Capital One-Discover Deal Aims to Challenge Visa, Mastercard (2)

For decades, Capital One Financial Corp. Chief Executive Officer Richard Fairbank watched as Discover Financial Services built one of the most coveted assets in the world of finance—a global payment network facilitating tens of millions of credit card transactions each day. On Feb. 19 he announced plans to buy it.

The $35 billion deal—the biggest merger announced globally this year—would unite two storied consumer-finance brands and create the largest credit card issuer in the US by loan volume, surpassing the likes of American Express, Citigroup and JPMorgan Chase.

Opposition emerged almost immediately from Democrats in the US Senate, where Ohio’s Sherrod Brown—chair of the Committee on Banking, Housing, and Urban Affairs—took a dim view of the deal’s size and Elizabeth Warren of Massachusetts expressed outright opposition. “A rubber-stamped merger that makes powerful financial companies even bigger and more powerful will do nothing for families,” Brown said in a statement. Warren said the deal should be blocked because it “threatens our financial stability,” cuts competition and brings higher costs for consumers. Fairbank told analysts during a conference call on Feb. 20 that the bank is “well-positioned for approval.”

Illustration: Janik Söllner for Bloomberg Businessweek

Analysts say the power of the market leaders in payments makes the question more complicated than simply the size of the combined companies, as creating a viable competitor could be considered a plus for merchants. If regulators block the deal, “they would be accused of protecting Visa and Mastercard,” says Ian Katz, a managing director at Capital Alpha Partners.

A successful merger would be the culmination of a growth strategy hatched by Fairbank when he helped found Capital One in the late 1980s to offer credit cards to consumers overlooked by the industry. Since then, he’s steadily transformed the company into a full-fledged bank providing services such as auto loans and savings accounts to more than 100 million customers.

What Capital One doesn’t have—and what it’s coveted from the start—is a payment network to take on Visa Inc. and Mastercard Inc. (the two largest) as well as No. 3 Amex. In the call with analysts, Fairbank described the combination of a credit card issuer and a network as the “Holy Grail.” “A network is a very, very rare asset,” he said. “There are very few of them, and I don’t think people are going to be building any of these anytime soon.”

Even after a deal, Discover would remain far behind Visa and Mastercard, says Sanjay Sakhrani, a managing director at Keefe, Bruyette & Woods Inc. But he says controlling the Discover network could help the bank forge closer ties with consumers and merchants, potentially generating more revenue. “You’re eliminating the middleman,” Sakhrani says. “And when you eliminate the middleman, you move the value to your own network.”

Capital One is the third-largest issuer of Mastercard and Visa plastic in the US, accounting for roughly 10% of US credit card spending, according to Mizuho Securities USA. Although Fairbank said he has no plans to abandon those card networks entirely, he predicted more than 25 million Capital One cardholders representing $175 billion in annual spending could be moved over to the Discover network in the coming years.

A deal would give the combined company more than $250 billion in credit card loan volume—debt that customers carry on their cards—as of Dec. 31, making it the No. 1 player. Yet in purchase volume, it would continue to lag the industry’s leaders. “It is not overtaking the competitors,” says TD Cowen analyst Moshe Orenbuch. “They will still need Visa and Mastercard, but they will not rely on them exclusively.”

Discover has long grappled with perception problems that will pose a challenge for Capital One. The brand was introduced in 1985 by midmarket retailer Sears, Roebuck & Co. and has lagged behind Amex in attracting wealthier cardholders, even after Sears spun it out in the early 1990s. Although Discover has steadily expanded its network to rival the size of the leaders in the US, consumers haven’t gotten the message, so Fairbank says Capital One will emphasize that the cards can be used virtually everywhere in the US that Visa and Mastercard are accepted. The brand continues to trail Visa and Mastercard internationally, and Fairbank says a key goal will be to sign up more non-US retailers.

Before starting Capital One, Fairbank and co-founder Nigel Morris tinkered with new ways of assessing credit card risk at a Washington-area consulting firm. Later, while working at Signet Bank’s card business, they pioneered concepts such as offers that would entice borrowers to transfer balances from other lenders. Signet in 1995 spun off the business, which it called Capital One, naming Fairbank CEO. But along the way, Morris says, the pair was inspired by the operation Discover was building, with its payment network alongside the card issuance business that allowed it to skirt Visa and Mastercard. “The roots of the idea go back 30 years,” says Morris, now managing partner at venture capital firm QED Investors. “We very quickly recognized that partnering with the merchant side of the business and creating the closed loop would be a strategic option down the road.”

(Adds Cowen analyst quote in third from last paragraph. An earlier version corrected the web headline to billion from million.)

To contact the authors of this story:
Jennifer Surane in London at jsurane4@bloomberg.net

Katherine Doherty in New York at kdoherty23@bloomberg.net

To contact the editor responsible for this story:
Sally Bakewell at sbakewell1@bloomberg.net

Laura Bliss
David Rocks

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