Spinoff of Discover card unit questioned

`It's primed for growth,' analyst says, or takeover

April 06, 2005|By Andrew Countryman | Andrew Countryman,CHICAGO TRIBUNE

Since Philip J. Purcell helped launch the Discover card at Sears, Roebuck and Co. in 1985, they both have undergone major changes.

Sears spun off the Dean Witter Discover unit in the early 1990s, and that merged with Morgan Stanley in 1997, with Purcell taking over as chief executive of the combined company.

Discover, meanwhile, has gone from an upstart challenger to Visa, MasterCard and American Express to an established, if somewhat lagging, player in the credit-card industry.

Now, change is occurring again. Purcell is preparing to spin off Morgan Stanley's Discover Financial Services unit, based in the Chicago suburb of Riverwoods, as he tries to fend off a challenge to his leadership at the giant investment banking firm.

The spinoff of Discover has been debated for months, but with some new tail winds for the unit, some analysts wonder if it's such a good idea.

"I think the Discover business has not done as well as people hoped, but I think it's primed for growth," said Morningstar analyst Meghan Crowe. "It's kind of a strange time to spin it off."

Jeffery Harte, an analyst at Sandler O'Neill & Partners, said Discover would have 18 to 24 months to show solid growth after becoming independent, or else "it becomes a prime target for industry consolidation."

Crowe said, "I think it was definitely a target before, but more so now. ... There are a lot of banks that would love to get their hands on a network" like Discover's.

Operating its own, independent network has made it necessary to grow from within, rather than through acquisitions.

"All of its growth is organic growth," said David Robertson, publisher of The Nilson Report, an industry newsletter. "Given the fact that their growth was organic, I'd say their growth was acceptable, but far from extraordinary."

Discover has about 50 million cardholders and $48 billion in managed loans, ranking it seventh among general-purpose card issuers in the United States, according to Nilson Report data. Both categories are up nearly 30 percent since the Morgan Stanley merger was announced eight years ago.

In terms of a potential takeover, Harte said, a portfolio that size "would be attractive to anyone seeking scale."

"They've had some growth in transaction volume. The thing that hasn't been able to grow is receivables," or the amount borrowers owe, Harte said. "Lack of penetration of wallets isn't so much the Discover issue."

For years, Discover faced a struggle against Visa and MasterCard, which would not allow their member financial institutions to issue credit cards on the Discover or American Express networks.

A recent Supreme Court case made that possible, and Discover has teamed up with Wal-Mart Stores Inc. and GE Consumer Finance Corp. for the new Wal-Mart Discover credit card.

The credit-card industry has seen slower growth in recent years, but Discover has entered the much faster-growing debit-card arena with its acquisition of the Pulse debit and ATM network.

Roger Hochschild, president of Discover Financial Services, said those steps will help Discover succeed independently.

"I think the main story is one of shareholder value," he said of the spinoff. "The value of Discover and its potential ... is not fully reflected in the Morgan Stanley stock."

About 2,500 people work at the Riverwoods facility, officials said. Hochschild declined to say if the spinoff would have any effect on staffing, but said it would mean "nothing but good things" for the headquarters.

"We don't plan on any significant changes in strategy as a result," he said.

Although growth has been sluggish, Discover remains highly profitable. Last year, credit services generated nearly $1.3 billion in pretax profit for Morgan Stanley, or 19 percent of its total. Its revenue reached $3.6 billion, or 15 percent of the total, though neither revenue nor profit growth has kept pace with the overall company's performance since 2002.

"You've got to like the profits. They know how to run a credit-card business," Robertson said.

He said Discover will need new products to help break out of the pack, noting it has been unable to successfully launch an upscale credit card or a small-business card, which Robertson said has been "one of the few growth spots in the credit-card business."

A captivating ad campaign wouldn't hurt, he said. "That's what Discover could use," he said.

Despite its challenges, Crowe said, she's reasonably optimistic about Discover's prospects.

"It remains a very competitive environment. They still have room to improve, but they still could fall as well," Crowe said. "I think I see it growing more than I see it falling further."

The Chicago Tribune is a Tribune Publishing newspaper.

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