Description

Background:

Discover Financial Services (DFS) is a great business. It has averaged a GAAP return on common equity of 24.9% annually over the last 10 years and was profitable for every year through the GFC. It owns one of the four major credit card schemes (the Discover Network) in the United States with 99% market acceptance. It also owns one of a small handful of debit card schemes (Pulse) in the United States. This debit network is extremely valuable as it allows DFS to issue debit cards that are exempt from the Durbin Amendment[1]. It is the fifth-largest credit card lender in the U.S. with a focus on the mass-market prime customer (80% of portfolio is >660 FICO score). It is also the 26^th-largest bank by deposits and has a high-quality, granular deposit base. 94% of DFS’s deposits are FDIC insured and more than 80% are small-balance deposits with an average balance of ~$13,000. DFS is also extremely well capitalized by bank regulatory standards, with a CET1 ratio of 10.9%, and has ample reserves (7.3% of total loans) and $74B of liquidity, which is nearly half of its assets.

On February 20, 2024, DFS announced a 100% stock merger with Capital One Financial Corp. (COF) at a 26.6% premium to DFS’s undisturbed price of $110.49. As of the time of this writing, DFS is up 15.7% since the merger announcement, while COF is up 6.8%. This implies 16.8% additional upside to DFS. The companies believe that the deal will close in late 2024 or early 2025. The merger arb community is more skeptical, with many suggesting that the deal will not close until 6/30/25, if it closes at all. The probability of deal closure is the subject of significant disagreement. While specialists, such as TD Cowen political/regulatory analyst Jaret Seiberg, tend to believe the deal will receive approval, talking heads like NYU Professor Scott Galloway have predicted that the deal will be blocked.

Thesis:

DFS suffered a series of setbacks in 2023, culminating in the ouster of its longtime CEO. These events weighed on DFS’s estimates and valuation (absolute and relative), creating a unique buying opportunity for patient investors. COF seized on this once-in-a-generation opportunity to acquire a wounded DFS and create a credit card and digital banking juggernaut. The deal has strong industrial logic and would likely result in even greater upside to DFS than the 16.8% highlighted above (because the combined company would be worth even more given the $2.7B of run-rate expense synergies and potential to exploit competitive advantages due to the Durbin exemption). However, we believe DFS will also do well if the merger does not go through. In fact, many of the issues that plagued DFS in 2023 are already improving. By mid-2025, we expect DFS to be worth materially more than the current price whether the deal breaks or is consummated. Market participants are currently too focused on the political theatre surrounding the proposed merger and missing the opportunity to buy a great business on sale.

Why DFS lagged in 2023:

• Compliance issues
  • On 7/20/23, DFS revealed that the FDIC was preparing a consent order regarding compliance issues at its banking unit.
  • This followed a 2015 consent order with the CFPB regarding its student loan servicing practices.
  • On the 2Q23 earnings call, DFS guided to compliance expenses rising by $300MM annually as a result of its remediation efforts.
• Sloppy business practices
  • On 7/20/23, DFS revealed that it had been overcharging merchants for card processing since mid-2007.
• Buyback suspension
  • DFS suspended its buyback as a result of the aforementioned compliance matters and the merchant mispricing issue.
  • This buyback suspension followed a similar halt in buybacks almost exactly a year earlier due to an internal investigation into compliance practices in its student loan servicing business. Notably, the buyback was resumed in December 2022 after the investigation revealed no major issues.
• Governance changes
  • In August 2023, DFS announced the immediate departure of long-time CEO Roger Hochschild, presumably as a result of his failure to implement a robust compliance management system and internal audit function.
  • In August 2023, DFS added former BancWest CEO J. Michael Shepherd to the board of directors, presumably due to his solid reputation with bank regulators.
  • In September 2023, DFS added former FDIC officer Kathy “Moe” Lonowski to its board of directors, further strengthening its risk oversight and compliance capabilities.
  • In December 2023, DFS announced the appointment of Michael Rhodes as CEO. Rhodes was previously an executive at TD Bank and MBNA and presumably had a strong reputation with regulators.
• Credit performance
  • DFS reported continued degradation in credit metrics due to what management described as “normalization and seasoning” of recent credit card vintages. The absolute levels of delinquencies and net charge-offs were high versus historical levels and out of step with those of its peers, as shown here:

Y/Y Change in 30+ Day DQs (through September 2023):

Y/Y Change in Net Charge-Offs (through September 2023):

• • Of note, stock prices of the credit card issuers tend to follow changes in the rates of change of delinquencies closely. DFS’s relatively poor performance, especially versus COF, was a key driver of underperformance in 2H23.

What issues remain in 2024:

• Compliance issues
  • Remediation work is ongoing, and compliance spending does not appear to have declined versus prior expectations. However, the 2023 FDIC consent order was published, and the contents were not especially concerning.
  • Many analysts and investors had compared DFS to Wells Fargo (WFC), which continues to languish in regulatory purgatory due to its repeated compliance issues in the mid 2000s, but DFS’s FDIC consent order did not reveal any smoking gun that would appear comparable to the WFC scandals.
• Sloppy business practices
  • DFS has reserved approximately $1.5B for remediation of this issue. While the legal process may take time to conclude, we have to believe that the financial impact of this issue has now been recognized.
  • A portion of the increased compliance spending is allocated to internal audit to prevent issues like merchant mispricing from metastasizing in the future.
• Buyback suspension
  • DFS CFO indicated that the company intended to wait for the 2024 CCAR cycle to request and resume a buyback. However, management indicated in late 2024 that it had no regulatory restrictions on resuming its buyback program.
  • Buybacks have been paused pending the closing of the merger with COF, so there will be no buyback support in the interim, but the company will continue to accumulate capital.
• Governance changes
  • The merger proxy filing states that talks with COF broke down in early December 2023, which led DFS’s board to announce Rhodes as the company’s new chief executive. When merger talks resumed in January 2024, Rhodes was likely the victim of an unpleasant surprise. He announced his departure shortly after the merger announcement and resurfaced immediately at Ally Financial (ALLY). We read little into this departure other than Rhodes believes the merger with COF will close and that he would no longer be CEO. He opted out to take another CEO position, which seems sensible.
  • J. Michael Shepherd has assumed the role of Interim CEO while DFS awaits regulatory review of the COF merger. We believe Shepherd will implement the changes to the compliance management system required under the consent order, but we doubt he will make any other major moves as CEO.
  • We see the DFS CEO opening as the most coveted job in financial services, as evidenced by how quickly it found Rhodes (and how desired Rhodes was as a CEO candidate given his rapid appointment as CEO of ALLY). We do not believe DFS would have any trouble finding an exceptional CEO should the COF merger fail.
• Credit performance
  • After lagging behind peers in 2023, DFS exhibited strong credit results in 1Q24, putting to bed the concerns that DFS had lost control of credit (see below). Given the previous comment about how stock returns of card companies track the second derivative of 30+ day delinquencies, the 1Q24 results likely would have triggered a significant re-rating in DFS stock (were it not for the pending merger).

Y/Y Change in 30+ Day DQs (through March 2024):

• Void of buyers
  • As we will discuss later, DFS trades at an unusual discount to its peers and at a cheap absolute valuation despite resolving many of the fundamental challenges that it faced in 2023. We attribute this to the long expected merger review timeline, which has created a vacuum of demand for the stock. Financial services specialists tend to view the odds of completion on the merger as fairly high but are reluctant to get involved in a merger arb situation (many firms have a policy that prohibits fundamental PMs from getting involved in merger situations). Merger arbs are generally more pessimistic about the odds of the merger closing, and Bloomberg’s expected closing date of June 30, 2025 is simply too far in the future to capture their attention.

What creates the opportunity?

Technical issues create a unique opportunity to buy a great business at a low price, with significant potential for idiosyncratic upside in the next year and modest downside risk. Fear of the merger review period has caused many fundamental investors to move to the sidelines, but we believe smart money will return to the name after reflecting on the company’s stand-alone value and improving business trends.

Conclusion:

The primary causes of the underperformance in DFS in 2023 have either stabilized or reversed. Credit has turned a corner, with the Y/Y increases in 30+ day card delinquencies slowing 20 bps in March 2024. When COF reported its first quarter of slowing Y/Y increases in the same metric on 10/26/23, it proceeded to outperform the other credit card issuers[2] by 700-2600 bps over the following two months. Since the day before the merger announcement, DFS has outperformed the same peer group by 300-1700 bps. For this reason, we argue that the current DFS price does not yet fully reflect the improved credit performance, let alone any premium for the COF acquisition. When considering the beat-and-raise quarter that DFS produced in 1Q24 (excluding the charge for the merchant mispricing reserve), which was clearly the best set of results in the peer group, DFS’s relative performance post the COF deal announcement is even more pedestrian. This prompts us to ask, does the COF merger even matter for the stock?

At this price, the potential merger with COF is a nearly free call option on a nearly 17% takeout premium plus potential for the combined business to outperform over the subsequent years due to its immense synergies. That’s an idiosyncratic catalyst that few other large-cap companies possess, and it creates interesting convexity in the stock. If the COF deal were to break now, we see limited or no downside, whereas we have clear line of sight to a high teens or better return if the deal closes. Consider that DFS has traded, on average over the last 10 years, at a 5% higher forward P/E multiple than COF. In spite of the proposed acquisition, DFS trades at a 3% discount to COF on 2025 P/E. If DFS were to return to its historical premium—and we see no reason why it would not—DFS would currently trade at 10.5x 2025 EPS, or $136.61. That price would be 7% higher than the most recent closing price.

Some might say that DFS has not resolved all of the items in its 2023 consent order. That is likely true. However, DFS management has stated that the 2023 consent order does not limit its ability to grow or return capital to shareholders, so we view any residual risk here as manageable. In fact, with Shepherd in the CEO seat, we expect the company will make great progress on any outstanding items (recall that he was added to the board because of his reputation with bank regulators).

Another argument against DFS returning to its customary premium valuation is that it has no CEO. Again, this is true. However, the company had no trouble recruiting a highly-regarded CEO in less than two quarters when it brought in Rhodes. The CEO seat at DFS would be even more desirable now with the merchant mispricing issue likely handled, credit inflecting positively, and remediation work on the consent order well under way. Investors also have to give credit to DFS’s board for acting decisively to first preserve shareholder value by parting ways with a longtime CEO and then creating value by entering into a transformational merger.

An additional criticism of DFS is that it cannot buy back stock while the merger is pending. This is also true, but the company can simply accumulate capital during this period. If the review period stretches deep into 2025, the company will likely have a large surplus of capital with which to buy back stock should the deal break. DFS historically repurchased $2-3B of stock annually, and management has indicated its planned sale of its student loan business will free up over $2B of capital later this year. By mid-2025, the total excess capital could amount to ~15% of DFS’s current market cap.

Some might also question why the board agreed to sell. Did they see serious problems ahead? We initially thought that credit might be worse than management indicated, but that no longer appears to be a concern. Perhaps the board was concerned about a protracted compliance remediation effort because of the depth of the compliance problems in the organization. However, COF performed extensive due diligence on DFS and appears to be eagerly entering into the merger, suggesting that any compliance issues are soluble. Instead, we believe that the board saw a rare opportunity to merge with a business in COF that can truly transform the Discover Network into a legitimate competitor to Visa and Mastercard. While there are other banks, such as JPMorgan Chase, that could have produced even greater value for the Discover Network, none of those other banks would have been permitted to acquire DFS due to deposit concentration issues. So, the board found a willing buyer in COF, extracted a 26.6% premium, and positioned the combined company to capture several billion dollars of synergies and to significantly raise the profile of the Discover Network.

In summary, DFS is a great business, the performance and valuation of which has been muddied by the potential merger with COF. We see a unique buying opportunity. To the extent that one’s investment mandate allows short selling, a DFS long/COF short pair is highly appealing, as it offers significant alpha while tightly hedging any pertinent macro risks.

Risks:

• A reversal in recent credit trends
• An additional compliance or regulatory issue
• Volatility due to political posturing ahead of the November elections

Catalyst

• Continued improvement in credit
• Passage of time (brings merger arb investors into the mix)
• Republican victory in November (decreases opposition to large-scale M&A)