Coming Of Age At Capital One

After a regulatory scare, management realizes that the startup era is over

The earnings report that Capital One Financial Corp. (COF ) issued on July 16, 2002, started with the exuberance that was typical of the brash credit-card issuer. Net income had hit another record, and the seven-year-old company was raising its 2002 earnings per share growth target from 20% to 30%. But then, three paragraphs in, came these ominous words: "Following a routine regulatory review...the company and its subsidiaries...expect to enter into an informal memorandum of understanding with bank regulators addressing certain regulatory matters."

It was the first indication that the go-go years were over for Cap One co-founders Richard D. Fairbank and Nigel W. Morris. By questioning the company's innovative model for assessing credit risk -- the very basis for its 30% annual earnings growth -- federal and state banking regulators scared the debt market into demanding a huge premium on the company's borrowings. To make matters worse, Chief Financial Officer David M. Willey resigned in March, 2003, after the Securities & Exchange Commission notified him that it was investigating him for insider trading. Charges have not been brought, but it was sobering news for investors. Cap One's shares sank to near their five-year low of $24.70, off 58% from a year earlier.

Today, it's clear that the worst fears about Cap One were unfounded. The company's data-intensive method of cutting risk and maximizing profits worked, and its credit portfolio didn't crash. Bad-loan charge-offs gradually dropped, and earnings per share rose 23% in 2003. On Jan. 29, regulators ended the memorandum of understanding. The stock trades at around $71, up 180% from last March.

`THE `B' WORD'. But regulators weren't all wrong -- Cap One had outgrown its controls, and Fairbank and Morris have been forced to rethink their freewheeling management style. "Capital One is a big company. We need to govern in a way consistent with that," says Morris, who used to hash out strategy with his partner on long drives between the company's facilities. "You can't have two guys driving up I-95 in a black Ford making business decisions. It just doesn't work anymore."

Instead of Nigel and Rich having brainstorming sessions, the company now is run by Fairbank and an executive committee that meets with him every Monday to formulate strategy. Those eight executives bear responsibility for making sure they understand how decisions are made underneath them -- a direct response to regulators' concerns. "I hate to use the 'b' word on them, but it's a little more bureaucratic. And to a certain extent it needed to be," says Keefe, Bruyette & Woods Inc. analyst Vincent Daniel. "Bank regulators don't necessarily want an extremely entrepreneurial culture."

The surest sign that the startup era is over: On Apr. 30, Morris will leave the company. He has spent the past year preparing, having announced his decision in April when he gave up the title of president to become vice-chairman. Acquaintances say he has been talking about it for years, and although Morris calls it the hardest thing he has ever done, he says he wants the chance to pursue other interests. He claims not to be interested in running a different public corporation.

CEO Fairbank is now alone atop a company that's looking more and more like a traditional bank. Cap One's U.S. credit-card business still dominates, accounting for almost two-thirds of loans outstanding. After attempts to extend their model of testing products and marketing into businesses ranging from cell-phone sales to vacation clubs, Fairbank has become more realistic about the limits of diversification. Now he looks for growth in other finance businesses, such as auto lending and international consumer finance.

The brush with regulators left a lasting mark on Cap One's customer base. To lower its risk, the company today does less lending to "subprime" borrowers and more lending to the A-list of credit quality. It's a safer bet, but one with a lot more competition. As a result revenue margins -- measuring top-line growth from the average loan -- have dropped to 16.7% in 2003 from 22.7% in 2000, and growth is slowing. This year earnings are expected to rise 16%, half the rate they averaged over the last five years.

Having seen his cost of borrowing skyrocket during the regulatory review, Fairbank now wants to build a base of deposits to lessen his reliance on institutions. Suddenly, an outfit that often mails more credit-card solicitations than any other U.S. company is moving past direct marketing. Fairbank wants to do branch banking, too. Says Fairbank: "It's one of the missing puzzle pieces to being a diversified consumer finance institution."

Corner banking is a long way from Cap One's roots. The company was spun out of Signet Bank in 1994 by Fairbank and Morris, who started out as a pair of consultants with no history of running an actual business. For years it operated almost as a laboratory for business theory. Fairbank thought that the future of marketing was one of mass customization, that mining data would give you enough information about a person to tailor your product and its price perfectly. Credit cards, it turned out, were a great vehicle for that. By the summer of 2002, Cap One had 48.6 million accounts and $53.2 billion in managed loans.

Much of that formula remains in place. Cap One continues to conduct tens of thousands of data "tests" -- 62,999 last year alone. And the results can be highly revealing: Someone who spends 45 minutes online researching a car purchase, for instance, is a good credit risk for the company's auto lending arm. But someone who calls up to apply for a credit card is riskier than someone who responds to a solicitation. Testing has been derided by critics as gimmicky, but it proved its value during the recession as Cap One's bad-loan and charge-off rates remained in check, while other lenders saw them balloon.

Nowadays, investors are just as impressed with Cap One's mundane fundamentals as they are with its big ideas. Thanks to the addition last July of a new CFO, Gary L. Perlin, formerly of the World Bank, Cap One has become much more focused on storing up borrowings to ensure it has plenty of financial flexibility. Since the regulatory all-clear sounded, both Fitch and Standard & Poor's have taken their outlook on the company from negative to stable.

Rumors that Capital One might be bought by a bigger bank have gained momentum since its numbers began showing improvement, but Fairbank seems reluctant. "We have been profoundly successful by virtue of our independence," he says. Now it's on his shoulders to prove that his latest vision for Cap One can do as well as his first brainstorm 18 years ago.

By Nanette Byrnes in McLean, Va.

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