What's in your wallet?

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Dump trucks roar through the woods near the new Route 288 superhighway on Richmond's western fringe. Miles from fast food eateries, hard-hatted construction workers huddle around an aluminum-paneled canteen truck serving lunch. Amidst the pine trees, jogging trails and access roads of the bucolic West Creek development, Capital One Financial Corp.'s new Richmond center is taking form.

The immense new office complex represents the biggest corporate expansion in Old Dominion history. Some 4,000 employees began reporting work to the facility in February, while another 750 are to move into a new consolidated headquarters location near Tysons Corner. By growing so much, so fast, Capital One is countering much of the economic pain that has swept through the Richmond area and the Old Dominion in the current downturn.

Capital One is the most contrarian of companies. The credit-card marketer originated as the unlikely idea of Richard Fairbank and Nigel Morris, mavericks who were convinced they could revolutionize the mass-market credit card business by slicing it into hundreds of niches. After spinning off from the Virginia bank that gave them their start, they grew the company into the fifth-largest issuer of credit cards in the U.S., with $45 billion in managed loans, $9.7 billion in annual revenue and $10.2 billion in market capitalization. In the process, they joined the Fortune 500 as one of Virginia's largest employers.
Along the way, Capital One built one of the largest consumer databases anywhere, which it mines to customize products for niche groups and to sell them effectively. Chairman and CEO Fairbank and President and COO Morris have developed a disciplined process for testing hundreds of permutations - from credit lines to direct-mail packaging - to ascertain what consumers respond to. Testing has become a company trademark, applied to everything from setting the right interest rate to selecting the best employees.

Now Capital One is becoming even better known. A slick television ad campaign, replete with cowboys and monsters, asks, "What's in your wallet?" The advertising onslaught has elevated Capital One to the hottest brand to emerge from Virginia since America Online.
Unlike the Internet giant, which merged with Time Warner and moved its corporate headquarters to New York, Capital One is likely to keep its leadership here. "Virginia has been a wonderful place to build the company from an employee point of view," says Fairbank. "We have found a deep, high-quality and diverse pool of labor here. Virginia has been and will always remain our home base."

Such loyalty is rare among corporate leaders these days, particularly for a company whose growth prospects include Western Europe, Latin America, Asia and even parts of Africa. It is even more unusual given that Fairbank and Morris had few ties to the region until the mid-1980s when they met at Strategic Planning Associates, a Washington, D.C.-based consultancy.

Together, Fairbank, a native Californian, and Morris, an Englishman with a background in experimental psychology, developed their ideas for applying information technology to the credit card business. They had little or no money, let alone practical management experience in banking. Nevertheless, they talked the former Signet Banking Corp. of Richmond - acquired in 1997 by First Union Corp., now Wachovia Corp. - into giving their ideas a try. They transformed the industry by offering introductory 9.9 percent interest rates to induce selected customers to transfer their credit balances from other cards. The standard rate at the time was 19.8 percent, regardless of credit rating. The results were so positive that by time the credit card unit spun off from Signet in 1994, it had cracked the top 20 in credit card loans.

The most important element in getting beyond the idea stage, says Fairbank, was the unwavering belief that he and Morris had in their dream. "From day one of conceiving this strategy, our mission has been to de-average the credit card business and bring better pricing and customized solutions to our customers. We used to tell people that we had destiny on our side. And wouldn't it be great if a little band of believers in Virginia was able to lead that?"

To many, the company's expansion in Virginia comes at an odd time. Most companies, particularly those who lend to consumers, typically rein in their capital spending during recessions. Not so Capital One. Besides the new Richmond and Tysons Corner facilities, last year the company invested nearly $1.1 billion in marketing, typically one of the first budgetary items to get cut when the economy slips. But, against the backdrop of problems befalling a host of major banks, the company saw its net income jump 36.7 percent during 2001, to $642 million, with expectations for that number to top $700 million in 2002.
Capital One's success is primarily the result of perfecting ways of tailoring credit card and loan products to diverse groups of consumers. The company has developed sophisticated data-mining techniques that not only collect mounds of information about individual customers - 20 pages of data on every adult in the United States, by some estimates - but tracks transaction activity to determine individual likes and dislikes. The company also uses its superior information technology to cull customers likely to get into credit trouble. Their loan losses translate into a rate of just 4.2 percent, the lowest in the industry and 20 percent less than the industry average of 5.4 percent.

According to Fairbank, it was overcoming an identity crisis that really kicked Capital One into high gear. By mid 2000, the company had built its 30 million-customer franchise primarily on the marketing muscle of the VISA and MasterCard brands. Its marketing prowess made it a direct rival of such monoliths as Citicorp, Bank One Corp. and MBNA Corp. But despite stuffing dozens of junk mail solicitations into the mailboxes of millions of American households each year, however, people didn't recognize the company's name.

"What we found was we had a 30 million-customer company, but the most unheard of 30 million-customer company in America," says Fairbank. Instead of seeing the company's cards as Capital One cards, consumers saw them as either VISA or MasterCards. And without name recognition, Capital One foresaw difficulty in converting customers to other financial products such as auto or home-improvement loans.

To overcome its identity muddle, the company augmented the surgical precision of direct mail strategy with the mass-market reach of television. "We took a leap of faith - without having the ability to incrementally test it - and created a national advertising campaign," Fairbank says.

Asking "What's in your wallet?" the ads tout the company and its "hassle-free" credit cards. The campaign has been a "home run," Fairbank says. The Capital One brand has vaulted into one of the most recognized in America, with a 95 percent national awareness among consumers in some surveys. In many cases, the company now has greater name recognition than either American Express or Discover.

Mass-market success won't spoil Capital One, Morris insists. The company will maintain its disciplined approach to targeting niches, rolling out new products, building employee loyalty and collecting debt. Testing is so ingrained in the company psyche, in fact, that last year alone Capital One tried 45,000 different product and marketing permutations. Inevitably, the company has launched a lot of duds, but that's the price of learning. "The organization culturally accepts that taking shortcuts is not acceptable," Morris says. "The organization is comfortable with failing, because most tests do fail."
Typically, failures occur during a product's embryonic stages when the cost is negligible. Occasionally, bad ideas survive the testing phase. That occurs either when a test market does not properly match a target market, says Morris, or when the market shifts after the test. The latter took place when the company tried its hand in the direct marketing of mobile phone services. After dedicating some 800 people and up to $20 million per quarter on marketing, the company pulled the plug on the experiment in mid-2000.

A price war erupted in wholesale telecommunications services, Morris says. Giants like MCI WorldCom, AT&T and Sprint discounted prices to the point where resellers like Capital One could not provide a competitively priced product. The margins were terrible. "If the returns are not there for our shareholders," he says, "we're not going to do it."

Testing has prevented some major missteps, Morris says. In contrast to competitors like Bank One Corp.'s First USA, Providian Financial Corp. and NextCard Inc., Capital One didn't jump into the Internet as a marketing channel. No one could figure out how to target individual customers through the new medium. And industry research indicated that payment fraud was 12 times higher than the off-line rate.
Others weren't as focused in their thinking. At the behest of its Bank One superiors, First USA charged into expensive contracts with a wide range of Web sites. The expected growth never materialized, losses mounted, and relations were so acrimonious that Bank One at one point considered selling its credit-card unit.

Ever the contrarian, Capital One bided its time, testing the new medium until it could devise a way to target customers effectively and manage its risk. "Our hypothesis going in was that this could be a difficult channel to manage," Morris says. "Testing put us in a position where we could build a decent-sized business on the Internet." By 2000, the company originated about 1 million new accounts online. It has not disclosed how many were originated last year.

Capital One extends its discipline to every endeavor. When a customer dials the company's call center, the company's information-technology plays a crucial role. A Cisco logistics system identifies the caller and accesses his records in an effort to divine the purpose of the call. Based on the determination, the system routes the caller to an appropriate representative, displays the customer's account on the computer screen and lists additional products the customer might want.

Such efforts have generated growth unparalleled in the financial services industry. Since 1994, the company has seen managed loans grow at a compounded annual rate of nearly 30 percent per year - more than 50 percent in 2001 - while earnings per share have posted annual gains in excess of 20 percent for seven years running.
Some investors are worried whether Capital One can maintain its loan quality during a period of hypergrowth. Fitch Inc., the New York-based bond rating agency, has given the company's debt rating a negative outlook. Thomas Abruzzo, a senior director, said the ratings firm would like to see the company "temper" its expansion in the coming year to ensure that it does not lose track of its borrowers. Some analysts think Capital One could be another disaster waiting to happen. They worry that, despite the razzle-dazzle about targeting the right customer, Capital One could become another Providian, a credit-card company whose aggressive lending to subprime customers generated hundreds of millions in losses last year. Guilt by association has driven Capital One's stock price 30 percent below its peak in October 2000.

Indeed, Capital One's loan-loss rate will rise, says David West, director of research with Davenport & Co. in Richmond. "There is no doubt it's going to happen. … We will see the ripple effects of a pretty severe compression in the economy during the third and fourth quarters of 2001." But Capital One has always been preoccupied with credit quality, and he doubts it will suffer losses on Providian's scale, he says.

The skeptics' views are based on misconceptions, contends Jeff Salmon, an analyst with Barclays Capital in New York who covers bonds backed by the Capital One credit-card loans. Capital One focuses more on consumers with stellar credit histories, the so-called "super-prime" customers, than many other companies do. This market segment doesn't generate as much interest revenue as less well-heeled customers, who carry bigger credit balances. But because super-primes rarely default, the segment will remain profitable.
Another 30 percent of Capital One's portfolio consists of "prime" customers - those with strong credit histories who also keep revolving balances. Defaults by these customers are more than offset by higher interest payments on the revolving balances. Even Capital One's sub-prime customers are profitable, despite higher defaults. The company manages its exposure by charging higher interest rates and issuing smaller credit lines.

Capital One can handle anything the economy throws at it, Fairbank says, because it prepares thoroughly for the unexpected. Even in good times, the company assumes that a recession might lurk just around the corner. It runs computer programs to test how a downturn might affect its loan portfolio. "In all of our projections, we worsen the performance data and only originate business that we see can be profitable in the worst scenario," he says. Even if a recession does occur, "It's business as usual." The company has applied that strategy successfully over the years, even when others have had problems, says Barclay Capital's Salmon. "You can't argue with their history, and you can't argue with their consistency."

Capital One has shown repeatedly that it can move quickly and nimbly, even in areas unrelated to credit cards and lending. A prime example occurred last September, just three days before the "Tribute to Heroes Telethon." Organizers raising funds for victims of the Sept. 11 terrorist attacks asked the company to handle the deluge of telephone calls expected from the event. Within three days, the company enlisted the voluntary help of 7,000 employees. The fundraiser went off without a hitch.

Fairbank, who was blocks away when the attacks occurred in New York and lost friends there, described the effort as profound. "It was really more than the money," he said. "A nation came together to share its grief and a collective sense of aching of the human spirit to make something good. … Those kinds of things are how we measure success."

The employees' can-do spirit is one of the company's greatest strengths. Capital One is just as strict in screening employee candidates as it is with potential borrowers, West says. Tests range from algebra exams to behavioral evaluations, depending on the position. The effort pays dividends in the long run. "They really try to foster an entrepreneurial atmosphere," West says. "Most of the people I know that work there give the company high marks as employers."

So does Fortune magazine. In each of the past four years, the company made it on the magazine's list of the "Best Places to Work in America." Likewise, the company ranked third in a recent survey conducted by the Sunday Times of London on the best places to work in the United Kingdom.

The entrepreneurial attitude starts at the top. In 1998, Fairbank and Morris agreed to forego all salary, bonus and benefits in favor of performance-based stock options. They hoped to re-create the entrepreneurial environment of the company's formative years. But the move also sent a powerful message to shareholders. "It's definitely a management team that puts its money where its mouth is," said West. The program, he added, "unites shareholders' interests with those of management."

With its special corporate culture, Capital One has rarely ventured into the acquisition market. Even as competitors like MBNA Corp. and First USA built credit-card loan portfolios approaching $100 billion by purchasing competitors, Capital One refrained. The company found it could acquire customers for one-fifth the cost using direct mail. Plus, its 20 percent returns on equity meant it couldn't afford to pay the same premium for a portfolio as a competitor earning 10 percent.
When the company has stepped into the acquisition arena, it has done so on a limited scale and with testing foremost in its mind. The purchase of Dallas-based Summit Acceptance Corp. in 1997, a lender to subprime auto buyers, tested the applicability of Capital One's information-based strategy to automobile lending. After finding that it worked, the company bought San Diego-based PeopleFirst Inc., an Internet-based lender to super-prime automobile buyers. By the end of 2001, the combined auto-finance business had become the company's fastest grower.

Because it's pursuing a strategy of internal growth, Capital One has little choice but to expand its existing operations, which are concentrated in Virginia. With a huge vested interest in the state's business climate, Morris says the company hopes to build the same productive relationship with Gov. Mark Warner that it had with his predecessor, Jim Gilmore. The feeling, undoubtedly, is mutual. The state has profited from the company's decision to build new tax-generating facilities in Tysons Corner, Fredericksburg and Richmond.
The company benefits from the reservoir of educated employees, good transportation and access to the mountains, beaches and Washington, D.C. Its experience working with state and local officials has been positive.

Increasingly, though, Capital One's future is overseas. Markets in the United Kingdom, where it is already profitable, and Canada are well established, and the company is making inroads into South Africa and Western Europe. Even economically troubled Latin America and Asia are possible growth targets. Expanding into the Third World at a time when developing nations have lost favor with investors would likely put the company at odds with conventional wisdom once again. But, as Virginians have discovered time and time again, this is a company that can deliver more than just junk mail.