Just the facts, finances and finale. Discover spinoff part 3 of 3

We’re just a few days out from the last day possible where an investor can buy Morgan Stanley and receive a share of Discover for every two shares of Morgan Stanley owned. I wanted to finish up my series by posting some final thoughts on Discover, and a brief discussion of a few facts related to Discover’s financial position.

I want to start off by saying, I’m not an equity analyst, I do this for fun. So any prices or attempts at valuation are based on simple factors such as P/E instead of some sort of black box Wall Street formula.

Discover financial position

I struggled with the best way to present this information, while reading the balance sheet I took some notes, so I’m going to make bullet points of my notes and give a small discussion for each.

• Discover has 5.119 billion dollars in cash, and will have 527 million shares outstanding which is $9.71 cash per share.

• They also have $41.40/share in credit card loans. The interest spread on this is between 5-6%. The interest income is earnings for Discover.

• $4.62/share in short term debt.

• $6.48/share in long term debt.

• Interest coverage ratio is 1.8

• $5.85 billion in debt

• $5.426 billion in equity giving Discover a debt to equity ratio of: 1.078

• 2006 earnings of $1.98/share

• 2007 earnings of $.44/share YTD

So doing a back of the napkin estimation valuing Discover at P/E 15x 2006 earnings we get a value of $29.70. I believe this is pretty accurate, trading began today for DFSWI and it traded between $28-30.

Backing this out of Morgan Stanley we get $14.85 is the value of each Discover share. So for today’s MS closing price of $89.30 the new price would be $74.45.

Final Thoughts

I think many people are looking at this spin off through the lens of MasterCard. I doubt Discover’s newly issued stock will do as well as MasterCard. MasterCard is a much different business model, and in general is a much stronger business. Discover is more similar to American Express in the sense that it backs the credit card loans it distributes.

I believe the value in this spinoff is in Morgan Stanley. Currently Morgan Stanley is trading pretty cheap due to some past failures. I believe by shedding Discover they will be able to refocus their business on investment banking and generate excellent returns for their shareholders.

Last thoughts:

For the short term trader: I think there is some potential for a nice move upwards with both Discover and Morgan Stanley. Especially with the rallies these past few days, I would expect 10-15% gain in a matter of weeks on Discover.

For the long term holder: I think the value in this play is Morgan Stanley. Discover seems to be doing well in a good economy, but I’m not sure how well they’ll do in a recession or downturn. I say this because with their debt there isn’t a lot of wiggle room. They do have the credit card loans which generate interest, but if a downturn hits hard many of their cardholders could stop paying their bills which would dry up that interest income stream. I would be cautious about buying Morgan Stanley for the Discover stock alone. If you want in on Discover I would purchase it on the open market starting July 2nd, or currently with the trading symbol DFSWI.

If anyone has any comments or feedback I would appreciate it. I hope to continue this type of coverage across many different companies and industries. If any readers have suggestions of stocks to look at please let me know. Thanks!

Discover spin-off part 2 of 3

I’ve been working my way through the prospectus and decided that instead of just writing this post on the financials of both companies to write about the risks and and discuss financials in the next post. I’m discussing risks because I believe there are some significant risks involved in this transaction which should be pointed out. Many investors might not realize such risks exist if they don’t read the Discover prospectus.

Risks

I believe there are a couple risk factors that should be taken very seriously, I detail each below.

Discover sell off from index funds
Morgan Stanley is a member of the S&P 500, so it’s stock is purchased as part of S&P 500 index funds. Billions of dollars are invested in the S&P 500 through retirement funds, and individual accounts. Pension funds also have billions of dollars invested in private funds that track the S&P 500.

For a stock to be included in the S&P 500 it needs to be publicly traded, have four quarters of profitable earnings, have trading liquidity, and meet certain market cap rules. Discover stock fails to meet the rules for the addition to the S&P 500 index. So when index fund managers who hold Morgan Stanley receive their spin-off shares of Discover they will be forced to sell the Discover stock because it doesn’t conform to the rules of their fund. All of the selling from fund manager could place a lot of downward pressure on the stock and depress the price.

Intercompany connections
Currently Discover and Morgan Stanley share many resources, which would be expected because Discover is owned by Morgan Stanley. One of the perks of being owned by Morgan Stanley is that you get good deals on debt. For anyone who’s read the prospectus you’ll know that Discover is leveraged beyond belief, most of this leverage is in the form of cheap debt financed through Morgan Stanley. When Discover spins off they might have to refinance some of the debt, and with what they carry they won’t be able to get any of the rates that they currently have. This could cause cash flow problems at some point in the future depending on what the debt rates rise to. As it stands now Discover has an interest coverage ratio of 1.8 so they don’t have a lot of wiggle room.

Need to develop new departments
This is a curious item mentioned in the prospectus. The prospectus mentions that Discover relies on certain departments and procedures of Morgan Stanley and after the spin-off will have to create departments, divisions, and procedures quickly to maintain current levels of service. The document doesn’t detail many specifics, so I’m unable to asertain how significance this item holds, but it’s still something to keep in mind.

Unprofitable UK division due to regulations
This was the biggest item I saw in the prospectus, and the one that carried the most weight. Currently Discover is one of the biggest brands for card carriers in the UK. The problem is the UK division of Discover is unprofitable due to regulations the UK government places on the card industry. This is a very significant item, first because Discover is unsure if they’ll be able to turn a profit in the UK, so a loss of this division would be a large loss customer wise. And secondly because the US congress is considering passing some new laws regulating the card industry. If congress passes laws that are similar in nature to the laws governing Discover in the UK the laws could possibly render Discover profitless.

Disclaimer: I am not an investment professional and if you plan on acting on any of my writings please consult one before making any decisions. Investing in equities may result in you losing some or all of your money. My posting of equities does not constitute a recommendation to buy or sell, these thoughts are soley my opinion alone. You are responsible for your own actions. I try to verify each item I post about but I can and do make mistakes please consult with an investment profession with any questions you might have.

Morgan Stanley spin-off….a good Discovery?

If you haven’t heard already Morgan Stanley plans on spinning off it’s Discover Card unit at the end of the month. Morgan Stanley currently owns 100% of the Discover stock, and plans to distribute it’s shares to current Morgan Stanley shareholders to the tune of one share of Discover (DFS) for every two shares of Morgan Stanley (MS). The distribution will have a record date of June 18th with trading of DFS to start on July 2nd.

This spin-off intrigues me, first because I’m a shareholder of MasterCard (MA), and secondly because I believe there might be some value that can be unlocked with the spin-off. I believe the card services industry is a solid cash generating industry with fat margins and limited competition. There are two main players Visa and MasterCard, Visa is estimated to control 61% of the market with MasterCard controlling 29%. That leaves 10% for American Express and Discover. Discover reports in it’s prospectus that it controls 5.6% of the market. I’m unable to find figures for American Express but I’m willing to believe that Visa’s share is a little lower and Amex is higher.

I would like to do a fairly exhaustive analysis of this spin-off, but I have a feeling it will need to be broken into a few different posts. In this post I will discuss the general business climate and factors that created this spin-off. I’m currently digging into the prospectus at EDGAR so I’m hoping to have a financial analysis up in a few days in a new post.

General Business Climate

The present is a great time for the card payment industry, everyday more consumers are turning to credit cards and debit cards for payment instead of using traditional cash and checks. Part of this is convenience it’s easier to carry around a card than a wad of cash if you’re not sure what or how much you’re going to purchase in a given day. Consumers are also turning to cards for identity theft protection, credit cards give certain protections that cash does not. Another big driver is the Internet. To complete a purchase on the internet a consumer must either pay using a linked bank account and a service such as PayPal, Google Checkout, BillPay, or use a credit card.

Spin-off

There was a very interesting article in the Wall Street Journal in the past few weeks detailing Morgan Stanley’s turnaround. To give a rough history Morgan Stanley is a large investment bank with institutional investors. A few years back they merged with Dean Witter to grow the personal brokerage services for small investors. The merger was a complete failure and Morgan Stanley is now shedding some of those personal brokerage services. But in the meantime the private equity and hedge fund industry has taken off, all while Morgan Stanley sits on the sidelines. Morgan Stanely brought back a previous CEO to be their current CEO in the last two years. The current CEO wants to have the institution focus on investment banking and private equity deals, and Discover is getting in the way of that. Morgan Stanley believes that they can enhance shareholder value by focusing on their core business and shedding a distraction which is Discover. Discover is a profitable venture on it’s own and provides a steady revenue stream to Morgan Stanley.

I liked the tone of the new CEO, I believe focusing on core competencies is a recipe for success. What worries me is that the private equity and hedge fund focus might be aligning the bank on a fad that could quickly bust.

This is just a general 10,000ft overview. As I posted above I’m still digging through the prospectus and looking at the financials and plan on detailing what this could mean for the stock in the next post.

Disclaimer: I am not an investment professional and if you plan on acting on any of my writings please consult one before making any decisions. Investing in equities may result in you losing some or all of your money. My posting of equities does not constitute a recommendation to buy or sell, these thoughts are soley my opinion alone. You are responsible for your own actions. I try to verify each item I post about but I can and do make mistakes please consult with an investment profession with any questions you might have.