Discover Financial Services: The Promise of Morgan Stanley's Spin-off

| About: Morgan Stanley (MS)

On Friday, I looked over the Form 10-12B for Morgan Stanley’s (NYSE:MS) Discover Financial Services (NYSE:DFS) spinoff. And although I haven’t yet considered the valuation (which can’t really be done until we know the price of MS on the distribution date), I have noticed some signs that Discover may have a promising future as a standalone company.

  • Amid Morgan Stanley’s focus on trading operations and insider conflicts, Discover may not have previously received the attention it deserved. Now the company is permitted to grow and is free of conflict.
  • As a division of Morgan Stanley, Discover had a hard time attracting card issuers, who are typically other big banks and see MS as a competitor.
  • MasterCard (NYSE:MA) and Visa previously prohibited their card issuers and merchants from offering competing card services. Discover, as a smaller player with 5.6% market share, was hurt by these practices which the DOJ has now ruled as anti-competitive. Discover may have the most to gain as a result of this ruling because of its relatively small size.
  • Finally, some analysts think Discover is an acquisition target. Perhaps Bank of America (NYSE:BAC), JPMorgan (NYSE:JPM), or Citigroup (NYSE:C) will look to acquire it. However, if this is an attractive target why doesn’t MS sell it instead?
  • There are some challenges facing Discover. Here are a few:

  • Merchants are suing the big card companies for the high fees they levy. You’d also have to look at the likelihood, and potential implications, of regulatory intervention.
  • Many believe card companies benefit from the large salesforce and financial backing of larger banks. Before MasterCard’s 2006 IPO it was owned by a consortium of banks, for example.
  • One last thing. This is not an IPO - it’s a spinoff - as evidenced by the 10-12B having been filed instead of an S-1. This means that underwriters don’t set the offering price and MS doesn’t receive proceeds from the transaction. Instead, shares are distributed to existing MS shareholders.

    I’ll be back to look at Discover in more detail; sustainable cash flows (after interest expense) and a reasonable price will be areas of focus. There is no hurry, because the spinoff isn’t expected until Q3 (the Form 10-12B doesn’t have a specific date). So investors have plenty of time to digest the information.