Take Gains on Discover Financial (DFS) To the Bank

Since we made DFS the Stock Pick of the Week on Feb 15, 2011, the stock is up about 14% while the S&P500 is up about 0.3%. The stock was super-cheap when we made the call, and that is no longer the case. After making the February and March lists, DFS is no longer one of our Most Attractive Stocks in April.

Normally, we do not write about stocks that come off our Most Attractive Stocks or Most Dangerous Stocks lists. However, we made an important update to our model for DFS that changes our opinion beyond the significant increase to the stock’s valuation.

Further review of DFS’ most recent 10-K reveals that the company did not over-reserve as much as we thought. Deep investigation into the company’s reserves reveals a new (to us at least) accounting trick: companies have changes in loan loss reserves that are unrelated to increases in the provision for losses or charge-offs, net of recoveries. As many financial firms consolidate previously-off-balance sheet loans, their reserves are affected by transactions other than the provisions for losses and charge-offs for the current on-balance sheet portfolio. In other words, as they repatriate loan portfolios, their reserves are changing due to loans unrelated to the on-balance sheet portfolio.

For example, in 2010 DFS consolidated previously off-balance-sheet credit card receivables upon adoption of SFAS 166 (ASC Topic 860). When DFS brought the receivables on to the balance sheet, it also brought on the allowance for losses on the receivables. This consolidation therefore increased the loan loss reserve by $2.1B, not because of an increase in the estimate of losses, but instead because of an accounting rule change. After we adjusted our DFS model for this issue and after the 14% appreciation in its valuation, its rating changed from Very Attractive to Dangerous. The net impact of loan losses on NOPAT went from a $1.66B charge to a $3.8B charge, the difference of which is related to removing the $2.1B increase in the reserve due to the accounting rule change.

We have adjusted all 3000+ of our models for this issue where needed.

Click here for our latest report (as of today) on Discover Financial Services (DFS): Dangerous Risk/Reward Rating.

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