Morningstar DBRS Confirms Capital One Financial Corporation at A (low), Stable Trend Following the Acquisition Announcement of Discover Financial Services

DBRS, Inc. (Morningstar DBRS) confirmed the credit ratings of Capital One Financial Corporation (Capital One or the Company), including its Long-Term Issuer Rating of A (low) and Short-Term Issuer Rating of R-1 (low). The trend on all ratings remains Stable. The credit ratings actions follows the announcement that Capital One will acquire Discover Financial Services (Discover) in an all-stock transaction that values Discover at $35.3 billion. The expected close of the transaction is late 2024 or early 2025, subject to customary regulatory and shareholder approvals.

KEY CREDIT RATING CONSIDERATIONS

The confirmation of the Company’s credit ratings reflects Morningstar DBRS’s view that the proposed acquisition will enable Capital One to become an even more formidable player in U.S credit card space and solidify its position by becoming the top credit card issuer. Capital One is also expected to capitalize on Discover’s proprietary (closed loop) payment network which in 2023 accounted for approximately 4% of the total general-purpose credit card purchase volume and approximately 6% of the total debit card purchase volume in the U.S., according to our estimates. The acquisition is expected to generate network synergies of $1.2 billion in 2027, driven by adding Capital One debit purchase volume and selected credit card purchase volume to the Discover network. While the Company historically has successfully integrated acquired companies, there remains a risk of uneven integration and lackluster realization of expected synergies and profitability, especially if the U.S. economic environment were not to be favorable at any time during the integration timeframe.

CREDIT RATING DRIVERS

Over the longer term, should the Company deliver on its integration assumptions related to the Discover acquisition and show sustained top tier earnings metrics while maintaining solid balance sheet fundamentals, the credit ratings would be upgraded. Conversely, if the integration of the proposed acquisition is poorly executed or a failure to sustain solid risk-adjusted profitability would lead to a downgrade of the credit ratings.

CREDIT RATING RATIONALE

Franchise Combined Building Block (BB) Assessment: Strong/Good

The Company has a solid franchise with strong brand recognition that includes a regional bank, an online direct bank and a national consumer lending franchise. The acquisition is expected to further support its franchise given Discover’s loyal customer base and historically high customer satisfaction rankings. Over time, by capitalizing and investing on the Discover payment network, Capital One could also be positioned as a notable player in the U.S. payment network space.

Earnings Combined Building Block (BB) Assessment: Strong/Good

The Company’s profitability is expected to improve over the medium-term as a result of the acquisition. Expense synergies are expected to total $1.5 billion in 2027 comprised of cost savings equivalent to 26% of Discover operating expenses (excl. marketing, phased in over three years), as well as 10% of Discover marketing expenses (phased in over two years), which will be partially offset by targeted investments in the Discover network. The Company expects the acquisition to be accretive to earnings (15% to adj. EPS in 2027). On the other hand, revenue concentration from the credit card portfolio will increase. The transaction is expected to deliver a return on invested capital of 16% in 2027. Capital One’s return on common equity was 9.10% in 2023, while Discover’s was 22%.

Risk Combined Building Block (BB) Assessment: Good/Moderate

Asset quality of the combined credit card portfolio is expected to improve moderately. Discover's credit card portfolio credit quality profile as measured by FICO score is viewed as stronger relative to Capital One's. Specifically, as of 3Q23, 81% of Discover's credit card outstanding were associated with a FICO score greater than or equal to 660 (typically defined as prime cardholders' credit score range) while for Capital One's domestic credit card portfolio its was 67%. Discover's portfolio's credit performance metrics also reflect the aforementioned strength. At YE23, the 30+ day delinquency rate for Discover's credit card portfolio was 3.87% while for Capital One's domestic cards it was 4.61%. Meanwhile, the net charge-off rate in 2023 for Discover was 3.90%, while for Capital One's domestic card portfolio it was 4.56%.

Funding and Liquidity Combined Building Block (BB) Assessment: Good

The incorporation of Discover's online deposit franchise should further bolster Capital One's deposit base and sound online deposit franchise. At YE23, approximately 77% of Discover's $108.9 billion deposit base was comprised of direct-to-consumer deposits with the remainder brokered deposits. Meanwhile, Capital One had $348 billion in total deposits with a minimal presence of brokered deposits. On a pro forma basis, 84% of the combined company’s deposits would be insured as of YE23, slightly higher than Capital One’s at 82%. While Capital One's deposit base was of a higher quality with a retail branch network anchoring the deposits, Discover's online bank has a similar strong reputation for customer service.

Capitalization Combined Building Block (BB) Assessment: Strong/Good

The proposed acquisition is expected to strengthen its capitalization. On a pro forma basis, the combined company would have a Common Equity Tier 1 (CET1) capital ratio of approximately 14% at closing. At YE23, Capital One had a CET1 ratio of 12.9% while Discover’s was 11.3%.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/427882.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

General Considerations

There were no Environmental/Social/Governance factor(s) that had significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at (January 23, 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

Notes:
All figures are in U.S. Dollars unless otherwise noted.

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 22, 2023):
https://dbrs.morningstar.com/research/415978/global-methodology-for-rating-banks-and-banking-organisations.

In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings. (January 23, 2024) in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The primary sources of information used for this credit rating include Morningstar, Inc. and company documents. Morningstar DBRS considers the information available to it for the purposes of providing this credit rating was of satisfactory quality.

The credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did not participate in the credit rating process for this credit rating action.

Morningstar DBRS did not have access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is an unsolicited credit rating.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS’ outlooks and credit ratings are under regular surveillance.

For more information on this credit or on this industry, visit dbrs.morningstar.com.

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