This Banking Behemoth Is Ready for Prime Time

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Ten years ago no one would have thought of Capital One (NYSE: COF) as a bank. It was a pure play on consumer credit with a focus on credit card lending. It had the backing of Wall Street, raising funds from the credit markets with debt issuances to make money available to its credit card customers.

Fast forward 10 years and Capital One is a diversified operation spanning everything from deposit accounts to commercial loans.

Here’s why this stock offers promise.

Capital One’s bold move

When companies raise money from Wall Street, they get a few favors along the way. More analysts cover the stock. Investment banks enjoy commissions from underwriting proceeds, and your brand enjoys better perception among those on the street.

Capital One ditched that model, later acquiring ING Direct to become a traditional banking operation. Now, credit cards are only 40% of its business, with another 40% coming from consumer lending and 20% from commercial.

ING Direct brought substantial low-cost financing to the table. Sourcing credit from deposits results in a much lower cost of capital. Capital One raises deposits at just 68 basis points; these assets are then invested in auto, consumer, and commercial loans several times higher.

As of the first quarter 2013, deposits made up 72% of its liabilities.

How Capital One can compete

Capital One is a very different play on banking. First, it does not have its own network, so its assets and earned income are the direct result of lending. American Express (NYSE: AXP) and Discover (NYSE: DFS) both own their own closed-loop networks, exposing them to profits from transaction fees – fees which may become the subject of future regulation and new payment innovation that may bypass traditional processors.

Second, Capital One sources assets less expensively than its peers. Discover’s deposits cost the company 1.8% per year, some 112 basis points higher than Capital One. Discover sources funds directly, and through the help of brokers, which increase its cost of funding.

American Express raises funds via the commercial paper and credit markets, and also from deposits. The company’s deposits came in at a cost of 1.3% in 2012, nearly twice as much as Capital One.

Rising on Bernanke

Banks borrow at one rate, and hope to lend at a higher rate. Since financial products are a relative commodity, customers frequently shop on price. The bank that can offer the lowest rate earns a customer’s business.

Sourcing funding with deposits allows for a much lower cost of financing. Capital One’s $190 billion in deposits make up a substantial portion of its asset base of $232 billion as of the first quarter 2013. 

Capital One's financing sources position it for perfection.

If Bernanke & Company go through with tapering, long-term rates will rise. Higher long-term rates will affect American Express and Discover, which use longer capital market debt financing, but Capital One’s short-term deposit costs are unlikely to move on changes on the long-end of the curve.

Bernanke will pull from his $85 billion long-dated U.S. Treasury and MBS purchases first. That affects the debt markets. The federal funds rate, the short term rate, is likely to go unchanged. Capital One's deposit costs are closely tied to federal funds rates, which are stuck at 0 to .25%. 

That’s why I think Capital One is the best play in credit card and consumer banking. The company has a very stable, low-cost asset base with very little interest rate sensitivity. Should rates head higher, expect net interest margin at other lenders to compress while Capital One’s net interest margin increases on everything from credit cards to automotive loans.

Capital One can use its funding advantage to 1) grow its business with price investments to steal share or 2) deliver more net income to shareholders. Either move is great for long-term Capital One bulls. I’m long COF on CAPS as a play on the company’s widening moat and the eventual effects of Fed tapering.

Many investors are terrified about investing in big banking stocks after the crash, but the sector has one notable stand-out. In a sea of mismanaged and dangerous peers, it rises above as "The Only Big Bank Built to Last." You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.

 


Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends American Express. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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