Description

With the selloff in financial stocks and uncertainty around funding gaps, cash sorting and the like, we like a short in a financial where the thesis isn’t predicated on the speed of NIM compression, deposit flight, cash sorting or other mark to markets — but those would be gravy. 

Thesis

Bread Financial (BFH) is a subprime lender of consumer credit cards that we believe may be forced to raise capital amounting to ~60% of their current market cap under the fraudulent conveyance as laid out in a recent 8K by Loyalty Ventures (LYLT).  BFH has a $1.5B market cap (1x tangible book), and we believe they are very clearly liable for ~$825mm of claims.  Further, we don’t believe they have capacity to raise any additional debt and still maintain appropriate bank equity ratios, so they could be forced to do a massively dilutive equity raise. 

On top of the impending fraudulent transfer issue, it’s an opportunity to be short a company that is lending to subprime consumers at just over 1x tangible book value heading into a potential recession AND has a potential additional regulatory pickle to boot.  We believe there could be 70% downside in the stock if/when they are found liable for fraudulent conveyance and get hit with proposed new CFPB regulations.

Quick Business Overview

BFH has a ~$21B loan portfolio, of which, 56% private label retail cards, 39% co-branded credit cards, 4% their own credit cards and 1% buy now pay later.   45% of their loans are to consumers with subprime credit ratings.  They fund the loans with a mix of retail deposits (26%), wholesale deposits (40%) and the rest from corporate borrowings. 

Fraudulent Conveyance

We believe BFH stole value from LYLT and is guilty of fraudulent conveyance.

Under federal law, a fraudulent transfer has occurred if, within two years before the bankruptcy filing, an entity transfers property or value from a debtor for which the debtor receives little or no consideration while the debtor was/is rendered insolvent.  We believe that is exactly what happened here and why LYLT creditors are going after BFH. 

Relevant corporate history:

1. LYLT, a loyalty rewards business, was spun out of BFH on 11/3/21

To capture value from the spin, BFH saddled LYLT with $650mm of debt, swept $100mm of cash from LYLT’s balance sheet, and set up tax agreements that made LYLT subject to additional liabilities of C$100mm (~$75mm), for a total of ~$825mm (not to mention some additional value transfer under Transition Services Agreements).  LYLT received nothing from BFH in return.

1. 1. This value transfer from LYLT set the spinco up for failure.  As an undercapitalized company, LYLT could neither support customers nor invest in the business.
2. Directly as a result of the overleveraging with insufficient consideration, LYLT filed for bankruptcy in the Southern District of Texas on 3/9/23 

We went from November 3, 2021 to March 9, 2023… so if I did my math right, that means they made it just over 16 months from the creation of the debtor at the spin to the bankruptcy filing, which we think makes it pretty clear that BFH stole value from LYLT and sent it off to certain corporate death, i.e. made a fraudulent transfer.

Under both federal and statutory bankruptcy law, we believe BFH is on the hook for stealing this value, as LYLT had unreasonably small capital and had more debt than it could support. 

Unsurprisingly, LYLT’s 8-K from March 23^rd said that their plan is exactly that, to go after Bread in bankruptcy:

Bread was clearly aware of this possible issue with a new addition at the end of their risk factor in their 2022 10K relating to the spin:

Notably, that language was absent from their 2021 10K risk factor… this is NOT boiler plate spin language

Financial Impact of the Fraudulent Conveyance

So what does that do to BFH’s financials?  Putting aside the gobs of legal fees they’ll need to incur along the way, if they have to provision for the liability, that would knock ~$16 / share off their TBV to ~$13. 

Tangible Common Equity / Total Assets (TCE/TA) which they’re targeting to be >8% is currently 6%.  If they had to take that $825mm provision, that would cut their TCE/TA to ~2.6%, not exactly the “fortress balance sheet” management has touted and would put them below the required CET1 4.5% capital ratio.  I’m not a banking analyst, but that seems like a problem. 

Other Fundamental Issues

1. They divested their ~$2B, mostly prime BJ’s Wholesale book of business, increasing their net exposure to subprime borrowers from 38% to 45% at the absolute wrong time
   1. Delinquencies have already risen from 5.5% at year end to almost 8% in February, though that is partially exacerbated by operational SNAFUs
   2. While they appear to have taken large reserves (11.5% up 100bps y/y), it’s predicated on unemployment staying below 5%
      1. Every 1% reserve on the book would be an incremental $200mm hit to equity
2. The CFPB has proposed regulation that could wipe out >50% of their earnings in 2024

On 2/1/23, the CFBP put out an NPRM that they intend to make the credit card lending much less profitable by capping late fees at $8 vs. current max of $41

Mgmt has not disclosed their late fees but has said they have more exposure to late fees than SYF.  SYF’s late fees are ~3% of loan balances and ~23% of revs.  Putting those same #s on BFH implies ~$600-900mm of late fees.  Alternatively, assuming their 12/31 balance of $1.1B of delinquent loans / $400 avg. PLCC balance * 6 late fees per card (a bit higher than CFPB averages) * $38 avg late fee = ~$630mm – similar ballpark.

If late fees were reduced to $8, they’d lose ~$500mm of high margin revenues.  Assuming they can offset some with other fees and pain sharing with their partners, we estimate the CFPB change will cut EPS by $5 which wipes out ~60% of their average EPS over the past several years. 

Conclusion

Taking this all together, we see Tangible Book value of $1.4B being cut by to less than $400mm ($8 / sh) from an $800mm+ hole from fraudulent conveyance + another potential $200mm+ from rising reserves on the weakening economy.  The market is paying 3.5x tangible book value for a stock that likely needs to raise capital while its earnings are impaired by impending regulation and potentially heading into a recession.  In contrast, SYF, which has less credit risk than BFH and no fraudulent conveyance issues, trades at 1.2x tangible book. 

Disclosure

At the time of its publication, funds and accounts managed by the author’s employer were short BFH.  Both before and after the publication of this post, without making any public or other disclosure or giving notice to any party, except as may be required by applicable law, such funds and accounts may, at any time, buy and sell securities of BFH (and other companies mentioned in this post), including by changing to a long in BFH. The information set forth in this post does not constitute a recommendation to buy or sell any security, or legal, tax, investment or other advice. This post represents the opinion of the author as of the date of this post. This post contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential,” “outlook,” “forecast,” “plan” and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This post is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. The author makes no representation as to the accuracy or completeness of the information set forth in this post and undertakes no duty to update its contents.

Catalyst

Monthly reports showing increasing delinquencies

Continued legal actions the fraudulent conveyance action detailed in LYLT’s 8K

Potential dilutive capital raise

Additional reserves / provisions / charge offs

Bankruptcies of its mall based (or other) retail partners