Stock Pick of the Week: Buy Discover Financial Services (DFS)- Very Attractive Rating

Almost never has a stock moved from our Most Attractive to Most Dangerous stocks list from one month to the next. Over the past 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 in our rating on a company 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. The result is that one of February’s Most Attractive stocks was on the Most Dangerous stocks list in January: Discover Financial Services (DFS). Our rating on DFS changed to “very attractive” on January 27^th, the day after the company filed its 2010 10-K with the SEC. That 10-K revealed a drastic improvement in the economic profitability of the company, which is disguised by an usually large credit loss provision of $3.2bn or 70% of Net Interest Income in 2010. Though this percentage is down from 125% in 2009, it results in an addition of $1.5bn (53% increase) to the company’s loan loss reserves in 2010. In 2009, the company added only $0.4bn (0.02% increase) to its loan loss reserves. Whenever the loan loss provision outstrips the actual realized loan losses by such a large amount ($1.5bn 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 $1.8bn while accounting earnings fell $0.55bn in 2010. Economic earnings, at $1.2bn, are also higher than the reported accounting earnings $0.7bn.

DFS is rare for other reasons, too. It is 1 of only 25 out of 325 banks and diversified financial companies that 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 50%.

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

HIDDEN GEMS:

1. Our dis­counted cash flow analy­sis shows that DFS’s cur­rent val­u­a­tion (stock price of $21.80) implies that the company’s prof­its will decline by 40% and never grow again.
2. Eco­nomic earn­ings are growing faster that reported accounting earnings.
3. Free cash flow of $2.8bn or 24% of its enterprise value during the last fiscal year.

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.

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