We closed this position on January 27, 2011. A copy of the associated Position Update report is here.
Some financial companies have fared better than others over the past twelve months. I believe that most financial firms have or are emerging from the recent crisis as winners or losers – very few are in-between. My reasoning is based on the theory that either financial services firms get their loan portfolios cleaned up and in good shape so they generate earnings that further the recapitalization process or they struggle to stay alive. Those firms with good balance sheets will be able to grow and take market share from those with ailing balance sheets. Those firms with ailing balance sheets will fall farther and farther behind until they are seized by the Feds or sell to a stronger firm at a discounted price. One of the losers, in my opinion, may be Discover Financial Services (DFS), which is one of December’s Most Dangerous Stocks. And like all of our Most Dangerous Stocks the company has (1) misleading earnings = accounting profits are positive and rising while true, economic profits are negative and falling and (2) high valuation = very high expectations embedded in the current valuation. DFS gets our “very dangerous” rating. See our report on DFS for more details.
- Misleading earnings: DFS reported a $295mm increase in GAAP earnings while our model shows economic earnings declined by $998mm (a difference of $1,293mm or over 100% of reported net income). The majority of the overstated reported earnings comes from a one-time gain from an anti-trust settlement of $1,892mm.
- Very dangerous valuation: stock price of $19 implies DFS must grow its NOPAT at over 10% compounded annually for 40 years. A 40-year growth appreciation period with a 10%+ compounding growth rate sets expectations for future cash flow performance quite high. Historical growth rates have never been much lower.
- Free Cash Flow was -$2,470mm or -26% of the company’s enterprise value last year.
- Asset write-offs of $428mm or 5% of net assets – this means that management has written off at least $0.05 of assets for every $1 on the current balance sheet. Writing off assets is the opposite of creating shareholder value as it reflects management’s inability to derive any profits for the investments it makes with shareholder funds.
- Off-balance sheet debt of $38mm or 0.5% of net assets.
- Outstanding stock option liability of $8mm or less than 1% of current market value.
Overall, the risk/reward of investing in DFS’s stock looks “very dangerous” to me. There is lots of downside risk given the misleading earnings and red flags while there is little upside reward given the already-rich expectations embedded in the stock price.
Our report on DFS has detailed appendices for you to see how we perform all calculations. The primary cause of the difference between economic versus accounting earnings is that DFS’s NOPAT rose much slower than its invested capital. See Appendix 4 to learn how DFS’s NOPAT rose more slowly than Net Income. See Appendix 5 for details on DFS’s invested capital and how off-balance sheet debt and asset write-offs are added back to provide a more accurate reflection of the capital invested in the business. Appendix 7 (in the return on invested capital section) shows how a slight rise in NOPAT margin paired with a big decrease in invested capital turns result in a decrease in return on invested capital (from 6.9% to 4.7%) and economic earnings.
In a business where investors make money by buying stocks with low expectations relative to their future potential, DFS fits the profile of a great stock to short or sell.
Note: Stock pick of the week is updated every Tuesday.