A Slower-Growing but Safer Capital One


By David Shook Back in mid-July, credit-card issuer Capital One Financial (COF), known for its slick TV campaigns and targeted direct marketing, outlined an informal agreement with banking regulators to increase its reserves and lessen its exposure to high-risk types of consumer lending known as the "subprime" market. Capital One, considered one of the best-managed, most financially sound banks in the credit-card industry, wasn't forced to disclose the agreement, and regulators took no formal action. But it did acknowledge that the government was concerned about its exposure to subprime lending in an environment in which that practice had created problems for other banks.

The voluntary disclosure sent investors running for the exits and analysts rethinking their adoring assumptions about Capital One. Its stock plummeted 40%, to $30 per share, on the July news, and some analysts downgraded it from a buy to the equivalent of a hold. Capital One's CEO Richard Fairbank quickly bought 150,000 shares of stock for $5 million, but his vote of confidence didn't ignite a rebound. Indeed, some 11 weeks later, the stock is still trading at $34, a 13% rebound but off 46% from a 52-week high reached in April.

BROADER PRODUCT LINE. Capital One had achieved its rapid growth by taking on risk. The challenge now is in diversifying to other types of loans to lessen exposure to the high-risk credit-card business, says Ian McDonald, analyst at Fox-Pitt, Kelton, which has no investment-banking relationship with Capital One.

Banks specializing in credit cards will be forced to act more like traditional banks in the coming years, McDonald estimates. That will involve selling a broader array of consumer loans and branching into Europe for new markets.

For Capital One, which became the model to follow among the pure-play or "monoline" credit-card banks, diversifying could lower its profit margins, analysts warn. But it likely will be a smart move as the economy and the consumer continue to show conflicting signs of weakness.

FUTURE REWARDS? And the beaten-down stock could present a buying opportunity for investors. If any company can adapt to the changing economics in the card business, it's probably Capital One. While the regulators' concerns are serious, the steps the bank must take to remedy the problem are achievable.

Investors who jump in now could be rewarded if Capital One delivers on its revised earnings guidance of $3.79 a share (or roughly $840 million in net income) for 2002 -- a 30% annual increase in profits, followed by earnings growth of "20% or more" in 2003, according to company predictions.

To protect against borrowers who can't pay their debts, Capital One has boosted its provisions for loan losses by $247 million in the second quarter and acknowledged that subprime lending in the second half will grow at a far slower rate than in previous quarters. This will allow it to reduce the percentage of subprime assets in its total loan portfolio -- most likely to levels below the industry average.

"NO CONCERN." "We plan to grow our [lower-risk] prime and super-prime credit-card lending at a faster rate than the subprime portion. In addition, we plan to diversify by focusing more on personal installment loans, auto loans, and consumer lending internationally," says spokeswoman Tatiana Stead. "Regulators have had no concern about our ability to manage credit risk."

The feds want to avoid any hint of another bank stumbling. While the Falls Church (Va.) outfit has chalked up stellar gains in part by targeting the high-risk sector of consumer borrowers, other card issuers have been stung in that business.

In 2001, the Office of the Comptroller of the Currency directed Providian Financial (PVN), a major subprime card lender, to cease making such loans because of concerns about its liquidity. Metris Cos. (MXT), another issuer struggling with high delinquencies among borrowers, also agreed at the behest of the OCC to "strenghten certain aspects of the safety and soundness of the bank's operations," Metris said in a statement earlier this year.

MORE RECORD PROFITS. In Capital One's case, the Federal Reserve Board and the Office of Thrift Supervision were looking for greater reserves. As of June 30, more than 26% of Capital One's total assets were subprime. Within Capital One's credit-card portfolio (excluding auto loans and other types of consumer borrowing), 39.8% of assets were subprime. Industrywide, the average is 36.6%.

The adjustments haven't been difficult for Capital One. In the second quarter, it reported its 20th consecutive quarter of record profits, $213.1 million, or 92 cents per share, compared to earnings of $155.3 million, or 70 cents per share, in the second quarter of last year. While the economic data on consumer spending is giving mixed signals, some economists believe it will remain fairly robust.

Moreover, the federal bankruptcy reform bill that has stalled in Congress may finally see a floor vote this fall. That legislation would make it far more difficult for consumers to wipe out unsecured credit-card debt by filing for personal bankruptcy. If signed into law, the bill wouldn't put more profits in the pockets of banks, but it would give them greater means to protect themselves against charge-offs and delinquencies.

END OF AN ERA. Though Capital One is now in better standing with regulators, it won't be able to earn the same lucrative profit margins on subprime cards, analysts say. They expect all card issuers to lessen exposure to the subprime market. Says one analyst at a major investment bank: "The issues at Capital One are definitely worth keeping an eye on. Capital One is an industry leader. Once regulators start to go after the leaders, people start rethinking their assumptions on the industry."

The pullback from high-risk credit-card lending means the end of a highly profitable era. However, it also means the beginning of a less risky period in which a top performer will diversify and have slower but higher-quality growth. In this environment, that's not such a bad idea for a bank whose current stock price likely doesn't reflect the rosy prospects in the months ahead. Shook is a reporter for BusinessWeek Online in New York


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