Credit and debit card issuer Capital One sees a path to make its blockbuster acquisition of Discover Financial even sweeter than investors currently expect it to be. It requires going abroad. At the heart of Capital One’s announced $35 billion all-stock deal for Discover, set to close next month, is Discover’s payment network – a rare asset in the U.S., with Visa , Mastercard and American Express as its primary rivals. By owning Discover, Capital One will become both a credit card issuer and a payment network operator, a lucrative setup that only American Express enjoys in the card business. Capital One’s new structure is expected to deliver billions of dollars in benefits — partially by using Visa and Mastercard less — and it is the main reason why the Club flocked to the stock earlier this year. It also will make Capital One the largest U.S. credit card issuer. The financial benefits could become even larger if Capital One is successfully able to expand Discover’s presence internationally. That was a key message that Capital One’s longtime CEO, Richard Fairbank, drove home on the company’s earnings call on April 22, just a few days after the deal secured approval from U.S. regulators. The comments offered investors a closer look at Fairbank’s vision for the soon-to-be combined company and, notably, how the merger could exceed its projection by 2027 of $2.7 billion in annual “synergies” — a catch-all term for the benefits added by a deal. Discover’s payment network generally trails Visa and Mastercard internationally. But if Capital One can close this gap, Fairbank said that would motivate the company to shift more of its Capital One-branded credit cards away from the networks of Mastercard and Visa than currently assumed in the synergy estimate. “When we announced the deal, we also said that we saw potentially significant long-term strategic and economic opportunities that we did not include in our synergy estimates or the deal model,” Fairbank said on the earnings call last month. “This would involve moving even more of our business onto the Discover network than what we put into the deal model. The path to get there is to build international acceptance of the Discover network and to enhance and elevate the Discover Global Network brand.” Global expansion of Discover’s network will create a “flywheel effect” for the combined business, the CEO said. “All roads lead through building more international acceptance and then really leaning into the global brand associated with that network,” he added. That should be music to long-term investors’ ears, even if the additional payoff takes time. COF YTD mountain Capital One Financial (COF) year-to-date performance Benefits breakdown Capital One has multiple levers to pull to unlock value from Discover even before a bigger international push comes into play. The company’s estimate of $2.7 billion in annual synergies by 2027 has two main buckets: Expense savings and network benefits. The company sees around $1.5 billion of synergies on the expense side — specifically, that figure includes 26% savings on Discover’s operating expenses and 10% of its marketing expenses, partially offset by some investments in Discover’s network. Capital One hasn’t detailed how, exactly, those costs will be reduced, but headcount reduction is typically part of a merger this size. “You don’t need two CFOs or two CEOs anymore. You don’t need two HR departments,” Bank of America analyst Mihir Bhatia said in a CNBC interview. He also pointed to more efficiency with infrastructure and bulk discounts for Capital One as a result. On the network side, Capital One expects synergies to the tune of $1.2 billion by 2027. The key to achieving these benefits is moving payment volume onto the Discover network that previously ran on Visa and Mastercard, saving on some fees previously paid to those rivals to facilitate the transactions. Bringing the Discover network in the fold will generate “significant revenue that doesn’t come with assets or credit risk, driving both growth and diversification of our revenue,” Fairbank said last year on an investor call after the deal was first announced. “Owning a network allows us to enjoy the benefits of vertical integration,” the CEO said. “Owning a network allows us to deal more directly with merchants rather than a network intermediary, create more value for merchants, small businesses and consumers, and capture the additional economics from vertical integration.” While Capital One plans to shift its entire debit-card volume over to the Discover network, only “a portion” of its credit-card business will be moved away from Mastercard and Visa to begin with, Fairbank said on the April 22 earnings call. In other words, Capital One will still lean on Mastercard and Visa – albeit less so than before. Debit card advantage Capital One’s debit-card business will receive a distinct regulatory benefit from running on the Discover network: It will no longer be subject to the so-called Durbin amendment, which put a cap on the swipe, or “interchange”, fee that can be charged for each debit-card transaction in an attempt to lower costs for merchants and consumers. The amendment was a part of a sweeping Wall Street reform following the 2008 financial crisis and named after Democratic Illinois Sen. Richard Durbin, who announced his retirement late last month. The way the legislation was written, though, made it so the cap on swipe fees exempted companies that both issued cards and operated a network, and American Express and Discover are the only ones. “As a result, [Capital One] will be able to charge more,” said Bhatia, who has a buy rating on Capital One’s stock. “Our analysis suggests that the difference is pretty meaningful.” In a note to clients earlier this year, Bhatia estimated that Capital One could generate more than $500 million in additional revenue by moving all of its debit volume to Discover’s network. That projection is based on Capital One’s 2023 debit volumes of $66 billion and Discover’s 1.26% swipe fee on debit transactions compared with 0.49% for Mastercard. Capital One’s ability to exceed the initial deal targets will not come overnight, though. It could take at least three to five years to build Discover’s international presence in a materially larger way, according to Bhatia. Capital One must build more partnerships to convince large swaths of merchants to accept Discover’s network. “It is hard to imagine [Capital One] executing it in the short term. It’s just a heavy lift. You think of someone like American Express. They’ve been trying to raise international acceptance for years. It just takes time because you have to go country by country, city by city,” Bhatia said. “Outside the U.S., people just don’t know the Discover brand [yet]. You have to make sure people understand.” Bottom line In the near term, however, Jim Cramer believes the benefits of the Discover acquisition should start showing up in Capital One’s share price. The Club initiated Capital One on March 6 and has been building the position gradually over seven subsequent buys. We most recently added shares on April 21 , the first day of trading after the deal cleared its final regulatory hurdle. “I would say that this still is the stock that has the most possible upside in the next month [out of the Club’s portfolio],” Jim said during last Wednesday’s Morning Meeting. “We are going to have more synergies when the deal closes in May.” (Jim Cramer’s Charitable Trust is long COF. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . 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Capital One and Discover credit cards arranged in Germantown, New York, US, on Tuesday, Feb. 20, 2024.
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Credit and debit card issuer Capital One sees a path to make its blockbuster acquisition of Discover Financial even sweeter than investors currently expect it to be. It requires going abroad.