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MasterCard shares have surged since its 2006 IPO, but Morgan Stanley's spin-off of its Discover unit on July 2 hasn't been nearly as well received
Americans are used to piles of credit-card solicitations arriving in the mail every week. But now investors are facing a similar array of choices in the stock market. One by one, the big brand names printed on those credit cards are going public.
MasterCard (MA) held one of the most successful initial public offerings of 2006: The stock has more than tripled in price since its debut in May, 2006.
That got other card companies thinking about following suit. On July 2, Discover Financial Services (DFS) was spun off by its previous owner, Morgan Stanley (MS). In the next several months, Visa is considering an IPO of its own.
While MasterCard's IPO was a resounding success, so far Discover is getting poor reviews from investors. The shares fell 3.5% on their first day of public trading, July 2, and fell another 7% the rest of the week. This may be because Discover is smaller, held in fewer wallets, and accepted by fewer merchants than rivals MasterCard, Visa, and American Express (AXP). "Many think of it as the ugly duckling of the industry," says Michael Kon, an analyst at Morningstar (MORN). (Kon, by the way, is pretty bullish on Discover, saying it has a strong brand name, loyal customers, and a good debit-card network, and notes Discover may be an acquisition target.)
Different Business Models
But the different receptions are better explained by a look at the firms' business models. As Moshe Katri of Cowen & Co. puts it, "MasterCard is not a credit-card company."
True, MasterCard and Visa logos appear on credit cards. But indebted consumers pay off their credit-card balances, not to MasterCard or Visa, but to the banks and other financial institutions that issued the cards in the first place. (These are the same lenders that still own much of MasterCard and all of Visa.) Instead, Visa and MasterCard run the networks that allow purchases to be made with the cards. They collect a fee on every transaction, but never see the interest or finance charges customers pay each month.
Discover and American Express run their own networks, too, but they also issue cards, send out bills, and charge customers interest on their unpaid balances.
Saturated U.S. Market
Analysts say the credit-card network business is actually growing much faster than the business of issuing cards and collecting debts. When it comes to credit cards, "the U.S. is a pretty saturated market," says Morgan Keegan analyst Robert Dodd. With most Americans carrying around at least a few cards, it's hard to boost the total number of credit cards outstanding.
Also, card issuers are exposed to the ups and downs of consumer credit. When bankruptcies increase, card issuers lose out. They benefit when the job market is strong and consumers can pay their minimum balance every month.
When they pull out their wallets, Americans continue to switch from paper to plastic. They're using cash and checks less often and credit and debit cards more. Credit-card transactions are growing 10% to 12% annually, and debit-card usage is growing even faster, according to Sanjay Sakhrani of Keefe, Bruyette & Woods (KBW). (KBW seeks investment banking business with Discover and MasterCard.) This growth really helps a company like MasterCard. Every time a card is used, the credit-card network takes a small percentage.
Sakhrani says investors have gradually realized the advantages of this credit-card network business model, and that's one reason for the rise in MasterCard stock.
A Matter of Market Share
Discover is less popular than its rivals, making it harder to capitalize on growing credit-card use. According to the Nilson Report, Visa processes more than 17 times more transactions than Discover, while MasterCard handles eight times more, and American Express three times more. Discover is hardly a player outside the U.S. and a few other countries, which means it loses out on possible tremendous growth in places where paying with plastic is a relatively novel idea. Being smaller also makes marketing and advertising more expensive.
That's not to say all is bleak for Discover. Kon notes that Discover tends to hold on to its customers for longer than its rivals. And, it's not too hard for those customers to find places to use their Discover cards. It is accepted at about 4.4 million merchants in the U.S., a number it's trying to boost. Visa and MasterCard are accepted at about 6.6 million establishments, and American Express at 4 million, according to the Nilson Report. It's "a global market-share battle," Dodd says. One of Discover's advantages is that it charges lower fees to merchants than its competitors.
"While they have a small part of the market share, that can grow," Sakhrani says. Even if it doesn't find ways to increase its market share, Discover can benefit simply by keeping its slice of the pie stable, as credit- and debit-card use increases, analysts say.
Concerns Fading About Legal Woes
Another reason for MasterCard's success is an easing of worries about the stock. MasterCard and Visa both face legal troubles due to allegations that their arrangements with financial institutions are anticompetitive. The risk of those lawsuits is one reason the banks that own both firms decided to take them public. Since last May, at least some of those worries have eased a bit, though Discover and other rivals could still get large payouts from the suits.
MasterCard also kept beating Wall Street's earnings estimates, thanks partly to a big drop in expenses. "The [business] model is just very solid," Cowen's Katri says of MasterCard's balance sheet.
Discover the Upside
A week into its life as a public company, Discover is down, but it's not out. Sakhrani says it's "too early" to tell how Discover shares will fare over the long term. Discover's public offering was a spin-off, not an IPO. Morgan Stanley shareholders automatically received Discover shares, which they were free to unload immediately on the markets. That may have led to a glut of shares on the market. In an IPO, the sale of new shares is often restricted for a period of time.
The biggest advantage for any company running a credit-card network is the shortage of competitors. It's hard to start up a national or global network from scratch. "There really aren't many viable networks out there," Katri says. With the global shift to electronic payment, "it seems like there is plenty of business for everyone." That kind of talk makes it more likely that a big financial institution could choose to buy Discover at some point, a possibility often mentioned by analysts.