Capital One buys Discover - now what? (Part 1/3)
Assessing the implications for customers, employees, shareholders, and the tech.
As the dust settles on Monday’s bombshell of Capital One announcing their intent to buy Discover Financial Services, I’ve been watching the reactions pour in and feeling a mixture of things, as I worked there for nine years and had some unbelievable career growth opportunities there (and simply put, I learned a ton). Of course, this is Fintech Compliance Chronicles, and so as I share my own thoughts on this news, we’re going to add a compliance-tinted flavor to all this. Buckle up because we’re about to go on a ride.
Intro
Some key facts to set the stage:
Biggest global merger or acquisition in 2024, as the purchase price is $35 billion
Creates the largest credit card issuer in the country - currently the largest is JP Morgan Chase based on a number of metrics
Expected closure date post approval from shareholders and regulators is late 2024 or early 2025
Link to the announcement
Link to yesterday’s webcast and presentation to investors and analysts
Shareholders
From the announcement, “Discover shareholders will receive 1.0192 Capital One shares for each Discover share, representing a premium of 26.6% based on Discover's closing price of $110.49 on February 16, 2024. At close, Capital One shareholders will own approximately 60% and Discover shareholders will own approximately 40% of the combined company.” This sounds great and all, until you realize the deal hasn’t closed yet and won’t close for a while. Given the wildly short-term nature of the market and ebbs and flows, I don’t think this is the time to load up on Discover stock or sell all your Discover stock either (although given the 12% increase today, it’s tempting to think about).
Other considerations is that Discover has a higher dividend yield than Capital One (2.44% vs 1.76%), and in fact increased its dividend for 12 years straight while Capital One cut its dividend by 30 cents during the pandemic. Discover’s net interest margin was also almost double that of Capital One as of this time last year, which reveals an ability to come out ahead when considering investment vs debt decision making. While Capital One has the significantly larger valuation and its stock has performed much better especially in the beginning of 2024, these are some considerations and food for thought from a shareholder point of view.
Customers
The buzz on various comment sections, Reddit and Twitter is that this is going to be a bad move for customers. Many of them love Discover, and this is no surprise as even on the call yesterday, Capital One CEO/Founder Richard Fairbank acknowledged that Discover has been ranked #1 or #2 in J.D. Power's overall credit card customer satisfaction rankings for 17 years running and the deep loyalty the customers have to Discover.
What has made Discover special for all these years from a customer perspective? It’s the ideal “first time credit card” with a great method to introduce folks new to credit to consumer finance, it has a simple and straightforward rewards program (they invented cashback rewards), it has 24/7 US-based customer service, and it has no annual fees just to name a few things. These are all things that appeal to the average consumer, and from my own time at Discover I can tell you there’s a lot of pride at serving working class everyday Americans.
Sadly, all of those things could be in trouble. Capital One, even as recently as the call yesterday, reiterated that their focus continues to be on the “top of the market,” acknowledging that this is different from Discover’s focus on the “mid-market.” While they certainly have products that can appeal to middle class folks, their underwriting is reported to be “inquiry sensitive”, they clearly value fees as evidenced by a number of their annual fee products, and they have a different philosophy on rewards and customer service (as we’ll discuss a bit later).
Does this impact existing customers? Perhaps not and probably not for a while, but customers that haven’t experienced Discover before will probably find a much different experience 2-3 years from now once the deal goes through and integration is completed.
People
This is the part that is getting a surprisingly small amount of mention by not only both companies, in their announcements and the call, but in the media as well. The emotions and worry are palpable as evidenced by the massive response to my on-a-whim post on LinkedIn yesterday. Discover has anywhere from 15 to 20 thousand employees, with a big chunk of those working in five call centers in Utah, Ohio, Delaware, Arizona and Illinois.
More than anything else, the customer service agents are the lifeblood of the company. They are the prominent feature of their advertising. They allow the company to proudly tout their US-based, 24/7 customer service, and more than anything the vibe inside these spaces is incredible. While the atmosphere in any call center is daunting and intense, in my many years of visiting Discover call centers the experience was truly special and the agents genuinely believed in the mission of the company and were taken care of.
What lies ahead is uncertain - while the barely-two-month-old CEO Michael Rhodes (who you have to wonder if he’s ever visited a Discover call center yet - it was a regular occurrence for former CEOs Roger Hochschild and before him, David Nelms) offered that the company “intends” to remain committed to Chicagoland and “our national servicing presence,” these words ring hollow knowing that Capital One has outsourced all of its human customer service (not including their marketing-driven cafes and deposit-focused bank locations) to other countries, namely the Philippines - with the exception of that for Venture X, which is one of their premium offerings and for which customer service is based in Tampa. The fact that they have taken this approach is consistent with the philosophy around focusing on “top of the market” - essentially, if you pay a hefty annual fee, you’ll get US-based customer service. If you don’t, you’ll get outsourced service - while still good, says something about their view of American workers. It makes you appreciate Discover’s commitment to smaller, not-so-affluent local communities in Utah, Arizona, Ohio and Delaware and even more recently their investment to Chatham in the south side of Chicago.
As for folks outside of the customer service space, concentrated mostly in Riverwoods, it will be a challenging time as the influence and security of being “in headquarters” will begin to slip away. The most obvious point to note is that the overall Payments business, which has been touted as the crown jewel of the acquisition, appears to be not only safe but in store for massive appreciation and even expansion, especially including personnel. The truth is that very few folks in the industry are capable of running multiple networks, let alone one, yet those working on Discover Network, PULSE, and Diners Club International are able to do so and have been doing it for years.
On the other hand, outside the payments business it gets murky. We’ll discuss the state of the other products in a bit, but for the issuing business, it’s hard to see how the workforce is going to stay as-is, with redundancies likely existing in servicing (as previously noted), marketing, and back-end processes like underwriting, fraud and collections. Several indicators seem to give an idea of what’s to come, with the ominous statement made on yesterday’s call saying “We expect to reduce Discover's operating expenses by 26%,” along with the note that three board members from Discover will join the Capital One board.
While the deal for shareholders is nice as they become 40% over the combined company, for personnel the board representation seems like a good barometer - there are around 20K Discover employees and 55K Cap One employees. If the three board members join the existing 12 Cap One board members, that essentially means legacy Discover leadership has a 20% representation in decision making. Translated to the personnel, when I do the math it means this combined workforce is going to need to take at least a 6% cut to become the “right size,” meaning where Discover employee representation aligns to what the board looks like - 20% of the workforce. Right now the workforce distribution is closer to 26/74.
You can guess what is likely coming next.
Modernization of Technology
On a brighter note, the tech story is a huge win for both companies. Much of Discover’s card business relies on legacy software and hardware, which “just works.” While change management issues exist when new enhancements are attempted or teams try to build around this tech, the tools get the job done for the most part, while the attempts to modernize other newer products has been a massive pain that has been one of the reasons behind regulatory failures. One of the downsides of a stable yet legacy stack is that there’s no hope at introducing any cool new features to this back-end, ie improving speed of issuing bank transactions, changing and adding new fields, using AI to simulate and predict outcomes, coming up with more creative customer-friendly billing techniques, and so on - the reason for this is because of the age of this tech stack (some of it dating back to the ‘80s). You wouldn’t want to scrap it because of the track record of trying to do modernization and failing for smaller products, but you also recognize it’s been close to 40 years and that is a very long time.
While Discover has attempted a few internal tech conversions over the years and had mixed results, Capital One was all too proud to mention on the call that “for 11 years, we have worked to rebuild our technology from the bottom of the tech stack, up. We transformed our talent, transformed how we build software, migrated entirely to the cloud, modernized our data ecosystem and modernized the 1,600 applications that drive the company.” Bringing this sort of success to Discover systems will at a minimum, reduce the need for a number of unnecessary and aging tools, and ideally could lead to improved application and infrastructure performance.
The network acquisition is obviously a massive tech modernization for Cap One in and of itself, but more on that later.
Tomorrow or in the next few days, we’ll talk about Brand, Location, Products and more, with our grand finale to touch on the Compliance/regulatory elements of this deal.
Stay tuned for more! And please subscribe to us.