Taking it to the bank
Capital One returns to its roots as it diversifies and shores up its funding base

by Jack Milligan
for Virginia Business
February 2007

When Signet Banking Corp. sold off Capital One Financial Corp. to the public in 1994, it seemed like a case of parental abandonment. How could a tiny credit card company hope to compete against giant banks in places like New York, Charlotte and San Francisco?

Quite nicely, it turns out. Indeed, Capital One provides a stirring example of how great timing and skillful execution can lead to tremendous success in business. In the early 1990s, the credit card industry was in the throes of a growth boom that would last for the next decade. And the voracious appetite of the nation's consumers for plastic credit - combined with the development of a highly sophisticated, technologically driven direct marketing strategy - made McLean-based Capital One one of the industry's largest and most successful players.

Ironically, Capital One has returned to its banking roots. In 2005, it paid about $5 billion to acquire New Orleans-based Hibernia Corp., followed by a second acquisition in March 2006, when it paid $14.6 billion for North Fork Bancorp in Melville, N.Y. The deals raised a lot of eyebrows on Wall Street since both companies are traditional commercial banks with large branch networks. The investment returns in traditional banking - mostly from consumer checking accounts and loans to small and medium-size businesses - aren't nearly as high as what the credit card sector has traditionally offered.

In the opinion of some investors, Capital One Chairman and Chief Executive Officer Richard Fairbank is adding unnecessary weight to his financial services dragster. Yet, Fairbank sees the acquisitions as transformational, necessary not only to keep the company in the race, but to provide fuel for the future, even though he has skeptical fans.

"I wasn't a fan of his entry into the broad banking business," says Tom Brown, president of Second Curve Capital, a New York-based hedge fund with investments in Capital One's stock. Through mid-January, the company's stock traded at about $77 a share - off sharply from the nearly $90-per-share price just days before the North Fork deal.

Traditional banks such as Hibernia and North Fork found themselves caught in a rate squeeze last year, which depressed the value of their stocks. The Federal Reserve kept short-term interest rates high to stamp out any signs of inflation, while concerns about a softening U.S. economy drove down long-term rates in the U.S. Treasury bond market. The result might be aptly described as a banker's version of hell: Companies like North Fork had to pay up to attract consumer deposits - but couldn't charge more for their business loans, where rates are influenced by goings-on in the bond market. The rate squeeze made many big institutional investors leery of bank stocks last year - and injected a degree of radioactivity into Capital One's stock that it otherwise might not have had. "I've had investors ask if this would be a $100 [per share] stock if it wasn't for North Fork," says securities analyst Scott Valentin at Friedman Billings Ramsey Group in Arlington.

Fairbank - a brainy, 55-year-old visionary with an MBA from the Stanford Graduate School of Business - defends both deals as critical events in the company's development. "As we evolved from a credit card company and consumer lending company, it was very clear that our opportunity for growth was going to be limited if we didn't transform the nature of our funding base, or if we didn't extend our distribution method to meet our customers' needs where they were," Fairbank told Virginia Business during an interview.

To understand what Fairbank is driving at, it helps to understand two things - beginning with his view of where banking in the United States is heading. Fairbank sees an industry that increasingly is taking on the shape of a barbell. On one end are the nation's mega-banks such as New York-based Citigroup and Charlotte-based Bank of America Corp., which now dominate consumer product categories such as credit cards, home mortgages and, to a lesser extent, car loans. These have become national consumer products businesses, just like toothpaste and paper towels.

On the other end of the spectrum are thousands of community and small regional banks that control local markets for consumer deposits and small business loans but have been elbowed out of the credit card and mortgage markets.

Fairbank intends to compete - and if possible, dominate - at both ends of the barbell. "We want to build a company that is a reflection of where banking is going," he says. "Half of banking is going national and half of banking is fiercely local."

Capital One was already an important player in a couple of national businesses. It's the fourth largest credit card company in the United States, with $51 billion in managed loans at the end of the third quarter last year. And it's also the third largest auto lender in the country. Acquiring Hibernia and North Fork provided Capital One with a local presence - particularly in the dense Manhattan and Long Island markets.

But this vision of banking's future wasn't the only factor that drove Fairbank to expand into branch banking. After a decade of acquisition-driven consolidation, the credit card industry is now effectively controlled by a handful of very large banks. While still quite profitable, the card business' best days are behind it, and Fairbank had to look elsewhere for growth.

Also as Capital One grew larger, Fairbank became increasingly concerned about the reliability of the company's funding base. To a large degree, banks fund their loans with low-cost consumer deposits - called core deposits in the trade - that include checking and savings accounts. Not only are these deposits a less expensive way of funding loans than selling high-rate certificates of deposit (CDs) or raising money on the capital markets by issuing various kinds of corporate debt, they're also more stable. It usually takes pretty bad service to make bank customers switch their checking accounts. The CD and capital markets, on the other hand, are highly rate sensitive. And the buyers of corporate debt also are likely to bolt if the company issuing that debt gets into trouble. It's no fun trying to run a company when you can't predict the cost or stability of your basic raw material - which in Capital One's case is money.

Fairbank also had reason to worry about his company's risk profile. While focusing on a few product categories can drive a financial company's earnings performance when those categories are booming - like plastic credit did through much of the 1990s - a lack of diversification can hurt if the company runs into a cyclical downturn. And that's pretty much what happened to Capital One in the summer of 2002.

Federal regulators were concerned about the company's rising exposure to subprime credit card borrowers, (people with less-than-stellar credit ratings). So, they forced Capital One to increase the amount of money it set aside to cover bad loans. Investors panicked, and Capital One's stock dropped 40 percent the next day.

Fast-forward four and half years and you'll find a much different situation today. Thanks to the Hibernia and North Fork acquisitions, credit card loans make up only a third of Capital One's loan portfolio compared with 68 percent in 2002. "From a risk diversification standpoint, [the acquisitions] have been transformational," Fairbank says. Another big improvement: The company gets about half of its funding from consumer deposits (including CDs). And thanks to its lower risk profile, Capital One has recently been awarded several credit rating upgrades from Standard & Poor's Corp. and Moody's Investor Corp.

Fairbank's diversification strategy has brought some tradeoffs as well. Most analysts expect that traditional banks - a label that now applies to Capital One - will struggle with an unfavorable interest-rate environment throughout most of this year. That could drive down their earnings - a prospect that probably explains the sharp drop in Capital One's stock price. "They entered the banking business at a very difficult time," says Second Curve Capital's Brown.

Instead of diversifying, Fairbank and Capital One's board of directors could have sold the company - and no doubt for a king's ransom. Another large credit card company, Newark, Del.-based MBNA Corp., sold itself to Bank of America in July 2005 - just a few months after Capital One bought Hibernia. In a deal valued at $34 billion, MBNA's shareholders received a 30 percent premium over the market price of their shares the day the buyout was announced. "Had [Fairbank] sold his company, I think he could have gotten [a premium for Capital One's stock] in the range of 20 to 40 percent," says Brown.

Assume for the moment that Capital One would have fetched the same 30 percent market premium as MBNA. On Friday, March 4, 2005 - two days before announcing its acquisition of Hibernia - Capital One's stock closed at $78.08 per share, according to the Wall Street Journal Online. A 30 percent premium would have bought out the company's stockholders at $101.50 a share. Compare that with where the company's shares are trading today and you can see why a Capital One investor might wonder if Fairbank's diversification strategy was such a good idea after all.

Although one could argue that he bought North Fork just as the rate squeeze was taking hold in consumer banking, Fairbank deserves time to prove that his strategy will work. And his record of success at Capital One is impressive enough that people like Brown and FBR's Valentin are willing to give him the benefit of the doubt. "When I look at what he has assembled, I think the franchise is still very strong," says Valentin. "I don't think he has damaged the [company's] franchise value at all."

Brown also has a high degree of confidence in Fairbank's management talents and believes he can still make a lot of money in the stock over time. "If they can get [the strategy] right, they'll be the best financial services company in the country," says Brown.

Still, those conservative investors who subscribe to the theory that a bird in the hand is worth two in the bush can't help but ruefully compare Capital One's share price today to what they might have received during a sale a few years ago. They're probably wishing that Fairbank was a little bit less of a visionary.