit monitoring services to credit card customers.

Capital One’s second-quarter provision for credit losses was $1.7 billion, which included the establishment of a $1.2 billion allowance for loan losses on the acquired HSBC loans. The provision for credit losses increased from $343 million in the first quarter, and a provision for loan and lease losses of $343 million in the second quarter of 2011.

These items led to second-quarter earnings of $92 million (16 cents per share), compared to a profit of $1.4 billion ($2.72) during the first quarter, and $911 million ($1.97) during the second quarter of 2011. The first-quarter results included a bargain purchase gain of $594 million, related to the company’s purchase of ING Direct (USA) from ING Groep (NYSE:ING).

Moving forward, investors would love to see a couple of “clean quarters” from Capital One, and the consensus among analysts is for the company to show profits of $1.70 a share in the third quarter, and $1.65 in the fourth quarter.

Like other major credit card lenders, Capital One reports monthly credit quality statistics, and the addition of the HSBC card portfolio — along with the second-credit marks made when the portfolio was purchased — led to sharp improvement in the company’s card quality ratios, which are expected to reverse to some extent over coming quarters, as the special reserve for the acquired HSBC loans is used up.

During July, Capital One’s annualized rate of net charge-offs to average domestic card loans was 2.62%, declining from 3.41% in June, and 3.37% in July 2011. Early-stage delinquencies also declined, with loans past due 30 days or more making up 3.16% of the domestic card portfolio as of July 30, flat with the previous month, and better than the 3.37% a year earlier.

Capital One’s average domestic credit card loans held for investment totaled $80.6 billion, increasing from $53.3 billion the previous month, because of the HSBC portfolio purchase. Net charge-offs — loan losses less recoveries — in the domestic card portfolio during July were $175 million, increasing from $151 million in June, but declining from $198 million a year earlier, when average domestic card loans totaled $53.8 billion.

Capital One also reported improved credit quality in its $8.8 billion international credit card portfolio, with a net charge-off rate of 4.97% during July, improving from 5.16% in June, and 6.59% in July of last year. The 30+ days delinquency rate in the international credit card portfolio improved to 4.78% in July, from 4.84% the previous month, and 5.34% a year earlier.

Capital One’s shares have moved ahead nicely so far during a transformational 2012, following the drag in the second half of last year, as the regulatory approval process for the ING Direct and HSBC card portfolio acquisitions dragged on and on. The shares remain cheaply priced to forward earnings estimates, and with a strong capital base and hopefully a smooth second half to show the benefits from the two acquisitions, investors can look forward to a capital return through an increased dividend and/or share buybacks during 2013.

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