This story appears in the April 2009 issue of Cards&Payments.
For Discover Financial Services, often cast as the underdog among both major issuers and other payment networks, the current economic crisis is presenting both opportunities and setbacks.
Discover's low-key issuing strategy may win it more business from customers increasingly frustrated with other issuers, many of which are facing greater losses than Discover is. But the recession also is retarding Discover's efforts to win more business to its third-party network from those same competitors, whose losses and capital concerns effectively are preventing them from considering new network partners.
Now Discover is attempting to balance its issuing business with a network that remains tiny in comparison with those of Visa Inc., MasterCard Worldwide and American Express Co.
Observers are divided about the long-term success of that balancing act, but Discover has allocated veteran talent to both sides. The company shuffled its management in December, promoting network head Harit Talwar to chief marketing officer and executive vice president of card programs, and consolidating its three network businesses under Diane E. Offereins, the longtime head of its Pulse debit network.
Both executives stress Discover's joint commitment to both sides of the business.
"He's now my client," Offereins says, "half joking," of Talwar, who sits two doors away from her office in the company's Chicago-area headquarters. But "clearly we partner on just about everything."
"We've always had a very strong collaboration between the cards side and the network, and that continues," Talwar agrees.
Offereins characterizes that closeness as an advantage for Discover as it attempts to grow its third-party network volumes. "In our business, we get used to managing very complex relationships," she says. From issuers, "I've never had any concern voiced to me. I've always had it characterized as, 'you understand the business that we're in.'"
The company has spent recent years attempting to increase those relationships and to build up its network infrastructure. Since 2006, it has signed deals with more than 96 major merchant acquirers to close the acceptance gap in the United States.
'Need A Little Time'
Discover says it now shares 99% of the potential acceptance points of both Visa and MasterCard, up from 77% in 2005. Last year, Discover bought Diners Club International from Citigroup Inc. in a $165 million all-cash deal that added 8 million Diners Club merchant and cash-access points in 185 countries to the Discover Network. Diners Club transactions gradually will migrate to the Discover network from MasterCard's network over next two years, a spokesperson for Discover said at the time ("Discover Dines In A Bigger Global Club," May 2008).
Now Offereins is mobilizing the beefed-up network infrastructure to win more business from banks. "Disruption happens all the time. Every once in a while someone comes along and shakes you up, and we want to be that someone," she says. "We've got the resources, and we're committed to investing in it, and we just need a little time."
But volumes on Discover's network still lag far behind those of the competition. Total sales volume during the fiscal first quarter ended Feb. 28 reached $57.5 billion, including $6.3 billion from Diners Club and $27.5 billion from Pulse; volume from third-party credit card issuers that used the Discover network was down, accounting for only $1.36 billion.
AmEx, by contrast, reported worldwide billed business of $160.5 billion (including cash advances) on its network for the quarter ended Dec. 31, both for its own cards and for those issued by other financial institutions. Not including cash volumes, Visa reported worldwide sales volume of $701 billion for the quarter ended Sept. 30, and MasterCard reported fourth-quarter worldwide sales volume of $455 billion.
The path is perhaps slightly clearer on the issuing side for Discover, as the economy has tumbled and most issuers have cut credit lines, raised interest rates, discontinued products and reduced reward programs, tarnishing their reputations in the eyes of alienated consumers.
"A lot of our competitors have been doing very, almost erratic line-management strategies, even with existing, active customers," Talwar says. "Our steadiness in a marketplace where maybe not all the competitors all the time are being steady is going to help us stand out."
Discover's charge-off rate of 6.48% for its fiscal first quarter was on the low end of the fourth-quarter rates reported by most major issuers in January.
Discover chief executive David Nelms told analysts in March that he expected loss rates to "exceed 7.5%" in the fiscal second quarter. But he said in an interview then that he expects even that elevated rate to remain low in comparison to other issuers.
"If you look in the securitization monthly data even through last month, the gap between us and some of the higher chargeoff and delinquency competitors continues to be there," he said.
Talwar, a veteran of Citigroup's card and retail banking businesses, ran Discover's network business for five years before the company promoted him late last year. In both of his new roles, his top priority is emphasizing a "consumer-friendly" strategy in the midst of issuer cutbacks to try to move Discover cards up to the top of holders' wallets. Discover is hoping the contrast helps win more business from its current cardholders.
Though Discover has used many of the same risk-management tactics as other card companies, analysts say its cutbacks have been more careful and targeted.
"We have entered into the cycle in a better position than our competitors. We have shown that our credit performance, while deteriorating, is better positioned than our competitors," Talwar says. "We entered it steady and conservative. We remain steady and conservative, and we are very hopeful and desirous of wanting to emerge out of this even stronger."
Michael Taiano, an analyst at Sandler O'Neill & Partners LP, agrees Discover has "taken the tack of being more consumer-friendly and trying to hold off on aggressively repricing" its accounts.
Discover, which says its average new cardholder has a FICO score of 734 and a credit line of $5,500, has tried to avoid acquiring riskier cardholders, a strategy that it says has helped it rely less on risk-management tactics that potentially can alienate good cardholders. It has "done them like everyone has, but to a lesser degree than some of their competitors," Taiano says. "Assuming that you're still doing all the right things from a risk-management perspective, the goal is to keep the best customers."
Gaining much more market share, especially from new customers, is a far-off goal for most issuers in the current retrenchment, analysts say. Talwar says Discover's primary goal is gaining more business from current customers instead of winning new ones.
Even today, observers generally are more optimistic about the success of this issuing strategy than that of the network side.
James Ellman, president of the hedge fund Seacliff Capital LLC and a longtime vocal proponent of Discover either shutting down or selling its network business, takes an even dimmer view of the unit these days. The network is "worth significantly less than had they sold it a year ago or two years ago," when more issuers would have been able to bid on it and drive up the price, he says. Now "it could be acquired by one of the big banks for, instead of a very large price, a very small price."
But other observers, who have questioned whether most banks had the ability to make such a purchase, now see potential advantages for Discover keeping the network and the issuing business tied together.
"Issuers are increasingly looking to diversify from their reliance on one specific network, particularly when that entity is a public company. It helps them reduce their reliance on just one brand," says Sanjay Sakhrani, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc.
And for Discover, "there are strategic advantages in being a closed-loop network and having a product on that side of the business and then branching out into the network as well, and those would be lost if you separate the two," he says.
Eric Grover, a former Visa executive and the principal of the U.S.-based consulting firm Intrepid Ventures, even argues that Discover's network, and not the issuing side of the company, has the most potential to drive long-term growth.
"They've been doing a lot of right things on the issuing side," he says, but this business, with "a spend-per-cardholder that has traditionally been a bit lower than [that of] a Visa or MasterCard cardholder," is unlikely to increase Discover's market valuation, Grover says. "If you can demonstrate that the network is viable over time, that's where you can boost the enterprise value of Discover," he says.
Offereins acknowledges that Discover cannot match such powerhouses as Visa and MasterCard in scale, but she says Discover hopes to attract issuer business with greater flexibility.
"They're big, there's no doubt about that, and they're well-established, and I think growth is always a challenge, but we're not trying to be them," Offereins says. "We're open to all sorts of ideas. … We're very flexible in terms of the way we want to work with our partners."
But flexibility can go only so far in a recessionary period when financial institutions are looking for ways to retrench instead of innovate, observers say.
"Product people love the flexibility of Discover. The problem is how they get the mindshare of a senior card executive" right now, says Philip J. Philliou, a former executive at MasterCard and AmEx and now a partner in the Philliou Selwanes Partners LLC consulting firm in New York. "Every credit card issuer is locked down right now, and it's very difficult for them to do any experimentation."
In a climate of increasing consolidation among debit card issuers, "the question remains whether or not the large bankcard issuers are willing to branch out," Sakhrani adds. "It seems like a lot of the large banks have stuck with the one solution."
Some industry players have told Sakhrani "they've definitely found other [Discover] products interesting, but I'm not sure they're willing to push the button," he says.
The economy is creating "a longer sales cycle, especially on the credit-issuing side," and both financial institutions and "nontraditional" payments companies, including retailers and mobile-phone service providers, have expressed interest in using the Discover network, Offereins says.
The company has renewed all the Diners Club issuers abroad whose contracts have expired since Discover bought the network in July, but few U.S. issuers have signed on to the Discover credit card network since 2005, when General Electric Co.'s consumer-finance unit and Metris Cos. Inc. did so. (Metris is now a part of HSBC Holdings PLC.)
Diners Club, with its franchise model, might provide more of an immediate opportunity for Discover to increase its network volumes. "There's a lot of interest in certain countries where you don't have an issuer today," Offereins says. "You'll see us add more franchises. … We're out there actively working."
Despite integrating the functions of Discover's three networks under one leader, the company will be maintaining three separate brands: Discover, Diners Club and Pulse.
"In the short run, we have to be committed to the Discover brand and Diners," says Offereins, who defines Pulse as "more of an acceptance mark" under Discover than its own brand identity. "If you look outside the U.S. at the way we're running the franchise model, there's a case to be made for the collaborative coexistence of the two brands."
But some observers raise their eyebrows at that plan.
"I don't understand that. I would encourage them to think about driving toward one brand," Philliou says. "For an issuer, you're looking to keep things simple. Especially in this day and age of limited budgets, and as you're looking to optimize your marketing dollars, subbrands don't seem a worthwhile investment."
Likewise, Grover calls Discover's reasoning "problematic," although he acknowledges the risks and delicacy of a rebranding operation. "They need to find a way to mix the brands together to make them coherent. They've got to get that right, and I'm not sure what they're doing now does that," he says. "To be a semi-viable network, you've got to find a way to tie in Diners and tie in Pulse in a more-effective manner. It's hard, and it's very risky, because if you get it wrong you can destroy a lot of value."
But Sakhrani points out that for Discover, "It would be a more monumental task of rebranding Diners Club at this point in time. To introduce a new brand into regions that have not necessarily heard of a brand is more difficult."
(Maria Aspan is a reporter with American Banker.)