Capital One’s Strategic Acquisition of Discover: A Potentially Game-Changer in the Credit Card Arena

Introduction and Deal Rationale

In February 2024, Capital One announced plans to acquire Discover Financial

Services for $35.3 billion, a move set to merge two of America’s largest credit card

companies. Discover also offers a payment network, making it a competitor with the likes of

Visa and Mastercard. This acquisition is occurring amidst a trend where consumers

increasingly favor credit cards over cash for their transactions. From 2017 to 2022, cash

payments in retail stores dropped by 25%, with credit or debit cards now accounting for

70% of all retail purchases, whether made in-person or online.

Pending regulatory approval, Capital One stands poised to claim the title of the sixth-largest

bank in the United States, alongside ownership of the fourth-largest credit-card payment

network. Regulatory bodies have expressed both apprehension and desire regarding Capital

One's prospective position as the largest card issuer in the country. While concerns persist

about potential monopolistic tendencies, there is a clear call for increased competition in the

payment processing arena to counteract the perceived duopoly of Visa and Mastercard.

Indeed, this acquisition holds the potential to disrupt the longstanding dominance of these

industry behemoths.

Data sourced from the U.S. Consumer Financial Protection Bureau indicates that, as of the

close of 2021, Visa controlled 48% of the credit cards in circulation, with Mastercard holding

approximately 36% of the market share. Discover and American Express jointly accounted

for the remaining 16% of credit cards. Capital One's successful transition of existing Visa and

Mastercard clientele to Discover, coupled with its ability to attract new customers to become

Discover cardholders, could catapult it to the position of the largest credit card lender in the

United States, surpassing current titleholder JPMorgan Chase.

If the acquisition progresses as planned, a notable consequence would be heightened

competition among card networks. Presently, while Capital One issues credit cards through

the Visa and Mastercard networks, it plans to migrate a segment of its card issuance to

Discover, all while maintaining positive relations with the industry giants. Should the

acquisition materialize, Capital One may transition approximately a quarter of its 100 million

cardholders to its new Discover network, potentially prompting Visa and Mastercard to offer

increased interchange fees to banks issuing cards, thus safeguarding their competitive

standing against Discover.

While larger interchange fees may benefit banks, they pose challenges for merchants,

particularly small businesses. This is because heightened competition among networks

tends to disadvantage merchants, as the primary focus lies in incentivizing issuers to adopt

the cards, rather than ensuring merchants benefit from lower acceptance fees.

Indicative Valuation – Implied multiples are in line with consensus

On 19 February 2024, Capital One Financial Corporation (NYSE:COF) entered into a

definitive agreement to acquire Discover Financial Services (NYSE:DFS) for USD 35.3 billion.

Under the terms of the agreement, Discover shareholders will receive 1.0192 Capital One

shares for each Discover share. At close, Capital One shareholders will own ~ 60% and

Discover shareholders will own ~40% of the combined company. Until the transaction

closes, Discover and Capital One remain separate, independent companies. A termination fee

of USD 1,380,000,000 will be payable by either Capital One or Discover, as applicable, in the

event of a termination of the Merger Agreement under certain circumstances involving

alternative acquisition proposals or changes in the recommendation of the other party’s

board of directors.

Considering the synergies, the enterprise value of the transaction translates to multiples of

12.4x P/E and 2.6x P/BV. We conducted Comparable Companies Analysis to determine a

range of possible valuations for the target, given its current Equity Value of USD 31.5 billion.

It is important to note that the implied valuation from trading comps is not meant to be a precise measure, but rather to set parameters for the target company based on the current market pricing of comparable companies, which might be skewed by irrational market sentiment. We identified four companies similar to Discover in terms of industry, geography (all operating in the US), market capitalisation (between USD 10 billion to USD 100 billion) and financials (LTM Revenue USD 10 billion to USD 30 billion). Our analysis shows that prior to acquisition, Discover appears overvalued compared to the industry's median P/BV and P/TBV multiples. However, the P/BV multiple of Discover is very closely aligned to the 85th percentile median P/BV value, suggesting that the target is considered to be of higher quality by investors who are willing to pay a premium for the book value of the company’s assets and therefore bade up the price. However, Discover seems slightly undervalued relative to the industry's median P/E multiples, which possibly suggests that investors have low expectations for future earnings growth of the company. From our results, we could see that the transaction implied P/E multiples aligned closely with the median P/E of the comparable companies, whereas the transaction implied P/BV multiple aligned closer to the 85th percentile P/BV multiple. This suggests that Capital One has paid a premium for Discover’s assets. This overvaluation is expected and in line with consensus given that Discover’s ROE ~20% in FY2023 is low compared to Financial Services Industry ROE ~22.36%.In Summary, the USD 35.3 billion implied valuation aligns more closely with the median P/E of the comparable companies. This deal is expected to be completed in late 2024 or early 2025, and it is expected to be more than 15% accretive to adjusted non-GAAP EPS in 2027.

Assessing the Implications: The Duel for Dominance in the Payment Processing Landscape

Despite claims by Capital One founder and CEO Richard Fairbank that a Capital One— Discover merger would yield more favorable terms for shareholders, consumers, and merchants, the opposite may be true. What separates Discover from other financial institutions, such as Citi Bank or JPM, is that besides а bank, it is also a network similar to American Express. Supporters of the merger argue that a combined Capital One—Discover will disrupt the payment processing duopoly of Visa and Mastercard, which lawmakers have long criticized. If Capital One successfully acquires Discover, it will own one of the most extensive card processing networks alongside Mastercard, Visa, and Amex. There has been a significant hike in payment processing rates in recent years, and a merger between Discover and Capital One will most likely continue that trend. However, with over 70 million locations, 99% of merchants that accept Visa and Mastercard also accept Discover, so there is a lack of an incentive for Capital One to reduce their processing fees to attract that 1% of vendors. Additionally, the deal will create the most prominent US credit card issuer by balances, and the significant market share will position them favorably to push the processing rates up. New research by the Consumer Financial Protection Bureau concluded that major credit card issuers charge higher fees than competitors with less market power and credit unions. The everyday consumer, regardless of their preferred payment method, will feel an immediate increase in the prices of goods, as merchants will have to adjust to the climb in processing fees. Although Discover holds a notably smaller position in the European credit card market, regulators on the continent cap processing fees lower than their US counterparts. Conversely, a merger between Capital One and Discover could create a more competitive card processing market. Both issuers would be compelled to offer more benefits and superior rewards to attract and retain users. Discover holds an edge over its competitors as the only card provider that gives cash-back on their debit cards, which would greatly benefit Capital One customers. Another advantage of the merger is the expanded access to services for cardholders of both financial institutions. While Capital One and Discover currently rely on Allpoint and MoneyPass fee-free ATMs, the merger would enable customers to transact at a combined network of over 140,000 ATMs across the United States. Moreover, with Discover currently lacking physical branches, the merger would allow its banking customers to manage their accounts through the approximately 750 branches of Capital One. With the increasing popularity of e-commerce, the security of online transactions has become a prominent concern. Merchants have a more challenging time verifying whether the personentering credit card details is the cardholder. To this end, vendors will be able to utilize the sophisticated antifraud technology of Capital One, which will be integrated into the Discover payment-processing network. Furthermore, gaining access to data from Discover transactions will allow Capital One to improve its software. A merger between Capital One and Discover could inject competition into the payment networks, offering a viable alternative to Visa and Mastercard's dominance. This could potentially raise shareholder value and expand access to Discover's network. Despite concerns and pushback from some consumers, regulators have pledged to act in the best interest of all parties. They have reassured the public that they will not allow executives and shareholders to enrich themselves at the expense of businesses and their customers, providing a level of oversight and protection in the merger process.

References

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