Sub-Prime Mortgage Weakness Not Spreading to Other Credit Products

Below is an excerpt from the first quarter earnings press release of a consumer lender that serves lower end customers, including some who would be classified as sub-prime borrowers, but is not involved in the mortgage:

“Factors adversely affecting our first quarter results included lower than expected fee assessments due to lower than expected delinquencies.”

No, that is not a typo. For all of those people who were expecting the sub-prime mortgage mess to spill over into other areas of credit such as credit cards and student loans, it appears the worries (and subsequent share price declines) were unfounded. Delinquencies were lower than expected!

It might seem baffling to many, but this is pretty good evidence that the sub-prime spillover effect is being greatly exaggerated, a theory I first rejected a month ago in a piece entitled Most Financials Dragged Down with Sub-Prime Lenders.

Capital One Reduces Guidance on Mortgage Weakness

Frankly, I prefer my headline above to the one I saw atop an Associated Press piece on Friday that was quite a bit more frightening:

“Capital One’s Mortgage Woes Lead To Profit Plunge”

It’s a shame that whoever wrote that article didn’t really do much research before writing about the company’s first quarter earnings report last week.

First, the facts:

1) Capital One’s first quarter earnings fell 43% to $1.62 per share from $2.86 in the year ago period.

2) Capital One reduced 2007 earnings guidance from $7.60 to $7.20 per share.

What about mortgage woes leading to a profit plunge? Why isn’t that fact number three? Well, that’s not really what happened. The year ago comparison was affected by one-time gains in 2006, so profits really didn’t fall by 43 percent on an apples-to-apples basis, despite what many articles have stated.

The weakness in the mortgage market was the main reason Capital One reduced guidance for the year by 40 cents, but it was not a large contributor to the widely reported (but misleading) 43% profit decline. Capital One’s mortgage business lost $12.6 million in the first quarter, reversing a year ago profit of $35.4 million.

Since Capital One has 415.5 million outstanding shares, we can calculate how much the mortgage business contributed to the profit decline. A delta of $48 million equates to a negative impact of $0.12 per share. Twelve cents! The sky is hardly falling. Capital One’s mortgage division is a very small part of their business. Last year they bought North Fork, a New York regional bank with a mortgage division called Greenpoint. Even after the acquisition, most of COF’s profit stills comes from credit cards, not mortgages.

As for Capital One stock, it’s no surprise that the shares fell more than $4 after releasing a weak earnings report and lower guidance. As I mentioned recently when talking about M&T Bank, the regional banks will have short term earnings pressure due to the flat yield curve and a weak mortgage environment. First quarter reports from these banks will be disappointing, as was the case with both MTB and COF.

However, investors in Capital One stock (myself included) should view the shares as a long term investment. The current banking environment (flat yield curve and unprofitable mortgage lending) will not persist forever. Now, I do not know when mortgages will return to the black (Capital One is assuming no incremental mortgage earnings in 2007) and I can not tell you when the yield curve will steepen. It might be six months, one year, two years, I just don’t know. Frankly, nobody predicted the yield curve would stay flat this long. In fact, this is the longest period it ever has stayed flat without a recession. However, that time will come. It always does.

Why should investors continue to hold consumer lending stocks like Capital One if 2007 earnings are likely to be weak and positive catalysts could be months or even years away? Because the stock is a bargain. If you wait until the mortgage market improves and the yield curve steepens, COF shares will be $90, not $70, and you will have missed 20 points very, very quickly.

How much downside is there in Capital One stock in the low 70’s? Not much in my view, it probably continues in its recent trading range (the stock has been dead money for a while). Even in the negative business environment we currently see for consumer lenders, COF is still most likely going to earn more than $7 per share this year, giving the stock a P/E of 10 on a depressed earnings level. Once things improve, earnings will soar and the multiple should expand. When that happens, COF could easily be in the triple digits, but unless you buy the stock beforehand, the train might leave the station without you.

Full Disclosure: Long shares of Capital One at time of writing

M&T Bank Preannouncement Shows Alt-A Mortgages Not Immune

Was anyone else surprised that news of a first quarter profit warning from M&T Bank (MTB) hardly had any effect on the market and received fairly little attention on Wall Street? One of the arguments we have heard from many Alt-A mortgage lenders is that the sub-prime mess is confined to that part of the spectrum, and Alt-A mortgages (given to home buyers with high credit scores but without verification of income, etc)are doing okay so far. M&T’s warning directly contradicts that view.

For those of you that missed it, M&T Bank (a regional bank in the Mid-Atlantic) projected first quarter earnings of $1.50 to $1.60 last week, far below consensus estimates of $1.86 per share. The culprit: Alt-A mortgage loans, which make up 30% of the bank’s mortgage portfolio. The company was forced to repurchase non-conforming loans and also decided to not sell some new loans due to inadequate pricing and a lack of bidders.

This news did hit MTB shares, which fell about 10 percent on the news, but very few others were affected. Other mortgages lenders heavy into Alt-A offerings such as IndyMac Bancorp (NDE) have come out publicly saying their mortgages are performing fine. The news from M&T, hardly an aggressive lender, show that the odds are good that Alt-A mortgages will become a problem for mortgage lenders as well as more diversified regional banks who make these types of loans.

This trend should continue to show up in first quarter earnings reports when they begin rolling in over the next month or so. As a result, playing the regional banks for a trade going into earnings season seems to be dangerous from the long side. Opportunities to get long may present themselves later, and companies highly levered to Alt-A may be good shorts heading into earnings, but I’d be cautious on the regionals heading into the upcoming reports. A good way to hedge existing positions would be to sell out-of-the-money calls to generate some additional income.

Full Disclosure: No position in MTB and short NDE at time of writing

Most Financials Dragged Down with Sub-Prime Lenders

Short term market movements are often the result of what I call “guilt by association” trading. Along with the dramatic decline in sub-prime mortgage lending stocks, there has been a huge drag on most financial services companies, even if there is little, if any, evidence that the meltdown in sub-prime is set to spill over into other areas.

One of the main reasons the market has been weak lately is because of the underperformance in the financial services sector, which is the largest segment of the S&P 500 index. While mortgage lenders should be tanking ( given that they lent money to people who could only afford the temporarily low monthly payments for their new homes, and not the higher payments that would take effect when the variable rate mortgages adjusted), should every consumer finance company be getting thrown out with the bath water?

Surely there will be some spillover, as there are always lenders with bad standard practices, but we’ve seen everything from credit card companies, to auto lenders, to bad debt collectors, to student loan companies (just to name a few) all get crushed in this environment. Unless you believe that every type of consumer lender had loose credit standards on par with the sub-prime mortgage lenders, there are opportunities everywhere to snap up cheap stocks. Wall Street is acting as if sub-prime loans are the majority of the loans out there, not a small minority. Investors can take advantage of that, and should.

There is an old saying that “the market can remain irrational far longer than you can remain solvent.” This is very true, and just because many financial stocks are trading at what I would consider unwarranted levels, it doesn’t mean they can’t go down further. You may even reach a point, like I did this week on one of my holdings, where the pain is so great (not really because of the drop in the stock price, but more because of the irrationality of the drop along with its magnitude) that you just throw in the towel like others are doing.

You know that doing so could very well mark the bottom and prove to be a horrible trading decision longer term, but in the short term it will help you psychologically to just not have to see the irrationality continue. Patience is the key for value investors, but sometimes it’s just too hard to be as patient as the market requires you to be. That is why the stock market is as much a psychological exercise as it is a quantitative one.

If you have some financial stocks, either in your portfolio, or on your watch list, that are getting unfairly punished recently, do your research and make sure the worries are relevant before selling the positions. If you can hold on (and even buy more) and not have it be a psychological drag on your trading mentality, you will likely be rewarded when all the dust settles, the truth comes out, and many of the current speculation is proved wrong.

 

Why Break Up Citigroup When You Can Just Change the Name?

Investors hoping Citigroup (C) CEO Chuck Prince would break up the company into smaller parts in order to significantly boost shareholder value will have to wait a little while, at least. After calling such break up talk ridiculous and stupid, Prince reportedly has decided to revamp the Citigroup’s brand by, hold your breath, shortening the company’s name to Citi and having each division’s arc on the logo be a different color. Such a move is an attempt to “unify the identity of Citigroup’s businesses” according to the Associated Press.Isn’t unifying the company’s identity the exact opposite of breaking the company up? Will the move do anything for the company’s lagging stock price (shares have risen a total of about 5% over the last 5 years)? Highly unlikely.

Without a break up, Citi sports a 6 to 7 percent earnings growth rate and a 12 P/E multiple. Such a ratio seems about right for that type of growth. By breaking up into smaller pieces, it would be much more obvious to investors that some of Citi’s businesses are growing much faster than the entire firm as a whole. In that case, higher multiples would clearly be afforded to some divisions.

The result would be increased shareholder value, not to mention better growth prospects given that it is much easier to grow a bunch of separately run, individualized, smaller firms than it is an enormous one. Just giving each business their own colored arc really doesn’t accomplish that feat quite as well.

Full Disclosure: No position

Will the Bull Market in Exchanges Ever End?

Over the last few years we have witnessed an undeniably sensational run in the stocks of various stock, bond, and derivative exchanges. Private and owned by seat holders for generations, the latest bull market in the equity market, which has lasted four years, has allowed the New York Stock Exchange (NYX), the NASDAQ (NDAQ), the Chicago Merc (CME), the Chicago Board of Trade (BOT), and the New York Mercantile Exchange (NMX), to all go public and see their stocks soar.I must say that I have avoided playing this sector. The stocks IPO’d to extreme fanfare, and with such jubilation came steep valuations that fell outside of my investment discipline. I have warned investors to be cautious with these stocks, many of which sport P/E ratios of 40, 50, even 60 times forward earnings. The Chicago Mercantile Exchange, which recently agreed to merge with the CBOT in an $8 billion deal, has risen more than 1,000% since it’s opening trade and now trades at nearly 20 times revenues.

Some readers might chalk up my negative comments as merely trying to rain on the parades of people who have actually made good money in these names. However, in all honestly, I merely want to let people know that these stocks, while they are all the rage right now, trade at levels that will be hard to justify if things start to go bad.

Is it reasonable to think the tide will shift in the other direction at some point? I think so, but the timing in impossible to know. Let’s focus on what factors have driven the bull market in these stocks. The last four years have brought the exchanges increased demand, and subsequently, increased volume. In response, they have been able to introduce new products and raise their fees on existing ones. More business, along with pricing power, leads to surging profits. Hence, the stocks have outperformed dramatically.

But, will the music stop? Eventually I think it has to. Why? Because bull markets end. Exchanges are very cyclical, though many investors don’t relaize this because they were private entities during the last bear market. What happens when the bear rears his ugly head? Prices drop, volume evaporates, demand is reduced, price increases aren’t possible, and all of the sudden, revenue and profits will decline. For companies already trading at 40 to 60 times earnings, with 20 percent plus growth rates projected, such a scenario would likely hurt investors in the exchanges immensely.

Do I know when the bull market will end? Of course not, nobody does. All I can tell you is that we have had a great run over the last four years, with the S&P 500 averaging mid double digit returns annually. If you feel comfortable owning these stocks and riding the momentum, that’s completely your call. I just want people to understand what the risks are. That way, when the next bear market hits, they understand it will be time to take whatever profits are left off of the table and move on to something else. Until that happens, I will continue to sit on the sidelines, in awe.

Nymex Insanity

November 7, 2006: 

An ownership seat on the Nymex division of Nymex Holdings Inc. sells for a record $5.8 million, just 10 days before the exchange plans to go public. The sale, which includes 90,000 shares, topped the previous record of $5.5 million on April 28.

November 17, 2006:

Nymex Holdings (NMX) goes public at $59 per share and trades at $140 in afternoon trading. The 90,000 shares that Nymex seat holders now own are worth $12.6 million. 
I’ll have more on the Nymex IPO in another post sometime next week, but I just wanted to mention this today since many retail investors are buying this IPO. Keep in mind that the value of a Nymex seat has more than doubled in the last 10 days. Does that make sense? Proceed with caution, please.

 

Commerce Bancorp Sale Unlikely

Shares of New Jersey based Commerce Bancorp (CBH) soared 6% Friday and are continuing to hit multi-month highs today, jumping as much as 2% in early trading. The jump is being attributed to continued speculation that CBH will be one of the next regional bank takeover targets. I think the odds of Commerce agreeing to a sale are extremely unlikely.

Close followers of CBH are aware that the company has been growing very rapidly in recent years and their expansion plans continue. Management has been able to maintain impressive levels of organic growth and even after years of expanding their banking branch footprint in the U.S., they remain only visible in a few main states. Commerce has a large presence in New Jersey, New York, and Pennsylvania, along with a recent move into Florida. Baltimore and Washington DC are also in CBH’s sights in coming years.

Given the success of the Commerce growth strategy, and the many areas that remain untouched, selling the company to a larger, more national bank makes little sense for the company at this time. While buyout rumors have been swirling for years now, and evidently continue to do so, investors should be wary of the stock’s recent run-up and that such talk will become reality. Commerce Bancorp has years of internal growth ahead of it, which will prove profitable for shareholders even without a buyout offer.

Full Disclosure: I own shares of Commerce Bancorp (CBH) personally as well as for clients.

Large Cap Stock Idea: Capital One

Last Friday I found myself astounded that shares of Capital One (COF) were hitting new 52-week lows at $69 and change. As far as large cap growth stocks go, I’m not sure there is any stock out there that looks more attractive to me at current levels than COF. Normally I might not share my best ideas on this blog, but in my mind this represents an excellent opportunity that I wanted to mention to my readers.

Of course, the stock has rebounded to $73 over the last several days, but the dichotomy between the company’s outlook and the stock price remains evident. Capital One is one of the cheapest non-cyclical names in the S&P 500 index right now. With such a meager valuation (around 9 times forward 12-month earnings) one might think the growth outlook for the company was murky. However, when I look at what they are doing, and at the expansion possibilities they have over the next several years and beyond, I can’t help but me completely baffled by the market’s recent distaste for the stock. Whenever this happens, I just sit back and hit the “buy” button.

As most of you probably know, Capital One made a name for itself in the consumer lending business via direct mail and media advertising. For the next leg of growth, COF management has decided it could leverage its brand awareness by expanding into retail banking and owning bricks and mortar branches as a new distribution network for its products. Capital One bought Hibernia Bank last year, entering the Louisiana and Texas markets. This year they announced plans to acquire New York based North Fork Bank. The deal is expected to close prior to year-end.

Since announcing the North Fork deal, COF shares have fallen 20% from their closing high of $90 per share. There are many reasons why investors could be concerned, but none of them really warrant the kind of price cut we’ve seen, in my view. Let’s go through the list of possible negatives for Capital One.

1) Mergers often go bad

Investors often get spooked by growth-via-acquisition strategies because so many mergers have failed to deliver the promises made by management at the time the deals were announced. Capital One has grown internally in the past, so it is true that they are new to the acquisition game. That said, combining a direct marketing plan with a branch distribution makes a lot of sense given Capital One’s high brand awareness. COF management has delivered for investors over the last decade since its IPO, so I would be hesitant to write them off without any evidence that they have lost their ability to boost shareholder value.

2) Flat or inverted yield curves hurt bank margins

There is no doubt that bank net interest margins are being squeezed heavily by the current inverted yield curve. While this will impact profits short-term, long term investors looking to play the Capital One growth story over the next 305 years should be unconcerned. Yield curves signal potential for a recession, and rarely persist for an extended period of time. The yield curve will eventually revert back to a normal shape, which will serve as a boost to overall company profits.

3) Hibernia was based in New Orleans

Investors got really nervous when Hurricane Katrina came through and closed many of Hibernia’s branches, just as the merger was about to be approved. Capital One renegotiated the purchase price lower and the company has not seen any negative effects from having a major presence in an area of the Gulf Coast that remains desolate in many areas. If the rebuilding of New Orleans eventually becomes a major priority, Capital One should be able to reap the benefits.

4) North Fork has a sizable mortgage business

The acquisition of North Fork has many people nervous because it gets Capital One into the mortgage business. With all of the talk of a housing bubble ready to collapse, investors are likely worried about the fallout it will have on Capital One’s business. There will likely be some effect, as there will be with most banks, but as long as interest rates do not spike to above-normal levels, I would not expect an outright housing collapse. Capital One has a very diverse business, and mortgages still represent a fairly small portion of the total for the company. Much of this concern has already been priced into the stock.

Now I can’t refute any of these bearish arguments outright. The only thing I can do is look at the track record of Capital One’s management, look at the strategy they are undertaking, consider the expansion opportunities left even after these two bank deals are digested, and determine if the company’s growth outlook for the next 3 to 5 years warrants a P/E ratio of 9 times earnings.

When the North Fork deal was first announced, COF presented a model to investors that showed an EPS target of $10 per share in 2008, the first full year after the integration, was possible. If they hit that number, we’re looking at only 7 times post-merger earnings power at current prices.

Given that Capital One’s expansion into retail banking will have only encompassed three states out of fifty by 2007, the growth opportunities for COF remain bright. There is no reason to doubt the company can deliver double digit earnings growth for the rest of the decade and perhaps beyond. And if they ever decide to sell COF outright, the stock trades at a price-to-book ratio of 1.4, whereas recent bank deals have been priced at 2.0 to 3.0 times book. All in all, a single digit multiple for COF, at this stage in their growth track, seems like one of the best large cap bargains around in the domestic equity market.

Capital One Earnings Miss Shouldn’t Be Surprising

Capital One (COF) blew past earnings projections, reporting $2.86 versus the consensus estimate of $2.06 per share. Despite the beat, the company kept its annual guidance steady at $7.40-$7.80 for 2006. Some investors were disappointed that Q1 was so strong but the company was seemingly being conservative about the year. When asked, management expressed that they saw things being tougher and uncertain later in the year, prompting them to reiterate their guidance rather than raise it.

Fast forward to last night and investors should be not shocked that Q2 earnings came in at $1.78 per share, shy of the $2.06 estimate. Despite the company’s own guidance ($7.60), analysts were at $7.91 in EPS for the year heading into the report. The stock reacted by dropping $6 to $80 per share after last night’s report. Given what we saw and heard in Q1, the earnings miss should not be as surprising as some seem to think. The stock’s drop appears very overdone and I would suggest long term growth oriented investors pick up Capital One shares today at a sale price of $80, or 10 times earnings. Several years from now it will prove an excellent entry point, in my view.