Read the case study below and make an
overview that summarizesthe following
component for your report:
1-a. Identify the executives from
Capital One who you expect to be in your audience.What can you establish about
the key members of Fairbank’s management team?
2-Your report and overview should
address the following key strategic issues, followed by a recommendation:
a. Conduct an External Environmental Analysis, and identify key environmentalforces that have immediate strategic
implications for Capital One.
b.
Conduct
an Internal Environmental Analysis, and identify the capabilities and
weaknesses within Capital One that have immediate strategic implications.
c.
Basedon your analysis of the external and internal environments
what would be your recommendation to the Chairman?
3. Based
on these strategic inputs, define Capital One’s business-level and
corporate-level strategies, and evaluate their potential for continued success.
4. Assess Capital One’s international position.
5. Evaluate the strategic fit of Capital One’s
recent acquisitions, and discuss the key strategic issues raised by the
company’s acquisition strategy.
6. Based on your complete analysis,
recommend actions for Capital One to sustain growth and ensure maximum
performance and value for shareholders.
7. Discuss the ethical ramifications of
sub-prime lending at high interest rates, (discuss pros and cons).
Capital One: The American Credit card Company’s Growth
Strategies
Susmita Nandi, Sumit Kumar Chaudhuri
ICFAI University
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
Corporation1 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
F.S.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 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: The Background
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 Inc., Goldman,
Sachs & Co. and Barney Inc. It is a part of the S&P 500 index, and also
trades on the New York Stock Exchange with the symbol COF.
Between 1994 and 2004, the
company grew at an annual compound rate of 29 percent,7 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 7,00010 variations 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 efficientby 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 are 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 pooror 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, 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.
Growth Strategies
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 U.S. credit card and our growing and profitable
diversification businesses.
—Richard D. Fairbank,
Chairman and CEO,
Capital One Financial Corporation
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 the sectors of Orthodontics and Dentistry. In 2001, it
pioneered the Family Fee plan, which was specifically designed for treatment of
infertility and are offered through Reproductive Endocrinologists and
infertility clinics.
The subsidiary formally became Capital One Healthcare Finance in April
2005.
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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 percent of the market share.
It provided an opportunity to Capital One Auto Finance Inc. (COAF) to introduce
innovative offers and increase its market share. COAF added $163.8 million 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 ONYX Acceptance Corporation (Onyx) for $191 million (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, coast
to-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 billion 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.” 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 $100,000 (previously
$75,000) for direct-to-consumer vehicle loans that have originated from its Website
(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 flexibility.” 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 U.S.
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.” In early March 2005, Capital One announced its
decision to purchase Hibernia National Bank. Hibernia is the largest bank in
Louisiana,25 with 316 branches in Louisiana and Texas, and $17.4 billion 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,27 and
a total of .jpg”>
$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. 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 of
lower 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.” 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. 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. 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, 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.
Potential Challenges
Early in the twenty-first
century, the U.S. 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 U.S. bank holding company with a combined asset
base of $1 trillion33 and 19.1 percent of the total credit card market share.
The U.S. 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. Market share of Capital One in the credit card
segment fell from 7.2 percent in 200335 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. It spent $285 million on advertisements, a total marketing expense of
$1.3 billion in 2004 and $5.4 million in January 2005, 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.
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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 customer’s vis-à-vis a rate of 25.9 percent 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 decline in its shares in one day (Appendix 2).
Management of Hibernia’s
branchbanking 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, 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.
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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.”
