5 key drivers of the Capital One-Discover merger

February 20, 2024 6:19 PM

Capital One Financial's deal to buy Discover Financial Services was in some ways a surprise, and in other ways long overdue.

While analysts were generally caught off guard by the news of Capital One's $35 billion offer, Discover's global card acceptance network has long been considered a sleeping giant that would make an ideal partner for a fintech or a bank.

The Discover network reaches 70 million merchants, and the company's Pulse debit network has agreements with about 4,000 banks, which would give Capital One the opportunity to shift tens of millions of its credit and debit transactions now carried by Mastercard and Visa to its own, proprietary network.

In addition to cutting costs by combining operations in key areas — Capital One foresees opportunities to save nearly $3 billion in costs from $1.5 billion in "expense synergies" and another $1.2 billion in network efficiencies — the combined entity would also gain vast capabilities to leverage data to customize and improve products for consumers and merchants.

The deal is subject to regulatory approval and it's already raised concern among watchdog groups like the National Community Reinvestment Coalition for its potential to combine two of the largest credit card issuers' portfolios. But Capital One's plan to flow a significant portion of its 100 million credit card users' transactions to the Discover network — which is much smaller than the three other U.S. card networks — could also give Discover the heft needed to compete more effectively with Visa and Mastercard, which together dominate the card industry.

Here are five compelling reasons behind the merger.

Network competition presents new opportunities

Sen. Dick Durbin, D-Ill., drove a key amendment around debit card interchange fees that took hold in 2011, and is currently co-sponsoring the Credit Card Competition Act that aims to alter credit card swipe fees.

Credit card swipe fees — largely dictated by Visa and Mastercard — have attracted a firestorm of complaints from merchants over the last decade. Regulators have stepped in to balance competition, such as with the Durbin amendment to the Dodd-Frank Act, which required banks with more than $10 billion of assets, to provide merchants with the option to use a lower-cost debit card network that wasn't Visa or Mastercard as of 2011. The Supreme Court this week is hearing a case brought by a North Dakota convenience store challenging the statute of limitations for the Federal Reserve's rule enforcing the Durbin amendment through Reg II as part of the Dodd-Frank Act.

By combining with Discover and expanding transaction volume on its network, Capital One could provide a more robust competitive option for merchants seeking alternatives to Visa, Mastercard or American Express.

Capital One had about 10% share of credit card purchase volume in 2022, and Discover had about 4% share, versus JPMorgan Chase at 21%, American Express at 19% and Citi at 10%, said analysts at William Blair in a Tuesday note to investors.

The network competition aspect may be the most interesting detail of the proposed merger, said Brian Graham, a partner and co-founder of the investment advisory firm Klaros Group.

"Recall that the Durbin amendment eliminated the vast bulk of debit interchange for all banks above $10 billion in assets, but in interpreting the legislation the Fed added an exemption for what are called 'three-party' networks where the issuer also acts as the card network," Graham said. Only American Express and Discover stood to benefit from this carve-out, he noted.

"By buying Discover and shifting its debit cards off of Visa and Mastercard to the Discover Network, Cap One can create for itself a Durbin exemption that its own investor deck says is worth $1.2 billion per year by 2027," Graham said.

Discover has hit a growth wall

Discover Financial Services got its start in 1985 under the umbrella of Sears, Roebuck and Co.'s Dean Witter brokerage unit.

From its improbable launch in 1985 as an arm of the former Dean Witter Reynolds brokerage firm — which parent company Sears, Roebuck envisioned as a financial juggernaut by combining stocks, credit cards, real estate, insurance and retail — Discover defied the odds. Skeptics claimed there was no need for another card network, but Discover turned profitable by 1988 and in March 1993 Sears spun it off as a standalone firm. In 1997 Discover merged with Morgan Stanley, but the investment firm divested the card issuer and its network in June 2007.

Targeting middle-income consumers, Discover developed a steadily growing business in credit cards, signature debit cards, personal loans and student loans. In 2005, still under Morgan Stanley's ownership, Discover in 2010 acquired Pulse, an independent debit network which brought connections to 4,100 banks and credit unions that use Pulse's rails to power debit and ATM payments.

Seeking a wider path to customers and growth, Discover in 2010 acquired Citigroup's Student Loan Corp., adding to its existing private student loans. The unit became an albatross in recent years, however, after Discover's loan-servicing approach drew consumer complaints that led to a consent order in 2015, followed by another disciplinary consent order in 2020. Discover last year announced plans to sell its $10 billion student loan portfolio, with a deal expected to close this year. Discover stopped accepting new student loan applications on Feb. 1.

Certain issues came to light just in the past year. For example, Discover announced it had overcharged certain merchants for 16 years, and the Federal Deposit Insurance Corporation announced another consent order touching Discover's customer servicing. Longtime CEO Roger Hochschild stepped down in August 2023.

Even before incoming Discover CEO Michael Rhodes took charge early this month, Discover had fallen into a financial trough. Amid a tougher economy, Discover card purchases through the fourth quarter of 2023 sagged while losses rose, causing Discover to predict flat sales for 2024.

As a card network, Discover on its own lacks enough scale to grow much more, said Richard Fairbank, Capital One's chairman and CEO, during a Tuesday conference call with analysts to discuss the proposed merger.

Capital One needs a bigger transaction highway

A Capital One Bank branch. — In the U.S. Capital One operates 250 branches, more than 50 Capital One Cafes and Capital One Lounges in three airports.

From its founding in 1988, Capital One has been steadily expanding its financial services reach so that today it has about 300 million cardholders, plus 250 branches, 80,000 ATMs and a network of cafes covering 21 of the 25 largest U.S. metropolitan areas. These cafes operate as marketing hubs to access digital banking and sign-up for Capital One's array of eight rewards-based credit cards.

By combining with Discover, Capital One gains "vertical integration" enabling the firm to compete against the nation's largest banks, according to Fairbank.

Capital One plans to move over 25 million Capital One cardholders to Discover's credit and debit card rails, amounting to more than $175 billion in Capital One purchase volume, by 2027.

"Bringing together the Capital One and Discover credit card businesses will unlock tremendous value as we take advantage of the benefits of scale," he added, noting that Discover brings $218 billion in annual card spending and $102 billion in loans to Capital One's credit card franchise. Capital One will also be able to extend ancillary services like shopping and travel to Discover cardholders, he said.

A data gold mine

At its core, the credit card business is about technology, information that's "all about data and analytics," according to Richard Fairbank, CEO of Capital One Financial.

Fairbank noted during the conference call that decades ago, "everybody was looking at credit cards as just another banking business, but really, it was a technology and information business, all about data and analytics and ultimately, things that drive scale."

One of the competitive advantages that Discover and American Express have long enjoyed over rivals is their insight into their customers' activity both as a card issuer and a card network, enabling them to directly act on merchant and consumer trends, he said.

Gaining access to richer merchant data will improve Capital One's fraud management and authorization rates. "By going directly through the [Discover] network, we can build even deeper merchant relationships and provide customized value," Fairbank said.

Capital One and Discover have a similar card-centric approach to financial services, which sets the firms apart from many other banks that issue credit cards, said Beth Robertson, managing director at financial services intelligence firm Keynova Group.

"The two firms each offer an array of card products for customers with different credit profiles, as well as targeted portfolios of retail banking services," Robertson said, which could make it easier to navigate through competitive or regulatory challenges. "The option to spin off business lines that aren't payments-centric may help the merger pass regulatory scrutiny, while the combined entity can also use cards [products and promotions] to generate cash to strengthen components of the core card business when needed."

Reckoning with Visa and Mastercard

One of Capital One's biggest motivations for the deal is gaining cost advantages and strategic benefits from owning its own payment network. While Capital One plans to transfer most of its debit volume to Discover's rails in the near term, initially it would move only a portion of credit card volume to Discover. This means Capital One will maintain existing relationships with Visa and Mastercard, Fairbank said, and this decision is not contingent on existing card contracts Capital One has with the two largest card networks.

"We have been partners with Visa and Mastercard for a long time … and we're talking about taking a network that is way, way smaller than those and giving it a chance to get more threshold scale, pick up momentum," Fairbank said, adding that the two giant networks will continue to be "very important partners with us because there's a lot of value that they still can add to our customers."

For one thing, Fairbank said he doesn't want to do anything that would be "jarring" for existing Capital One customers, and coexisting with them isn't a barrier to success. Fairbank used the example of how U.S. Bank and American Express operate as partners and competitors. U.S. Bank issues some cards on the Amex network, while Amex and U.S. Bank continue to compete against each other in winning new customers in similar niches including travel spending.

Visa and Mastercard also offer services Capital One may need. As downward pressure on swipe fees has intensified, as has the threat of competition from real-time payments traveling on ACH and other rails, Visa and Mastercard have been working to diversify beyond merely acting as card-network switches. Examples include the two networks' role in driving tokenization of transactions for greater security and utility, and investing in digital identity and payment credentials management.

Most banks lean on the global reach of Visa and Mastercard for the card networks' robust support of consumer and business-to-business cross-border payments services, along with cloud-based card security, risk and dispute management services. Altogether, Visa expects its revenue from "new flows" in 2024 to exceed consumer payments revenue, CEO Ryan McInerney told investors in January when announcing Visa's quarterly results.