Discover's Big Push

  Discover Financial Services is betting heavily on a broad expansion plan whose results over the next year could determine Discover's future as a standalone card brand.
  Following Discover's mid-year spin-off from Morgan Stanley, the publicly traded company has embarked on an aggressive campaign to open its once-proprietary network to outside merchant and issuer processors. Discover's hope is that by streamlining those channels it will experience a surge in the issuance and use of its cards.
  "Over the next 18 months to two years, as these new merchant-processor agreements go live, we are going to see a significant boost in activity on the Discover Network," says Roger C. Hochschild, Discover president and chief operating officer.
  Discover executives also have high hopes for the company's continued expansion of its prepaid and debit card businesses, and Hochschild says the company is likely to acquire other payment networks in its bid to expand.
  "We see some growth opportunities with smaller networks that could be attractive opportunities for the Discover brand," he says. Hochschild also hints that a new marketing campaign may be in the works to tout Discover's reach and array of new products.
  But some industry experts say Discover's multifaceted growth plan lacks cohesiveness.
  "I see Discover making a lot of moves with little pieces of its business that each seem to make sense on its own, but I can't envision how they all weave together," says Brian Riley, senior research analyst in the bankcard group at TowerGroup, the Needham, Mass.-based research arm of MasterCard Worldwide. "There may very well be logic in each of these moves, but I've yet to see a single, tied-together strategy here."
  Discover's financial performance and sagging stock price in recent months have put the company under Wall Street analysts' microscopes. Several speculate that Discover might reap more profits by folding its network into another one or by being acquired by a bank (see sidebar on page 35).
  Takeover talk aside, Discover's management team, under a new board of directors, is committed to pursuing its expansion plan on all cylinders, observers say.
  "Discover's spin-off from Morgan Stanley is fairly fresh, and management has indicated they want to see if they can create more shareholder value," says Sanjay Sakhrani, an analyst with Keefe, Bruyette & Woods, a New York-based equity firm.
  For the first time in more than two decades, Discover's management has free rein to cut deals with partners and to expand without the constraints of a parent company.
  "Now that we're out on our own, our opportunity to expand through partnerships with other companies and make acquisitions with our own capital are very exciting," Hochschild says.
  The pressure to improve shareholder value is intense. Discover's stock value has fallen about 25% since the spin-off in June. Discover also reported a 16% decline in net income for the third quarter ended Aug. 31, to $202 million from $241 million from the same period a year earlier. Sales volume on Discover credit cards during the third quarter was $26.8 billion, up 4% from $25.7 billion for the same period a year earlier.
  Discover executives attribute a large share of the profit decline to losses from credit card operations in the United Kingdom, including its Goldfish credit card unit.
  OBSTACLE COURSE
  Discover has a track record in overcoming obstacles. When Sears, Roebuck and Co. launched Discover within its Dean Witter unit in 1986 as the nation's fourth major consumer credit card brand after Visa, MasterCard and American Express, some analysts doubted Discover would succeed.
  But after two years the issuer had its first profitable quarter, powered by its trend-setting "Cashback Bonus" rewards program that competitors promptly copied. Discover's closed-loop network also helped to foster consistency in its relationships with merchants and consumers.
  Cross-marketing opportunities with Dean Witter fell short of expectations, and in 1993 the retailer spun off Discover with its financial-services unit. In 1997, Dean Witter and its Discover unit merged with Morgan Stanley. Analysts say the unit was never an ideal fit with the investment bank, and Discover finally gained independence on June 30.
  One of Discover's biggest distinctions has been its closed-loop network. In October, Discover Card won kudos for its customer service, ranking second among the top 10 credit card issuers studied by J.D. Power and Associates in its inaugural 2007 Credit Card Satisfaction Study. (AmEx, which also operates a closed-loop network, ranked first.)
  By opening its network through merchant-processor and issue-processor agreements, Discover hopes to achieve the best of both worlds by creating a "hybrid" network, Hochschild says.
  "We will still work directly with our largest retailers to provide them with the value-added programs, but we're getting a lot of help on the front end in expanding Discover to a lot of existing and new merchants," he says.
  Discover has 50 million cardholders and says its cards are accepted at about 4 million merchant locations in North and South America and the Caribbean. Comparatively, MasterCard and Visa each claim to have 7 million merchant-acceptance points in the U.S.
  ACCEPTANCE LACKING
  Over the past 18 months or so, Discover has opened its closed-loop network for the first time to outside processors. By the end of September, it had made agreements with nine merchant processors so that merchants can accept Discover, MasterCard and Visa cards under a single pricing format and receive a single transaction statement.
  First Data Corp., Chase Paymentech Solutions, Global Payments Inc. and Wells Fargo Merchant Services LLC are among the large merchant processors that have struck such deals with Discover. Those deals, which will kick in over the next several months, could go a long way to help Discover expand its merchant acceptance, says Bruce Cundiff, senior analyst with Pleasanton, Calif.-based Javelin Strategy & Research.
  Card-industry analysts also perceive the lack of an international acceptance network as limiting Discover's ability to be an all-purpose payment brand.
  Although Discover has made efforts to increase its international acceptance, the impact of alliances the company has formed with credit card networks in China and Japan is unknown so far.
  In 2005 Discover formed a reciprocal acceptance partnership with China Unionpay, China's national bankcard payment network. Under that agreement, 480,000 merchant locations and more than 90,000 ATMs in China now accept Discover cards.
  Last year Discover finalized a deal with JCB Co. Ltd., Japan's largest card network. JCB cardholders can use their cards on the Discover Network in the U.S. Beginning next year, Discover cardholders will be able to use their cards at JCB merchant locations and ATMs in Japan. Neither JCB nor Discover could confirm the number of JCB locations that will accept Discover cards.
  Discover executives decline to break out bottom-line results from Discover's two-way Asian acceptance deals, but Hochschild notes that Discover will have better acceptance than MasterCard, Visa and American Express at the 2008 Summer Olympic Games in Beijing.
  In general, however, analysts are not impressed with Discover's scattered array of international acceptance deals.
  "Piecing together a mosaic of international acceptance through different relationships is better than having no acceptance overseas, but it's a difficult route to go," says Red Gillen, a senior analyst with Celent LLC a Boston-based consultancy.
  ISSUING OPPORTUNITY
  The U.S. Supreme Court's decision in 2004 to let stand lower-court decisions that Visa USA and MasterCard International (now MasterCard Worldwide) illegally blocked their member issuers from issuing Discover and AmEx cards opened the door for broader issuance of Discover cards. But the brand has had little success thus far wooing any large issuers.
  Analysts say one of Discover's growth impediments is its lack of a retail or branch network to help market and distribute its cards. Many banks now rely more on their branches to promote their card products.
  The acquisition three years ago of the Pulse electronic funds transfer network, whose members include 4,400 financial institutions, is a beacon of hope for Discover's transaction growth through EFT and third-party payments. In the third quarter of this year, transactions processed through the Pulse network reached 593,866, a 26% increase over 472,866 from the same period a year earlier.
  Discover also made a key move in October, when it signed an issuer-processor agreement with Total System Services Inc., or TSYS, to process Discover credit and prepaid debit card transactions. The deal will make it easier for banks that use TSYS to process their cards to add Discover to their card lineups, a Discover spokesperson says.
  No such arrangements have yet been announced, but Celent's Gillen says the TSYS deal is a step in the right direction. Banks adding Discover to the product lineups "could give banks a little more leverage in their negotiations with Visa and MasterCard," he says.
  In April, Discover spruced up its card products. It renamed its basic Platinum card Discover More. Discover also launched new products, including a Business Miles card that targets small-business owners and the Motiva card, which rewards customers who make six on-time payments in a row by rebating the following month's interest.
  A new marketing campaign to pull together all the elements of Discover's new reach would be a likely next step, Gillen says. "Discover isn't the preferred card in most consumers' wallets," he says. "It's not accepted everywhere, and it's trying to achieve in a short time what Visa and MasterCard have spent 30 years and billions of dollars doing."
  Hochschild would not elaborate on Discover's marketing plans, but he says the company hopes to reverse the fortunes of its flagging Goldfish brand in the UK next year.
  "We've hired a new chief marketing officer for Goldfish, and we're putting some plans in place to enhance the [Goldfish] brand. We're very excited about that acquisition," Hochschild says.
  If each of its different growth initiatives succeeds, Discover still has a long road ahead as it waits for the various and diverse elements of its expansion plan to yield results, Gillen says.
  "Discover is taking the long, hard route to building out its network to compete with Visa and MasterCard," he says. "It's one brick at a time."
  Management may be committed to Discover's long-term, slow-growth model. But time may become a factor if investors keep up the pressure to show results soon.
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