Capital One On Hold: Consumer-Driven Banks Could Face Recession Headwinds In 2023

Summary:

• A potential recession in 2023 could hit consumer-driven banks hardest.
• Capital One has lacked YoY growth in dividends or capital ratios.
• Unlike its larger banking sector peers, Capital One is too concentrated in consumer banking and credit.
• A risk to my bearish outlook could be a favorable interest rate environment throughout 2023 and recession projections being wrong.

Capital One Financial (NYSE:COF) released its Q1 2023 earnings recently on April 27th, and I am calling a bearish rating on this bank for the rest of 2023.

My thesis is based on several notable projections of a potential recession in 2023 which could impact consumers, the lack of YoY growth in dividends and capital ratios by this bank, and the lack of business segment diversification unlike its larger banking peers who also generate sizeable income from wealth management and asset management fees, and trading.

A potential risk to my argument could be that the recession projections turn out wrong and there is a consumer-driven economic tailwind this year, but also a continuing interest rate environment that will boost all banks’ interest revenue for 2023, driving a tailwind into Capital One’s next few earning reports as well.

Here is a closer study into my thesis below, and as a reference here is are the official consolidated Q1 2023 results of Capital One:

As the consolidated results show, net interest income grew YoY, while net income fell YoY, as did earnings per share. At the same time, dividends remained flat and had no growth YoY, remaining at $0.60 per common share.

A potential recession in 2023 could hit consumer-driven banks hardest.

I would argue that a mild recession is in store sometime in 2023, and this will affect consumer spending and borrowing habits, as well as increase potential defaults on loans, which can affect consumer-driven banks like Capital One.

My sentiment is driven by the fact that credit is becoming just too expensive, and the US and Europe are both very credit-driven economies. It is simply costing too much to borrow, combined with costing too much to buy things due to inflation, with the overlay in recent months of many layoffs.

In fact, just a few days ago, a May 2 Reuters article remarked that “U.S. job openings fell for a third straight month in March and layoffs increased to the highest level in more than two years.”

Capital One Financial, according to its website, does have a commercial banking division as well, but its roots in 1988 are that of a credit card company at heart and in my opinion they are known more for their consumer products.. particularly cards, no-fee checking accounts, auto loans, and more recently their promoting of certificates of deposit, some of which I have seen offering as high as a 5% APR. In fact, I have personally gotten many of their credit card and CD offers in the mail many times.

My sentiment of a potential recession affecting this bank specifically was echoed as early as January in an article in financial portal Pymnts.com. According to the analysis,

As The Wall Street Journal reported Monday Jan. 30, Capital One and American Express are among the companies that increased their rainy day funds, an indication they’re anticipating an end to an era of high consumer spending and record low unemployment.

As early as last November, talk of potential recession was already in the air. It was echoed in this article on Bankrate that reiterated :

There is widespread agreement that a recession is likely in 2023 or early 2024. Many observers feel that a recession is the only logical outcome of the Federal Reserve’s quest to lower the highest inflation readings in 40 years with an aggressive series of interest rate hikes.

Let’s overlay that with Capital One’s recent Q1 figures, which clearly show that both their allowance for credit losses went up 27% YoY and the net charge-offs went up 121% YoY:

Capital One has had no growth in dividends or capital ratios.

One thing I care about when analyzing a bank is growth in dividends over an extended period, as well as increase in capital ratios. I want to see that a bank is increasing the amount it is paying back to its common shareholders, as a sign of capital strength.

In the case of Capital One, as you can see from its Q1 2023 results below, its dividends were flat YoY and its capital ratios YoY actually went down.

As you can see, its CET1 capital dropped slightly to 12.5% from 12.7% the same quarter a year ago.

Below, you can see that the dividend growth was flat at $0.60 per common share, not having increased at all YoY.

Some of the larger players in the banking sector, such as Bank of New York Mellon, actually increased their dividends YoY, from $0.34 to $0.37.

This tells me that a company is in a healthy capital position to return more money back to shareholders. I am concerned that Capital One is still flat on dividend growth and is therefore trying to preserve liquidity.

Unlike its larger banking sector peers, Capital One is too heavy in consumer banking and credit.

In my opinion, the fact that Capital One does not have much of a business in asset management, wealth management, custodian banking, trading, and the scale of one of the global systematically critical banks listed by the Financial Stability Board, but rather is known for consumer banking & credit products primarily, makes me hesitant in the current environment to be bullish on it.

This sentiment was echoed in an analysis in financial portal The Motley Fool, which affirmed that:

Capital One is uniquely vulnerable.. it is a credit card player, serving over 100 million customers. The company has historically aimed its offerings at consumers with less-than-ideal credit scores.

A risk to my bearish outlook could be a favorable interest rate environment throughout 2023 and recession projections being wrong.

On a positive note, I want to highlight the growth in net interest revenue that Capital One has achieved in its most recent results above.

Based on the latest May 3 decision by the Fed, I would admit that Capital One could continue to benefit from the current rate environment, in terms of its interest-bearing assets, so this could be a tailwind for it in 2023.

According to a story in NBC News,

The Federal Reserve announced Wednesday it was raising its key federal funds rate to more than 5% — a 16-year high. The latest decision comes at a fraught moment as high prices, high interest rates and slowing growth would all seem to spell an economic downturn.

However, a contrarian view to that is of St. Louis Fed President James Bullard, who shrugged off the potential for a recession back in early April. In an article in Business Insider, he stated that “the conditions are not strong enough to draw the US into a recession — especially as recent lending facilities extended to banks have been proven effective.”

If he is right, the risk to my thesis is that Capital One Financial could end 2023 in a much stronger position than where it looks now, and at a much stronger share price driven by a new investor confidence in the banking sector sometime in Q2 or Q3 of this year, perhaps.

Share Price Potential for 2024.

Looking forward at price potential for Capital One for the rest of 2023 and going into 2024, if the recession predictions play out and the next quarterly results for Capital One are lackluster, I don’t believe there will be a lot to drive its share price too much past its early May range in the $88 – $90 vicinity, especially if a few more regional banks fail, causing downward pressure on bank stocks in general, as we have seen with the March dip after the failure of a few regional banks in the US.

Here is the price chart since the beginning of 2022, with the 30-day simple moving average as an overlay.

Much like other equities, Capital One faced the dual market shock of war and rising inflation in 2022, then generally followed a downward price trend, with a rebound in early 2023, then hit with the banking crisis of recent bank failures in March, and more recently the failure of First Republic Bank.

I don’t see a lot of bullish potential for Capital One until at least 2024, when I expect the rate environment to stabilize and recession talk to ease, causing equities and the S&P500 to get back to the levels they were at during the start of 2022.

Conclusion.

In conclusion, I am reaffirming my bearish outlook for Capital One Financial.

To summarize, my rating is due to increased probability of a recession in 2023, the bank’s weak growth in dividends & capital ratios, and lack of business segment diversification.

To reiterate, a risk to this bearish rating could come from recession projections being wrong and consumer banks benefiting, but also a continued interest rate environment which will be favorable to most banks in general and will continue to help boost Capital One’s fundamentals. This is also why I did not choose a Sell rating but rather a Hold rating at this time, since the interest rate environment is still in all banks favor.

When it comes to being bullish, at this time I personally am sticking to the much larger, more diversified banks not heavily exposed to consumer banking.

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