Capital One buys Discover - now what? (Finale)

Just over a week after the big news, we come to the end of this series. I didn’t expect this to go multiple parts and especially not four, but I can’t help but find it compelling (for reasons that I think you’ll have already figured out by now). In this final part, we review the implications of the deal on merchants and what it could mean for rewards as a result, along with the bonus round of digging into the 10-Ks of each company, which were released on February 23 and contain some interesting truths about where the companies see risk in this acquisition.

Merchant and Rewards Implications

One of the points that was touted on the shareholder call last Tuesday by Cap One CEO Richard Fairbank was the huge merchant-related synergies that would result, citing its Capital One Shopping product as something they have already offered to merchants (their deal shopping tool that steers customers towards those merchants that are on this platform) and note that with the Discover network in the fold, they can offer even more “customized support” for these merchants which was cited as better fraud management, improved authorization, and access to more data/consumer insights. The only problem? These merchants already had that with Discover - is the lift from a combined organization really going to be as significant as the other side of the equation (which we talked about last time) where merchants have to pay higher interchange when Cap One debit customers get shifted to Discover (thanks Durbin)?

Furthermore, merchants likely aren’t exactly feeling too great towards Discover these days because of the 16-year-long $375 million merchant pricing problem they are just beginning to remediate. There is also a class-action lawsuit in progress on this topic and a shareholder derivative lawsuit that includes this issue as well, citing Discover leaders and directors current and past as co-defendants. The most that I could realistically see Capital One doing is saving Discover from a long, drawn-out remediation process and legal saga by not only throwing money at the remediation but also swiftly settling these lawsuits to move forward. But it’s not a great starting point and doesn’t as much bring synergies as it does clear the board of all potential headaches.

On the flip side, Capital One’s attention to technology innovation that has helped their infrastructure can now potentially be turned towards competing with Visa and Mastercard, namely with Visa Direct’s cross-border payment solution and Mastercard’s moves into open banking, crypto, identity verification and more. Any additional advances here will just give acquirers more options to benefit from beyond just being able to have their merchants engage with cards. Yet another example of where the story is much brighter and makes a case for competition if Capital One focuses more on what it can do to compete with Visa and Mastercard, rather than talk about the issuing advantages it will have over everyone else. While I still think the deal happens, focusing more on the issuing side including interchange will likely ramp up the likelihood of more questions and the chance that the deal doesn’t pass.

From the rewards perspective, it’s worth mentioning that these programs are not free for issuers. Rewards basically come out of interchange. From a debit perspective, you can see with the ability to be exempt from Durbin that Capital One will benefit handsomely with a reduction in interchange and things will be looking super rosy for consumers (assuming Cap One doesn’t pocket all the savings) from a rewards perspective. From a credit perspective, Capital One appears to be pretty loaded on the rewards front, with fee and non fee cards in its arsenal that offer up to 8% cashback so if you’re a fan of your rewards, I wouldn’t expect too much to change.

However, Nerdwallet’s Melissa Lambarena raises a good question, asking whether rewards programs from both companies will have any opportunity to be combined once the deal goes through. This could be an awesome win for Discover cardholders and perhaps for Cap One cardholders who may get an opportunity for more usage of cashback at higher rewards rates. However, I don’t expect that to last long if at all, since giving more consumers more access to more rewards will come at a great cost to the company. I expect initially to get folks excited they’ll boast of cross-issuer benefits but then will scale them back once they’ve achieved usage targets.

Somewhat unrelated and a little more broad, she also raises past examples of relatively botched issuer transitions, citing Costco’s move from Amex to Citi (2016), Walmart’s move from Synchrony to Capital One (2019), and AARP’s move from Chase to Barclay’s (2020). While these are all instances of cobranded cards and not primary cards like all of Discover’s are, the Walmart move to Cap One shows that Cap One has some prior history of being on the receiving end of rocky conversions; with this conversion arguably being the most alarming of the three she cites due to the fact that customer credit scores somehow declined when the cards changed from Synchrony to Cap One. Can customers expect similar drama if and when there is some issuer conversion? We know network conversion is coming for sure, but what if some of the “lesser known” Discover cards (i.e. miles, student, gas/restaurant) get converted to Cap One equivalents?

10-K Revelations

This next area is why we stretched this series to four parts. Discover and Capital One both released their 10-Ks, or annual reports for the prior year, on the same day - February 23 - one week ago today and just four days after the big announcement. The section to look at is “Risk Factors,” which is a typical section in any 10-K full of goodies, but is particularly fascinating for both companies given the deal. We decided to create a comparison table which puts both companies’ risk factors for the deal up against each other:

It is pretty interesting to see the similarities and differences in focus when you line them up against one another. Some thoughts:

• Discover is unique in that it calls out failure to complete the merger as a risk in and of itself and then separately for the resulting losses if it doesn’t go through. By comparison, Capital One doesn’t have a single risk solely dedicated to the deal not happening - potentially indicating just how confident they feel about the company’s future regardless of whether or not the deal happens. It doesn’t call this out specifically, but one point that made headlines last week was that if Discover pulled out of the deal or found another buyer, they would have to pay Capital One $1.38 billion; the only way the fee doesn’t apply is if the regulators reject the deal. This comes out to about 4% of the overall deal price tag of $35 billion, which is about the same as what BB&T and SunTrust agreed to when proposing the deal that eventually led to Truist. Surprising that this explicit point isn’t mentioned, but to be fair the reputational damage would be significant if the deal fell apart and given Discover is already dealing with some big issues with its regulatory matters (noted last time) and given that it is already selling off businesses (student loans) and just beginning the tenure of what was likely a CEO appointed just to oversee the sale, it would be in dire straits if it had to go back to handling all these issues with $1.4 billion less to work with.
• Perhaps Capital One is being more broad, but Discover has two stand alone risks focusing on its shareholders while Capital One has none. One focuses on shareholder litigation and specifically on litigation related to the deal (Discover is likely spooked because of already having to deal with the aforementioned shareholder derivative lawsuit). Another focuses on potential loss to DFS shareholders due to fluctuation of Capital One stock price, which Capital One only briefly touches on potential impact to the stock as part of another risk but not to shareholder dissatisfaction; rather to “results” which seems to indicate their priority being at a more overall outcome level rather than at a “who are we serving” level.
• The people part is the most interesting section of this whole thing. On the surface, it appears Discover is highlighting the value of their employees by devoting a standalone risk to them, and even noting the same for Capital One employees, saying that retention of both sets of employees is important. However, digging further into the details of this risk Discover’s focus is almost entirely on expertise and knowledge lost, which makes sense from my own experience as I’ve known and have worked with a number of folks who have been with Discover for a long time - some even for decades (known affectionately as “Dawners” - referring to the “Dawn” of Discover in 1985).And then comes the biggest punchline of this whole series - while Capital One doesn’t have a stand alone risk on employees, they make some bold statements that seemingly indicate just how much they are actually worried about the employee situation going sideways - I’d argue they go farther than Discover does at any point in their 10-K - some good, some bad, all fascinating. Some highlights:“We have incurred and expect to incur a number of costs associated with the Transaction and the integration of Discover. These costs include…severance/employee benefit-related costs…”“The success of the Transaction…will depend…on our ability to…successfully integrate Discover into our…corporate culture. The process of integration operations could result in a loss of key personnel…”“Employee retention may be challenging for Discover before completion of the Transaction, as certain employees of Discover may experience uncertainty about their future roles with us following the Transaction, and these retention challenges will require us to incur additional expenses in order to retain key employees of Discover. If key employees of Discover depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with Discover or with us following the Transaction, the benefits of the Transaction could be materially diminished.” In these quotes, you get an almost-confirmation of what’s to come - a) There will likely be layoffs based on the comment about severances. b) Capital One’s corporate culture is going to be the primary guide for the combined company. c) They are really worried about “key” employees leaving - read between the lines, and it likely a reference to the payments/network folks whose knowledge is essential to help the Cap One team understand how everything works and the possibilities for integration. d) The Discover employees they want to keep are going to get big raises/retention bonuses. e) They expect it to be a slog trying to bring the companies together from a technical/operational perspective. Make of all that what you will - perhaps it doesn’t tell us anything new, but seeing it in a legally filed document, even as "just” risks, from Cap One themselves no less, seems to solidify and give us a roadmap of what they are thinking and what the future holds.

Conclusion

And with that note, we have reached the end of our coverage of the Capital One/Discover deal. This series started with humans, and it ends with humans as you can see in that last part. We touched on regulations, operations, customers, shareholders, and employees, merchants, rewards, and so much more. Now we sit back and wait to see whether anyone backs out, if this deal is approved, what happens when the companies try to integrate after approval, and the long-term outcome for everyone interacting with the combined behemoth of a firm. Thank you for sticking with us, and hope you enjoyed it!

We normally don’t publish this frequently, so we will back away from your inboxes a bit and resume our weekly analysis schedule, but stay tuned for some big announcement coming soon about some exciting happenings from us this April!