Would Warren Buffett Approve of this Deal?
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Other than money, rumors seem to be the life blood of Wall Street. Whether it’s simply human nature to want to speculate or the desire to trade ahead of the crowd, it seems that there are daily whispers of another big merger that is either under consideration or at least should be. Just the other day I read that Discover Financial Services (NYSE: DFS) would make sense as part of Wells Fargo (NYSE: WFC). Maybe it would, but it wouldn’t stand a chance of happening if Warren Buffett, one of Wells Fargo’s largest shareholders, didn’t agree.
The thesis put forward by an analyst at Susquehanna Financial is that the deal would benefit both companies. For Wells Fargo it would enable them to rapidly expand their modest credit card business while allowing Discover to have access to both lower cost of funding and increase their cardholders as they could be cross sold throughout Wells Fargo’s branch network. To get the deal done he suggested a $23.7 billion price tag, which would be a 20% premium to Discover’s current price and a value of 2.7 times book value. However, is that deal really in the best interests of the companies, their shareholders and their customers?
One shareholder in particular, Berkshire Hathaway’s (NYSE: BRK-B) Warren Buffett, would certainly have some thoughts on any deal. Berkshire already owns $14.3 billion worth of Wells Fargo stock, which is equal to a 7.8% stake in the company. It’s the bank that Warren likes the best; in fact he said that he likes “Wells better than anything by far…I like loading up on the one I like best.” So obviously he’d raise an eyebrow on them deviating from their current plan by buying out Discover Financial.
We know that he likes credit card companies and is particularly fond of American Express (NYSE: AXP) a company that is his fourth largest portfolio holding (Wells Fargo is number two). At $8.7 billion, his stake in the company is 13.3%, which again is not insignificant. He’s the largest shareholder of both Wells Fargo and American Express. He also has relatively minuscule stakes in both Visa (NYSE: V) and Master Card (NYSE: MA) but not a dime in Discover. It makes you wonder why.
First off, it’s important to know that the business model of American Express in inherently different form both Visa and Master, Card which could be one reason why he owns more of American Express. They operate a “closed-loop network,” meaning they issue cards and manage the card base, originate the loans to users and then manage and run their network with merchants. It’s this control that is important because it gives them a competitive advantage over their peers as they can earn more on each transaction. Discover operates in a similar way but not on the same scale and not with the same customer base.
Both Visa and Master Card are card processors, meaning that the issuing banks are responsible for cardholder debts while American Express and Discover directly lend to consumers. The difference is in who they lend to, as American Express typically lends to more affluent customers, is a top choice among small business owners and is tops in customer satisfaction. Discover, though, has always been the fourth player in the market, they do not have as extensive a merchant network as the other three players (from experience I’ve had to choose another card all too often when I was told the merchant doesn’t take Discover) and has been trying to grow into more of a bank holding company, especially pushing into student loans.
Well Fargo, as one of the nation’s largest banks, is also among its most conservative. Despite this, they earn above industry margins and returns. During the credit crisis they were able to acquire floundering Wachovia, growing their network of branches and boosting the opportunities for cross selling. It’s this cross sale opportunity that has made a deal for Discover an interesting idea, yet Wells Fargo already has a relationship with Visa, and Visa is more widely accepted. Finally, and as a bit of history, the same individuals who founded Wells Fargo actually founded the original American Express, which at the time was an express mail service.
So we have one of the nation’s largest, most conservative and well run banks and a credit card and student loan company that is by all indications a fair operator. It just doesn’t make sense to me and I can’t see how it would make sense to Warren Buffett for these two companies to join forces. From all indications, Discover isn’t a company he’d be interested in buying, so why would he want one of his largest holdings to do so? I think Warren would rather they leave Wells alone to keep doing what they do best and leave Discover to keep going down their own path.
latimerburned has options on American Express and Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway, MasterCard, and Wells Fargo & Company and has the following options: short OCT 2012 $55.00 puts on American Express Company, short OCT 2012 $60.00 calls on American Express Company, long OCT 2012 $65.00 calls on American Express Company, short OCT 2012 $33.00 puts on Wells Fargo & Company, and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend American Express Company, Berkshire Hathaway, Visa, and Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.