Capital One Stock: Will Subprime Borrowers Spoil the Rally?

 | Jan 30, 2023 01:32AM ET

  • Net credit card charge-offs and delinquencies continue to rise as consumers suffer from rising interest rates and a weakening economy.
  • Capital One has the most exposure to subprime borrowers and the demographics most affected by a worsening economic climate.
  • Rising interest rates may improve margins but increase the risk of consumers being unable to repay loans.
  • Capital One shares trade at 8X forward earnings with a 2.04% annual dividend yield.
  • Financial services holding company Capital One Financial (NYSE:COF) stock has been hit due to its exposure to subprime borrowers. As the economy contracts amidst rising interest rates, middle to lower-income consumers tends to feel the brunt of the financial stress. This is Capital One's wheelhouse demographic.

    While credit card debt continues to rise, the Company believes this is part of the normalization since the pandemic, along with other consumer banks and credit card companies like Bank of America (NYSE:BAC), Citigroup (NYSE:C), and Wells Fargo & Company (NYSE:WFC).

    Capital One is also bracing for the potential for higher delinquencies in the face of a recession. Its loan loss provisions ballooned quickly in its Q4 2022 earnings report. Its competitor Discover Financial Services (NYSE:DFS), warned in its Q4 2022 conference call that the full-year 2023 net charge-off rate could rise from 3.5% to 3.9%, nearly double the 1.8% charge-off rate in 2022.

    h2 December Credit Card Metrics/h2

    Its recent December credit card delinquency and net charge-off rates were still below pre-pandemic levels but have risen due to normalization. The credit card delinquency rate rose to 3.43%, up from 2.22% in December 2021 but still below 3.93% in December 2019.

    The net charge-off rate rose to 3.57%, up from 1.76% in December 2021 but well below 4.55% in December 2019. Credit card loans rose to $131.6 billion at the end of December, up from $127.7 billion at the end of November 2022.

    h2 Earnings Miss/h2

    On Jan. 24, 2023, Capital One released its fiscal fourth-quarter 2022 results for the quarter ending December 2022. The Company reported earnings-per-share (EPS) of $2.82, missing consensus analyst estimates of $3.86, by ($1.04). Net income was $1.2 billion versus $1.7 billion in the prior year's quarter.

    Total revenues grew 11.4% year-over-year (YoY) to $9.04 billion, falling short of consensus analyst estimates of $9.07 billion. Capital One Founder and CEO Richard Fairbank commented, "We posted strong top-line growth throughout 2022. As a result of our investments to transform our technology and to drive resilient growth, we're in a strong position to deliver compelling long-term shareholder value and thrive in a broad range of possible economic scenarios."

    h2 Credit Card Business /h2
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    The credit card segment had strong YoY growth in every top-line metric in its domestic credit card business. Purchase volumes were up 9% YoY. Ending loan balances rose $22.9 billion, up 21%. Ending loans rose 8% sequentially, and revenues rose 19% YoY, mainly driven by solid revenue margin for purchase volumes. Charge-offs and delinquency rates were below pre-pandemic levels and continued to normalize.

    h2 Ballooning Loan Loss Provisions/h2

    Capital One's provision for credit losses rose to $2.42 billion, up from $1.67 billion from the prior quarter and $381 million in Q4 2021. The rapid interest rate hikes in 2022 set the stage for impacting new credit card demand and the risk of defaults.

    While the Fed is expected to pause its rate hikes at some point in 2023, there is a broad consensus that they will first push the federal funds rate to over 5%. It can set a perfect storm of high inflation, slowing economic growth, high-interest rate, and growing unemployment, all impacting disposable income and further impairing consumers' ability to repay credit card debt.

    The market will eventually decide if investors are too paranoid or not paranoid enough over potential loan losses in 2023. The MarketBeat MarketRank™ Forecast gives Capital One Financial 3 out of 5 stars with a 4.1% upside price target as insiders sold $2.76 million of stock in the last quarter.