The Capital One - Discover Deal

Last week Capital One (COF) announced an agreement to acquire Discover Financial (DFS). This is a major deal and the strategic alliance will be positive for both companies. Combining the Discover Network with Capital One’s debit & credit book and modernized technology infrastructure could lead to a significant upside in growth and returns.

Here are a few notes that we’ve put together on the deal from various sources:

Q: What was the announcement made by COF on Monday, Feb 19, 2024?

A: COF announced an agreement to acquire Discover Financial in an all-stock deal valued at $35.3bn, expected to close by early 2025.

• Discover shareholders will receive 1.0192 Capital One shares for each Discover share. This represents a premium of 26.6% based on DFS’s closing price of $110.49 on Feb 16, 2024.

• At close, Capital One shareholders will own approximately 60% and Discover shareholders will own approximately 40% of the combined company.

Q: What are the expected financial impacts of the acquisition?

A: The acquisition is projected to be more than 15% accretive in 2027 on an adjusted non-GAAP EPS basis, excluding certain costs, and be break-even on a GAAP basis by 2027. The deal will deliver a Return on Invested Capital (ROIC) of 16% in 2027 and an Internal Rate of Return (IRR) of over 20%.

Q: What are the strategic considerations behind the acquisition?

A: The deal aims to make COF the largest credit card issuer in the US, allowing it to compete with major banks, enhance its network, and realize potential synergies estimated at around $1.2bn by 2027 driven by their volume of $175bn of COF’s products. Across debit and credit, they expect to add over 25 million Capital One cardholders.

Q: How will the acquisition affect COF's scale?

A: The proposed deal is expected to increase COF's total assets by approximately 30% to around $620bn, excluding ~$10.5bn of student loans that COF intends to exit. They should have cost savings and an earnings uplift once the switch to Discover’s payments network is done.

COF card issuances that are currently through Visa and Mastercard could progressively be moved to the DFS network. The combined company would have a market share of about ~ 25% vs. JP Morgan with ~21% share.

Adding DFS’s fast-growing national direct savings bank will increase the combined company’s scare to compete with the nation’s largest banks. 84% of company deposits would be insured as of year-end 2023.

Q: What are the projected synergies and cost savings?

A: The combination of earnings uplift and cost savings is expected to generate approximately $2.7bn in total pre-tax synergies, with significant expense synergies from reducing DFS's operating expenses by 26% or around $1.5bn. These synergies will be phased in between 2025 and 2028. COF’s investment in technology over the last few years will immensely benefit Discover’s business.

Q: How does the acquisition impact COF's financial statements?

A: Post-acquisition, COF's capital levels are expected to be around 14%, which may be utilized for share repurchases.

They will incur $2.8bn of acquisition and integration expenses by 26%, largely driven by savings in their common businesses of Card and Banking

They expect to book $3.5bn in goodwill.

There are a few considerations here in merging the portfolios of credit cards and loans which will create intangibles of about $10.4bn.

• The existing credit limits need to be merged

• Bad loans need to be accounted for - this will be done by taking the fair value of the loans amortized over 2 - 3 years

• Delinquent accounts and overdue accounts will need to be absorbed

Looking at a rough estimate based on the management summary figures of costs and the Tangible Book Value before and after the acquisition, we see that the Tangible Book Value per Share will decline from $99.8 to ~$84.3. This is a dilution of about 15.5% in the Tangible Book Value for Capital One.

Takeaways

• The deal will create the largest card issuer in the US

• There will be significant accretion (15%) through synergies and cost savings. ROIC will be about 16% and IRR over 20%.

• The deal, however, will dilute the Tangible Book Value of Capital One, roughly by -15.5%

• The deal still needs to pass regulatory approvals. However, given that Visa and MasterCard already operated practically as a duopoly, this could actually be a net positive for the industry.