Capital One Deserves More Respect

We believe

While much of its success can be attributed to an unrelenting focus on operations and organic growth, Capital One has periodically created significant value by acquiring businesses opportunistically and, most important, at attractive prices. We believe the acquisitions of HSBC’s cobranded card business and ING Direct exemplify the company’s aim to acquire good strategic assets cheaply. Using its patient acquisition philosophy, Capital One has become a stronger, diversified consumer lender.

We believe the bank understands that returns arise not only from acquisitions and share repurchases, but also from internal investment in operations and IT systems. We believe the bank’s focus on IT and data has enabled it to be a leader in measuring and forecasting consumer credit quality, resulting in better credit performance. During the financial crisis, the company remained profitable and charge-offs peaked at 5.9% of loans, significantly outperforming rivals whose charge-offs exceeded 8%. In addition, Capital One was early to warn about the dangers of subprime auto lending, where the company has partly limited its exposure.

While some are concerned about the recent rise in card charge-offs, we buy the company’s argument that it’s a result of new cardholders, or what management calls growth math. Cardholder growth generally results in increased charge-offs during the first two years after a card is issued. This short-term headwind is the price an issuer must pay to build a high-quality, seasoned book of profitable cardholders.

Valuable Cardholder Base We believe Capital One has developed a narrow moat from cost advantages through years of steady internal investment in information technology, rewards programs, advertising platforms, and well-timed acquisitions, resulting in a captive cardholder base. In addition, we believe Capital One benefits from switching costs as cardholders do display mild loyalty after being issued a card. We think this results in a loan portfolio that is highly balanced and would take years to replicate.

It would be challenging to overemphasize the importance of nationwide scale when analyzing a consumer lender specializing in credit cards. National scale enables Capital One to have a diversified cardholder base across multiple geographies and FICO scores, which results in incremental earnings from sales growth as a large portion of the company’s costs are fixed. In addition, it gives the company the ability and expertise to expand into adjacent loan categories and modify its existing offerings. Specifically, Capital One’s size and highly advanced IT infrastructure and data capabilities enable the firm to experiment with its products. A smaller, less diversified consumer lender would probably not have the resources and flexibility to do this. We point to the example of the 84-month auto loan. This is a type of loan many auto lenders have never even attempted, but recently, it has been heralded by some of Capital One’s competitors as the future of auto lending. Capital One was able to quickly run trials of 84-month loans using a small sample size and, in our view, correctly determined it was a losing proposition. Increasingly, we view consumer lending as data driven. To compete, incumbents must develop the necessary proprietary data sets and IP that Capital One has spent many years assembling over a large population. While capital expenditure gets overlooked in financials, we believe its importance is paramount as consumer lenders seek to compete in a world where the winners may be determined by which companies can best analyze and interpret large sets of data. We believe Capital One’s commitment to capital expenditures, internal investment, and the time required to build these assets enables the company to broaden its moat while raising the bar for competitors.

We also believe that Capital One’s moat results from the stickiness of its high-quality, seasoned back book of cardholders. In an ideal situation, Capital One would gather as many high-spender/low-balance cardholders as possible. Most of these cardholders would pay off their entire balance each month, which results in significant interchange revenue for Capital One but little interest income. However, a small percentage of these high-quality cardholders would maintain a balance despite having the financial resources to pay off the balance. It is here where Capital One excels. The balances of this small collection of cardholders initially compound slowly each year but gradually result in significant interest income and minimal charge-offs. To get these high-quality cardholders, issuers must issue cards to an even larger sample and gradually weed out the weaker cardholders through charge-offs and attrition over two to three years. It takes a long time to assemble this high-quality back book, and many companies simply do not have the patience to do this. As Capital One states, this is not a business where an issuer can jump in and out and expect to generate significant returns.

In addition, scale affords Capital One advantages in national advertising. We believe its size and volume give the company some clout with advertisers when purchasing television commercials or digital display ads in bulk. We’re also encouraged by the company’s large investment in digital marketing and advertising. While most of these expenditures are expensed today, we believe these outlays represent a long-term investment in Capital One’s brand and put pressure on rivals. While the Chase JPM Sapphire card is a formidable competitor, we believe it’s harder for Capital One’s peers to differentiate their card offerings when they are attached to larger entities whose main focus isn’t consumer credit. Capital One has been able to succeed in this arena through years of patient and expensive investments in marketing. Also, the company still invests in low-tech mass mailings across the country. While postage is a variable expense, we believe staying committed to national mass marketing campaigns is a fixed investment. Finally, we suspect Capital One’s magnitude enables it to negotiate better terms with rewards vendors such as airlines for greater benefits for cardholders. This bolsters our argument that size matters when it comes to consumer lending.

While some may claim that Capital One’s size results in funding advantages, we still believe the company has a way to go in building a reliable, low-cost source of deposits that results in a moat. In 2016, the bank derived nearly 80% of its funding from deposits, up from 61% before the crisis--a significant improvement. However, the company still securitizes a significant portion of cardholder receivables that have been a growing source of funds for Capital One the past two years. Currently, the bank’s cost of deposits is 0.61% annually; in comparison, Citi’s C cost of domestic deposits hovered around 0.49% in 2016. Unlike Citi, the biggest difference is that much of Capital One’s deposits are brokered deposits in the form of CDs and money market funds. These forms of deposits aren’t as sticky and will probably require the company to pay up when interest rates rise. That’s why we believe the company is right to still securitize some receivables. While this may not be the cheapest form of funding, we think Capital One is correct in relying on multiple sources of funding as a rise in interest rates may not affect all forms of funding equally. We have been impressed by the company’s habit of investing in long-term flexibility over short-term profitability.

Capital One operates in the U.S. banking system, which we assess as fair from a stability perspective. Though regulation has become considerably stronger in the past several years, the country still uses a complex and somewhat archaic system of regulation. Furthermore, the company’s banking market is quite fragmented; Capital One must compete with a variety of regional and community banks as well as large money-center institutions. Over the past 50 years, the banking system has achieved returns in line with its cost of capital, which supports our view of the environment as intensely competitive. Our outlook is more positive from a macroeconomic and political standpoint. The United States is still the world’s leading democracy, has increased GDP at a steady pace for years, and maintains the world’s reserve currency, all of which contribute to banking stability.

Change in Culture Is a Risk The greatest risk we see at Capital One would be a gradual change in its culture over time that might cause the company to offer loans and credit products that may generate great short-term profits but aren't resilient over an entire economic cycle. Thus far, Capital One has avoided this, and we believe it's partly related to the company's long-term focus and culture. Richard Fairbank is 66 years old and the only CEO the company has ever known. Eventually, he will be succeeded, and the bank's culture and mission could come under threat. All the structural advantages in the world won't prevent a good company from making bad loans. In banking, it is our conviction that a company's culture and values are the greatest deterrents in taking on excess financial risk.

In addition, we worry a change in culture would change the company’s acquisition philosophy and result in some bad deals. Despite a strong culture, it doesn’t ensure that Capital One won’t make bad acquisitions. As the bank gets larger, it’ll be harder to find acquisition candidates that move the needle. We believe Capital One’s size is one of its biggest threats.

We believe the company is in strong financial position. At the end of 2016, Capital One was leveraged at 7.5 times equity. We don’t believe the company is taking on too much financial risk. Furthermore, it continues to pursue multiple avenues of funding. While returns and margins might improve if Capital One were to only pursue brokered deposits, we believe the company is right to remain flexible and pursue multiple funding options.

Subprime credit cards have become an increased portion of Capital One’s total credit card portfolio. At the end of 2016, credits with a FICO score below 660 were 36% of the entire domestic portfolio, up from 34% the previous year. While this is concerning, we believe it’s related to many issuers avoiding subprime credits altogether, creating an opportunity for Capital One. In addition, the company has maintained that it has avoided cardholders with large revolving balances, irrespective of their FICO score.

Stewardship Is Exemplary Rarely do we see a company stress the importance of rewarding the interests of all stakeholders--which goes beyond just investors and includes the employees, partners, and borrowers that Capital One needs in order to create long-term value. Richard Fairbank has been CEO of Capital One since before it was spun out of Signet Bank in 1995. While Fairbank doesn't have a cash salary, he did take $16.7 million in compensation in 2015. His performance objectives are somewhat subjective, but executives can lose much of their compensation through clawbacks if the company fails to generate a positive adjusted return on assets.

We are highly impressed by management’s acquisition and investment philosophy. It takes advantage of bear markets and motivated sellers to acquire valuable assets. In part, it’s why we’re not extremely concerned about a consumer-led recession. If this were to happen, we are confident that management would use it as an opportunity to acquire assets on the cheap.

We credit Fairbank with cultivating Capital One’s culture. In an era where short-termism and cutting corners are the norm, Capital One has prioritized creating a long-term sustainable competitive advantage over maximizing short-term returns on equity. Where many companies might cut marketing and IT expenses, we believe Capital One views brand building and having the most sophisticated IT and data systems as essential investments it needs to survive.