Return to Virginia Business - September 2003

Changing course
Yanked by federal regulators, Capital One moves away from sub-prime market customers, slowing its growth. What does the transition mean for Virginia where the company employs thousands and is in the middle of a huge corporate expansion?

Related story:
- Q&A with Richard Fairbank

by Jack Milligan
Virginia Business
September 2003

Since its birth in 1994 as a spin-off of a regional bank, credit card powerhouse Capital One Financial Corp. has barged ahead at just one speed: fast forward. Led by Californian Richard Fairbank and Englishman Nigel Morris, the Virginia-based company tore through the credit-card business in the 1990s, digging through reams of consumer data to create scores of customized products for niche groups.

While its stodgier competitors stuck with double-digit interest rates, Capital One rolled out the first balance-transfer cards with low teaser rates and then barraged selected customers with marketing. The strategy was amazingly successful. The company quickly became one of the top issuers of credit cards in the U.S., racking up huge stock gains and a compound annual growth rate of more than 30 percent. It built new corporate locations in Northern Virginia and near Richmond and boasted that its “What’s In Your Wallet?” ad campaign made it one of the country’s best-known brands. Fairbank and Morris were heralded as visionaries.

In July 2002, though, the wild romp ended. First came federal regulators wanting to know, well, what was in Capital One’s wallet. Nervous about the company’s fast growth and appetite for higher-risk sub-prime customers, they ordered it to double the capital it held against sub-prime loans and increase its loan loss reserves. The intervention made investors nervous, and the company’s shares dropped 40 percent in one day to $30.48.

Soon to follow was a class-action lawsuit brought (and later dismissed) by disgruntled shareholders who alleged insider trading by some Capital One executives prior to the Fed’s regulatory action. Then March of this year brought another blow: CFO David M. Willey resigned after learning that securities regulators planned civil action against him for alleged insider trading. So far no charges have been brought against Willey or any other Capital One executive, but the SEC probe raised questions about the company’s internal controls.
Finally, in April, Morris, 44 — the company’s president and COO and Fairbank’s longtime business partner — stepped down, citing personal reasons. He serves now as vice chairman of the board of directors, but plans to leave for good in April 2004.

Clearly, this is going to be a different company, one that perhaps makes less money but won’t get its leash yanked by regulators or investors. Fairbank, 52, is remaking the company into a tamer version of itself. He’s moving it away from sub-prime customers with poor credit histories who worried investors and attracted regulators, and going after safer but less-profitable prime and super-prime customers. Even before the feds stepped in the company had been diversifying, with 30 percent of its portfolio now comprised of automobile, international and installment loans. “We’ve been able to go through this very noisy period and come out the other side a stronger company for having gone through it,” Fairbank says.

Capital One’s stock has rebounded and second-quarter earnings were $286.8 million, up 34 percent from the same period a year ago. The company has told Wall Street analysts that it expects earnings to grow 16 percent in 2003. Capital One expects that a lower growth rate of between 15 percent and 20 percent will be a more realistic target in the years ahead.

But questions remain about whether Capital One’s new strategy can produce even those returns. The top end of the credit card market may entail less risk, but it’s also extremely competitive and generally offers a lower return, because you can’t charge creditworthy customers as much interest as those with questionable credit histories. Plus, as it moves up market, Capital One will be competing with financial services giants such as Citigroup, MBNA Corp. and Bank One Corp.

So far, reaction to this shift in portfolio has been mixed. “It’s a difficult execution and that creates uncertainty in terms of the earnings outlook,” says stock analyst Reilly Tierney at securities firm Fox-Pitt, Kelton Inc. in New York. “It’s difficult to get really high earnings growth from that model.” One analyst who follows the company expressed relief. “Prior to this year, the growth had been at an astounding rate — growing more than 50 percent in some cases. You just can’t sustain those rates,” says David M. West, director of research at Davenport & Co. in Richmond. “It’s a good thing for the company in the long-term, though it may be painful in the short-term.”

There’s another question no one can answer yet. Can a slower-growing company with lower returns still command a major following on Wall Street? And what does the transition mean for Virginia, where Capital One employs more than 10,000 people and is in the middle of one of the largest corporate expansions in state history? If the company meets its targets of between 15 percent and 20 percent, that growth rate compares favorably to other public companies today. “I would say they have a shot at 20 percent for a couple more years,” says securities analyst Moshe Orenbuch at New York-based Credit Suisse First Boston. “I’d say that 15 percent is more likely — but there are very few companies that even grow at 15 percent.”
Tierney at Fox-Pitt isn’t so sure that the large institutional investors who comprise most of Capital One’s shareholder base will find a 15 percent growth rate all that appealing, given that it still has more risk than a regional bank. Through early August the company’s stock was trading at about 10 times earnings — well down from a high of 25 just two years ago. Tierney says the company’s strategic mix offers mixed benefits to investors. “Ultimately the market will be able to sleep at night, but I don’t think [the stock] will get a multiple of 20.”

Besides calming skittish investors, Fairbank has had his hands full responding to the turnover in senior management. He has completely overhauled Capital One’s management structure by creating an executive committee comprised of the heads of key business lines who report directly to him. Willey has been replaced with Gary L. Perlin, previously the CFO at the Washington, D.C.-based World Bank. Morris, Fairbank’s alter ego since the late 1980s, was harder to replace. Together, the duo pioneered the information-based strategy that remains the company’s hallmark for operations today. Under the new structure there is no COO, although the committee has taken on the position's key responsibilities.

After spending the past 17 years working 70-hour weeks building Capital One’s business, Morris says he wants more time with his family. He and his wife have four children, ages five to 15. He quickly dispels any notion that his departure is related to the company’s new course. “Capital One has a very bright future ahead of it and has made the right strategic decisions,” he says. “This [decision to leave] is about me and my personal needs.” The company announced last month that Morris will sell 3 million shares of Capital One stock over the next year to “diversify his financial assets,” leaving him with about 3.3 million options. He’s also signing a noncompete agreement and in exchange getting nearly $3.8 million over five years.

The strategic moves to shore up the company’s stock and management are good news for Virginia too, since Capital One is a major employer. In metropolitan Richmond, the company is the largest nongovernmental employer, with 9,279 workers and offices in Henrico, Chesterfield and Goochland counties. Capital One became one of Virginia’s most prized corporate citizens in 2000 when it announced a $700 million expansion and thousands of new jobs. Despite the challenges of the last year, the brick and mortar part of the expansion seems to be on track. Earlier this year, Capital One relocated its corporate headquarters from Falls Church to McLean, moving into a gleaming new office building near Tysons Corner. In the Richmond area, construction continues at its new West Creek campus in Goochland, where four of seven planned buildings for staff operations are already up.

The slow economy, however, makes it unlikely that Capital One will hire an additional 8,000 employees, as it projected, by 2004. Six thousand of the jobs were planned for the Goochland campus. “Our headcount has been flat over the last few years. We’ve continued to hire, but often that’s been offset by attrition,” says company spokesman Hamilton Holloway. The company is closing its call center in Spotsylvania County this December, and offering workers there jobs in Richmond-area locations.

Capital One’s massive expansion was secured in part by the state and localities putting together a $27 million package of cash, incentives and training services. Some of the training assistance will only be available if the company meets hiring thresholds.

Lately Capital One’s reputation as a good place to work has slipped. It made Fortune magazine’s “100 Best Places To Work in America” list four years in a row, from 1999 to 2002, but failed to make this year’s list, with rankings determined primarily by employee surveys. Last December, a group of former employees filed an age-discrimination lawsuit seeking $50 million in damages. The suit, settled in June under undisclosed terms, alleged unfair treatment after some employees were fired following Capital One’s implementation of a new employee-ranking program.

One employee takes a philosophic view about the company’s recent ups and downs. “The honeymoon period can’t last forever. Now we’re starting to function more like a corporation that’s adjusting to problems and changes in the climate.” Still, Capital One offers perks workers rarely find other places, such as “fun days” — employee outings paid for by the company. “Next week,” says the employee, “we’re going sailing on the Chesapeake Bay.”

Still, it’s by no means clear sailing yet for Capital One. The company continues to operate under a “memorandum of understanding” with regulators at the Federal Reserve and U.S. Department of Treasury’s Office of Thrift Supervision. It is an informal but nonetheless binding agreement, and the company will continue to operate under greater regulatory scrutiny until the Fed’s concerns have eased.

Perhaps even more troubling at this point is the large number of investors who still maintain short positions in Capital One’s stock, hoping to profit from another collapse in its price. Nearly 24 million Capital One shares had been shorted as of late July — half of the outstanding short position in April, but still significant. “There’s still a lot of skepticism,” says Tom Brown, president of Second Curve Capital, a New York-based hedge fund that has invested in the company. “People still believe it’s going to blow up at some point.”
That skepticism stems in part from problems the credit-card sector has had lately. Among independent credit card companies only Capital One and Wilmington, Del.-based MBNA remain healthy and growing. Two others that specialized in sub-prime lending — San Francisco-based Providian Financial and Minnetonka, Minn.-based Metris Cos. Inc. — have been whacked by the soft economy and lost most of their market value since 2001. A third, NextCard Inc., filed for Chapter 11 bankruptcy protection last year. Fairbank counted 50 independent finance companies (known in the industry as monolines) back in the 1990s. “Today there are very few left,” he says. “Many are dead. A lot have been sold. And of the remaining companies, many of them are hanging by their fingernails.”

The recession that began in 2001 and the terrorist attacks that year depressed the stocks of financial services companies, which depend on consumer spending. As the economy remained weak into 2002, Wall Street grew concerned about the sub-prime credit card sector, where Capital One was increasingly seeking new customers. Those accounts tended to generate higher returns since issuers can charge heftier fees and higher rates. Overall, the company expanded its loan portfolio (all loans-not just sub-prime) 46 percent in 2000 and 53 percent in 2001.

With companies getting into trouble, investors and regulators responded. “The logical thing to do was to look at who else is out there with the risk factors that correlated with trouble for other companies: a monoline sort of structure, some degree of sub-prime, fast growth and credit cards. [People] saw all those things present at Capital One,” Fairbank says.

At Capital One though, Fairbank believes the reality wasn’t as bad as the perception. Until late last year it compared favorably with the industry average for charging off bad credit card loans, evidence, in the company’s view, that it makes sound and conservative credit decisions in the sub-prime market. According to the company’s own analysis, its charge-off rate was at or below the industry average from 1999 until the third quarter of 2002, when it was slightly above average. By the second quarter of this year, the company’s charge-off rate had declined to 6.32 percent — seventh best in the credit card industry and 1.21 percent behind industry leader Bank One.

However, none of those six companies has nearly as high a percentage of sub-prime loans on their books as Capital One.
The company has told analysts that its loss rate may rise slightly in the second half of the year (due to technical factors not affected by sub-prime assets), then improve through 2004 as the overall concentration of sub-prime loans is gradually reduced to the industry average of 36 percent.

As it moves away from sub-prime, Capital One is courting customers with good credit records. It has rolled out a fixed 4.99 percent MasterCard that waives both membership and cash-advance fees for such customers, although some competitors are going after the same pool with zero percent interest rates, at least for a time. Capital One is also issuing more credit cards in the United Kingdom and to a lesser extent in Canada, France and South Africa.

Broadening the company’s product base is also part of the plan. The company now sells life insurance and makes installment, medical, mortgage and car loans. Of these, auto loans offer the greatest short-term promise. Capital One has been building the business since 1997 and has originated $8 billion in loans so far. “This is a business that will enjoy a meaningful improvement in returns and dollar earnings contributions,” says securities analyst Orenbuch.

Although its strategic transformation is far from complete, Capital One seems to have rebounded from its earlier difficulties. Its stock price is up around $50, recovering from its 52-week low of $24.91 in March. At the end of the second quarter, the company reported 46 million managed credit card accounts and $60 billion in managed loans. Its market capitalization stood at $11.3 billion last month, and revenues for fiscal 2002 were more than $8 billion.

There was a time last winter, when the consumer finance industry was beginning to look pretty ragged, that there was considerable speculation that Capital One might be forced to find a buyer. Fairbank, though, seems determined for now to keep on an independent course. Stock analyst Tierney doubts that Fairbank, who owns 869,163 shares and holds 11.4 million options, has any interest in selling out. “I think he’s having fun. ... I don’t think he labored so hard over the last two years to punt now.”

Indeed a more likely alternative would be for Capital One to some day buy a regional bank. Such a move would provide the company with a broader funding base in the form of insured bank deposits, while giving it additional distribution channels. “Since most retail products in America are sold through traditional, on-the-ground, face-to-face networks, I think some involvement in those will be inevitable,” Fairbank says. “In the long run, I think it’s part of our destiny.”

So maybe the company will come full circle. In the meantime, Fairbank oversees the company’s evolution from a fast-growing independent credit card company to a more broadly diversified and slower-growing financial services company, confident that it can learn some new tricks.

Return to Virginia Business - September 2003