"It's all about the network" is a slogan for the Internet age. However, credit card issuer Discover Financial Services, a unit of Morgan Stanley (NYSE:MS), is finding that it's also fully relevant to the humdrum business of facilitating credit and debit card payments.
Last Friday, Discover and processing giant First Data Corp. (NYSE:FDC) announced that they had reached an agreement in which the latter will enable Discover card acceptance at small- and medium-sized merchants. Pilot programs could begin this summer, with a wider rollout planned for the fourth quarter. The terms of the agreement were not disclosed.
Morgan Stanley delivered great earnings last quarter, and Discover was no laggard, with net revenues and pre-tax income up 34% and 106%, respectively. However, the strength of Discover's results was partly attributable to the acquisition of the Goldfish credit card business in Europe. If the company is to achieve meaningful organic growth, it must increase its penetration with merchants in order to compete with better-established rivals. With more than four million merchant locations, Discover is dwarfed by Visa and Motley Fool Inside Value pick MasterCard (NYSE:MA), both of which are accepted at 24 million locations.
The problem with trying to add smaller merchants directly to your network is twofold. First, the market is fragmented, and consequently, the sales process is expensive relative to the size of the accounts. Second, although these businesses would like to be able to offer their customers the option to pay with a Discover card, they don't want the added complexity that goes with managing multiple providers.
The decision to partner with First Data is a great example of coop-etition. The agreement allows Discover to avoid choosing between abandoning expansion in the small-business category altogether and mounting an expensive drive that would potentially harm profitability. Small businesses will now be able to add Discover as a payment method and maintain a single point of contact for their payment solution. First Data's Merchant Services segment, which accounted for 36% of total operating profit in 2005, already provides transaction-processing services in partnership with numerous financial institutions and the two major card associations (Visa and MasterCard). For First Data, the arrangement with Discover is part of its "bread and butter" activity, and it increases the value of its own network of 4.6 million merchant locations.
While Discover remains the red-headed stepchild at Morgan Stanley, the top brass appears to have dropped the idea of a sale. If Discover can deliver growth to go with its consistent profitability (14.8% ROE on a TTM basis), the unit would further silence its detractors within the firm. This latest initiative looks like a step in the right direction.
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Fool contributor Alex Dumortier has a beneficial interest in MasterCard, but none in any of the other companies mentioned in this article. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.
