Eight years after AmEx proposed partnerships with banks, Discover is now courting banks to issue its cards. Is this a belated move by a cautious competitor or a timely growth strategy?
David Nelms is pushing Visa and MasterCard issuers to discover Discover.
Not that Discover is hard to find. The Riverwoods, Ill.-based card business of Morgan Stanley has nearly $50 billion in receivables and more than 46 million account holders, a merchant base nearing parity with the Visa/MasterCard base, and the lowest merchant discount rates among the major card networks.
Nelms, the chairman and chief executive of Discover Financial Services Inc., issuer of the Discover card, wants Visa and MasterCard issuers to begin thinking about making deals in which they would issue Discover-branded cards now that the card industry appears to be on the verge of a watershed event: the end of Visa and MasterCard rules banning association members from striking issuing partnerships with network competitors such as American Express Co. and Discover.
Visa and MasterCard are waiting for a final decision on the matter from the U.S. Supreme Court, and they haven't paid a lot of attention to Discover. Instead, the card associations, especially Visa, have focused their venom on American Express, which first proposed the idea in 1996.
Despite that, MBNA Corp., the No. 2 card issuer, has signed an agreement with AmEx to issue AmEx-branded cards in the U.S. AmEx has issuing partnerships with about 80 foreign banks. Other U.S. bank card issuers reportedly are contemplating doing the same thing. Nelms believes that MBNA's decision will make it easier to persuade other issuers to make agreements outside the Visa/MasterCard system.
While Discover says it has had some discussions with banks, it hasn't gotten nearly the attention that American Express has when it comes to shaking up the card industry's status quo. A partial explanation might be that Discover's market share of U.S. general-purpose credit card charge volume has been stuck in the 6% range for years, about 10 percentage points below AmEx's. AmEx delivers affluent, high-spending cardholders while Discover is a card for Everyman.
But another explanation may lie in Discover's whole approach to the issue. American Express first floated the idea of banks issuing AmEx-branded cards in a high-profile keynote address in 1996 by then-CEO Harvey Golub at an Atlanta conference sponsored by Credit Card Management. Under Golub's plan, partner issuers would get access to attractive account holders they found hard to reach, and AmEx would get profitable transactions on its merchant network, legendary for its ability to generate cash flow.
The stickler was that Visa USA and MasterCard banned such partnerships in the United States. AmEx kept the issue in business-press headlines for years, and it became a key part of the U.S. Department of Justice's antitrust action against Visa and MasterCard in 1998.
Above the Fray
All the while, Discover stayed out of the fray. That position was in keeping with its long-standing strategy as an alternative to the bank cards that did things its own way.
"We didn't say anything (about the issue) at the time and for a long time thereafter," Nelms says.
Since then a lot of things have changed for the industry and Discover.
In October 2001, U.S. District Court Judge Barbara S. Jones ruled illegal Visa and MasterCard's exclusionary rules. And in January, the full Second U.S. Circuit Court of Appeals in New York upheld her ruling.
The Second Circuit, however, stayed Jones' decision pending appeals by the card associations to the Supreme Court. MasterCard and Visa filed their appeals in early May. The Supreme Court was expected to decide in late spring or early summer if it would take the case. Most legal handicappers were betting that the bans would fall quickly because of the associations' dominant position in the card market. MBNA is prepared to go forward with its AmEx-branded card products as soon as the legal hurdles are cleared.
"The DOJ's antitrust action is prompting Nelms to do this," says John Grund, a partner at Linthicum, Md.-based First Annapolis Consulting Inc. "He believes Visa's and MasterCard's legal fight is all over."
Against that background, Nelms delivered a keynote address at Thomson Media's 16th Annual Card Forum & Expo in May in Orlando, Fla. In fact, he rolled out the red carpet for bank card issuers.
'Open for Your Business'
"The associations would have you to believe that there is only one other network that wants your business, which is American Express," he said. "However, this morning I want to let you know that Discover is also open for your business and to let you know why issuing on our network makes sense for many issuers."
He explained what the issuers already know: that the card industry has slid into a period of single-digit growth after decades of double-digit increases. Nelms then laid out three scenarios as to how they can grow their card programs as the U.S. card market continues to mature.
Issuers can grow organically, which has become very expensive. They also can buy card portfolios. This also requires deep pockets-up to $400 per account, he said. But that's often impractical because the number of available portfolios with any scale is rapidly dwindling.
"(With) 85% of the U.S. industry now controlled by the top 10 issuers, there's not much left to buy anyway," he told the audience of 800, adding that smaller regional issuers also are feeling left out and are at a loss about how to compete with the whales that dominate the card business.
A third choice is to partner with Discover. "We believe issuing on the Discover/Novus network can play an important role for both the mega-issuers and smaller issuers to differentiate and grow their business profitably," Nelms said. He later said that the Discover card's physical appearance makes it look different in the eyes of the public, many of whom believe MasterCard and Visa are one and the same.
Nelms also addressed the issue of merchant acceptance of Discover. "We're accepted at 4.9 million merchant locations, fewer than Visa's and MasterCard's 5.2 million, but more than AmEx's 3.5 million," he said.
And he used his keynote address to announce that processors First Data Corp., Total System Services Inc. (TSYS) and Metavante Corp. have taken steps with Discover to ensure that their financial-institution clients can issue cards on the Discover/Novus network.
Nelms also addressed the concerns of merchants by attacking Visa's and MasterCard's continual increases in interchange, the amount of a bank card sale that the merchant acquirer must forward to the card issuer. Merchants pay the cost through their discount rates.
"Since 1996, Visa's and MasterCard's price increases, along with significant volume growth, have resulted in a 119% cost increase for U.S. merchants who now annually pay an estimated $20 billion for accepting their credit cards alone," Nelms said.
Nelms mentioned the 2003 settlements by Visa and MasterCard of the class-action merchant lawsuit over signature-based debit cards led by Wal-Mart Stores Inc. The settlements led to temporary reductions in debit interchange of about 30%, but they didn't prevent the associations from raising debit interchange for smaller merchants this year. Some credit card rates, including the ones merchants pay for card-present, point-of-sale retail transactions, also went up.
"During recent visits with our merchant partners, I have heard directly from their perspective U.S. bank card interchange has simply gotten too high," Nelms said.
Furthermore, merchants could be antagonized when bank card issuers start offering AmEx cards that will be assessed the industry's highest discount rates, Nelms said.
At this point, he made his pitch. "As the lowest-price network, with an attractive cost structure, we expect to continue to sign hundreds of thousands of merchant outlets every year and to add more and more places that exclusively accept credit cards on Discover's network to the current list that already includes Sam's Club, KinderCare and many others," Nelms said.
Sam's Club, which is owned by Wal-Mart, doesn't exclusively accept Discover, but it comes pretty close. The retailer, which is the nation's second-largest warehouse chain, operates 538 stores. Only 44 accept Visa and MasterCard credit cards.
"We were attracted by Discover's merchant discount rate," says a Sam's Club spokesperson. "We don't want to see a sizable mark-up at the point of sale."
Discover is making a strong appeal to merchants because they may feel emboldened by the class-action settlements. "They (Discover executives) see an opportunity based on activity in the legal environment. It's a strategy," says Paul Grill, a principal at First Annapolis.
Grill warns, however, that Discover will have to perform a delicate balancing act to make its network appealing to both issuers and merchants.
Nelms has thought about this. "One of the first questions potential partners have for us is given your merchant discount rate disadvantage versus Visa and MasterCard, can your economics to us be competitive?" he said. "Of course, our merchant partners view our lower discount rate as an advantage, not a disadvantage. But for issuers, Discover has an attractive cost structure and, given mostly fixed network costs, aggressively priced incremental volume can still be profitable for us." He did not elaborate.
Kenneth Posner, an equity analyst for Discover's parent company, Morgan Stanley, declined to take questions about Discover, but in April he wrote a report entitled "Attacking the Death Star." In it, Morgan Stanley said Discover's merchant discount rate averaged 1.5% of the sale compared with 2% for Visa/MasterCard acquirers and American Express' 2.5%.
Last year, 628,000 new merchant outlets started accepting Discover, up slightly from 602,000 in 2002 but down from 726,000 in 2001, according to Morgan Stanley's annual report. Prior to 2001, there was a steady growth in the numbers of new outlets that accepted Discover beginning with 394,000 in 1998.
While more merchant acceptance has been one of Discover's success stories, some of the company's other key measures are off of late. In fiscal 2003, Morgan Stanley's Discover-issuing Credit Services arm reported net income of $688 million, down 10% from $760 million in 2002. Last year's revenues were $5.5 billion, down 7% from $5.9 billion in 2002. Managed receivables declined 6% to $48.4 billion while accounts declined 1% to 46.1 million. Morgan Stanley blamed the situation on bad debt and subsequent efforts to clean it up.
In an interview with CCM after his speech, Nelms and an aide brushed off an apparently anticipated question about whether Morgan Stanley might be positioning Discover for a sale.
"They (outside commentators) say that all of the time," they said in unison, never directly answering the question.
He did, however, project optimism about Discover's future and noted how it has grown since he took the helm of Discover in 1998 after serving as vice chairman of MBNA.
"When I arrived, Discover had $32 billion in receivables, now it has $50 billion," he says. "During my first three years we grew the company organically."
And yes, receivables growth has been flat recently, but there is a good reason for this, he says, explaining that Discover has backed away from balance transfers to improve its credit profile. Meanwhile, the firm continues to increase acceptance and create new products.
Discover has been innovative. It launched a Morgan Stanley MasterCard credit card business in the United Kingdom that now has more than 1 million customers. It also has issued the Discover2GO card that fits on a key chain. And it popularized the cash-back concept, which has been widely copied by other issuers.
Despite those innovations and more, Discover, at least until now, has had a much tougher time than AmEx in getting banks to give it serious attention.
"It's a defense tactic by Visa and MasterCard to talk up American Express' more expensive network in the Department of Justice case while deflecting attention away from Discover's," Nelms says.
Nelms doesn't seem to have overly optimistic notions about how many banks may accept Discover's new invitation. He believes there will be a cautious start involving tests before there are long-term agreements.
"The issuers have worked with Visa and MasterCard for 30 years, and I don't think there will be a rapid movement by them to form new partnerships," he says.
Still, his direct invitation to banks may have worked. After Nelms completed his keynote address, a very long line of people waited patiently to shake his hand and exchange business cards. Several were overheard saying, "I think we can do business."
Nelms also spent several hours with one of his top lieutenants at his side walking around the exhibition hall and introducing himself to vendors. The message for the bankers all around was clear: It pays to Discover.
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