At 30 years old, Discover's (NYSE:DFS) card network seems like something that has been around forever. It's easy to forget that it was the last entrant into the network business, having launched in 1985 in a move its executives said would be "impossible" today. Back then, Discover had the advantage of being owned by Sears, then one of the nation's dominant retailers.
With all the backing of a leading retail store to distribute its cards, Discover was still off to a rocky start. Its network simply wasn't gaining much traction. American Express (NYSE:AXP), Visa (NYSE:V), and MasterCard (NYSE:MA) effectively cornered the market for themselves. It decided its best course of action was to compete aggressively on pricing.
In a speech to an industry group in 1999, the company's president outlined its plan to partner with its merchants, lower fees, and drive payment volume to its network. It even went so far to send a letter to every single one of its merchants highlighting how American Express, Visa, and MasterCard were raising fees. Discover, on the other hand, was cutting them.
Unfortunately for Discover, it never quite panned out. Discover cut rates for its merchants, but its merchants had agreements with competing companies that forbid them from favoring Discover cards over others. Realizing that if it couldn't beat them, it should join them, Discover reversed policy within a year. From 2000 to 2007, it raised its fees by 24% to move in line with higher-priced networks.
The gavel falls
Earlier this year, the very provisions that keep merchants from steering payment volume to a lower-priced card network were ruled anti-competitive by a Department of Justice decision against American Express. Merchants, the DOJ believes, should have the right to steer customers toward cards that charge lower fees to entice competition.
The missing link that led to the failure of Discover's low-cost strategy in 1999 is now in place. And Discover, a relative "also-ran" in merchant fees, has every reason to try the low-cost strategy once more.
We often think of Discover and American Express as being similar in the same way that Visa and MasterCard are similar. Discover and AmEx have so-called "closed-loop networks" in which they single-handedly take care of all that happens when you swipe a card, from lending their customers money to making sure payments move to the correct accounts. Visa and MasterCard simply provide the network -- banks do most of the heavy lifting when it comes to the money.
In reality, American Express is perhaps more like Visa and MasterCard. The fees it makes on each swipe are its bread and butter. Discover is the outlier. It's more like a bank; only a fraction of Discover's revenue comes from its network. To this day, a majority of its revenue and profits come from lending money to its customers.
In the first six months of 2015, Discover's transaction-related revenue made up less than one-fifth of its total revenue after provisions. Discover arguably has much more to gain by slashing fees and taking market share than it has to lose.
Is this Discover's second act?
As recently as 2011, when Visa and MasterCard settled with the DOJ rather than make their case for anti-steering clauses in their contracts, Discover executives considered the idea of lowering fees to incentivize spending on its network. In reviewing the data, however, Discover found that its 100 largest merchants had deals with AmEx that forbade them from steering payment volume to a lower-cost network. American Express refused to settle with the DOJ like Visa and MasterCard in 2011, thus bringing about the unfavorable decision against the company in 2015.
But now, the low-cost strategy is back on the table for Discover. Thanks to the Department of Justice, American Express can't require its merchants to stay quiet when their customers present its higher-fee cards. And Discover, with less than a 5% share of credit card volume, has every reason to compete on price to win network business.
The question is whether or not it will. It certainly has the capacity to do so, and merchants have every reason to minimize their merchant fees. This has all the makings of a bitter and ugly battle in which a fourth-place competitor has little to lose by destroying the extraordinarily large margins its competitors earn on every swipe.
If Discover decides to play ball, the consequences could be severe for everyone. That is, everyone except for Discover.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends MasterCard and Visa. The Motley Fool recommends American Express. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.