Capital One Stock: 30%+ Growth Potential Next Year (NYSE:COF)

introduction

In May 2023, it received a Buy rating on Capital One (New York Stock Exchange: COF). At the time, my argument was based on manageable delinquency rates, strong deposit inflows, and attractive valuations. Today, the company’s share price has risen by about 56%, I think Capital One offers an attractive entry point for investors. The pace at which delinquency rates are increasing shows signs of slowing, indicating an improving collection environment in the coming quarters. This potentially creates 30%+ net income and potential valuation appreciation. Finally, given the upside factors, I believe Capital One’s valuation remains attractive at current levels. Therefore, I still think Capital One is a buy.

The growth of the delinquency rate is slowing

During the pandemic and the few quarters immediately following this period, consumer loan delinquencies were extremely low due to the sheer volume Government stimulus and a strong labor market following loose monetary and fiscal policy. However, as direct stimulus in the economy slowed in times when inflation became rampant, consumer loan delinquencies began to show strong increases, prompting companies like Capital One to take on higher discounting costs and provisions for credit losses. Fortunately, in the past few quarters, there have been early signs of consumer loan delinquency growth slowing, creating macroeconomic tailwinds for Capital One.

(source)

The chart above shows that total consumer loan delinquencies increased sharply from lows during the pandemic before beginning to level off in recent months. Looking at the chart, the compromise may not be obvious, but the fundamental data tells a different story. Consumer loan delinquency rates have slowed sharply on a quarterly basis since peaking in late 2022 and early 2023. The chart below shows a quarter-over-quarter change in the growth of the consumer loan delinquency rate, and clearly depicts the trend in which increases in loan delinquency are slowing Consumerism.

(Chart created by author using source)

Therefore, I believe the current macroeconomic trend of decelerating delinquency rate growth will create a tremendous tailwind for Capital One in the next few quarters as slow increases turn into no increases or even declines in the overall delinquency rate.

Strengthen the trend

Data on loan delinquencies over the past few quarters suggest that the general trend toward lower growth has already begun without any clear signs of the trend ending, but how realistic is it to say that the current trend will continue for the foreseeable future?

I believe consumer loan delinquency rates will continue their constructive trend toward eventual decline in consumer loan delinquency rates as inflation slows and consumer debt service as a percentage of disposable income remains good or in line with pre-pandemic time periods.

First, the chart below shows household debt payments as a percentage of disposable income, clearly showing that households are not burdened by debt. The level of debt payments is similar to pre-pandemic levels, which in my opinion means that the current increase in loan delinquencies is simply a normalizing trend that will eventually stabilize near pre-pandemic delinquency rate levels.

(source)

Moreover, as the chart below shows, the Consumer Price Index that depicts inflation has slowed from its peak. While it is true that the Fed is struggling to bring inflation closer to its 2% target range, inflation has successfully stabilized near 3% levels as the Fed continues its efforts to suppress it and will likely rescue consumers from a recession. Additional financial burdens.

(Chart created by author using YCharts)

Finally, Capital One shares the view that the current increase in consumer loan delinquencies is temporary. During the first quarter 2024 earnings call, the company’s management team said that “the pace of year-over-year increases in both the discount rate and the delinquency rate has declined steadily for several quarters and continued to contract in the first quarter.”

So, given these catalysts that support consumers’ financial health, I think it’s reasonable to discuss two things. First, the improving trend of consumer loan delinquency rates will continue for the foreseeable future. Second, after this period of normalization, consumer delinquency rates will likely return to pre-pandemic levels.

How will this be useful?

Capital One will certainly benefit from lower consumer loan delinquency growth, but to what extent will the company see its profits increase?

Based on the above arguments, assuming that consumer loan delinquency rates trend toward the pre-pandemic level of about 2.47% in the first quarter of 2020, Capital One could see a notable expansion of its bottom line.

First, Capital One will be able to reduce its provision coverage ratio for potential credit losses. As of Q1 2024, the company’s credit card allowance coverage ratio was 7.81%, well above the pre-pandemic coverage level of 6.31%. As such, as delinquency and collection trends normalize, Capital One will be able to release the reserve. For the sake of argument, if Capital One can lower its provision coverage ratio to a level closer to the pre-pandemic level of 6.50%, Capital One’s bottom line could see an additional $1,971.55 billion added for a period in which the company reduces its provision coverage ratio. . Given that Capital One reported annual net income of $4.77 billion in 2023, the tailwind from the low coverage ratio could be significant as $1.971 billion equates to about 41.3% of 2023 net income.

Second, Capital One could see a significant expansion in net income as a result of lower provisions for credit loss requirements. In the first quarter of 2024, Capital One’s net discount costs were $2.616 billion. However, in the second quarter of 2023, when market consumer loan delinquency rates reached 2.37%, similar to pre-pandemic delinquency rates, Capital One reported net delinquency costs of approximately $2.185 billion. As overall consumer loan delinquency rates rose from 2.37% to 2.68%, Capital One’s net debt collection costs also rose. As such, if consumer loan delinquency rates decline and eventually begin to decline toward pre-pandemic levels, Capital One’s provisions for credit losses could see gains of $431 million per quarter without accounting for any organic growth. The company’s net income for the first quarter of 2024 was $1.28 billion, so a lower provision for credit losses could add about 37% to the bottom line.

The decline in fees and many other factors, including the current macroeconomic condition and expected macroeconomic conditions will determine the reserve ratio. Capital One’s net income and credit loss provisions also vary quarter-to-quarter. However, I think one thing is clear. As consumer loan delinquency rates in the market begin to decline over the coming quarters, Capital One will likely see significant gains of perhaps 30%+. So, looking at both potentials, I think Capital One has a great opportunity to appreciate valuation in the coming quarters from potential bottom line expansion.

Risks facing the thesis

In my bullish theory, I expect positive macroeconomic winds to unfold, which include a continued decline in the overall interest rate along with strength in consumers’ financial health. However, if this is the case and inflation proves to be persistent in a way that it begins to increase, consumers may see more financial pressures from daily living costs and possibly higher interest rates. Therefore, the current trend and momentum of delinquency rates could reverse negatively impacting Capital One and my bullish thesis.

summary

The momentum with which delinquency rates are increasing has been steadily weakening, which may eventually lead to a decline in delinquency rates from current high levels to a level similar to pre-pandemic times. This trend is supported by the strong financial position of consumers coupled with low overall inflation rate, which creates positive tailwinds for Capital One. As the pressure from rising loan delinquencies eases, Capital One could see a benefit of more than 30% to its bottom line and thus to its overall stock price. So, I think Capital One is a buy.