What's in your wallet? If you're Capital One, until 48 hours ago, it was a ticking, public-relations time bomb called GreenPoint. This mortgage-lending subsidiary threatened to explode in the back pocket of a financial-services company that has become large and profitable by peddling credit cards. (Perhaps you've seen Capital One's "what's in your wallet?" ad campaign on television.)
On August 20, Capital One (symbol COF) announced that it would shut down GreenPoint Mortgage and lay off its 1,900 employees in 31 offices. For several weeks prior to the announcement the company's shares had taken a severe beating on Wall Street. But on August 21, investors rewarded Capital One's prudence by bidding up its share price 2.6%, to $68.47. Analysts applauded the company's foresight. "While we are disappointed to find the company's investment in GreenPoint must be fully written off, at least there will no longer be uncertainty regarding GreenPoint's prospects," Bear Stearns analyst David Hochstim wrote.
And uncertainty (read: fear) is the ruling emotion in the market today when it comes to anything remotely associated with the subprime mortgage lending meltdown. The press certainly has joined the hysteria. For instance, an online article from Fortune called Capital One's move "the latest mortgage-banking explosion to bump Wall Street's panic meter up a notch."
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Explosion? Really?
Maybe Capital One did need to pay off the barbarians at the gate with the sacrifice of GreenPoint, just as Rome paid off the Visigoths to avoid a sacking. But fear fades, fundamentals will prevail overtime, and Capital One's numbers were good even with GreenPoint.
Consider what a small portion mortgage banking played in Capital One's income picture. In the quarter that ended June 30, Capital One's interest income (generated mainly from all those credit-card balances we should, but don't always, pay off) was $2.7 billion. Income from mortgage banking was 3% of that. To thoroughly rid itself of GreenPoint, Capital One is taking a write down of $860 million, most of that in goodwill. GreenPoint was part of an acquisition that Capital One made just last year when it bought NorthFork Bank.
Capital One's shares topped $80 early this year. The GreenPoint taint in particular and the sell-off in the financial sector explain the decline only partly. Morningstar analyst Michael Kon says Capital One's attempt to diversify into banking with acquisitions such as the NorthFolk purchase has left many investors cold. "People are waiting for more evidence that Capital One can be successful in banking," he says. In addition, Capital One has had a number of write-offs in the past year that worry investors.
But such things are to be expected when putting together a new business, Kon says: "It requires a lot of work. You have to integrate banks, create management team ... there are a lot of moving parts involved." Investors are waiting to see the end result before they jump on board with Capital One, and Kon thinks that's being too cautious.
The success of Capital One's credit-card business, which Kon calls a cash cow, limits the stock's downside risk. And when you think of the credit-card business versus the mortgage business, cash cow may be an understatement. Americans can live without houses, but credit cards are a different story.
If you consider what the banking business may be worth in the future and take into account Capital One's strong cash flow, you can make a strong case that the stock is well below the company's worth. The GreenPoint write-down aside, analysts expect Capital One to earn $7.05 per share in 2007 and $8.31 next year. So the stock sells for less than ten times '07 numbers and just a bit more than eight times '08 estimates. Once the fear factor fades and assuming that credit cards aren't found to be carcinogens or some other calamity befalls Capital One, the stock could trade at $100 over the next year.
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