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.

Citigroup Shareholders Beware

If you own stocks, undoubtedly you want management teams to feel an obligation to work for the shareholders. This boils down to striving to maximize shareholder value. Of course, attaining customer and employee satisfaction is important too, but succeeding on those fronts will usually aid in boosting a company’s public market value, so these factors go hand in hand.

If you own shares of Citigroup (Peridot does not) you might want to consider what CEO Chuck Prince said in response to a piece in Barron’s over the weekend about the possibility of breaking up the financial services giant. The weekly paper suggested that if Citigroup’s stock remains sluggish, there could be calls for the company to be broken up. The following is an excerpt from a Reuters story published Monday.

“In the article, however, Prince flatly rejected any discussion of splitting up the company into separate units. “Breaking up Citigroup is the dumbest idea I’ve ever heard of,” Barron’s quotes Prince as saying. “You would take a franchise that people have worked almost 200 years to build and break it up into two or three parts, only to see the parts acquired by others.”

Now why should Citigroup investors be upset with this? Within the financial services sector, only insurance companies garner P/E ratios lower than the big, diversified banking giants. Citigroup, along with JPMorgan Chase and Bank of America trade at only 10 or 11 times earnings. Many investors see this as cheap, but if the multiples don’t expand, share price appreciation will only come from earnings growth, which is hard to attain in any meaningful way since these firms are so huge.

The argument for breaking up a company like Citigroup is twofold; to achieve operational efficiencies, as well as a higher public market valuation. On the operations side, smaller firms are easier to manage and can move at a much faster pace in adapting to changing business environments. From the investor perspective, right now all of Citi’s business units are getting the meager 10 or 11 multiple. Breaking up into several pieces, the logic goes, will allow some units to get higher valuations, and thus the entire Citigroup enterprise would be more valuable.

I have seen specific break up estimates on Citigroup that value the parts at between $60 and $70 per share, versus the current price in the high 40’s. By splitting into 4 smaller companies (domestic retail banking, international retail banking, global asset management, and investment banking), Citigroup shareholders could make a hefty profit, perhaps 30% or more. Chuck Prince’s blatant dismissal of the idea doesn’t bode well for investors.

Was the Mastercard IPO Underpriced?

Lead underwriters Goldman Sachs (GS) and Citigroup (C) priced the Mastercard (MA) IPO Wednesday night at $39, below the expected range of $40 to $43 per share. On Thursday shares opened at $40.30 and then soared another $6 to close at $46 each. That trading action is quite baffling if you ask me.

Usually where the IPO is priced tells you how strong demand is, and subsequently, how well the stock will do upon opening for trading. The $39 pricing indicated to me that the smart money wasn’t very enthusiastic about the deal. Then less than 24 hours later the stock is fetching $46. If demand was that strong, they easily could have priced it within the proposed range.

The conclusion I draw from this is that the smart institutional money wasn’t sold on the price, but retail interest after the stock opened was strong. Following the retail crowd is rarely a good strategy, so I will put more weight into the $39 pricing than the $46 first day closing price. The stock’s valuation also supports the cautious view. Mastercard earned about $2 per share in 2005, so the P/E is north of 20x, very high for a financial services company.

Investors Punishing Legg Mason Unfairly

Shares of Baltimore-based Legg Mason (LM), a leading asset management firm, have been crushed lately and now sit more than 20 percent below their highs. At a recent quote of $111, the stock looks expensive at first glance. The company will report its fiscal fourth quarter numbers on May 10th, with consensus estimates at $4.18 in EPS for the year. How then are LM shares attractive at 26.5 times those profit expectations?

With their recently completed asset swap with Citigroup (C), Legg is now a pure play on asset management and should be able to boost margins substantially. Looking out to calendar year 2007, after the acquisitions has been fully digested and integrated, LM should be able to earn at least $7 per share. Put a reasonable 20 P/E on those profits, based on a double-digit growth rate and within the company’s historical valuation range, and you have a solid 30 points of upside.

Capital Depreciation

Shares of Capital One (COF) are continuing to fall after news of their nearly $15 billion bid for North Fork Bank (NFB). After hitting new highs at $90 per share, COF stock has dropped more than 10 percent to $80 and change. This sell-off is exactly what we saw after the company announced plans to buy Hibernia a year ago. History tends to repeat itself, and this instance should reinforce that view. Patient buyers will be well rewarded once the deal closes and investors realize how strong of a move it was. Momentum traders and merger arbs are causing longer term investors such as myself to salivate at the stock’s current price.

Capital One Gobbles Up 2nd Bank in North Fork

Given that Capital One Financial (COF) recently closed its acquisition of Hibernia, I was a little surprised to see that they are buying New York based North Fork (NFB) so soon after. Also interesting was the fact that news of this deal did not leak out whatsoever ahead of time. In case you missed it (I didn’t given that COF is a long-time Peridot holding), Capital One stock was up $4 on Friday to an all-time high.

Given that merger arbs will be shorting Capital One stock to play the deal out, we will likely see some of that huge gain given back this week. The stock is down $5 in pre-market trading. Nonetheless, COF management continues to execute on their strategy and shareholders will likely continue to reap the benefits. The NFB deal appears to be a good one for everyone involved. NFB holders get more than a 20 percent premium to Friday’s closing price, and yet COF is only paying 1.6 times book value, which is hardly considered high in the world of bank buyouts.

NYSE Investors Beware

Before you get caught up in the hype and go out and buy shares in NYSE Group (NYX), I urge you to do some basic valuation work. Shares of NYX, the newly formed public combination of Archipelago and the New York Stock Exchange, opened at $67 per share yesterday and proceeded to close at $80. Today the stock is up another $6 at the open. Current market value at $86 per share: $13.6 billion, based on 158 million shares outstanding.

The reason for the rise has more to do with limited supply than anything else. Retail investor interest has been strong so far, and there simply aren’t many shares available to buy. Much of the stock is being held by NYSE seat owners and member firms, who can’t sell it right now. A supply-demand imbalance is causing a short term spike, but a closer look at the company’s valuation makes it clear that anyone paying $86 is playing with fire.

Keep in mind that Archipelago (AX) stock traded at $17 before the merger with the NYSE was announced last year. The combination has resulted in a 400% increase in the value of that equity (AX shares became NYX shares beginning yesterday). I don’t doubt the deal will be accretive, but isn’t 400% a bit extreme?

AX was expected to earn $1.11 per share in 2006 before the deal closed. Even if that number winds up being $1.50 after the merger (a VERY optimistic projection), the current forward P/E of NYSE Group is 57 times. Buyer beware.

Investment Banks Shed Profitable Asset Management Divisions

Last year’s asset swap between Citigroup (C) and Legg Mason (LM) looked like a great move on the part of Legg. After all, retail brokers are hardly the future. Individual investors can only tolerate absurdly high commissions for so long, I would hope. Trading their retail brokers for Citi’s huge asset management division, including Smith Barney’s mutual funds, should be a huge lift for LM shareholders, and the stock’s movement since the deal was announced bears that out.Now we learn that Merrill Lynch (MER) has decided to send Merrill Lynch Investment Management (MLIM) to BlackRock (BLK) in exchange for a 49% stake in the newly formed asset management giant. As was the case with Legg Mason, Blackrock stock has gone through the roof on news of a deal.

Evidently this Merrill deal was a much better alternative than the “let’s change our fund company’s name to Princeton Research and Management and see if that helps get us more business.” Once Morgan Stanley’s deal to acquire BlackRock fell through, Merrill swooped in and decided it was a much better idea to hand over MLIM to a somebody who could better run it. Doing so also rids Merrill of having the appearance of conflicts of interest with its investment bankers, research analysts, and mutual fund managers all under the same roof.

So in a matter of months both Legg Mason and Blackrock have strengthened themselves as pure play asset managers, a business that has great margins. With the growing popularity of hedge funds and international investment options, their fortunes will be much less tied to the direction of the S&P 500 than they were five or ten years ago.

The stocks have soared, and on current profit estimates they do look pricey. However, it is apparent that margin expansion will occur, both due to cost-cutting and an overall higher average profit margin across the business. Accordingly, current analyst expectations for profits (about $6 for LM in 2006 and $5 for BLK) will prove quite conservative.

And they better since LM is trading over $130 and BLK recently hit $150 per share. It is entirely possible that 2006 is a transition year for the integration of these very large deals, but come 2007 and 2008, they should be coining money. Add in the fact that asset managers have always traded at a premium to the overall market and financial services sector, and the stocks could outperform for the rest of the decade even after the recent run-ups we’ve seen. Of the two, Legg Mason looks cheaper than Blockrock, however.

 

Flat Curve Could Hamper Commerce in Short Term

Shares of New Jersey based Commerce Bancorp (CBH) have been strong lately, along with other bank stocks, as investors hope the Fed will stop hiking interest rates when the Fed Funds rate hits 4.5% early next year. However, after a run from $27-$28 to $33-$34, shares of CBH could see weakness in the short term.

Although the company’s long term growth prospects remain among the brightest in the industry, the flatness of the yield curve will make it difficult for CBH to beat, or even meet, Wall Street’s profit expectations in both the fourth quarter and early 2006.

Any guidance reduction in Commerce’s soon-to-be-released mi- quarter update will likely cause a 5 to 10 percent sell-off in the stock. At that point, long term investors can be more aggressive with their positions.