Capital One Deal a Home Run

Philip van Doorn - The Street  AUG 10, 2011 1:15 PM

Capital One's deal to acquire HSBC's U.S. credit card underscores a wonderful opportunity for investors.


Capital One's (COF) deal to pay $2.6 billion to acquire HSBC's (HBC) $30 billion U.S. credit card portfolio underscores how attractive the credit card business is at this stage in a weak economic recovery.

Investors seem to concur, as the shares were up over 3% to $41.93 in pre-market trading, after rising 8% Tuesday.

The deal is expected to close in the second quarter of 2012, and follows Capital One's agreement to purchase ING Direct from ING Groep (ING), which included a $2 billion capital raise that was completed in July.

Capital One said that it planned to raise an additional $1.25 billion in capital to partially fund the HSBC card acquisition. Assuming a $40 price for a common equity offering -- and factoring in the coming issuance of 55.9 million shares to ING Groep when that deal is completed in late 2011 or early 2012 -- the coming capital raise for the HSBC deal represents a further 6% increase to Capital One's common share count.

That dilution is mitigated by the shares' 10% pullback over the past week, to Tuesday's closing price of $40.82.

In its deal announcement, Capital One touted its increased liquidity from the ING Direct Deal, which would provide the cash needed to fund the HSBC card portfolio. The company also said the card portfolio acquisition would be accretive to 2013 earnings, with a "return on invested capital expected to be greater than 25 percent."

One analyst estimated that the deal would add $1.25 a share to the company's 2013 earnings. The current consensus EPS estimate for Capital One in 2013 is $6.01 a share, among analysts polled by FactSet.

Despite the U.S. housing market still going through a multi-year shakeout, credit card quality has improved dramatically and Capital One posted strong earnings over the past year, an increase focused on card lending, combined with the dramatic increase in cheap core deposits from the ING deal, looks like a home run for Capital One.

In addition to the 10% pullback for the shares over the past week -- factoring-in Tuesday's 8% rise in the share price -- the shares were cheaply valued at 1.3 times a tangible book value of $31.41 a share, according to SNL Financial.

The shares were trading for just six times the consensus 2012 earnings estimate of $6.08. That's an amazingly cheap valuation to forward earnings.

The largest U.S. banks are also trading at low forward price multiples, but none are as profitable as Capital One.

Shares of Bank of America (BAC) closed at $7.60 Tuesday, and were trading for just four times the consensus 2012 earnings estimate of $1.51 a share. The company booked an $8.8 billion second-quarter loss, and its operating return on average assets (ROAA) for the 12-month period ended June 30, was a negative 0.65%, according to SNL.

JPMorgan (JPM) closed at $36.40 Tuesday, or six times the consensus 2012 EPS estimate of $5.68. The company's 12-month ROA was 0.96%, according to SNL.

Wells Fargo (WFC) closed at $24.78, for a forward P/E of 6.5, based on the consensus 2012 EPS estimate of $3.51. The company's 12-month ROA was 1.20%.

Citigroup (C) closed at $31.82 Tuesday, or five times the consensus 2012 earnings estimate of $5.13, with a 12-month ROA of 0.52%.

Meanwhile, Capital One's 12-month return on average assets was 1.77%, according to SNL.

Even with the further dilution from the HSBC card deal, Capital One looks like a winner for long-term investors with any confidence in the U.S. economy. The card business is far more profitable than the more diversified but slow-growing -- or shrinking -- loan businesses of the largest U.S. banks. The deal also fits in quite well with the ING Direct deal, and dilution concerns are mitigated by the stock's historically low valuation.