Credit card debt has surged during the past couple of years, and lenders have seen net charge-offs and delinquencies rise. Capital One Financial(NYSE: COF), which is one of the largest consumer credit card issuers in the U.S., has seen its consumer credit quality decline. Despite this, the stock has surged 67% during the past year.
Capital One stock trades at a slight premium to its historical value, and its merger with Discover Financial Services(NYSE: DFS) remains in the air. If you're thinking of buying Capital One stock today, consider the following.
Consumer credit metrics have weakened since 2021
Consumer credit card debt is at a record $1.14 trillion, and credit card interest rates are also near the highest they've ever been. Rising debt and interest payments are a burden for consumers, and those on the lower end of the credit rating spectrum -- a demographic that's a significant portion of Capital One's customer base -- could be more vulnerable to an economic downturn.
At the end of the quarter, nearly a third of Capital One's credit card loans and 47% of its automotive loans were issued to customers with FICO scores below 660, which is considered below prime.
Credit card net charge-offs (NCOs) have increased across the banking industry. Data from the Federal Reserve Bank of St. Louis shows that card NCOs rose from 1.57% in the fourth quarter of 2021 to 4.73% in the second quarter of this year, marking the highest charge-off rate since 2011. During that same time, Capital One's NCOs on credit cards have gone from 1.42% to 5.6%.
Big bank executives haven't shown much concern about the consumer. In fact, many see consumer resilience as the reason the U.S. economy hasn't tipped into a recession yet.
Capital One Chief Executive Officer Richard Fairbank told analysts during the company's third-quarter earnings call that "the U.S. consumer remains a source of relative strength in the overall economy." However, he also cautioned that "there are some pockets of pressure that will persist until we fully work through this cycle essentially of inflation and elevated interest rates."
A soft landing could give it a boost
In the third quarter, Capital One charged off $2.6 billion across its entire portfolio and its NCO rate was 3.27%. The 30-day delinquency rate, viewed as a leading indicator of consumer credit health, was 3.89%.
To account for this risk, Capital One sets aside an allowance for credit losses to estimate how much debt it's unlikely to recover. Currently, the company has an allowance for credit losses totaling $16.6 billion, giving it a coverage ratio of 5.16%.
This allowance exceeds its current NCO rate and should cover its losses. However, if net charge-offs and delinquencies increase meaningfully from here, Capital One may have to increase this allowance.
Conversely, consumer credit metrics could improve if the Federal Reserve manages to achieve a soft landing (bringing down inflation without tipping the economy into a recession). In such a scenario, Capital One and other banks could see credit metrics improve and release some of these reserves, which would flow back and boost their net income.
Its merger with Discover Financial Services is up in the air
Investors will also want to watch for Capital One's proposed merger with Discover Financial Services. This month, New York Attorney General Letitia James is conducting a probe to determine whether Capital One's proposed takeover of Discover Financial Services violates the state's antitrust law.
Capital One said in a statement that it would respond to James through appropriate legal channels and believes it's "well positioned" to win merger approval from federal banking regulators.
However, risks remain for the merger, and investors must decide if they want to wait to invest due to these risks or if the upside potential of the merger is worth it. The bank expects to get a decision on the merger early next year.
Is it a buy?
Investors should monitor Capital One's credit card NCO rate. Because of the credit profile of its customer base, it may be more vulnerable than peer banks if the economy weakens.
Today, Capital One stock, measured by its price-to-book value (P/B), is slightly above its 10-year average. However, if the proposed merger with Discover is approved, Capital One can run transactions through its own network, which will help it expand margins and earn the stock a higher valuation. While uncertainty about the merger remains, I believe it will go through early next year -- making the stock a good buy for long-term investors today.
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Discover Financial Services is an advertising partner of The Ascent, a Motley Fool company. Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool recommends Discover Financial Services. The Motley Fool has a disclosure policy.