Discover Financial Services

Discover Financial Services

RCMP presentation12.06.2007

Zhifeng (Jack) ChenGloria HoJonathan LiSwechha SalgiaJeremy SmithZheng(Andrea) Zhang

Agenda

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

Company Overview

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

Recent Key News

• June 2007 officially spun off from Morgan Stanley• July 1, 2007 DFS Added To S&P 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 96.593.4 from

Oct. to Nov.

Discover Bank Discover Card Payment Networks

• Offers housing and student loans to customers

• Offers CD’s and money market deposits

• Issuer of credit, debit, and stored charge (gift cards)

• First to provide incentivized rewards programs

• Discover Network supports Discover Card transactions

• Pulse Network supports Visa, MasterCard ATM users

Key Businesses

Key Businesses

Discover Bank Discover Card Payment Networks

• Offers housing and student loans to customers

• Offers CD’s and money market deposits

• Issuer of credit, debit, and stored charge (gift cards)

• First to provide incentivized rewards programs

• Discover Network supports Discover Card transactions

• Pulse Network supports Visa, MasterCard ATM users

Credit Card Company

Credit Card Issuer

Consumer Merchant

Credit Card Company

Payment Network

Credit Card Issuer$100 $98

$.25

$1.75

Monthly Fee

• Discover owns all aspects of Credit card payment operations, and thus captures all revenue points in this model

Consumer Merchant

Monthly Fee

Transaction Fee

Visa/MasterCard:

Discover:

Business Model

2006 Revenue *Consumer Loans Asset Securitizations Payment Networks

5.2 B 2.1B 2.3B .8B

*Mostly Credit Card revenue

Revenue Breakdown

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.

Industry Overview

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

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

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 <http://www2.fdic.gov/qbp/2007sep/qbp.pdf>.

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

SWOT Analysis

Strengths

• “One-of-a-kind company”: 4th-largest network, 6th-largest credit card issuer, owns the nation’s 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

Weaknesses

• Continued losses in DFS's U.K. business due to UK’s 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 MasterCard’s 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

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.

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

Stock Performance

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.com/quotes/stock_charting.html?symbol

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.com/quotes/stock_charting.html?symbol

RCMP Position

• DFS Position• 201 shares by virtue of spin off on 2nd July 2007 @ 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?k=pf_1

DFS Percentage in RCMP

41.30%

5.69%

8.73%

7.34%

0.87%

9.87%

2.81%

5.50%

2.03%

6.29%

4.77%

4.80%

0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00%

CASH

AEE

AEO

CPRT

DFS

FR

JKHY

KMB

MVSN

SRCL

SRZ

WAGS

tock

Nam

e

Percentage

RCMP Profit/Loss

• Net Profit as of 12/03/07• $ 92173

• DFS Loss • $ 617

Source: Yahoo Finance: http://finance.yahoo.com/p?k=pf_1

Percentage Profit/Loss

1.74%

27.47%

24.32%

13.89%

7.66%

1.87%

21.72%

-4.41%

6.22%

-0.67%

0.20%

-10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%

AEE

AEO

CPRT

DFS

FR

JKHY

KMB

MVSN

SRCL

SRZ

WAG

Sto

ck N

ame

Percentage

RCMP LOSS

Contribution to Loss

DFS, 13.72%

MVSN, -4.13%

SRZ, 90.42%

• Total Loss as of 12/03/07• $ 4499

• DFS Loss • $ 617.07

Source: Yahoo Finance: http://finance.yahoo.com/p?k=pf_1

Valuation

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 securitiesChanges in market value

• Loan quality Young as a stand-alone company

Multiple Valuation

Company *P/E Price/Sales Price/BookPrice to

OCF

Discover 17.43 2.40 1.49 8.38

Mastercard 528.65 7.98 11.23 40.86

American Express 19.2 2.56 6.62 7.73

AIG 10.77 1.34 1.49 22.17

Industry 11.55 1.95 N/A N/A

Multiple Used 14.98 1.95 4.05 14.95

IMPLIED PRICE: $25.5- $55.96

* Figures represent trailing PE multiple. Forward earnings are applied to this multiple to arrive at valuation.

Recommendation

• Short history as a standing along company• It’s 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 company’s young history

Hold!

Thank you!