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Discover Financial Services
RCMP presentation
12.06.2007
Zhifeng (Jack) Chen
Gloria Ho
Jonathan Li
Swechha Salgia
Jeremy Smith
Zheng(Andrea) Zhang
Agenda
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Company Overview - Jack
Business Model - Jonathan
Industry Overview - Jeremey
SWOT - Andrea
Stock Performance – Swechha
RCMP Position - Swechha
Valuation: Multiplies - Gloria
Recommendation - Gloria
Company Overview
Company Overview
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A leading credit card issuer and electronic payment service company in US
and UK
Three major business segments:
 U.S. card  50m card members, $47.4b receivable
 Third party payment  PULSE, 2.8b transactions
 International card  Goldfish Bank, 2m card members, $4.4b receivable
Primary revenue source:
 Interest income
 Securitization income
 Fees from card members, merchants
Operating capital source:
 Asset securitization
 Consumer deposits
Recent Key News
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June 2007 officially spun off from Morgan Stanley
July 1, 2007 DFS Added To S&P 500
July 2, 2007 DFS Debuts On NYSE
Sept. 25 2007 DFS Profit Falls in the 3rd quarter ER due to higher marketing
and interest expenses
• Dec. 3 2007 DFS to take big charge for UK card business in its 4th quarter
ER (about $422M, equal to its half-year earning)
• Dec. 5 2007 Discovery's Consumer Spending Index Down 96.593.4 from
Oct. to Nov.
Key Businesses
Discover Bank
Discover Card
Payment
Networks
• Offers housing and
student loans to
customers
• Issuer of credit,
debit, and stored
charge (gift cards)
• Discover Network
supports Discover
Card transactions
• Offers CD’s and
money market
deposits
• First to provide
incentivized rewards
programs
• Pulse Network
supports Visa,
MasterCard ATM
users
Key Businesses
Discover Bank
Discover Card
Payment
Networks
• Offers housing and
student loans to
customers
• Issuer of credit,
debit, and stored
charge (gift cards)
• Discover Network
supports Discover
Card transactions
• Offers CD’s and
money market
deposits
• First to provide
incentivized rewards
programs
• Pulse Network
supports Visa,
MasterCard ATM
users
Business Model
Visa/MasterCard:
Credit Card Company
Credit Card Company $.25
Consumer
$100
Merchant
$98
Credit Card Issuer
Payment Network
Credit Card Issuer
Monthly Fee
$1.75
Discover:
• Discover owns all aspects of Credit card payment operations, and thus captures all
revenue points in this model
Monthly Fee
Consumer
Merchant
Transaction Fee
Revenue Breakdown
2006 Revenue
*Consumer Loans
Asset Securitizations
Payment Networks
5.2 B
2.1B
2.3B
.8B
*Mostly Credit Card revenue
Future Strategies
• Focus on credit quality
 Delinquency and charge-off rates significantly less than
competition.
 Average credit score 734.
• Increase third-party revenues
 Pulse network, debit cards.
• International Partnerships
 Reciprocal acceptance agreements with Asian credit card
companies.
 Challenge Visa/MasterCard dominance in this space.
Industry Overview
Industry History
• Diner Club Program, first general-purpose charge card established in
1949
 Bilateral Model
• In late 1950s, Bank of America started to issue first credit card
nationally, evolved to Visa network later on
 Multiple Card Issuer Model
• In 1966, MasterCard network was established
 Multiple Card Issuer Model
• American Express (1958) and Discover Card (1986)
 single-issuer model
Credit Card Industry
• Highly competitive among concentrated market
 American Express, Visa, Mastercard, Discover
• Declining credit quality
• Mortgage Crisis (for some)
 Failure of loan payments
• Increase in Charge-offs
• DFS susceptible to loss rates
• Heavily influenced from consumer spending
 Threatened by tightening of lending practices
Credit Market
• Home mortgage defaults biggest factor
• Increase in bad loans expense (3rd quarter)
 Loan-loss expense $16.6BN v. $7.5BN in 3rd quarter 06
• Net charge-offs up 200% last year
 $10.7BN total (3rd quarter 07’) vs. $3.6BN(06’)
• Significant decline in stock values of all the biggest US banks
 DFS hurt from sale of asset backed loans to big investors
• Further loss expected in near future
"FDIC Quarterly Banking Profile ." Third Quarter 20072 December 2007 <http://www2.fdic.gov/qbp/2007sep/qbp.pdf>.
Current Market
• Is a mature market
• Estimated 76% of American families had credit card in 2001
• Average card number for all households: 6.3
• Nearly all retail establishments can process credit card
SWOT Analysis
Strengths
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“One-of-a-kind company”:
 4th-largest network, 6th-largest credit card issuer, owns the nation’s 3rdlargest debit network.
 Potential as a top-tier issuer and processor in a secularly growing market.
Good credit quality: 3.12% delinquency rate 2Q07
Focus on lending to the prime credit segment and strengthening its portfolio:
no direct exposure to housing or housing credit market
Attractive and stable card member base
 Higher income, better educated, higher percentage of home ownership
 Highest percentage that cardmembers stay longer than 5 years
Possibility of a future acquisition
Weaknesses
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Continued losses in DFS's U.K. business due to UK’s weak economy.
Lack of global diversification:
 Recently inaugurated joint programs with China UnionPay and JCB in
Japan.
 Has no plans to expand in Europe or Latin America, where the usage of
card is growing at double digit rate in selecting countries.
The core Discover Network business, experienced transaction growth of just
4.8% in 3Q07 comparing to MasterCard’s 15.3% in 2Q07
Lower spending per card than peers: the active account rate is only 44%.
Marketing the brand to a desirable product is a primary issue.
0% introductory interest rate: 16 out of 17, or 94% of its lending card by
discovery carries a 6 or 12 months APR, the highest percentage among peers,
where industry average is 73%
Economy of scale: much smaller than Visa and MasterCard
Opportunities
• Continued migration from cash spend to plastic and other electronic
forms of payment within the U.S. and continued card penetration
internationally
• U.S. charge-offs were a solid 3.7% in Aug-Q
• Possible take over target
• Debit cards usage is growing much faster than the consumer spending
and the card usage.
Threats
• On housing and credit related issues,
• Possible deterioration of US consumer confidence that would have an
impact on consumer spending
• A rise in unemployment that would pressure credit quality.
• The competition of the industry is very intense: competitors offer
identical or similar products
Stock Performance
DFS Stock Performance
• Closed at $ 16.45 on 5th Dec 2007
• 52 Week high low : $ 32.17 - $ 15.72
Source: Wall Street Journal : http://online.wsj.com/quotes/stock_charting.html?symbol
DFS Stock Performance
• International losses have contributed to 39% decline since its spin-off especially Europe
• International card business suffered $ 67 million pretax loss in the third quarter
Source: Wall Street Journal : http://online.wsj.com/quotes/stock_charting.html?symbol
RCMP Position
WAG
4.80%
SRZ
4.77%
6.29%
SRCL
MVSN
2.03%
Stock Name
KMB
JKHY
DFS Percentage in RCMP
5.50%
2.81%
FR
DFS
9.87%
0.87%
7.34%
CPRT
AEO
AEE
8.73%
5.69%
41.30%
CASH
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
Percentage
• DFS Position
• 201 shares by virtue of spin off on 2nd July 2007 @ 19.52 per share
• .87 % of RCMP Value
• Total RCMP value as of 12/03/07
• $ 379895
Source: Yahoo Finance: http://finance.yahoo.com/p?k=pf_1
30.00%
35.00%
40.00%
45.00%
RCMP Profit/Loss
Percentage Profit/Loss
6.22%
WAG
-4.41%
SRZ
21.72%
SRCL
MVSN
Stock Name
KMB
0.20%
1.87%
JKHY
7.66%
FR
-0.67%
13.89%
DFS
CPRT
24.32%
AEO
AEE
-10.00%
-5.00%
0.00%
27.47%
1.74%
5.00%
10.00%
Percentage
• Net Profit as of 12/03/07
• $ 92173
• DFS Loss
• $ 617
Source: Yahoo Finance: http://finance.yahoo.com/p?k=pf_1
15.00%
20.00%
25.00%
30.00%
RCMP LOSS
Contribution to Loss
DFS, 13.72%
MVSN, -4.13%
SRZ, 90.42%
• Total Loss as of 12/03/07
• $ 4499
• DFS Loss
• $ 617.07
Source: Yahoo Finance: http://finance.yahoo.com/p?k=pf_1
Valuation
Valuation
• Difficulties in valuing DFS by cash flow and DCF
 Profitability depend on
• Interest spread on loans
• Investment income
incl. profit / loss from sales of securities
Changes in market value
• Loan quality
 Young as a stand-alone company
Multiple Valuation
Company
*P/E
Price/Sales
Price/Book
Price to
OCF
Discover
17.43
2.40
1.49
8.38
Mastercard
528.65
7.98
11.23
40.86
American Express
19.2
2.56
6.62
7.73
AIG
10.77
1.34
1.49
22.17
Industry
11.55
1.95
N/A
N/A
Multiple Used
14.98
1.95
4.05
14.95
* Figures represent trailing PE multiple. Forward earnings are applied to this multiple to
arrive at valuation.
IMPLIED PRICE: $25.5- $55.96
Recommendation
• Short history as a standing along company
• It’s hard to forecast whether the management is able to bring the
company out of current trouble
• Although multiple valuation gives a high target price, we are hesitant
to recommend a buy at this juncture in the company’s young history
Hold!
Thank you!