Discover’s Spin-Off Could Lead to Major Changes, But Not Immediately

A spin-off of Discover Financial Services Inc. by its parent, Morgan Stanley, won't likely change the card network's strategy, but an acquisition of the newly independent company would likely occur soon after the spin-off, leading to probable changes in direction at the 20-year-old card company, including a possible break-up, according to expert observers. “A spin-off isn't likely to change the nature of Discover,” says Gwenn Bezard, research director at Aite Group, a consulting and research firm in Boston. Bezard says Discover's two-pronged strategy?building up its network via signing major banks and retailers, and establishing itself as a major player in debit cards?will stay in place as the company struggles with highly competitive markets, particularly credit cards. At the same time, observers see Discover continuing to capitalize on its payments network to attract major retailers, in the way it has done recently to clinch card-issuing deals with Wal-Mart Stores Inc. and its Sam's Warehouse chain. “What will affect strategy at Discover is the constraints of the market,” says Bezard. “The credit card market is very competitive, and they've had a hard time growing that portfolio. It's not likely the credit card business is going to be less competitive. I would see potentially Discover trying to position itself as an alternative network for major merchants. The deal with Wal-Mart might be indicative of that.” Morgan Stanley's board of directors late yesterday authorized the company's management to pursue a spin-off of Discover, which the investment-banking firm has owned since 1997. Stock analysts figure an independent, publicly held Discover–which holds $48 billion in receivables and maintains 50 million cardholder accounts, while supporting 4 million merchants and cash-access locations on its network–could be worth about $14 billion. But many observers doubt that the newly minted unit would remain independent for long. Major banks and processors?including J.P. Morgan Chase & Co., Bank of America Corp., HSBC Holding PLC, and First Data Corp.?are said to be interested in acquiring Discover. Indeed, Bezard figures an acquisition could be announced within six months of the spin-off. Private-equity firms, he adds, might also be candidates to buy the company. To make a $14 billion prize more easily digestible to potential acquirers, Discover might end up being bought in two pieces, Bezard says, with a bank acquiring its receivables and a processor or private-equity firm taking the network. “You really have two different businesses,” he says. Whether as an independent company or as part of a new parent, Discover's challenge will be to grow its network for both credit and debit card processing. Late last year, it bought the Pulse electronic funds transfer network for $311 million, which gave the Riverwoods, Ill.-based company instant credibility in the fast-growing debit market. Now, Bezard argues, it will need to ignite growth in both credit and debit by clearly setting itself apart from Visa, MasterCard, and American Express while rolling out new incentives for merchants and cardholders to participate in the network. “You need to create incentives for merchants to participate and for consumers to use the cards, a network effect a la PayPal,” Bezard says. He points to cash-back offers, which Discover has stressed in its Wal-Mart and Sam's Club deals, as important incentives, while adding that Discover could set itself apart in a major way by allowing interchange-free transactions for merchants. “They'll have to side with the merchants to make a real difference,” he says. “For now they're very much like Visa, MasterCard, and AmEx.”