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Capital One to Buy Discover for $35 Billion

COF stock buys DFS stock.

The country’s ninth-largest bank, Capital One (NYSE: COF), shocked the finance world when it announced that it will buy Discover Financial Services (NYSE: DFS) for a staggering $35 billion. This all-stock deal is set to be one of the biggest M&A deals of 2024, bringing together two of the nation’s credit card giants to create a true global payments powerhouse.

But, what drove Capital One to make this move? It’s clear as day that the Berkshire Hathaway-backed (NYSE: BRK.B) Capital One has finally had enough of the sky-high fees associated with Visa (NYSE: V) and Mastercard (NYSE: MA).

By snatching up Discover, Capital One won’t just compete with these industry titans, but it could break free from their clutches altogether. After the news, DFS stock rose 15.6% in premarket trading, while COF stock fell by 3.5%. But there’s just one problem: The rise in DFS stock doesn’t reflect the nearly 27% premium Capital One valued Discover at, which could suggest that investors aren’t entirely convinced that this deal will come to fruition.

The Deal

Under the terms of the all-stock deal, if you’re a Discover shareholder, you’ll receive 1.0192 shares of COF stock for each DFS stock you own. And what’s really interesting about this is that Discover has a market cap of $27.6 billion, and the deal is valued at $35 billion, which means it’s a 26.6% premium over its closing price on the 16th of February. Moreover, after the deal closes, Capital One shareholders will hold roughly 60% of the combined company, while Discover shareholders will own the remaining 40%.

What is Capital One Getting?

For starters, now is a good time for credit card companies to make big moves like this one. There’s a boom in the credit card sector because more and more customers are switching from paying with cash to cards. This is largely thanks to generous rewards programs and the strong rise in e-commerce, which started to take off during the pandemic. Additionally, card issuers are getting a boost from increasing credit card debt, which continued to increase last year amid rising prices and declining savings.

As for what it’s getting from the deal, buying Discover would give Capital One a large card network, greatly increasing its power in the payments ecosystem. And this is important because card networks are essential for making transactions happen, as well as setting the fees that sellers pay when customers shop with their credit cards.

This would allow Capital One to negotiate interchange fees and other terms directly with merchants, making Capital One more of a competitor to companies like Visa and Mastercard. Notably, shares of Visa were down 1.8% in premarket trading after the news, while Mastercard stock was down 3.2%.

The deal would also increase the number of cardholders Capital One counts as customers for its credit-card lending business. This deal doesn’t just give Capital One numbers, but quality too, since many Discover cardholders have high credit scores. The deal would also allow Capital One to get its hands on the consumer deposits in Discover’s savings accounts, an area where it already has a large presence but would like to continue growing.

When you compare Discover to competitors like Visa and Mastercard, you’d think that Discover is a very small company, but what makes it unique is that it’s one of the few U.S. card issuers that actually have payment networks. Which is the main reason why Capital One is buying it in the first place. Even though it uses Visa and Mastercard for most of the cards it issues, it will likely begin switching some of its cards to Discover after the deal closes.

Even after the deal closes, Capital One will continue using Visa and Mastercard thanks to its wider reach. For example, Discover currently has 70 million merchant acceptance, compared to Visa’s 130 million and Mastercard’s nearly 100 million.

Still, this could be a play from Capital One to reduce its dependence on Visa and Mastercard, as the pair have come under fire recently for their high fees they charge for processing payments. Some lawmakers have even accused them of forming a “duopoly”.

Discover’s Recent Troubles

For Discover, the deal couldn’t have come at a better time. The company was going through a tumultuous period with increased regulatory scrutiny and two changes in its leadership.

Discover’s troubles are a result of a statement issued last year, in which it stated that it had misclassified certain credit card accounts beginning in 2007 and had incorrectly placed them in the highest pricing tier. As a result, the company was forced to record a liability of $365 million in estimated compensation for everyone involved.

In addition to that, Discover received a consent order from the FDIC regarding consumer compliance, but Discover did not release many details about the matter. Discover escaped a fine from regulators after reaching an agreement with the FDIC to improve its compliance management system.

A Decade of Offers

Interestingly, this is not the first time Discover was approached by a large bank or even a tech company for an acquisition. In fact, the company has been receiving offers for the last decade, especially from tech companies. The reason Discover accepted this deal and not those from tech companies is likely because they were only interested in its payments and card network. For tech companies, Discover offered an opportunity to play a more central role in payments. But, Discover’s older management wasn’t interested in separating the company’s credit card lending side from the network, which is why many deals were rejected.

On the other hand, Capital One said that it’s planning to keep the Discover brand on the cards and network. If the deal happens, it will certainly rank among the biggest deals so far for 2024. After a slowdown in M&A activity in 2023 due to increased interest rates that reduced the appetite for massive deals, this deal between Capital One and Discover could reignite interest in this market.

The Combined Company

There’s an opportunity here to create a new credit card giant, but the main concern for shareholders of COF stock and DFS stock can be summed up in one question: Will the resulting company outperform the broader market in the long-term?

Over the past 10 years, COF stock has underperformed SPY with an annualized return of 8.39%, while SPY has yielded a comparatively higher 12.62% annualized return. Compared to the XLF, COF stock has also underpeformed offering an annualized return of 8.39% over the last 10 years, while XLF has yielded 13.08% annualized return.

The same can be said for DFS stock which underperformed the XLF during this same period and compared to the SPY, achieved an annualized return of only 9.97% compared to the SPY’s 12.62% annualized return.

It’s possible that these two companies hope that combined, they will be able to outperform these benchmarks and take on industry giants. With this merger, the resulting company would create the largest card issuer in the US – immediately surpassing JPMorgan Chase.

While Jamie Dimon brushed it off saying “let them compete. Let them try”, the merging companies are likely hoping to capitalize on the credit card sector boom and use their advantages and synergies to generate higher profits and shareholder value than COF stock or DFS stock could achieve on their own.

COF Stock Forecast

If the deal is approved by regulators, the COF stock forecast looks notably bullish. In fact, Citi analysts stated that with Discover’s valuable payments network it will unlock value that neither company could achieve on its own. As a result, Citi increased its price target for COF stock to $152, offering 11% upside from its closing price on the 16th of February.

However, one glaring risk is the fact that M&As of large companies are super hard to pull off. Together, Capital One and Discover will become the sixth-largest bank in the US, with consolidated assets of almost $625 billion. A combination like this will undoubtedly come under intense antitrust scrutiny.

The deal is already seeing push back from Senator Warren and 12 congressional Democrats who wrote Acting Comptroller Michael Hsu and the Michael Barr, urging them to block the deal. This appeal is based on their belief that the deal would reduce competition and reduce card issuers’ incentives to offer customers favorable terms.

However, its possible that regulators will be more amenable to this deal, since Capital One is a well known company and considered to be a “good actor”. Not to mention, Discover previously pledged to invest $500 million to better its compliance operations after its troubles with the FDIC.

Setting aside these regulatory concerns, the two companies expect the deal to close late this year or in early 2025. There is a lot at stake for Capital One which stated that shifting away from Visa and Mastercard’s “duopoly” would help it generate an extra $1.2 billion in revenue in 2027.

While COF stock offers a tempting opportunity for long-term investors, veteran investors have seen time and again major deals fall through. Whether it was the collapse of Adobe’s acquisition of Figma or the UK’s decision to block Microsoft’s $69 billion acquisition of Activision Blizzard, its not unusual for these deals to fall through or at the very least face hurdles such as in Microsoft’s case.


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