Capital One's Credit Cards Drive Loan Growth, but Credit Results Are Rapidly Returning to Normal

Equity Analyst

Michael Miller

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Capital One maintains a more limited branch network than its traditional banking peers, using its online and mobile channels to acquire customers and service its accounts. The focus on online bank accounts has allowed the company to establish a national presence broader than what its narrow branch network would traditionally allow. This dynamic allows Capital One to enjoy the benefits of being a large bank without the expense of operating the branch system of a large bank.

Capital One’s largest driver is its credit cards, which make up around 44% of its total loans. The bank’s remaining business mostly consists of commercial loans and auto loans through its consumer banking segment. The bank’s narrow product offering focuses its assets, giving Capital One the benefit of scale in its chosen business lines. This does have the consequence of leaving the bank undiversified as it is reliant on its credit cards and auto lending business. 

Capital One's credit card receivable balances increased around 20% in 2022 as a combination of high consumer spending and heavy marketing drove impressive growth for the company. That said, the bank will need to compete aggressively with other credit card issuers to maintain this growth, particularly as it expands into the luxury travel card space. Capital One has also turned to the private label and co-branded credit card market for a boost, winning the BJ's Wholesale Club portfolio in 2022. While we appreciate the extra growth, private label cards typically require revenue sharing agreements with the partnered merchants, reducing returns. 

On the other hand, credit costs are rising as net charge-offs normalize from unusually low levels in 2022. We do expect net charge-offs to continue to rise in 2023 and into 2024 as there are clear signs of normalization in the bank's credit metrics and we anticipate deeper economic pressure on its cardholder base as the impact of higher interest rates and the end of student debt forbearance filter though the economy. However, Capital One remains in a healthy financial position, and we do not foresee material financial strain, particularly if the labor market remains as resilient as it has been.

Business Strategy & Outlook

In our view, Capital One has a Narrow Morningstar Economic Moat Rating, as we believe it has durable competitive advantages that will allow it to continue to earn returns on tangible equity that are above its cost of capital. The company’s heavy investment in technology and marketing has enabled it to use online bank accounts to build an asset and deposit base that is national in scope while maintaining a limited branch network. This has given Capital One the scale necessary to compete effectively in its business lines while keeping operational costs under control. In turn, this has allowed Capital One to enjoy returns on tangible equity that have been comfortably above its cost of capital.

Banks typically create cost advantages by controlling operating expenses, building low-cost deposit bases, and utilizing effective underwriting to keep credit costs below their peers. Capital One has been particularly successful in keeping its operating structure lean. The company’s efficiency ratio has averaged below 55% since 2012. This is better than peers, which as a group typically see efficiency ratios between 55% and 65%. The persistent difference in cost structure is a sign that the company has a competitive advantage through its cost management. This operating efficiency comes despite the company’s heavy investments in marketing and technology, areas where the firm regularly spends more than 7% and 4% of its net revenue, respectively. Capital One makes up for its high marketing spending with low labor costs, which are typically only around 20%-25% of net revenue. While marketing spending is a key part of Capital One’s strategy, the expense is not core to the company’s day-to-day operations. During periods of duress, the firm can turn and has turned to this line item to reduce its cost structure further when it needs to. We are confident in Capital One’s ability to continue managing noninterest costs and expect its efficiency ratio to improve over time.

In our view, Capital One’s cost efficiency is driven by its large scale and small physical footprint relative to its size. Capital One’s consumer lending and credit card business lines are fully national with no region making up an outsize portion of its nearly $200 billion consumer loan book. Its commercial lending business is more focused, with roughly 50% of its roughly $70 billion in loans concentrated in the Northeast, where the company’s branch network has historically been focused. Despite its size, Capital One has fewer than 500 branches, which is down from its peak of over 700 as the firm has been shrinking its already small footprint while expanding its deposit base and assets. This is achieved through Capital One’s heavy use of online deposits, which was jump-started in 2012 through its acquisition of ING Direct, now rebranded as Capital One 360. Online deposit gathering has allowed Capital One to develop and maintain a deposit base of sufficient size to finance a national lending arm while maintaining a slim service profile. 

Lending, particularly consumer lending, benefits significantly from scale as incremental sales growth can drive higher earnings against fixed costs. Additionally, much of Capital One’s consumer lending is supported by relationships with third parties, and the attractiveness of Capital One as a partner is enhanced by its size. The company’s auto lending business (which has more than 95% of Capital One’s consumer banking assets) only makes loans for cars from participating dealerships. Capital One’s customers can shop for cars on its Auto Navigator website or its mobile app and get preapproved for a loan for a specific car before going to the dealership. The incentive for auto dealers to integrate their inventory with Capital One’s platform and participate in its lending program is that they gain access to Capital One’s client base. As Capital One is one of the largest auto lenders in the country, the incentive to be a part of its platform is considerable, given the size of its customer base. Additionally, while it is not the focus of the credit card business, Capital One does have a number of partnership agreements with retailers for private-label and cobranded general-purpose credit cards. A partnership agreement with a large national retailer can create billions in receivables that the credit card issuer is expected to finance safely. Most partnership agreements carry a targeted program size and approval rate. A certain level of scale is a prerequisite for banks to participate in this market. 

The size and geographical breadth of Capital One’s loans also diversifies them across multiple regions and FICO scores. This reduces the bank’s dependence on the economic conditions of any particular region in the country and allows it to accumulate a diverse array of lending data. Consumer lending is increasingly data driven as large proprietary data sets are needed to build the kinds of credit models necessary to make fast and effective underwriting decisions. As rapid credit decisions become the norm, access to large data sets and the ability to analyze them are increasingly a requirement to compete in consumer lending. Capital One’s heavy technology investments are enabled by its size and allow the company to utilize its broad lending data to support the moat around its business. Capital One’s size also allows it to market itself cost-effectively. We expect the company to continue spending heavily on marketing in order to increase its brand presence and drive incremental growth. Size allows Capital One to purchase video and display ads in bulk and finance national ad campaigns. 

While online deposits have allowed Capital One to increase the size and geographical breadth of its deposit base quickly, the heavy use of this funding source is not entirely without consequence. Enabled by the lack of physical infrastructure, savings accounts at online banks typically offer higher interest rates to depositors. Capital One’s own online accounts operate under a hybridized model in which clients manage their accounts through online or mobile access but still have access to Capital One’s small branch network. Despite the availability of its branches, Capital One still competes with online banks for deposits, which means they need to offer competitive interest rates to their depositors. This leads Capital One to have a high cost of funding from its interest-bearing deposit base relative to more traditional banks. Furthermore, only around 10% of Capital One’s deposits are non-interest-bearing, well below its peers. The result of this is that despite its success in building a large deposit base, with deposits making up more than 80% of its total funding, Capital One still has a relatively high cost of funding (3.11% in the first half of 2023). That said, the interest cost disadvantage of Capital One’s funding choices is outweighed by the cost efficiencies that they enable. Ultimately, Capital One does enjoy ROTE in the low double digits and has an efficiency ratio below its peers. These figures are important data points that point to Capital One having achieved a narrow moat through operating efficiency. 

On the regulatory front, Capital One is not considered large enough to be a global systemically important bank, allowing it to avoid the heaviest regulatory requirements. However, with over $250 billion in assets, Capital One is required to participate in the Federal Reserve’s annual stress tests and is subject to the full liquidity coverage requirements. Still, Capital One is large relative to other non-GSIB firms, placing it in a strong position from a relative regulatory cost perspective.

Narrow

Economic Moat

Capital One

Capital One Financial Corp. operates as a financial holding company. The firm engages in the provision of financial products and services. It operates through the following segments: Credit Card, Consumer Banking and Commercial Banking. The Credit Card segment includes domestic consumer and small business card lending, and international card lending businesses. The Consumer Banking segment consists of branch-based lending and deposit gathering activities for consumers and small businesses. The Commercial Banking segment includes lending, deposit gathering and treasury management services to commercial real estate and commercial and industrial customers. The company was founded by Richard D. Fairbank on July 21, 1994, and is headquartered in McLean, VA.

Earnings data Q1 2024

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