Now Independent, Discover Looks to Grow Issuing, Acquiring, Debit

Discover Financial Services LLC, whose shares began trading on Monday on the New York Stock Exchange, is finally on its own as a corporate entity for the first time in its 22-year- history. But while the spin-off from parent company Morgan Stanley is complete, Discover's mission of gaining market share as an independent card issuer and the No. 4 payment network in a fast-changing industry is just beginning. Though the big picture may be somewhat cloudy, Discover chief executive David Nelms is basking in the bright if brief sunlight of Wall Street celebrity. “We're excited; it's a great day,” Nelms tells Digital Transactions News. Nelms rang the bell Friday at the NYSE, where Discover's shares now trade under the ticker symbol DFS. Discover's stock didn't give an immediate, spectacular performance the way MasterCard Inc.'s did in May 2006 when MasterCard did its initial public offering, but few expected one. A spin-off?in this case one Discover share for every two a Morgan Stanley investor owns?is different from an IPO. After trading for a few weeks on a “when-issued” basis for settlement later, Discover's shares opened this morning at $28.55 and rose slightly but then dipped, with the price at $27.81 in mid-day trading, a decline of 2.6%. Nelms says he's not worried by short-run fluctuations, especially in the immediate aftermath of a spin-off. “I think that's a different bar,” he says. “We can be very successful and not have the run up that MasterCard did.” Riverwoods, Ill.-based Discover's challenges include, as an issuer, getting more share than the approximate 6% slice of the U.S. general-purpose market that it currently has; gaining more acceptance locations, especially among small merchants; and becoming a major player in the fast-growing debit card business and new payments markets such as mobile commerce. “They're going to going have to plow unbelievable amounts of money into the rewards program,” notes consultant Allen Weinberg, managing partner of Glenbrook Partners LLC, Menlo Park, Calif. Drawing comparisons with American Express Co.'s rapid growth of recent years, Weinberg says more rewards would induce consumers to use their Discover cards more often, making it harder for merchants to say no to accepting Discover. Nelms didn't talk in specifics, but seems to be thinking along those lines. “We'll be reinvesting capital back into the business,” he says. While it has more than 4 million merchant locations and strong acceptance among large retailers, Discover's traditional weakness has been among small merchants. To address that, Discover about a year ago announced a program to enlist bank card merchant acquirers to sign small merchants as Discover acceptors. Discover already had some independent sales organizations as partners, but the new program broke with Discover's traditional model of direct merchant-account ownership and let the outside acquirers own the relationships. Nelms says the effort, which included the sale of some merchant relationships to the acquirers, still has about two years to go but has been successful so far. He says acquirers representing 50% of total U.S. transaction volume now work on behalf of Discover, including First Data Corp. and Global Payments Inc. (Digital Transactions News, July 14, 2006). “That's going to be a dramatic difference for our cardholders,” Nelms says. Like AmEx, Discover also is working to find banks to issue credit and debit cards on its network and that of Pulse, the big electronic funds transfer network that it bought in early 2005. That possibility arose out of a federal court ruling, upheld on appeal, in favor of the U.S. Department of Justice in its 1998 lawsuit challenging Visa U.S.A. and MasterCard bans on members striking issuing deals with competing payment networks. Discover says it already has signed some banks to issue cards on its network and in fiscal 2006 reported $29 million in pre-tax income on a managed basis from its third-party relationships. One proven bright spot for Discover is Houston-based Pulse, which now has 4,400 member financial institutions. Pulse processed 1.86 billion transactions in 2006, up 19% from 2005. Meanwhile, Nelms says Discover will continue development of new payment forms such as contactless transactions. The company recently completed a cell-phone test with Motorola Inc. that let users purchase items and manage their Discover accounts using Motorola's M-Wallet technology (Digital Transactions News, Feb 13). The test, conducted in the Riverwoods area and in Salt Lake City, Utah, resulted in “a lot of learnings,” Nelms says, but he adds that more work remains to be done. “There are changes that are needed both at point of sale in terms of putting in wireless readers as well as the phones themselves,” he says. Discover posted pro forma net income of $1.03 billion in fiscal 2006 ended last Nov. 30 on revenues of $5.1 billion. Credit card charge volume totaled $114.8 billion, and managed receivables were $50.4 billion.