How Is Discover Financial’s Business Model Different From Visa’s?

In a recent article, we looked at card giant Visa’s (NYSE:V) business model. The company’s cards are issued by banking partners and used by cardholders to purchase goods or services from a merchant via an electronic transaction. In this article, we compare Visa’s model with that of another card company, Discover Financial (NYSE:DFS).

Discover has been expanding its direct banking services offering personal, home and student loans but credit cards remain its most important business; credit card loans account for 80% of the company’s loan portfolio.

Our $46 price estimate for Discover Financial implies a discount of 20% to the current market price.

See Our Full Analysis for : Discover Financial|Visa

A Recap Of Visa’s Model

Once a cardholder uses a Visa card to carry out a transaction, information is transferred via Visa’s network to the issuer bank and to the merchant’s bank, known as the acquirer, for authorization. The acquirer sends a clearing file containing transaction data which is processed for the final settlement between the issuer and the acquirer. This three-step process is known as authorization, clearing and settlement and is the primary service offered by Visa through its network. Visa also offers value added services like account level processing, loyalty reports and dispute resolution.

When a Visa credit card is used by a consumer, he or she is issued a loan, the risk of which is borne by the issuer and not Visa. The issuer earns interest from the cardholder on the loan and also charges a card fee for the use of its card. The interest rate and the fee are decided by the issuer. The merchant is charged a merchant discount fee by the acquirer. On purchase transactions, acquirers are required to pay an interchange reimbursement fee to the issuer bank. Visa does not earn any of the aforementioned fees. Instead, it charges data processing fees and service fees from its financial clients. These fees are charged on the basis of the volume of transactions processed of a client and the gross dollar volume of the transactions. Visa’s business is thus volume dependent; the more times the company’s cards are used, the more it earns.

What About Discover?

Discover has a closed-loop network, acting both as the issuer and acquirer. Unlike Visa, Discover issues credit cards directly to consumers, allowing customers to maintain revolving credit card balances on which the company earns interest. This interest income accounts for more than 60% of Discover’s revenue.  Discover also earns discount revenues from merchants and fees for late payments, cash advance transactions and balance transfer transactions from cardholders. Fees and interest rates are set in contractual agreements with merchants and cardholders.

Discover’s Strength

Unlike Visa, Discover’s business is not volume driven but is more reliant on the loan balance that the company is able to maintain and the interest it can earn on this balance. Therefore, it is important for Discover to promote the use of its cards over those of competitors. To this end Discover’s main strength is its Cashback Bonus rewards program, which allows cardholders to earn rewards when they use Discover credit cards. Some of the most popular products offered include:

1)      Discover IT card and Discover More card, which offer 5% cash back on various categories which change throughout the year.

2)      Discover Open Road Card, which offers 2% cash back on the first $250 spent in combined gas and restaurant purchases each billing period.

3)      Discover Motiva card, which offers cash back of 5% of interest charges each month for making on-time payments.

4)      Discover Business card, which offers 5% cash back on the first $2,000 spent on purchasing office supplies each year.

Note: Discover does not report the cash returned to customers as an expense item but records it as a reduction in fee revenue.

Through 2013, Discover was able to maintain a 4% card receivable growth rate, higher than the overall market growth of 1%. ^[1] The company’s share of the total outstanding revolving consumer debt went up from 5.3% at the end of 2011 to 6% in the last quarter and management expects future growth to be at the top end of the targeted 2% to 5% range. ^[2] Discover’s historical performance suggests that it will be able to achieve this target as the U.S. economy improves.

The Risk

Unlike Visa, Discover has to bear credit risk on the loans it issues to cardholders. This risk can be measured in terms of the delinquency rate, or the percentage of total loans that are past due, and the charge off rate, which is the percentage of loans that are considered unredeemable.

The 2008 recession shook consumers across the U.S. as credit card customers started paying off their loans in time in order to avoid being in debt during the financial crunch. The delinquency rate on credit card loans for all commercial banks in the U.S. dropped from 6.76% in the second quarter of 2009 to 2.39% in the fourth quarter of 2013. ^[3] In the same period, the charge off rate on credit card loans for the top 100 banks ranked by assets in the country dropped from 9.59% to 3.28%. ^[4]

Discover has maintained a good risk profile, and its credit card net charge-off rate was 2.09% during the fourth quarter of 2013 while the 30-day delinquency rate was 1.72%. Discover did not sell off any of its charged-off accounts after the recession and was able to record strong recoveries on its inventory of charge-offs as the U.S. economy recovered. As a percentage of average credit card loans, the provisions were around 2.76% in 2008 but increased to 6.63% in 2010. In 2011 and 2012, the company benefited from the aforementioned recoveries and its provisions as a percentage of average credit card loans fell to 1.54%. However, in the coming years, the company does not expect the same level of recoveries and is making adjustments to its loan reserves.  Provisions for loan losses increased 27% through 2013.  We expect a steady rise in the metric in the coming years as the market normalizes with the economic recovery and provisions reach pre-recession levels. You can modify the interactive chart below to gauge the effect a change in forecast would have on our price estimate.

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1. Consumer Credit Outstanding (Levels) [↩]
2. Discover Financial Services Management Discusses Q4 2013 Results – Earnings Call Transcript [↩]
3. Delinquency Rate On Credit Card Loans, All Commercial Banks, Board of Governors of the Federal Reserve System [↩]
4. Charge-Off Rate On Credit Card Loans, Top 100 Banks Ranked By Assets, Board of Governors of the Federal Reserve System [↩]