INSIGHT-Discover’s card processing network hides value

* Mobile phone venture could boost Discover profile

* Analysts see potential value in selling network

* CEO: Discover network ‘valuable to our shareholders’

* Discover shares trading up 1.7 percent on Tuesday

By Maria Aspan

NEW YORK, Aug 31 (BestGrowthStock) – Discover Financial Services
(DFS.N: ) is best known as a credit card lender, but it also has
a transaction processing business that could give a jolt to the
company’s share price, analysts said.

The network is small by comparison to Visa (V.N: ) and
MasterCard (MA.N: ), but Discover could boost its profitability
by working with telecom companies to process payments on mobile
phones.

The credit card company could even choose to sell its
transaction processing unit at some point, giving more than a
billion dollars of value to a company whose market value is
currently around $8 billion, analysts said.

For now, Discover has no plans to sell the processing
business, the company’s chief executive told Reuters.

Discover’s network “is becoming more and more valuable to
us and our shareholders,” CEO David Nelms said in an
interview.

Nelms is following a strategy similar to American Express
Co (AXP.N: ), which like Discover processes transactions over its
network and makes credit card loans.

American Express expects much of its future growth to come
from processing transactions, which is seen as lower-risk than
lending.

Transaction processing networks like Visa and Master Card
make their money by sending information between a merchant’s
bank and a consumer’s.

Every time the consumer swipes a credit or debit card — or
makes a purchase using a mobile phone — the networks and their
bank partners receive about 2 percent of the purchase amount in
processing fees.

The network of merchants that accept Discover cards — and
generate processing fees for the company — is about the same
size as American Express’s, analysts said.

But Discover cards are accepted at fewer high-end merchants
than American Express’s, limiting the processing fees Discover
receives, which may be why investors don’t assign much value to
its network.

Discover shares currently trade at about eight times
estimated 2011 earnings, while Capital One Financial Corp
(COF.N: ) shares trade at about nine times estimated earnings,
said FBR Capital Markets analyst Scott Valentin.

In other words, Capital One, which does not have a payments
network, gets a higher earnings multiple than Discover, which
does.

Discover is still poorly understood by investors, even
after three years as an independent company, Valentin said.
Morgan Stanley (MS.N: ) (Read more about the money market today. ) spun it off in June 2007.

MOBILE WALLET

The payments network could be a real source of growth for
Discover, as mobile phone companies look to turn cell phones
into the wallets of the future. In Asia-Pacific countries like
Japan and South Korea, consumers already use their phones to
make $11.7 billion of payments a year, or almost ten times the
amount of mobile payments made in North America, according to
the research firm Gartner Inc.

Discover is working with Verizon (VZ.N: ) Wireless, AT&T
(T.N: ) and T-Mobile [TMOG.UL] USA to form a joint venture aimed
at offering mobile payments services, people familiar with the
matter told Reuters. [ID:nN19102622]

That type of joint venture could generate additional
processing revenue for Discover. Gartner estimates that North
American consumers will be using their cell phones to make
about $23 billion of payments by 2014, making this area one of
the fastest growing in payment processing.

Discover’s potential joint venture will not have an
immediate impact on its earnings, but it could help the company
get a foothold in the market, FBR’s Valentin said.

“It validates Discover,” he said. “If you’re the two
biggest mobile networks in the U.S., you’re not going to choose
a weak network.”

Discover’s Nelms would not discuss the reports of the joint
venture during an interview last week, except to say that
Discover is focused on mobile and “we’re talking to a number
of” potential partners.

APPEALING TARGET?

Alternatively, Discover could sell its network, and unlock
the value for shareholders immediately. Sandler O’Neill analyst
Michael Taiano believes the network could be worth about $1.4
billion, which is material for a company whose market cap is
about $8 billion. Discover shares were trading up 1.7 percent
at $14.56 late on Tuesday morning.

If Discover is unwilling to sell the processing business
alone, potential acquirers might instead buy the whole company,
analysts said.

Discover would be “appealing for a large international
company or another large bank,” especially once banks have
complied with new global capital requirements, said Jason
Arnold, analyst at RBC Capital Markets.

Large U.S. banks could be interested in buying Discover’s
network as a way to process their own transactions, instead of
paying Visa or MasterCard to do it, he said.

Philip Philliou, a payments consultant and former executive
for MasterCard and American Express (AXP.N: ), said, “There’s a
tremendous opportunity for someone to partner with, acquire or
somehow leverage … this potentially very valuable network
that just seems to be incredibly underestimated.”

Discover has already tried to expand its international
processing business through joint ventures and acquisitions. It
bought the travel-and-entertainment network Diners Club
International from Citigroup Inc (C.N: ) in 2008, and has signed
processing partnerships with Japan’s JCB network and China
UnionPay.

Discover is also competing with more traditional banks by
expanding its other financial products, including private
student loans and online deposit accounts. Those deposits now
account for about a third of Discover’s total funding.

Nelms plans to eventually offer most of the products that
customers can find at more traditional competitors, including
“a Discover home loan product or a Discover checking account
product,” he said.

But buying a traditional bank branch network is not in the
cards.

Direct online banking is “of the future,” Nelms said. “Why
would I want to buy something that’s of the past?”
(Reporting by Maria Aspan, editing by Matthew Lewis)

INSIGHT-Discover’s card processing network hides value