Capital One shocked investors and the financial community last week when it announced a definitive agreement to buy Discover Financial in a $35.3 billion all-stock deal. It’s a very smart move and here is why:

The Discover Network

As a lender, most of Cap1’s revenue is related to credit risk. Essentially, the more profitable customers are usually the riskier. Finding lucrative customers without taking on too much risk is an art and a challenging endeavor which, if managed improperly, could inflict significant financial damage. With Discover, Cap1 can be an alternative network for other banks, generating “easy” money that is not based on managing credit risk. For reference, Visa has a gross and operating margin of 98% and 67% respectively, without having to obsess over whether a borrower is credit worthy. If you ran Capital One, would you welcome that kind of additional revenue?

As an issuer bank, Capital One earns interchange revenue from merchants on every transaction. In a deck presentation to investors, the bank said that owning a network enables them to work more closely with merchants and be more flexible, instead of being at the mercy of Visa or Mastercard. I get the sentiment, but I doubt they can realize this idea any time soon. The primary reason why I am skeptical is that merchants care more about the popularity of a network than anything else. If a network is not used by millions of consumers (like Discover), then what’s the point of new innovative features?

Additionally, because Discover is exempt from the Durbin rule, their debit interchange rates are not regulated like financial institutions with more than $10 billion in assets. Moving the debit purchase volume to the Discover network will result in meaning extra interchange revenue for Capital One. Let’s say, if the bank moves $150 billion of debit purchase volume over to Discover and earns 100 more basis points in interchange rates, the windfall will amount to $1.5 billion. Not bad, heh?

Last but not least, this move can help Capital One prepare for the Credit Card Competition Act. The proposed law mandates that any card issuer with more than $100 billion in assets must use one other network in addition to Visa/Mastercard. Owning Discover will make Capital One a strong candidate for “the other network” and compete directly with American Express. Right now, the Act is still in limbo, but hey, it doesn’t hurt to have optionality.

Strategic Fit

The Discover brand is better known in the US than overseas. Between the two companies, Capital One is clearly THE master in marketing and branding, evidenced by its catchy “What’s in your wallet?” slogan and effective marketing campaigns . Hence, it makes sense to let the acquirer take the reins and market the Discover name globally. If the ultimate intention is to build a worthy alternative to Visa or Mastercard, there is no better option than letting Cap1 lead the combined entity. If Discover brings a payment rail to the table, Cap1 brings marketing expertise to help scale it.

In the credit card space, the two companies complement each other. Discover has a strong presence in the student and thin-file market, but lacks products in the high-end and co-brand segment. On the other hand, Cap1 has a decent affinity portfolio and is attacking the premium segment with the Venture line-up, new airport lounges and the acquisition of Velocity Black, a digital concierge company. As a result, the combined company has the capability to offer products to all consumers across the credit profile and income spectrum. Richard Fairbank made an interesting observation that further highlighted the strategic fit of this acquisition:

Discover has been more of a mid-market kind of broad national focus as opposed to going after the very top of the market. So in that sense, we don’t get a lot of scale on that. But we do — but still indirectly, we get a lift on things like brand scale because here’s the thing that we have found, when we are advertising and pushing our heavy spender products it provides lift for the whole company because building an aspirational brand lifts all aspects of a company. So while it’s not a direct lift on our upper end strategy, it actually indirectly will provide quite a bit of scale benefit to that quest and that quest will absolutely continue

Scale, Scale, Scale

Per Richard Fairbank, the CEO of Capital One:

Bringing together the Capital One and Discover credit card businesses will unlock tremendous value as we take advantage of the benefits of scale in a business in which scale is critical. Scale really matters in consumer financial services. In addition to the classic operating scale, the business requires high levels of investment, which are independent of volume, underscoring the importance of technology scale, information scale and brand scale.

The credit card business is — and I think this really applies to consumer financial services businesses in general, but certainly to credit cards, are very scale-driven, and I think, in many ways, more scale-driven than a lot of other parts of banking, for example, small business banking, even commercial banking tends to be a little bit more fragmented across many banks. But what’s happened on the consumer side, the reason there’s been more consolidation is just the underlying just incredible power and physics of scale. 

And when you think about it, it’s — there’s obviously operating scale, but virtually every business has operating scale, but we’re talking about tens of millions of customers. When you get into those kind of numbers the scale economies become pretty big, but the operating scales, the less significant scale actually in the math to me compared to the — some of the things that have even a higher fixed cost component like tech scale, data scale, and brand scale.

As the combined entity will have the largest credit card loan book in the US, it will have significantly increased bargaining power to negotiate with key partners. Visa and Mastercard will make concessions to compete for business from Capital One/Discover. Credit bureaus like Experian will also have to up their game and offer more finanlly friendly terms. Printing houses will surely offer discounts now that the mail volume from Capital One will grow significantly. Cloud providers, technology suppliers and marketing firms will also be more friendly.

These synergies, when combined, will bring about significant savings over time.

All in all, I think this is a smart move by Capital One. Very smart indeed. It shows the business is serious about challenging for the top spots in banking, credit card and payment networks. The question revolves around whether the deal will be approved by regulators. Two Senators (Hawley and Warren) already called for the deal to be nipped in the bud. However, I don’t think we can count out the possibility that the deal will go through. I suspect that the government could approve the deal because they hate the duopoly of Visa/Mastercard and want another player competing with those two giants.

Featured Image by Cytonn Photography on Unsplash