Discover at 25

 

Discover can point to some major triumphs since it was launched by Sears a quarter-century ago, not least its success in taking on Visa and MasterCard. But a fast-changing payments landscape offers no assurance of future success. Discover’s plan: It pays to network.

 

By Jim Daly

 

 

 

The fastest-rising expense item at Discover Financial Services is party hats, occasioned by celebrations in 2011 of milestone birthdays for all three of the company’s payment networks. The core Discover network and credit card is now 25 years old, while Diners Club, the original U.S. general-purpose card network, just turned 60 and the Pulse debit network turned 30.

 

“We are the oldest and youngest network in the world,” says chairman and chief executive David W. Nelms in an interview with Digital Transactions at Discover’s busy headquarters in Riverwoods, Ill., 23 miles northwest of downtown Chicago.

 

Born in 1986 of Sears, Roebuck and Co., at the time the world’s largest retailer, Discover survived and thrived with its card for the middle class, ultimately becoming the last company to successfully build a national general-purpose credit card network from scratch.

 

Others have tried, but the only company to come close to replicating Discover’s feat is PayPal Inc., though some would argue that Discover and PayPal aren’t really comparable because PayPal partially rides on the existing card networks for customer funding.

 

Today, Discover’s network is near or at parity with the Visa/MasterCard merchant base in the U.S. Pulse, the third-largest electronic funds transfer network, provides Discover with a major debit base, and Diners Club and a growing number of what Discover calls “net-to-net” agreements give Discover an international reach it lacked just a few years ago. Total charge volume in fiscal 2011’s first nine months had surpassed $211 billion, up 15% from a year earlier.

 

On the lending side, the Discover credit card is humming along again after a bruising by chargeoffs during the recession, though they were not nearly as bad as the losses sustained by some of its big-bank rivals.

 

Now the company, a big seller of certificates of deposit, is expanding its low-cost, direct-banking business into private student loans and mortgage originations.

 

Through it all, Discover has retained its “Cashback Bonus,” which in basic form rebates up to 1% of Discover purchases and more depending on the transaction and merchant, with more than $8 billion paid since 1986.

 

And the company still uses the “It Pays to Discover” slogan. But the marketing and rewards have been modified and expanded in all manner of ways over the years, especially as Discover developed rewards programs with merchants—a key advantage over the bank card networks of being both issuer and network provider.

 

“They have the best rewards card going, it has been for years,” says payments consultant and former MasterCard executive Steve Mott, chief executive of Stamford, Conn.-based BetterBuyDesign.

 

Launched as a unit within Sears’s Dean Witter brokerage subsidiary, Discover later became a subsidiary of giant investment bank Morgan Stanley. But since 2007, it has stood on its own as a New York Stock Exchange-traded company (timeline, page 31).

 

The company’s shares are up more than 40% over the past two years, slightly trailing only MasterCard Inc. in a cohort that also includes Visa Inc. and American Express Co., according to Yahoo! Finance.

 

Network ‘Foundation’

 

Discover has stubbed its toes along the way, however. A foray into credit card lending in the United Kingdom through its $1.7 billion purchase of the Goldfish rewards card portfolio in 2006 went badly for Discover. Chargeoffs ballooned, and Discover underestimated the proclivity of British consumers to file for bankruptcy, according to press accounts at the time. Discover sold the business to Barclays Bank in 2008 for a mere $70 million.

 

In the U.S., the 1995 re-christening of the Discover network under the “Novus” (Latin for “new”) brand to distinguish it from the Discover card didn’t get much traction. Discover dropped the Novus name four years later, bringing all of its credit card business once again under the Discover brand.

 

If anything, however, the renewed focus on the Discover name for the network reinforced the company’s growth throughout the 2000s and positioned Discover as a serious competitor in a payments world that now includes Visa and MasterCard as aggressive, publicly held companies.

 

Then there are newer form factors and technologies, including mobile payments through smart phones, contactless cards, and the likely appearance of contact chip cards under the EMV standard.

 

While U.S. lending generates more revenues for Discover than the networks do, it’s the network side of the business that gives Discover a solid platform for expansion in both in North America and abroad.

 

“The Discover network is the entire foundation for the Discover card,” says Nelms, a tall, friendly 50-year-old who looks about 35.

 

A veteran of credit card pure play MBNA Corp., Nelms joined Discover in 1998 as president and chief operating officer. He has a bachelor’s degree in mechanical engineering and an M.B.A. from Harvard Business School.

 

Nelms succeeded Tom Butler, who retired after leading Discover through its first dozen years following a career at Sears, and then became chief executive in 2004 and board chairman in 2009.

 

Heading up the company’s network business is executive vice president Diane E. Offereins, whose other titles include president, Payment Services, and chief executive of Pulse. She’s another alumnus of MBNA, now part of Bank of America Corp., and has been with Discover since 1998.

 

Nelms and Offereins have steadily expanded Discover’s acceptance over the years. Like American Express, Discover functions as both card issuer and merchant acquirer. To build volume for the cards it first gave to Sears’s customers, Discover set about early to sign large, national merchants and did a pretty good job of it.

 

‘Home Run’

 

In 2006, however, Discover embarked on a concerted effort to fill what it recognized as a big hole in its network—sparse acceptance by smaller merchants. The strategy involved enlisting bank card merchant acquirers to sign local and regional retailers, restaurants, and other Visa/MasterCard-accepting businesses for Discover acceptance too.

 

The hook for merchants: Discover transactions would be included on their statements along with Visa/MasterCard transactions, and the same acquirer also would handle customer service and settlement.

 

Merchants would no longer be able to refuse to accept Discover on the grounds that it was the exception brand with separate statements, separate phone numbers, and separate settlement.

 

The hook for acquirers: Discover would continue to directly acquire large merchants (currently about 1,500), but would sell to the new partners portfolios of smaller merchants. Sales were based mainly on which bank card processing platform the merchants used. The acquirers would own the merchant relationships and pay interchange to Discover on Discover card transactions.

 

Discover recruited First Data Corp. as its first acquirer and over the next five years added about 125 more that in total account for 99% of bank card volume. Offereins says the number active merchants, those submitting at least one transaction per month, is up 40% in the past four years.

 

Discover now claims 7 million active merchants versus about 8 million total U.S. locations for MasterCard and Visa. How many of the bank card locations are active is uncertain, but what’s clear is that Discover is now close or equal to the bank card base.

 

“I would tell you that the whole arrangement with the acquirers has been a home run for us,” says Offereins.

 

But exactly how much more market share Discover’s U.S. credit card operation commands as a result of the effort is difficult to ascertain because of the differing ways the networks publicly report key measures of their activity.

 

For years, Discover was the No. 4 network after Visa, MasterCard, and American Express, with about 6% of U.S. credit card charge volume. Discover maintains that it has gained share in recent years as U.S. consumers delveraged, causing its major competitors to downsize, but moving the credit card market-share needle is tough.

 

“It’s a constant, uphill battle,” says Mott.

 

Discover, however, unquestionably is now a major international player. Through most of its existence, Discover was a domestic card, with some acceptance elsewhere in North America at locations frequented by Americans. Like the other networks, it recognized that the big growth opportunities lie abroad.

 

Discover made probably the most dramatic single move in its history in 2008 when it bought the venerable Diners Club International business from Citigroup Inc. for $165 million. The purchase gave Discover the Diners network, its employees, brand and trademarks, and its agreements with 44 network licensees around the world that actually issue Diners Club cards.

 

The deal instantly brought under Discover’s wing $30 billion in new annual charge volume and 8 million new merchant and cash-access locations in 185 countries.

 

Started as a travel-and-entertainment card in New York, Diners is now mostly a corporate card for business people. Citi, long-time holder of the North American Diners Club franchise, sold that business in 2009 to Toronto-based Bank of Montreal.

 

After the purchase, Discover set about integrating its network with Diners’ so that Discover cardholders could use their cards wherever Diners is accepted. And when Discover signs new acceptance agreements with foreign acquirers, the deal is for both brands. That’s the case with new pacts involving ConCardis in Germany and WorldPay in the U.K.

 

“Our whole network strategy is Diners and Discover,” says Offereins.

 

While individual deals with acquirers are part of the strategy to expand acceptance, a bigger part is the net-to-net agreements. Under these arrangements, cardholders of a Discover partner network can use their cards at Discover locations in the U.S. and Discover cardholders can use theirs at the partners’ locations.

 

In the home country, a Discover transaction is the partner’s, while in the U.S. or at a Diners Club/Discover location abroad, it’s Discover’s. According to Nelms, Discover has identified about 50 such networks that could be partners.

 

The two biggest already are in Discover’s camp—the Chinese processor China UnionPay, signed in 2005, and Japan’s JCB, signed in 2006. Since then Discover has added Serbia’s DinaCard and South Korea’s BCcard. Offereins hopes to sign about five more in the coming year.

 

JCB already had a presence in the U.S. but its acceptance quadrupled after the Discover deal, Nelms says. That’s particularly advantageous for Discover because of the heavy travel to the U.S. by Japanese business people and tourists.

 

“We’ve opened up our whole 7 million merchant locations to them [and] they’ve opened up Japan for us,” he says.

 

By piecing together a co-operative of networks, Discover can distinguish itself from Visa and MasterCard, generate new volume, and attract partners that want to keep transactions in their home countries on their own networks, according to Offereins.

 

“Different regions of the world want to have something like that,” she says. “That’s an idea we love and part of the strategy we’re focused on … it’s a beautiful thing when you find the right partner.”

 

Banks Balk

 

The net-to-net strategy is proving more fruitful than another part of Discover’s plan to leverage the network, that being recruiting U.S. financial institutions to issue Discover-branded credit or even signature debit cards.

 

For years, while they were bank-owned associations, Visa and MasterCard banned their members from issuing cards on the networks of rivals Discover and American Express. The U.S. Department of Justice successfully overturned those bans in 2004, and both AmEx and Discover sued the bank card networks for damages from lost business.

 

Visa and MasterCard settled with Discover in late 2008 for a total of $2.75 billion, but Discover had to pay $775 million of that to former parent Morgan Stanley.

 

Discover has now recruited about 30 third-party credit card issuers. But Offereins admits it’s been tough to convince banks to issue anything other than Visa or MasterCard-branded cards. “That would be the part of the business that has been a little more difficult for us to break into,” she says.

 

For now, the third-party option remains in Discover’s toolbox, but Offereins is not expecting “huge growth” from it unless there is a change in card issuers’ mindset.

 

“Hopefully, over time, people are going to want diversify out their business a bit, and we stand ready in a very unique way to partner, not in the one size fits all, but I think we can be more flexible [than Visa or MasterCard],” she says.

 

Other components of the network strategy include white-labeling the network so that other payments companies can use it, such as PayPal’s BillMeLater transactional credit unit.

 

Not ‘Sitting Back’

 

Meanwhile, the source of most transactions in the Discover family is Houston-based Pulse, which Discover acquired in 2005. Pulse handled 950 million transactions in Discover Financial Services’ third fiscal quarter ended Aug. 31, more than twice the 451 million on the Discover network.

 

Pulse has a nice, big business going along—4,400 financial-institution customers, $106 billion in purchase volume in fiscal 2011’s first nine months, up 22%, acceptance at 380,000 ATMs in the U.S., and more than 800,000 worldwide—that network president Dave Schneider calls “an integral part” of Discover.

 

But on Oct. 1, like all debit networks, Pulse found the old ways of doing things upended by the Federal Reserve Board’s rules implementing the Durbin Amendment in 2010’s Dodd-Frank Act.

 

The Durbin Amendment imposes price controls on the interchange of debit card issuers with more than $10 billion in assets and requires each debit card to give merchants access to at least one unaffiliated network.

 

That means that exclusive arrangements between issuers and Visa, for instance, to issue cards with only the Visa brand for signature debit and the Visa-owned Interlink network for PIN debit are now illegal. Plus, networks and issuers can’t interfere with merchants’ transaction-routing choices.

 

With the Visa-Interlink duo dominating debit, the conventional wisdom has it that Pulse, First Data’s Star, MasterCard’s Maestro, FIS’s NYCE, Fiserv Inc.’s Accel/Exchange, and other EFT networks could pick up a lot of new business as debit issuers shop for unaffiliated brands.

 

But how that all will play out remains to be seen. Under the old model, networks raised interchange rates with little regard for merchants, which pay interchange, to attract card issuers, which receive interchange. Now networks have more of an incentive to hold rates in check or even lower them, to attract volume from merchants.

 

“We are really involved in an unprecedented number of sales opportunities to help them [issuers] make the right choices for the business,” says Schneider.

 

Pulse, however, is promoting its fraud-control capabilities, reporting and data analytics, and other network features rather than just price to attract issuers, according to Schneider. “It’s never been our practice to buy the business or heavily discount the value proposition,” he says.

 

Consultant Mott, however, thinks Pulse and other EFT networks might be expecting too much easy new volume from Durbin. He notes that Visa recently began playing up an apparently longstanding but obscure capability that suddenly has new value in the Durbin era, that being the VisaNet network’s ability to handle both signature and PIN debit transactions.

 

That means Visa could still capture a PIN-debit transaction even if a debit card doesn’t bear the Interlink logo. “Your enemy has not been sleeping,” Mott says.

 

Schneider, however, says, “I can tell you we’ve been doing anything but sitting back.” He notes that Pulse has “invested a significant amount of resources” in the past year expanding its capacity and assessing the potential impacts of Durbin.

 

Testing the Tech

 

Besides rowing through the newly muddied debit waters, Discover is trying to figure out which new payments technologies will stand out in the reeds as likely winners. For now, it’s placing multiple bets.

 

In contactless payments, Discover has the Zip brand, which it quietly tested for years and rolled out in late 2010. About 500,000 cardholders now have a Discover card with a contactless chip or a contactless sticker that attaches to their mobile phone, according to Nelms.

 

Zip is usable at about 200,000 locations, the same as the other networks’ contactless cards since they’re all built on the same specifications.

 

In mobile payments, Nelms notes that Discover is working with everyone from Google Inc. to Isis, the mobile-payments and electronic-wallet joint venture of AT&T, Verizon Wireless, and T-Mobile.

 

Secretive Isis, the subject of intense speculation over the past year, announced Discover as its original card network, but later added Visa, MasterCard, and AmEx to its mix. Some observers wondered if Discover had been dissed, but Offereins doesn’t take the development as a slight. Rather, she says, any market confusion about Isis’s plans may have been caused by the venture’s own statements.

 

“The wallet was always going to be open,” she says.

 

Last year, Discover struck an agreement with Qualcomm Inc.’s Firethorn subsidiary to process transactions for Firethorn’s SWAGG mobile gift card application to be marketed by national retailers.

 

So far, Discover hasn’t taken a public position on EMV, the so-called Europay-MasterCard-Visa contact chip card technology that replaces the magnetic-stripe card and is already established in or coming to most of the world, the United States being the major exception.

 

In August, Visa announced a multipart plan to simultaneously encourage EMV and mobile-payments adoption in the U.S. Visa’s plan has some attractive features for acquirers and merchants, which would have to pay for chip-reading terminals, especially its waiver of annual validation of Payment Card Industry data-security standard (PCI) compliance.

 

But critics, many of whom fretted about Visa’s apparent sidelining of PIN authentication, said the No. 1 network was trying to impose its vision of EMV and mobile payments on the U.S.

 

“I haven’t seen the merchants jumping up and down saying they want EMV,” says Offereins. “I think they’d like to have a vote. So I think we’re going to take a more thoughtful approach and actually talk to our constituents, and chat with the acquirers and merchants and do something that balances everybody’s interests.”

 

For now, Discover is content to try out as many new technologies as possible.

 

“It’s too early to pick the winners and losers, and in fact there may be multiple things that work,” says Nelms. “Our strategy has been to be the most flexible partner and to not put all our eggs in any one basket.”

 

Mobile-payments consultant Todd Ablowitz, president of Centennial, Colo.-based Double Diamond Group, says Discover’s multipronged partnerships and ventures show the company has “been laying the groundwork for their play in mobile. Discover will not let themselves be left behind.”

 

Fulfilling Sears’s Plan

 

While mobile and contactless payments present new opportunities for Discover to leverage its networks further, the company has already developed them enough that it could be a good acquisition target, according to BetterBuyDesign’s Mott.

 

Potential buyers, in his view: a well-capitalized big bank that wants to diversify beyond Visa and MasterCard, or even a non-payments company such as Google that decides to get into the business directly.

 

“I think Discover is going to be bought by somebody in a year,” he says. “It’s too valuable of a network play to sit on the sidelines.”

 

Nelms downplays such talk.

 

“Being acquired, I think, is less likely than it probably ever has been before,” he says. He notes that a buyout would be expensive since Discover shares are trading at about two times book value, twice the level of most of the company’s big-bank rivals, and any proposed merger would likely face intense antitrust scrutiny.

 

Instead, Discover intends to realize, through direct banking and cards, at least part of the vision Sears laid out for its planned Sears Financial Network in the ‘80s. Through its subsidiaries, the giant retailer wanted to become a monetary supermarket for the masses, with brokerage services from Dean Witter, credit cards from Discover, insurance from Allstate, and real-estate services from Coldwell Banker.

 

Sears never fulfilled that dream and sold its financial subsidiaries as it struggled against rising discount retailers, especially Wal-Mart Stores Inc. and Target Corp.

 

“It was almost a vision that was ahead of its time,” Nelms says.

 

Discover sees itself as the 21st Century inheritor of a good idea, with its networks as the foundation. Says Nelms: “We’re much more on the map now.”

 

 

 

 

 

A Discover Timeline

 

1985 – Test marketing begins in Atlanta and San Diego. A Sears, Roebuck & Co. employee makes the first Discover card purchase on Sept. 17 for $26.77 at a Sears store in Atlanta.

 

1986 – Sears subsidiary Dean Witter launches Discover, highlighted by a TV commercial during Super Bowl XX. Heading Discover is former Sears executive Thomas Butler.

 

1989 – Discover signs its 1 millionth merchant, a restaurant in Wilmington, Del.

 

1993 – Sears relinquishes ownership of Discover with its March 1 spin-off of Dean Witter, Discover & Co. as a publicly traded company.

 

1995 – DiscoverCard.com launches in September.

 

1995 – Dean Witter Discover subsidiary Discover Card Services Inc. changes its name to Novus (Latin for \”new\”) Services Inc. to distinguish its expanding network from the Discover card.

 

1997 – Morgan Stanley Group Inc. acquires Dean Witter, Discover & Co.

 

1998 – Butler retires; MBNA veteran David W. Nelms named Novus/Discover\'s president and COO.

 

1999 – Novus Services Inc. changes its name to Discover Financial Services.

 

1999 – Discover launches the Morgan Stanley Card in the United Kingdom, the company\'s first international expansion.

 

2000 – Greenwood Trust Co., Discover\'s card-issuing subsidiary, is renamed Discover Bank.

 

2002 – Discover launches the 2Go card, the industry\'s first keychain credit card.

 

2003 – General-purpose Discover gift cards are announced.

 

2003 – Acceptance of Discover cards begins in Mexico.

 

2004 – Nelms becomes chief executive officer.

 

2004 – Resolution of U.S. Department of Justice anti-trust action against Visa and MasterCard clears the way for banks to issue cards on the Discover and American Express networks. Metris Cos. Inc. became Discover\'s first third-party issuer in September 2005.

 

2005 – Discover buys the Pulse EFT network.

 

2005 – Discover, Wal-Mart and GE Consumer Finance announce plans to offer a GE-issued Wal-Mart credit card on the Discover network.

 

2005 – Under a reciprocal agreement with merchant processor China UnionPay, Chinese bank cards can be used for U.S. purchases, via the Discover network. The first purchase on a Discover card in China occurs in 2006.

 

2006 – In February, launches Discover Debit, the first signature debit card to compete with Visa and MasterCard debit cards.

 

2006 – Discover buys Goldfish, a U.K. rewards card portfolio with 2 million cardholders, from Lloyds TSB for $1.7 billion.

 

2006 – JCB, the largest card issuer and acquirer in Japan, and Discover sign a reciprocal acceptance agreement.

 

2006 – First Data Corp. in July becomes the first of eventually more than 100 bank card acquirers Discover enlists to sell Discover acceptance to small and mid-sized merchants.

 

2007 – Morgan Stanley spins off Discover Financial Services as a public company, shares begin trading July 2 on the New York Stock Exchange.

 

2008 – Discover sells the Goldfish card to Barclays Bank for $70 million.

 

2008 – Discover buys Diners Club International that July, opening the way for global acceptance.

 

2008 – Visa and MasterCard settle for $2.75 billion Discover\'s lawsuit seeking damages for the time the networks banned their member banks from issuing Discover cards.

 

2010 – Discover announces network-to-network alliance with Korea\'s BCcard.

 

2010 – Discover takes over sponsorship of college football\'s Orange Bowl.

 

2010 – Mobile-payments joint venture Isis names Discover as its first card-network partner.

 

2010 – Discover announces plans in September to buy $4.2 billion in private student loans and other assets from The Student Loan Corp.

 

2011 – Announces agreement to buy Tree.com Inc.\'s mortgage-origination business for $55.9 million.