Description

Executive Summary:

• SYF is trading at 4.7x trailing earnings vs. an average of 9.3x since 2014 IPO
• The shares are cheap primarily because of recent banking stress, recession fears, and some regulatory uncertainty
• Recent bank failures and stressed regional banks shows relative strength of SYF's operating model
• Recession fears are overblown, SYF can weather an economic storm should it come, there's reason to believe the recession everyone is expecting won't materialize
• Regulators have proposed curbing late fees, which would hurt SYF's top line; it can offset this by charging more in interest and/or less in retail share agreements
• Opportunity to purchase wonderful company, which has generated average return on tangible equity of mid-20% since going public in 2014, at a wonderful price
• Accretive share repurchases will allow company to rapidly grow EPS over next few years

Note: estimates shown above are current consensus estimates.

Synchrony Financial (SYF) has been written up on VIC multiple times and is well-covered by Wall Street sellside analysts. The stock currently screens optically cheap. Surely there must be a good reason, right?

In this write-up, I offer a unique framing for thinking about SYF, and argue that investors are underestimating the durabilty of the company's earnings power. Additionally, I make the case that current recession fears are overblown, and that many headwinds faced by the company and industry in 2022 won't repeat in 2023. Finally, I argue that, at 5x earnings this stock is trading below intrinsic value and will most likely take advantage with accretive share repurchases that will help drive per-share earnings growth.

Overview

As all previous write-ups have noted, SYF is the largest private label credit card issuer in the US. What’s been underemphasized, or outright omitted, is that SYF is a federally chartered bank (or more precisely, Synchrony Bank is a wholly-owned subsidiary of Synchrony Financial). I bring this up because analysts and investors generally categorize SYF as a Consumer Finance company, because of the consumer loans on the asset side of its balance sheet, rather than as a bank. But as the recent stress in the regional banking sector has demonstrated, the structure of a financial company’s liabilities is perhaps even more important than its assets.

SYF has recently been dragged down with the sector weakness in financials. However, a closer look reveals the strength of SYF’s operating model. As we saw with the collapse of Silicon Valley Bank, flighty depositors can destroy a bank, regardless of the quality of the bank’s assets. Unrealized gains (instead of losses) in SVB’s HTM portfolio would not have saved it from failure; it failed because its depositors decided to run.

Banks vary in approach to the problem of deposit-flight risk. SVB explicitly wrote covenants in its loan contracts that required creditors to keep their deposits with it. Because these were unconventional loans, many to early-stage businesses that lacked positive cash flow, SVB’s customers were willing to comply (until they weren’t). First Republic relied on a high-touch model, with best-in-class customer service. This requires abnormally high operating expenses, somewhat offset by sticky, low-cost deposits. As we all know, FRC’s focus on customer service didn’t help prevent the recent deposit outflows, pushing it to the brink of failure before 11 banks got together and agreed to make a $30bn deposit infusion into the bank.

By contrast, SYF (similar to ALLY) operates a low-touch “direct bank” whereby it offers deposit products exclusively online (it has no brick and mortar banking presence). In 2022, 81% of SYF deposits were held by retail customers: CDs, savings accounts, money market and demand accounts. The balance was brokered deposits. As of year-end 2022, SYF had $71.7bn deposits, $56.2bn (78%) of which were FDIC-insured. Deposits made up 84% of SYF’s total funding sources as of year-end, and the average maturity of SYF’s deposits was 1.3 years.

Turning to the asset side, most of SYF’s loans receivable (95%) are consumer credit cards, while the balance is consumer installment loans (3%), commercial credit products and other. SYF’s total loan receivables before allowance for credit losses was $92.5bn as of 12/31/22, and total interest-earning assets was $100bn. Notably, 97% of SYF’s loans receivable are due within 1 year.

Taking a step back for a moment, it’s worth highlighting the contrast between SYF and the regional bank stocks who have suffered huge losses over the last month (including SVB and FRC). Much of the criticisms of SVB and FRC has been that they took too much duration and liquidity risk: they had large uninsured deposit balances that were immediately redeemable upon demand, while their assets were tied up in low-yielding loans and securities which suffered M2M hits after the Fed raised rates dramatically in 2022. Many of the regionals also have exposure to CRE including office properties that are distressed. SYF has none of those problems: again with 97% of loan receivables due within a year, and an average maturity of 1.3 years on their deposits, they have none of the “borrow short lend long” risks that are typical of a commercial bank. They pay competitive rates on deposits, 78% of which are insured by the FDIC, which they are able to afford because they don’t have any physical bank branches and their assets are extremely high-yielding.

As a white-label credit card issuer, SYF partners with retailers, doing the credit underwriting, lending, and collections work while the retailer manages the customer acquisition and relationship. SYF also offers Dual Card and general purpose co-branded cards, which when used outside of partner networks generate interchange fee income. Other sources of income include debt cancellation fees.

Like any other bank, SYF’s profitability is predominantly derived from the net interest income it generates on its interest-earning assets. In this respect, SYF generates extremely high net interest margin (NIM) compared with more “conventional” banks: over the last ten years, SYF’s NIM has averaged 16%, vs. industry average of around 3%. However, SYF has much higher average credit losses and than traditional banks and also shares a portion of its net income with its retail partners. Referred to as Retail Share Agreement (RSA), this is a variable cost that functions as a hedge for SYF: when SYF’s net interest and credit performance is strong, RSA costs go up; when net interest and credit costs weaken, RSA costs go down. This not only properly aligns incentives with its retail partners, it also creates a more predictable income stream. Adjusting for RSA and provision for credit losses, SYF’s “adjusted” NIM has averaged around 8%:

Using this framing, we can see SYF’s earnings are predictable and durable, and a recession won’t be as devastating to SYF’s earnings as everyone seems to think (if the market believed the earnings were durable, the stock wouldn't be trading at 5x earnings).

Scenario Analysis

While SYF’s efficiency ratio (non-interest expenses as a % of NII) has historically averaged an impressive 33% (37% in FY22), using the adjusted NIM shows a more pedestrian 54% average. With current tax rates around 23%, we can build a reasonably simple model projection for SYF’s earnings over the next few years, with growth in interest-earning assets as the key driver (perhaps with some modest fixed-cost leverage on non-interest related expenses):

SYF has been very active repurchasers of its own stock; over the last two years, the company has bought back $6.2bn of stock using proceeds from cash generated from operations as well as sales of Gap and BP loans receivable. That amount is nearly half of SYF’s 2022 year-end book equity capital. The accretion of these buybacks has been incredible: in the same year, SYF raised its per-share dividend rate by 5% and yet paid out fewer total dollars in dividends to shareholders:

The difference between what SYF paid out in 1Q22 vs. 4Q22 ($11m) saves the company $44m cash per annum, more than covering what SYF paid out in dividends to preferred stockholders ($42m). Using the scenario analysis outlined earlier, below is a hypothetical share repurchase outcome through 2025:

Valuation

Assuming the above, at today’s $29/share, we are currently creating SYF equity at anywhere from 2.8x to 3.6x 2025 earnings. Assuming 6x as our fair value multiple for SYF, which I still think is far too cheap, SYF is worth anywhere from $49 to $62, or 69% to 114% above today’s price. Since its 2014 IPO, SYF has traded at an average multiple of around 9x; if it does $10 in EPS in 2025, and trades at that historical average multiple, that would imply a three-bagger on the stock.

A strong case can be made that SYF deserves a higher multiple. While reported returns are somewhat lumpy, SYF has generated returns on tangible equity that have averaged mid-20% for the last decade:

The reason that SYF is able to earn above-average returns is because for many of its partners, Synchrony has written in exclusivity clauses in its contracts that grants them a legal monopoly for financing products offered by that partner. Contract terms generally range from 3 to 10 years, often with automatic renewals built in (unless the partner decides to terminate). Thus, these lucrative contracts are sticky and insulate SYF from competition. And as a chartered bank, Synchrony has a lower cost of funding than non-bank consumer lenders, but with sufficient scale and expertise to manage the heavy regulatory burden.

Further, this is not an easily replicable easy business, and I would argue that the $12.8bn of book equity understates the “replacement cost” of SYF’s assets. SYF was spun out of GE and has been lending to American consumers for over a century. The accumulated data, expertise, customer relationships, brand/reputation and process improvements that have taken place over that time are extremely difficult to replicate. The Masters of the Universe over at Goldman Sachs launched their own consumer lending platform in 2016 and recently announced intentions to scale-down and/or exit that business after incurring billions of losses for shareholders. In 2022, GS had an average of $3.5bn of equity capital in its Platform Solutions segment, and recorded a pre-tax loss of nearly $2bn:

Source: Goldman Sachs investor presentation

The fact that GS can’t compete in this industry despite spending billions is proof of SYF’s durable business model.

And while analysts were worried about SYF’s go-forward earnings after losing its Walmart contract in 2018, it appears they dodged a bullet as Walmart is a notoriously difficult partner who beats suppliers down on pricing. As reported in the WSJ over the weekend, Walmart is now suing Capital One in an effort to terminate and/or renegotiate their card deal. COF took over for SYF in 2019 and it sounds like Walmart is unhappy with them as a partner. Per the article, “Walmart alleged that Capital One didn’t provide the customer service it was obligated to offer, such as replacing lost cards promptly. It also alleged that Capital One didn’t promptly post some transactions and payments to cardholders’ accounts.” Once again, this is not an easy business, and SYF has found plenty of new partners in lieu of Walmart, including Venmo, Amazon, and Verizon. It has also expanded into new industries such as petcare and dental.

Another reason SYF doesn’t get the credit its due is because of its classification as a Consumer Finance company instead of a bank. Take for example the following from a JPMorgan report. SYF trades at a similar (actually slightly lower) earnings multiple than OneMain Financial (OMF):

Source: JPMorgan

OMF is a non-bank consumer finance company. Its balance sheet is about one-fifth of SYF’s and it has a higher cost of funds because it’s not a chartered bank and therefore can’t accept government-guaranteed deposits. These companies’ loans receivable carry similar credit risks – here is OMF’s delinquency stats as of the end of 2022:

136m + 92m + 160m = 388m or 3.5% of the 11bn total loans outstanding. SYF is similar at 3.7%:

Both companies have similar credit assets, but SYF has better scale and lower cost of funds, and yet they trade at nearly the same multiple. If investors are worried about recession risks, they could do worse than pairing a long SYF position with a short position in OMF. In my opinion, SYF’s status as a chartered bank makes it less risky and should enable it to command a higher multiple than OMF.

Risks

Finally, I’d like to address the elephant in the room: recession risk. While few people if any would argue SYF’s shares aren’t optically cheap, there is a widespread expectation of economic recession in the coming quarters. SYF CEO Doubles acknowledged this during an industry conference late last year. I have already made the argument that SYF’s business model, particularly its retailer share agreements, helps insulate it during recessions. The company has short-duration credit assets and can “trade up” to higher credit-quality borrowers in a downturn. As of year-end, it had a CET1 ratio of 12.8%, 10.3% reserve coverage and 22.4% loss absorption capacity. In addition, liquid assets made up 13.6% of total assets.

I also think there is a strong case to be made that recession fears are overblown, for several reasons. First, this rate-hiking cycle is different than in past cycles, because the ratio of US national debt/GDP is near historic highs (~120%). The largest holders of US debt are domestic: households, firms and municipalities hold approximately three-quarters of the national debt (a quarter of it is held by foreigners). What this means is that as the Fed raises interest rates, it increases the amount of interest income the US private sector receives on its Treasury holdings. As of 4Q22, the run rate for interest paid on the US government’s debt was $852.6bn, an increase of +42% vs. 600.4bn in 4Q21:

That difference is material; $250bn/yr is approximately 1% of GDP, so assuming 75% of that goes to US holders, it adds 0.75pts to total US GDP, helping support aggregate demand.

Not only that, but since 2008, the Fed started paying interest on reserve balances. Since then, the Fed has replaced Treasury securities with reserves by way of its various QE programs. Over most of that period, the Fed kept rates paid on reserves very low, close to zero. However, the Fed now pays nearly 5% on reserve balances. Thus, the Fed is mistaking the brakes for the gas pedal, turbocharging the amount of interest paid to holdings of Treasuries and reserves and rapidly adding to the federal budget deficit. One of the recipients of this free handout from the Fed is SYF, who as a chartered bank holds a reserve account at the Fed and therefore is eligible to receive interest on its reserves.

Just about everyone, including Wall Street and the PhD’s at the Fed, believe the rate hikes are “tightening” credit. However, total bank credit grew about 6% in 2022:

There are other items that are causing an increase in the budget deficit as well, including COLA-based increases to social security and the various spending bills passed in 2022. Through the first five months of fiscal year 2023, total spending by the federal government has increased by $247 billion compared with 2022, an increase of 52%. Recall that, by virtue of accounting reality, the federal government’s budget deficit creates a surplus in the private sector:

 In FY2022, the deficit decreased by a record $1.2 trillion vs. FY2021, bringing it from nearly 12% of GDP to around 5%:

The fiscal tightening was sufficient to slow GDP growth substantially in 2022; we had two straight quarters of negative GDP growth in 1H22 but no recession. In my opinion, this was the “soft landing” everyone keeps waiting for. So far in FY2023, the federal government’s budget deficit is trending to be around 6.5% of GDP. For context, the deficit averaged 3.5% from 2013 through 2019. This deficit spending is supportive of aggregate demand and GDP growth, helped in part by the Fed’s rate hikes. So while many point to the recent stress in the regional banking system as a catalyst for a slowdown in credit growth and therefore recession, even if that shaves off 3pts of GDP the net effect from that and government fiscal spending would be equal 3.5% of GDP, equal to what the average government deficit was from 2013 to 2019, a period which had no recessions. Therefore, I think the odds of recession are low. As I write this, the front page of today’s FT wrote about how global economic growth has exceeded expectations. Unemployment ticked down to 3.5% on last Friday’s job release, and we recently had a multi-decade low 3.4% unemployment print this past January. When unemployment is low, people have jobs and therefore have income to support loan repayments, which is undeniably positive for SYF. The reason economists and Wall Street analysts have gotten this so wrong is because of a lack of emphasis and/or understanding about deficits supporting GDP growth.

Given that SYF’s performance is directly linked to consumer spending, it’s reasonable to consider consumer sentiment as a factor for the company’s outlook. Arguably the biggest factor in consumer sentiment is inflation (or perhaps more precisely, gas prices and groceries). Both of these items are impacted meaningfully by the price of oil. As we all know, Russia’s invasion of Ukraine in 2022 caused the price of oil and natural gas to spike, leading to the highest inflation in decades. The Michigan consumer sentiment survey hit an all-time low in June 2022. Consumer sentiment and the price of oil are closely linked – the below shows the Univ. of Michigan survey results compared to the price of crude, with the latter inverted for clarity (this has a correlation of 0.6):

So, in 2022 we had record fiscal tightening, record rate hikes, a massive spike in the price of oil and other commodities, the highest inflation in four decades, two straight quarters of negative GDP growth, and an all-time low read in consumer sentiment, and yet SYF still managed to generate $3bn in earnings. These headwinds are flipping to tailwinds in 2023: crude is down 33% from its June 2022 peak and flat YTD, the Fed almost certainly will not increase FFR by another 6,000%, consumer sentiment is improving, and the federal government is pumping more money into the economy than it did a year ago, and much more than it did pre-COVID. Given these factors, I expect consumer spending to grow this year, and SYF will be a major beneficiary.

SYF is seen to be at risk given approximately one-quarter of its revenues are late fees, and the CFPB has proposed severely curtailing how much banks can charge in late fees. However, such a change would result in credit card issuers like SYF charging higher rates on loans, offsetting the impact. Additionally, if SYF’s net interest income falls (fees are included in interest income), that will be somewhat offset by lower RSA expenses. Therefore, I don’t see this proposed change as devastating to SYF’s go-forward earnings.

Catalyst

Share repurchases