In consumer lending, every product is evolving in the same direction as credit cards-toward large, national-scale consolidators replacing local, face-to-face lending. That evolution has happened in credit cards. It’s well under way in auto finance, mortgages, and home equity. Its coming more slowly in installment lending. So consumer lending, a major part of the asset side of banking, is all flowing toward national consolidators like Capital One. -RICHARD D. FAIRBANK, CEO AND CHAIRMAN, CAPITAL ONE FINANCIAL CORPORATION’
United Kingdom, the Hfs Group, to strengthen its Global Financial services (GFS) subsidiary in the British market. As of April 2005, it possessed sufficient liquidity ($21 billion) and capital ($9.2 billion)4 to enable its famous brand to expand into new markets and seize the right opportunities for profitable growth. Although the company’s acquisition of Hibernia in March 2005 provided it an opportunity to enter the fast-developing Texas markets of Houston and Dallas, it might face stiff competition from other large credit companies, such as Citigroup and J.P. Morgan.
Capital One Financial Corporation is a diversified bank holding company, with a 2005 market value of $18.92 billion. It provides a gamut of financial services through its main subsidiaries-Capital One Bank, Capital One FS.B. (which offers consumer and commercial lending and consumer deposit products), and Capital One Auto Finance Inc (COAF). From a small local bankcard issuer in 1995, the company has transformed itself into one of the largest financial institutions in the United States by continually introducing a steady stream of products. It features one of the most recognized brands in the industry, which it leverages along with its strategies of direct marketing, risk analysis, and information technology to grow and diversify into other businesses.
Ranked 206th in the Fortune 500 list in 2005,2 the company has been gradually transforming itself from a credit card company to an institution that provides banking and other financial services to consumers. By January 2005, it was the 31st largest deposit institution in the United States with $25.6 billion3 in interest-bearing deposits. Capital One has been on the path of diversification from the late 1990s and has made three acquisitions between 2004 and 2005: Onyx Acceptance Corporation, eSmartloan, and Hibernia National Bank. It has also acquired a home equity brokerage company in the Capital One is the fifth largest credit card provider in the United States5 and one of the largest issuers of MasterCard and Visa credit cards. It was founded as a wholly owned subsidiary of Virginia-based Signet Bank when Richard D. Fairbank, CEO and chairman of Capital One, was invited by the bank to head its bankcard division.
It began its operations in 1953, the same year MasterCard International was formed. Fairbank and the former vice chairman of Capital One, Nigel Morris, realized that traditional banks offered loans without focusing on the customers-like analyzing their risk characteristics. They decided that by using technology and data mining techniques in the decision- making process of providing credit, the bank could charge the appropriate interest rates more accurately and earn greater profits. In 1994, Capital One was spun off from Signet as a public credit card company and established itself in McLean, Virginia. It had an initial public offering of 7,125,000 shares of common stock in the United States and Canada, at a price of $16 per share,6 which was managed by J.P. Morgan Securities Ine., Goldman, Sachs & Co. and Barney Ine. It is a part of the S&P 500 index, and also trades on the New York Stock Exchange with the symbol COF
~ This case was written by Susmita Nandi, under the direction of Sumit Kumar Chaudhuri, ICFAI Business School Case Development Centre. It is intended to be :;: used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from 25 published sources. © 2005, ICFAI Business School Case Development Centre. No part of this publication may be copied, stored, transmitted, reproduced, or © distributed in any form or medium whatsoever without the permission of the copyright owner.
Between 1994 and 2004, the company grew at an annual compound rate of 29 percent/ both in terms of its EPS and the number of customers. In 2004, its earnings were $1.5 billion, and the EPS was at $6.21.8 At the end of 2004, the company and its subsidiaries held 48.6 million accounts and $79.9 billion9 in managed loans outstanding, which grew by 12 percent ($8.6 billion) over the previous year (see Exhibit 1). It had 17,760 employees in March 2005. The bank offers 7,00010variations of its MasterCard and Visa cards, each one is customized to appeal to different customer preferences and needs by combining product features such as different backgrounds and colors, along with varied annual percentage rates, credit limits, fees, and rewards programs. Capital One’s pricing strategy is based on the risk level of its customers.
It offers platinum and gold cards to its preferred customers with excellent credit history and a wide range of secured and unsecured cards to customers with limited or poor credit history. The company also provides a range of consumer products like auto finanCing, mortgage services, credit insurance, and home-equity loans. Customizations of credit cards at Capital One are made with the support of its Information-Based Strategy (IBS), which uses sophisticated data-mining techniques to match its credit cards (its combination of interest rates, fees, rewards, and other conditions) with targeted customers based on their credit scores, credit uses, and other parameters. IBS is the fusion of one of the world’s largest databases, information systems, a well-trained team of analysts and statisticians, and advanced scoring models. The company’s decision-making process is made efficient by bringing together marketing, credit, risk, and information technology. It selects its most profitable customers and the appropriate rate by using the rigorous testing of econometric and time series models.
The credit ratings of customers is based on the Fair Isaac Corporation (FICO) scores, which are used to predict payment risk by looking at several variables, including credit history. The IBS system uses FICO scores to divide its customers into three groups of super-prime (with excellent credit history), prime (average credit history), and sub-prime (with poor or very little credit history). Through the use of IBS, the company has been able to locate a group of students who were not included in the mailing lists of other credit card companies because these students, mostly unemployed and little or no credit histories, were considered high risk.
Capital One’s strategy of sending credit card applications, which were tailored to the needs of these students, proved effective, as 70 percent of the applications were filled and mailed back, thus creating a new market for the company. IBS has also helped Capital One avoid customers who do not pay interest charges on loans. The charge-off rate (for bad debt) of Capital One is the industry’s lowest, and for 2004 was at 4.37 percent, compared to 5.32 percent in the previous year.
Capital One’s GFS segment offers a portfolio of diverse products to both domestic and international consumers. In the domestic market, the GFS segment includes installment lending, health care finance, mortgage lending services, and small business lending services. GFS has been on a growth curve and in 2004, it accounted for 27 percent of Capital One’s total managed loans, which are comprised of reported loans and off-balance sheet securitized loans. It also accounts for 14 percent of its earnings. Its international portfolio primarily consists of credit card business in the United Kingdom and Canada, valued at $8.2 billion and $2.4 billion,12 respectively. Capital One is the United Kingdom’s seventh largest credit card issuer, and among the top ten of the same in Canada. In January 2005, the company completed the formalities to acquire a British equity brokerage firm called Hfs Group to strengthen its position in the United Kingdom. Although Capital One had holdings in France and South Africa, it exited these markets due to lack of growth opportunities.
Capital One generated strong earnings and loan growth again in 2004, as it has each year since its initial public offering ten years ago. The company is well positioned for continued success in 2005 in both our Us. credit card and our growing and profitable diversification businesses. -RICHARD D. FAIRBANK, CHAIRMAN CAPITAL AND CEO, CORPORATION” ONE FINANCIAL
Capital One grew at 30 percent14 (see Exhibit 2, on page 68) between 1994 and 2004 by issuing credit cards at attractive interest rates. Most of its business is conducted via direct mail (junk-mail solicitations), although it also markets its products through television and Internet (http://www .capitalone.com). It expanded its credit card operations in Canada, Europe, and South Africa in the late 1990s. At the same time, the company also made strategic moves toward diversifying its portfolio by entering into financing of automobiles and other motor vehicles, mortgage and home equity loans, insurance, and other consumer lending products.
Although 60 percent of its total managed loans is in its credit cards business (see Exhibit 3, on page 68), the company is gradually increasing its operations in other business segments. In 1998, Capital One bought Amerifee, a company that provided financing for elective surgeries such as orthodontic, vision, and cosmetic procedures. It became a wholly owned subsidiary of Capital One in May 2001. Amerifee is a market leader known for introducing Orthodontists Fee and Dental Fee plans in 1993 and 1998, respectively. These fee plans are the largest patient payment plans in (dollars in millions, except per-share data)
Reproductive Endocrinologists and infertility clinics. IS The subsidiary formally became Capital One Healthcare Finance in April 2005. Capital One soon realized that the auto financing market is double that of the credit card market, and therefore it has a strong growth potential in that segment. This market is highly fragmented and no company holds more than 20 percent16 of the market share. It provided an opportunity to Capital One Auto Finance Ine. (COAF) to introduce innovative offers and increase its market share. COAF added $163.8 millionl? to the company’s earnings in 2004, and has continued to be on a high growth curve. To strengthen its market position in the automobile finance segment, the company acquired ONYXAcceptance Corporation (Onyx) for $191 millionl8 (in an all cash transaction) on January 11, 2005. It also acquired InsLogic, an insurance brokerage firm, from Onyx’s management team.
The purchase strengthened the Auto Finance subsidiary of Capital One and enhanced its dealer relationships, coastto-coast market penetration in the United States, and its product line among the prime borrowers. Onyx is based in Foothills, California, and provides automobile loans to certain independent and franchise dealerships all over the United States. Onyx claims to have purchased and securitized $10 billionl9 in auto loans since its inception in 1993, and will add 12,000 new dealerships to Capital One’s list. According to David R. Lawson, Capital One’s executive vice president, and president of COAF, “This transaction combines two strong franchises with complementary strengths.
Onyx’s significant and long-standing presence with California dealerships coupled with its strong prime product offering fills out both COAF’s product line and geographic footprint. Together, we expect to realize significant revenue and cost synergies:’20 This acquisition may make COAF the second largest auto lender in the United States. COAF has announced that it has raised its car loan limit to $100,00021 (previously $75,000) for direct-toconsumer vehicle loans that have originated from its Web site (http://capitaloneautofinance.com) in February 2005. This move was made in response to the growing demand for luxury cars such as Corvette by Chevrolet, so that the company can get more business from this customer segment. This extension is limited to only those with excellent credit histories (super-prime customers). The vice president of COAF, Brian Reed, said, “Car buyers have more choices than ever today at the higher end of the car spectrum, so we’ve adjusted our limit to offer consumers greater flexibilit/’22 The competitive advantage of COAF is that the loan process takes place on the Internet and requires no legacy fees.
Also, its IBS system allows it to charge varying interest rates depending on the customer’s risk levels. In February 2005, Capital One purchased eSmartloans .com for $155 million,23 one of the largest online providers of home equity loans mortgages in the United States. Headquartered in Overland Park, Kansas, the company offers a variety of products that are marketed and delivered directly to homeowners. The purchase is meant to broaden Capital One’s offering of consumer loans and deepen its position in the growing US. home equity market. Larry Klane, Capital One’s executive vice president of Global Financial Services, said, “eSmartloan has succeeded in building a scalable technology platform, a highly skilled sales team, and an outstanding reputation for customer service and speed to close.
By combining these strengths with Capital One’s powerful national brand, access to 47 million accounts, and expertise in direct marketing, we will enhance the growth of our home equity lending business:’24 In early March 2005, Capital One announced its decision to purchase Hibernia National Bank. Hibernia is the largest bank in Louisiana,2s with 316 branches in Louisiana and Texas, and $17.4 billion26 in deposits. It provides a wide assortment of financial products and services through its banking and non-banking subsidiaries that ranges from deposit products, small business, commercial, mortgage, private and international banking, to trust and investment management, brokerage, investment banking, and insurance. Capital One paid a 24 percent premium over Hibernia’s closing stock price of $26.57 as on March 4, or $33 per share,27and a total of$5.3 billion for the purchase.
The merger is expected to cost $175 million in restructuring expenses and result in near-term synergies of$135 million.28 According to Fairbank, “This acquisition is a natural extension of the diversification strategy we have been pursuing for some time. The transaction brings together two financial companies with complementary strengths and represents a compelling long-term value proposition for shareholders of both companies. Hibernia’s leading market share in Louisiana and its promising Texas branch expansion create not only a solid growth platform as we continue to expand, but also an additional source oflower
cost funding. Additionally, we believe our national brand, 48 million accounts, broad product offerings, asset generation capabilities, and market expertise will drive profitable growth in branch banking:’ 29 Capital One wanted to purchase a commercial bank with a strong management team and a large local market share. Hibernia has both these qualities as well as the potential to expand extensively into Texas markets. Currently it has only 109 branches in Texas, but the cities of Dallas and Houston are number 2 and 3 in terms of fastest growing markets in the metro cities, a seemingly untapped potential for capturing market share in that region.30 The main advantage of purchasing Hibernia is that Capital One gains access to a lower cost of funding at 1.38 percent against a rate of 4.24 percent.3l One third of Capital One’s funding is obtained from the deposits in its fully owned Internet bank at 4 percent, which is higher than that paid by any of its rivals.
The rest of it comes from securitization, which is risky as well as costlier than its other avenues of sourcing funds. It can increase ratio of funding from deposits from the previous 30 percent to 40 percent,32 to support its lending operations in the areas of credit cards, auto finance and mortgages. Acquiring Hibernia is also expected to increase its profit margins due to decreased interest expenses and bring stability to its businesses of consumer lending and other financial products. It now has the ability to use Hibernia’s brick -and- mortar branches as a launching pad to market its range of offerings in combination with its IBS techniques. The deal also provides Capital One with the opportunity to enter the debit -card market and also introduce its own home equity credit line.
Early in the twenty-first century, the US. credit card industry witnessed a high level of competition and was also going through a phase of consolidation. For example, J.P. Morgan merged with Chase in 2000, and the combined group merged with Bank One in July 2004 to form the second largest US. bank holding company with a combined asset base of $1 trillion33 and 19.1 percent of the total credit card market share. The US. consumer debt amount of $2.1 trillion (Federal Reserve Bank data) in January 2005 was mostly due to the top ten credit card companies, which held 85 percent of the market share.34 Market share of Capital One in the credit card segment fell from 7.2 percent in 200Ys to 6.8 percent (see Exhibit 4) in 2004.
Capital One was left with no innovative ideas such as being the first bank to offer automatic balance transfers, which could grab business from other banks. The rise in personal bankruptcies and the economic recession between 2001 and 2004, coupled with the saturation of the credit card market diminished growth opportunities for Capital One in that market. This necessitated its diversification into other consumer lending operations through different distribution channels such as Hibernia. Capital One has been bombarding the Internet, radio, and television with its advertisement, “What’s in your wallet?” with one of the versions featuring the famous Hollywood comedian David Spade (Appendix 1). It spent $285 million on advertisements, a total marketing expense of $1.3 billion36 in 2004 and $5.4 million in January 2005,37 which was more than competitors such as American Express. In a consumer survey conducted by USA Today’s weekly poll, 30 percent of the people “disliked” the advertisement, while 12 percent liked it “a lot;’ suggesting that it did not receive the popularity it wanted.
It was opined that the advertisement expense has been eating into Capital One’s profits. Another potential hurdle for Capital One is its potentially risky source of funding from securitization. It pools together the loans it originates and invests pieces from that collection in different securities. Because the investment is dependent on the stock market price fluctuations, this source of funding involves a great deal of uncertainty and risks of monetary loss. It has also amassed a large portfolio of sub-prime customers as it relies on its IBS system to guide it toward greater profit margins (related to greater risk), without incurring heavy losses. Due to federal regulations and a great many of its customers defaulting on their loans, Capital One had to shift away from subprime to a greater proportion of prime and super-prime customers.
This change led to smaller margins as the company offered an introductory rate of 9.9 percent to its super-prime customers vis-a-vis a rate of25.9 percent3s charged to sub-prime customers who are associated with high probability of delinquency. In July 2002, the company disclosed its decision to tighten controls over its loan disbursements (mainly to sub-prime lenders) to meet the banking regulators’ demands, leading to a 40 percent decline39 in its shares in one day (Appendix 2). Management of Hibernia’s branch banking and its non-consumer lending operations, after the merger is complete, might pose a challenge for Capital One because it lacks experience in those fields.
The non-consumer lending portfolio consists of commercial and industrial loans (C&I) and commercial real-estate (CRE) loans. Hibernia’s combined portfolio of C&I and CRE is worth $4 billion,40 and its small business portfolio is valued at $3.2 billion. The challenge will be to efficiently integrate Hibernia into its system and strategy, which includes incorporation of its retail branch banking, and review of its business and asset integration plans. For the short term, it might need to rely on Hibernia’s management team in making any strategic decisions. Part of the strategic long-term vision, as announced by the company is to expand further into the state of Texas, especially in Dallas and Houston, and establish new branches there. In expanding in that direction, Capital One is likely to face stiff competition from several major players in the credit card and banking industry such as JP Morgan, Citigroup, Bank of America, and American Express.
It may be difficult for Capital One to steal any business away from these giants, even with its innovative ideas and products, because the bigger players have strong presence in that region. Analyst and credit rating agencies like Fitch have warned that Capital One’s growth depends on its ability to aggreSSively defend and maintain market positions in the states of Louisiana and Texas. Fairbanks said, “We’re well positioned to continue our profitable growth. Financially, we’ve never been stronger. Our flagship credit card business is thriving.
We’re successfully taking IBS, the strategy that made Capital One a winner in credit cards and auto finance, to new businesses. And, we have a powerful brand and huge customer base to fuel our growth and diversification. Our people have pulled together to make Capital One the strong, diversified company it is today. And I am confident that they will sustain our momentum as we enter our second decade as a public company:
M. McNamee, 2005, Capital One’s concrete step, http://www .businessweek.com, March 11. http://wwwfortune.com. http://wwwcapitalone.com. Ibid. N. Slaughter, 2005, Capital One shells out http://wwwfoolcom, March 7 1994, Capital One financial corporation completes initial public offering, http://wwwbusinesswire.com. http://wwwfortune.com. Ibid. 2005, Capital One to acquire Hibernia Corporation for $5.3 billion in stock and cash, http://biz.yahoo.com, March 6. M. McNamee, 1999, Capital One: Isn’t there more to life than plastic?” http://wwwbusinessweek.com. http://wwwcapitalone.com. Ibid. http://wwwcapitalone.com. 2005, A capital idea, http://wwweconomist.eom, http://wwwcapitalonehealthcarefinance.com. Ibid. http://wwwcapitalone.com. Ibid. http://wwwonyxacceptance.com. http://wwwcapitalone.com. 2005, Capital One announces new online auto loan
limit of $100,000, http://wwwpwrebdireCl.com. February 25. Ibid. March 10. November 22. November 15.
http://wwwmccollpartners.com . http://wwwcapitalone.com. Louisiana is one of the southern-most located between Texas and Mississippi. A capital idea, op. cil.
states in the U.S. and is
2005, Capital One buying Hibernia for $5.3B, http://wwwcnnmoney. com, March 7 http://wwwCapitalone.com. Capital One to acquire Hibernia Corporation for $5.3 billion in stock and cash, op. cil. Capital One’s concrete step, op. cil. A capital idea, op. cil. Ibid. 1 Locke, 2005, Bank One, JPMorgan merger ups the ante in Colorado banking game, http://wwwbizjournals.com. A capital idea, op. cil. March 25
K. Maguire, 2005, Capital One rolls with the punches, http://news.yahoo.com, March 21 http://wwwcapitalone.com. M. McCarthy, 2005, Capital One’s ‘What’s in your wallet?’ ads filling airwaves, http://wwwusatoday.com. March 13. S. Maranjian, 2005, How to owe $40,000 by doing nothing, http://wwwfoolcom, February 11. R. Barker, 2003, Who’s minding the store at Capital One? http://wwwbusinessweek.com. March 24. 2005, Fitch places Capital One on rating watch positive; Hibernia on watch negative, http://wwwbloomberg.com. March 7 http://wwwcapitalone.com.