INSIGHT-Discover's card processing network hides value

* Mobile phone venture could boost Discover profile

* Analysts see potential value in selling network

* CEO: Discover network 'valuable to our shareholders'

* Discover shares trading up 1.7 percent on Tuesday

By Maria Aspan

NEW YORK, Aug 31 (Reuters) - Discover Financial Services (DFS.N) is best known as a credit card lender, but it also has a transaction processing business that could give a jolt to the company's share price, analysts said.

The network is small by comparison to Visa (V.N) and MasterCard (MA.N), but Discover could boost its profitability by working with telecom companies to process payments on mobile phones.

The credit card company could even choose to sell its transaction processing unit at some point, giving more than a billion dollars of value to a company whose market value is currently around $8 billion, analysts said.

For now, Discover has no plans to sell the processing business, the company's chief executive told Reuters.

Discover's network "is becoming more and more valuable to us and our shareholders," CEO David Nelms said in an interview.

Nelms is following a strategy similar to American Express Co (AXP.N), which like Discover processes transactions over its network and makes credit card loans.

American Express expects much of its future growth to come from processing transactions, which is seen as lower-risk than lending.

Transaction processing networks like Visa and Master Card make their money by sending information between a merchant's bank and a consumer's.

Every time the consumer swipes a credit or debit card -- or makes a purchase using a mobile phone -- the networks and their bank partners receive about 2 percent of the purchase amount in processing fees.

The network of merchants that accept Discover cards -- and generate processing fees for the company -- is about the same size as American Express's, analysts said.

But Discover cards are accepted at fewer high-end merchants than American Express's, limiting the processing fees Discover receives, which may be why investors don't assign much value to its network.

Discover shares currently trade at about eight times estimated 2011 earnings, while Capital One Financial Corp (COF.N) shares trade at about nine times estimated earnings, said FBR Capital Markets analyst Scott Valentin.

In other words, Capital One, which does not have a payments network, gets a higher earnings multiple than Discover, which does.

Discover is still poorly understood by investors, even after three years as an independent company, Valentin said. Morgan Stanley (MS.N) spun it off in June 2007.

MOBILE WALLET

The payments network could be a real source of growth for Discover, as mobile phone companies look to turn cell phones into the wallets of the future. In Asia-Pacific countries like Japan and South Korea, consumers already use their phones to make $11.7 billion of payments a year, or almost ten times the amount of mobile payments made in North America, according to the research firm Gartner Inc.

Discover is working with Verizon (VZ.N) Wireless, AT&T (T.N) and T-Mobile [TMOG.UL] USA to form a joint venture aimed at offering mobile payments services, people familiar with the matter told Reuters. [ID:nN19102622]

That type of joint venture could generate additional processing revenue for Discover. Gartner estimates that North American consumers will be using their cell phones to make about $23 billion of payments by 2014, making this area one of the fastest growing in payment processing.

Discover's potential joint venture will not have an immediate impact on its earnings, but it could help the company get a foothold in the market, FBR's Valentin said.

"It validates Discover," he said. "If you're the two biggest mobile networks in the U.S., you're not going to choose a weak network."

Discover's Nelms would not discuss the reports of the joint venture during an interview last week, except to say that Discover is focused on mobile and "we're talking to a number of" potential partners.

APPEALING TARGET?

Alternatively, Discover could sell its network, and unlock the value for shareholders immediately. Sandler O'Neill analyst Michael Taiano believes the network could be worth about $1.4 billion, which is material for a company whose market cap is about $8 billion. Discover shares were trading up 1.7 percent at $14.56 late on Tuesday morning.

If Discover is unwilling to sell the processing business alone, potential acquirers might instead buy the whole company, analysts said.

Discover would be "appealing for a large international company or another large bank," especially once banks have complied with new global capital requirements, said Jason Arnold, analyst at RBC Capital Markets.

Large U.S. banks could be interested in buying Discover's network as a way to process their own transactions, instead of paying Visa or MasterCard to do it, he said.

Philip Philliou, a payments consultant and former executive for MasterCard and American Express (AXP.N), said, "There's a tremendous opportunity for someone to partner with, acquire or somehow leverage ... this potentially very valuable network that just seems to be incredibly underestimated."

Discover has already tried to expand its international processing business through joint ventures and acquisitions. It bought the travel-and-entertainment network Diners Club International from Citigroup Inc (C.N) in 2008, and has signed processing partnerships with Japan's JCB network and China UnionPay.

Discover is also competing with more traditional banks by expanding its other financial products, including private student loans and online deposit accounts. Those deposits now account for about a third of Discover's total funding.

Nelms plans to eventually offer most of the products that customers can find at more traditional competitors, including "a Discover home loan product or a Discover checking account product," he said.

But buying a traditional bank branch network is not in the cards.

Direct online banking is "of the future," Nelms said. "Why would I want to buy something that's of the past?" (Reporting by Maria Aspan, editing by Matthew Lewis)