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Discover Needs Plastic Surgery

Fears of a consumer slowdown have hurt its stock, but the credit-card issuer's big problem is its image

Discover Financial Services (DFS) couldn't have picked a worse time to become an independent company. The credit-card issuer, which was spun off from Morgan Stanley (MS) on June 30, collided head-on with a credit crunch and mounting fears about a slowdown in consumer spending. In five months the stock has sunk more than 40%.

At a recent share price of roughly 17, Discover sells at 10 times earnings, compared with 17 times for American Express (AXP). Discover's depressed price may eventually pique the interest of a potential acquirer like General Electric (GE), which has a portfolio of credit cards. But despite the low valuation, the stock might not be a bargain: The problems at Discover, which lacks the cachet and retail acceptance of other cards, go far beyond the credit-market catastrophe.

After MasterCard's (MA) debut in May, 2006, its shares soared from 39 to more than 180 in a year. MasterCard's stock has continued to chug along despite the broader credit problems. Most figured Discover's new stock would prosper as well. As an independent company, Discover could pour its profits back into the business and become a nimbler competitor. "Discover remains a strong standalone company focused on growing revenues, managing costs, and continuing to deliver innovative products and superior customer service," says Discover Chief Executive David Nelms.

So what might boost Discover's stock price and perhaps stave off unwanted suitors? A revival in the credit markets would help. Unlike MasterCard, which makes money largely off credit-card transactions, Discover also lends directly to consumers. It then sells off some 60% of that debt to big investors. Discover's profits have suffered in recent months as demand for such asset-backed securities has waned. Net income dropped 16%, to $202.2 million, in the third quarter.

More importantly, the company needs to persuade cardholders such as Rhett Millsaps II, a New York lawyer, to use the Discover card that's gathering dust in his wallet. Attracted by the cash-back rewards, the 28-year-old got the card when he was a junior in college. Now he rarely uses it, opting instead for his American Express, which offers higher-end luxury perks. "Sometimes I'm embarrassed to use it," says Millsaps of his Discover card. "I hate having to go through the rigmarole of asking if places take it and then inevitably hearing

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