CEO Richard Fairbank has groomed Capital One into a credit-card powerhouse, elevating information-based marketing to an art form and stirring envy in the hearts of rival issuers. Now he has his sights set on reinventing retail banking. Presumptuous? Perhaps. But with the recent acquisitions of Hibernia and North Fork, there's a method to his madness, and plenty of money and analytic firepower to support it.
John Kanas has always played the role of hunter, adeptly managing his own consolidation play in the heart of the nation's largest banking market, New York City. So when it was announced in March that Kanas was selling Melville, NY-based North Fork Bancorp, it raised some eyebrows-but not nearly so much as his chosen acquirer, credit-card giant Capital One Financial Corp.
Over the course of several years, Kanas had developed a cordial relationship with Capital One CEO Richard Fairbank. The two would talk informally about the industry's evolution, and each company's place in it. Last November, over a round of golf at an industry conference, those discussions got more serious. Fairbank was committed to an "endgame" vision that would marry Capital One's vaunted information and asset-generation skills with local branch banking. Earlier in 2005 he had bought Hibernia Corp. in New Orleans, and once had made a run at Greenpoint Financial, a big New York mortgage lender that was eventually acquired by North Fork. Kanas, meanwhile, was grappling with intense deposit competition and the effects of a flattening yield curve on its mortgage business.
As the conversation progressed, "John and I found we were soul mates in some very profound ways," Fairbank says. "We shared the background of entrepreneurs who had turned into large-company CEOs. ...[And] we had a shared vision of where banking was going. We both felt that if our institutions were together we could create something that was a lot better than either of us could do on our own."
Those discussions culminated in Capital One's $14.6 billion stock-and-cash acquisition of North Fork in March. The price was considered rich, at 16 times projected 2006 earnings and 4.9 times tangible book value. But when the deal closes later this year, Capital One-only two years ago a fringe player to most traditional bankers-will be a top-10 banking company, with more than $140 billion in assets, $60 billion in deposits and some 650 branches in greater New York, Louisiana and Texas. "In a very short time, they've transformed themselves from a monoline credit-card company to a big, diversified consumer bank," says Stephen Schulz, an analyst with Keefe Bruyette & Woods in New York. "It happened faster than most people expected, but they had to seize the opportunity when it came."
Fairbank's rapid-fire acquisitions, not to mention his openly stated view that retail banking is "ripe for reinvention," might seem a bit presumptuous. After all, what does a high-flying, technology-centered credit-card operator with 50 million customers served mostly through call centers know about an ostensibly relationship-driven business like banking? Nor does Capital One appear to need a dramatic overhaul. In the first quarter, the McLean, VA, company earned $883 million, or $2.86 per share-up 44 percent from a year earlier-with an ROE of 24.1 percent and an ROA of 3.97 percent. It's already the nation's No. 4 credit-card issuer, and the second-biggest non-captive auto lender. With its $1.5 billion marketing budget and omnipresent "What's in your wallet?" ad campaign, the company boasts one of the best-known brands in financial services.
Even some supporters think Fairbank's banking quest is a reach. "He's making an enormous bet," says Tom Brown, CEO of hedge fund Second Curve Capital, which owns Capital One shares. Brown, a big Fairbank fan, thinks the capital spent on North Fork and Hibernia could be deployed in more profitable areas. "I don't like it. But Rich has examined the situation and determined that the future of the company depends on its being successful in branch banking."
There's a method-and plenty of strategic thought-to this bank-buying madness. In the late '90s, Fairbank began focusing his attentions on the industry's long-term evolution. "Most companies say, 'Here's where we are, and here's where we think we can get to,'" Fairbank explains. "We've said, 'This is where we think the market is going. How can we get to that endgame?'" Such an approach "prescribes bigger, bolder, sooner moves than one would otherwise be comfortable doing," he adds. "But the most important part of strategy is not determining what you're going to do, it's figuring out where the market's headed...and then getting there first."
While most bankers think about consolidation in terms of one institution at a time, Fairbank says a better construct is "by market and product." Asset classes will consolidate nationally, and success will come to companies with strong brands and large-enough databases to "statistically assess their customers" and make customized lending decisions, he says. This has already occurred with credit cards, where 10 lenders control 90 percent of outstanding assets; other areas, such as home equity, mortgage and auto aren't far behind. Deposits, on the other hand, are crucial for the stable, low-cost funding they provide, but collecting them is a fiercely local endeavor, necessitating a branch-banking presence.
Fairbank believes that combining these two separate forces- in essence funding national asset businesses with local deposits-is a formula for future success. The key is building critical mass on both sides of the balance sheet before the music stops. In other words, the race is on. Which more or less explains the rush when it comes to buying banks.
It'd be easy to dismiss Fairbank as an interloper, but that would be a mistake. Despite his misgivings about the strategy, Brown argues that bankers have much more to fear from Capital One's incursion into their space than, say, Wal-Mart's efforts to set up a bank. "This is the best financial services company in America, and it's decided to take on the branch banking business," Brown says. "At the very least, Capital One won't make a big mistake. With its powerful brand, the question is: How good can it be?"
The son of a NASA scientist who regularly preached "success is about having a bold quest," Fairbank has made a habit of defying convention. As a consultant in the 1980s, he and partner Nigel Morris hatched a vision of building massive databases of consumer information, and then using statistical prediction and testing to build dynamic credit profiles and customize lending decisions. Even then, Fairbank says, he envisioned getting into banking. Cards, however, would be the easiest place to gain traction for his ideas.
The duo shopped the notion to various big banks, including the likes of Citibank and Bank of America, in search of a platform. None would bite on a fix for a card business that was already profitable using simple judgmental criteria. They eventually found a taker in Signet Banking Corp., and began work on a super-prime card product that offered single-digit APRs to good credit risks. "My goal was to smash the price of credit" with risk-based pricing, Fairbank recalls. "But it was too hard for people to move their balances." In late 1991, Fairbank came up with a needle-moving innovation: the balance transfer. Combining good rates with an easy way to shift account balances was a home run. Two years later, Capital One outgrew Signet, and was spun off as an independent company. (Signet was acquired in 1997 by the old First Union.)
Independence allowed Fairbank to diversify into other consumer lending lines, such as auto finance and home equity. Along the way, he fashioned a corporate culture that is highly analytical and performance-based. All employees, down to the lowliest call-center rep, are meticulously tested before they're hired, and measured continuously. Think of it as a science lab for financial services, filled with math PhDs and statisticians, constantly testing and reconfiguring products, and the way they're collected on and offered.
"They'll say, 'If we increase the font size on our solicitations to 12 and make it a brighter color, we'll get a higher response rate,'" says Scott Valentin, an analyst with Friedman, Billings, Ramsey. "And then they'll test that hypothesis with control groups." Another example involves finding the point of diminishing returns in collection efforts. "Wall Street might like collections to be higher, but they're not going to spend $1.50 to collect $1," Brown says. "They're not just more thorough. They test whether being more thorough makes economic sense."
But all business models evolve, and just beneath the surface lie some compelling reasons for the strategic shift. Growth in the card business is slowing, and the company's lack of diversification has left investors jittery. Having to rely solely on securitizations for funding was another strike against it. The sense of urgency increased in 2002, when the card industry hit a rough patch. After regulators slapped Capital One with a memorandum of understanding over concerns about its controls and credit-risk assessment processes, investors in its asset-backed securities demanded higher premiums, exposing vulnerabilities to the securitization market.
In 2003, Fairbank began signaling that he might acquire a bank. By the time Bank of America acquired MBNA in 2005-following similar sales of Providian Financial (to Washington Mutual) and Metris (to HSBC)-Capital One appeared left with a choice: Join the monoline crowd and become part of a big banking company, (Wachovia, which tried to buy MBNA, was a rumored candidate), or be a buyer itself. "They decided to take their skills in channels, analysis and customer-management, and take the driver's seat by running a bank," says Charles Wendel, president of Financial Institutions Consulting in Ridgefield, CT. "If they hadn't, they would be part of someone else today."
Not wanting a repair job, Fairbank sought out targets with strong market shares and management teams, and proven organic-growth abilities. The pickings, he says, were surprisingly slim. "Most banks, when you ask about their growth plans, they'll talk about buying other banks," he chuckles. "We wanted to buy the ingredients and add water, in terms of brand, our information-based strategy and the investment dollars to grow."
In Hibernia, he found a market-share leader in Louisiana with a solid de novo branching strategy in Texas. North Fork's story is even more compelling: No. 3 in metro New York, with a compounded annualized deposit growth rate of 13.8 percent over the past five years. Once North Fork closes, cards will generate just 50 percent of Capital One's earnings, while 30 percent of funding will come from deposits. Ratings agencies have responded with significant upgrades. "They've created tremendous value by de-risking the balance sheet," Schulz explains. "If the capital markets seize up again, investors can sleep well knowing [Capital One] has access to a deep pool of funding."
Beyond the balance-sheet ballast, Fairbank aims to shift some of that low-cost local deposit base out of mortgages and other low-margin banking products, and into higher-yielding assets, such as cards, auto or small business. Cross selling products and services between the two sides-such as getting New York card customers to open checking accounts at North Fork-is naturally attractive, as well. He also thinks that Capital One's IT prowess can add oomph to how the banks design products and underwrite loans. "Banking products are fundamentally digital; they're contracts between a company and a customer," he explains. That means they're capable of being transformed by smarter usage of information databases and technology.
Not everyone is convinced this will work. Brown worries about meshing Capital One's brainy, test-oriented culture with those of two banks. "Controlling thousands of frontline employees in a branch-banking environment isn't as easy as in a call center," he says. Since no one has ever done so before, it's not clear if Fairbank's vision of running parallel national and local businesses under one roof can produce the results he expects. Some also wonder what will become of North Fork's big middle-market lending business, which doesn't fit Fairbank's consumer mold. But Kanas, who will head the banking unit, is good at integrating mergers, and Capital One has a reputation for supporting non-card acquisitions without micromanaging. "They stay in the background, focus on big-picture strategy and their core competency-using data to effectively price products -but let people on the ground run the execution," Schulz says.
And once the integration is complete? Fairbank is mum on plans, but most analysts expect an increase in de novo branch openings and additional consumer-bank acquisitions. "If it works like we think it will, the P/E will expand and they'll have the currency to do more deals," Valentin says. Brown suggests New Jersey's Commerce Bancorp and BankAtlantic in Florida as good fits. Further down the road, the new, bigger Capital One could be attractive to a company like Wachovia, which also reportedly pursued North Fork. "Once they get to the endgame, they'll probably look to do right by shareholders and sell," Valentin says. Given Fairbank's grand ambitions, don't bet on it.
