Stock Pick of the Week: Sell/Short Discover Financial Services (DFS) – Very Dangerous Rating

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.

RED FLAGS:

1. 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.
2. 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.
3. Free Cash Flow was -$2,470mm or -26% of the company’s enterprise value last year.
4. 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.
5. Off-balance sheet debt of $38mm or 0.5% of net assets.
6. 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.

See my blog for all of my stock picks and pans. Samples of some recent picks: Buy MSFT and buy IBM. Short CBG and short VMC.

Note: Stock pick of the week is updated every Tuesday.