A Top Credit Card Stock Pick

Investors looking to put money to work in a credit card stock face two challenges: valuations and the risks of worsening consumer credit quality. However, that doesn’t mean it’s impossible to find a credit card stock that can weather the credit cycle and is trading at an attractive price, according to Morningstar analyst Michael Miller.

“While we think some of the fears surrounding credit card defaults are overstated, both net charge-offs and delinquencies are now solidly above normal levels,” he says. “Despite this, we still see opportunity in the sector.”

Against fears around the resilience of credit card stocks, Miller points to his top pick: Capital One Financial COF.

Credit Quality Challenges for Card Issuers

Since credit quality is a significant variable for credit card issuers, that places the focus on the economy’s health. Credit quality is tied particularly closely to changes in unemployment. In recent months, hiring has slowed and the unemployment rate has jumped after a long period of stability. While the US labor market has been surprisingly resilient, it has been showing signs of a slowdown.

Inflation has also hurt consumer balance sheets. “While consumers have come under material pressure, this has mostly been from inflation and its impact on household costs,” Miller says. ”Inflation has fallen significantly from its highs, and while this does not reverse the damage that has been done, it does mean that consumer spending power is not continuing to deteriorate, adding to the likelihood of credit stabilization, particularly as the effect of tighter underwriting filters through.”

He says that while net charge-offs and delinquencies are solidly above normal levels, long-term recovery is still expected. “We expect rising net charge-offs to plateau in the second half of 2024 and 2025. But we believe a recovery in credit losses will take time, with a meaningful decline in net charge-offs not beginning until 2026.”

However, credit card companies have another lever: being choosier about who they issue cards to. “This will place downward pressure on credit quality, but the impact of tighter underwriting will offset this,” Miller says.

Net Charge-Off Rates

Net charge-offs have risen across the industry from their post-pandemic lows, and now sit modestly above historical averages. Miller says American Express AXP has been an exception to the trend. The company has delivered credit losses still below 2019 levels, thanks to the strength of its affluent cardholder base.

Miller is more cautious about private-label issuers Bread Financial Holdings BFH and Synchrony Financial SYF, citing their weaker credit profiles and reliance on interest income. “Their weaker credit and lack of noninterest revenue makes them more sensitive to credit losses if economic conditions deteriorate more than expected,” he says.

Credit Card Issuer Stock Valuations

Despite the headwinds, these stocks have broadly been solid performers in 2024. Bread leads the group with an impressive gain of 43.90%, followed by American Express at 36.75%. Synchrony has posted a solid 22.00% return, while Capital One has contributed a respectable 5.45% to the overall positive trend.

However, for investors looking to put new money to work in the group, that limits attractive options. “Valuations have recovered from their lows in 2023, and we no longer think the sector as a whole is materially undervalued,” says Miller.

While American Express remains the most competitively advantaged firm in the space, its current price of $244.06 is above Morningstar’s fair value estimate of $211.00, earning the stock a 2-star rating and limiting its appeal. “We still see American Express as the most competitively advantaged firm in our coverage, but it trades at a premium to our fair value estimate, and the high expectations implied make it less attractive to us,” says Miller.

“Our preferred name is Capital One, which trades at a significant discount to our fair value estimate, unlike American Express, and is not nearly as exposed to the new late fee rules that threaten the economics of Synchrony and Bread’s businesses,” says Miller. “While Capital One’s acquisition of Discover Financial Services DFS does add some uncertainty, as it will likely face challenges from regulators, we are generally neutral on the deal and do not expect its success or failure to materially affect our valuation or our belief that the firm trades at a discount to its fair value.”

Capital One Financial

• Fair Value Estimate: $170.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Narrow
• Fair Value Uncertainty: High

“Despite its credit exposure to credit cards and auto loans, we believe Capital One is in a strong financial position. At the end of June 2024, Capital One had a common equity Tier 1 ratio of 13.2%, up from 12.7% last year, and well above its long-term goal of 11%. This is despite Capital One building additional reserves in 2023 and 2024, with its allowance for bad loans now at 5.23% of existing receivables.

“These figures do need to be viewed in the context of Capital One’s exposure to subprime credit cards and subprime auto loans. Roughly 31% of the bank’s domestic credit card portfolio is with cardholders whose FICO scores were below 660, and a similar portion of its auto loans is from borrowers with FICO scores below 620. Additionally, we foresee higher credit costs for Capital One in 2023 and beyond as higher debt levels, higher interest rates, and elevated prices for goods and services pressure consumer credit quality. We expect credit card net charge-offs to rise to 5.80% in 2024 as credit conditions deteriorate in a slowing economy, but we do not foresee any material stress being placed on Capital One’s balance sheet.”

Read more of Michael Miller’s analyst notes here.