Capital One Charts a New Course

In 1994, Signet Banking Corp. – Richmond, Virginia-based regional bank – took the unusual step off spinning of its credit card division through an initial public offering. With just one product and no retail deposit base to fund its loans, the decision might have seemed foolhardyu00e2u20ac”or at best, quixotic. How could a tiny start-up hope to survive against the giant money-center banks that dominated the credit card business? Surely it would be stomped on.

In one of the great corporate success stories of the 1990s, that little company, Capital One Financial Corp., grew up to be one of the card industry’s largest and most dominant players. The timing of Capital One’s spin off was darn near perfect. The credit card industry was starting to boom and the company, which had established its headquarters in the Washington, D.C. suburb of Falls Church, Virginia, boomed along with it. Wall Street was happy to fund Capital One’s operations by turning its credit card loans into securities, and from 1996-2004 its annual return on equity never slipped below 21%, or its earnings-per-share growth below 20%. The company’s national advertising campaign features a merry band of Vikings who ask, “What’s in your wallet?” For much of its 12-year history, Capital One has done a great job of fattening its shareholders’ wallets.

But for all of Capital One’s success, there was one person who was never entirely sold on its so-called monoline structure. Almost from the beginning, Chairman and Chief Executive Officer Rich Fairbank pursued a strategy of diversification on both sides of the balance sheet. The execution of that strategy was cautious and incremental at first, but took a dramatic turn in March 2005 when Capital One acquired Hibernia Corp., a New Orleans-based regional bank with operations in Louisiana and Texas. Fairbank struck again in March 2006 when he bought North Fork Bancorp. in Melville, New York, another regional bank that had expanded beyond its traditional Long Island market into Manhattan, New Jersey, and southern Connecticut.

In just 12 months, Fairbank has dramatically transformed his company into something very different, and his execution has been bold and decisive. But Capital One never does anything without studying it closely first, and Fairbank has been driven by his vision of where the financial services industry is heading. Fairbank sees a world in which other major consumer lending businesses are consolidating rapidlyu00e2u20ac”just as the card sector already has doneu00e2u20ac”but where deposit gathering remains a local market dominated by well entrenched local players. And it is this national/local dichotomy that Fairbank intends to exploit by playing both games simultaneously.

“To compete nationally in national businesses and locally in local businesses, this is the blueprint we’re working from,” says Fairbank.

Fairbank’s diversification strategy is one he has discussed at great length with his board, which director W. Ronald Dietz says has been actively participating with the CEO as a “strategic collaborator.” In separate and lengthy interviews with Bank Director, both Fairbank and Dietz detailed the long evolution of Capital One’s diversification plan Dietz, president of a facilities management outsourcing firm and a director since 1995, says in the mid-1990s it was an intense two-day retreat. “It was pretty clear in everybody’s mind that diversification would be an important part of our future,” he says. But a CEO’s long-range vision can be easily stymied by a myopic board that cares only about next quarter’s earnings. In the Capital One board, Fairbank found a close partner.

“Boards of directors can amplify Wall Street’s focus on short-term performance,” Fairbank says. “And it can be a lonely place for a CEO who’s trying to craft a long-term strategy with a board having limited patience.”

In the credit card business, Capital One is known for its innovation and experimentation terms that can also be applied to this latest manifestation of Fairbank’s diversification strategy. Thomas K. Brown, president and founder of Second Curve Capital, a New York-based hedge fund that specializes in financial stocks (and also a regular columnist for this magazine), considers Fairbank to be the “best strategic thinker of any financial services CEO I know.” His fund has been a long-time investor in Capital One stock, and he continues to support the company. But Brown is also somewhat skeptical about whether Fairbank’s strategy of pursuing dual national and local strategies will succeed.

“He’s trying to do what no other financial services company has done manage national businesses nationally and local businesses locally,” says Brown. “They involve totally different mind-sets. I don’t know if you can do that.”

From a line-of-business perspective, Capital One had gradually become more diversified even before the Hibernia deal. In recent years the company has pushed into auto finance and in 2005, it was the second-largest noncaptive originator of car loans after J.P. Morgan Chase & Co. with 6.4% market share (captive finance companies like General Motors Acceptance Corp. dominate the auto finance business). The company also markets small-business loans and home equity lines of credit, and it makes installment loans through direct mail pitches and over the Internet.

The acquisition of $22 billion Hibernia gave Capital One a commanding presence in the Louisiana banking market and a foothold in neighboring Texas, where Hibernia had already launched a modest de novo branching effort. More importantly, it gave Capital One access to a rich trove of retail bank deposits that could be used to reduce its reliance on the capital markets for its funding.

But when viewed from the perspective of profitability even after factoring in the acquisition of Hibernia Capital One still has an overwhelming reliance on credit cards. The company reported net income in 2005 of $1.8 billion, more than 80% of which came from cards, including small operations in Canada and the United Kingdom. Capital One ranked fourth among credit card issuers with managed loans totaling $49.5 billion.

From the very beginning, the heart of Capital One’s credit card strategy has been a highly analytical approach to product design and marketing that the company refers to as its information-based strategy, or IBS. Capital One uses its technology-based analytical skills and a vast proprietary database to tailor products that will appeal to specific individuals rather than broad demographic groups of potential customers. Before rolling out a major campaign, the company rigorously tests a product or marketing idea to refine it first. For example, it might divide the population into small segments and pitch a slightly different credit card offer to each group in order to see what works and what doesn’t. Most of the company’s card marketing efforts are accomplished through direct mail campaigns, and according to a published report, it once experimented with the placement of an important sentence on the back of an envelope for a direct mail piece to see what effect it would have.

Capital One’s highly analytic culture which is also evident in its hiring practices and even in its philanthropic activities is the product of Fairbank and former colleague Nigel Morris, who resigned in 2004 as president and chief operating officer. A native of California, the 55-year-old Fairbank graduated from the Stanford Graduate School of Business in 1981 with his MBA. He subsequently joined a consulting firm where he became interested in how the power of information technology could be applied to consumer marketing. Among Fairbank’s clients were a number of banks that were in the credit card business, and he eventually decided to see if he could find a bank that would hire him to build a credit card portfolio using his information-based strategy.

Fairbank recruited Morris, an Englishman who had joined the same consulting firm after graduating from the London Business School, in the effort. According to a 2004 case study on Capital One published by the Stanford business school, Fairbank and Morris pitched the idea to approximately 25 banks before Signet hired them in 1988 to put their ideas into action. Their first big breakthrough came three years later when they launched a low-introductory-rate balance-transfer card that was an overnight success. By 1994, Signet’s credit card revenue had grown so fast that the division was actually larger than the rest of the bank, so the unit was spun off in an IPO in order to more fully capture its economic value.

Fairbank also pegs Capital One’s diversification strategy back to the mid-1990s when he initially discussed with his board the necessity of evolving beyond credit cards. The company’s first meaningful attempt to expand outside the credit card arena occurred in 1996 when it tried to build a business reselling blocks of cellular calling time to consumers. Plagued by overcapacity, the wireless telecommunications industry later went through a painful restructuring, and the cellular product bombed. Capital One pulled the plug on it in 2001.

The company had much better luck in car loans. In 1998 it acquired Summit Acceptance Corp., a Dallas-based subprime lender that did business in 26 states. Capital One has successfully applied its IBS approach to the auto sector and now has $16.4 billion in managed car loans, its second-largest loan portfolio after cards. Since then, the company has also become the third-largest Small Business Administration lender in the country. And it has also used its IBS approach, direct mail skills, and some small acquisitions to establish beachheads in the home equity and consumer lending markets.

Fairbank never intended that his diversification strategy be limited to the asset side of the balance sheet. He was probably even more eager to diversify on the liability sideu00e2u20ac”and the events of 1998 lent a sense of great urgency to the obtainment of that objective. When the Russian government defaulted on its bonds that year, it set off a chain reaction throughout the global capital markets that culminated in the U.S. with the failure of Long-Term Capital Management, a high-profile hedge fund that invested in a dizzying array of U.S. government securities, sovereign debt, and various derivative-type instruments. The entire affair put the U.S. capital market into a deep chill and made it difficult and more expensive for companies like Capital One to fund their activities. “Every CEO who runs a monoline company and doesn’t have deposit funding wakes up every morning and says, ‘Gee, I’m really at the mercy of the capital markets,’” says John Chrin, managing director for the financial institutions group at J.P. Morgan Securities in New York, which represented Hibernia in its acquisition by Capital One.

The second shock occurred in 2002 when the Federal Reserve and Office of Thrift Supervisionu00e2u20ac”Capital One conducts some of its business through a federally chartered thriftu00e2u20ac”forced the company to double the amount of capital it held against its subprime loans and increase its loss reserves. The company had moved aggressively into the subprime market where the returns are higher, and the feds thought it was taking on too much risk. That rebuke caused nearly a 50% drop in Capital One’s market value in a single day and made Fairbank even more determined to reduce the company’s risk profile through greater diversification. “I was a believer before that, but for anyone who might have been a doubter, that event was Exhibit A for the vulnerability of the company,” he says.

When it comes to corporate strategy, Fairbank believes most corporations do it all wrong. “Most companies really don’t have what I would call a strategy,” he says. “They have a set of goals, things like ‘We want to grow, we want to cut costs (and) improve service quality.’ Those are just objectives.

“A strategy must begin with identifying where the market is going,” Fairbank continues. “What’s the end game and how is the company going to win?” In other words, CEOs and their boards need to figure out where the market is heading and work back from there. “Typically, companies work forward from where they are,” Fairbank says. “And they think it is a bold move to change 10% from where they are. But when one starts with ‘This is the market, this is the end game, this is where the market is heading, and this is the timing of when the market is likely to get there,’ you are faced with a very different kind of reality. It creates a much greater sense of urgency and allows the company to make bold moves from a position of strength.”

And the financial services marketplace Fairbank sees when he gazes into his crystal ball is one that presents banks and specialty finance companies like Capital One with an interesting dichotomy. On the one hand, Fairbank expects to see rapid consolidation of the consumer lending business, a process that is effectively over in the credit card sector. According to Capital One’s own data, the 10 largest credit card issuers now control over 90% of the market. The consolidation phase is not quite so advanced in four other consumer loan categoriesu00e2u20ac”home equity, mortgage, student, and autou00e2u20ac”where the 10 largest players control smaller but still sizeable market shares, ranging from 66% for home equity to 42% for auto. And two consumer segmentsu00e2u20ac”installment loans and small-business lendingu00e2u20ac”are highly fragmented, with the top 10 players controlling just 22% and 16%, respectively.

“Banks talk about consolidation, but they tend to talk about it one institution at a time,” Fairbank says. “There is a much more rapid consolidation that’s happening and that is consolidation one [retail] product at a time. Long before the 8,000 banks in America consolidate to a much smaller number, the [consumer] marketplace will have already played out one product at a time. On the consumer lending side, these are becoming massive, national-scale businesses because they have huge economies of scaleu00e2u20ac”and most important, scaled economies around the information scale.” And in case you missed the point that Fairbank is really trying make, they’re businesses that lend themselves nicely to Capital One’s data-intensive IBS approach. What Fairbank did in credit cards, he hopes to do in these other consumer lending businesses as well.

“I think virtually all of these consumer lending businesses are going to play out like the credit card business,” he says. “It will be a handful of players in the end who will be competitive and relevant.”

Fairbank sees a much different situation in the retail deposit marketplace, which remains highly fragmented and community oriented. “This is a fiercely local business,” he says. “It is about local scale and local execution. Players who are very large in their local geographies do generate more than their share of deposits.”

Fairbank also believes that this dichotomyu00e2u20ac”a rapidly consolidating consumer lending market juxtaposed with a deposit market that remains local in its orientationu00e2u20ac”presents a particularly difficult challenge for the banking industry’s largest companies. While some of them have been successful players in the asset consolidation game, the scale of their multistate branch networks hasn’t helped them as much when it comes to growing deposits.

“While the big banks are building national-scale consumer lending businesses, they have really struggled to be competitive in some of their branch banking activities,” Fairbank says. “And I think their struggle is how to execute locally in some of the businesses while executing nationally in others. It’s culturally a very hard thing to do.”

Scott Valentin, a bank stock analyst who covers Capital One for Friedman, Billings, Ramsey & Co. in Arlington, Virginia, concurs with Fairbank’s indictment of the big banks. “Being a national player really plays no role in getting deposits,” he says.

Fairbank’s solution to the dichotomization of the retail financial services marketplace has been to play in both markets at the same time, but in ways that will best ensure success. Capital One already knew how to compete as a national consolidator on the lending side, but as a direct mail company it lacked a presence in local deposit markets. What it needed was a bank with a brick-and-mortar branch franchise, and Dietz says he first remembers Fairbank raising the possibility of acquiring a depository institution shortly after the failure of Long-Term Capital sent the capital markets into high alert and threatened the company’s funding.

Capital One is a company that rarely does anything without studying it exhaustingly first, and five years before the Hibernia deal Fairbank had assembled a group of strategic planners, analysts, and bankers to scout for potential bank acquisitions. The company even went so far as to announce in 2003 that it was considering the possibility of buying a bank, an unusual step that Dietz describes as a “strategic disclosure.” Because this would clearly be a transformational deal that might run into some resistance on Wall Street, Capital One thought it best to signal its intentions early. “It gave people a better comfort [level] and a sense of expectation, getting people used to the idea,” Dietz explains.

It ended up taking nearly two years for Fairbank to find the right strategic partner. It turned out to be Hibernia, which Capital One acquired in March 2005 for $5.3 billion. Hibernia might have seemed like an odd choice for a national consumer lender headquartered in Northern Virginia, but in some ways it was just the kind of bank Fairbank had been looking for. Hibernia had the largest deposit market shareu00e2u20ac”21.1%u00e2u20ac”of any bank in Louisiana, so it had the local scale Fairbank wanted. The bank had also started expanding into Texas under President and CEO J. Herbert Boydstun, which gave Capital One a small wedge into a large market with good growth characteristics.

Furthermore, Hibernia would also enable Capital One to lessen reliance on the capital markets for its funding. “That market is a better source of deposits than a source of loans,” says Sanjiv Sobti, a senior managing director in the financial institutions group at Bear Stearns Companies Inc., which represented Hibernia in the deal. Even before Hurricane Katrina devastated New Orleans and the surrounding area last year, Louisiana had one of the slowest-growing economies in the country, and Hibernia actually had more deposits than loans.

However, it did take time for the Hibernia board to understand what its future would be like as a subsidiary of a credit card company. Chrin at J.P. Morgan says that Hibernia’s board was conservative by nature, and some of its directors tended to see credit cards as a high-risk business. Boydstun agrees that it took time for some of his directors to become comfortable with the proposed transaction. “Their reaction was, ‘Herb, tell us why this deal makes sense. How does this create value for our shareholders? How do we fit with Capital One?’”

But Fairbank ended up making a strong presentation to the board, and Capital One did offer certain advantages as an acquirer that became obvious to Hibernia’s directors. With no overlap, Hibernia’s employees would be better protected than if the acquirer were another bank with an overlapping Louisiana branch network of its own. According to Boydstun, who stayed on to run the new operation, Capital One’s deep pockets have enabled him to accelerate Hibernia’s de novo branching effort in Texas, where the company had little brand awareness. “A brand like Capital One has enabled us to grow even faster than we were growing,” says Boydstun.

Capital One’s broad product arsenal also provided many cross-sell opportunities with Hibernia branch customersu00e2u20ac”in fact, Capital One has more customers in Louisiana than the old Hibernia did. “We came to the conclusion that we could be a better company as part of Capital One,” Boydstun says.

Unfortunately, between the announcement of the Hibernia acquisition and its closing, Hurricane Katrina devastated the region. As Louisiana’s largest bank, Hibernia was certain to be affected, although how much no one knew for sure. Dietz says the Capital One board wrestled with whether it should back out of the deal or stand up to its commitment. “Was the value of this acquisition such that we should take on the uncertainty of the hurricane damage? What was the resiliency of the city in terms of its ability to recover? What would be the effect on the people?” Of course, the answers to these questions were not within reachu00e2u20ac”not a comfortable position for a deeply analytical company that prefers to make decisions based on fact rather than intuition. “At the end of the day, you’ve got to throw your coin into the Trevi Fountain,” says Dietz. “It was as much based on intangibles as anything empirical.” Capital One and Hibernia did agree to reduce the purchase price by $300 million, but otherwise the deal stayed the same.

There’s an adage in the M&A business that banks are sold rather than bought, which is to say the seller usually controls the timing. One year after the Hibernia deal, Fairbank agreed to pay $14.6 billion to acquire North Forku00e2u20ac”a company he had coveted for some time. The timing was less than ideal since Capital One hadn’t completed the integration of Hibernia yet. “We didn’t plan on making another acquisition so soon,” Fairbank told analysts and investors during a webcast the day the deal was formally announced. “But we can’t pick the time when banks are interested in selling to us.”

According to analysts and merger advisers, CEO John Kansas’s hand was forced by the negative impact a flat yield curve was having on the bank’s profitability. It had been funding its longer-maturity assets with short-term funds, and as interest rates rose under persistent tightening by the Federal Reserve, the bank’s profitability came under pressure. “It chose to play the yield curve game more than most,” says Brown at Second Curve Capital. “[Kanas] was looking at a down year in 2006 compared to 2005.” And the longer Kanas waited to sell, the less he was likely to get.

When Capital One analyzed potential acquisitions, North Fork stood out as being a particularly desirable strategic partner. Fairbank and Kanas had gotten together a few years earlier to talk about their respective banks. “We compared notes on our business models,” Fairbank says. “We had been very interested in John’s business model from the outset.” The two CEOs kept their dialogue going by, among other things, playing an occasional round of golf together. [Kanas did not respond to an interview request for this story.] “North Fork was one [acquisition target] we thought we’d never get,” says Fairbank.

It’s easy to see why Fairbank would be so interested in acquiring North Fork. It commands the third-largest retail deposit base in the greater New York market, which includes the five boroughs of New York City, Long Island, Northern New Jersey, and southern Connecticut. It also has the fourth-largest deposit market share in Manhattan, which has an estimated $431 billion in total retail and small business deposits and dwarfs the second-largest marketu00e2u20ac”Los Angelesu00e2u20ac”which has a mere $238 billion. Looked at another way, North Fork has plenty of local scale in the richest deposit market in the country. “The depth of [the] New York [deposit market] is incredible,” says Fairbank.

The acquisition will benefit the asset side of the balance sheet as well. North Fork is the third-largest small business lender in the New York market, and also the 13th-largest home equity loan originator in the country, so the deal will help Capital One build more scale in those categories. Moreover, North Fork is the country’s seventh-largest originator of low-documentation mortgage loans, referred to in the trade as the Alt-A market, which gives Capital One a foothold in the mortgage businessu00e2u20ac”the one major consumer loan segment where it did not have a presence. Ironically, North Fork got into this business in 2004 after it acquired New York-based GreenPoint Financial Corp., the state’s second-largest thrift. According to Brown, Capital One tried to acquire GreenPoint itself but was rebuffed.

Under the terms of the proposed acquisition, Kanas will stay on to run Capital One’s banking business and will report to Fairbank. Boydstun will continue to run the Louisiana and Texas banking operations and will report to Kanas.

If Fairbank’s strategic objective was to create a more diversified company with local scale, he seems to have done so. Once the North Fork deal closes, core deposits will account for 32% of Capital One’s overall fundingu00e2u20ac”up from practically zilch just a year and a half ago. The credit card operation will account for only 51% of the company’s earnings, so Capital One will also be a more balanced company. And it gains an important foothold in the mortgage business, which is key to Fairbank’s objective of becoming a major consolidator in the consumer lending market.

Although he wishes the two deals could have been spread further apart, Valentin at Friedman, Billings says he’s still on board with Fairbank’s diversification strategy. “If they just maintained their credit card strategy, their growth would slow drastically,” he says. “Long term, are you building a company that’s more valuable? I think so.”

But there are elements of Fairbank’s diversification strategy that entail more than a little risku00e2u20ac”beginning with the fact that no other financial services company has organized itself specifically to exploit the national/local dichotomy that Fairbank likes to talk about. Brown says he tried on two occasions to persuade Fairbank not to acquire a bank, but was spurned each time. And the second time, according to Brown, “He said, ‘Tom, acquiring a branch bank is in the company’s destiny, so get used to it.’”

Dietz alluded to the same concerns when describing some of the conversations Capital One’s board had a few years ago about Fairbank’s diversification strategy. “Capital One is a direct marketing company,” Dietz says. “We are highly analytical around segmentation and around credit differentiators. We are a national player in the selected markets we have entered in terms of lending. Meanwhile, the deposit business is a personal selling business. It’s a brick-and-mortar business. It’s a local color business. And obviously one question [the board asked] was how comfortable we were with our ability to excel in that business.”

One important factor in making the local strategy work, according to Brown, will be to keep the highly regarded Kanas involved. Kanas signed a three-year contract as part of the merger agreement, but Brown and others wonder how well he will adapt to no longer being the lead dog pulling the sled. “I think as long as they keep Kanas engaged and don’t change North Fork’s way of doing business, the deal has some good potential,” says John Duffy, CEO and president of New York-based Keefe Bruyette & Woods, which advised North Fork in the transaction.

There is another risk that Fairbank may be taking with his diversification strategy. As the bank expands into new businesses and broadens its focus, it will need to guard against its financial results trending down toward the average performance of most other highly diversified banks. Fairbank acknowledges the risk and says it will be important to “choose businesses that are structurally attractive. There are a lot of businesses in banking that are not structurally attractive.”

But Capital One will also have to show that it can build a successful business model around two very different culturesu00e2u20ac”one deeply analytical and the other people-centered. As the financial services industry evolves toward its own end game, Fairbank says it’s important to understand the difference between businesses that are national and local, and run them accordingly. “We have a chance to do things differently,” he says.

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