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 no.'"

STRUGGLING OVERSEASThat's a central concern for Discover, whose image as a second-rate card in the U.S. made it the butt of a joke in the Fox TV cartoon The Family Guy, earlier this year. The card is accepted at only 60% of the U.S. retailers that take MasterCard and Visa. Last year, Discover had $113.7 billion worth of transactions in the U.S., compared with $862 billion for MasterCard, according to industry publication the Nilson Report.

The company also needs to improve its game overseas. Discover is seldom accepted internationally, and the company's acquisitions outside the U.S. have so far been lackluster. It bought Goldfish, a British credit-card company that operates on MasterCard and Visa networks, in 2006. But in the latest quarter Goldfish posted a $67 million loss, vs. a $30 million gain the previous year.

Discover has made some smart moves. It got into faster-growing debit cards with its 2004 purchase of the Pulse network. As part of a broader effort to put its plastic in more wallets, Discover is teaming up with third parties like Wal-Mart Stores (WMT) on co-branded credit cards. And it's beefing up its marketing to small and midsize retailers, a segment where it's especially weak. "Over the next two years we expect to largely close the gap, which will allow our customers to earn their cash-back bonus everywhere around the country," says Nelms.

That may not be enough to make investors happy. Analysts are predicting earnings per share will slip slightly in fiscal 2008. Says Craig Maurer, an analyst with Ceylon Securities, an independent research firm: "Discover needs to totally reinvent itself or the stock will continue to drop."

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