I recently spent some time researching Capital One
Capital One has spent a decade climbing the ranks in the credit card industry and branching out into other consumer-lending areas. In the U.S., the company is now the fourth-largest Visa and MasterCard
Capital One's virtuous cycle
Credit-card companies make money by lending to borrowers. The company takes the risk that borrowers won't pay up, but it gets compensated for that risk by charging interest rates on credit card debt and collecting fees from merchants who accept its cards. When a borrower fails to pay off his or her debt, the credit-card company eats the loss, so the card issuer naturally wants to charge high interest rates to collect from those who do pay, to make up for those who don't. But to balance things out, credit-card companies have to offer rates competitive with their competitors if they want to get more customers.
Card issuers operate with mostly fixed-cost structures. They have to advertise to promote their brand and attract customers, build expensive technology infrastructure to handle back-office duties such as account maintenance, and hire staff to perform duties such as credit risk management and customer service. As a result, marginal costs, or the cost of adding an additional customer, are minimal. All the card issuer has to do is print out a piece of plastic and mail it to the customer.
Clearly, the credit card business is a game of scale. It wouldn't be cost-effective for a card company with 1,000 customers to run million-dollar Super Bowl commercials, but Capital One, with its 49 million customer accounts, can easily swallow such costs. Furthermore, having more customers means having more customer data. That data can be fed into credit-risk models to more accurately price the risk of customer defaults. In 2005, Capital One's U.S. card charge-off rate was 5%, which trailed only the Wells Fargo
Data can also be used to figure out things such as how to lower customer-acquisition costs. Thus, scale becomes a virtuous cycle for credit card companies. Companies like American Express and Capital One can spread their technology and customer-service costs over a wide base of customers and spend that extra money on advertising, lowering interest rates, and offering customer rewards, all of which helps to gain more customers and better data. I think that Capital One's scale advantages give it a sturdy economic moat.
Capital One also has a history of knowing when to zig when others zag. Historically, the 0% teaser rate has been an extremely potent weapon in getting borrowers to switch credit-card companies. Capital One helped pioneer the 0% strategy, which helped it take market share from competitors. Lately, the credit-card industry has gotten extremely competitive. Competitors have been lowering interest rates, sending out too many promo cards in the mail, and offering 0% teaser rates to customers with risky credit profiles. Capital One, thanks to its massive database of customer information, has run the numbers through its models and figured out that card mailings and 0% teaser rates no longer offer the returns they once did and, in fact, often attract disloyal and risky customers -- the kind card companies lose money on. As a result, Capital One has cut 0% teaser rates to 8% of mail volume, by far the lowest out of its major competitors, and has shifted to higher-return distribution channels, such as the Internet. Although loan growth and customer count have slowed as a result, Capital One should be healthy when the time comes to absorb new business during future credit crunches.
In their wallet, in your portfolio?
I believe Capital One is one of the most innovative companies in its space. Whereas competitors such as Providian, Metris, and MBNA sold themselves to big consumer banks such as Washington Mutual
I've thought for a while now about why people insist on banking locally and borrowing nationally. My theory is that it simply comes down to whether you're handing over your money or receiving it. I know that when I'm paying out money, I want a face-to-face relationship to make sure I know whom I'm giving my money to. However, when someone's giving me money, I just want the best deal. In college I had a summer job with Ditech. I remember thinking that borrowers around the country probably had no idea that I was sitting in a building in Costa Mesa, Calif., processing what might be the most important financial transaction in their life. The borrowers probably didn't care, as long as they got their money at a low interest rate. For this reason, I believe that Capital One's strategy is the correct one and will pay off in spades in the future.
Many potential pitfalls await consumer lenders, such as rising interest rates and the possibility of a recession accompanied by rising default rates from debt-laden customers. However, I welcome such adverse developments, if it gives me the opportunity to buy shares of Capital One, which already looks cheap at 11 times trailing earnings relative to comparable companies, at a better price. I'll be waiting.
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 and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.