Friday, 11 July 2008 01:00

Reggie Middleton on Consumer Finance Shorts

I have decided to share a portion of my interest in the consumer finance sector with the blog. I put a team together to focus on this sector before moving on to develop the next leg of my investment thesis. We have shortlisted 8 companies in the US consumer lending sector for further fundamental analysis. We will be looking more closely at these companies and reviewing their financial statements and foot notes. I'll share the procedure and two of the finalists (sounds like a beauty pageant, doesn't it?) as well as one that was booted from the list.

We selected these companies based on the following procedure:

From our initial list of 825 companies globally, we selected 525 companies by excluding 290 companies for which price information was not available and were having market cap of less than 2.5 mn. Of the remaining 525 companies, we selected 146 companies based on relevance of business in the following line of business - Credit cards consumer installment, credits loan guarantees, secured/unsecured consumer lending, real estate lending, consumer lending and financing, capital funding service, outsourced receivables management, pawn brokering services, financial guarantee insurance.

Of the remaining 146 companies we excluded 26 companies which had witnessed price decline of more than 65% over the past one year. We obtained 34 US companies (in the remaining list of 120 companies), of which 6 were excluded with market cap of less than $10 mn.

The following are 3 out of the 8 companies that were shortlisted from the list of 28 US companies for further scrutiny:

American express (AXP) :

· AXP with adjusted P/B of 6.47x trades higher than most of its peers.

· The company’s net charge-off’s to loans in 2007 was 4.0% while its total allowances to loans was 3.4% suggesting that the company might have inadequate provisioning

· AXP’s total debt to common stood at 662.3% at the end of 2007 while its leverage at 13.6x is considerably high when compared to its peer group.

Capital One (COF) :

· COF’s five year EPS growth (geometric) is at a negative of 0.3% reflecting the company’s dismal performance.

· COF’s return on equity and return on assets at 6.3% and 1.0% , respectively for 2007 is significantly lower than its peer group.

· 30 day+ delinquency rates for credit card segment increased to 4% in 1Q2008 from 3% in 1Q2007 while charge-offs for US credit card segment had increased to 5.85% from 3.72% in the comparable period.

SLM Corporation (SLM) :

· SLM’s 5 year geometric EPS and NIM growth of -6.1% and 2.2% is quite low when compared to its peer group.

· SLM has very thin NIM margin of 1.3%.

· The company is highly leveraged with leverage ratio of 29.7x and total debt to capital at 4,019% (sourced from Bloomberg)

· SLM’s total reserves at 0.8% of total loans could be inadequate to cover for future charge-offs.

· Although the stock has declined nearly 63% over the past one year its still trading at $19.4 . A further probe revealed that there was not enough meat left on the bone for significant downside potential from the current levels.

The next step was to whittle down the 8 companies chosen to a manageable chunk...

Among the 8 companies shortlisted for further scrutiny, we have looked at the first 7 and have shortlisted 3 companies based on the following observations (I'm only publsihing two for now).

Capital One:

· Note: Capital One was on my radar last year and earlier this year as having the highest default rate among its peers, but I decided to move on to other targets on both occasions. Despite the price drop and a more stringent screening process, it shows up in the scan once again. Capital One’s loan portfolio comprising credit card business, auto finance business and international business is facing problems as reflected by higher delinquency rates (30+ days) in its US credit card business, auto finance business and international business at 4.04%, 6.42% and 5.12%, respectively in 1Q2008, up from 3.06%, 4.64% and 4.78%, respectively in 1Q2007.

· Its net charge offs increased 78% to $767 mn in 1Q2008. Also, its allowances for loan losses increased 44% to $3.3 bn.

· Despite increase in delinquency and charge-offs, the company’s provisioning for loan losses seems inadequate. In 1Q2008 COF’s provision to loans were 1.10% while chare-offs to loans stood at 3.07%. Its provision to losses was consistently below its charge-off rate in the previous four quarters

· Its net interest income growth (q-on-q) slowed down drastically to 2.8% in 1Q2008 from 5.6% and 8.5% in 3Q2007 and 4Q2007, respectively.

· Non interest income growth (q-on-q) was negative 4.7% in 1Q2008 compared to 11.1%, 9.0% and 0.4% in 2Q2007, 3Q007 and 4Q2007, respectively.

· Its adjusted leverage also increased from 11.7x in 1Q2007 to 13.4x in 1Q2008

American Express (AXP)

· AXP’s ‘reserves as % of consumer receivables’ at 3.6% in 1Q2008 as against ‘loans 90 days past as % of loans’ at 4.4% reflect that the company has inadequate allowances for bad loans.

· AXP’s write-offs for consumer receivable loans have increased to 0.78% of loans from 0.62% in 1Q2007 while write-offs for Card member loans have increased to 0.74% in 1Q2008 from 0.55% in 1Q2007.

· Despite increase in charge offs and inadequate provisioning, AXP’s adjusted P/B of 6.47x seems significantly higher than its peers

· Leverage has increased from 11.7x in 1Q2007 to 14.6x in 1Q2008.

SLM corporation has also witnessed similar trend in its provision for loan losses and write offs but the stock has already witnessed around 65% decline in its price over the last 12 months. Therefore, the same has been excluded from our list of 3 shortlisted banks.

Of the above companies, AXP and Capital One appear more venerable based on initial analysis.

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Market metrics

COF US EQUITY

AXP US EQUITY

Consumer Fin

Consumer Fin

Line of business

Credit card & consumer lending

Travel related

Consumer Fin

Consumer Fin

Business descrption

Capital
One Financial Corporation provides a variety of products and services to
consumers through its subsidiaries. The Company through Capital One Bank
offers credit card products. Capital One F.S.B. provides certain consumer
lending and deposit services. Capital One Services Inc. provides operating
administration and other services to the Corporation. Obvious credit risk
abounds.

American
Express Company through its subsidiaries provides travel-related financial
advisory and international banking services around the world. The Company's
products include the American Express Card the Optima Card and American
Express Travelers Cheque. Exposed to credit risk and the coming consumer
entrenchment and global slowdown – effected by higher fuel prices that hamper
travel and lower real wages that hamper spending the proclivity to pay back
loans.

Share price


38.0


37.7

Shares outstanding


372.9


1,158.0

Market Capitalization


14,261.1

43,637.4

Enterprise Value


40,939.2


98,676.4

52 Week High

79.4


65.9

52 Week low


37.3


37.6

- Price as % of 52 week high

Price Performance (%
change)

3 months

-20%

-10%

12 months

-48%

-33%

Valuation metrics

COF US EQUITY

AXP US EQUITY

Book value per share


65.16


9.52

Tangible book value per share


30.74

8.05

Earnings per share


4.02


3.42

Revenue per share

49.02


26.90

Price / Sales


0.95

1.92

Price / Earnings


6.87


15.10

Price / Book Value

0.71


5.42

Price / Adjusted Book value


1.54


6.47

Price / FCF


1.57


8.03

Ratios (2007)

COF US EQUITY

AXP US EQUITY

5 yr EPS growth

(0.3)


11.1

5 yr NIM growth


19.2

1.1

NIM Margin


5.3


5.4

Efficency ratio

54.4


65.6

Net Revenue Margin


76.2


87.9

Operating Margin


20.9


17.8

Pre tax margin


20.2

17.6

Provision for loan loss to Total
Loans


2.7


7.8

Reserve for loan loss to Total
Loans


2.9


3.4

Net Charge off to Average Loans

2.0


4.0

Net Interest Income to Earnings
Assets


3.2


(0.5)

Interest Income to Average Loans


10.2


14.9

Interest expense to Total Deposits

5.4


27.9

Earnings assets to Interest
bearing liabilities


101.3

80.5

Return on assets


1.0


2.9

Return on common equity

6.3


37.3

Total debt to common equity


153.5

662.3

Total debt to Assets


24.8


48.8

Total loans to total assets

67.6


36.9

Total loans to total capital


165.3


65.8

Leverage (x)


6.2


13.6

Interest income

10,127


7,416

Net Interest income


6,530


3,590

Provision for loan loss


2,637


3,901

Interest expenses


4,548

3,826

Non interest expenses


7,940


18,198

Earnings assets

121,903


71,176

Total Shareholder's equity


24,294


11,029

Total Assets


150,590


149,830

Reserve for loan losses


2,963


1,876

Net Income


1,570


4,012

Non performing assets

936

Last modified on Friday, 11 July 2008 01:00

12 comments

  • Comment Link Tony Piggs Sunday, 13 July 2008 20:53 posted by Tony Piggs

    I also spent time comparing AXP to DFS and see two fairly similar companies in very different positions. DFS hasn't grown their card portfolio aggressively at all, likely due to dealing with the Morgan Stanley spinoff. Also MS seems to have funded DFS pretty well for the spin. DFS also has less exposure to CA&FL and their clients are pretty seasoned -the average card holder has been with them over 5 years (I think 80%, if I remember correctly). Their processing business is growing nicely too, even though it is a second rate processor. DFS's debt to equity is markedly lower than AXP's. DFS will have to take up reserves too, but probably not as much as the rest of the industry. This one might make a nice long. I welcome any readers' comments that may have looked at it.

    Report
  • Comment Link Phil V Sunday, 13 July 2008 01:40 posted by Phil V

    fcampbel:

    That makes sense on AXP. As for european banks, didn't reggie mention HSBC as a suitable candidate? I think banks with substantial exposure to the PIGS and UK and eastern-europe are the obvious short-candidates.

    Report
  • Comment Link Tony Piggs Saturday, 12 July 2008 23:58 posted by Tony Piggs

    My work on AXP suggestes we could easily see it in the low 30's. Reserves will almost certainly have to increase as a large % of their client base is in CA&FL. They have grown too aggressively and their debt/equity has increase dramatically (more than doubled) over the last 5 years.

    Report
  • Comment Link Tony Piggs Saturday, 12 July 2008 23:54 posted by Tony Piggs

    Regarding the world crashing, if you're interested in getting in early on shorts, I would look to European banks. Europe had the same insane house price appreciation that we did and its banks are in the same situation as ours. Europe hasn't hit the wall yet, but is starting to.

    Report
  • Comment Link Phil V Saturday, 12 July 2008 19:56 posted by Phil V

    Does shorting AXP make sense? Are their customers really defaulting? Every business class seat to and from Dubai is totally packed. Even damascus is hopping!

    The US is sunk, but I totally disagree that the world is crashing.

    Report
  • Comment Link D Jester Saturday, 12 July 2008 01:41 posted by D Jester

    Interesting screening criteria, kicking out the names that have already declined more than 65% in the past year. Sometimes, the easiest shorts are the ones that have already declined a lot.

    As one acquaintance said, somewhat crudely, he likes to look for a animal on a roadside that has by a car and is staggering. Then he pulls up real easy and shoots.

    Report
  • Comment Link ralph allen Friday, 11 July 2008 13:03 posted by ralph allen

    I currently have puts on COF at 35 Strike expiring Jan 09 and I am short the stock. I cashed out of some of my 55s last week. Not a great Idea, but plowed some of the profits into the 35 puts. IMHO taking profits and redistributing is always a safer way to move.

    I did not short AXP since most of it customers do not float the balance. Limited funds kept me to COP. This is a target rich environment for shorting.

    The biggest missed opportunity was GM. When the CEO said they were putting Hybrid technology on the Yukon I knew this guy had lost touch with reality. GM was a great short since gas and the economy was going to have double impacts. Hind sight is always 20/20. One lesson to take away is ALWAYS bet against stupidity!
    I think that many foreign corporations in the banking industry will be the next target. Like on guest on the boat said some foreign banks are not learning from America’s mistakes.

    As always I stand in admiration of your analytical abilities.
    Thanks Ralph

    Report
  • Comment Link a b Friday, 11 July 2008 04:52 posted by a b

    I'm sure you mean "vulnerable" not "venerable" above.

    Report
  • Comment Link a b Friday, 11 July 2008 03:46 posted by a b

    Of course. Argentina most recently; Russia defaulted on its debt in '98. The Ottoman Empire declared bankruptcy in 1875.

    Report
  • Comment Link Johnny Lay Friday, 11 July 2008 02:54 posted by Johnny Lay

    Is it possible for National Government to go bankrupt?

    Oh, and about that spellin above...mulishness
    n : the trait of being difficult to handle or overcome

    Report
  • Comment Link Reed Harvey Friday, 11 July 2008 02:37 posted by Reed Harvey

    One thing about COF is that it a bank. It offers insured accounts at very good interest rates. I used to have a bank account there until early 2007 when I saw the writing on the wall. I would be more interested in a company that is completely leveraged to consumer debt.

    Report
  • Comment Link Johnny Lay Friday, 11 July 2008 02:31 posted by Johnny Lay

    Maybe we are up early...

    CR has a post on a 'third' way for Fannie or Freddie.

    http://calculatedrisk.blogspot.com/2008/07/conservatorship-for-fannie-or-freddie.html

    As one of 'Reggie's Regulars' ( a soon to be FAMOUS Regiment in the 'Money Mulish-a').

    I'm in already.

    Maybe I been up too long.

    Report
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