Description

NOTE: First post – application idea. I just noticed wjv submitted this idea in December ’15, and we share some thesis components around secular growth and capital returns. I introduce some additional points and analysis around normalized loss ratios and RSA’s. Also, I think this thesis is worth revisiting now in light of recent trading history and changes in the tax and regulatory reform / interest rate environment.

BASIC THESIS: SYF IS A SECULAR WINNER IN PAYMENTS THAT CAN SUSTAINABLY GROW EPS IN THE DOUBLE DIGITS AT 20%+ ROE’s. IT TRADES AT 8.1x MY FORECASTED ’18 EPS, WHICH TRANSLATES TO 7.0X EPS AFTER ADJUSTING FOR EXCESS CAPITAL. IT HAS A 1-YEAR TOTAL RETURN OF 60%+, WITH ASYMMETRIC UPSIDE FROM REGULATORY AND TAX REFORMS.

COMPANY OVERVIEW: SYF IS A $20BN+ MARKET CAP COMPANY, SPLIT OFF FROM GENERAL ELECTRIC IN 2014-2015, THAT IS THE MARKET LEADING ISSUER IN PRIVATE LABEL CREDIT CARDS. 

Description

SYF provides credit products to buy goods and services through its partners’ 365K+ physical locations in the US / Canada as well as their websites and mobile applications. SYF’s partners include some of the leading consumer brands, such as Lowe’s, Walmart, Amazon, and Ashley Furniture HomeStore. SYF is the private label credit card (PLCC) market leader with 38.5% market share in ’15 (+110bps YoY). Other players in this segment are Citi and ADS with 29% and 10% market share, respectively. SYF has a long operating history, but has only been a public company since July 2014 when it was spun off from General Electric.

Segments

SYF operates in 3 main segments: Retail Card, Payment Solutions, and CareCredit comprising 74%, 13%, and 13% of revenues, respectively. Retail Card provides private label and dual credit cards, whereas the other 2 segments offer promotional financing for major consumer purchases. Payment Solutions caters to the auto, home, and electronics & appliances end markets, while CareCredit focuses on cosmetics, dental, and veterinary customers.

Business Model

SYF offers customers credit card and promotional financing, which it funds through a combination of deposits, securitized loans, and unsecured debt which comprised 72%, 17%, and 11% of funding sources, respectively. SYF earns a yield on its loan receivables (~21%) and cash (~0.5%) and pays interest rates (~2%) to earn the “spread.” This spread, plus a modest amount of interchange income (~5% of revenues), net of provisions for losses on loans, overhead, and taxes, yields profit to shareholders.

INVESTMENT THESIS POINT #1: SYF IS A SECULAR WINNER IN THE PAYMENTS ECOSYSTEM. IT IS THE MARKET LEADER IN PRIVATE LABEL CARDS, IS GAINING SHARE, AND HAS MULTIPLE AVENUES TO SUSTAIN DOUBLE DIGIT TOP-LINE GROWTH. 

Expand Existing Relationships with Partners

SYF has historically driven 8.95% purchase volume growth vs. 2.95% sales growth in its retail categories at large via increased penetration into its partners’ customer base (Exhibit 1). SYF is able to expand these relationships by (a) adding customers with new card offerings that have superior rewards to alternative credit cards and (b) using data collected on customers to deliver targeted marketing and increase customer purchase activity with a given retailer.

As a result of these efforts, SYF has increased penetration in its top 5 accounts (50%+ of its revenues) from 13.2% in 2013 to 16.5% in 2016 (Exhibit 1). The rate of penetration has accelerated in ’14 and ’15, and management believes that there is significant runway to continue to expand penetration to 30%+ before increasing share of wallet begins to become incrementally more difficult.

Add Programs De Novo or from Competitors

SYF can add programs by (a) acquiring portfolios from partners who seek to outsource existing programs, (b) winning business away from competitors when contracts arise for re-bid, and (c) launching programs with new partners.

The first two categories are only minor contributors to SYF loan growth – over 2011-2016, only ~75bps out of 10%+ of receivable growth has been attributable to the acquisition of new portfolios (Toys “R” Us, Phillips 66, and BP). This is because (a) after a long term secular trend towards outsourcing, many retail card programs are now managed by specialist 3^rd party issuers and (b) private label card relationships are now held by a concentrated group of scale players and very sticky.

In terms of new programs, SYF has a great track record of launching creative offerings at new partners. For example, in 2016 they launched programs with Citgo, Marvel, Google Store, and Fareportal and in 2017 they will start programs with Nissan, Cathay Pacific, and At Home, among others.

Build Online / Mobile eCommerce Capabilities

eCommerce is still <10% of all retail sales, however it is critical for all of SYF’s customers because it will represent a larger portion of their sales mix in the future. Given its importance, SYF has invested heavily in its digital capabilities including integration with Apple Pay, Samsung Pay, and retailers’ own mobile applications as well as building online account servicing / banking capabilities for account holders.

The shift to Ecommerce helps SYF’s business as it lowers the largest barrier to adoption by customers by removing the inconvenience of carrying multiple physical credit cards. Customers can use their “digital wallets,” which offer the convenience of credit card information stored in the retailers’ app or websites.

This has manifested itself in SYF’s high online penetration (23% vs. overall average which is <20%). Thus, as eCommerce becomes a larger % of retail sales, it is a tailwind to SYF’s share of wallet at its retailers due to its relatively higher online vs. in-store penetration. SYF’s online purchase volume growth rates have been accelerating and were 18%, 21% and 26% during 2014-2016.

INVESTMENT THESIS POINT #2: SYF’S LOSS RATIOS WILL NORMALIZE SOONER AND AT A STRUCTURALLY LOWER RATE THAN THE MARKET ANTICIPATES DUE TO A HIGHER QUALITY LOAN PORTFOLIO THAN ANY POINT IN ITS HISTORY. 

Historically, SYF’s mid-cycle net charge-offs (NCO’s) were in the low 6%’s (quoted as % of loan receivables), ranging from the low 4%’s in the mid 2000’s to 10%+ in 2009. Over the past 5 years, average NCO’s have been ~4.5% which is below average due to the favorable credit environment after the financial crisis which has led to the notion among investors that SYF is over-earning. This view was reinforced when (a) SYF built reserves by increasing provisions $1Bn YoY in ’16 and Q1 ‘17 (vs. ~flat YoY in’15) and (b) NCO’s ticked up 21bps in ’15-’16 and 59bps in Q1 ’17. But, the market is over-estimating the degree and length of time of SYF’s NCO normalization.

First, SYF’s NCO ratio will be structurally lower than its historical average by 100bps (5.2% vs. 6.2% of loans). The quality of its portfolio is better today than it has been historically due to better underwriting – SYF’s exposure to the high loss deep subprime FICO category has dropped from 19% of loans to just 7%, and comprises only 1% of new business implying a further reduction in exposure over time (Exhibit 2). In fact, on the most recent Q1 ’17 earnings call, for the first time, SYF management indicated they expect NCO’s to stabilize in ’18 in the low-to-mid 5%’s, which is similar to levels guided to in ’17. This implies provisioning expense headwinds to EPS will abate in the near future.

Second, read-throughs from SYF’s competitor Alliance Data Systems (ADS) confirm credit should stabilize in the near future. This is represented by comments from ADS’s CEO on his Q4 2016 earnings call such as “We had a strong conviction that this would be a sort of year and a half, two year cycle to normalize … [charge offs] are normalizing as we look out six months.” More specifically, he calls for flat NCO’s YoY in 2018 which will “slingshot and accelerate [earnings] growth.”

Thus, the market fears NCO’s will deteriorate and approach historical averages of 6%+ of loan receivables or even worse if the credit cycle is turning over. However, I believe that NCO normalization will be largely complete in 2017-2018 and at levels significantly lower in the low 5%’s.

INVESTMENT THESIS POINT #3: RETAILER SHARE AGREEMENTS (RSA’S) ARE UNIQUE TO SYF AND A COUNTER-CYCLICAL BUFFER TO EPS. THE MARKET IS UNDERESTIMATING THE STABILITY IN SYF’S EARNINGS.

RSA’s are a feature unique to SYF among credit issuers whereby any excess returns above a program hurdle rate are split between SYF and its retail partners – thus, RSA’s are an expense line on SYF’s P&L. As will be explained, RSA’s reduced SYF’s earnings cyclicality but are poorly understood by the market because SYF was spun out <3 years ago from GE, so their impact through a full credit cycle has not yet been demonstrated while SYF has been a standalone public company.

In a worsening credit cycle, such as SYF is in today, RSA’s mean that SYF will only participate in 50% of the downside to its EPS from factors such as increased NCO’s and provisioning relative to a scenario where these RSA’s do not exist. In other words, given SYF’s 2016 EPS of $2.71, to drive a $0.50 decline in EPS, NCO’s would have to increase 1.50% (from ~4.5% to 6% of loans) with RSA’s vs. only 0.75% if SYF did not have RSA’s (Exhibit 3).

Thus, as SYF’s credit program returns moderate due to increased NCO’s, and even should NCO’s worsen more than I expect due to greater normalization than anticipated or an economic downturn, the RSA’s will offset some of the incremental loan loss provisioning expense in SYF’s P&L. This dynamic played out in SYF’s Q1 ’17, where RSA expense decreased 2%, despite a 12% increase in net interest income, due to higher loan loss rates.

INVESTMENT THESIS POINT #4: SYF HOLDS EXCESS CAPITAL OF 20%+ OF ITS MARKET CAP. IT BEGAN CAPITAL RETURNS IN 2016 WHICH WILL ACCELERATE GOING FORWARD.

Post its spin-off from GE, SYF has been unable to return capital to shareholders to comply with Federal Reserve regulations. As a result, their Basel III Common Equity Tier 1 (CET1) Ratio rose from 14.5% to 17.0% (of risk-weighted assets) in ’16 and 18.0% in Q1 ’18 vs. peers who have a current ratio of 11.7% and a long-term target closer to 10.0%. This means SYF is holding up to 20%+ of its market cap as excess capital, which has been a headwind to financial performance because this excess capital is held in liquid securities earning <1.0%. 

However, 2016 was an inflection in SYF’s capital return program and the market has failed to appreciate the impact of this change. In 2016, SYF received Fed approval for its 1^st capital return program, and SYF has indicated an intention to be more aggressive with its programs going forward. For example, SYF’s CFO has specifically said, “We would expect or hope to move our capital ratios more in line with the peer set.”

To illustrate the magnitude, if SYF used all its excess capital to repurchase shares then its 2016 EPS would increase from $2.71 to $3.52 (3-% EPS accretion), and its ROE would increase from 16.5% to 26.8% (increase of ~1,000bps). In other words, SYF’s excess capital is worth ~2.3 turns of ’16 EPS multiple and, once adjusted for excess capital, its 2016 P/E multiple would be 7.7x vs. 10.0x (Exhibit 4).

FINANCIAL FORECAST: SYF’S STRONG ORGANIC PERFORMANCE WILL TRANSLATE TO EPS ACCELERATION FROM ~FLAT SINCE THE GE SPLIT-OFF TO SUSTAINABLE DOUBLE DIGIT GROWTH AS CREDIT-RELATED HEADWINDS ABATE AND SHARE REPURCHASES INCREASE.

Loan Growth

Receivables growth has been accelerating with growth of 7.0%, 11.4%, and 11.8% in 2014-2016. I forecast receivables growth of 11.0% and 10.6% in 2017-2018, reflecting organic growth momentum in line with 2016 due to the strengthening US consumer (consumer confidence at record highs), tailwinds from the mix shift to eCommerce, and the possibility of the acquisition of new credit portfolios.

Net Interest Margin

Net interest margins were 17.25%, 15.82%, and 16.04% in 2014-2016. The decline in net interest margins has been driven largely by the increase in SYF’s excess capital balances, which yield <1% vs. 21%+ for SYF’s other interest-earning assets. Going forward, I forecast net interest margin to stabilize at 16.06% and 16.23% in 2017-2018 due to the return of excess capital and increasing interest rates.

NCO’s and Provisions

NCO’s were 4.51%, 4.34%, and 4.55% in 2014-2016 which are below-average rates per the discussion in above. I forecast normalization of NCO’s to mid-cycle levels, with rates of 5.1% and 5.3% in 2017-2018. Additionally, I expect provisions / NCO’s to remain fairly stable at ~1.2x, substantially greater than 1.0x to cover the continued growth in the loan receivables portfolio.

Efficiency Ratio

SYF’s efficiency ratio (non-interest expense as a % of income) was 31.7%, 33.5%, and 31.1% in 2014-2016. It increased in ‘15 due to public company expenses post SYF’s spin out, but has since declined due to operating leverage. I forecast ratios of 30.9% and 29.9% in 2017-2018 due to continued operating leverage - this implies ~+$300M of expenses each year, compared to just $150M of added expense in 2016 YoY.

Earnings per Share

EPS has been $2.89, $2.65, and $2.71 in 2014-2016 – SYF’s strong loan growth has not translated to EPS growth due to net interest margin and loan loss headwinds combined with some incremental public company expenses. 2017 is a turning point at which these headwinds will subside and I forecast EPS of $2.76 and $3.31 in 2017-2018. This implies a dramatic acceleration of EPS growth in 2H ’17 and ’18 due to stabilizing provisions and increasing capital returns.

ROA and ROE

ROA’s have been 3.2%, 2.9%, and 2.7% and ROE’s have been 27.0%, 19.1%, and 16.6% during 2014-2016. While still strong and significantly over SYF’s cost of capital, these numbers have declined for the same reasons which have impacted EPS. However, I forecast that in 2017-2018 ROA’s will stabilize at 2.5% and ROE’s will rebound to ~18% due to strong business performance and the return of excess capital.

VALUATION: SYF WILL RE-RATE HIGHER AS CREDIT NORMALIZATION COMPLETES, “MID-CYCLE” EARNINGS POWER BECOMES APPARENT TO THE MARKET, AND EPS GROWTH ACCELERATES.

Price target is $43, which represents 13.0x '18E headline EPS, and 11.3x ‘18E "core" EPS. “Core” EPS adjusts SYF’s earnings for its excess capital worth ~20% of its market cap by assuming all excess capital is used for share repurchases.

Current NTM P/E multiples for SYF and COF / DFS, and AXP are 10.1x and 9.6x, respectively, based on consensus forecasts (Exhibit 5). SYF's multiple is being benchmarked to COF / DFS but will re-rate higher once the market realizes (a) SYF’s potential to grow organically at 10%+ with ROE’s in excess of 20% is best-in-class (b) the market is applying a peak cycle multiple to SYF EPS that is closer to mid-cycle, and (c) SYF's business is relatively more stable due to the RSA dynamics.

My NTM headline P/E multiple for SYF equal to ~13x compares to SYF’s historical max multiple of ~12.6x in mid-2015 - however, SYF’s EPS growth prospects are better and its EPS is closer to mid-cycle than it was in ‘15. Given SYF’s ROE and growth prospects, such a steep discount to the market multiple on close to mid-cycle earnings does not seem appropriate. Furthermore, SYF’s 10%+ ’18 earnings yield, combined with its double digit EPS growth potential, implies a very attractive return of 20%+ regardless of re-rating.

CONCLUDING THOUGHTS: SYF IS A BUY WITH 1-YEAR UPSIDE OF 60%+, INCLUDING DIVIDENDS, AND ASYMMETRIC UPSIDE FROM TAX REFORM.

SYF is a BUY with a 1-year price target of $43, representing a total shareholder return of 60%+ including dividends.

In addition to the core thesis, SYF has asymmetric upside from tax reform and interest rates. First, SYF is a full tax US tax payer, and a reduction in the US federal rate to 20% would yield 12% to 24% EPS accretion, depending on the treatment of interest tax deductibility. Second, SYF is asset sensitive and each +100bps in the Federal Funds rate increases its net interest income by $113M or $0.10 of EPS (3% accretion).

Overall, SYF is a quality company with strong growth prospects, under-appreciated earnings stability, significant excess capital it will return to shareholders, and asymmetric upside from tax reform and interest rates.

KEY RISKS: THE TWO MAJOR RISKS TO THE THESIS ARE CUSTOMER CONCENTRATION AND A WORSE THAN AVERAGE CREDIT CYCLE.

First, SYF has 50%+ of loan receivables with its top 5 customers - Wal-Mart US, Sam’s Club, Lowe’s, Gap, and JC Penney – so the loss of any of them would be material. However, these relationships are sticky and long-term (10+ years), and my diligence indicates that SYF is viewed positively. Also, while these are not high growth companies, SYF (a) has a long runway to increase penetration of tender share within their partners and (b) also is the platform for AMZN’s card so in theory captures some of the lost $’s at these mostly brick-and-mortar retailers. None of these retailers is in imminent danger of bankruptcy, and a bankruptcy filing by any of them (i.e. JCP) would most likely be a reorganization vs. liquidation.

Second, a worse than average credit cycle environment would impact SYF’s results. However, current macro indicators such as consumer confidence and debt to discretionary income, as well as commentary from credit-focused companies, do not suggest an impending downturn. Also, SYF is conservatively financed and any diminution in its earning would be temporary and unlikely to be a permanent impairment of value. 

 

EXHIBITS 

 

Exhibit 1 – Strong Organic Growth Within Existing Customers

 

Exhibit 2 – SYF Will Have Structurally Lower NCO’s

 

 

Exhibit 3 – RSA’s Reduce SYF’s Cyclicality

 

Exhibit 4 – SYF Holds Substantial Excess Capital

 

 

Exhibit 5 – Trading Comparables

 

 

Catalyst

First, credit normalization will end in 2017-2017 – this will conclude a multi-year EPS headwind and also the valuation overhang on the stock from concerns SYF is over-earning and substantially above mid-cycle. EPS growth is set to accelerate from flattish to double digits.

Second, capital returns commenced for the first time in ‘16 and mgmt. plans to increase payout ratios going forward. Share buybacks and dividends will not only drive EPS growth and total shareholder return, but will also cause the market to recognize SYF’s heavily discounted multiple given its excess balance sheet assets.

Third, SYF management has a history of conservative guidance and ’17 is no different. They have guided to 8% loan growth (vs. 10%+ in ’15A and ’16A), an interest margin which assumes 1 Fed rate hike (vs. est. 2-4), and an efficiency ratio of 32% (vs. 31% in ’16 and in a growing business with operating leverage). Similarly, sellside expectations are too low. I forecast EPS of $3.31 vs. consensus of $3.18 in 2018.

Fourth, SYF is a full US tax payer and heavily regulated as a bank – any policy reform would be beneficial. For example, a reduction in federal tax rates to 20% would yield EPS upside of 12%-24% (range depends on interest expense deductibility).