Fool on the Street: Capital One's Capital Strategy

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At a recent Goldman Sachs Financial Services conference, Capital One (NYSE: COF) CEO Richard Fairbank talked about Capital One's strategy and recent developments. I'm a big fan of the company, and I believe that Fairbank plays the lending game like a chess grandmaster, able to anticipate several moves into the future.

Although big mergers almost invariably destroy shareholder value, Capital One's $5 billion and $13 billion purchases of regional banks Hibernia and North Fork could create substantial value for long-term shareholders. Instead of "deworsifying," it seems like Capital One has smartly diversified.

Thanks to the mergers, Capital One has the 10th largest banking branch network in the U.S., and according to Fairbank, has diversified from a pure-play credit card lender to a company where a third of assets and half of earnings are credit-card based, and a third of its funding comes from core deposits.

Zigging when others zag
Unlike competitors Providian and MBNA, which sold themselves to large retail banks Washington Mutual (NYSE: WM) and Bank of America (NYSE: BAC), Capital One decided to do the opposite and buy some banks in accordance with its "bank local, lend national" strategy.

The key takeaway from the conference call was that the combination of Capital One and Hibernia/North Fork will allow for smarter asset deployment. As a lender, Capital One doesn't have much trouble generating interest-earning assets via its credit card, auto financing, and other loan production platforms -- in other words, it can find ways to profitably allocate capital. However, credit card lenders have a higher cost of funds than banks. According to Bankrate.com, Capital One is offering a juicy 4.8% yield on its money market account. On the other hand, a well-run regional bank has no problem generating deposits, but as a spread lender paying interest on deposits, it has a harder time efficiently investing its funds. For example, in 2004, Capital One's cost of funds (its cost of liabilities) was 4.47%, and its interest earning assets (its loans) yielded 10.28%. In the same year, North Fork's cost of funds was lower, at 3.75%, but so was its earning asset yield of 5.46%.

Thus, it makes sense to combine Capital One's loan production prowess with North Fork and Hibernia's deposit-gathering abilities. Fairbank also mentioned that Capital One planned on restructuring North Fork by reducing $14 billion in mortgages on its balance sheet; these lower margin assets can be reallocated via Capital One into higher-yielding loans.

Fairbank mentioned that every time there's a merger (including Capital One's recent activity), local banks throw a party because they know they can out-local big clumsy players who have scale but can't execute locally. Whereas Capital One's purchase and rebranding of the regional banks certainly carries execution and customer loyalty risks, it also carries substantial rewards. Capital One has built the fourth-largest credit card issuer in the U.S. by connecting with customers only through mail, call centers, and commercials with Vikings in them -- it'll be interesting to see what it can do with a local and face-to-face presence. I wouldn't bet against it.

• Capital One's Bright Future
• Fool on the Street: If I Could Be Like Wells Fargo

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.