Description

Intro

Bread Financial, formerly called Alliance Data, is down 90% since its $312 high in the second quarter of 2015. I believe it is worth more today than it was in 2015. Let's look at a quick comparison.

I believe the superior balance sheet makes Bread more valuable today. The loan book is also more diversified today and less dependent on mall-based retailers. While earnings visibility is almost non-existent in 2024 and 2025 primarily due to pending regulation on credit card late fees, the company is likely to generate a 20% or more ROE through the cycle. This seems like a bargain at today's price of 78% of tangible book value.

Business overview

The company is an issuer of private label and co-brand credit cards. Private label credit cards are partner-branded credit cards that are used exclusively for the purchase of goods and services from that particular partner. Co-brand credit cards are also partner-branded but they can be used at all retailers, wherever cards from those card networks are accepted. Some of BFH’s largest partners are AAA, Academy Sports + Outdoors, Caesars, Michaels, the NFL, Signet, Ulta and Victoria’s Secret. The company also offers its own proprietary credit card, the Bread Cashback American Express credit card. The main benefit of this card is as a potential customer retention tool whenever the company loses a contract with one of its private label and co-brand partners.  

The company finances these loans through deposits and loan syndications.

BFH is the most subprime of all the publicly traded credit card companies. Its average loan balance is $870. Its private label portfolio has a balance that is even lower than that. As a result, BFH boasts the highest loan yields among its peers. Peers like Capital One also have loans outside of credit cards which further lowers their average loan yield.

The company shares revenues with its partners through Retailer Share Agreements or RSAs. BFH does not break out this amount but it amounts to 18% of interest income and 3.7% as a % of interest-earning assets for Synchrony, the closest peer. It is likely even more than that for BFH.

History and current balance sheet

Alliance Data was written up seven times on VIC. Since the renaming, Bread Financial has been written up once as a short on VIC. While the stock is down 90% since 2015, the underlying earning power has not changed that much. I believe this is the result of investors and management evaluating the company today on more conservative metrics than in 2015. Today the company is largely being evaluated on GAAP EPS. In 2015 management and investors focused on adj EBITDA, FCF and adj EPS. Furthermore GAAP EPS today is more conservative than GAAP EPS in 2015 due to CECL accounting. This becomes clear if we compare 2023 pre-tax pre-provision earnings of $2.1bn with 2014 pre-tax pre-provision earnings of $1.6bn. And this doesn’t even adjust for the fact that the company disposed of two large divisions. Because of these two other asset light businesses the company owned and because the company was less dependent on deposits, BFH was not regulated and was not susceptible to capital ratios in 2014. Hence the company was able to operate with a negative tangible book value and negative capital ratios. Since then these two businesses have been disposed, deposits have grown and new management is operating the company more like a traditional financial. Bread has spent the last few years rebuilding its balance sheet. In Q3 2023, BFH disclosed for the first time its CET 1 ratio for the entire company, 12.9%. I think it is important to note that the fact that Bread was able to over-leverage and have a negative tangible book value is a result of its high return on capital business. Its return on capital is much higher than other balance sheet - intensive financials. Leverage was high compared to its assets but not that high in comparison to its earning power.

Recent trends

Delinquencies, charge offs and provisioning has increased recently. While unemployment is still strong, management says that its customers are significantly impacted by inflation.

Regulation on credit card late fees

On top of the worsening credit trends, the CFPB is expected to finalize its credit card late fee rule in January. The proposed rule would lower late fees from $30 for the first late payment and $41 for subsequent late payments to a max of $8. It is expected that the rule will be implemented in H2 2024. While the credit card companies don’t disclose late fees, this should have a material effect on top lines. As BFH has the lowest average account balances in the space, it is logical to assume that it generates the highest amount of late fees as a % of revenue. Management has confirmed this. Below are estimates from Barclays on how much late fees BFH generates. I think their numbers are in the right ball park.

While analysts show the analyses above, they are not incorporating this analysis in estimates for 2024. I am sure there are many short sellers that are excited that these companies will miss earnings this year. However I don’t believe that means that no one is aware of this. Late fees have been discussed on every single earnings call and conference event that BFH and peers have attended. Sell side analysts simply don’t make forecasts like this when they don’t have any details on the changes. I believe BFH’s valuation showcases that the market is very aware of this.

Fraudulent conveyance lawsuit

The last BFH short write-up on VIC also highlights the fraudulent conveyance lawsuit that BFH is facing due to the Loyalty Ventures bankruptcy. BFH spun LYLT off in 2021 and LYLT went bankrupt within less than 2 years. I am certainly no expert on fraudulent conveyances but I don’t believe this is a large risk. My primary reasons for thinking this are the following: 1) when LYLT was spun off it raised new debt, it is not like BFH fraudulently transferred debt from the credit card business to LYLT. 2) The biggest trigger for the bankruptcy was the loss of LYLT’s largest customer that came after the spinoff and from all we know, management was not aware of this before the spinoff. 3) Lastly, management has said that this is not an issue.

Fantastic return on assets

In good times, BFH is a fantastically profitable business. This is best illustrated by one of the charts in the investor presentation. The chart below shows pre-tax pre-provision earnings as % of average loans. There are very few financials that have an ROA as high as BFH. The chart shows that even if credit losses were to approach 2009 levels, the company would generate a pre-tax ROA of 1%. The company is currently levered about 10x assets-to-equity and going forward this will be around 8x. The chart shows a pre-tax ROA of 4.5% to 5% through the cycle. This would translate to an ROE of 27% (4.5*0.75*8) at 8x leverage. That sounds like a great business. It also has higher returns than its peers through the cycle albeit higher risk in a downcycle. If this is true, then why is it the case that BFH has higher returns than peers? I think some of the higher returns are simply compensation for the higher risk and higher cyclicality. But I also think that Bread’s smaller partners are more attractive than serving large retailers like Costco, Walmart or Apple. This niche is too small for some of the larger peers (BFH has $20bn in assets vs SYF at $110bn).

Conclusion

The pending regulation on late fees represents a watershed moment for Bread. I think demand for credit will always be there and the market will adapt to any regulations that come its way. The question is if Bread will be left behind or change with the market. One or some variation of these three scenarios should happen:

1) Bread raises APRs and introduces a bunch of fees that make up for the loss of late fees
2) Bread customers are no longer profitable for Bread and move to a different slice of the loan market (payday loans, installment loans, pawn shops, etc). Bread is not able to replace these customers and dramatically shrinks or goes out of business
3) Scenario two happens but prime customers also become more risky for banks and these customers shift down to Bread. Bread’s business stays the same as it now generates slightly lower loan yields but also lower credit losses

Given the strengthened balance sheet I think BFH should survive as long as earnings this year are 0 or slightly negative. Even if its business worsens thereafter and goes from a 30% ROE down to a 15% ROE, it should be a great investment at 78% of tangible book value. Given this tremendous upside, I have bought into BFH before the final CFPB rule is announced and plan on riding through what should be a very turbulent two years.

Catalyst

- Surviving 2024