Conventional wisdom has it that the logical beneficiary of the legal blows to Visa U.S.A. and MasterCard International would be American Express Co., which has made it clear for years that it wants to work with U.S. banks.
As it turns out, Discover Financial Services Inc., the sixth-largest U.S. credit card issuer, is waiting in the wings just as eagerly for the courts to strike down Visa's and MasterCard's exclusionary rules.
"As soon as the appeal is finished, we look forward to partnering" with banks, said David Nelms, Discover's top executive, in an interview last week.
In anticipation of working with banks, Discover is grooming itself to be a more attractive partner. Mr. Nelms said it is adding 500,000 merchants a year to its card-acceptance network, which is now the third-largest in the United States. Furthermore, it is raising the merchant discount rate to be more profitable to potential bank partners, which could use the network without necessarily issuing cards under the Discover name.
Another big selling point, from Discover's perspective, is its Cashback Bonus program, which it says other issuers have not been able to copy successfully.
"It is my hope that bank owners will take more control and do what's in their interest, as opposed to letting the staff of the associations [perpetuate] anticompetitive practices that are not in their interests," said Mr. Nelms, who is the president and chief executive officer of Discover, a Riverwoods, Ill., subsidiary of Morgan Stanley.
Moreover, he said, the fact that Discover is "not spending time fighting lawsuits all around the world has got to be attractive."
Since Discover does not issue debit cards, it may not feel a direct impact from the Wal-Mart case, which Visa and MasterCard settled a month ago with concessions including an agreement to lower the rates they charge merchants for signature debit transactions. But reports that some banks, particularly smaller ones, are not pleased with the settlements could turn some attention to alternative networks, such as Discover's.
More promising still for Discover is an appeals court ruling expected in an antitrust case brought by the Justice Department. Visa and MasterCard appealed the part of Judge Barbara Jones' 2001 decision that would force them to let member banks issue other card brands; arguments were heard this month by the U.S. Court of Appeal for the Second Circuit.
With Visa and MasterCard stewing in their own bylaws, Discover is contemplating new prospects. Partnerships with retail banks and their customers could deliver the shot in the arm that analysts say Discover and its Novus network need to remain viable.
Mr. Nelms said Discover already has partnerships with merchant-acquiring banks that sell its acceptance services to retailers. In March, Discover expanded its network to Mexico by signing on with Citigroup Inc.'s Grupo Financiero Banamex.
Last year, in response to aggressive efforts by banks - including Citi - to copy its 17-year-old Cashback Bonus program, Discover doubled the reward to 2% for redemption at select merchants.
Mr. Nelms' strategy for weathering the economic downturn is easy to summarize: play up the Discover brand, showcase the Cashback offer, do not make any rash moves.
"We've focused our efforts on cash back because that's what we're known for, and it's worked well," he said.
Analysts have questioned what they see as Discover's one-trick-pony business model, noting the lack of debit products and the minimal presence in international markets. The exclusive focus on the U.S. credit card market seems out of date, they say, and the Novus network may not be able to keep up with the rapid technological advances of competing networks, such as those run by First Data Corp.
Purchase volume on Discover cards in 2002 was $97.2 billion, which represented 6.45% of the $1.5 trillion credit card pie. In volume, Discover came a rather distant fourth to American Express, with $234.1 billion; MasterCard, with $485.9 billion; and Visa's $690.3 billion, according to Sanford C. Bernstein & Co. LLC, a subsidiary of Alliance Capital Management LP.
Nevertheless, Mr. Nelms said, Discover competes more as a credit card issuer than as a payments network - a perspective that could receive an interesting twist were bank partnerships to become possible. "We view ourselves as a card issuer that happens to have a proprietary network. Our competitors are Citibank, MBNA, [Bank One Corp.'s] First USA, and the like," rather than Visa and MasterCard, he said.
Between 30% and 40% of U.S. households have a Discover card, he said. "That's far more than the next-biggest issuer, whether that's Citibank or American Express."
It is hard to fault Discover, which has provided a consistent ballast to its parent company's balance sheet. Last year the card business contributed 25%of Morgan Stanley's net income, according to Bernstein analysts. In an April research note they wrote: "For investors who over the last three years have lived through the earnings downturn of Morgan Stanley's institutional securities, retail brokerage, and asset management businesses, they can only say - 'Thank you Discover!' "
But Bernstein analysts also noted that despite its profitability Discover "suffers from slower growth prospects relative to a series of increasingly powerful competitors and may be facing a strategic dead end." Discover's ability to undercut Visa's and MasterCard's merchant discount rates does not outweigh its relatively weak volume, they wrote. And the race for scale in network services may eventually prove too fast for the company, they wrote.
According to the Justice Department, Discover's merchant rate is 1.5% of the transaction amount, compared with 2.73% by American Express and roughly 2% by Visa and MasterCard.
"People have always been concerned about Discover's ability to grow," Mr. Nelms said. "But no one else has grown a $50 billion portfolio without acquisitions."
"For a U.S. card business in a mature market to have had that kind of growth for the last four years" - from $32.8 billion - proves the popularity of Discover's brand and the endurance of cash back, Mr. Nelms said. Competitors have not been able to replicate its offer successfully, he said.
In March, the announcement by Sears, Roebuck and Co. that it would sell its $30.8 billion credit card portfolio spurred rumors that Discover was a potential buyer - despite the widespread impression that it was not interested in acquisitions. Mr. Nelms would not discuss Sears, saying only that "in general, Visa and MasterCard portfolios have been available for the last few years, and we have not actively pursued them in the U.S."
With Discover's acquisition costs at less than $100 per account, he said, "it still seems more attractive to [grow] organically."
International expansion is a slightly different story. Mr. Nelms said Morgan Stanley continues to bid on portfolios abroad, though "so far we haven't found the right deal at the right price." Over time, he said, Morgan Stanley would like to issue cards in foreign countries besides the United Kingdom, "but we are in a go-slow mode because of credit quality issues back home and the desire to have adequate scale in every market we're in."
Morgan Stanley "does not want to be like Bank of America, Chase, First USA, or any of the others who went [abroad] and came back" discouraged by how hard it was to build adequate volume, he said.
So far he sees the Morgan Stanley-branded MasterCard business in the United Kingdom as a good harbinger, with one million cards and $2 billion of receivables after three years. "We expect to make a little bit of money in the U.K. this year," he said - "and for the fourth year of a start-up, we think that's excellent."
The issuer is also "actively looking" to introduce a business card, which it only recently obtained legal clearance to do, because of a change in laws governing its bank charter.
Another novelty for this closely managed business: Discover has cut costs by outsourcing some of its merchant-acquiring functions to First Data.
"We moved a couple of years ago from thinking we needed to do everything ourselves to considering what was the best way to perform any individual function," Mr. Nelms said. Acquiring merchants was expensive for Discover but "an easy add" for First Data, he said.
Outsourcing "was a big change," Mr. Nelms said, and "to a large degree responsible for closing our acceptance gap" - though that, he said, is still an unfinished project.
