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.

Does the Jobs/Schmidt Pairing Signal a Future Alliance?

Who are the two leading innovators in the technology industry today? Google (GOOG) and Apple (AAPL) would likely garner a lot of votes should we take an official survey. News that Google CEO Eric Schmidt will join Steve Jobs on Apple’s Board of Directors is very interesting. Warren Buffett and Bill Gates expanded their relationship in part via sharing seats on a board. That relationship has grown over the years and eventually resulted in Buffett’s gigantic donation to the Gates Foundation.

Does this mean that some sort of Apple-Google alliance or partnership is only a matter of time now that Jobs and Schmidt are on the same board? Not necessarily. Closer relationships can certainly lead to business ventures, but this is by no means assured. Does the potential for two technology leaders mean investors should consider buying shares of Apple or Google based on this news? Hardly.

Nonetheless, it is clear that Steve Jobs feels strongly that input from Google’s CEO could help it continue to grow. Five years ago Apple and Google would have had no place on a list of leading innovators in Silicon Valley. Things certainly do change rapidly in the industry, and that won’t be changing anytime soon.

 

Despite Housing Weakness, Cashouts to Jump in 2006

Given that we know the housing martket is slowing dramatically and interest rates have been on the rise for a while now, it may be surprising to many that Americans are expected to draw $257 billion out of their homes in 2006, up $13 billion versus 2005 levels, according to Freddie Mac. This likely helps to partly explain why the consumer has yet to fall of a cliff despite housing market woes.

The bearish argument for consumers has been the fact that billions in adjustible rate mortgages are set to begin resetting this year, which will shock the monthly budgets of many people who could only move into the house they wanted with very low teaser mortgage rates. However, it appears that refinance activity is picking up as ARMs are about to readjust. With 30-year fixed rates around 6.5%, hardly an unaffordable rate for most, refinancing adjustible rate mortgages into fixed mortgages are helping to cushion the blow.

Now it’s certainly true that even a move from 3% to 6% might prove too much of an increase for some lower end home buyers and speculators, but it is hardly something that seems likely to send the U.S. economy into recession all by itself. I do expect housing to remain weak for a while, given that inventories are hitting multi-year highs. However, unless mortgage rates take a dramatic turn upwards, say to 8 or 9 percent, consumers might be able to hold up a little better than some expect.

Hurricane Season Tepid Thus Far

Here we are halfway through hurricane season and we’ve seen very little activity. In fact, peak season is coming up here in September, so if we can get through another month without a major storm, investors need to consider the ramifications of an average season after last year’s devastation.

The prime beneficiaries of a light-to-average hurricane season would be the re-insurers who decided to continue offering coverage, albeit at much higher premiums, in the Gulf Coast and Atlantic regions even in the wake of Katrina. Higher premium income and lower claim payouts make for solid profitability. The catastrophic loss re-insurers are still down considerably from their highs after the Katrina backlash, so upside remains fairly meaningful. It is true, however, that it only takes one storm to ruin everyone’s year.

Without major storms disrupting the nation’s energy supply, we might also have seen the peak in oil for now. Any spikes in natural gas might also be avoided in the short term. The future direction of the energy markets will then likely be determined by how cold of a winter we get. Last year a mild winter brought natural gas prices down considerably, from a Katrina high of $15 down to under $6. Colder weather this year could serve to boost natural gas prices back up as supplies would be diminished greatly. Aside from geopolitical events, it appears that crude oil prices have peaked, at least for now, as summer driving season will be coming to an end.

So, just to recap. Take a look at the catastrophic re-insurers, and if you are interested in energy, there is probably more upside in natural gas than crude oil over the next quarter or two.

Sears Contemplates Next Act

Sears Holdings (SHLD) received a lot of attention when it announced that it would not offer any guidance to Wall Street whatsoever. They don’t even host conference calls to discuss quarterly financial results. I don’t know of any other large cap company that doesn’t host at least four calls a year. As a result of the lack of transparency, only a handful of analysts cover the stock.

Based on their track record, it was very interesting to read the company’s press release last week detailing their second quarter results. Buried toward the end of the unusually lengthy release was a section entitled “Investment of Available Capital.” Below are a couple of excerpts:

“The Company has also repurchased $1.1 billion of its common shares since the merger and expects to continue to repurchase shares subject to market conditions and board authorization. In addition, the Company may pursue investments in the form of acquisitions, joint ventures and partnerships where the Company believes attractive returns can be obtained. Further, the Company may determine under certain market conditions that available capital is best utilized to fund investments that it believes offer the Company attractive return opportunities, whether or not related to its ongoing business activities.”

“Our strong financial position and cash flow generation provide us with the flexibility to capitalize on a wide range of market opportunities as they arise. In addition to investing in our business and acquiring our shares, we are prepared to invest substantial amounts of capital if we identify other attractive investment opportunities which have the potential for returns we believe appropriately compensate the Company for the associated risks.”

The significance of these statements might not be obvious at first blush, but you need to take into account that this is a company that keeps everything very close to its chest. They rarely offer a glimpse into their strategy. Heck, for years the media has been reporting that the Sears/Kmart deal was about real estate. When was the last time they did a real estate deal.

To me it’s pretty clear why, for the first time, Sears has chosen to tell investors a little but more about their plans. They’re going to do something, and it’s not necessarily going to have anything to do with Sears or Kmart. And it might not make any sense whatsoever when it happens. After all, everybody thought Lampert was crazy buying Kmart in bankruptcy and swapping his debt for new equity at $15 per share. Well, that $15 stock that nobody wanted to touch went up 11-fold in only a few years.

I have no idea what he has up his sleeve this time, but I’m very interested and I don’t think we’ll have to wait too long to find out. Stay tuned.

Where is this Consumer Carnage I Keep Hearing About?

Many of my comments in recent weeks have centered on the consumer sector. The reason is pretty simple. Most people have been recommending investors shun consumer discretionary names in their portfolios, and the stocks have indeed reacted to the fear of a slowing consumer by getting absolutely decimated. Now, with many of these retail related business reporting their second quarter results in August, and issuing outlooks for the second half of 2006, it is becoming clear that, just as I have been suspecting and writing about for some time, sentiment seems to be unfairly negative as far as consumer spending is concerned.

Aside from Wal-Mart, retailers like Target (TGT), Kohl’s (KSS), JC Penney (JCP), Federated (FD), and Coach (COH), to name a few, have reported very good results. Last night Abercrombie and Fitch (ANF), a Peridot holding, raised guidance for the second half of 2006 and the stock is up nearly $7 per share today.

The takeaway point here is that even though the housing market is soft, interest rates have risen substantially, and gas is north of $3 per gallon, the U.S. consumer is not going into hiding. Gas prices were over $3 this time last year, interest rates are still not extremely high compared with historical averages, and most people don’t have adjustable rate mortgages or rely on investment properties for income.

There is no doubt that the lower end will struggle to make ends meet more-so than others, and Wal-Mart’s lackluster results shows evidence of that. However, if you focus on areas of consumer spending that won’t be adversely affected as much, namely the high end and the teenage segment, stock prices could do very well despite all of the people out there warning of impending doom.

Market Struggling to Break Out

The 1,280 level on the S&P 500 seems to be a very difficult area for the market to break through. The fizzling of yesterday’s early rally didn’t feel very reassuring and again today we have an early morning rally that puts the S&P right around 1,280. If we get more sellers in the afternoon and lose a 100 point advance again, the bears will use it as fuel to remain unimpressed with recent market action.

As for ways to make money in this trading range environment, Sears Holdings (SHLD) reports earnings on Thursday. I would expect a bottom line that exceeds expectations. Whether or not it results in a huge stock price move or not, I don’t know. However, the shares are trading $20 per share below the highs made after their last quarterly report. Retail earnings from Target, Kohl’s, Federated, and Dillard’s have been strong, much to the surprise of those warning of impending consumer doom. This bodes well for the Sears report.

Is Annual Guidance a Reasonable Expectation for Investors?

Regular readers of this blog are aware that I think public companies giving out quarterly earnings guidance is something that should be eliminated in order to ensure that management teams run their businesses for the long term, not with a goal of “hitting the quarter” any way possible.

It is also fairly unreasonable to expect a CFO to be able to predict whether certain expected revenue will be booked in June or July several months in advance. It can make all the difference in the world in trying to meet or exceed previously issued guidance on a three-month basis, but should investors really care if a big order is shipped on June 25th or July 5th? I tend to think not.

Fortunately, many companies have ceased issuing quarterly guidance. Some, however, are taking this practice a step further by halting annual guidance as well. I was listening in on the Affiliated Computer Services (ACS) quarterly conference call yesterday afternoon, and they announced that they will no longer provide revenue or earnings guidance on an annual basis. ACS’s 2007 fiscal year began in July, so investors looking to get some sort of idea of how the next year will shape up are at a loss.

So, this brings us to an important point. Should investors be upset if they aren’t provided annual guidance? I tend to say “yes.” Forecasting an entire year (without breaking it down by month, quarter, or even half) shouldn’t be as difficult and unproductive as issuing quarterly guidance. I don’t care if some business gets pushed into Q2 from Q1 at the last second, but I still want to have some idea of how 2007 is going to look compared with 2006.

If I don’t have any idea how fast a company will grow its earnings, how can I assign the stock a multiple that I think represents fair value? It makes life awfully difficult. Just give us a range of, say 5%, for forward annual growth. If ACS says 2007 growth in earnings will be 5%-10%, I have an idea of how much to pay for the stock. If I don’t know if growth is expected to be 0% or 15%, the fair value ranges I could come up with become so wide they are fairly useless.

 

Google/MySpace Deal is a Win-Win

Yesterday Google (GOOG) was awarded an exclusive online advertising deal with News Corp (NWS) subsidiary MySpace.com. The agreement, valued at $900 million, runs through 2010.

The reason I think it is a win-win for both companies is fairly simple. MySpace has done an exceptional job attracting users (around 100 million and counting at last count) but thus far has not really focused on monetizing that traffic. By bringing in Google to provide search and online ads to the site, they get the best-in-class company to manage that aspect of the business for them. And given that Google has billions in cash, MySpace likely chose them (over the likes of Yahoo, MSN, Ask, and AOL) not only for their superior technology, but also because Google’s huge war chest allowed them to offer the most revenue share.

From Google’s perspective, it is also a smart deal. Sure, $900 million over three years is a lot of money to spend, but they have been raising additional capital for these types of investments ever since their IPO. Think of this very similarly to the $1 billion they shelled out to get their Google Pack software pre-installed on all new Dell systems.

With Google running away with the U.S. online ad market, the market is becoming more and more saturated. Keys sites like MySpace, that don’t have advertising partners yet, are few and far between, and are crucial partners if Google is going to continue to grow at the rates investors expect. The potential for international growth surely trounces that of the United States, but Google has had a tougher time dominating the online ad market overseas thus far, making continued U.S. dominance very important.

Google needs growth. MySpace needs to make some money. As a result, this deal seems like a perfect match to me.

 

Fed Meeting Preview

As we head into the FOMC meeting today, I wish I was a bit more optimistic. The market has priced in a pause in rate increases and a definitively more “dovish” policy statement. The last time I saw the Fed Futures it was around 18% for a rate hike today at 2:15 ET.

Even if we get what the market expects, will the market make a nice run to the upside? I doubt it. We could get an immediate pop, but I don’t think it would hold up. There will be plenty of sellers looking to slim down positions if we get something like +100 on the Dow this afternoon.

The other alternatives suggest we might see reasonable selling pressure. I’ve said here lately that I think we could very well get a 25 basis point hike today. I think the 18% chance that the futures markets have priced in is too optimistic. That said, the hike itself isn’t catastrophic, so long as the Fed makes it clear in their statement that it is the last one for a while.

This is where the problem comes in. I don’t think the Fed will want to say anything that makes them look “dovish” on inflation. Their policy statement, whether they raise rates today or not, might very well talk tough on inflation and indicate that while they are pausing for now, if they continue to see inflation pressures they won’t hesitate to raise rates later in the year.

Such a development would likely cause a market sell-off, making today’s highly anticipated Fed meeting fairly disappointing for those of us who own stocks. I sure hope I’m wrong and we see stock price advances from here over the near term. But if that happens, I would be tempted to take some money off the table. If others feel the same way, any rally will likely be short-lived.

*Update*
Full Disclosure: With the Dow +43 this morning, I have initiated a short trading position in the Spiders (SPY) for my personal account in anticipation of the gains fading after the Fed decision is released.