The Capacity To Suffer, Lcv/Cac, In Addition To Working Capital Alphabetic Quality Ane Financial
January 25, 2019
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Earlier this week, Capital One Financial (COF US) - a stock I ain - announced a 4Q18 number which, spell higher upward expectations at the EPS draw on a reported basis, was below expectations after excluding diverse 'one-off' items. Markets sent the stock downwards 6.2%.
COF is a the States banking concern focused to a greater extent than frequently than non on the credit carte segment. The argue for the lady friend was that the fellowship had seen an chance inwards the marketplace inwards 4Q to add together a lot of novel accounts, together with so had boosted marketing spending yesteryear 80% QoQ. The displace was a success. They added a lot of novel accounts, at an attractive cost of acquisition. However, novel accounts don't right away generate a lot of revenue. Indeed, frequently they involve an upfront striking to earnings, because non only do novel customers cost coin to acquire, but they also conduct maintain fourth dimension to ramp upward their balances; upfront provisions demand to endure taken against novel draw of piece of job concern human relationship balances for expected credit losses over the lifetime of the loans (whereas the involvement is only accrued together with recognised month-to-month); together with it also takes fourth dimension to sift through which are the practiced customers together with which are the bad, together with adjust credit lines accordingly, so every bit to emerge amongst a robust back-book of draw of piece of job concern several years hence.
Furthermore, the stride of credit carte loan residual growth was only 2% YoY, despite a 11% YoY growth inwards client credit carte spending, undershooting expectations. COF emphasised that this was due to a deliberate determination to curtail credit limits, given where they currently meet the credit cycle. Indeed, they conduct maintain been scaling dorsum high credit bound customers for several years now. They could really easily boost profits at this phase of the wheel yesteryear expanding credit limits, but they don't meet that every bit prudent. That's precisely how you lot desire a CEO running a fiscal you lot ain to think.
On the conference call, analysts soundless asked a lot of questions that manifested anxiety nearly the outlook for EPS growth side yesteryear side year, including whether the electrical flow marketing pass run-rate would continue; why loan growth was disappointing; together with why the fellowship wasn't trying to detect investment opportunities that ameliorate matched nigh term costs amongst nigh term revenues.
The reaction to the EPS miss, every bit good every bit many of these analyst questions, though perfectly understandable, completely lady friend the point. The object of a fellowship is non to maximise accounting profits per se - which are mere volume entries - but rather to detect opportunities to invest $1, where they volition larn dorsum much to a greater extent than than $1 over time, together with at a salubrious risk-adjusted charge per unit of measurement of return.
Accrual accounting policies endeavor to gibe the recognition of revenues amongst their associated costs, but the procedure is imperfect, together with inwards practise in that location are many cases where costs demand to endure expensed upfront, but the revenues only recognised much after over time. If a fellowship invests inwards a novel factory, that expenditure gets capitalised, together with so does non touching nigh terms earnings, fifty-fifty though it entails an upfront cash outflow. That is because the cost of the constitute is 'matched' amongst revenues, together with written off gradually over fourth dimension against those revenues via the depreciation line. If a high-ROIC manufacturing flora expansion that promises to boost revenues together with profits is undertaken, markets together with analysts would applaud it, because it volition boost the medium term outlook for EPS growth.
However, if the exact same economic science of 'cash out upfront for to a greater extent than cash inwards later, at a high ROIC' are at play, but instead involve expensing rather than capitalising the upfront costs, all of a precipitous this becomes a bad thought together with people sell downwards the stock. An representative is a marketing displace that allows you lot to larn a large number of novel customers. But the economic science of the cash flows are precisely the same, together with so this reaction makes absolutely no sense. The destination of a fellowship is to maximise value, non to maximise small term book-entry earnings.
Funnily enough, tech investors larn this. They don't focus on accounting profits so much every bit 'unit economics', together with focus on the primal LCV/CAC equation - lifetime client value every bit a multiple of client acquisition costs. If client acquisition costs are existence expensed upfront, but the lifetime value of acquired customers are many multiples of these acquisition costs, tech companies are encouraged together with rewarded for task these investments, every bit they add together value to the company. Such investments may penalise profits upfront, but over time, the fellowship volition earn to a greater extent than yesteryear aggressively investing inwards client acquisition. Investors hither focus on user growth over electrical flow earnings.
Amazon has understood this for years, together with taken payoff of many companies' lack of 'capacity to suffer' profits hits inwards the nigh term. This aversion creates exploitable draw of piece of job concern opportunities for companies that are willing to conduct maintain a longer term view. And the marketplace seat has tended to applaud tech companies when they do this, together with honor them amongst higher rather than lower portion prices.
However, when an 'old world' credit carte fellowship similar COF does the exact same thing, the marketplace seat reaction is solely the opposite. They ignore the LCV role of the equation, together with focus only on the CAC role of the equation. They penalise the fellowship for incurring to a greater extent than upfront costs, spell giving them no credit for the novel customers they conduct maintain added. And they do this fifty-fifty if the LCV/CAC calculus is truly probable to endure favourable over time, given the company's history (excellent administration together with high returns on capital). This creates an chance for longer term investors.
The below is the answer from COF's CEO Richard Fairbank to analyst questions on why the fellowship hasn't been trying to ameliorate gibe the costs of expansion/growth amongst small term revenues (i.e., so they won't entail such a pregnant nigh term headwind to EPS), together with also why loan growth has been below expectations. Fairbank's answer pretty much demonstrates everything you lot would desire to listen from a banking concern CEO:
So what are the really positive things this comment has to enjoin nearly Fairbank's stewardship of COF, that you lot would aspect for inwards a fiscal you lot own? The following:
*Firstly, from an investment standpoint, in that location is a 'capacity to suffer' a small term striking to EPS if it makes economical sense for the draw of piece of job concern long term. He is non focused on maximising EPS, but on maximising value, together with doesn't attention if in that location is a small term upfront touching to profits if it makes sense for the business. While in that location is a preference for matching, if the best draw of piece of job concern opportunities are inwards areas where the booking of expenses together with revenues are misaligned, together with then so endure it.
*Secondly, in that location is also a willingness to penalise small term profits inwards lodge to mitigate risk. He notes they could easily boost profits yesteryear expanding credit lines, but don't believe it is prudent to do so at this betoken inwards the cycle. The fact that credit carte loan growth was only 1-2% inwards 2018 was their ain pick - a deliberate curtailment inwards supply, non a lack of demand. They conduct maintain been proactively reducing high-balance revolvers for years. That agency the character of COF's profits is high, because they are much higher on a 'risk adjusted' footing than companies showing less caution, together with are hence probable to test far to a greater extent than resilient inwards a downturn. This was precisely COF's sense during the GFC, where it's accuse off rates were good below peers, together with the fellowship did non demand whatsoever authorities assistance/bailout.
*Thirdly, an agreement of the importance of investing counter-cyclically. Fairbank notes that the best opportunities are frequently doing the exact reverse of what most of your competitors are doing (much every bit it is inwards the stock market). That's precisely what you lot desire inwards a manager.
*Lastly, the approach taken to internal investment decisions/initiatives is opportunistic rather than deterministic/bureaucratic. A high grade 'strategic decision' isn't made together with and then adhered to automatically over several years, irrespective of feedback from the marketplace. They accommodate their marketing spend, for instance, to what their competitors are doing, together with when together with where they meet actual opportunities inwards the market. That's why they wouldn't commit to guidance on marketing pass for this twelvemonth - how much it is volition depend on the marketplace, non pre-existing budgets. This entrepreneurial approach is vastly preferable to to a greater extent than bureaucratic agency of running companies.
I for ane thought COF deserved ameliorate than a 6.2% sell-off (albeit the stock recouped about of that sell off yesterday). I bought to a greater extent than at US$78.30. The reaction was specially dizzy inwards low-cal of the fact that the fellowship truly earned to a greater extent than during the quarter than expected, but the marketplace seat excluded 'one fourth dimension gains' that to a greater extent than than offset the growth inwards marketing spend, but did non also excluded the elevated marketing pass that drove existent long term value for the company. So when all was said together with done, the fellowship (1) earned to a greater extent than inwards 4Q than expected; together with (2) added to a greater extent than accounts than expected. So the sell-off makes no rational sense. So much for marketplace seat efficiency. Investor short-termism, together with obsession over small term optical EPS growth together with P/Es, is a fantastic chance for longer term investors.
LT3000
DISCLAIMER: The higher upward is for informational/entertainment purposes only, together with should non endure construed every bit a recommendation to merchandise inwards the securities mentioned inwards this article. While provided inwards practiced faith, the writer provides no warranty every bit to the accuracy of the higher upward analysis. The writer owns shares inwards Capital One Financial together with may sell this seat or purchase to a greater extent than shares at whatsoever fourth dimension without notice.
COF is a the States banking concern focused to a greater extent than frequently than non on the credit carte segment. The argue for the lady friend was that the fellowship had seen an chance inwards the marketplace inwards 4Q to add together a lot of novel accounts, together with so had boosted marketing spending yesteryear 80% QoQ. The displace was a success. They added a lot of novel accounts, at an attractive cost of acquisition. However, novel accounts don't right away generate a lot of revenue. Indeed, frequently they involve an upfront striking to earnings, because non only do novel customers cost coin to acquire, but they also conduct maintain fourth dimension to ramp upward their balances; upfront provisions demand to endure taken against novel draw of piece of job concern human relationship balances for expected credit losses over the lifetime of the loans (whereas the involvement is only accrued together with recognised month-to-month); together with it also takes fourth dimension to sift through which are the practiced customers together with which are the bad, together with adjust credit lines accordingly, so every bit to emerge amongst a robust back-book of draw of piece of job concern several years hence.
Furthermore, the stride of credit carte loan residual growth was only 2% YoY, despite a 11% YoY growth inwards client credit carte spending, undershooting expectations. COF emphasised that this was due to a deliberate determination to curtail credit limits, given where they currently meet the credit cycle. Indeed, they conduct maintain been scaling dorsum high credit bound customers for several years now. They could really easily boost profits at this phase of the wheel yesteryear expanding credit limits, but they don't meet that every bit prudent. That's precisely how you lot desire a CEO running a fiscal you lot ain to think.
On the conference call, analysts soundless asked a lot of questions that manifested anxiety nearly the outlook for EPS growth side yesteryear side year, including whether the electrical flow marketing pass run-rate would continue; why loan growth was disappointing; together with why the fellowship wasn't trying to detect investment opportunities that ameliorate matched nigh term costs amongst nigh term revenues.
The reaction to the EPS miss, every bit good every bit many of these analyst questions, though perfectly understandable, completely lady friend the point. The object of a fellowship is non to maximise accounting profits per se - which are mere volume entries - but rather to detect opportunities to invest $1, where they volition larn dorsum much to a greater extent than than $1 over time, together with at a salubrious risk-adjusted charge per unit of measurement of return.
Accrual accounting policies endeavor to gibe the recognition of revenues amongst their associated costs, but the procedure is imperfect, together with inwards practise in that location are many cases where costs demand to endure expensed upfront, but the revenues only recognised much after over time. If a fellowship invests inwards a novel factory, that expenditure gets capitalised, together with so does non touching nigh terms earnings, fifty-fifty though it entails an upfront cash outflow. That is because the cost of the constitute is 'matched' amongst revenues, together with written off gradually over fourth dimension against those revenues via the depreciation line. If a high-ROIC manufacturing flora expansion that promises to boost revenues together with profits is undertaken, markets together with analysts would applaud it, because it volition boost the medium term outlook for EPS growth.
However, if the exact same economic science of 'cash out upfront for to a greater extent than cash inwards later, at a high ROIC' are at play, but instead involve expensing rather than capitalising the upfront costs, all of a precipitous this becomes a bad thought together with people sell downwards the stock. An representative is a marketing displace that allows you lot to larn a large number of novel customers. But the economic science of the cash flows are precisely the same, together with so this reaction makes absolutely no sense. The destination of a fellowship is to maximise value, non to maximise small term book-entry earnings.
Funnily enough, tech investors larn this. They don't focus on accounting profits so much every bit 'unit economics', together with focus on the primal LCV/CAC equation - lifetime client value every bit a multiple of client acquisition costs. If client acquisition costs are existence expensed upfront, but the lifetime value of acquired customers are many multiples of these acquisition costs, tech companies are encouraged together with rewarded for task these investments, every bit they add together value to the company. Such investments may penalise profits upfront, but over time, the fellowship volition earn to a greater extent than yesteryear aggressively investing inwards client acquisition. Investors hither focus on user growth over electrical flow earnings.
Amazon has understood this for years, together with taken payoff of many companies' lack of 'capacity to suffer' profits hits inwards the nigh term. This aversion creates exploitable draw of piece of job concern opportunities for companies that are willing to conduct maintain a longer term view. And the marketplace seat has tended to applaud tech companies when they do this, together with honor them amongst higher rather than lower portion prices.
However, when an 'old world' credit carte fellowship similar COF does the exact same thing, the marketplace seat reaction is solely the opposite. They ignore the LCV role of the equation, together with focus only on the CAC role of the equation. They penalise the fellowship for incurring to a greater extent than upfront costs, spell giving them no credit for the novel customers they conduct maintain added. And they do this fifty-fifty if the LCV/CAC calculus is truly probable to endure favourable over time, given the company's history (excellent administration together with high returns on capital). This creates an chance for longer term investors.
The below is the answer from COF's CEO Richard Fairbank to analyst questions on why the fellowship hasn't been trying to ameliorate gibe the costs of expansion/growth amongst small term revenues (i.e., so they won't entail such a pregnant nigh term headwind to EPS), together with also why loan growth has been below expectations. Fairbank's answer pretty much demonstrates everything you lot would desire to listen from a banking concern CEO:
"Yeah. So, allow me snuff it dorsum to start amongst Moshe's really heartfelt lament. It would endure prissy to meet to a greater extent than matching of spending together with return. Boy, isn't that the – that would endure my wishing for this business. And inwards fact, over the years, the matching has larn fifty-fifty to a greater extent than non aligned every bit amongst FAS 166/167, the massive allowance builds, growth math, a lot of things inwards this draw of piece of job concern larn pretty disaligned. Now, a lot of it is inherent inwards the actual mechanics of how accounting together with the draw of piece of job concern works. This item alignment we're talking nearly hither is – now, about of it is inherent inwards the sense that whenever ane spends a lot of coin on marketing to generate accounts, accounts don't brand whatsoever money. So, the only things that convey 2nd revenue are going to create that alignment together with things similar large residual transfers. It's truly basically things that convey a lot of balances inwards that's what creates that alignment.
One of the things we've done over fourth dimension – it's funny, I haven't dusted off this phrase for a pair of years now. But you lot volition remember, Chris, for years nosotros were proverb nosotros were running downwards high residual revolvers. And nosotros conduct maintain continued to – now, we're to a greater extent than inwards equilibrium amongst honour to that. But in that location are a lot of things that inwards the practiced times brand a lot of money. And I seat high residual revolvers at the top, number ane on that list. The number is the resilience of that item segment. So, nosotros – only every bit – because of who nosotros are at Capital One, nosotros conduct maintain focused tremendously on resilience together with we, over the years, conduct maintain truly driven downwards the proportion of our volume that's high residual revolvers.
Now, the – together with to the specific number today, it's a pretty much ane judgement respond every bit to why the draw of piece of job concern human relationship growth together with the loan growth are non connected, together with that is our pick on credit line. And the – spell the CARD Act makes belike the stakes – well, non belike – the CARD Act makes the stakes fifty-fifty higher to brand certain that one's underwriting decisions are correct the offset time. We believe – nosotros pass a lot of our liberate energy looking at the competitive marketplace, looking at the credit cycle, together with and then trying to brand our choices accordingly. And a lot of times, nosotros zig spell others zag, together with it's non an accident. It's truly a causal human relationship because a lot of where chance lies together with where endangerment exists is the flipside of what competitors are doing.
So, inwards this item case, together with I truly desire to stress, we're capitalizing on the opportunities the marketplace presents together with the success that nosotros are seeing inwards our private programs inwards the carte business. We volition lean into that together with capitalize on the growth opportunity. While our credit numbers are slap-up together with you lot tin meet the same numbers that nosotros see, nosotros are deep into the credit cycle, together with nobody knows when this affair is going to turn. But nosotros believe that the prudent affair to do is conduct maintain our pes on the gas of draw of piece of job concern human relationship originations together with our pes a fiddling chip on the brake amongst honour to credit draw extension. But it only turns out that that method of driving, if you lot will, creates about truly asymmetrical timing inwards numbers together with causes a bunch of people to scratch their heads together with wonder what we're doing. All I tin enjoin is that's belike a manifestation of the way that nosotros think together with way nosotros conduct maintain thought over all these years. This item disconnect of brake together with accelerator is amid the highest examples of that that I tin retrieve inwards our history."
So what are the really positive things this comment has to enjoin nearly Fairbank's stewardship of COF, that you lot would aspect for inwards a fiscal you lot own? The following:
*Firstly, from an investment standpoint, in that location is a 'capacity to suffer' a small term striking to EPS if it makes economical sense for the draw of piece of job concern long term. He is non focused on maximising EPS, but on maximising value, together with doesn't attention if in that location is a small term upfront touching to profits if it makes sense for the business. While in that location is a preference for matching, if the best draw of piece of job concern opportunities are inwards areas where the booking of expenses together with revenues are misaligned, together with then so endure it.
*Secondly, in that location is also a willingness to penalise small term profits inwards lodge to mitigate risk. He notes they could easily boost profits yesteryear expanding credit lines, but don't believe it is prudent to do so at this betoken inwards the cycle. The fact that credit carte loan growth was only 1-2% inwards 2018 was their ain pick - a deliberate curtailment inwards supply, non a lack of demand. They conduct maintain been proactively reducing high-balance revolvers for years. That agency the character of COF's profits is high, because they are much higher on a 'risk adjusted' footing than companies showing less caution, together with are hence probable to test far to a greater extent than resilient inwards a downturn. This was precisely COF's sense during the GFC, where it's accuse off rates were good below peers, together with the fellowship did non demand whatsoever authorities assistance/bailout.
*Thirdly, an agreement of the importance of investing counter-cyclically. Fairbank notes that the best opportunities are frequently doing the exact reverse of what most of your competitors are doing (much every bit it is inwards the stock market). That's precisely what you lot desire inwards a manager.
*Lastly, the approach taken to internal investment decisions/initiatives is opportunistic rather than deterministic/bureaucratic. A high grade 'strategic decision' isn't made together with and then adhered to automatically over several years, irrespective of feedback from the marketplace. They accommodate their marketing spend, for instance, to what their competitors are doing, together with when together with where they meet actual opportunities inwards the market. That's why they wouldn't commit to guidance on marketing pass for this twelvemonth - how much it is volition depend on the marketplace, non pre-existing budgets. This entrepreneurial approach is vastly preferable to to a greater extent than bureaucratic agency of running companies.
I for ane thought COF deserved ameliorate than a 6.2% sell-off (albeit the stock recouped about of that sell off yesterday). I bought to a greater extent than at US$78.30. The reaction was specially dizzy inwards low-cal of the fact that the fellowship truly earned to a greater extent than during the quarter than expected, but the marketplace seat excluded 'one fourth dimension gains' that to a greater extent than than offset the growth inwards marketing spend, but did non also excluded the elevated marketing pass that drove existent long term value for the company. So when all was said together with done, the fellowship (1) earned to a greater extent than inwards 4Q than expected; together with (2) added to a greater extent than accounts than expected. So the sell-off makes no rational sense. So much for marketplace seat efficiency. Investor short-termism, together with obsession over small term optical EPS growth together with P/Es, is a fantastic chance for longer term investors.
LT3000
DISCLAIMER: The higher upward is for informational/entertainment purposes only, together with should non endure construed every bit a recommendation to merchandise inwards the securities mentioned inwards this article. While provided inwards practiced faith, the writer provides no warranty every bit to the accuracy of the higher upward analysis. The writer owns shares inwards Capital One Financial together with may sell this seat or purchase to a greater extent than shares at whatsoever fourth dimension without notice.