Capital One stock remains resilient despite increased amortization. Here’s why now may be a good time to buy.
Credit card debt has skyrocketed over the past few years, with lenders seeing an increase in net charge-offs and delinquencies. Capital One Financial (COF -1.44%), one of the largest consumer credit card issuers in the United States, has seen declines in consumer credit quality. Despite this, the stock price has risen 67% over the past year.
Capital One stock is trading at a slight premium to its historical value, and its merger with Discover Financial Services (DFS -1.40%) remains up in the air. If you’re thinking of buying Capital One stock right now, consider the following:
Consumer credit indicators will worsen from 2021 onwards
Consumer credit card debt has reached an all-time high of $1.14 trillion, and credit card interest rates are near all-time highs. Rising debt and interest payments are a burden on consumers, and those at the lower end of the credit rating spectrum, who make up a significant portion of Capital One’s customer base, could be more vulnerable to economic downturns. There is sex.
At the end of the quarter, about one-third of Capital One’s credit card loans and 47% of its auto loans were issued to customers with FICO scores below 660, considered below prime.
Credit card net charge-offs (NCOs) are increasing across the banking industry. Card NCOs rose from 1.57% in the fourth quarter of 2021 to 4.73% in the second quarter of this year, marking the highest charge-off rate since 2011, according to data from the Federal Reserve Bank of St. Louis. Capital One’s NCO on credit cards increased from 1.42% to 5.6%.
Big bank executives aren’t expressing much concern about consumers. In fact, many believe consumer resilience is the reason the U.S. economy has not yet fallen into recession.
“The U.S. consumer continues to be a source of relative strength across the economy,” Capital One CEO Richard Fairbank told analysts on the company’s third-quarter earnings call. he said. But he also cautioned that “some pressures will remain until we get completely out of this cycle of essentially inflation and rising interest rates.”
Soft landing could gain momentum
In the third quarter, Capital One wrote down $2.6 billion across its portfolio, resulting in an NCO rate of 3.27%. The 30-day delinquency rate, a leading indicator of consumer credit health, was 3.89%.
To address this risk, Capital One maintains a reserve for credit losses to estimate the amount of debt that is unlikely to be collected. The company currently has credit loss reserves totaling $16.6 billion, with a coverage ratio of 5.16%.
Consider Loan/Lease Loss (Quarterly) data from COF YCharts.
This provision exceeds the current NCO rate and should cover the loss. However, if net charge-offs and delinquencies increase significantly in the future, Capital One may be required to increase this reserve.
Conversely, if the Federal Reserve is able to achieve a soft landing (controlling inflation without sending the economy into recession), consumer credit metrics could improve. In such a scenario, Capital One and other banks could see improved credit metrics and be able to release some of these reserves, which could flow back and increase net income.
Merger with Discover Financial Services is up in the air
Investors will also want to keep an eye on the proposed merger between Capital One and Discover Financial Services. New York Attorney General Letitia James is conducting an investigation this month to determine whether Capital One’s planned acquisition of Discover Financial Services violates the state’s antitrust laws.
Capital One said in a statement that it will address Mr. James through appropriate legal channels and believes it is “well-positioned” to obtain merger approval from federal banking regulators.
However, risks remain with mergers, and investors need to decide whether to wait to invest because of these risks or whether the potential upside from a merger is worth it. The bank expects a decision on the merger to be taken early next year.
Is it a buy?
Investors should monitor Capital One’s credit card NCO rates. The credit profile of the company’s customer base could make it more vulnerable than peer banks in the event of an economic downturn.
COF Price vs. Book Value data by YCharts.
Capital One stock currently trades slightly above its 10-year average, as measured by its price-to-book ratio (P/B). But if the proposed merger with Discover were approved, Capital One would be able to trade through its own network, expand profit margins and increase stock valuations. Although uncertainty remains regarding the merger, I believe it will close early next year, making the stock a good buy for long-term investors today.
Discover Financial Services is an advertising partner of The Motley Fool’s Ascent. Courtney Carlsen has no position in any stocks mentioned. The Motley Fool recommends Discover Financial Services. The Motley Fool has a disclosure policy.
