The Long and Short
Capital One discovers new opportunities
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
Capital One Financial (COF: Baa1/*-/BBB/A-) recently announced plans to merge with Discover Financial Services (DFS: Baa2*/BBB-*+/BBB+*+), triggering a rally in DFS debt. The intermediate bonds of the smaller, lower-rated DFS moved from about 50 bp wide of COF to only 25 bp to 30 bp wide. With bank debt still looking undervalued against the broader investment grade market and COF debt offering strong standalone relative value, investors would be well served to keep accumulating the name. As for DFS, given what is very likely to be a long and bumpy regulatory approval process for the merger, there could be more attractive entry points to add exposure to that name in the near future, potentially at a greater discount to COF.
The proposed all-stock $35 billion deal would create the fifth largest bank in the US by total assets at approximately $630 billion, just behind USB at $663 billion, and would represent a larger tie-up than the BBT/STI merger that created Truist Financial. Ownership will be 60% with COF shareholders and 40% with DFS shareholders. COF would become the largest US issuer of credit cards with credit card loans outstanding of approximately $250 billion, surpassing JPM, AXP and Citi. For this reason, along with the current backdrop in domestic banking due to the NYCB disclosures, we expect this deal to receive tremendous regulatory scrutiny during the approval process. COF has indicated that they intend to keep the Discover Card branding. The deal would add tremendous size to COF, offering economies of scale, expense synergies, etc; however, perhaps the most attractive element of the merger would be the addition of DFS’ payments network, which would enable the combined entity to compete more directly with Mastercard and Visa.
Exhibit 1. DFS debt securities now trading in a much tighter band relative to COF
Source: Santander US Capital Markets LLC, Bloomberg/TRACE G-spread indications
Given the all-stock structuring of the proposed transaction, there would be limited immediate impact to COF credit without the prospect of a huge cash/debt funding component to the deal. Nevertheless, Moody’s placed the Baa1 senior rating on review for potential downgrade. The rating agency cited the size and integration risks associated with the transaction, as well as the regulatory risks of potentially pushing the combined entity closer to the $700 billion total asset threshold after which it would be categorized as a Category II bank. Also under consideration are the concentration risks of combining COF and DFS. Credit card loans account for 48% of COF’s total loans and 80% of DFS’ loans, meaning the resulting company would be far more concentrated to consumer lending than standalone COF. Meanwhile, the lower-rated DFS, seeing the rapid impact of being potentially folded into the higher-rated COF capital structure, was placed on watch positive by S&P and Fitch, and watch developing by Moody’s. All three agencies anticipate raising DFS’s ratings in-line with those of COF with the completion of the merger.
In the company’s M&A presentation, COF projects that they could achieve $1.3 billion in operating expense synergies by 2027, with an additional $100 million in marketing expense synergies and a $1.2 billion network synergy opportunity by adding DFS. That could potentially take out approximately 26% of DFS’ expense base. Management expects Tier 1 common (CET1) capital ratio to be 13.9% for the combined entity at the closing of the transaction, with DFS suspending share repurchases through the closing, and then assumes consensus pro forma CET1 of $12.5% in 2026 and beyond. COF’s CET1 ratio as of year-end 2023 was 12.9% versus 11.32% at DFS.
The proposed transaction is already generating political opposition from various lawmakers in the press, suggesting it would eliminate competition among top lenders in the consumer finance markets. COF management would likely argue that preventing the deal would only serve to strengthen the market position of Visa and Mastercard. A more formidable competitor with its own payment network created in large part by DFS would help level the playing field. However, further complicating matters is the residual fallout from last year’s regional banking crisis, as well as the more recent difficulties experienced at New York Community Bancorp. Both instances serve as reminders of the delicate nature of the US banking system, and how quickly contagion fears can spread to peers when problems arise. COF had $321 billion in total loans and $348 billion in total deposits as of year-end 2023, while DFS was at $128 billion and $109 billion, respectively. Opposition would argue that the combination would potentially create another “too big to fail” institution, and one that is highly susceptible to a breakdown or crisis of the US consumer. At any rate, a quick and easy conclusion by the various regulatory bodies (FDIC, OCC, Fed, etc) seems highly unlikely in this instance and approval would appear a long and potentially bumpy road ahead.
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