David Nelms is going on an African safari this winter. An adventurer who enjoys power boating, scuba diving and piloting planes, Nelms should find that trip a lot more predictable than running a consumer credit and payment company. The chairman and CEO of Discover Financial Services has faced many challenges since the financial crisis shook his industry.
With a market capitalization of $13 billion, Discover is the sixth-largest U.S. credit card issuer; one in four U.S. households uses its plastic. It’s also the No. 2 U.S. card company with its own network, after American Express Co. But Riverwoods, Illinois–based Discover almost didn’t make it after spinning out from Morgan Stanley in the third quarter of 2007, just ahead of the Bear Stearns Cos. collapse.
More recently, the 11,000-employee firm has contended with increased regulation thanks to the Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009, which aims to protect consumers from predatory lending practices.
But Nelms, who was named CEO in 2004 and chairman in 2009, has much to celebrate. The Discover card is turning 25 with the highest sales and lowest delinquency rates since its 1986 launch by Dean Witter Financial Services Group, then a division of Sears, Roebuck and Co. In the third quarter of 2011, card sales volume reached a record $26.3 billion, up 9 percent from the same period in 2010. Meanwhile, credit card loans more than 30 days past due hit an all-time low of 2.43 percent.
Nelms, 50, joined what is now Discover as president and COO in 1998, the year after Dean Witter, Discover & Co. merged with Morgan Stanley Group. The St. Petersburg, Florida, native, who has an MBA from Harvard Business School, had previously been vice chairman of credit card company MBNA America Bank.
Nelms helped to diversify Discover’s business by expanding into other banking areas, such as personal and student loans, prepaid cards and deposit products. He also acquired the Pulse debit and ATM network in 2005 and the Diners Club International credit card network when Citigroup spun it off in 2008. Diners Club gave Discover cardholders entrée to millions of merchants in 185 countries and territories.
Discover has a distinctly different business model from MasterCard and Visa, both of which process payments made by consumers using bank-issued cards that run on the banks’ networks. Both a network and a direct bank, Discover issues its own cards. Like American Express, the other major vertically integrated card company, it holds all customer debt itself. If that debt offers greater earning potential, it also makes Discover more sensitive to economic shocks.
Before the financial crisis, Nelms took a conservative approach to the subprime credit card market, then a key source of growth for banks affiliated with MasterCard and Visa. During the meltdown, the industry’s account write-offs peaked at 12 percent in August 2009; Discover’s high was between 9 and 10 percent. In 2008, Discover won a $2.75 billion settlement from a 2004 antitrust lawsuit against MasterCard and Visa for blocking banks from issuing cards on the Discover network.
Discover signs merchants to its network rather than leaving the task to banks or other entities. Ironically, the credit crunch made this job easier. During the past few years, as Discover worked to increase so-called merchant acceptance, competing card issuers closed more accounts than it did while raising their interest rates. In 2006, Discover’s merchant acceptance was only 76 percent of MasterCard’s and Visa’s; today it’s almost equal.
Earnings have followed. In the third quarter of 2011, Discover earned $649 million, compared with $261 million during the same period in 2010, a year when total net income was $765 million. Revenue before credit loss provisions was $6.7 billion in 2010, versus $4.8 billion in 2009.
Jason Arnold, a consumer finance analyst at RBC Capital Markets in San Francisco, is impressed with Nelms’s leadership skills and calls Discover a strong buy. “David manages the business like a long-term investor,” Arnold says. After dropping to $4.73 in March 2009, the company’s stock regained 2007 levels this past July by climbing above $27; in early December it was about $24 a share.
As he looks ahead, Nelms must boost card member spending. Discover’s transaction volume, which includes purchases and cash advances, totaled only $114 billion in 2010, compared with $852 billion for Visa, the No. 1 credit card company. To meet this challenge, Nelms has ventured into mobile apps through Discover’s Zip and Google Wallet. “We think that the phone will increasingly become the access device for the credit card account,” he says.
Senior Writer Frances Denmark recently spoke with Nelms about the Morgan Stanley spin-off, the credit crisis and new regulations.
Institutional Investor: What was it like to spin off Discover just before the financial meltdown?
Nelms: We came out almost right at the peak in financial stock prices, so our price was a lot higher than we expected it to trade at the outset. We didn’t raise any money. We were a dividend to shareholders, but it quickly traded off. After that all heck broke loose with Lehman Brothers, Countrywide, AIG and the rest. We went through quite a roller coaster.
What were your top challenges in running a newly independent firm?
The first two Bear Stearns funds failed within two months of our becoming a public company. Then things quickly deteriorated. Had we not gone public when we did, we could not have gotten the funding and completed the spin-off. We didn’t have a big balance sheet standing behind us. Another challenge was building functions like treasury, human resources and some of the legal functions from scratch. On the other hand, we were able to do the right thing for Discover without being distracted by some of the other problems that the parent company had to deal with after we left.
What helped get Discover through the financial crisis?
First, we had a very experienced and stable management team. I had been running the company for more than a decade before the spin-off, and most of my team had been with us during that entire period. Second, we had been pretty conservative on credit going into the crisis. We had actually given up some market share because we didn’t participate in some of what we considered at the time to be too-aggressive lending, so our credit customer base was very sound as we entered. Third, we had been fairly conservative in how we capitalized the company, how we funded it and the amount of leverage we had. We were starting from a solid foundation. Interestingly, some of the biggest challenges for us were changes that happened at the same time as the crisis or came out of it.
What challenges were those?
Everyone talks about Dodd-Frank or the health care bill, but the CARD Act affected us more significantly. The act and regulations flowing from it had hundreds of pages of new rules that required the credit card industry to make fundamental changes to many of its business practices, including marketing, pricing and billing.
What were some of the costs of complying with these regulations?
To some degree, we went back to how credit cards used to work in the 1990s, before risk-based pricing and promotional rates. So it wasn’t the end of the world, but it was a huge adjustment, and there are some things that are gone. As an example, we can’t charge over-limit fees anymore, so maybe we have to be a little more careful about who we allow in to take a card. There was a lot coming at us. But the good news is, we reinvented our strategy.
How did you do that?
A lot of people recommended that we buy a bank and have branches and stable deposits. We considered and rejected that. We came to the conclusion that direct banking is the future, not going backward and getting branches. When you get branches, you do pick up a good source of deposits, but you also pick up a lot of expense. You also have to be in all the products. The direct model is less expensive. My feeling is that ATMs essentially are the branches we needed, so during the process we built a global ATM network; it’s got about 800,000 ATMs around the world. You don’t have to have a branch. We can offer a better value to consumers. We’re open 24 hours a day, moving to the Internet.
How is that playing out?
We said we’re going to focus on direct banking and payments. One of the great things about our model is that we can pick and choose which products we think will be profitable and serve customers well. We got into student loans just as some others were getting out of them. We got into personal loans to help consumers consolidate their debt and pay it down, taking advantage of the deleveraging that so many consumers are focused on. And we got really big in direct deposits. We had $3 billion worth of certificates of deposit and money markets as we spun out of Morgan Stanley. We now have $25 billion; that’s our single largest source of funds. Securitizations are a much smaller part of our funding.
That was all on the direct banking side. On the payment side we bought Pulse six years ago to be in both debit and credit. When the crisis hit, Diners Club became available out of Citibank, and we bought it. It was the original card network and our way to get international acceptance. So we now have the broad suite of payments products from which we can not only service our Discover card but also service financial services, take advantage of some of the new mobile opportunities and be in the higher-growth area of banking, which is payments.
What represents good customer service in your industry?
We view the time when we talk to customers as a way to reinforce cash-back bonus and build more loyalty. We see it as a revenue-enhancing opportunity, not a cost. With many of our competitors, customers get stuck in computer IVR [interactive voice response] purgatory. With account information on the screen, we’ll use our data to say, “Well, what else might they most be interested in? Are they not using their Discover card in restaurants?” Maybe we’ll tell them about a great 5 percent program for using Discover in restaurants over the next two months. It’s better training, trying to hire and retain the right people in the field, but frankly, just having them in Salt Lake City working for Discover versus in India being subcontracted is a real competitive advantage. I travel out to the call centers. That’s where I learn the most about what’s going on.
What’s next?
Our goal is to be as ubiquitous as Visa and MasterCard in the U.S. and as good as American Express around the rest of the world. We think owning the network is a big competitive advantage. One of the most important ways to grow is not to lose your current customers. We’re at historically low attrition rates. We have focused on retaining our customers and attracting new people through the value and service and rewards.
