Description

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Synchrony Financial was written up 3 times on VIC, each with a lower stock price.  Today’s writeup will buck the trend and is presented at the highest stock price yet.  In all seriousness though, I think that at current stock price level, Synchrony’s stock provides an opportunity for a 2x return in the next couple of years with a limited downside risk.

After 3 writeups, I believe that a short intro would suffice.  I prefer to focus this one on the current opportunity.

Background

Synchrony is a private label credit company.  It teams up with retailers (Physical ones like Lowe’s / TJX or online ones like Amazon / PayPal) and it uses the retailer's sales channels to acquire customers and issue them credit cards. 

When customers use the credit card (within the retailer or outside of it), Synchrony generates income (mostly interest income plus a smaller amount of fee income).  This income is normally shared with the retailers in the following way:

1.       Synchrony will keep the first 1.5% ROA generated on the program.

2.       Synchrony and the retailer will split evenly anything over the first 1.5% ROA.  The retailer part is called Retailer Share Agreement (RSA) and was covered on the previous writeups.

This model cuts the CAC, which is very expensive for traditional credit card issuers and is negligible in this case.  The flip side is that Synchrony has to split some of the economic benefits.  Since the spinoff, the average ROE was 20% and the ROA was 3%.  The ROE is consistent with competitors (say DFS) while Synchrony’s ROA is higher.  This is because of the over-capitalization which is part of the opportunity and will be discussed later on.

In recent years the company lost some of its big customers such as Walmart and Gap.  The loss of customers that had been served for decades demonstrates that the business is not as sticky as some once believed to be.  However, it also demonstrates one more thing.  It shows that management will not sacrifice profitability or returns for the sake of top line growth.  They clearly prefer a smaller / higher ROE business to a larger one with a lower ROE.

In the Gap case, it wanted Synchrony to guarantee a minimum income level to Gap.  This income would have been higher than the then program income even though the program is declining (along with Gap’s business).  For some reason, Barclays happily signed on to these terms.  It did not make sense for Synchrony who said at the time that by selling the receivables to Barclays and repurchasing shares with the proceeds, the divestiture will be EPS neutral before the contribution of the gain on sale.  Since management disclosed the economic rational of their decision, the stock price went down, making the repurchase alternative look even more attractive.

Core Business

The core business of Synchrony is making money of its receivables.  While the company lost large customers it also gained new ones recently.  Among them are:

1.       Venmo

2.       Verizon

3.       Walgreens

Management commented that each of the above programs is expected to become a top-10 customer for the company.  In addition, Synchrony had been expanding outside of retail and into new niches such as veterinary care, ortho / dental practices and so on.

The company reported that it does not have any major account renewals before 2024.  This provides 2 years of organic growth before the possibility of losing a major customer.

On the Sep 2021 investor day, management guided to a 7-10% long term growth rate in its receivables.  Two full years of this growth can more than offset a loss of 1 or even 2 of its largest accounts.

During COVID, Synchrony’s customers (and pretty much every other consumer) took far less credit card debt than normal, because the government sent them checks when they have been mostly at home, spending less.  The decline in overall US credit card debt had bottomed and is increasing again, but the current total US credit card balances are still 10% below the 2019 peak[i].   I expect credit card spending to increase as people get back to normal and no longer have the benefit of government money.

Another factor that can support the loan receivables growth is inflation.  People will have to spend more on pretty much everything.

Capitalization

The company had been overcapitalized since the spinoff.  Management acknowledged that and deployed capital to fund growth, dividends and share repurchases.  The latter part was the largest piece of the mix, allowing the company to retire 1/3 of its shares in the past 5 years.

When COVID hit, the company obviously slowed down credit expansion.  Then, the government started writing people checks, which blunts the need for credit card debt.  In addition, people locked at home spend less than people out and about.  At the same time, the regulators stopped banks from repurchasing shares.  The impact of all this was a buildup of capital.

Coming out of COVID, the company is overcapitalized by a large margin.  The Total Capitalization ratio was 18.3% at yearend vs a 10% regulatory requirement.  Management said that they want to get far closer to this limit (which again, the company was on its way to it pre-COVID, but built a lot of capital during the recession).  Getting to 12%, frees up  ~$5B of capital that can be used for repurchases on top of the ongoing repurchases that are funded from earnings.

Needless to say that earnings need to fund loan growth (because loan growth requires capital).  I find the following framework helpful in thinking about how earnings funds growth.  If the company has 20% ROE (more like 25% with the right capital structure) and it wants to grow loans 7-10% a year, than it will need to retain 35-50% of earnings to keep capital ratios flat.  This means that the company can use at ~half of earnings for share repurchases + deploy the $5B in excess capital (I assume the spare will be used for dividends).

Management

The fact that management will let go of big accounts when they don’t meet its profitability hurdles and then deploy the freed-up capital into buybacks speaks loudly to their priorities, which are increasing the per share value.  This is always important, but even more so for a financial company.

Valuation

A simple model could be estimating the 2024 receivables size, applying an NII and calculating the EPS based on the number of shares we think the company will have at the time.

If we assume a 5% annual growth rate in receivables (no renewals until 2024, management guided to 7-10% annual growth rate), the company will end 2024 with $93.5B of receivables.  Historically, that would translate to total interest earning assets of over $103B. Let’s round it down to $100B.  NIM is guided to be 16%.  If we cut it down to 15.5% we get an NII of $15.5B.  RSA + NCO should be 10% of receivables (they offset each other as explained on the previous writeups).  This leaves us with $6.15B before corporate expenses and other income.  Applying the 32% efficiency rate (had better than that pre-COVID), and adding $400M of other income (is already closer to $500M), leaves us with an EBT of 2.8B, or just over $2B after tax and preferred dividends.

Assuming the company repurchases $2.5B / year + $1B from the Gap receivables, that’s $8.5B worth of shares will be purchased.  If repurchases are done with an average stock price of $50 (33% higher than today’s price), they could retire 170M shares, leaving 360M shares outstanding.  EPS would then be $5.5 and the P/E based on the current share price would be 6.8x. 

Note that this scenario would still leave them at over 16% of Total Risk Based Capital ratio.  Getting to 12% would “require” repurchasing another 60M shares, leaving only 300M shares outstanding.  In this scenario the EPS will be $6.7 and the P/E 5.5.

The above excludes the possibility of a faster post-COVID growth rate and basically takes a haircut to any management guidance or past performance.  Note that a big piece of the value will come from share repurchases and I assumed here that they are done at $50 / share.  If the buybacks are done at the current share price, the actual number of shares outstanding will be 304M or 280M in the two scenarios above.  The EPS will be $6.6 or $7.1 and the PE 5.7 or 5.3.  Seems like a double in any reasonable scenario.

Let’s talk about downside protection.

Alternative Book Value

Synchrony is an example of a financial company that operates with a business model of high interest rate loans coupled with relatively high loan losses.  The introduction of CECL in 2020[ii] made the GAAP book value of these type of businesses even sillier than it was before.  The reason for that is that under CECL, Synchrony needs to take a provision for the expected losses for the entire expected lifetime of the loan.  On the other hand, the interest on a loan is recognized as the loan amortizes.   This creates two distortions in the financials:

1)      The P&L will look less good than it really is when the company is growing its loan receivables.  I would ignore this because it is not that meaningful for Synchrony’s expected growth rates.

2)      Book value is heavily distorted.  It was already bad pre-CECL, but with CECL the allowance for loan losses almost doubled.  This is the quirk I wanted to emphasize and explain here.

By recognizing all future possible losses (but none of the associated income), the book value under CECL does not represent the economic book value.

For this reason, I like adding back the allowance for loan losses to get an Alternative Book Value and an Alternative ROE. 

This is not my version of WeWork’s Community based Adjusted EBITDAR.  This truly describes the economic reality of the business.  For example, when Synchrony sold the Walmart and Gap receivables, they:

a.       Received the full value of the receivables.

b.       Received a premium on top of the face value (gain on sale).

c.       Released the loan loss reserves.

The Alternative Book Value at yearend 2021 was $41 and will probably be over $47 by yearend 2022.  This provides downside protection even if the business is completely broken.  Based on this data, even if the business is broken beyond repair and will be liquidated, Synchrony should still trade 25% higher this year (probably more, because we Alternative BV ignores the gain on sale).

As a side comment, I want to add a bit of color on the Alternative ROE (ROE when using the Alternative BV rather than the GAAP BV).  I do this to make sure the business is generating enough returns even ignoring the CECL quirk.  Since the spinoff, the average Alternative ROE was 15%, demonstrating the strength of the core business.  It also answers the question ‘why should Synchrony earn 20-25% ROE when others can settle for 10-15%?’.  As this matric demonstrates, if the accounting would reflect the economic reality, Synchrony would not have reported the stated 20-25%, but rather a 15% ROE.

Risks

1)      Competitors have lower ROE expectations and can underprice

a.       The Walmart / Gap experience demonstrates that long time customers do not need Synchrony and can take on the likes of Barclays and Capital One, who have far lower returns requirements.

b.       However, it does seem like Synchrony is providing a lot of value to startup programs as evident from their wins over the years.

c.       Startup programs are signed for long term periods (e.g., 10 years), providing enough runway to generate strong returns before there’s even an opportunity for replacement.

d.       Also, remember the Alternative ROE.

e.       Even if Synchrony will lose the bulk of its business, shareholders are still going to make money (Alternative BV protection).

f.        Finally, I asked Discover once why they are not in the private label business and their response was that it was more complicated than one might expect and that it requires scale.  Obviously, there are already enough competitors in the business, but thought it was an interesting comment.

2)      Dependence on key customers

a.       Top 5 customers represent half of receivables. 

b.       Loss of each will be material, but as shown on the previous losses, can be fully offset with reallocation of the freed-up capital into share repurchases.

3)      General financial black-box nature.  Hard to gauge credit quality until it is too late

a.       The company has a great track record and was profitable in 2008-2009.  Based on my model it will be making money with the charge off levels experienced in 2008-2009 (LSD ROE).

b.       Management gave up on two large customers when the program was below their return hurdle and then they returned the capital to shareholders.

4)      Regulation / “Usury rates” rhetoric

a.       I do not have specific insights.

b.       It is not a new industry and the FCPB has been around for over a decade.

5)      Credit cycle turning

a.       Unlikely an immediate threat given the savings and overall debt levels.

b.       Synchrony has a good track record of not losing money in a downturn (including 2008-2009).  Their customer credit profile had never been better (highest FICOs, etc.).

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

[i] https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2021Q4

[ii] https://www.occ.treas.gov/topics/supervision-and-examination/bank-operations/accounting/current-expected-credit-losses/index-current-expected-credit-losses.html

Catalyst

Large share repurchases announced after the capital plan is approved (should be in the next few months).