R. Christopher Whalen
Feb 214 min
February 21, 2024 | Premium Service | Readers of The Institutional Risk Analyst will be interested to hear that we’ve been working on several bank indices for the past little while with our partners at Thematic in Menlo Park. The WGA Bank Index is a census of superior banks which draws upon our work at Institutional Risk Analytics.
We feature the top performing 10, 25 & 50 publicly listed banks in Peer Group 1 based upon four key measures of financial performance and market returns. The index is weighted by the actual test results, ensuring that the righteous banks have the greatest impact. No zombies please. More on this project soon.
Imagine our surprise, therefore, when CapitalOne Financial (COF) announced the acquisition of one of the best performing banks in the US, Discover Financial Services (DFS). The fact that DFS trades at twice the book value of COF is just the start of our questions about this transaction. Below is a side-by-side comparison of the two banks based upon several key metrics.
Source: EDGAR, FFIEC
COF will pay 1.01192 of its own shares for every share of DFS, a 26% premium to the closing price on February 16th. As the table above suggests, the price paid for DFS will leave the COF shareholders with just 60% of the company if the deal closes. So why has COF decided to pursue this transaction? 1) Slowing growth for credit cards and 2) the hidden jewels of DFS, namely the payments platform.
Readers of The IRA will recall in our comments about U.S. Bancorp (USB) that we’ve noted that the off-balance sheet business, including the bank’s payments platform, is one of the key assets for the franchise. Another factor that will surprise readers is that COF did not own its own rails as a card issuer and was reliant upon Visa (V) and Mastercard (BC) to issue credit cards. The investor presentation from COF is below.
We tend to discount the claims of “synergies” from COF management, in part because COF’s operating costs are twenty points higher than DFS. If COF follows the form of past acquisitions, it will lose most of the deposit relationships built by DFS. But acquiring the payments platform, card relationships, brands and other assets may be sufficient reason to do the transaction. The one saving grace may be found in the fact that DFS is also a card issuer. COF has made many acquisitions of nonbank lenders and businesses, but the purchases of Hibernia Bank (2005) and North Fork (2006) were less successful.
COF is buying one of the best performing banks in the US in DFS. Sure, COF is also a good performer, but DFS has seen stellar equity returns going back years and has often been in the top ten best performing banks in the US. But with single digit market share for its main brand and dwindling usage for the Diners Club franchise, DFS needed to be bought. The slide below from the COF investor presentation tells the story.
The key assumption for this deal is that the combination of the superior payments platform of DFS with the larger brand of COF will be a winner and, more importantly, position the combined company to compete with JPMorgan (JPM) and American Express (AXP). But can COF up its game and run as fast at DFS in terms of operating efficiency and equity returns?
We have always had great respect for COF as a consumer lender, but have watched them try and fail repeatedly over the years when it comes to growing its banking business beyond consumer and cards. DFS actually has a broader business than COF, but we’ll wait to see if COF destroys these businesses or grows them. COF is buying DFS because there are not a lot of other choices for either franchise. But Senator Elizabeth Warren (D-MA) and other progressives in Congress should be supporting COF's purchase of Discover as a way to compete with market leaders JPM and AXP.
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