Morgan Stanley Outlines Risks for an Independent Discover

Broadening merchant acceptance and negotiating the shoals of merchant pricing will be key parts of Discover Financial Services LLC's strategy to survive and grow once parent company Morgan Stanley spins off the No. 4 payments network. Morgan Stanley, a New York City-based investment bank, late on Friday filed a document with the Securities and Exchange Commission outlining its previously announced plans to spin off Discover to Morgan Stanley shareholders (Digital Transactions News, Dec. 19, 2006). The 181-page “information statement,” effectively a preliminary prospectus, outlines Discover's business and the competitive landscape in which it will operate. The filing does not place a value on Discover's shares. Morgan Stanley hopes to do the tax-free spin-off in the third quarter, though it hasn't set a date yet. Riverwoods, Ill.-based Discover, which owns the Pulse electronic-funds transfer network, claims about 4 million acceptance locations in the United States, Canada, Mexico, and the Caribbean, but the filing notes that Discover's charge volume is concentrated on the high-volume end of the merchant spectrum, limiting cardholder choice and making Discover vulnerable to price competition. It also notes that the banks Discover is trying to attract as issuers could exert price pressure that would hurt Discover's margins. “Discover Card transaction volume was concentrated among our 100 largest merchants in 2006,” the filing says. “These merchants may pressure us to reduce our rates by continuing to participate in the Discover Network only on the condition that we change the terms of their economic participation. At the same time, we are subject to increasing pricing pressure from third-party issuers as a result of the continued consolidation in the banking industry, which results in fewer large issuers that, in turn, generally have a greater ability to negotiate pricing discounts.” In an effort to beef up its acceptance among less price-sensitive small and mid-sized merchants, Discover last year started signing merchant acquirers, including heavyweights such as First Data Corp. and Global Payments Inc., to sell Discover acceptance to their client merchants (Digital Transactions News, July 14, 2006). Continuing that initiative will increase usage of Discover by cardholders and “will create significant opportunities for our card-issuing and third-party payments businesses,” the filing says. Some observers speculate that Discover, whose spin-off will come more than a year after MasterCard Inc.'s highly successful initial public offering and presumably a short time before bank-controlled Visa USA's planned conversion into a public company, might have a short life as a standalone entity before a bigger company swallows it up. They point out that Discover, which has about $50 billion in receivables, still has a single-digit share of U.S. credit card volume more than 20 years after Sears, Roebuck and Co. created it as a general-purpose card for its customers. But payments consultant Allen Weinberg, managing partner of Menlo Park, Calif.-based Glenbrook Partners LLC, notes that Discover is solidly profitable and seems quite qualified to make a go of it on its own. The unit posted net income of $1.08 billion in fiscal 2006 ended Nov. 30, up 87% from $577.9 million in fiscal 2005. Charge volume hit a record $114.8 billion in fiscal 2006. “Discover is still wildly financially successful,” he says. “This thing's throwing off cash like nobody's business. This is hardly a dog.”