Our tour of the credit card industry recently led us to Capital One (NYSE: COF), headquartered in Falls Church, Virginia. Paul Paquin, Capital One's vice president of investor relations, took us on an expedition through the credit card industry and Capital One's position as one of the fastest growing and most profitable of the major credit card companies.
We've covered our bases in the Rule Maker Portfolio with an investment in American Express (NYSE: AXP), the premier brand name in the credit and charge card business. It's difficult building a brand in the financial services industry given the dry, faceless nature of the services offered, yet American Express has established a brand consumers recognize and trust. This is a powerful asset, not merely for the company's credit and charge card business, but for its banking and financial services units, which increasingly acquire customers who originate in the company's card division. The uniqueness of this brand gives the American Express franchise durability.
However, a brand strategy isn't the only one way to succeed in the credit card industry. The best players -- American Express, Capital One, Citigroup (NYSE: C), MBNA (NYSE: KRB), and Morgan Stanley's (NYSE: MWD) Discover -- pick one of three ways to succeed: a brand strategy, an affinity strategy (when a card company gives customers the opportunity to get a card from an entity that means something to them, such as their alma mater), or an information-based strategy.
Capital One is the lead steer in the information strategy camp. The company's strategy is basically a software-driven testing protocol that allows it to test products -- that is, estimate response rates, credit quality, and attrition rates -- before it sends out a single card. It's aimed at getting the right credit card to the right customer. Do this and the customer will use the card, pay his bills, and pay on time.
In 1998 it implemented an information-based calling system that identifies incoming callers before the first ring, predicts why they're calling, and then routes the call to the proper automated message or service representative, who's ready to cross-sell a targeted financial services product.
Unlike many bankcard issuers, Capital One processes all its transactions. It sends out roughly 36.5 million bills per month and it considers all of these "customer touches" critical to its information-gatherer approach. Last year it conducted 45,000 product tests and spent more than $900 million in marketing to learn more about its customers and potential customers. Even though it has just 5% of the U.S. credit card industry's total receivables (all the balances outstanding on credit cards), it sent out 30% of the more than 3 billion pieces of credit card mail sent to consumers by all the card companies last year. Giant Citigroup, which has about 17% of the industry's total receivables, was the runner-up in terms of mail volume with about 14%, or half as much volume as Capital One.
Capital One sends out all this mail so it knows what customers to target and what products to offer. The company's sales have grown at a compound annual rate of 41% since 1995. The industry as a whole is growing much slower, which means the bulk of Capital One's growth comes from stealing market share in a consolidating industry. Over the same period, its earnings grew 29% and its average return on equity -- an important measure of profitability for financial services companies -- was 25%.
With fast growth in the loan business, of course, comes risk. Investors considering an investment in a financial services industry need to understand that the loan business is all about managing risk. In addition to company-specific risk, financial services companies face significant market risk. The performance of these stocks is tied to the economy, business growth, and interest rates. A company like Capital One, for example, has three primary sources of funds: bank notes, asset-backed securities, and deposits, all of which are tied to interest rates. When interest rates go up, so does the company's cost of capital. Therefore, these stocks tend to move with the business cycle.
Still, Capital One stands out for its asset quality. It has the lowest charge-off rate of all the major lenders -- at 3.75% for the latest quarter, compared to an industry average of about 6%. Also, its average credit line is just one-third the industry average, which means it maintains credit quality by keeping a tight rein on spending limits. Rather than using blanket formulas to determine spending limits in different credit segments, its information system has the power to parse a customer base of 37 million accounts.
In a way, the company reminds me of Rule Maker Nokia (NYSE: NOK), another player in a mass-market business that drives volume by segmenting its customer base. Nokia understood consumers wanted personalized phones -- different colors, different covers, different tones, different styles -- before any of its rivals. That's why it's constantly selling new models, tweaking the product, and innovating. It's not easy getting this close to a customer base of millions, but the best companies find a way.
On Capital One's latest conference call, Richard Fairbank, the company's chief executive, said its information strategy, which allows it to shift its mix of loans from subprime (lower credit quality) to prime (good credit quality) and superprime (superior credit quality) opportunistically, is aimed at identifying the subprime customers who behave like prime, the prime customers who behave like superprime, and the superprime who are some of the most profitable customers in the industry.
In earlier stories we've written about the credit card industry, we've stressed that credit and charge cards, managed properly, are a marvelous product for consumers and a very profitable business. (The top five companies, mentioned above, generate a return on equity above 22%.) The consumer who pays off his balances gets a 30-day interest-free loan, along with the convenience and simplicity of credit. Working with cash is a hassle. It's hard to carry and count. It gets dirty. You don't know how much you're going to need, and you have to pay a fee at most ATMs to get more. The importance of the credit, charge, and debit cards as transaction platforms will keep growing as better products find their way into consumers' hands and as use of the Internet grows.
Therefore, for the best players, the industry is a growth business and it makes sense for the Rule Maker Port to keep its eye on those with the best strategies. My take on Capital One is that it has the potential to emerge as more than a leading financial services company. It's not too much of a stretch to see Capital One emerging as a well-known consumer brand company.
Currently, the Capital One brand isn't well-known. This is because it issues bankcards (Visa and Mastercard products) and these household names soak up all the brand attention. This may be changing. As Fairbank said on the conference call, with 36.5 million accounts and earnings growth of 30% annually, Capital One is getting too big to ignore. Capital One is using its knowledge base to push into new markets such as installment loans, auto loans, and insurance. As it gains scale in other businesses that touch consumers, the company's name recognition as an innovator will grow.
It is as an innovator that the Capital One brand name will catch fire. Prior to the 1990s, consumers either qualified for credit and had a credit card, or they didn't qualify and they had nothing. Capital One used its information systems to change this, to find the unserved customers it believed would become faithfully paying customers and offer them a tailored product.
Capital One pioneered the balance transfer program and the teaser rate. It also helped legitimize the secured credit business. A secured credit card is a product sold to a customer who wouldn't normally qualify for credit. In exchange for a card with, say, a $500 credit limit, which makes it possible to rent a car, reserve a hotel room, and establish a credit history, the consumer sends $500 to Capital One, which puts it in an escrow account in case of default. The consumer pays a 19.8% interest rate on balances, minus 4% interest earned on the principal in the escrow account, which means the consumer pays a 15.8% annual rate on a product that could easily cost 30% if it's pitched by some vendor to the late-night-television crowd.
Southwest Airlines (NYSE: LUV), Wal-Mart (NYSE: WMT), and Dell (Nasdaq: DELL) created billions' worth of brand equity by carving out new markets with their innovative products. In essence, these companies created new customers, and a lasting name for themselves, with their ability to address new markets. (I wrote about this in a Fool on the Hill story last week.) I think Capital One is on the same path.
Next week, we'll dig further into the financial engine that makes Capital One tick.
Have a great day.
Richard McCaffery, who thinks there are smarter things to do than open a margin account with cash drawn from a credit card, owns shares of Dell. The Motley Fool is investors writing for investors.
