By Jian Wee Soh, Bharath Sivakumar, Aaren Tan, Arfred Garcia (Imperial College London) and Nancy Huang, Minh Ngoc Nguyen, William Hodgson, Joanne Zhu, Jingheng Xu, Enya Loo Yingshan, Kayley Maree Portelli (University of Melbourne)
Photo: rupixen (Unsplash)
Overview of the deal
Acquirer: Capital One Financial Corporation
Target: Discover Financial Services
Total Transaction Size: $35.3 billion
Closed Date: Q12025E
Acquirer advisor: Centerview Partners LLC (financial); Wachtell, Lipton, Rosen & Katz (legal).
Target advisors: PJT Partners and Morgan Stanley & Co. LLC (financial); Sullivan & Cromwell LLP (legal).
On February 19th 2024, Capital One Financial Corporation (“the Acquirer”) and Discover Financial Services (“the Target”) issued a joint press release detailing the agreement and execution plan of a merger between the two entities. Consideration will be wholly paid in scrip (shares) of the Acquirer, whereby Target shareholders will receive 1.0192 shares in the Acquirer per share owned; representing a premium of 26.6% to the Target’s closing price as of 16/2/2024 ($110.49). The Target’s Shareholders will expect to hold 40% of the combined entity.
Capital One have invested substantially in developing cutting edge technological payment systems and infrastructure over the past eleven years, which through utilizing Discover’s extensive customer base of over 70 million merchants across 200 countries, they expect to realise substantial returns to scale.
In the joint press release, the companies detail how they expect the combined entities financial position and performance to strengthen. Driven largely by cutting the Target’s operating and marketing expenses, the combined entity is expected to realise $1.5 billion in cost synergies in 2027. The deal is also expected to be accretive to adjusted non-GAAP EPS, translating to a return on invested capital of 16% and positive internal rate of return more than 20%.
“This acquisition adds scale and investment, enabling the Discover network to be more competitive with the largest payment networks” - (Capital One Financial Corporation)
Company Details (Acquirer - Capital One Financial Corporation)
Capital One Financial Corporation is a US based financial holding corporation with over $478.5 billion USD in total assets as of December 31, 2023. They operate across North America and the United Kingdom and offer a wide range of financial products and services to consumers, small businesses, and institutions.
Founded in 1994, headquartered in: McLean, Virginia (USA)
CEO: Richard Fairbank
Number of employees: 51,987
Market Cap: $53.5 billion (as at 13/03/2024)
LTM Revenue: $36.787 billion
LTM Interest Income: $41.938 billion
LTM P/E: 10.9x
LTM P/BV: 1.4x
Recent Transactions: Paribus (2016), General Electric Healthcare Financial Services (2015), HSBC’s US Credit Card Portfolio (2011)
Company Details (Target - Discover Financial Services)
Discover Financial Services (DFS), headquartered in Riverwoods, Illinois, is a leading financial services company with a focus on direct banking and payment services. It operates one of the largest credit card brands in the U.S. and offers various financial products, including credit cards, personal loans, private student loans, home equity loans, and deposit solutions like checking, savings, and retirement accounts. DFS owns the Discover Global Network, which encompasses its Discover, PULSE, and Diners Club International brands. It also provides payment processing and settlement services globally through this network. The company was initially founded in 1986 under the Sears, Roebuck and Co. umbrella and has since expanded, introducing products like the Discover Card and branching out into online banking and loan services.
Founded in 1986, headquartered in Riverwoods, Illinois
CEO: Michael Rhodes
Number of employees: 21,000
Market Cap: $31.3 billion (as of 03/05/2024)
LTM Revenue: $9.9 billion
Projections and Assumptions
Short-term consequences
This acquisition will form the sixth-largest US bank by assets and provide Capital One with ownership of one of the biggest payment processing networks in the US, allowing it to compete against the three larger networks: Visa, MasterCard and American Express. By bringing their processing network in-house, it could potentially lower costs, passing on that benefit to customers in the form of lower fees and more rewards.
Three Discovery Board members will join the new Capital One Board of Directors. In terms of product offerings, rewards and benefits could be extended across both Capital One and Discover cardholders, providing consumers with access to extended warranty, travel insurance and other products offered by Capital One’s extensive partnerships. The risk lies in the successful integration of business and operations, which is likely to be a costly operation. Other short-term effects include the dilution caused by the issuance of additional shares, costs due to unforeseen events and the complexity of business and other supervisory issues.
Upon announcement, the acquisition has received scrutiny from industry professionals regarding the likelihood of higher rates and fees due to the decrease in competition from the consolidation. Ultimately the success of the deal is reliant on whether it passes potential antitrust inquiries from regulators.
Long-term Upsides
The acquisition by Capital One of Discover is a long-term bet that the two can pave a way towards creating a globally competitive payments network, one in which can compete with the likes of the big three US-based networks, namely Visa, Mastercard and American Express. Despite Discover being available in over 200 countries and over 70 million merchant acceptance points worldwide, this move enables the company to acquire portions of a market which could be worth trillions in the future. There is anticipation that Capital One intends to switch all of its debit volume and share of credit card flows to Discover’s network, which carried out $550 billion transactions in the last year, and also shift dependency away from Visa and Mastercard in which they had been reliant on before. Capital One is renowned as being one of the only major banks with no fees, no minimums and no overdraft fees. This, coupled with Discover’s payment network, paves a way in which both companies can synergise their value propositions to scale up their distribution worldwide. Moreover, based on purchasing volume alone, the combined company would also be the third largest credit card issuer after JPMorgan Chase and American Express.
These long-term synergies are reflected in the synergies posted in the press release, where pre-tax expense synergies and pre-tax network synergies are expected to be $1.5 billion and $1.2 billion by 2027 respectively. ROIC is expected to be 16% by 2027, with an internal rate of return of exceeding 20%. There is also the benefit of the strengthening of Capital One’s balance sheet, where the combined company would have a CET1 ratio of approximately 14% upon closing of the deal.
Risks and Uncertainties
Currently, the merger faces regulatory scrutiny, with a letter from 13 congressional Democrats citing that the deal would harm consumers as it would lead to the combined company becoming the largest credit card lender by balance owed, potentially leading to higher interest rates and reduced competition in the subprime market. The long regulatory timeframe means the deal may not be completed until early next year.
Capital One has concentration risk in their loan portfolio as it has a high amount of consumer and auto loans on its balance sheet, with credit card loans making up 47% of Capital One’s loan portfolio. With Discover’s credit card loans making up 79% of its loan portfolio, this means the assets of the combined company would be significantly more affected in an economic downturn. Additionally, delinquency rates for both Capital One and Discover are the highest of the 6 major lenders at 2.03% and 1.69% respectively (Jan 24), with a third of Capital One’s credit card loans given to near and subprime consumers, increasing their susceptibility in a downturn.
Whilst regulators are unlikely to block this merger, rigorous scrutiny will be conducted to address antitrust concerns regarding increased interest rate to cardholders, which would especially affect subprime borrowers.
Sources