Cover Story: Discover Sees Growth As It Flies Solo

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Spreading  its wings for the first time as an independent company, Discover Financial Services in 2007 moved decisively to broaden card acceptance and enrich its product lineup. Morgan Stanley spun off its Discover unit in July.

Steep losses from Discover's troubled United Kingdom-based Goldfish credit card unit hurt earnings throughout the year, dampening Discover's stock price and fueling speculation that Discover might be ripe for takeover. Discover's stock opened near $30 per share and declined steadily, ending the year at about $15 per share. Shares were selling for about $17 in early April.

Sanjay Sakhrani, an analyst with the equity research firm Keefe, Bruyette and Woods, says Discover has potential. "Discover's share prices have underperformed the broader market, largely due to the fact that investors [have been anticipating] challenging market conditions for the company," he says, adding that Discover's growth plans make sense for the company.

Indeed, Discover executives insist the company's future is healthy, thanks to initiatives designed to increase card acceptance and drive more card usage.

U.S. receivables on a managed basis totaled $48.2 billion in fiscal 2007, up 5.2% from $45.8 billion the previous year See chart. Discover's fiscal year ends Nov. 30. Worldwide loan receivables, including the U.S., reached $52.6 billion, up 4.4% from $50.4 billion in 2006. Discover also increased its provision for loan losses worldwide, on a managed basis, to $2.2 billion in 2007, up 15.8% from $1.9 billion the previous year, in anticipation of rising charge-offs stemming from a softening U.S. economy and the effects of the real-estate crash.

Discover's third-party payments business, including the Pulse electronic funds transfer network and transaction volume from Discover cards issued by other banks, is growing. Network volume for all third-party payments increased 25.3%, to $91.7 billion compared with $73.2 billion during the previous year. Pretax income from third-party payments, on a managed basis, grew 27.6%, to $37 million from $29 million in fiscal 2006.

U.S. card-sales volume rose 4.5%, to $90.3 billion compared with $86.4 billion. Revenue net of interest expense for fiscal 2007 was up slightly, to $5.75 billion compared with $5.7 billion in fiscal 2006. Pretax income was down 8.5%, to $1.5 billion compared with $1.6 billion.

For the international card segment, card-sales volume rose 26.2%, to $13 billion from $10.3 billion. Revenue net of interest expense fell 0.5% in fiscal 2007, to $403.2 million from $405.1 million a year earlier. The international card segment posted a pretax loss of $596.2 million. That compares with a net loss of $87 million during the same period a year earlier.

Discover attributed the fiscal 2007 loss to steeper losses from its Goldfish unit caused by widespread bankruptcy filings in the UK consumer credit card market. The company sold Goldfish earlier this year to Barclays Bank Plc.

In its bid to expand card acceptance by opening its network to third-party processors, Discover throughout 2007 forged new relationships with merchant processors. By year-end, nine processors had agreed to process their merchants' Discover transactions, including Chase Paymentech Solutions, Global Payments Inc. and Wells Fargo Merchant Services. Discover also is buying Diners Club International from Citigroup (see News story on page 8).

Discover CEO David Nelms told analysts early this year that as processors integrate Discover into their systems, he expects Discover to have acceptance parity with Visa and MasterCard sometime in 2009. And adding Diners Club will strengthen international acceptance.  CP