Capital One buys Discover - now what? (Part 2/3)

Evaluating brand, product, and more implications - illustration by Janik Söllner for BusinessWeek

Welcome back. Last time we focused on the human impact of the deal, with how it could affect shareholders, customers, and employees, along with non-network tech-related implications. As Monday’s news is beginning to sink in and the initial hot takes have been dropped, we’re continuing our analysis of the proposed acquisition with today’s special edition of our newsletter focusing on brand and product implications, along with a few other elements (i.e. location). We’ll close out this series with our final part looking at all things regulatory and merchant/rewards impact.

With that out of the way, let’s dig in.

Brand

As with many acquisitions, one would expect that the acquiring company may want to impose their brand onto the purchase. However, anyone expecting “Capital One it” should take a deep breath - based on his comments on Tuesday’s shareholder call, Cap One CEO Richard Fairbank is bullish on the Discover brand, stating that Cap One intends to “lean hard into further building” it. Later on in the call, he adds a bit of a caveat, noting that the long-term plan is for the Discover issued card to become part of the “brand family of products we have at Capital One.” Given the market focus that Capital One has which is wildly different than Discover’s (“top of the market” vs “mid-market” on Discover’s side), Capital One has two options here - they could do either of the following:

• Leave all 7 of the card offerings as-is in Discover’s portfolio and merge them with Capital One’s 32 card offerings - hey, what’s 7 more when you have 32?!?

• Noting that Capital One already has student, secured, and miles cards, keep the original Discover it since it offers 5% cashback quarterly by category (which Capital One does not) along with the card dedicated to gas and restaurants (which again, Capital One does not have); remove the other 3-4 cards from Discover’s side.

It really comes down to how aggressive Capital One will be about integration, but I don’t think we’ll ever lose the original “it” Card so there’s that.

Turning to the network, Cap One went out of their way to distinguish the network’s brand compared to the issuer’s brand, calling it a “branded treasure” and that they would “absolutely keep” the brand. With everything they’ve talked about on the call, don’t expect the Discover name to go away, in fact expect it to become bigger and bigger. The question which Fairbank responded to here was interesting, because the analyst seemed to almost demonstrate his skepticism with the question framed as “will [you] really continue to run these as 2 separate brands…?” What Fairbank proposes isn’t entirely out of left field though - Disney owns Lucasfilm and Marvel, yet hasn’t slapped the Disney name on either of those properties (although some of the influence/decision-making post-acquisition leaves a bit to be desired from this fan’s point of view). Discover used the same approach when it acquired PULSE (its debit network) in 2004, keeping the name and much of the staff where they were, recognizing the value and opportunity they had with a debit network - indeed, the props for PULSE are continuing as Fairbank quickly announced that Capital One’s entire debit card business would shift to PULSE. In any case, I expect the same approach of keeping the acquired brand strong to continue with the overall network (and hopefully without the bad decision making a la Disney).

For the issuer side, speaking from experience, it sounds a bit more like what I recall from my days at Caremark when it “merged” with CVS. Initially, the deal was literally called a “merger of equals,” with the Caremark CEO Mac Crawford becoming the chairman of the combined company and the CVS CEO Tom Ryan becoming the overall CEO. However, just a few months later Crawford stepped down and Ryan took over the Chairmanship as well. It took a few years after that, but eventually as integration began to ramp up, the job losses started in some of the support functions and then gradually, the Caremark name disappeared from the overall company branding and was reduced to a sub-product aka the PBM (pharmacy benefit manager), as the company renamed itself to CVS Health (from their perspective, probably necessary as they continued to and are still buying up healthcare companies left and right and becoming bigger and bigger to this day). Most of the company leadership was fully settled in Rhode Island within a few years and the Chicago, Phoenix and Nashville hubs were essentially turned into unspectacular support centers with the PBM centers staying as-is. I could see this happening with the issuing business, with the Network eventually being the only remnant of Discover and any memory of it ever being an issuer gone after 3-5 years.

Product

Here, I think it’s important to spend time product by product on the Discover side and talk about what the future could look like for each of these.

Issuing

This is the toughest part of the deal to talk about, and believe me I know because I lived this business for over eight years. If you played the “network drinking game” during the Tuesday call, or if like me you don’t drink and just kept count, the word “issuer” was only mentioned ten times while the word “network” was mentioned 110 times. But for all the talk about the network as the selling point of this deal, most of Discover’s operations, support, and money came from the issuing business - from a revenue perspective, we’re talking anywhere from 85-90% of the money was in card issuing. The payments business only made about 10% of that at most. So this is not a small amount to just say goodbye to. However, at the same time, net income (mostly driven by the issuing business) tanked 62% YOY in the last reported financials for Q4 2023. That is a massive plunge and the biggest YOY quarterly hit the company has taken since the pandemic (Q2 2020). The compliance issues that swelled to massive levels in the second half of last year were clearly having an impact on the balance sheet, with the expense required to invest in improving capabilities and trying to get out of a very public FDIC consent order that cost former CEO Hochschild his job. Doing a quick comparison, Discover’s card issuing business nets about 1 billion of income per quarter in a normal year (i.e. when there’s no pandemic and no consent order hanging around) while Capital One’s issuing business has income of about a half a billion more when you look at the quarter I used for for comparison (Q3 2022), which isn’t too much larger interestingly enough.

Nevertheless, there will inevitably be redundancies that will have to be sorted out. We talked a little bit about personnel and systems last time, however the operations themselves will likely take years to integrate as Discover’s been around for almost 40 years and can’t just be shut down overnight and has a lot of advantages to offer Cap One (perhaps Cap One may decide certain aspects of their issuing business should be replaced with Discover ops instead). Areas to consider that should be worth some deep thought in terms of how to integrate/come to the same page:

• Fraud Modeling and Strategies

• Credit Reporting

• Collections Vendors and Strategies

• Credit Risk Profile - things like interest rates, late fees, underwriting, etc

• Free (and paid) credit building type products - both companies have things like free FICO scores, budgeting tools, and more

• The NHL sponsorship and whether it fits the marketing/branding direction Capital One had, and whether Cap One may change its approach to match Discover’s

Just to name a few. For all the talk about similarities, the two companies will find a lot of differences in how they ran things and even the “acquirers” aka Capital One won’t just be able to pull in Discover’s loans and continue to do the same thing as they were doing before - with the size of the combined issuing business significantly growing and in fact becoming the largest issuer in the country, they’ll have to reconsider their approach for the combined organization and see what makes most sense at scale.

Network

So much to talk about here, but there’s a lot that’s already been said by the talking heads on this topic so I won’t add too much more. The things to note are that Discover has three networks at the moment comprising the payments business - Discover Network, PULSE, and Diners’ Club International. We heard a lot of talk about the Discover brand when it came to the network, and taking it further internationally (which Discover to date has tried to do with its net-to-net deals, i.e. allying with local networks like JCB, RuPay, UnionPay, etc) and we also heard the big news about PULSE, that Capital One would move its debit business entirely to PULSE.

However, Diners was only mentioned once which makes me wonder whether there’s a future here - while the brand has a lot of history, it was bought from Citi and never really took off, as Discover rather than run it on its own used a franchise approach and had third parties essentially with their own issuers that were allowed to use Discover’s rails, branded as Diners’. I wonder if Capital One will be willing to continue that approach especially given some of the AML and oversight risks with letting your network be used by franchise owners that might find ways to limit scrutiny, or if they’ll go a different route in just trying to cut deals with bigger banks globally given the deeper pockets of the combined org and begin to compete with Visa/Mastercard directly in certain markets.

And then the takeaway from that is what happens to the Visa/MasterCard relationship for Cap One? While it is a no-brainer to not damage the relationship with the two largest networks in the world, there have already been small hints dropped about competing, as there would be in a theoretical scenario of trying to take the Discover brand more globally on its own (rather than having to rely on using net-to-net deals or DCI branding/franchising). The biggest hint was in the call where Fairbank said “we will move some of our credit card volume over to the network to enhance its scale and we will lean hard into further building the brand and the perceived acceptance of the credit card network here in the United States.” I’d argue he should tread carefully on this one, not because of Visa/Mastercard themselves, but because while Discover customers are fiercely loyal and will be keen to make sure their experience doesn’t get messed up, many folks who have only one Visa or Mastercard that happens to be issued by Capital One might be furious if they wake up one day and find out that their card is now a Capital One issued Discover card. Like it or not, despite the almost universal acceptance that Fairbank touts, there are still certain places where Discover is not accepted and a Visa/MC is needed for overseas usage because the vision of taking Discover more global simply hasn’t happened yet and will take time to scale.

This could actually be a great place for Capital One to look into the dual-network approach that was propositioned, of all places, by the Credit Card Competition Act aka Durbin II. I did a podcast with friend of the newsletter Alan Kaplinsky of Ballard Spahr back in October of this past year where I theorized what a dual-network world under the CCCA could look like, and from my perspective this would be the best way to go if Cap One plans on moving existing customers over to the network so that it doesn’t create an unintended wave of customer dissatisfaction. At the same time, the easiest approach might be to limit the move of volume to the Discover network to newly issued Cap One cards and leave existing cards as-is. We’ll see how it plays out.

Regarding PULSE, while the news is great for its scale, a historical note must be mentioned that PULSE has been fighting a war in the courts against Visa and Mastercard on the debit side of things for over a decade, and has been a popular choice for many community banks to issue debit cards with primarily because they offer better pricing on interchange than Visa and Mastercard (a key sticking point of the court cases is that Visa specifically strongarmed merchants into entering what are essentially exclusivity agreements to try and keep PULSE from having any chance at real penetration). With the backing of Capital One along with the revival a few years ago of a dormant court case PULSE had filed against Visa, Visa may have its hands full and may not be able to prevent PULSE from gaining a stronghold this time around. As debit usage is skyrocketing across the country, with it being used more than any form of payment in the US as of 2023 per JD Power, Capital One’s move to shift all of its debit business to the underdog seems like they’re definitely sensing the winds blowing in a certain direction. Interestingly, Capital One doesn’t have any debit relationship with Visa (they partner exclusively with MasterCard for debit), so there may not be much holding them back from keeping this fight going.

Deposits

With the talk about PULSE, you also have to talk about Discover’s deposits business. While there was not too much chatter about this on the call, unlike the sort of lukewarm mentions of the issuing business Fairbank noted the amount of deposits on hand that Discover had by mentioning the $84 billion figure and was pretty complimentary of the product. With the decision to move debit to the PULSE, the ATM access is expected to rise and what’s more, Discover’s deposit customers will finally have access to in-person banking services as a no-branch philosophy was a strategic move by Discover well before the rise of digital banking - although bank branches are shutting down left and right across the industry, Capital One and others have recognized the branding opportunity that even a few branches can offer, as they love to point out with the existence of their Capital One cafes.

Nerdwallet also points out in their discussion with Prof Michael Imerman of UC Irvine that the combined company resources could be in a better position to counter and possibly even partner with fintechs in the deposits space. For example, neither company has made much progress on their own in the business banking front (Capital One at least has a Commercial Banking division while Discover retired their Small Business Card a few years ago), but as a combined entity perhaps this could be one direction for them to explore.

Student Loans

This product was already under exploration for sale before the acquisition, so now I expect efforts to unload this business to accelerate to help ensure no hiccups in the approval process especially with regulators. Discover never really had the best of luck with this product, as it was a regulatory “gift” originally passed along to them from Citi which turned out to be full of problems that led to multiple consent orders, and attempts to create their own “organic” portfolio never really took off - also for regulatory reasons, but also because of the pandemic and resulting federal loan student forgiveness.

In the event no buyers emerge, which could be completely possible given the consent issues hanging over this portfolio and no one else wanting to inherit them, this could be something that Discover and then Capital One may need to dump a whole bunch of money into to fix leading up to and after the approval, and then try selling again once they’ve resolved/remediated the regulatory concerns (Discover is already doing this even as they transferred servicing to Nelnet just a few weeks ago - we did a piece about student loan horror stories here which included them). Although this isn’t being really mentioned, from my perspective I’d watch this space since it could become an unexpected albatross for the combined organization if they can’t resolve the issues in time and find a buyer to take it off their hands.

Personal Loans and Home (Equity) Loans

Very little has been said about these two products in the days after the deal. Capital One already offers these two products, although Discover’s personal loan business is growing at a faster rate than its Cap One counterpart in terms of volume. The personal loan business wasn’t mentioned on the call, and up until the point of the sale announcement there wasn’t any indication that Discover intended to sell it so we’ll see what happens here. Given the home equity business is so small in both companies, I suspect we won’t see much there beyond selling off the loans and not dealing with an integration. But regarding the personal loan situation, stay tuned.

Location

To close out this part of our deep dive, I’d be remiss if I didn’t talk about the regional dynamics in play. Discover is notable in that it’s headquartered in Chicago, a rarity in today’s business world where sadly many companies are packing up and leaving the Windy City (Caterpillar, Citadel, Boeing and Tyson Foods all left this past year). Not only did Discover choose to stay, but they doubled down with the opening of the Chatham Contact Center which was a huge story because of a company the size of Discover committing to the South Side of the city in such a huge way and providing high quality jobs to local residents.

With the lukewarm comments in the call on Tuesday, while Discover will likely never fully abandon Chicago, the headquarters in Riverwoods and the call centers across the country present quite a dilemma especially if the intent is to keep HQ in McLean, VA as was mentioned and the company begins to look at right sizing or re-organizing the combined workforce in a few years. Certainly, once the deal goes through, tough questions may be asked whether in an age where most companies are shifting to hybrid or remote models, does it make sense to have such a huge campus in a metro where talent and businesses are departing? Discover has been in the same location and has owned the same building in Riverwoods, IL for decades (and it is indeed an iconic and beautiful campus in the woods of North Chicago suburbs); could we see a scenario where that building is sold off and the workforce is shifted to the downtown area, becoming renters in high-rises the owners of whom I’m sure would love to pack with workers in what currently are empty buildings? And what happens to the call centers in the various operating centers if they slim down and jobs are shifted to the Phillipines?

Additionally, with the focus on the networks, does the combined company invest more into the physical presence of PULSE, much of the talent of which has always been and continues to be based in Houston? Perhaps an expansion of the location there to account for potentially more staff could be on the horizon, especially with so much talent migration already happening to various Texas locations in Austin and Dallas.

I don’t mean to be flippant in any way about these possibilities - as I mentioned last time, there is a huge human element involved here especially for the employees. And for those who have worked in these locations for years, it is probably painful to read these possibilities - for some it may in fact feel like their world is ending as Discover has had a lot of loyal, long-time employees (some folks have worked there over 20 years). The hope is that by laying out these possibilities, for those currently working there who read this, they can be prepared for what might happen and begin thinking about their next steps well in advance.

Next Time

When we come back, we’ll close out this series with a deep dive into the heart and soul of this newsletter - all things regulation related to this deal! We will go over the regulatory approval and how likely we think it is that regulators may object, what will happen with the existing regulatory compliance issues that got Discover in so much hot water last year, how the CCCA and the Durbin Amendment come into play, and what this deal means for Merchants and Rewards. Thanks and if you enjoyed reading this, please subscribe and pass it along to a friend!