Discover Financial Services' deal to buy the Diners Club International network from Citigroup Inc. for $165 million could go a long way toward expanding acceptance of Discover cards — an area where it has lagged its rivals.
To date Discover's efforts to boost acceptance have focused on the United States, where it has been making deals with merchant acquirers for small and midsize retailers. Buying Diners Club would open up a new frontier in nearly 185 countries where Discover does not operate and perhaps boost its appeal for U.S. consumers, who would have more options for using the cards when traveling abroad.
Moreover, the mix of business on the Discover network, whose U.S. business has been built on low-fee transactions, would shift toward travel and entertainment spending, which commands higher acceptance fees from merchants.
The sale would complete Citi's exit from the card network business. In 2004 it transferred processing of Diners Club cards in North America to MasterCard Inc. (That arrangement would not be affected.) Citi's chief executive, Vikram Pandit, is conducting a companywide review of capital allocation to slash expenses and restore profits.
Citi has signed a long-term deal to continue issuing Diners Club-branded cards, and it would remain the largest issuer of such cards. Discover, which like other issuers has posted higher credit losses recently, would not issue any Diners Club cards.
Buying Diners Club would be a "great foundation" for Discover, "both for our cardholders, for additional Discover network issuers, and then through volume coming from our new international partners," David W. Nelms, the Riverwoods, Ill., company's CEO, said in an interview Monday. "It gives us quite a few more degrees of freedom for growth."
On a conference call with investors, Mr. Nelms said the deal "changes us from a regional network to a global network." In the past "job one" had been increasing acceptance of Discover cards in North America. "It's not that global acceptance wasn't important; it just wasn't particularly achievable up until now at a reasonable cost and in a reasonable time frame. This changes all of that."
(Aside from the United States, Discover cards are accepted in Canada, Mexico, the Caribbean, Central America, Japan, and China.)
MasterCard said that "the overwhelming majority" of the processing volume it handles for Diners Club is on cards issued to North American customers, and that the sale would have "almost no financial impact to us as it represents an insignificant percentage of our overall credit card volume." Tim Murphy, the U.S. regional president at MasterCard, said in an interview, "For us, it's principally a story" of retaining the North American processing business "which we're very gratified for."
The Diners Club network handled about $30 billion of spending outside North America last year, and Discover would get 8 million "merchant and cash access locations."
Discover's third-party payment network handled $96.8 billion of transactions in the 12 months that ended Feb. 29, with 94% of that activity in its Pulse debit network. Discover projected that in addition to boosting that volume by about 30%, the acquisition would lift third-party payment revenue by about 60%.
On the call, Mr. Nelms said the revenue gain would be so large because Discover gets lower fees on processing debit transactions than credit transactions, while Diners Club is an "upscale network" that carries a significant amount of travel and entertainment business. "The mix of spending" will tend toward "the higher end" of the interchange fee spectrum and will often involve foreign exchange fees.
But because Discover plans to "reinvest to build network interoperability for Discover and the licensees and provide enhanced marketing support" during the next two years, Mr. Nelms said, it expects the acquisition to make only "a modest positive" earnings contribution initially.
(Third-party processing accounts for a sliver of Discover's overall business, generating $15.5 million of pretax profit during its first fiscal quarter, which ended Feb. 29, or 4.1% of the contribution of its U.S. card business, which managed $47 billion of receivables.)
The integration should take two to three years, according to Discover.
"As we turn on [Discover acceptance in] the rest of the world, that will enable Discover cardholders … to use their cards as their primary cards and make us a more effective choice for consumers and financial institutions," Mr. Nelms said.
Discover shares gained about 5.5% Monday.
Sanjay Sakhrani, an analyst with KBW Inc.'s Keefe, Bruyette & Woods Inc., called the deal "a mild positive" for Discover. "It's still going to take a while for them to get critical acceptance internationally and traction internationally, but … it's a step in the right direction."
In a press release, Ed Eger, Citi's head of international cards, called selling the network a "strategic decision" that is "consistent with Citi's efforts to streamline its businesses" to focus on what it does best. "For Citi, this means growing our card-issuing businesses."
Philip J. Philliou, a partner at the New York payment consulting firm Philliou Selwanes Partners LLC, said that Citi can "monetize this asset that they would've had to otherwise keep investing in." He agreed that Diners Club would be a better fit for Discover. "For Citi to be running that would have required additional focus … not just capital resources, but executive resources."
The deal is scheduled to close in 90 days.
