Discover: Capital, Opportunity, and Discipline

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

March 31, 2014

Discover: Capital, Opportunity, and Discipline

  • We estimate DFS has excess capital of $2.5bn (given that its 2015 Tier 1 common ratio is 8.7% under the CCAR severe-stress scenario, after the just-approved capital plan, versus a minimum requirement of 5% of risk-weighted assets that are currently $68.7bn). The firm has prioritized organic growth over buyback (notwithstanding the buyback of 5% of stock in 2013 and a 67% payout ratio), and will deploy this excess capital into prime-lending where bank competition has retrenched (because it is highly stress-capital intensive with card-lending generating, under the severe-stress scenario, almost as much loss as the $98bn modeled by the Fed for Wall Street trading operations).
  • DFS has already diversified into a broad-line prime lender from its legacy at the time of the June, 2007 spin-off from Morgan Stanley as an ABS-funded card business (so that non-card loans are now 20% of the book and direct-to-consumer deposits 43% of funding) by: (i) leveraging brand awareness from its payments business; and (ii) cross-selling deposit products and debt consolidation “personal” and, going forward, home-equity loans to card customers (60% of personal loan and deposit customers have another DFS product). That said, we see lending share gains by DFS (e.g. 6% growth in the prime-revolver card segment in 2013 vs. flat for the industry and leadership in personal loans with an 11% share of the $28bn market) as a function more of capital than competitive advantage:
  • Capital Advantage: In the severe stress scenario, DFS generated a total loan loss ratio of over 15% compared with 12% for COF, 7% for JPM, and below 6% for BAC (see Exhibit below). Nonetheless, the trough Tier 1 common ratio (before capital payout) was 13.2% well above 6.3% at JPM, 5.9% at BAC; after the approved capital payout, the Tier 1 common ratios modeled at 8.7%, 5.5%, and 5.3% respectively for 2015 (vs. the minimum 5% threshold).
  • Efficiency: The competitive advantage to DFS of “branchless banking” may be overstated. While its 37% efficiency ratio compares favorably with an average of 66% for large banks, this is largely because of business mix; for example, JPM’s card, merchant, and auto business segment has an efficiency ratio of 43%. It is true that the cost-to-serve online deposits is less than branch deposits but this is reflected in the price: in 2013, DFS paid an average rate of 1.44% for interest-bearing deposits versus 18-32 basis points at large branch-bank competitors. We expect the gap to widen as short rates increase because branch deposit customers tend to be less rate-sensitive.
  • While the returns from non-card prime lending are lower than those from card-lending (no merchant fees, for a start), we expect DFS to maintain a 25% tangible ROE as the dilution is offset by absorption of excess capital into the loan book. On this basis, our TBV-regression model suggests DFS is ~20% undervalued, and this excludes the optionality in the payments business from arbitrage of Durbin regulation and the emerging distribution channels with online players and retailers allowing DFS to end-around the bank channel which has been locked up by V and MA (and which, unlike AXP, DFS does not have the premium economics in credit to penetrate).
  • Durbin arbitrage: As closed-loops, AXP and DFS are not subject to the Durbin interchange cap when they manage the cardholder funding account. AXP exploits this with its Serve-branded prepaid products which, because of check access and online bill pay, function as checking-account substitutes and are offered free to consumers who enroll for direct payroll deposit. DFS is exploiting it with the launch of cashback checking providing customers with a 10 cent reward for each debit, checking, and online bill pay transaction. With debit interchange capped by Durbin, and large branch networks to amortize, banks cannot match these economics.
  • Emerging distribution: The PayPal partnership provides DFS with access to 60mm active Payroll accounts versus its current tally of 63mm credit card accounts; this provides DFS with the opportunity to sell physical cards, along with loan and deposit products, even if the PayPal mobile wallet disappoints and PayPal loses share online as consumers shift to identifying themselves with (tokenized) bank credentials as in “Pay with Chase”, for example.
  • We see the most significant (albeit speculative) opportunity for DFS being to partner with the merchants’ payments consortium, MCX. While MCX will work with FIS to process payments acquired by consortium-members, MCX is likely to want their payment products to have utility at merchants who are not yet consortium-members and this will require partnership with an acceptance brand. DFS is a natural fit because it has the acceptance footprint of V and MA (9.2mmm acceptance locations at DFS versus 9.6mm at V) without the history of antagonism and litigation.
  • Indeed, customers who open a DFS cashback checking account when they enrol for an MCX card are likely to get a better debit value proposition whether they shop at MCX merchants (to qualify for premium rewards MCX members will use to steer customers to their products) or at merchants who are not MCX members (because of the Durbin-exempt character of DFS “closed-loop” cards). As in the case of PayPal, the access to MCX customers will allow DFS to sell physical cards and other product whether or not the MCX mobile wallet meets expectations.

Exhibit: Total Loan Loss Rates (as % average balances) for 2013Q4-2015Q4 in Severely Adverse Scenario

Overview

DFS appears fairly valued using our TBV-regression (see Exhibit 1) but this does not take into account the fact it appears to have ~$2.5bn of excess capital (representing 25% of Tier 1 common capital of $9.8bn) or optionality for the payments business. We arrive at our estimate of over-capitalization by noting the Tier 1 common capital ratio is 8.7% under the 2015 CCAR severe-stress scenario representing an excess of 3.7% over the minimum and translating (given risk-weighted assets of $69bn) to a buffer of $2.5bn.

Exhibit 1: Bank Valuation – DFS in the Top Right

Notwithstanding its repurchase of 5% of common stock in 2013 (with a total payout ratio, including dividends, of 67%), DFS prioritizes organic growth over stock buyback, and this is reflected in its focus on prime lending (both in card and personal lending) which banks have de-emphasized because it is highly stress-capital intensive; indeed, in the severe stress test, the Fed has industry card losses of $93bn over the 9-quarter model-period versus $98bn for securities trading. The focus has been timely as, in the aftermath of the financial crisis, consumers have improved household balance sheets by lowering debt service including through the consolidation of card loans into lower-cost personal loans (so that revolving credit has declined relative to total consumer credit – see Exhibit 2).

Exhibit 2: Consumers Lower Debt Service By Consolidating Card Loans

DFS’ strategy led to growth in its prime-revolver card-loan book of 6% in 2013 while prime-lending for the industry was flat, and DFS is now the leading provider of prime personal loans (with an 11% share of the $24bn market). The tilt to prime-lending meant that the loss ratio for the DFS loan book was over 15% for the CCAR severe-stress scenario compared with 12% for COF, 7% for JPM, and under 6% for BAC. Given its strong relative captial position, particularly under stress, we believe DFS can continue to grow in prime lending, and that the firmwide tangible-ROE will be stable as the diversification from the high-return card business (to non-card loans which are now 20% of the book versus 7% in 2009) is offset by the absorption into the loan book of excess (and currently idled) capital.

While the payments business at DFS is losing share (in credit because it does not have the premium economics to generate the rewards demanded by transactors and in debit because of Visa’s market power and implementation of PAVD[1]), there is significant optionality as the structure of the US payments industry evolves. One of the most important of these changes is a regulatory asymmetry between DFS and AXP which are not subject to the Durbin cap on debit interchange (because, technically, there is no interchange in a closed-loop when DFS and AXP administer the funding account). As a result, DFS enjoys premium economics in debit and so is able to fund checking-account rewards (evident in its new cashback checking account which offers 10 cents for each check, debit, and online bill pay transaction) which would be uneconomic for banks on the V and MA systems; in addition, of course, DFS is not maintaining the branch infrastructures of most banks. We see funding accounts (whether the Serve prepaid account from AXP of cashback rewards checking account from DFS) with debit-access provided by Durbin-exempt closed-loop networks as a potential catalyst for consumers to move to branchless banking, and having significant upside.

A more general evolution in payments is the emergence of distribution channels for network services that, unlike the bank distribution channel, have a broader economic model than maximizing interchange and, indeed, may be looking to minimize interchange and, more generally, for lowest-cost routing. The profitability of PayPal, for example, depends on the spread between its charge to the merchant (referred to as the “take rate” which, in 2013, was an average of 3.69% of volume) and the transaction expense and loss rate; in 2013, the transaction expense was 1.02% (and loss rate just over 0.3%) of volume, and PayPal can manage this down by shifting the consumer funding mix to low-interchange networks including ACH in debit and Discover in credit. For Discover, the PayPal relationship provides access to 60mm active PayPal accounts which is approximately the same as the number of current DFS credit card accounts. This access may allow DFS to sell physical cards and other products even if the PayPal mobile wallet struggles in a cluttered landscape and if PayPal loses share in online payments because of the consumer use of (tokenized) bank credentials for online and mobile authentication (as in Pay with Chase, for example) rather than third-party credentials (whether PayPal, iTunes, Amazon, or Google).

All that said, the most significant opportunity for DFS may be to partner with the merchants’ payments consortium, MCX. We acknowledge investor skepticism around merchants coordinating successfully with each other (and with WMT), but expect MCX to be a transformative force in US payments and to gain at least a 20% share of US tender (as REDcards have done already within TGT stores). Merchants have a shared objectives to harness their data on customer shopping habit for loyalty programs and to escape the supra-competitive fees imposed by V and MA; and they are structurally-advantaged over banks as a distribution channel for payments product particularly as mobile catalyzes the integration of loyalty coupons into the payments stream (as just implemented by the USB-owned acquirer, Elavon, for example). Furthermore, MCX has an accomplished CEO in Dekkers Davidson and is working with strong partners (FIS, Paydiant, and Gemalto); FIS, in particular, is a current partner of the zero-interchange payments systems in Canada and Australia.

While MCX will work with FIS to process payments acquired by consortium-members, MCX is likely to want their payment products to have utility at merchants who are not yet consortium-members and this will require partnership with an acceptance brand. DFS is a natural fit because it has the acceptance footprint of V and MA without the history of antagonism and litigation. Indeed, customers who open a DFS cashback checking account at the time they enrol for an MCX card are likely to get a better debit value proposition whether they shop at MCX merchants (to qualify for premium rewards MCX members will use to steer customers to their products) or at merchants who are not MCX members (because of the Durbin-exempt character of DFS “closed-loop” cards). Just as in the case of PayPal, the access to MCX customers will allow DFS to sell physical cards and other product whether or not the MCX mobile wallet meets expectations.

Distribution Bottleneck

DFS and AXP share a common legacy: competing against networks which locked up the bank distribution channel for payment products first through the exclusionary rules (forbidding their distributors from working with DFS and AXP) and then, when these were struck down by the Courts in 2003, through exclusive routing which, notwithstanding the Durbin Amendment, is the standard in credit and signature-authenticated debit. The result is that both, but particularly DFS, are sub-scale in payments with a 5.3% share of purchase volumes of $2.4tn on credit cards and, through Pulse (since the signature debit business at DFS is not meaningful) an 8% share of purchase volumes of $2tn on debit cards (see Exhibit 3).

Exhibit 3: DFS Share of Purchase Volumes on US Credit and Debit

Source: DFS 2014 Financial Community Briefing

The legacy of these distribution constraints is evident in the US today with DFS having 64mm credit cards in circulation and Amex 53mm. The equivalent figures for V and MA are over 254mm and ~178mm for credit cards (excluding 431mm and 158mm respectively for debit cards). Given network effects, and in particular that cardholder adoption begets merchant adoption, V and MA have broader footprints being accepted at 9.4mm locations in the US versus 6.4mm for AXP. DFS has closed the acceptance gap through working with merchant acquirers such as GPN, VNTV, and TSS (thereby sacrificing some control over the network as evidenced by the need to negotiate with these processors to carry the PayPal brand), and is now accepted at 9.2mm locations in the US (up 24% from 7.4mm in 2009) versus V and MA (up 17% from 8.2mm in 2009) and AXP (up 30% from 4.9mm).

Lend Focus at DFS vs. Spend Focus at AXP

DFS and AXP have responded differently to the distribution bottlenecks, but both are meaningfully more profitable than banks albeit less profitable than V and MA (whose 2013 return on assets were 14% and 25% respectively – see Exhibit 4).

Exhibit 4: Pre-Tax Return on Assets (before Extraordinary) for 2013

As discussed in our note of March 24th, “The Structurally Improving Business Model at AXP”, AXP has remained focused on payments-network business and addressed the distribution constraints imposed by V and MA through integrating forward into the channel (i.e. issuing its own “proprietary” cards such as the eponymous charge card). The presence of this issuing bank lowers returns relative to V and MA but distribution through Global Network Services (GNS) partners including banks and retailers, and already accounting for 15% of billings and 25% of earnings, has grown since 2004 at 20% annually and, after a slowdown in 2013 (see Exhibit 5), we expect it to increase towards this level again with the introduction of the WFC and USB credit partnerships in the US and increasing consumer adoption of Serve-branded prepaid products distributed through retail partners.

Exhibit 5: AXP Billings $bn

Source: Company Reports and Nilson 1033 for US volumes on GNS. USCS and ICS are US and International Card Services respectively, and GCS is Global Commercial Services. GNS partners account for 10mm cards in the US.

DFS, on the other hand, is looking to diversify to become a leading direct bank so that presently ~20% of loans are non-card loans (up from 7% in 2009 and including $8bn of private student loans, of which $4bn are balances on purchased portfolios, and $3bn of personal loans) with the ratio likely to increase as DFS builds a home-equity loan business after the 2012 purchase of an online distribution platform from Tree.com. Indeed, DFS is now the leading provider of prime personal loans (with an 11% share of the $24bn market) and third-largest private student lender (with a 16% share of the market behind SLM at 54% and WFC at 20%). On the liability side, DFS has $28bn of direct-to-consumer deposits representing 43% of funding (up from 23% in 2009 and less than 5% at the time of the June 2007 spin-off from Morgan Stanley) and has launched a cashback checking account (for existing customers) which pays 10c rewards for debit swipes (so more than 1% on purchases of less than $10), checks, and online bill pay.

These bank businesses leverage the proprietary payments network through the brand which has been advanced by increases in merchant acceptance (one study, for example, puts unaided brand awareness for DFS at the same level as AXP and more than twice that of leading banks – see Exhibit 6) and, in the case of the checking account, Durbin-free economics. The Discover network is not covered by the Durbin amendment when consumers access checking accounts held by DFS so that there is no restriction, as faced on debit card issued by regulated banks, to 24 cents for a debit transaction; as a result (like AXP in its Serve product), DFS has a regulatory advantage as a provider of debit cards and hence checking accounts.

Exhibit 6: Index of Unaided Brand Awareness Through 2013

Source: DFS 2014 Financial Community Briefing

DFS also notes that direct banking generates higher returns because there is no branch overhead, and comments that its efficiency ratio is 37% versus a 66% average for banks (other than Ally Financial and Santander) participating in the Fed CCAR process. However, this overstates the benefit since there are important mix-effects: JPM’s card, merchant services, and auto business runs at an efficiency ratio of 43%, for example. True, for deposits, it is cheaper to originate online than in branches but this is reflected in the price: DFS paid an average rate of 1.44% on its deposits during 2013 compared with 18-37 basis points for large branch-banks (with WFC at the low-end and KEY at the high-end). The test for DFS will be when short rates rise because online accounts tend to attract more rate-sensitive customers than branches. DFS notes that over 60% of direct-to-consumer deposit balances are from card or affinity customers but it is not clear whether this will improve deposit-stickiness in an environment where

Optionality in DFS Payments Business

As a payments company, DFS is losing share. In credit, it is not growing transactor-volumes but rather focusing on the prime-revolver segment; hence, while purchase volume in this segment grew 9% (versus industry growth of 5% – see Exhibit 7), purchase volume on credit cards as a whole grew 4% versus 8% for the industry (to $2.4tn of which DFS has a 5.3% share). DFS’ long-run positioning with low merchant-fees (which, on average, run below 1.5% versus 1.9% for V and nearer 2.5% for premium rewards cards) means it is economically disadvantaged in funding transactor-rewards. The low-fee does, however, make DFS an attractive partner for channels who are looking to reduce acceptance costs to merchant and develop a value proposition for consumers that is not exclusively around card rewards: PayPal is the obvious example (and potentially provides DFS access to 60mm active PayPal account holders) , but we also expect DFS to be a payments- and credit-partner of the merchants’ payments consortium, MCX.

Exhibit 7: DFS Gaining Share of Prime Revolver Card Business

Source: DFS 2014 Financial Community Briefing

In debit, DFS is a victim of broader industry shifts and Visa’s strategy around leveraging market power in signature debit to gain share in PIN debit through PIN-Authenticated Visa Debit (PAVD). In April 2012, the Durbin network exclusivity rules for debit went into effect preventing Visa from monopolizing cards (i.e. providing the only debit brands for which a card was enabled); as a result, on many cards enabled for Visa signature debit, the Visa-owned Interlink network for PIN debit was replaced by a competing network including Pulse which is owned by Discover. Pulse initially gained share and grew purchase volumes by 14% in 2012 but then lost share in 2013 with the Visa’s implementation of PAVD; this allows PIN debit transactions to be processed across Visa’s signature network (so that Visa can capture PIN debit transactions even if a card is not enabled for its Interlink debit network). With no growth (see Exhibit 8) and a decline of 25% in revenue/transaction because of the competitive impact of Durbin caps on interchange (combined, in the case of PIN, with merchants having routing options), pre-tax income in DFS’s payment services segment (principally Pulse) fell by 50% to $80mm accounting for just 2% of 2013 firmwide earnings of $3.9tn.

Exhibit 8: Payment Volumes for DFS in $bn

Source: DFS Financial Community Presentation 2014. Diners Club is issued under license outside of North America

The root challenge for DFS in payments is that V and MA control the bank distribution channel, and DFS does not have the high merchant fees to buy its way in. The optionality in DFS payments business arises because the broader industry is evolving and new distribution channels – particularly large online players such as PayPal and retailers – are emerging. These new channels for payments services need an acceptance footprint for their payment products, and DFS is a natural candidate with 9.2mm acceptance locations (a near match for the 9.6mm acceptance locations of V) and a more flexible approach to partnering than the legacy rule-based rigidity of V (and, to a lesser extent today, MA). For DFS, the partnership with new channels provides access to new accounts albeit with some overlap; for example, the relationship with PayPal provides access to 60mm active PayPal accounts which is nearly as many as DFS’ current credit card accounts of 63mm.

While individual retailers are distributing payment product (as in the case of WMT’s partnership with AXP over Bluebird, for example), we see the most promising, albeit speculative, opportunity for DFS as the merchant payments consortium, MCX. While MCX will work with FIS to process payments acquired by consortium-members, MCX is likely to want their payment products to have utility at merchants who are not yet consortium-members and this will require partnership with an acceptance brand. FIS NYCE network is a candidate (and, through its relationship with Interac, would provide utility in Canada) but DFS is a more natural fit given its broad acceptance footprint and ability to offer rewards at non-MCX merchants. Indeed, customers who open a DFS cashback checking account at the time they enrol for an MCX card are likely to get a better debit value proposition whether they shop at MCX merchants (to qualify for premium rewards MCX members will use to steer customers to their products) or at merchants who are not MCX members (because of the Durbin-exempt character of DFS “closed-loop” cards).

  1. Pin-Authenticated Visa Debit which has reversed the share declines experienced by Visa in PIN debit when the Durbin network exclusivity rules (preventing Visa from monopolizing a debit card) went into effect in April 2012; PAVD allows PIN debit transactions to be routed over Visa’s signature network so that Visa can compete for these transactions on Visa-branded debit cards even if these cards are not enabled for the Visa-owned Interlink PIN debit network.
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