Capital One (NYSE: COF): Slowing Delinquency Rates and Strong Fundamentals Signal a Buy Opportunity

Overview

Capital One Financial Corporation has demonstrated a strong performance rebound since my initial buy rating in May 2023. The company’s stock has appreciated by approximately 56%, supported by manageable delinquency rates, robust deposit inflows, and attractive valuation. Despite the impressive stock price increase, Capital One remains a compelling investment opportunity due to the slowing pace of delinquency rate growth, signaling a potentially improving charge-off environment. This situation presents a significant upside for Capital One, with an anticipated 30%+ net income and valuation appreciation potential, making the stock an attractive buy at current levels.

Delinquency Rate Growth is Slowing

The pandemic initially led to abnormally low consumer loan delinquency rates due to extensive government stimulus and a robust labor market. However, as these stimuli faded, delinquency rates rose, increasing charge-off costs for companies like Capital One. Recently, the rate of increase in consumer loan delinquencies has slowed, suggesting a stabilizing macroeconomic environment.

Key Points:

• Delinquency Rate Trends: Data from the Federal Reserve Bank of St. Louis indicates that while delinquency rates spiked post-pandemic, they have begun to level off.
• Quarter-Over-Quarter Changes: The quarter-over-quarter growth in delinquency rates has slowed significantly since peaking in late 2022 and early 2023.

Strengthening Trend

The trend of slowing delinquency rate growth is expected to continue, supported by stable inflation and healthy household debt levels. The following factors contribute to this positive outlook:

1. Household Debt Payments: Household debt service payments as a percentage of disposable income are consistent with pre-pandemic levels, indicating that consumers are not overly burdened by debt.
2. Inflation Rates: Inflation, measured by the Consumer Price Index (CPI), has stabilized around 3%, down from its peak, easing financial pressures on consumers.
3. Management’s Outlook: Capital One’s management has expressed confidence that the current delinquency increases are temporary, expecting improvements in the coming quarters.

Impact on Capital One

The anticipated decline in delinquency rates will likely benefit Capital One significantly, enhancing its profitability through two main channels:

1. Reduction in Allowance Coverage Ratio: As delinquency rates normalize, Capital One can reduce its credit loss allowances. A decrease in the allowance coverage ratio from 7.81% to pre-pandemic levels around 6.50% could add approximately $1.97 billion to the company’s bottom line, representing a 41.3% increase over the 2023 net income.
2. Lower Provisions for Credit Losses: With a decline in delinquency rates, the provisions for credit losses will decrease, further boosting net income. For example, a reduction in net charge-off costs could add $431 million each quarter, equating to a 37% increase in quarterly net income.

Risks to the Thesis

The primary risk to this bullish outlook is the macroeconomic environment. Should inflation persist or increase, it could pressure consumer finances and potentially reverse the current positive trends in delinquency rates. This scenario would negatively impact Capital One’s financial performance and stock price.

Conclusion

Capital One presents a robust investment opportunity, driven by the slowing growth in delinquency rates, healthy consumer financial positions, and stabilizing inflation. These factors are expected to enhance the company’s profitability significantly, with an estimated 30%+ increase in net income and stock valuation. Despite the potential macroeconomic risks, the current trends support a bullish outlook for Capital One, reaffirming its status as a buy.