Morgan Stanley's decision in April to spin off Discover Financial Services, issuer of the Discover card, caused some industry observers to believe Morgan Stanley also would be willing to discuss a sale of the unit to prospective buyers. And retailers, fuming over continued interchange rate increases from Visa USA and MasterCard International, helped fuel such speculation.
Four days after Visa and MasterCard rebuked the National Retail Federation for complaining about the card associations' latest interchange rate increases, Mallory Duncan, the federation's senior vice president and general counsel, says the plans for a Discover spin-off may have turned the issue in retailers' favor. Riverwoods, Ill.-based Discover's interchange rate is lower than Visa's and MasterCard's, and Mallory says he has had phone conversations with retailers since Morgan Stanley's announcement.
"It's early, but there's a general sense of excitement that a retailer, a consortium of retailers or GE Consumer Finance, which issues private-label cards for retailers, might buy Discover," he told CCM sister publication CardLine.
Of course, many things would have to occur to make that happen. The plan calls for a spin-off, not a sale, so Morgan Stanley would have to change its corporate mind.
During an analyst conference call on April 4, Phillip Purcell, Morgan Stanley chairman and chief executive, noted that the company would face paying much in taxes with a sale, whereas the goal is to make the spin-off as tax free as possible. "So we think shareholder value will be enhanced with a [spin-off] versus a sale," he said. "It's time for Discover to be on its own."
A report by New York-based Bernstein Investment Research and Management noted the potential tax hit from selling Discover would be $2 billion to $3 billion. Spinning the business off would avoid the adverse tax effects, but an independent Discover would not be able to pursue a sale of the company for two years after the separation to receive the tax benefit.
On the legal front, antitrust enforcers could view a major bank buyer, such as J.P. Morgan Chase & Co. or Bank of America Corp., that is a large Visa issuer as being the equivalent of Visa buying Discover. "I don't see a large bank aligned with Visa or MasterCard being allowed to make this deal," says one antitrust expert who asked not to be identified. "It would raise massive antitrust implications." American Express Co. as a potential buyer also would face antitrust scrutiny for similar reasons, but not to the extent of a Visa- or MasterCard-member buyer because of its relatively low market share, he says.
First Data Corp. would be another "interesting" potential buyer, the antitrust expert says, but the U.S. Department of Justice successfully forced First Data to sell the NYCE electronic funds transfer network as a condition for First Data's acquisition of Concord EFS Inc. and its Star network. First Data likely would have to sell or spin off the Pulse network, which is owned by Discover and is essentially equal in size to NYCE, for a Discover deal to pass antitrust muster, the expert says.
The rationale for the Discover spin-off, Purcell said, would be to maximize shareholder value in the card division and allow management of the business to capitalize on the momentum, both in performance and in opportunities opening up in the payments market. It also would further intensify the company's focus on the high-return growth opportunities within its integrated securities businesses, he said.
David Sidwell, Morgan Stanley's managing director, says the spin-off could occur in three to six months. Executives did not disclose the potential value of Discover as a stand-alone company. Wall Street is estimating Discover could be worth as much as $14 billion in the planned spin-off, though some observers put the value at billions less than that.
If a sale were to occur instead, Duncan envisions a retailer-sympathetic Discover owner getting more Discover cards into the hands of consumers. "It would absolutely put pressure on [Visa and MasterCard] to bring their interchange down," he says.
Bernstein came to the same conclusion. In a research report issued April 5 concerning Discover's spin-off, Bernstein says if a merchant-focused entity such as GE buys Discover's network/acquiring business, "it will likely catalyze a decline in interchange." Visa and MasterCard raised their interchange rates in April.
Morgan Stanley's decision to spin off Discover comes just months after the U.S. Supreme Court refused to review two lower-court decisions striking down Visa's and MasterCard's exclusionary rules that prohibited member banks from forming partnerships with Discover and AmEx. The Supreme Court's decision was seen as opening the door for Discover to grow its card business, which had not been growing for various reasons, sparking rumors for years that it was on the sales block. Following the legal ruling, Discover's business began to take off (see Merchant Support Bolsters Discover, page 32).
The spin-off is expected to be a bitter pill for Purcell, who launched Discover in 1986 when he was CEO of Dean Witter. He was considered Discover's biggest backer. But David Nelms, Discover's chairman and CEO, is all smiles. "We could not be more excited about the opportunities ahead for Discover," he says.
Discover has beat long odds to become a top-10 issuer and network, and it could stand on its own away from parent Morgan Stanley, says Scott Strumello, a consultant with Auriemma Consulting Group Inc.
John Grund, a partner at payments consultant First Annapolis Consulting, says an independent Discover would be more flexible and better able to focus on its core business, skills often lost as part of a large institution. He says speculation of a Discover sale creates a potential double-edged sword because a large processor might only want the network, preferring to stay out of the issuing business.
Discover's network in North America includes its closed-loop communications infrastructure, a sales force and a card-accepting relationship with about 4 million merchants. Strumello notes that major Wall Street investors long have urged Discover to sell its network to focus on its well-known card brand.
Stock analysts seem to agree that it is unlikely another card issuer would buy the company. Laura Kaster, an analyst with Sandler O'Neill & Partners LP, does not see Discover's largely blue-collar cardholders fitting with an issuer that would have the resources to make a bid. Ed Groshans, specialty and mortgage finance analyst at New York-based Fox-Pitt, Kelton, says spinning off Discover could make it more valuable down the road.
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