Discover Financial Services is hoping its $2.75 billion settlement with Visa Inc. and MasterCard Inc. will help it snag more business from major credit card issuers.
"The settlement will clear the air with some of the larger financial institutions," Roger C. Hochschild, the president and chief operating officer of Discover, said in an interview Tuesday. "There was somewhat of an overhang" from the litigation that left "a lot of issuers not wanting to do business with us."
How much of the settlement will go to Discover is unclear. Morgan Stanley is due a portion of it under the terms of its 2007 spinoff of the card company, but Discover said Monday that its former parent violated some of the terms of the spinoff agreement and that the size of the payout remains in dispute.
Whatever cash Discover does receive will cushion its balance sheet and could be used to finance acquisitions at a time when some of its competitors are squeezed for funds and reining in spending.
"The vast majority of the settlement money will go to our earnings and our capital base, but it does open up opportunities to grow the business," he said.
He would not discuss specific buyout plans. In July, Discover bought the Diners Club International network, and in 2005 it bought the Pulse Network LLC debit network.
While many financial companies are hoarding capital, Discover is willing to look for acquisitions, Mr. Hochschild said. "Sometimes the best opportunities occur at tough times in the cycle when people need to get rid of bad assets," he said. "Given the strength of our capital position, we continue to look for opportunities every day."
Such opportunities could be scarce, observers said. Because Discover is "relatively small," its "universe of acquisitions is relatively limited as well," said James Ellman, the president of the hedge fund Seacliff Capital LLC. The payments networks like Visa and MasterCard have "really locked up" the debit business, and "stand-alone credit card companies" will come with credit-quality risks, he said.
Bryan Derman, a partner at Glenbrook Partners LLC, a consulting firm in Menlo Park, Calif., said a debit processing platform or another PIN debit network could be acquisition targets for Discover, but getting more financial companies to issue Discover cards "might be the best opportunity" for growth.
"If we buy into the notion that they'll have the acceptance side in the U.S. at parity" with Visa and MasterCard by the end of next year, as Discover has predicted, Mr. Derman said, "the challenge now is how I get some issuers on board … to really exploit the value of a network. They really need some third-party issuers."
Mr. Ellman said he was skeptical that the settlement would make Discover's network more appealing to other issuers. "I think in normal business times, that's a very reasonable argument, but it holds very little weight in the current environment," he said. "There's already a significant retrenchment among issuers," which creates a "more difficult time for them to get particularly incented in offering Discover cards."
Michael Taiano, an analyst with Sandler O'Neill & Partners LP, said Discover's plans to hold on to most of the capital from whatever portion of the settlement it receives "is totally logical, given the number of headwinds" facing the industry. "In light of current market conditions, there's no such thing as too much capital," he said. "In a time when banks are getting capital from the federal government and it's not clear whether Discover has an ability to get any of that, this gives Discover the opportunity to bolster their capital."
(Mr. Hochschild said Discover is "looking at the different components" of the government assistance proposals and that it has "not made any decisions; we are looking very carefully at those to see if any represent good opportunities for Discover.")
Like American Express Co., which settled with MasterCard in June and with Visa last year for up to $4.05 billion, Discover had filed an antitrust lawsuit against the networks for their policies that restrained bank members of the two card networks from issuing products with competing brands. Visa said Monday night that it would pay Discover up to $1.8875 billion; MasterCard said it would pay up to $862.5 million.
The total amount of money Discover will receive from the settlement, however, is still up in the air.
Lauren Smith, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc., wrote in a research note Monday that the original spinoff agreement called for Discover to give Morgan Stanley the first $700 million of any settlement, plus half of any additional payments exceeding $1.5 billion, to a maximum payout of $1.5 billion.
But Discover said Monday night when it announced the amount of the settlement that "Morgan Stanley is in breach of the agreement and the amount of Morgan Stanley's special dividend is a matter of dispute."
Discover would not discuss the nature of the dispute further.
A Morgan Stanley spokeswoman told American Banker by e-mail Tuesday that Morgan Stanley is "due to receive approximately $1.2 billion, pre-tax, pursuant to the terms of a special dividend agreement negotiated at the time of Discover's spinoff." She said "there is absolutely no basis for Discover's claim that the agreement was breached."
Morgan Stanley filed a lawsuit in New York State Supreme Court last week to resolve the dispute.
Roy A. Guthrie, Discover's chief financial officer, said in a conference call with investors Tuesday that Discover would "direct some of the proceeds to further build out our deposit-gathering capabilities" in an effort to make the company less reliant on the asset-backed securitization market.
"The current high cost and difficult conditions in the asset-backed securitization market … make it likely that the entire $2.6 billion of fourth-quarter maturities will be funded by our deposit programs rather than through new asset-backed transactions," he said.
Responding to questions from analysts, Mr. Guthrie said he was particularly eager to increase Discover's direct-to-consumer deposit access, but he would not discuss details. "We have a high interest in continuing to develop out that infrastructure and its market reach," he said. As for acquisitions, he said "we monitor the market obviously very closely, and I think to the extent that direct-to-consumer-type opportunities emerge, those would clearly be in our wheelhouse."
The Visa and MasterCard bans on third-party issuance were removed in 2004 when a Supreme Court action allowed the two companies' members to issue cards on the Amex and Discover networks. Since then Amex has attracted larger issuers, including MBNA Corp., which Bank of America Corp. bought in 2006, and Citigroup Inc. Discover issuers include General Electric Co.'s consumer finance unit and HSBC Holdings PLC's U.S. division.
On Tuesday representatives of B of A, Citi, and JPMorgan Chase & Co. declined to discuss whether they would consider issuing Discover cards.