Discover This Land Mine Before It Blows Up Your Portfolio

| About: Discover Financial (DFS)

Some financial companies have fared better than others over the past 12 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 financial-services firms either 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 behind until they are seized by the Feds or sell to a stronger firm at a discounted price. Some of the winners -- including Goldman Sachs (NYSE:GS) and Travelers (NYSE:TRV) -- are already turning their businesses around; one of the losers, in my opinion, may be Discover Financial Services (NYSE:DFS).

As one of December’s most dan­ger­ous stocks, DFS has mis­lead­ing earn­ings (account­ing prof­its are positive and ris­ing while eco­nomic prof­its are neg­a­tive and falling) and high val­u­a­tion, with very high expectations embed­ded in its cur­rent valuation. DFS gets our “very dangerous” rating.

Below are the specific red flags my research reveals:

  1. Mis­lead­ing earn­ings: DFS reported a $295m increase in GAAP earn­ings, while our model shows eco­nomic earn­ings declined by $998m (a dif­fer­ence of $1,293m or over 100% of reported net income) during the last fiscal year. The majority of the overstated reported earnings comes from a one-time gain from an anti-trust settlement of $1,892m.
  2. Very dan­ger­ous val­u­a­tion: A 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 -$2,470m or -26% of the company’s enterprise value last year.
  4. Asset write-offs of $428m 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 $38m or 0.5% of net assets.
  6. Outstanding stock option liability of $8m 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.

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.

Disclosure: I am long TRV.