Capital One to Acquire Discover Financial

Key Morningstar Metrics for Capital One Financial

• Fair Value Estimate: $153.00
• Morningstar Rating: 3 stars
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: High

Key Morningstar Metrics for Discover Financial Services

• Fair Value Estimate: $141.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: High

Capital One Financial COF has agreed to acquire Discover Financial Services DFS in an all-stock deal worth $35 billion, with the acquisition expected to close in late 2024 or early 2025. In general, we are neutral on the deal. We see strategic value in it, particularly around Discover’s network. Additionally, we believe Capital One is paying a fair price, with the implied transaction price of $139.86 per share at the time of announcement nearly equal to our $141 fair value estimate for Discover. That said, there will be meaningful integration risk, and some uncertainty surrounds regulatory approval, as the combined company would be the largest credit card issuer in the United States by loan volume. Because of this, we do not expect our fair value estimate to change.

Capital One hopes to realize $1.4 billion in operating expense synergies, or roughly 23% of Discover’s 2023 operating expenses, which strikes us as achievable. While Discover has historically been known for its lean cost structure, more recently it has had to significantly increase spending on compliance and risk management to correct for past underinvestment, with 2023 operating expenses increasing 15% from 2022. Additionally, Capital One intends to transfer $175 billion in purchasing volume to the Discover network by 2027, which would include all its debit card volume. This will allow the bank to bolster the scale of the Discover payment network while saving on network fees, with Capital One guiding for $1.2 billion in additional cost savings from network synergies. We think this is a reliable method to extract value from the deal, as the combined company benefits from being vertically integrated.

While Discover has nearly replicated the acceptance rates of Mastercard MA and Visa V in the U.S., it trails internationally. We expect lower acceptance rates will be a headwind to moving more of Capital One’s credit card volume to the Discover network, though this will represent an ongoing cost-saving opportunity for the company if it can improve the network’s international acceptance and consumer perceptions.

We do expect this deal to bolster Capital One’s ongoing efforts to expand into the premium card segment. The firm’s ability to work with merchants to create cardholder rewards will benefit meaningfully from the increased scale of the combined businesses and its access to a payment network. Additionally, the larger scale of the company will make the costs of the bank’s efforts to move into the segment more manageable. That said, the deal does not provide Capital One with a preexisting pool of affluent cardholders, which remains a competitive advantage for incumbents in the segment like American Express AXP. We expect the firm’s efforts in the segment to remain an uphill battle.