Description

A quality company operating in a growth market, with a dominant market share, strong moats and a fortress balance sheet, trading on 11x P/E because it’s relatively unknown. Upcoming quarterly results should unlock the value, I see 50% upside from here on conservative assumptions.

Company

Synchrony Financial (SYF) is the largest issuer of private label credit cards in the US (40% market share). It was spun out of GE last month.

-    Private label or merchant branded cards – eg Walmart credit cards – appeal to merchants because the closed loop system allows them to save the large interchange fees paid to Visa/Mastercard/Amex with general purpose credit cards.

-    Additionally, the merchant likes the ability to create customer loyalty and grow revenues with merchant-specific royalty schemes.

-    SYF provides the consumer with credit and manages the credit card process in return for interest income generated from revolving credit balances. SYF targets a minimum 2% ROA and generally splits any excess return with the merchant partner. Equally, the merchant absorbs part of the net charge offs in more challenging times.

Additionally Synchrony operates 2 smaller businesses: Payment Solutions and CareCredit. These generate less than 5% of earnings combined and are not crucial to the investment case.

-    Payment solutions provide private label financing options for major consumer purchases (70% home furnishing and electric appliances). In other words you can get ‘Sleepy’ financing when you buy a bed at their store.

-    CareCredit provides financing for elective healthcare procedures and services. Around 60% is dental and 15% veterinary related.

Fundamentals

SYF is a winner in the changing payment / retail landscape and should be able to grow faster for longer

Private label cards are gaining market share from general purpose cards

The economics of general purpose cards are increasingly under pressure.

-    External pressure

o    Merchants are increasingly questioning the high fees of general purpose cards (typically around 2.5% all-in) and the return they get on that investment. Volume and margin pressure on traditional retailers from internet players is leading to an increased focus on return on investment. And the expanding array of alternative payment systems is adding to the focus on credit card costs.

o    Regulators are also increasingly looking into the interchange economics, which has resulted in fees being capped at lower levels in Europe and Australia. The debate is ongoing in the US and to be fair it doesn’t look like we will see a legislative intervention any time soon, but it is a longer-term risk as the fee gap with the rest of the world is growing. Interchange fees range from 1.59% to 2.07% in the US, which compares to for example Switzerland lowering the cap from 0.95% to 0.70% this year and scheduling a further cut to 0.44% by August 2017. Even Canada has now capped the fee at 1.50%. And the US has already capped debit card fees at 21 cents + 0.05% of the transaction (Durbin Act).

-    Internal factors

o    High returns have attracted general purpose card competition, resulting in rising rewards spending (more points / cash back) and therefore margin pressure.

Private label cards are gaining market share, without much margin pressure.

-    They are increasingly favoured by merchants

o    There is no interchange fee. It’s a closed loop system and the private label card issuer simply makes money from interest income on revolving credit balances.

o    So rather than spending 2.5% per transaction on generating loyalty for the general purpose credit card (eg funding air miles for BA American Express), merchants can spend money on loyalty programs and promotions related to their company and products. With rewards mostly merchant-funded, the private label card issuer is more insulated from the inflationary trend in reward costs compared to general purpose cards.

o    And merchants get full access to the data generated by the private label credit card, which in turn helps to optimise marketing strategies and drive top-line growth.

-    They are increasingly favoured by consumers

o    Consumers owning private label cards are increasingly using them. A stronger focus by merchants on private label results in better marketing and better offers, which is creating a virtuous cycle.

o    Synchrony is also rolling out dual purpose cards, which are increasingly popular. These are credit cards that can be used for general purchases, not just merchant specific purchases, with the rewards program linked to the issuing merchant.

-    The emergence of electronic payment options could accelerate the penetration of private label cards.

o    Synchrony is working with all new electronic payment platforms. It is the house card of PayPal, works with Apple Pay, etc.

o    But the real dream is electronic wallets. If customers no longer need to carry different private label cards for different stores in their ‘real world’ wallet, but are able to store them electronically instead, we might see an acceleration in the private label card penetration.

o    It’s hard to say who the platform winner will be, so SYF is just working with everyone and has refrained from trying to build their own platform. Having an extra player involved potentially means giving up a small part of the margin, but that should be compensated by accelerated volume growth.

Synchrony is gaining market share within private label

-    Synchrony has 40% market share and gained 800bp over the past decade.

-    The company has no doubt benefited from Citi and other banks being focused on shrinking their balance sheets rather than generating new business in recent years. But even in today’s more competitive environment, Synchrony continues to gain new contracts (they just won BP). Competitive advantages include focus (only pure play aside from Alliance Data Systems), experience and size (merchants need to be comfortable that you have the balance sheet to provide liquidity to their clients).

-    And SYF might be a winner of the migration from off-line to on-line shopping given that they are the preferred partner of the big internet retailers.

o    Synchrony is the private label partner of Ebay, Paypal, QVC, etc. But the most exciting opportunity is no doubt their relationship with Amazon.

o    SYF has been working with Amazon for 7 years and Amazon is now looking to increase the penetration of its private credit card amongst customers. To that extent they are soft trialling a 5% (!) cash back card for Amazon Prime members. They can afford to offer 5% because

§  They save 2.5% in general purpose fees

§  Prime members pay a $99 fee per year. If you assume that this covers the other 2.5%, customers will need to spend over $4,000 a year on Amazon before they break-even.

§  Of course prime also covers free next day delivery and video streaming, so the real break-even level is lower. But the reality is that Amazon doesn’t even care if they lose money on this in the short-term, they just want to lock-in as many customers as they can.

o    Amazon is also planning to make the private label card the default payment option for anyone who owns the private label card. So paying with a general purpose cards will require extra steps in the check-out process.

SYF should be able to grow the top-line at a high-single-digit pace for the foreseeable future

Revenues have grown 11.9%, 9.5% and 7.8% in FY12, FY13 and FY14 and we are on track to achieve 9% in FY15 (winning the BP contract has taken loan growth to 12% in Q3). Key drivers include the increasing use of cards versus cash, the earlier discussed market share gains of private label versus general purpose cards and the market share gains of SYF within private label, rising overall consumer spending, and consumers rolling over larger balances.

Unfortunately SYF does not break down its growth in the different components. But absent a recession (see risks), there is circumstantial evidence that points towards higher growth for longer.

-    SYF does not disclose the customer penetration per merchant aside from the fact that it ranges from 1% to 50%. However, we do know that they have managed to increase the penetration substantially with their longest standing retailers and that 47% of revenues are currently generated by the top 5 clients (GAP, JC Penny, Lowe’s, Sam’s Club and Walmart – roughly 10% each). I’ll come back on the risk of a concentrated customer (contracts have recently been renewed and now extend to at least 2019), but with regards to the top-line growth I believe that this illustrates the large opportunity that exists with the many clients that have signed up more recently.

-    SYF should continue to gain market share within private label. I expect that this will be at a slower pace in a more competitive environment, but the recent BP win shows that they continue to win new business. Equally important, SYF is unlikely to lose big contracts, making it easier to deliver yoy growth. The split from GE changes the legal entity of the business, which has forced SYF to draft new client contracts. They took the opportunity to extent contracts, and so far they managed to renew 92% of the contracts until at least FY19. The turnover has been very low (they only lost 1 contract, department store operator Dillards). The remaining 8% are all small contracts (<1% of revenues) and are currently being re-negotiated.

-    Some investors are worried about the slowdown in US retail spending in general and at Walmart in particular given that the latter is a top 5 customer. I take comfort from the fact that top-line growth did not slow in recent years, despite one of the other top 5 customers - JC Penney - going through a much tougher time than Walmart is at the moment. SYF management is guiding for top-line growth that is at least 3x the top-line growth of its end clients.

-    And finally, research shows that US revolving consumer credit grew at around 5% at this part in the cycle, slightly ahead of personal consumption growth (unfortunately I can’t seem to attach the charts to illustrate this. You can find them in the UBS research if you have access).

The SYF split-off was a big deal and sell side analysts are all over it. Consensus numbers therefore seem quite realistic and my model is in-line. The investment opportunity is about the stock being priced cheaply so that the deal could go ahead. The credit card peer group has de-rated in recent years on the back of low growth, low interest rates, an increasingly competitive general purpose credit card environment and regulatory pressure. And SYF is valued at the bottom of the peer group range, despite the stronger fundamental outlook for private label cards and for SYF.

Key assumptions:

-    8% loan and revenue growth on average over the coming years

-    6% pre-tax income growth on moderate expense inflation

-    High SD EPS growth after share buybacks.

-    Loan loss provisions remain at 5%, which compares to current net charge offs and 30+ day delinquencies at 4%. Every 25bp change in provisions leads to a 5% change in EPS.

There are no complicated tax structures. SYF pays 37.5% in taxes and is scheduled to continue to do so.

Strong moats

Focus, size and experience

-    The only other pure play is Alliance Data Systems. However, ADS only focuses on companies that are 1) mid cap in size, 2) retailers, and 3) willing to outsource the consumer marketing to ADS. It’s a great business model and the company has been very successful at helping smaller retailers grow revenues. If the stock wasn’t trading on 20x P/E and 8x P/B, I would have written up ADS instead.

-    SYF is the only option for larger retailers looking for a partner who is focused on private label credit cards and has the balance sheet to provide sufficient credit to a large consumer base.

-    Various general purpose card issuers have tried to enter the private label market, but most of them have pulled out after a while. They tend to be good at lending, but have little to offer in terms of marketing skills and ways to help grow a merchant’s top-line.

Relationships tend to be sticky

-    Switching private label card issuers is complex and costly. The private label company usually has dedicated teams working within the retailer’s marketing and data analysis department, it requires integrating the retailer’s systems into a new network, and issuing customers with new cards. SYF has an average relationship of 11 years with its current partners and Dillards is the only sizeable contract that has been lost in recent years.

-    Average contract lengths are 7-10 years with 5-7 year extensions which are usually negotiated well in advance of the contract expiring. Contract renewals are usually less focused on price and more on how the companies can cooperate to maximise top-line growth.

Cost advantage.

-    SYF has the lowest efficiency ratio of the traditional banking / card coverage of sell side analysts, around 35% versus the average company at 60%. The main driver behind the higher margins and returns is the limited physical infrastructure (internet bank funding and internet card issuing).

-    The efficiency ratio has expanded in recent years on the back of GE separation expenses, the roll-out of EMV chips in credit cards and some marketing cost inflation. I expect that the efficiency ratio will continue to trend upwards albeit at a slower pace after the split-off. The gap with peers should remain substantial.

Fortress Balance Sheet

In light of becoming a stand-alone company, SYF spent the past few years building a deposit base through the internet bank, reducing its dependence on wholesale financing. This has resulted in a strong balance sheet at the expense of somewhat higher funding costs. There are no off-balance sheet liabilities.

SYF has a Tier 1 ratio of 16.6%, the highest ratio of the traditional US credit card and banking peer group. This ratio is scheduled to rise over the coming 3 years if the company does not increase its pay-out ratio from the current 60% guidance. Morgan Stanley’s B3 CET1 stress test shows a decline to 12.8% next year versus a regulatory requirement of 4.5%.

SYF has more sub-prime exposure than general purpose card operators. But only 14% of customers have a FICO score below 625 and this percentage is shrinking. More importantly, the net charge offs of SYF were not higher than the net charge offs of Discover or Capital One during the financial crisis (around 10%). And merchants pic up part of the bill of net charge offs. Fyi, the average revolving balance is estimated to be around $400 and the repayment rate is low (below 15%).

The payment solutions book (financing beds, etc) is higher quality (FICO below 625 is less than 10%), turns over quickly (mostly less than 1 year, 90% of the book has been written post-recession) and delinquency rates are currently 3%. The carecredit book (elective healthcare procedures) is higher risk with delinquencies around 6% and 20% of the book with a FICO score below 625. But this is a fairly small business.

The company typically holds reserves covering 14 months of total expected portfolio losses. So the current 5% provisions is not under-reserving versus the 4% net charge offs and delinquencies.

The Card Act of 2009 has tied interest rates charged to the Prime rate and therefore effectively the FED rate. Therefore a rising interest rate should be positive for SYF. However, some of the benefit might be competed away given the high NIM (16%) relative to history (10%, the difference can largely be explained by the reduced funding costs and the industry discipline that has come with the Card Act). So I expect less of a tailwind from rising interest rates for the credit cards compared to the banks.

Expect an acceleration in capital returns

While not official subject to CCAR because SYF has been recognised as a savings & loans business, management has opted to voluntarily apply for FED approval for its capital returns. Given the strength of the balance sheet this won’t be a problem, but it has resulted in conservative guidance with regards to capital returns. The IPO due diligence report guides for a 30% dividend pay-out ratio in 2016 and buybacks as of 2H16 with the total pay-out ratio rising to 60% in the first year.

I include this in my model, but believe that a 60% pay-out ratio is the bear case. Over time, I assume that the pay-out ratio will rise to 100%, in-line with other card operators (Discovery and American Express are both at 100%, Capital One is at 95%), which I model as of FY18. The bull case would be that the pay-out ratio rises above 100% in order to reduce the Tier 1 ratio to levels more in-line with peers. A Tier 1 ratio of 12% would allow for an extra 10-20% return of capital (the range reflects different time horizons) and a 5%+ increase in the ROE.

A 12% CET1 ratio is probably wishful thinking by analysts, but none of them model more than the current 60% pay-out guidance. Therefore higher buybacks provide a modest source of earnings upside from FY17 onwards.

Management incentives aligned with shareholders

Management pay is reasonable for a $25bn mcap company. The CEO makes around $4mn per year and top management receives $1-2mn. There is a fair mix between base salaries and short-term and long-term bonuses, with the latter based on both qualitative and quantitative metrics. These include operating earnings, cash flow generation, balance sheet and risk management metrics, but also measures related to a successful split from GE, the buildout of technology infrastructure and transparent relationships with regulators.

In 2014, key employees also received “Founders’ Grants”, packages of 70% restricted stock and 30% 10 year stock options with a 4 year cliff vesting period. The exercise price is the IPO price and dividends will be reinvested. The Founders’ Grants were designed to replace GE incentives and make sure that management pay is aligned with SYF performance. They are sizeable but not outrageous (around $10mn for the CEO and $2-6mn for top management) and indeed make sure that management interests are aligned with ours.

Valuation

Credit card operators Capital One and Discover Financial have historically (over the past 15 years excluding the recession) traded within a 10-13x P/E range. I believe SYF deserves to trade at least at the high end of that range given the attractive characteristics / growth of private label credit cards /SYF and the superior balance sheet and capital return potential of the company.

Using 13x P/E leads to a $39, $41 and $44 target price on a 1, 2 and 3 year horizon, or 30%, 37% and 47% upside from today’s $30. Additionally we get 1.5% rising to 3.0% in dividends per year.

The target prices require a 2.2x P/B, which seems reasonable for a company with a 19% ROE generated on an overcapitalised balance sheet.

And the valuation multiples used look attractive relative to other financials. US Banks have traded at 10-12x P/E over the past 5 years despite inferior returns and growth potential. And the payment networks / Alliance Data Services trade at meaningful premiums (17-26x P/E), which can be justified to some extent by the higher income from fees.

Risks

Cyclical downturn

-    The risk is that we are picking up pennies in front of a steamroller. When the cycle turns, provisions rise quickly, offsetting any top-line growth, eventually followed by a slowdown in top-line growth and a pick-up in net charge offs.

-    The bearish view is that net charge offs and provisions are currently at cyclically low levels, while the NIM is at record high levels. There is plenty wrong with the world and the senior loan officers’ survey is potentially signalling a tightening cycle (too early to  call 1 quarter a trend, but if this continues it has been a good leading indicator for rising provisions and charge offs historically).

-    The bull case is that investors are so traumatised by the losses of the previous financial crisis that they’ve become overly focused on predicting the next crisis. Credit card lenders have been exceptionally disciplined in recent years and most consumers who were at risk of defaulting have done so in the 2008 crisis. That explains why the net charge offs of Capital One and Discovery have fallen to 2%, half the level of the previous cycle. We are now entering the point where they will loosen standard somewhat, trading in higher growth for somewhat higher charge offs over time. But this all adds up to mid-cycle behaviour rather than end-cycle behaviour.

-    I find it very hard to make a call on the cycle today. Relative to other financials and cyclicals, I see a company trading at a reasonable valuation, with decent growth momentum and less sensitivity to smaller changes in GDP growth. That seems appealing in a muddle through environment, even though I acknowledge that this will likely turn out to be a trade rather than a longer-term investment.  If we see a full blown cyclical upturn, there is probably less upside in SYF than in some of the beaten down industrial or material companies. In the event of a downturn, there is some cushion from the fact that merchants are locked in with longer term contracts and that they are on the hook for a portion of the credit losses.

-    The key warnings signs to watch out for are further developments in the loan officers’ survey, initial jobless claims, provision/bad debt guidance from the company and peers, and changes to competitive dynamics.

The payment revolution

-    Whilst I believe that SYF is currently benefiting from the changing retail landscape (more on-line) and from the changing payment landscape (retailers more focused on private label and technology making it easier for consumers to sign up), there are also risks to the emergence of new technology and new financing options.

-    Mobile wallets might lead to consumers having more visibility into the large interest payments on their revolving private label credit. We should definitely keep a close eye on developments in this area.

-    And peer-to-peer lending has grabbed some headlines in the sector recently. Basically peer-to-peer lending provides cheaper funding to consumers, which in return can be used to pay down more costly sources of debt such as credit cards. I’m less worried about this trend as the size of the peer-to-peer lending market is still small relative to other sources of credit. And it remains to be seen how this business survives a recession.

Regulatory interference

-    There are no interchange fees with private label cards, but consumers get charged high interest fees. So regulators might look into this at some point. Given that there is nothing on the horizon at the moment and that regulatory pressure is actually working in favour of private label, I labelled the risk green.

Customer concentration

-    Generating 47% of revenues from your top 5 clients obviously carries risk (roughly 10% each). However, with 92% of contracts now renewed until at least 2019, I don’t consider this a risk that falls within our investment horizon. The company does not disclose who the remaining 8% are or when the contracts expire, but we do know that they are all small contracts (less than 1% of revenues).

What is a plausible downside valuation scenario?

-    Most brokers assume that earnings fall by around 25% in a moderate recession environment, which is reasonable. The difficulty is attaching a multiple to this. Historically, credit card multiples have gone up in a recessionary environment and attaching a multiple above 10x does limit the downside from here, resulting in the attractive risk/reward picture painted by brokers (Morgan Stanley has a worst case value of $27, Barclays has $29). Capital One and Discover indeed did not underperform the S&P500 in the 2008 recession until Lehman actually went bankrupt.

-    However, if a recession would occur next year I expect that SYF would be hit disproportionate relative to peers given that investors are less familiar with the name. So I wouldn’t bet on multiple expansion and assume that the stock will underperform the market in a downturn.

Disclaimer

Past performance is no guide to future performance and the value of investments and income from them can fall as well as rise. Data is for illustrative purposes only. This information does not constitute an offer, solicitation or recommendation for the purchase or sale of securities or other financial instruments, nor does the information constitute advice or an expression of my view as to whether a particular security or financial instrument is appropriate. I, my employer and/or others we advise hold a material investment in the issuer's securities.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

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