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.