Discover Financial Services

1
Discover Financial Services
Zhifeng (Jack) Chen Gloria Ho Jonathan Li Swechha
Salgia Jeremy Smith Zheng(Andrea) Zhang

• RCMP presentation
• 12.06.2007

2
Agenda

• Company Overview - Jack
• Business Model - Jonathan
• Industry Overview - Jeremey
• SWOT - Andrea
• Stock Performance Swechha
• RCMP Position - Swechha
• Valuation Multiplies - Gloria
• Recommendation - Gloria

3
Company Overview
4
Company Overview

• A leading credit card issuer and electronic
  payment service company in US and UK
• Three major business segments
• U.S. card ? 50m card members, 47.4b receivable
• Third party payment ? PULSE, 2.8b transactions
• International card ? Goldfish Bank, 2m card
  members, 4.4b receivable
• Primary revenue source
• Interest income
• Securitization income
• Fees from card members, merchants
• Operating capital source
• Asset securitization
• Consumer deposits

5
Recent Key News

• June 2007 officially spun off from Morgan Stanley
• July 1, 2007 DFS Added To SP 500
• July 2, 2007 DFS Debuts On NYSE
• Sept. 25 2007 DFS Profit Falls in the 3rd quarter
  ER due to higher marketing and interest expenses
• Dec. 3 2007 DFS to take big charge for UK card
  business in its 4th quarter ER (about 422M,
  equal to its half-year earning)
• Dec. 5 2007 Discovery's Consumer Spending Index
  Down 96.5?93.4 from Oct. to Nov.

6
Key Businesses
7
Key Businesses
8
Business Model
Discover
9
Revenue Breakdown
Mostly Credit Card revenue
10
Future Strategies

• Focus on credit quality
• Delinquency and charge-off rates significantly
  less than competition.
• Average credit score 734.
• Increase third-party revenues
• Pulse network, debit cards.
• International Partnerships
• Reciprocal acceptance agreements with Asian
  credit card companies.
• Challenge Visa/MasterCard dominance in this
  space.

11
Industry Overview
12
Industry History

• Diner Club Program, first general-purpose charge
  card established in 1949
• Bilateral Model
• In late 1950s, Bank of America started to issue
  first credit card nationally, evolved to Visa
  network later on
• Multiple Card Issuer Model
• In 1966, MasterCard network was established
• Multiple Card Issuer Model
• American Express (1958) and Discover Card (1986)
• single-issuer model

13
Credit Card Industry

• Highly competitive among concentrated market
• American Express, Visa, Mastercard, Discover
• Declining credit quality
• Mortgage Crisis (for some)
• Failure of loan payments
• Increase in Charge-offs
• DFS susceptible to loss rates
• Heavily influenced from consumer spending
• Threatened by tightening of lending practices

14
Credit Market

• Home mortgage defaults biggest factor
• Increase in bad loans expense (3rd quarter)
• Loan-loss expense 16.6BN v. 7.5BN in 3rd
  quarter 06
• Net charge-offs up 200 last year
• 10.7BN total (3rd quarter 07) vs. 3.6BN(06)
• Significant decline in stock values of all the
  biggest US banks
• DFS hurt from sale of asset backed loans to big
  investors
• Further loss expected in near future

"FDIC Quarterly Banking Profile ." Third Quarter
20072 December 2007 lthttp//www2.fdic.gov/qbp/2007
sep/qbp.pdfgt.
15
Current Market

• Is a mature market
• Estimated 76 of American families had credit
  card in 2001
• Average card number for all households 6.3
• Nearly all retail establishments can process
  credit card

16
SWOT Analysis
17
Strengths

• One-of-a-kind company
• 4th-largest network, 6th-largest credit card
  issuer, owns the nations 3rd-largest debit
  network.
• Potential as a top-tier issuer and processor in a
  secularly growing market.
• Good credit quality 3.12 delinquency rate 2Q07
• Focus on lending to the prime credit segment and
  strengthening its portfolio no direct exposure
  to housing or housing credit market
• Attractive and stable card member base
• Higher income, better educated, higher percentage
  of home ownership
• Highest percentage that cardmembers stay longer
  than 5 years
• Possibility of a future acquisition

18
Weaknesses

• Continued losses in DFS's U.K. business due to
  UKs weak economy.
• Lack of global diversification
• Recently inaugurated joint programs with China
  UnionPay and JCB in Japan.
• Has no plans to expand in Europe or Latin
  America, where the usage of card is growing at
  double digit rate in selecting countries.
• The core Discover Network business, experienced
  transaction growth of just 4.8 in 3Q07 comparing
  to MasterCards 15.3 in 2Q07
• Lower spending per card than peers the active
  account rate is only 44. Marketing the brand to
  a desirable product is a primary issue.
• 0 introductory interest rate 16 out of 17, or
  94 of its lending card by discovery carries a 6
  or 12 months APR, the highest percentage among
  peers, where industry average is 73
• Economy of scale much smaller than Visa and
  MasterCard

19
Opportunities

• Continued migration from cash spend to plastic
  and other electronic forms of payment within the
  U.S. and continued card penetration
  internationally
• U.S. charge-offs were a solid 3.7 in Aug-Q
• Possible take over target
• Debit cards usage is growing much faster than the
  consumer spending and the card usage.

20
Threats

• On housing and credit related issues,
• Possible deterioration of US consumer confidence
  that would have an impact on consumer spending
• A rise in unemployment that would pressure credit
  quality.
• The competition of the industry is very intense
  competitors offer identical or similar products

21
Stock Performance
22
DFS Stock Performance

• Closed at 16.45 on 5th Dec 2007
• 52 Week high low 32.17 - 15.72

Source Wall Street Journal http//online.wsj.co
m/quotes/stock_charting.html?symbol
23
DFS Stock Performance

• International losses have contributed to 39
  decline since its spin-off especially Europe
• International card business suffered 67
  million pretax loss in the third quarter

Source Wall Street Journal http//online.wsj.co
m/quotes/stock_charting.html?symbol
24
RCMP Position

• DFS Position
• 201 shares by virtue of spin off on 2nd July
  2007 _at_ 19.52 per share
• .87 of RCMP Value
• Total RCMP value as of 12/03/07
• 379895

Source Yahoo Finance http//finance.yahoo.com/p?
kpf_1
25
RCMP Profit/Loss

• Net Profit as of 12/03/07
• 92173
• DFS Loss
• 617

Source Yahoo Finance http//finance.yahoo.com/p?
kpf_1
26
RCMP LOSS

• Total Loss as of 12/03/07
• 4499
• DFS Loss
• 617.07

Source Yahoo Finance http//finance.yahoo.com/p?
kpf_1
27
Valuation
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Valuation

• Difficulties in valuing DFS by cash flow and DCF
• Profitability depend on
• Interest spread on loans
• Investment income
• incl. profit / loss from sales of securities
• Changes in market value
• Loan quality
• Young as a stand-alone company

29
Multiple Valuation
Figures represent trailing PE multiple. Forward
earnings are applied to this multiple to arrive
at valuation.
30
Recommendation

• Short history as a standing along company
• Its hard to forecast whether the management is
  able to bring the company out of current trouble
• Although multiple valuation gives a high target
  price, we are hesitant to recommend a buy at
  this juncture in the companys young history
• Hold!
• Thank you!