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Discover: Credit Where Credit Is Due
2009-02-14
During the era of easy money, Discover Financial Services was dismissed as a second-rate credit card company that lacked the cachet and retail acceptance of rivals. Its profits paled next to those of titans American Express and Bank of America (NYSE:BAC - News). The company's low-rent image was even lampooned on the Fox TV cartoon series Family Guy. Discover, the sixth-largest credit card issuer, is the one laughing now. Earnings jumped 57% in the past fiscal year, compared with a 34% decline at AmEx and a $46 million loss at Capital One Financial (NYSE:COF - News). The company is trying to capitalize on others' pain to gain market share and boost its international presence. "This is the classic tale of slow but steady winning the race," says Dennis Moroney, a research director at TowerGroup. Discover is performing better during the bust because of sound strategy -- and a measure of luck. In the later stages of the mortgage boom, while other issuers were still courting customers with multiple mortgages, Discover flagged borrowers with two home loans, keeping their credit limits low. As a result, say analysts, Discover has less exposure to the riskiest markets, including California and Florida, where borrowers' mortgage woes are translating into credit card problems. Those two states account for 15% of Discover's customers, vs. 26% for AmEx and 22% for Citigroup's (NYSE:C - News) credit card operation. "Managing our business conservatively has helped (us) weather a tough economic environment," says David W. Nelms, Discover's CEO. The newly independent Discover, for years the ugly stepchild of department store Sears (NYSE:S - News) and later Morgan Stanley (NYSE:MS - News), also benefited from a brand problem. Consumers, many of whom considered Discover an ancillary card, used it less often than their Visas or MasterCards -- or snubbed it altogether. It also didn't help that only some 65% of merchants take Discover, compared with near-ubiquitous acceptance for Visa and MasterCard. Those weaknesses have turned out to be strengths. Discover's total outstanding loan balances increased just 15%, to $47.5 billion, over the past three years. Peers' portfolios rose by 40% or more in the same period, a time when lending standards slipped. All that has served Discover well. Delinquent accounts stand at 4.7%, up from 3.7% last year. But that's mild compared with 7% or more at Capital One and others. Discover is "one of the few issuers where credit quality is going to outperform even optimistic expectations," says analyst Sanjay Sakhrani of Keefe, Bruyette & Woods. So while competitors are working to simply survive the credit crisis, Discover wants to grow. The company picked up a rival, Diners Club, for $165 million this past summer from Citigroup. Management plans to continue offering the card, which is accepted in 185 countries. The new platform should help Discover expand overseas, where it has been weak. Management is also trying to encourage customers to use their cards more frequently. It revamped its loyalty program for all cardholders last year, increasing cash-back earnings from 1% to as much as 5% in categories such as travel and home goods. Discover is also retooling the rewards program to strengthen existing relationships with merchants by enticing cardholders to spend more at specific retailers. For example, if a customer earns $30 in cash-back rewards throughout the year, the cardholder can decide to instead collect a $40 gift card at Macy's (NYSE:M - News). Says Nelms: "I couldn't be more enthusiastic about Discover's position to seize the many opportunities that will come."
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