Discover Responds to Lowered APR of American Express

Case Type: business competition, competitive response; operations strategy.
Consulting Firm: American Express first round full time job interview.
Industry Coverage: financial services; credit cards.

Case Interview Question #01301: Your client Mr. Roger Hochschild is the CEO of Discover Financial Services, Inc. (NYSE: DFS), an American financial services company that owns and operates Discover Bank and Discover credit card network. Discover is one of the largest credit card brand in the U.S., with nearly 20 million American cardholders as of 2017.

Discover Bank issues standard credit cards with an annual percentage rate (APR) of 19% to prime-rated customers. For years, all of the company’s competitors (American Express, Visa, MasterCard, etc.) also issued credit cards with a 19% APR. However, now Discover Bank is faced with a challenge. Mr. Roger Hochschild just read in this morning’s Wall Street Journal that his biggest competitor, American Express (AMEX), has lowered its credit card rate to 15% APR. The CEO immediately calls your consulting firm seeking a solution. As a consultant working on this case, what is your take?

Possible Answers:

1. Case Overview

This “competitive response” case will likely require some heavy number crunching, but the candidate need a lot more information. A great way to approach a case like this is to start with an appropriate general framework and work your way down to the calculations (likely some sort of break-even analysis or profitability impact calculation).

Since we have some information about competition and customers, we will start with the Four C’s framework (Customer, Competition, Costs, Capabilities). Don’t forget to state all of your assumptions clearly at the very outset, consider marketing and implementation issues, and provide suitable recommendations.

2. Detailed Analysis

Candidate: Well, I’m surprised the CEO of Discover had to read about this change in the paper! Let’s start with the competition, which seems to be the most important issue given AMEX’s announcement. Who are the other competitors in the market, and what are they expected to do?

Interviewer: While there are many competitors, including banks and finance companies, AMEX and Discover are the two biggest in the industry. Both are well entrenched in several regions throughout the country. The indications we have received so far is that no other competitors have reacted so far. In all likelihood, they are waiting for us to react in some manner before doing something on their own.

Candidate: (The CEO’s reply implies that the rest of the competition is not a major concern at this stage, so you can effectively ignore that issue). What are the financials of the competitor, AMEX?

Interviewer: Specifics are not available. However, we know they are similar to Discover Bank. AMEX’s financial statements indicate similarity in cost structure.

Note: The candidate can assume that a lot of the financial information he/she gathers for Discover will apply to its competitor.

Candidate: Is AMEX’s credit card any different from the one that is offered by Discover at 19% APR?

Interviewer: There are no substantial differences. Both of them offer similar benefits.

Candidate: What other products does AMEX offer?

Interviewer: AMEX’s products are similar to ours.

Candidate: That’s probably enough information about the competition for now. Let’s move on to the customer base. Who are the customers? Have you tried to target specific customer segments in different regions?

Interviewer: The customers are prime-rated credit card holders who maintain an average account balance of $2,000 per year. There are 20,000,000 Discover card holders in the U.S. We have not targeted any specific customer base.

Candidate: While we’re on the topic of customers, what can you tell me about the revenue Discover’s customers generate? What other sources of revenue are there?

Interviewer: Let’s assume that interest on account balances is the only source of revenue.

Candidate: Since we just talked about revenues, let’s move into costs. What are the expenses of Discover Bank?

Interviewer: Cost of funds is 6% of average account balances, general and administrative (G&A) expenses are 3% and losses are 4%.

Candidate: Are there any immediate opportunities for cost reduction at Discover? Are there any economies of scale? Do the costs decrease when we get more customers?

Interviewer: We continuously look for cost reduction opportunities and there appear to be no significant opportunities at this time. No, there aren’t any economies of scale.

Candidate: That’s a lot of useful information. Let’s touch on capabilities before we move onto some calculations. What is our competitive situation in terms of systems and organizational structure?

Interviewer: Both Discover and AMEX use industry standard computer systems, and there is no opportunity for significant improvement in the time frame that will affect the pricing challenge. Discover Bank is building a data warehouse. As far as the organizational structure, ours is very similar to the one prevalent in the banking industry.

Candidate: What advertising and promotion campaigns are planned?

Interviewer: The client Discover periodically uses direct mail campaigns and will continue to do so. We send customers letters separately from their monthly statement.

Candidate: (Since the candidate now has most of the information, they should start providing recommendations based on all the information they have gathered. Although recommendations have to be very specific, it is always better to provide several alternatives). All right, I would now like to take a couple of minutes to consolidate this information into a brief income statement. I would like to see how Discover’s financials look at the 15% APR.

Interviewer: That’s fine. Take your time.

Note: The candidates have a few ways to proceed at this point. They could present the information in the form of income statement tables or a straightforward P&L calculation. Moreover, they could take a moment to calculate things and then walk through them, or they could think through their calculations out loud for the interviewer.

Candidate: Basically, there are two scenarios. The client Discover can either hold rates steady at 19% or it can match the competitor’s 15% APR rate. At 15%, we would lose revenue, but with a lower rate we would likely gain more customers. The question is how many. Based on the financial data, I have constructed a break-even analysis to determine how many customers we would need to retain our current level of income should we decide to match the competitor’s 15% APR.

At this point, walk your interviewer through your income statement line by line. Beware! Some interviewers will pretend to not know what an income statement is, so be prepared to explain the income statement with exhaustive simplicity.

Table. Discover Income Statement Analysis

Candidate: We can see that at the current customer count 20 million, switching to the 15% APR rate would result in about 66% reduction in net income. Therefore, holding rates steady at 19% is more profitable for Discover unless more than 66% of Discover’s customers leave for AMEX. While the client Discover should obviously attempt to retain as many of its customers as possible, I think they should be able to retain at least 34% of its customers to justify sticking with the 19 percent rate. I would recommend that Discover continue with the 19% rate while attempting to prevent customers from switching to AMEX.

Interviewer: Those are some very interesting numbers, and your recommendation makes sense. But what are some ways we could prevent customers from switching to AMEX? I bet that lower rate looks awfully appealing to most credit card holders.

Candidate: There are a number of ways we could attack the problem. For example, opportunities could be identified using customer data to promote other Discover network products or products offered through strategic alliances with other companies. Promotional campaigns could be targeted at customers who are likely to carry a revolving balance. Promotional campaigns can also be carried out through the company web site or through Discover network partners’ web sites. Other data-based marketing opportunities include customized mailings based on past spending habits, pre-approved loans based on life events such as marriage, birth of children and home purchase, etc.

Interviewer: Those sound expensive!

Candidate: They can be, but there are ways to accomplish this at reasonable costs. For example, direct mailing involves additional expenditure in terms of postage costs and materials, so it would be better to have statement inserts, those little slips of paper we put inside customers’ monthly statements, which they return to us when they mail us their payments. Statement messages, a line or two of text typed on the remittance stub of each statement, might be effective as well.

Interviewer: Those are good ideas. What else?

Candidate: Over the long term, the client Discover should consider using its data warehouse as a competitive advantage to segment its customer base and target those customers who are likely to be loyal. It’s possible that AMEX is doing the same thing, so we might want to start this process in the near future. Data warehouse technology can also be used to mitigate risk by targeting customers who are unlikely to default. That said, while the data warehouse can be a competitive advantage, it will not solve the immediate challenge of a competitor who just lowered its price. But it will definitely provide information on how many customers will remain loyal to Discover or switch to AMEX.

In addition, the client Discover could diversify its product line by offering products to customers in different segments such as subprime borrowers and students. It could also offer Gold and Platinum cards to differentiate customers. Other benefits like airlines miles, temporarily low APR’s on balance transfers from other credit cards to Discover and auto insurance could be offered to retain loyal customers and lure new ones.

Interviewer: Those are all good ideas. Let’s wrap it up here.