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