Discover Financial: A Dramatic Turnaround Story

| About: Discover Financial (DFS)

Almost never has a stock moved from our Most Dangerous to Most Attractive stocks list from one month to the next. Over the five years that we have tracked our daily ratings on 3000 stocks, a company's rating has switched from 'very dangerous' to 'very attractive' only a few times. Such a drastic change is possible only when two rare events occur simultaneously:

  1. The business accomplishes a dramatic improvement in its underlying economics, and
  2. The market price fails to recognize the turnaround

These two rare events occurred in late January, and the result is that one of February's Most Attractive stocks was on the Most Dangerous stocks list in January: Discover Financial Services (NYSE:DFS).

Our rating on DFS changed to "very attractive" on January 27th, the day after the company filed its 2010 10-K with the SEC, revealing a drastic improvement in the economic profitability of the company, which is disguised by an usually large credit loss provision of $3.2B, or 70% of net interest income in 2010. Though this percentage is down from 125% in 2009, it results in an addition of $1.5B (53% increase) to the company's loan-loss reserves in 2010. In 2009, the company added only $0.4B (0.02% increase) to its loan-loss reserves. Whenever the loan-loss provision outstrips the actual realized loan losses by such a large amount ($1.5B or 23% of revenue), the reported accounting earnings can look worse than the actual economic earnings. And this is true for DFS, whose economic earnings rose $1.8B even as book earnings fell $0.55B.

DFS is rare for other reasons, too. It is one of only twenty-five out of 325 banks and diversified financial companies we cover to have a top-quintile return on invested capital (ROIC). DFS' ROIC, at 22.5%, ranks #1 among the 15 consumer finance companies we cover. For comparison, the ROIC for some of DFS's peers is much lower: COF's ROIC is 1.6%. BAC is 6.2%. And CSH is 8.7%.

As most of our readers know, a high ROIC alone will not get a stock on our Most Attractive Stocks list. The valuation of the stock must be very cheap as well. And DFS fits the bill nicely with a price-to-economic book-value ratio of 0.6 - which means the current stock price (~$22) implies the company's profits will permanently decline by 40%. In other words, the valuation not only implies no future growth, it implies a perpetual 40% reduction in profits. Market expectations are setting the future-profit-growth bar quite low for this stock.

DFS gets our Very Attractive stock rating because the business is throwing off a lot of cash, showing strong growth in profits, while its valuation implies economic earnings will decline permanently by 40%.

DFS fits the risk/reward profile of a great stock to buy.

For details on what causes the difference between economic versus accounting profits during the last five fiscal years, see Appendix 3 on page 10 of our report on DFS. See Appendix 4 to learn how DFS increased net operating profit after tax (NOPAT) and its NOPAT margin from 11% to 35%. DFS's ROIC (detailed in Appendix 7) rose from 5% to 23%. DFS's invested capital grew more slowly than revenues; so invested capital turns rose from 0.45x to 0.65x during the last fiscal year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.