What Investors Should Know About the Capital One-Discover Deal | Investing

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Key Takeaways:

  • On Feb. 19, Capital One announced plans to acquire Discover in an all-stock deal valued at $35.3 billion.
  • One of the key benefits Capital One is gaining by acquiring Discover is Discover’s payments network, its unique communication system that connects banks with businesses and allows them to process customer credit or debit card purchases.
  • Capital One expects the acquisition to close in late 2024 or early 2025, pending approval by shareholders and regulators.

On Monday, Capital One Financial Corp. (ticker: COF) announced plans to acquire Discover Financial Services (DFS) in an all-stock deal valued at $35.3 billion. Capital One and Discover are two of the largest U.S. credit card companies, and the combined company would potentially serve as a formidable competitor to industry leaders Visa Inc. (V) and Mastercard Inc. (MA).

Capital One says the deal will help the company leverage its large customer base, technology and data collection to generate more sales for merchants and better deals for small businesses and credit card users. But critics of the acquisition are concerned it could reduce competition in the credit card market, potentially resulting in higher fees and credit costs for card users.

Acquisition Details

If the all-stock acquisition deal is completed, Discover shareholders will receive 1.0192 shares of Capital One stock for each share of Discover stock they own. The acquisition price represents a roughly 26.6% premium to Discover’s closing price of $110.49 on Feb. 16.

Capital One estimates the combined company would have more than 100 million customers and serve 70 million merchants in more than 200 countries and territories around the world. The company anticipates about $2.7 billion in pre-tax deal synergies and says the acquisition will boost adjusted non-GAAP earnings per share by greater than 15% by 2027. Capital One also says the post-deal company will generate a 16% return on invested capital with an internal rate of return in excess of 20% in 2027. The deal will also potentially improve Capital One’s balance sheet by adding high-quality deposits that improve key capital ratios.

Capital One has said it intends to maintain the Discover branding on at least some of its credit cards. Capital One expects the acquisition to close in late 2024 or early 2025, pending approval by shareholders and regulators.

As of Feb. 20, the combined company would have a market cap of about $83 billion compared to Mastercard’s $421 billion and Visa’s $552 billion. Shares of Discover traded higher on Tuesday following the announcement, while Visa and Mastercard shares were lower.

Pros and Cons of Capital One Acquiring Discover

One of the key benefits Capital One is gaining by acquiring Discover is Discover’s payments network, its unique communication system that connects banks with businesses and allows them to process customer credit or debit card purchases. While Capital One is one of the largest banks and credit card issuers in the U.S., it currently relies on the payment networks of Visa and Mastercard to process credit card transactions.

Because Discover credit cards are primarily cash-back cards and Capital One cards offer a variety of rewards, the acquisition could lead to better rewards offerings from both companies.

The combined company would hold about $267 billion in credit card loans compared to $211 billion for JPMorgan Chase & Co. (JPM), making Capital One the single largest U.S. credit card lender. Given Capital One’s access to Discover’s payment network, Capital One may be positioned to negotiate better deals with Visa and Mastercard for use of their networks, potentially lowering costs for customers and merchants.

While Capital One will likely continue to argue that the acquisition is good news for customers and merchant partners, Sen. Elizabeth Warren – who serves on various financial oversight committees – has called for regulators to block the acquisition:

A recent report by the Consumer Financial Protection Bureau found the 25 largest credit card issuers charge customers interest rates that are 8 to 10 percentage points higher than small and medium-sized banks and credit unions.

Warren and other critics are concerned about the potential for consolidation in the credit card industry to reduce competition and increase costs for customers, but blocking the Capital One-Discovery deal could also be seen as helping Visa and Mastercard preserve their market dominance.

The two companies reportedly hold a combined 83% of the credit card processing market and are even the target of a bipartisan bill that would require the largest bank credit card issuers to offer at least one credit card network option to merchants that is not Visa or Mastercard.

Kevin Kennedy, an analyst at research firm Third Bridge, anticipates a lengthy regulatory discourse surrounding the proposed acquisition.

“On one hand, it benefits the proponents of the Credit Card Competition Act in providing an alternative routing option to Visa and Mastercard, while on the other hand it significantly consolidates the credit card lending industry in a way that could reverberate antitrust rhetoric from the (Federal Trade Commission),” Kennedy says.

Should You Buy Capital One Stock?

Despite the positive initial market reaction on Tuesday, Wall Street analysts say Capital One investors could be in for a bumpy ride in coming years.

Morningstar analyst Michael Miller says Capital One’s initial cost savings estimates seem reasonable, but there is also plenty of uncertainty surrounding the deal at this point.

“In general, we are neutral on the deal as we do see strategic value to it, particularly as it relates to Discover’s network,” Miller wrote in a Feb. 20 research note.

“That said, there will be meaningful integration risk and some uncertainty around regulatory approval, as the combined company would be the largest credit card issuer in the U.S. by loan volume.”

Morningstar has a “hold” rating and $153 fair value estimate for Capital One stock, which closed at $137.39 on Feb. 20.

Bank of America analyst Mihir Bhatia says the Discover network is clearly the prime motivation for the acquisition, but Capital One could also improve the quality of its credit card loan portfolio.

“Our conversations with industry experts and the company itself suggest COF has historically specialized in near-prime and super-prime underwriting, so DFS’ prime-heavy card holder base could be a nice strategic fit,” Bhatia wrote in a Feb. 20 note.

He doesn’t anticipate regulators will block the deal.

“Given the highly competitive credit card industry with many large banks having a strong presence, we think anti-trust concerns appear largely manageable,” Bhatia wrote.

Furthermore, he says the combined company would be well positioned to generate high returns on equity, allowing it to quickly build up capital to ease concerns of regulators.

Bank of America has a “buy” rating and $146 price target for COF stock, implying a 6.3% upside from its Feb. 20 closing price.

As far as impact on the competition, Bhatia estimates that Mastercard could lose about 25% of its U.S. credit volume and Visa about 9% of its U.S. volume in a theoretical worst-case scenario where all of Capital One’s credit cards start using the Discover network.

In addition to volatility in Capital One and Discover shares tied to the acquisition proposal, the news may prompt further consolidation in the credit card industry as other companies seek their own consolidation deals.

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