Digging Into Discover

As president and COO of Discover Financial Services (NYSE: DFS  ) , Roger Hochschild oversees cardmember services, marketing, the Discover network, and the U.K. card business. I recently spoke with Hochschild by phone to get the lowdown on Discover's newly established independence and the credit card company's future plans. (My own notes are in italics.)

Emil Lee: What are the biggest differences between Discover, the Morgan Stanley (NYSE: MS  ) subsidiary, versus Discover, the independent company?

Roger Hochschild: Under Morgan Stanley, we operated for the most part autonomously, with our own brand, marketing, and operations management teams. As a result, the biggest change has been in some of the corporate functions such as compensation, benefits, and treasury, which are areas we've had to build on our own.

The second biggest difference is in our capital management. Over the last five or six years, we've upstreamed roughly $3 billion in capital to Morgan Stanley. Going forward, we will have capital to deploy for the benefit of our own shareholders, whether that's through a possible dividend, acquisitions, or stock buybacks that we could consider.

Lee: Can you describe the competitive landscape? Is Discover the low-cost provider, and do you have a general idea of how Discover's interchange fees compare to MasterCard (NYSE: MA  ) and Visa's, as well as its APR rates versus other card issuers' rates? (I assume American Express (NYSE: AXP  ) obviously has higher interchange fees.)

Hochschild: We compete against card issuers three times our size, where there are economies of scale. We think we're positioned in the sweet spot as a card issuer. We are big enough to leverage technology and marketing expenditures, but small enough to still grow organically. It's very challenging to grow organically once you reach a certain size.

In terms of pricing and how our rates compare, we tend to be very competitive. But we're focused on more than rates. We differentiate ourselves in areas that matter to consumers. We have high customer-service ratings and low attrition rates.

As you mentioned, for the interchange fees, we are lower than American Express. For Visa and MasterCard, once you normalize for product mix, our interchange rates are very competitive. We also don't do significant advertising or sponsorships for our network, which enables us to be more efficient and keep expenses down.

Lee: In terms of credit quality, it seems Discover has shifted up to members with better credit. Is there a substantial difference in the credit profiles of your aggregate cardmember base between now (where you're running at a roughly 4% net charge-off rate) versus 2001-2003, where you were running at 5%-6% net charge-off? How much of that is due to "macro" vs. "micro" factors?

Net charge-offs measure the portion of credit card loans that are written off as uncollectible.

Hochschild: It's a mix of both. A significant component has been our own focus on improving our credit quality. We put on a lot of new accounts in 2000-2001, and new accounts reach their new peak loss in two to three years [which contributed to the higher charge-off rates of 2002-2003]. Last quarter, we posted our lowest delinquency rates ever.

Lee: What tangible equity to managed asset ratio do you feel comfortable with? Right now you're at a 10% tangible equity-to-managed assets (TETMA). Are share buybacks in the cards?

The TETMA ratio is a measure of leverage.

Hochschild: We are very comfortable with where we came out (in terms of capitalization). Morgan Stanley had always allocated equity to us as if we were independent. We will work with our board on how to deploy future capital in the best interests of our shareholders.

Lee: How did the Visa/MasterCard ruling affect Discover's competitiveness?

Hochschild: It really allowed us to get into the payments business for the first time, enabling us to sign third-party issuers, get into the debit business, and let us sign with merchant acquirers.

Lee: How hard is it to get the smaller merchants to sign on with Discover?

Hochschild: Most smaller merchants want to take Discover -- it's just been too complicated for some in the past. Now, merchant acquirers such as Global Payments (NYSE: GPN  ) or First Data (NYSE: FDC  ) can go into a restaurant and say, I'll sign you up for Visa, MasterCard, and Discover at the same rate on a single billing statement -- as opposed to merchants having to sign up for Discover on their own. Previously [because of anticompetitive measures], banks could issue Visa and MasterCard, but not Discover. This kept us out of third-party issuance and out of debit. It's as if Coke and Pepsi went to supermarkets and said, "You can carry Coke or Pepsi, but if you carry Snapple, you're out." This also prevented merchant acquirers from signing merchants for Discover.

Lee: Can you talk about the implications of outsourcing merchant acquiring?

Hochschild: There are three parts to it. One is being integrated on the front end when they sign new merchants. The second is that merchant acquirers can go back to their existing portfolio of merchants and offer Discover at the same bundled rate -- all they have to do is put on the sticker. Third is that we also sell to merchant acquirers the Discover relationship with small merchants. They're excited about that, because it gives them more volume at little additional cost. And it helps us get out of the business of doing merchant-acquiring for smaller merchants.

Lee: So how do you measure your progress with increasing penetration?

Hochschild: We really started looking at this immediately after the DOJ ruling. We put the systems in place and already have the transactions on the new model, but it's too early to see the impact on the P&L. We hope to largely close the gap with Visa and MasterCard over the next two years.

Related Foolishness:

MasterCard shares have returned more than 250% since being recommended in the Motley Fool Inside Value newsletter service, while First Data is a former recommendation. Check out an all-access 30-day free trial to see what other values Philip Durell and his team of analysts are recommending to subscribers right now.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. Bank of America is an Income Investor recommendation. The Motley Fool's disclosure policy is worth discovering.

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