Credit quality remains a big swing factor for capital

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Credit quality remains a big swing factor for Capital One, as the level of charge-offs and loss provisions can substantially impact quarterly results. Loss reserve building in recent periods has reflected the seasoning of new loans and what management calls “growth math,” — the upward pressure on delinquencies and charge-offs as new loan balances season and become a larger portion of the overall portfolio. The company sees only a modest impact from growth math on loss rates in 2018, with delinquencies more subject to broad industry trends. In 2018, we look for a gradual rise from the 2017 net charge-off rate of 2.59% as the credit- quality cycle matures, with a slightly higher average rate of 2.75%. The company continues to spend aggressively on marketing and digital programs, although we expect revenue growth to run at a faster pace, allowing for some improvement in the efficiency ratio. On the 4Q earnings call in January, management guided toward a 19% effective tax rate in 2018 (down from 29% in 2017), following the passage of the Tax Cuts and Jobs Act; however, on the 1Q call, it revised this forecast to 20%. We are raising our 2018 EPS estimate to $10.04 from $9.63 based on our expectations for stronger credit quality than we previously projected, partly offset by slower growth in lending volumes and the slightly higher tax rate forecast. We are also trimming our 2019 EPS forecast to $10.64 from $10.70. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating for Capital One is High. Capital One estimated a common equity Tier 1 capital ratio under the Basel III standardized approach of 10.5% at March 31, 2018. In June 2017, Capital One announced that it received a conditional nonobjection from the Federal Reserve for its 2017 Comprehensive Capital Analysis and Review plan (CCAR), which includes the repurchase of up to $1.85 billion of stock from 3Q17 through 2Q18. The plan does not include an increase in the quarterly dividend, currently at $0.40 per share. On the 1Q18 earnings call, the company said it would halt repurchases for the balance of the approved period to build capital ahead of the next CCAR process. We estimate dividends of $1.70 in 2018 and $1.86 in 2019, implying a payout ratio of about 17% for both years. The current yield is about 1.7%. RISKS As a domestic bank with nearly 80% of its earnings derived from lending, Capital One’s results are levered to general U.S. economic conditions, primarily related to employment, consumer spending, and debt leverage. The actions of the Consumer Financial Protection Bureau (CFPB) also bear watching, as Capital One’s presence in subprime consumer lending could come under increased scrutiny. COMPANY DESCRIPTION Ranked by assets and deposits, Capital One is one of the largest banks in the U.S., with top-tier national businesses in credit card and auto lending and a retail and commercial banking presence in the New York, Metro D.C., and the Louisiana/Texas markets. Capital One’s mix of loans is about 43% card loans, 30% consumer loans, and 27% commercial loans.
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