Note to Discover: Innovate or perish
Solid second quarter, check. But more products, merchants, customers, needed.
NEW YORK (CNNMoney.com) -- Discover Card may not be the golden boy of the credit card industry but with some loyal backing from its parent Morgan Stanley and surprisingly strong financial results in recent quarters, the company has proven it has staying power in a fiercely competitive market.
Discover surprised Wall Street in the second quarter as the company more than doubled its pretax earnings from the prior year on fewer credit losses.
The company, like so much of the industry, got hurt in 2005 by a rush of consumer bankruptcy filings ahead of stricter laws enacted late in the year that pushed up credit losses for card issuers.
The unit contributed to a solid earnings report for Morgan Stanley (Charts), which reiterated its commitment to the credit card division and put to rest for now rumors that Morgan Stanley may spin off or sell Discover down the road.
Stepping up its game
But rather than get complacent, Discover will have to battle to sustain its strength when the credit environment returns to normal and credit losses start swelling again, as early as next year, industry analysts said.
Discover's main tasks? Improve marketing, and get more merchants and customers to use its cards.
David Hendler, senior financial analyst at CreditSights, said Discover will have to embrace innovation if it wants to attract customers away from competitors such as MasterCard, Visa, or American Express.
"Discover Card was innovative 20 years ago with its (cash-back) strategy," Hendler said. "But since then it really hasn't enamored the card-holding population."
Competitors like Visa and MasterCard (Charts) have made strides with cards that appeal to niche markets and entered relationships with other retailers to provide consumers with rewards like airline miles or points for buying books and other products and services.
Analysts said those type of deals have made Discover's competitors a success while Discover is still struggling to attract consumers.
"Consumers still think of Discover as just a rebate card," said Dan Schatt, senior analyst at independent research and consulting firm Celent LLC.
In an interview, Discover CEO David Nelms said the company has been adding customers and is still an innovator - and he pointed to a 14 percent jump, to $24 billion, in second-quarter purchases made with Discover cards.
He said the company's cash-back reward card was just one of many ideas since copied by competitors, noting that more recently, Discover was first to make small "key chain" credit cards and is testing new "biometric" technology to help build more secure cards.
Nelms added Discover is optimistic about a new card aimed at small business and that a card that pays 5 percent cash back for gasoline and airline tickets is off to a good start.
But analysts said Discover's strong second-quarter came in part from the acquisition of the European Goldfish credit card business.
"In any given quarter, they might do better but in general volume has lagged (behind its competitors)," CreditSights' Hendler said, adding that none of the new innovations were "knock-out successes."
The quest for merchants
One of Discover's biggest problems is it's never been as widely accepted at merchants across the U.S. as its major rivals.
"I would describe it as an opportunity and a work in progress," Nelms said regarding that issue. "We're still the new kids on the block but we have better acceptance in the U.S. than American Express ... and our goal is to close in on MasterCard and Visa."
Analysts said Discover's recent acquisition of the PULSE ATM/debit network, which serves more than 4,200 financial institutions, should help the company broaden the number of merchants accepting the card.
Discover, along with American Express, won an important battle at the Supreme Court last year that means the companies can make deals with banks that previously issued only Visa and MasterCard brand cards.
Since the ruling, American Express entered partnerships with Citigroup and Bank of America to offer co-branded cards. Nelms said Discover partnered with companies such as GE Consumer Credit and HSBC to offer cards.
But Dick Bove, analyst at Punk, Ziegel & Co., said Discover is going to have to enter more high-profile banking relationships and improve its marketing to win more consumers.
To that end, Nelms said the company plans to spend more in the second half on advertising and marketing, though he declined to provide figures. Discover plans a mass market ad campaign this fall, he added.
The Morgan connection
And to Discover's credit, it has the support of parent Morgan Stanley - a far cry from just a year ago when former Morgan CEO Philip Purcell considered putting Discover on the auction block. That was before he was ousted by Morgan Stanley's board and replaced by current CEO John Mack.
But analysts said Morgan Stanley's new-found commitment to Discover may have less to do with its prospects going forward than with its ability to throw off a lot of cash to its parent.
"Even in the worst of times, Discover produces excess cash and provides some stability in earnings" for Morgan Stanley, said Bove at Punk, Ziegel. "I don't think this is a good fit for Morgan Stanley but at the same time I don't think they should spin it off."
But Nelms had a different view of Morgan Stanley's faith in the unit.
"We had a lot of fresh eyes take a look at Discover and they were happy with what they saw," he said. "To some degree, I feel Morgan Stanley and Discover are back on the offense."
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