The Danger of Owning Capital One

In a rare move toward consolidation in the credit card industry, Capital One (NYSE:COF) recently offered $35.3 billion to purchase Discover Financial Services (NYSE:DFS).

Although these two companies put together could be quite successful, numerous risks, pitfalls and uncertainties threaten the deal. 

So, what’s going to happen if the acquisition goes through?

Discover’s Pros and Cons

On the upside of Capital One’s bid to acquire Discover is the fact that DFS is highly profitable. The company achieved net margins of 14.3% over the last 12 months and delivered net income of $2.9 billion.

Capital One’s net margin over the same period was 9.9%, and its net income totaled $4.9 billion. As such, adding Discover to its own operations could lead to a combined entity with enormous profitability.

Furthermore, there are significant opportunities for synergy between these two companies. Capital One has been investing heavily in machine learning, AI and other cutting-edge technologies to improve customer experiences.

Discover, meanwhile has expanded its operations heavily into growing its consumer banking business. Together, the two companies would become the sixth-largest American bank, and Capital One estimates synergies of around $2.7 billion resulting from the combination of the two businesses.

On the downside, Discover’s delinquency rate has been rising, hitting 3.9% in Q4. As a result, management reportedly expects losses to continue rising through the first half of 2024 before plateauing into the second half of the year. This increase in delinquencies has contributed to a dramatic contraction in earnings. Q4’s net income of $388 million was 62% lower than the $1.03 billion it reported in 2022.

Discover has also been involved in a string of regulatory issues over the past year that would ultimately become liabilities to Capital One in the event that the acquisition deal goes through. Compliance charges brought by the FDIC ultimately resulted in the resignation of former CEO Roger Hochschild, and the company is expected to spend $500 million on compliance upgrades this year.

Discover’s Valuation Is High

While Discover is profitable and has the potential to add to Capital One’s earnings, it’s also important to consider how much Capital One is paying to acquire its rival.

Discover’s trailing 12-month revenues amounted to $20.6 billion, meaning that Capital One is paying 1.7x revenue for the company. Though slightly high given the company’s rising delinquency rate, this multiple is well within the range Discover has historically traded at on public markets.

Looking at earnings, however, Capital One may not be getting quite so attractive a bargain. Given Discover’s trailing 12-month earnings, Capital One is paying around 12.1x earnings for Discover. DFS has rarely traded above 10x earnings over the past decade.

It should be noted that a buyer premium is standard in acquisitions, but Capital One could be overpaying for Discover. Capital One itself noted that it would be paying a premium of 26.6% relative to the closing price of DFS the day before the offer was announced. This is roughly in line with the 30% premium typically paid in acquisitions, but the size of the Discover purchase could make such a premium difficult for COF shareholders to support.

Capital One Faces Short-term Downside

In instances of large acquisitions, it’s fairly common for the acquiring company’s shares to fall due to the premium paid for the acquisition target.

In the case of the Discover, lower earnings and regulatory issues may cause Capital One shareholders to take a dimmer view of the stock. So far, COF shares have been fairly stable since the announcement, likely because it’s still not definite that the deal will go through.

The question, of course, is whether Capital One can leverage Discover’s customer base and assets to grow its own earnings over time. Given the compatibility between the two companies, there’s a strong argument to be made that the purchase could be accretive to Capital One’s earnings in the long run.

What Happens If Capital One Buys Discover?

If Capital One buys Discover its stock is likely to fall to reflect the premium it is paying for the acquired company.

While there’s much to be said for combining Discover and Capital One to create a credit card and banking behemoth, the short-term outlook could be very choppy.

To begin with, Discover is currently a somewhat distressed asset that could take some time to fully turn around. There are also the ordinary pitfalls of combining two massive, independent businesses. Logistical snarls could delay significant earnings accretion and slow returns for Capital One investors.

It’s also worth noting the regulatory hurdles facing deal consummation. A large group of Democratic lawmakers, headed by Senator Elizabeth Warren, called for action to block the consolidation shortly after Capital One announced its intention to buy Discover.

Arguments against the deal focus on consumer protection and competition, both of which could carry weight with the Biden White House and ultimately cause federal regulators to block the purchase.

Capital One is also facing its own challenges that investors should take into consideration. The company has reported negative earnings growth in seven of the last eight quarters, raising questions about its ability to generate reliable forward earnings growth. Further, it operates in the same economic context as Discover, meaning that it will likely face gradual increases in delinquency rates as US consumer debt grows.

At this point, there are still too many uncertainties surrounding the decision for investors to jump on Capital One at the moment. Given the premium being offered, it’s also quite likely that COF shares could move downward if and when the deal is approved.

With that said, investors may want to keep an eye on the acquisition deal and the combined credit card company that could emerge from it. Such a company could establish a significant moat and become a major competitor to the likes of Visa and MasterCard. For now, though, investors may be wise to hold off on buying Capital One until the picture becomes clearer.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.