Now May Be The Best Time For Wells Fargo To Consider Acquiring Discover

The idea of Wells Fargo (NYSE:WFC) potentially acquiring Discover Financial Services (NYSE:DFS) has been around for several years now (see Wells Fargo & Discover: A Deal Waiting To Materialize?). But if the U.S. banking giant is interested in making a deal for the card issuer, then now may be the best time to do so. Besides being a strong strategic fit, a potential deal will go a long way in mitigating the slowdown in Wells Fargo’s new card issuances in the aftermath of its fake account opening scandal (see Wells Fargo’s Account Opening Scandal Weighs On Q1 Results; Impact Likely To Linger). At the same time, market sentiment towards the card industry in general has turned negative over the last few weeks due to an unexpected increase in card loan charge-offs – something that has led share prices for all major card lenders tumbling (see Card Charge-Off Rates For The Largest U.S. Issuers Rising Faster Than The Industry).

While an acquisition of this size could face some regulatory hurdles – especially given Wells Fargo’s recent misgivings – we believe that if a deal goes through successfully, then it could unlock considerably value for shareholders at Wells Fargo as well as Discover.

See the full Trefis analysis for Wells Fargo | Discover

Discover Represents The Missing Piece In Wells Fargo’s Business Model

Discover is currently the 5th largest credit card issuer in the U.S. (see The Four Largest U.S. Card Issuers Now Hold 60% of All Credit Card Debt In The Country). While Wells Fargo has the largest loan portfolio among all U.S. banks, its credit card business is extremely small in comparison, with the bank being ranked 8th in terms of card loans outstanding. The bank has mentioned on several occasions that its long-term growth strategy involves focusing on issuing cards, which makes sense given the high yield margins on credit card loans when compared to other loan categories. And taken together, the combined card portfolio would make Wells Fargo the third largest player in the U.S. card industry after JPMorgan Chase (NYSE:JPM) and Citigroup (NYSE:C).

Wells Fargo also has a negligible presence in the country’s payment processing industry. In fact, its substantially smaller rival U.S. Bancorp generates much higher payment processing fees. This would also change if Wells Fargo were to acquire Discover, as the latter is the 4th largest payments processing network after Visa (NYSE:V), MasterCard (NYSE:MA) and American Express (NYSE:AXP). The combined entity would be able to leverage Wells Fargo’s strong retail banking presence as well as Discover’s end-to-end card processing capabilities.

In addition to all of this, a deal would also add about $15.5 billion in non-card loans to Wells Fargo’s balance sheet – including about $9 billion in student loans and another $6.5 billion in personal loans.

A Deal Would Bring Risks, But They Could Be Managed

As we pointed out earlier, the biggest hurdle to a potential acquisition of Discover by Wells Fargo will be the intense regulatory scrutiny it will attract. Regulators have been known to be averse to inorganic growth by large banks, and as Wells Fargo is a global systemically important financial institution (SIFI) it would have to go through a stringent regulatory review. The account opening scandal has already called into question the bank’s internal control processes, which would only make getting approval more difficult.

Also, the sharp increase in card charge-off rates could continue in the future – presenting a sizable downside risk to Discover’s existing card loan portfolio. While this is definitely a possibility, we believe that any increase in card industry charge-off rates will be subdued in the future. As we pointed out in a recent article (see Concerns Over Increase In Capital One’s Q1 Loan Charge-Offs Are Overblown), the recent increase in card charge-off rates is essentially a normalization in the figure after it remained at a 20-year low of under 3% over 2015-16.

How Much Could Wells Fargo Pay For Discover?

To answer this question, it helps to start with the basic operating metrics for Wells Fargo and Discover. The table below captures our estimates for revenues and pre-tax profits (EBT) for both companies over 2017, and also highlights the implied forward P/EBT multiple assigned by investors to each company.

Notably, card-related revenues are expected to be just about 9% of Wells Fargo’s total revenues, as opposed to almost 85% of the total for Discover. It should be noted that Wells Fargo’s card fees also include revenues from its debit cards, which are greater than the fees earned from its credit cards. While we expect Wells Fargo’s total card balances in 2017 to average around $37 billion, the figure is about $60 billion for Discover. Additionally, the combined market value of these companies is currently just under $300 billion, with Wells Fargo enjoying a higher P/EBT multiple (8x) compared to Discover (6x).

To value the combined entity, we first added the individual items line-by-line to arrive at total revenues of $101.9 billion (simply the sum of our revenue forecasts of $92.4 billion for Wells Fargo and $9.6 billion for Discover, with a minor difference due to rounding). Next, we assume that all cost synergies are realized immediately on acquisition – helping the EBT Margin for the combined entity increase to 37.7%. This is a rather conservative estimate for the EBT figure, as it represents annual cost savings of just $300 million from the integration, which is roughly 8% of Discover’s total operating costs of $3.6 billion for a year. In reality, savings could potentially reach $600 million as marketing and other overhead costs for Discover could be almost completely eliminated, and total employee costs will shrink considerably as Discover’s credit card and personal loan divisions would be absorbed by the respective Wells Fargo units.

Using Wells Fargo’s P/EBT multiple figure of 8x, this implies synergy-related gains of almost $10 billion for the bank from a combination. This would allow Wells Fargo to bid as much as $32.4 billion to acquire Discover – a figure that is a good 42% higher than Discover’s current market cap of $22.8 billion. In other words, despite our conservative estimates, Wells Fargo could potentially gain even if it acquires Discover at $85 a share. Notably, Discover’s shares have historically traded at a high of $74 (in January 2017), with the estimated maximum acquisition price coming in a good 15% higher than that record level.

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