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WIKI ANALYSIS
Capital One Financial Corp. (NYSE: COF) is a diversified financial services company and the 5th largest credit card company in the United States. Established in 1988, Capital One emerged as a Fortune 500 company within a decade by aggressively growing its credit card service through analytical, data-centric approach that helped grab credit card market share and slash its costs. Following its success in the credit card market, it has branched out to become a major player in retail banking, auto finance, mortgage lending, and other financial services. The company generated $15.2 billion in revenue in 2006 with an operating margin of 32%.
The company is continuing to ride the wave of consolidation in financial services that helped bring it to prominence in the card industry and is using returns to scale and powerful data analysis to cut operational costs. Its recent purchase of Louisiana and Texas bank Hibernia in 2005 and New York bank North Fork in December 2006 has positioned Capital One as the 11th largest bank in the United States and allowed the company to tap low-cost deposits to fund its lending. There is an opportunity for synergies between Capital One's legacy operations and its new banking arm, pending a successful integration of North Fork operations. In addition, it still remains susceptible to changes in consumer credit quality related to macroeconomic performance.
Business Segments
Established in 1995 as a credit card company, Capital One emerged as a diversified financial services Fortune 500 company within a decade by aggressively growing its credit card service into the 5th largest in the nation. Following its success in the credit card market, it has branched out to become a major player in retail banking, auto finance, mortgage lending, and other financial services.
In the wake of August's U.S. residential mortgage market disruption, in August 2007 Capital One announced that it is shutting down its mortgage lending segment and laying off 1900 employees.
Capital One has four segments: U.S. Card, Capital One Auto Finance, Global Financial Services, and Banking.
U.S. Card
With 44 million consumer card accounts, the U.S. Card segment is the dominant money-maker for Capital One. U.S. Card generated $1.8 billion in 2006 net income. Capital One has developed strong brand identity and now ranks as the 5th largest credit card issuer in the industry.
A new credit card entrant in 1995, Capital One leveraged the power of its innovative Information-Based Strategy to grab market share in a consolidating industry through aggressive marketing, teaser rate offerings, and mass customization of its products.
Shifting its strategy away from the use of teaser rate offerings, the company recently changed its focus toward marketing rewards cards and attracting transaction-oriented customers in an effort to build long-term customer loyalty and reduce charge-offs. With revenues steady as a result of Capital One's recent focus on expanding into other markets and wooing higher-end customers, net income in this category still posted consistent double-digit growth thanks to increasing efficiency (see chart).
With limited opportunities in the consolidated U.S. credit card industry, the company embarked on a campaign of geographic and product diversification that began with its 1998 purchase of auto finance firm Summit Acceptance Corp. Since then, Capital One has extended its credit card offerings to the U.K. and Canada and expanded its lending to include auto loans, small business loans, residential mortgages, and home equity. Most recently, it entered commercial and retail banking with its $5.0 billion purchase of Louisiana and Texas bank Hibernia in 2005 and its $14.6 billion purchase of New York metro area bank North Fork, allowing the company to access lower-cost deposit funding and lower its overall risk profile. While its flagship credit card business still accounts for the lion's share of its earnings, the share has been on the decline and may well decrease in coming years as Capital One's diversification plan marches on.
Capital One Auto Finance (COAF)
Capital One Auto Finance is the 3rd largest auto financer in the United States. The fourth largest segment of Capital One, it accounts for about 7% of the company's earnings. With over 1.5 million customer accounts and $234 million in net income, COAF (with 4.7% share of the domestic auto finance market) is the number three non-captive auto lender in the nation after J P Morgan Chase (JPM) (5.2%) and Wells Fargo (WFC) (4.8%).
Global Financing Services (GFS)
The third largest segment of Capital One, Global Financing Services (GFS) makes up 9% of earnings. GFS comprises Capital One's U.K. and Canada credit card divisions as well as domestic small business, installment lending, home equity, and health care financing. Capital One is the 11th provider of home equity and 14th provider of mortgages in the United States.
Banking
Capital One is the 11th bank in the U.S. by deposits. The second largest segment of Capital One business, banking is expected to make up 27% of 2007 earnings (from 7% in 2006). The banking segment comprises local banking operations, including consumer, small business and commercial deposits and lending.
The company entered regional banking with its 2005 purchase of Hibernia National Bank (with over 350 branches in Louisiana and Texas), its 2006 purchase of North Fork Bancorporation (with over 350 branches in the New York metro area), and the further addition of new branches. For the short term, the integration of the newly acquired banks with Capital One's legacy operations remains a management priority.
The addition of the banking business to its portfolio has raised Capital One's debt rating and lowered its cost of capital, which will allow it to take on more investments in the future.
Information-Based Strategy
Driving Capital One's success and efficiency has been its innovative Information-Based Strategy (IBS). With a wealth of data from its 50 million consumer and business accounts, Capital One analyzes its profitability down to the individual customer level and tracks the behavior of its customers in order to statistically analyze micro-segments of the consumer market.
Capital One has used IBS to great effect in the credit card division both in creating revenues and in cutting costs. Capital One has been able to innovate intelligently and rapidly by testing new marketing strategies on small groups before engaging in full-scale marketing. This approach allows the company to predict results of rolling out new products and rapidly scale up successful new promotion schemes before competitors have a chance to copy. IBS has also provided a high level of product customization. Capital One redefined the credit card industry in the 1990s with its personal pricing and credit line sizing, achieving low risk and default rates through personalized pricing. Setting price and line size for individual customers, Capital One took the most profitable business from competitors using aggregate pricing schemes and has consistently had the highest credit card profit margins among competitors.
One of the company's main competitive advantages, Capital One will continue to lean upon IBS as it expands into other financial territories. The success of IBS points to the existence of informational returns to scale in consumer lending, allowing large financial players to reap information-based efficiencies from market share consolidation.
How Capital One Makes its Money
Merchants pay a small fee (called the discount rate) to COF every time customers use their credit cards to purchase something.
In Smiley v. Citibank (1996) the Supreme Court lifted the limit on what credit card companies can charge in fees. Late and over-the-limit fees have climbed from about $10 then to an average of $35 today. With banks collecting about $17 billion in credit card penalty fees in 2006, these fees now account for a major part of industry revenues. About one in three accounts incurs fees.
The majority of credit card revenues come from debt. About half of all credit card accounts carry balances from month to month and accrue interest charges; these are Credit card companies' most profitable customers. Card companies borrow money at short-term rates and lend at higher rates, with greater margins than in many other kinds of lending. The average interest rate on credit card debt is 13.79%. The great profitability of credit card lending is reflected in the fact that Capital One's card division accounts for a majority of its earnings but a much smaller percent of its loans (see chart)
Capital One's banking, auto finance, and GFS divisions also earn revenues from interest rate margins. About 65% of Capital One's net earnings come from interest income.
Important Trends
Consumer Credit Quality
When customers do not pay their debts, credit card companies write off, or "charge off", the delinquent balances as operating losses. Card companies typically expect yearly loss rates of a few percentage points, and Capital One has an average 4% net charge-off rate. Consumer credit quality is cyclical and is highly correlated with economic performance indicators, especially unemployment and bankruptcy rates.
In the wake of August's U.S. mortgage market difficulties, in August 2007 Capital One announced that it is closing its mortgage lending segment,
Economies of Scale
The card industry is characterized by economies of scale. Fixed costs, like advertising and IT expenses, need to be spread over a wide base of customers. Once a card company hits critical mass, incremental returns can rise quickly. In addition, in an industry that relies on having a lot of information to price risk and increase customer spending, having more accounts translates into an information advantage.
Industry Consolidation
Many financial segments are experiencing consolidation into the hands of a few key players. A significant part of revenue growth coming years will come from expanding market share.
- Card Industry: In 2006 the top five U.S. card issuers held 76% of nationwide credit card balances, as compared to 37% in 1994.
- Auto Finance Industry: In 2006 the top ten non-captive auto finance lenders represented 26% of originations, as compared to 14% in 1999.
- Mortgage Industry: In 2006 the top five mortgage lenders were responsible for 42% of originations, as compared with 12% in 1990.
Interest Rates
Capital One borrows money at short-term rates and lends to its customers at a higher rate, profiting from the margin. Net interest income accounts for about 65% of Capital One’s total revenues.
Capital One's revenues are not highly sensitive to interest rate changes. In 2007 the company reported that a 200bp change in interest rates will only affect total revenues by 2%.
However, the shape of the yield curve describes expectations about the health of the economy in future periods, and the health of the economy affects consumer credit quality.
Legislation
Card companies owe their large profits in part to tactics that have been under widespread criticism. The industry has recently come under scrutiny for its employment of confusing billing practices buried in impenetrable fine print. For example, a single late payment may trigger a large rise in interest rates, and payments received on the due date may still incur a steep late fee if received after 4:00pm and even 12:00pm in some cases.
In January 2007 the U.S. Senate held hearings to determine whether or not to introduce legislation punishing card companies for preying on consumers, with executives from Bank of America (BAC), J P Morgan Chase (JPM), and Citigroup (C) on hand to defend industry practices. Capital One has recently declared that it is voluntarily simplifying its fee structure to avoid antagonizing customers as it makes building brand loyalty a priority.
On the other hand, legislation can also change the lending environment to credit card companies' advantage. A tightening of bankruptcy laws in late 2005 led to a temporary spike in bankruptcy rates due to early filing followed by a sustained lower level of bankruptcy rates, leading to a lower level of charge-offs across the industry. This one-time "shake-off" has been followed by a very gradual return to previous levels.
Real Estate Financing Substitution
During good real estate market performance, the "home equity effect" may reduce credit card revenues. Under these conditions consumers choose to refinance mortgages and borrow against home equity instead of higher-interest borrowing on plastic.
Competition
Capital One's main competitors are the other credit card industry leaders, such as American Express Company (AXP), Bank of America (BAC), Citigroup (C), Discover (owned by Morgan Stanley), and J P Morgan Chase (JPM). All of these competitors, except for American Express, also offer diversified banking services. Capital One's IBS continues to drive operational efficiencies in excess of those of its competitors.
Comparative Metrics
The following table shows Capital One's credit card market share by volume for the first six months of 2006.
| Rank | Charge Volume ($B) | Market Share | |
|---|---|---|---|
| American Express | 1 | $195 | 20.4% |
| JPMorgan Chase | 2 | $168 | 17.4% |
| Bank of America | 3 | $154 | 16.1% |
| Citigroup | 4 | $129 | 13.5% |
| Capital One | 5 | $60 | 6.2% |
| Discover | 6 | $47 | 4.9% |
Source: Company Reports.
Capital One beats its competitors in operational efficiency: it consistently maintains lower net charge-off rates and higher returns on its credit card loans than its competitors.
| Net Charge-Offs | Return on Loans |
|---|
| 2004 | 2005 | 2006 | 2004 | 2005 | 2006 | ||
|---|---|---|---|---|---|---|---|
| Capital One | 5.05% | 5.01% | 3.37% | 3.0% | 3.4% | 3.7% | |
| Bank of America | 5.63% | 6.85% | 3.78% | 3.1% | 2.2% | 3.0% | |
| Citigroup | 5.92% | 5.78% | 3.84% | 2.6% | 2.0% | 2.8% | |
| JPMorgan Chase | 5.29% | 5.21% | 3.33% | 1.4% | 1.4% | 2.3% | |
| Discover | 6.00% | 5.23% | 4.74% | 1.7% | 1.2% | 2.2% |
Source: Company reports.
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