Friday, 11 July 2008 01:00

Reggie Middleton on Consumer Finance Shorts

Written by

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

Thursday, 10 July 2008 01:00

An inspiring email from a reader

Written by

Quite a few readers have emailed me with similar stories. I thought I would post this one, with permission, of course.

I know that I've said thanks. I'll say it more before its over, no doubt.

Since Jan 16, 2008....we have doubled my initial investment while keeping over 50% in cash. Thats short term - pay taxes on it and I'm sittin on half that much paper gain.

I don't know much but I can read. That was achived usin what I've come to call 'sell and wait'.

About 3 months in I noticed I was 'early' often. I took a nore relaxed approach and things got easier.

I 'missed' bear btw so this wasn't a 1 shot deal.

I've learned and hopefully will be more adept as time goes on.

My major drawback is I take too many naps. :-)

The mortgage market has not even started to "really" fall apart yet. The "worst is behind us", indeed!

U.S. Mulls Future of Fannie, Freddie

The Bush administration has held talks about what to do in the event mortgage giants Fannie Mae and Freddie Mac falter, according to three people familiar with the matter, as the stock prices of both companies continue to fall sharply.

These were two of the most obvious shorts to make in the mortgage crisis -pure mortgage lenders and insurers!

From Bloomberg: Fannie Mae, Freddie Losses Make Them `Insolvent,' Poole Says :

Chances are increasing that the U.S. may need to bail out
Fannie Mae and the smaller Freddie Mac, former St. Louis Federal
Reserve President William Poole said in an interview. Freddie
Mac owed $5.2 billion more than its assets were worth in the
first quarter, making it insolvent under fair value accounting
rules, he said. The fair value of Fannie Mae's assets fell 66
percent to $12.2 billion, data provided by the Washington-based
company show, and may be negative next quarter, Poole said.

``Congress ought to recognize that these firms are
insolvent, that it is allowing these firms to continue to exist
as bastions of privilege, financed by the taxpayer,'' Poole, 71,
who left the Fed in March, said in the interview yesterday.

For those that have been following my posts on the investment banks, these companies have been quite profitable for my proprietary account. To date:

Morgan Stanley Lost Money Trading 16 Days in Second Quarter, Filing Shows

July 9 (Bloomberg) -- Morgan Stanley, the second-biggest U.S. securities firm by market value, lost money on 16 trading days during the second quarter, twice as many as in the prior period, as the firm made wrong-way bets on energy and stocks.

The firm also earned $125 million or more on 10 trading days during the period, one day less than in the first quarter, according to a filing with the U.S. Securities and Exchange Commission today. Goldman Sachs Group Inc., the largest U.S. securities firm, said this week that it lost money on 20 days in the second quarter, up from 17 days in the first quarter.

... During the second quarter, Morgan Stanley reclassified to Level 3 from Level 2 about $7.2 billion of corporate and other debt, including commercial mortgage loans and commercial mortgage-backed securities, because of a decline in trading and available market prices. At the same time, about $5.8 billion was reclassified to Level 2 from Level 3 as trading resumed for certain corporate loans and loan commitments.

Goldman Sachs this week said Level 3 assets fell to 7 percent of the total from 8.1 percent in the first quarter.

Morgan Stanley's so-called Tier 1 ratio, which bank regulators monitor to gauge a lender's ability to withstand loan losses, was 12.4 percent in the second quarter. That compares with 10.8 percent at Goldman.