Description

Summary

Recommend buying BFH ($69 price target, 54% upside) as one of the few remaining mispriced assets within financials. Credit is stabilizing, capital is significant and growing, the CFPB late fee rule¹ (and the accompanying short thesis) is dead for now, and the 20%+ ROTCE profile at a sub-TBV valuation are a tantalizing combination. BFH is entering a new era. With the rehabilitation of credit and capital complete, we see the company pivoting back to growth, showing improving returns, and delivering upside to consensus estimates.

Background

Bread Financial Holdings, Inc. (formerly Alliance Data Systems, or “ADS”) is a leading private-label and co-branded credit card provider. The company has over 39MM accounts and facilitated $28B in annual spend across over 100 credit card partners, including several well-known retail brands like Signet Jewelers, Victoria’s Secret, the NFL, Ulta Beauty, and Dell.

We have historically had a negative bias toward BFH for various reasons: a slippery management team, high leverage and low regulatory capital ratios, outsized subprime consumer exposure, over-reliance on a handful of private label partnerships, and, more recently, dependence on late fees, which are the target of the CFPB’s crusade against “junk fees.” However, objectively, the story has changed. Current CEO Ralph Andretta assumed his position about four years ago. He has done yeoman’s work, replaced the C-suite, rebuilt the balance sheet, and turned over a number of retailer partners. CFO Perry Beberman is a sober, clear communicator who manages expectations well. In sum, this is no longer the ADS that burned many an investor.

Thesis

Our thesis on BFH is straightforward, and it checks many of the key KPI boxes for consumer finance investors: (1) credit performance is showing signs of stabilization, with delinquency formation slowing following tightening of the underwriting box; (2) capital levels and TBV have significantly improved as the company has de-levered over the past several years; (3) not only have the odds of late fee rule implementation become diminished, but there’s also an increasing chance that earnings and ROTCE will actually reset to a higher level if the rule never becomes law; and (4) it’s one of the cheapest stocks in the overall financials subsector on an earnings and P/TBV basis, despite a top-quartile projected ROTCE.

1) Credit: Stabilizing, Improvement on the Horizon

The credit card sector – and consumer finance more broadly – is hypercyclical, and BFH is no different than any other name in the group in terms of the importance of credit performance. Simply put, when credit trends show signs of stabilization/improvement, the stocks typically outperform, and vice versa. 

During COVID, stimulus checks and a general pull-back in consumer spending resulted in historically low delinquency and net charge-off (NCO) rates.  Beginning in mid-2022, as spending levels resumed and consumer savings levels began to bleed down, delinquency formation across the industry began to reaccelerate. 

It took essentially one full year (June 2023) before credit first showed signs of stabilization – at COF – where the YOY change in the delinquency rate began to decelerate. COF's stock followed suit, with the P/E multiple expanding nearly 2 turns over the following 6-12 months.

For BFH, stabilization has taken a bit longer, but we are now starting to see it emerge following management’s efforts to tighten underwriting over the past few years (VantageScore is now up to 715, and the percentage of borrowers with VantageScores above 660 is up to 56%, from 53% pre-COVID).  As illustrated by Figures 1 and 2 below, we have now seen six consecutive months of stable or decelerating delinquency rates at BFH, with the May 2024 rate of 5.90% up just 40 bps YOY. 

Figure 1: Credit Card Delinquency Rates

Source: Company documents

Figure 2: YOY change in Delinquency Rate

Source: Company documents

From an NCO rate perspective, while the May rate of 8.8% remains high, we would note that a) the YOY change decelerated to +40 bps, from +80 bps in April and +210 bps in March; and b) it came in below guidance of 9%.  More importantly, at its recent investor day, the company reiterated expectations for the NCO rate to peak in May before improving the rest of the year (largely a function of the slowing DQ formation), which implies an NCO rate sub-8.8% for 2Q24, below consensus of 8.9%.

To be clear, we are not out of the woods yet for BFH, or the subsector more broadly. Consumers’ excess savings have dried up and inflation remains sticky, and the employment backdrop remains favorable. If we get a turn in employment, we could easily see pressure reemerge. However, these early signs of stabilization – combined with the tightened underwriting – give us comfort that the worst may be behind us on the credit front.

Finally, BFH has the highest reserve levels in the sector (even amongst near-prime/subprime peers), at 12.4% of total loans, and it has seen the biggest increase in reserves versus its day-one CECL levels (Figures 3 and 4), leaving BFH with a) plenty of coverage in the event credit performance worsens again, and b) room to drive further earnings growth through reserve releases should the macro environment cooperate.

We concede that BFH should have the highest reserves given the higher expected losses, but it’s important to point out that the company is also getting paid for the risk – the company’s credit card yield of 27.2% in 2023 compares to its peer average (SYF, COF, and DFS) of 18.5%, and when accounting for its higher NCO rate, BFH’s risk-adjusted yields were still more than 560 bps higher than the peer average.

Figure 3: BFH Has the Highest Reserve Levels in the Sector

Source: Company documents

Figure 4: And It Has Taken Reserves Up the Most vs. Day 1 CECL Levels

Source: Company documents

2) Capital: Transformation Nearly Complete, Buybacks on the Come

BFH has meaningfully improved its capital position by focusing on deleveraging. Through ongoing cash flow generation and the disposition of the lower-margin Loyalty Ventures business, the company has paid down $1.8B in parent-level debt (-58%) and driven tangible common equity up threefold since 2020 (Figure 5). 

Figure 5: Meaningful Capital/TBV Improvement through De-levering

Source: Company documents

BFH’s Common Equity Tier 1 (CET1) level is up 230 bps since 4Q21 and sits below only COF among credit-card peers. Furthermore, the company’s $4.5B of tangible common equity plus reserves now sits at 211% of its current market cap, which is significantly above the peer average (Figure 6). With ongoing uncertainty around the late fee rule, management’s decision to continue to build capital near-term is prudent. However, should the rule get watered down, delayed, or invalidated (more on this below), we could see share repurchase activity sooner.

Figure 6: Reserve/Capital Comparison

Source: Company documents

3) Late Fees: Risk Diminished, Blue Sky Scenario a Distinct Possibility

BFH is the most exposed card issuer to the CFPB’s late fee rule, but we believe the odds now favor the rule stalling out before it becomes law. Accordingly, we believe BFH’s underlying earnings power is likely stronger than expected as some level of the company’s mitigating actions could persist even if the rule never comes to fruition.

By way of background, as part of its crackdown on “junk fees,” the CFPB has proposed cutting the allowable credit card late fee to $8, from the current average of approximately $32. The rule was finalized on March 5, 2024, but the industry filed an immediate lawsuit challenging the merits of the rule in a district court in Texas.

The judge, Mark Pittman, initially attempted to transfer the case to D.C., arguing that the Texas jurisdiction was inappropriate, but the case was soon kicked back to Texas after the 5^th Circuit Court of Appeals (which has shown favorability to industry in other cases) overruled that decision. Judge Pittman then issued a preliminary injunction against the rule becoming law pending the outcome of the Supreme Court’s review of the CFPB’s funding structure, while acknowledging that there were merits to the industry’s case.  The Supreme Court wound up upholding the CFPB’s funding structure, which then prompted the CFPB to once again attempt to have the case transferred to D.C. On June 18^th, the 5^th Circuit Court issued a final ruling that will keep the case in Texas. In the meantime, the rule is stayed. 

From here, we expect a drawn-out legal process to determine the ultimate fate of the rule, but the fact that it is staying in Texas is an important, positive development. First, as mentioned above, Judge Pittman, without actually ruling on the legality of the rule, acknowledged that there was some merit to the industry’s case. Second, as demonstrated by the venue saga, the 5^th Circuit is willing and able to come over the top of Judge Pittman, in the event that his ruling were to go against the industry.  Accordingly, we believe the odds favor the rule ultimately dying on the vine.

In the meantime, BFH is not standing still. The company has implemented several measures to blunt the ultimate impact of the rule should it become law, including: increasing APRs, introducing promotional fees, paper statement and annual fees, and revising retailer share agreements (Figure 7). While the full impact of these mitigants will take 2-3 years to earn in, some of the fee initiatives will be realized this year.  

Figure 7: Late Fee Rule Mitigants

Source: Company documents

Importantly, at the company’s June 18^th Investor Day, management provided favorable intermediate and long-term guidance that includes the impact of the late fee changes, which still forecasts a low- to mid-20% ROTCE in the medium term (2-3 years), and a mid-20% ROTCE over the long term (Figure 8). While our view is that the late fee rule will not come to fruition and some of these mitigating actions will remain in place (driving a stronger earnings profile), even a 20% ROTCE should support a valuation closer to 2-3x TBV vs. BFH’s current sub-1x level.

Figure 8: Late Fee Rule Mitigants

Source: Company documents

4) Valuation: ROTCE Profile Supports Meaningful P/TBV Expansion

BFH trades at 7x 2025E EPS vs. credit card and other consumer finance peers at ~10x.  On a P/TBV basis, the stock trades at 0.98x vs. peers at 1.9x.  As discussed above, BFH’s normalized ROTCE is in the 20%+ range, and as illustrated in Figure 9, peers that generate over 20% ROTCEs trade in a range of 1.5-7.0x TBV.  Even the low end of 1.5x would imply a $69 stock, or 54% upside from current levels. 

Figure 9: BFH’s Pro Forma 20%+ ROE* Supports a Higher P/TBV Multiple

*Chart denotes P/TBV vs. 2025E ROE as per Bloomberg Consensus.  For BFH, the ROE reflects the 20%+ intermediate term guidance.

Source: Bloomberg, company documents

Risks

• Late fee rule, as currently written, becomes law
• Macro deterioration pressuring consumer credit

Endnotes

1 - https://www.consumerfinance.gov/about-us/newsroom/cfpb-bans-excessive-credit-card-late-fees-lowers-typical-fee-from-32-to-8/

Catalyst

• Late fee rule becomes invalidated in court
• Credit improvement drives reserve releases in 4Q24/2025
• Potential capital return program commences in 2025