CAPITAL ONE FINANCIAL CORP by niusheng11

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									               UNIVERSITY OF OREGON                                                                                                                February 15, 2002
                                                                                                                                                                  Financials
                            INVESTMENT GROUP


CAPITAL ONE FINANCIAL CORP.
                                                                                                                        HOLD

                                                                                                      Daily Closing Price
 Stock Data
                                                   80
        Price (52 weeks)    $36 - $76              75
     Symbol/Exchange        COF/NYSE               70
                    Beta    1.47                   65
                                                   60
         Dividend yield     0.24%                  55
    Fully diluted shares    214.9 million          50
 Average daily volume       2.7 million            45
    Current market cap      $10.7 billion          40
                                                   35
     Book Value/Share       $14.14                 30
               LTD ratio    1.83%                    Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec- Jan-
                                                      01 01     01   01   01   01   01   01  01    01   01   02
 Valuation (per share)
         FCF Analysis       $15.12
 Comparables Analysis       $52.74                                                                  Daily Volume
         Current Price      $47.11                 5,500,000
                                                   5,000,000
                                                   4,500,000
                                                   4,000,000
 Summary Financials (in millions)                  3,500,000
                                                   3,000,000
                                2001A              2,500,000
                                                   2,000,000
            Revenue            $7254.3             1,500,000
            Earnings            $643.9             1,000,000

     Free Cash Flow             $259.2
                                                               Feb-01

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                                                                                                                                                         Dec-01
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                                                                                                                                                                  Jan-02
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                                                                                                                                       Oct-01


Business Overview

Capital One Financial Corporation (COF) is a holding company, incorporated on July 21, 1994 via a spin-off
from Signet Bank. They provide a variety of products and services to consumers using its customized
information-based strategy (IBS). COF's principal subsidiary is Capital One Bank, a limited-purpose credit
card bank, which provides various lines of credit card products. It is one of the top ten credit card issuers in
the U.S. and one of the largest providers of Visa and MasterCard. Capital One, F.S.B. (Savings Bank), a
federally chartered savings bank, offers consumer lending and deposit products. Capital One Services Inc.,
provides various operating, administrative and other services to COF and its subsidiaries. COF's business
consists of both lending and non-lending activities. Its lending activities consist primarily of credit card
products, but also include other consumer lending activities, such as unsecured installment lending and
automobile financing. Its non-lending business activities consist primarily of its retail deposit-taking business
and various non-lending new business initiatives.

In June 1996, COF established F.S.B. to expand its product offerings and its relationship with its cardholders.
F.S.B. takes deposits and offers a variety of credit card and installment loan products. Through F.S.B., COF
expects to offer multiple financial products and services to existing cardholders and other households
applying IBS and existing information technology systems. In 1998, COF acquired Summit Acceptance Corp.,
a small auto finance company and renamed it Capital One Auto Finance.
Capital One Financial Corp.                                          university of oregon investment group
                                                                                      http://uoig.uoregon.edu


COF had 43.8 million customers and $45.3 billion in managed loans outstanding for the year ended 2001.
COF’s managed loan portfolio grew 53% in 2001. This helped COF to boost its earnings by 31% in the past
year. The auto loan portfolio grew by 175%. This accounted for 13% of the loan outstanding growth for 2001.
This extensive growth seems to be fueled by COF’s risky borrowing to consumers with iffy credit histories.

International Operations

COF offers credit card products outside of the United States through Capital One Bank (Europe) PLC, an
indirect subsidiary of the Capital One Bank, organized and located in the United Kingdom through a branch of
the Bank in Canada, and through the COF's involvement in a joint venture with a South African financial
institution Nedcor. COF has foreign operations primarily in the United Kingdom and Canada, with
additional operations in South Africa and France.

Information-based Strategy (IBS)

In an industry where “one size fits all” was the standard for meeting credit requirements, Information-based
Strategy changed the standards. The credit card industry managed risk by charging all customers the same
high interest rates and refusing credit to those who did not fit narrow credit parameters. IBS allowed many
customers their first access to credit. COF customized its products by combining different product features,
including annual percentage rates, fees and credit limits, rewards programs and other special features. COF's
customized products include both products targeted at a range of consumer credit risk profiles, such as low-
rate cards and secured cards, as well as products aimed at special consumer interests, such as affinity, co-
brand and student cards. The COF's pricing strategies are risk-based, with lower-risk customers more likely to
be offered products with more favorable pricing. IBS follows rigorous scientific testing protocol to find
successful products. IBS is implemented throughout all of COF’s subsidiaries. IBS is also used by human
resources to help identify the best job candidates and to cut recruiting costs.

Marketing Campaign

COF has spent nearly $1 billion on advertisement campaigns to promote the “Capital One” brand. You may
all be familiar with the slogan Capital ONE, “What’s in your wallet?” They have twice as many solicitors as
the nearest competitor. COF is one of the largest providers of Visa and MasterCard. Sponsorships have also
played a key role in COF’s marketing strategy. It has formed alliances with Kmart (now defunct) and BMG
Entertainment to provide benefits with the co-branded Visas. Some of the more popular co-branded credit
cards have been through airlines, where customers can earn skymiles when using their cards.

Human Capital

COF has over 20,000 associates within its company. It has been ranked as one of the “Best Companies to Work
for in the U.S.” for 4 years straight by Fortune magazine. COF emphasizes the balance of work and family for
its associates. The company encourages community involvement and participation in social programs for
underprivileged kids and also with assisting in improving and restructuring community services. In internal
survey was conducted showed that 96% of its associates were happy to work for COF.




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Capital One Financial Corp.                                                    university of oregon investment group
                                                                                                   http://uoig.uoregon.edu


Internet Services

In 2000, the Company launched CapitalOnePlace.com, where it offers consumers a variety of products
available for purchase online, some of which are offered in partnership with other companies. Capital One's
Internet services provide significant support for its lending business. Services include account decisions, real-
time account numbering and account servicing. Like other credit card providers, COF is able to process,
customize, and issue credit card accounts in a matter of seconds. Customers are able to track their spending,
payments, account balance, and limit through the site.

Enronitis / CFO Rumors

After increasing its managed loan portfolio by 53% and posting a 31% earnings growth over the past year,
COF has come under fire by its rivals for declining to divide up its managed loan portfolio. The extensive
earnings growth is fueled by a substantial increase in its auto loan segment. Its auto loan portfolio grew by a
whopping 175% over the past year and accounted for 13% growth of its loan portfolio as a whole. Its rivals are
speculating that COF has strayed away from its standard and stringent lending policies and have loaned credit
to high-risk borrowers with dark credit histories. COF could show its earnings are not heavily reliant on its
auto loan portfolio and maybe cause its stock to rise, although COF declined to publicly divide its managed
loan portfolio, raising questions about its creditworthiness. Especially after the Enron scandal, this has raised
a red light to its investors and the industry.

There have been rumors throughout the industry saying that Executive VP and CFO David Willey is leaving
and that the company is searching for a replacement. COF have denied the rumors, but in the wake of
accounting troubles in the corporate world, many are taking these rumors much more seriously.

Selling of Notes / Stock Shelf

Last month, COF sold $300 million in five-year notes. On February 6, COF sold $1.5 billion in debt securities in
order to pay off short-term debt, for possible acquisitions, investments in, extensions of credit to, and its
subsidiaries and securities investments. Stock shelf: a company may sell securities from time to time in one or more offerings
in amounts, at prices and on terms to be determined at the time of sale.

Insider Trading Activity

Over the last six months, there have been four share acquisitions and one transaction as a gift.




                                                                                                                            3
Capital One Financial Corp.                                          university of oregon investment group
                                                                                       http://uoig.uoregon.edu


Industry Analysis

Consumer credit in November jumped by a record $19.9 billion, to $1.653 trillion, amid a boom in mortgage
refinancing and car sales. Consumer spending in November was at record levels due to special 0% financing
offers by the big three automakers in the U.S. The increase was the largest nominal rise since the Federal
Reserve began reporting consumer credit data almost 60 years ago. The Federal Reserve cut the interest rates a
record 11 times during 2001 lowering the funds rate from 6.5% to 1.75% at the beginning of 2002. Consumer
spending is not likely to grow at a healthy rate in the first half of 2002 due to heavy spending in the last
quarter of 2001.

Recession

In November, the National Bureau of Economic Research said the U.S. economy entered a recession the
previous March. Optimists have been hoping that means a turnaround is already under way and that
noticeable economic improvements will be evident by the second half of 2002. During the past 50 years, the
average recession has lasted about 11 months. In times of recession, credit card companies are hammered by
many effects. The rate of borrowing is down and credit losses pile up. Delinquent accounts are up. Credit
quality is down, which leads to higher loan loss provisions. Credit risk and defaults remain the prime concern
within the industry, especially with the recession in play. Many companies are moving toward customers
with lower credit quality to in order to keep up growth.

Consolidation

This topic continues to be on the radars of most companies within the financials industry. Firms are on the
lookout for other firms to merge with or acquire to expand into new geographical markets and to add new
product lines. M&A is forecasted to pick up in the second half of 2002.

Bankruptcy Reform

In March of 2001, Congress passed a bankruptcy reform bill that would have made difficult, and in some cases
impossible, for borrowers to file for personal bankruptcy protection. The President’s signature was all that
was needed to put it into effect. Then came September 11 and its endless stream of events. Since then, this
topic has become a backseat focus in Congress and has yet to breathe life. With recession and terrorism issues
at the top of the list, it seems like it will take time for the reform bill to be enacted. The American Banking
Association and the Federal Reserve have been aggressively backing the reform bill and now see little hope in
quick reform.

Nearly 1.5 million people filed for personal bankruptcy in 2001. The average household owes 104% of its after-
tax income. Credit card user growth is the highest in households with below median earnings. Consumer
savings rate plunged from 8.7% in 1992 to 1% in 2000. The heavy spending by consumers was not done out of
wealth, but on credit.




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Capital One Financial Corp.                                            university of oregon investment group
                                                                                         http://uoig.uoregon.edu


Outlook

With slow growth in the mature lending business, M&A activity is likely to pick up in order to increase
revenues and efficiency. S & P expects unemployment to peak at 6.5% in the early third quarter. The Labor
Department said Thursday that initial unemployment claims for the week ended Jan. 5 fell 56,000, to 395,000,
which some viewed as a sign of stabilization in the job market. Current worries are not only the recession, but
fears of geopolitical risks and terrorist attacks. As bankruptcy reform is aggressively pushed for and as the
Enron effect stabilizes, the industry is expected to become more regulated.


Discounted Cash Flow Analysis

I used a percentage of interest income/non-interest income for COF’s cash flow analysis. With per unit or
service revenues not valid in this case, I forecasted separate income streams for interest income and non-
interest income. Interest income would be considered income from loans on credit card purchases and non-
interest income would be the service fees charged to a cardholder. With that in mind, I found forecasting each
of these income streams to be quite difficult. With historical growth rates fluctuating and a recession at hand, I
attempted to be conservative, yet at the same time tried to keep COF’s strategy and characteristics in mind
when forecasting its performance. For the interest income, I felt that the 50% growth rates in the past were not
attainable in the future. Also, with lending policies becoming more scrutinized by investors and the industry,
I did not think COF would be able to consistently expand its cardholder base as it did in the past. With debt
on the rise and with record spending in the last quarter of 2001, I felt interest income would grow by 15% in
2002 as cardholders payoff debt and still use their credit cards for primary and essential goods. I slowly
tapered off the growth rate for interest income forecasting a more heavily concentrated market and higher
competition. For non-interest income, this is where I see COF maintaining high grow rates. I forecasted a
decreasing trend assuming competition will likely limit higher or extensive service fees. I see this portion of
COF and the overall banking industry focusing more on fee-based revenue streams to maintain growth and
income in the future.

For interest income expense, I forecasted fairly consist rates considering COF will have even more stricter
lending policies, which may cause them to lend to cardholders that are more persistent in paying account
balances and limiting usage (my goal after college). For non-interest income expense, I continued the trend of
50% rates since marketing expenses are part of this cost structure. With COF heavily oriented in its marketing
campaigns, I believe it will continue to spend extensive resources to further promote the COF brand, especially
with intense competition.

Loan loss provisions have historically ranged from 9-14% in the past. For 2002, I see it rising to 15.7% of
income due to my assumptions that the record spending in late 2001 will affect account receivables in 2002. As
the economy settles, I see the provisions dropping to 11-13% levels in the future forecasted years.

Depreciation and amortization were kept near consistent levels. Possible acquisitions may affect this rate in
the future. I forecasted interest expense would be higher in 2003 as delinquent and default accounts from
previous years would have to be closed. Overall, I forecasted possible acquisitions in 2004, increasing the
interest expense amount and corresponding accounts.

I basically kept change in NWC as a constant, except for 2002 where I see slight fluctuations in asset (down)
and liabilities (up) due to recessional and seasonal cycles. For capital expenditures, I did not see COF



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Capital One Financial Corp.                                              university of oregon investment group
                                                                                            http://uoig.uoregon.edu


spending substantial capital on new buildings, although acquisitions may cause this line item to increase
higher than I stated.

I feel I did not fully reflect COF’s optimism and strategy in the DCF. I did this for two reasons: 1) I felt COF’s
current lending practices can only be maintained in the short-run. 2) COF’s differentiating strategy will have to
change in order to a find a place in the industry’s future. Also, after not disclosing its managed loan portfolio
structure, it makes you wonder what else is under their X-files. With long-term debt and capital leases only
representing 0.73% of COF’s capital structure, the WACC came to be 15.21%. My implied share price came out
to be $15.12.



Comparables Valuation

Competitors
(company profiles via Hoovers)

Providian (PVN)
The company that has been synonymous with subprime credit cards has been kicked out of the business. One
of the top US credit card outfits, Providian Financial issues mainly secured credit cards to more than 16 million
customers, most with spotty credit histories; it also issues credit cards to those with better credit. Providian
solicits new customers via direct mail, phone, and online advertising. The company also offers money market
accounts, CDs, and home equity loans; its GetSmart.com is an online lender and deposit institution. High
charge-offs have led to a management shake-up, job cuts, and talk of putting the company up for sale;
meanwhile, regulators ordered the company to stop issuing new subprime cards.

MBNA (KRB)
MBNA is one of the largest issuers of credit cards and the #1 issuer of affinity cards (marketed through such
organizations as sports teams or universities). It targets middle- to upper-middle-income customers who pay
their bills promptly and carry a sizeable credit card balance. MBNA also offers deposit products, such as
savings accounts and CDs. Through MBNA Canada Bank and MBNA Europe Bank, the company has
operations in Canada, Ireland, and the UK. Other subsidiaries offer home equity loans and perform data
processing and card production.

Bank One (ONE)
Bank One, the #6 bank in the US (after Citigroup, J. P. Morgan Chase & Co., Bank of America, Wachovia, and
Wells Fargo), is a super regional bank with some 1,800 branches in 14 mostly Midwestern and Southeastern
states. Through subsidiary First USA, the company is also one of the largest issuers of credit cards in the
world. Its other business activities -- which span the US and about a dozen other countries -- include
commercial, corporate, and institutional banking; services for retail and small-business customers; loan and
leasing services; and investment, brokerage, and insurance services. Bank One has purchased Wachovia's
consumer credit card portfolio.

American Express (AXP)
American Express makes money even if you do leave home without its charge card. The financial services
giant is the world's #1 travel agency (in addition to being the #1 issuer of charge cards). It also issues traveler's
checks, publishes magazines (Food & Wine, Travel & Leisure), and provides financial advisory services. The
company's operations include Travel-Related Services, Financial Advisors, and Express Bank. American
Express has taken to the Internet with an online bank (Membership Banking) and online mortgage and


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Capital One Financial Corp.                                           university of oregon investment group
                                                                                        http://uoig.uoregon.edu


brokerage services. Warren Buffett's Berkshire Hathaway owns about 11% of the company, which has fallen on
tough times because of bad junk bond investments and the terrorist attacks on the US.

Analysis

I chose four comparable companies that were all in the top ten in the U.S. for issuing credit cards. Although
they were not similar in size or performance, each company offered similar product lines to COF. In exhibit 3,
I included all four companies when calculating the implied share price. With each company and ratio equally
weighted, I came to a share price of $52.74. Then I calculated an implied share price using PVN & KRB for one
and ONE & AXP as the other. Predictability, my share price using PVN & KRB (exhibit 3.1) came to a share
price of $43.52, which is lower than my primary comparables analysis of $52.74. With ONE & AXP as the main
comparables, I came to a share price of $61.95. I feel the comparables in exhibit 3 are the most accurate in
portraying COF’s implied share price because each one is a direct competitor of COF and is always
benchmarked against each other in the industry.



Recommendation

As the corporate world is being more closely watched now that the Enron debacle have stirred things up,
companies will not benefit from tighter accounting policies. In the scope of COF, it is currently a buy with
many analysts. Also with that, are the many issues lingering above COF. The vagueness of its annual report
(especially financial statements) , its reporting policies, CFO rumors, and lending practices have come to heat
as of late. Performance-wise, it’s one of the industry leaders, although as of now, I am not confident that the
company has shown its true colors, and that is what I am concerned about. In this case, I feel my DCF share
price of $15.12 more accurately reflects the current position of the company and therefore I rate it a Hold.




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UNIVERSITY OF OREGON            February 15, 2002
                                       Financials
             INVESTMENT GROUP
Capital One Financial Corp.   university of oregon investment group
                                             http://uoig.uoregon.edu




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Capital One Financial Corp.                                                            university of oregon investment group
                                                                                                             http://uoig.uoregon.edu



 Exhibit 3
 Capital One Financial Corp.
                                   COF             PVN             KRB         ONE            AXP         Industry Avg.
 Price                            47.11            4.31           33.05        36.2          33.52
 Beta                              1.47            1.64            1.48        1.33           1.23            1.79
 Market Cap.                    10.7 billion    1.2 billion    28.2 billion 42.2 billion   44.7 billion
 Revenue                        7.3 billion     2.6 billion     9.4 billion 25.2 billion   22.6 billion
 Profit Margin                   22.60%           4.10%          17.00%       6.50%          5.80%           12.00%
 ROA                              3.03%           0.54%           4.20%       0.99%          0.88%            1.90%
 ROE                             25.33%           4.81%          24.24%      13.93%         11.01%           20.40%
 Cash                          707.2 million   449.6 million         0           0              0
                                                                                                                          Mean     Implied Price
 Price to Earnings                15.68             13.26        17.20         26.70         34.34            16.00       22.88       68.34
 Price to Book                     3.23              0.51         3.80          2.08         3.66             3.14        2.51        34.87
 Price to Sales                    3.55              0.48         3.20          1.67         1.99             1.86        1.84        55.00

                                                                                                                          Implied: $        52.74


 Exhibit 3.1                                                                Exhibit 3.2
                               PVN & KRB                                                   ONE & AXP
                                 Mean              Implied                                   Mean           Implied
 Price to Earnings               15.23              45.50                                    30.52           91.18
 Price to Book                   2.155              29.91                                    2.87            39.84
 Price to Sales                   1.84              55.15                                    1.83            54.85

                                   Implied:    $       43.52                                   Implied: $        61.95




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