Capital One's (COF 0.56%) credit card business is a highly profitable one. Thanks to the average credit card APR of about 25% in the current environment and relatively low deposit costs, Capital One has a net interest margin (NIM) of about 6.7% throughout its business. Other big banks would typically be happy with a NIM in the 2%-3% range.
However, the business is about to get a whole lot bigger. Capital One announced in February that it had agreed to acquire Discover (DFS 0.44%) in an all-stock transaction that values the business at about $35 billion. While this clearly is a big move for Discover, I think it can be an even bigger deal than many investors believe. Here's why I think the Discover merger could eventually put Capital One in the same realm as Visa (V 1.90%) and Mastercard (MA 1.61%).
What does Discover add to Capital One?
It might not seem like it, but this move will make Capital One's credit card business several times larger. The bank currently has about 100 million credit card customers, while Discover has three times as many. This size could create some major efficiency advantages, and many of the credit card programs could be complimentary in nature. For example, Capital One currently doesn't offer a card with rotating cash back categories like the popular Discover it Cash Back card, and Discover doesn't offer high-end travel cards like the Capital One Venture X. The combination will have a far more complete line of cards to offer customers.
In addition to its credit cards, Discover also has $20 billion in private student loans and personal loans, as well as $87 billion in consumer deposits.
In addition to the scale benefits, there could be other positives as well. For example, while Discover also offers bank accounts, Capital One has a significantly lower average cost of deposits, so combining the business under Capital One's ecosystem could help expand margins. In all, the transaction is expected to deliver $1.5 billion in expense synergies by 2027.
The real game-changer could be Discover's payment network
For one thing, Capital One plans to move a significant amount of its own debit and credit cards to the Discover network. This would result in significant cost savings (currently, it pays Visa and Mastercard for processing), and management expects $1.2 billion in network synergies by 2027, in addition to the expense synergies already mentioned.
However, the real long-term game changer could be owning Discover's payment network and the potential that it brings. Capital One could potentially let third-party issuers use the network for processing and profit from interchange (swipe) fees, just to name one example. Discover has historically been a distant fourth among the four major payment networks, and Capital One could choose to invest in its growth.
For context, Discover's network processed $225 billion in volume last year, compared with $12.3 trillion for Visa. And it's important to emphasize the profitability of the payment processing business. Over the past four quarters, Visa has produced a 54% net profit margin and generated over $18 billion in net income from payment processing. For context, that is roughly five times Capital One's net income.
Could Capital One be the next Visa or Mastercard?
To be clear, I'm not saying that Capital One will leverage its Discover acquisition to the point where it becomes as large of a payment processor as Visa or Mastercard. at least not quickly. But the point is that aside from American Express (AXP 0.92%), which doesn't exactly have a full suite of banking products and services, there isn't a major bank that owns a major payment network yet, and doing so creates a ton of interesting long-term possibilities for Capital One.
With its stock trading for a 10% discount to book value, the market doesn't appear to put much faith in the accretive potential of the merger or the long-term possibilities that come with owning a payment network. But Capital One has jumped to the top of my watch list recently, and I think this could be a great entry point for long-term investors.
