Synchrony - Everything A Value Investor Could Want

Summary

• While the loss of possibly its most important customer is undoubtedly a major setback, the decline in the share price is overdone, providing a great buying opportunity.
• We expect future dividend growth to easily exceed the dividend growth of the S&P 500 in the years ahead.
• While there is room for improvement in diversifying its customer base, Synchrony has a host of long-standing relationships with a diverse set of retail partners.
• With a PE of 10.45, stable operating results, and a growing dividend, Synchrony offers value investors everything they are looking for.

Synchrony Financial (NYSE:SYF) is down 22% for the year. The downward move accelerated on July 26th when the company announced that the Walmart (WMT) program agreement would not be renewed and would expire on July 31st, 2019. Retailer arrangements such as the one with Walmart provide for payment to the partner if the economic performance of the program exceeds a threshold defined in the contract. Walmart appears to have demanded better terms that made the deal unattractive for Synchrony. Synchrony provided detail on two alternatives it is considering for its Walmart Portfolio which would both be accretive to earnings and are discussed below.

Walmart Portfolio Options

The first option is to sell the portfolio. Under this option, the portfolio would transfer to the new issuer after the contract expiration at the end of July of 2019. The size of the portfolio is approximately $10 billion, and selling it would free up about $2.5 billion of capital. About $1.5 billion comes from the capital currently supporting the portfolio while some comes from the release reserve associated with the portfolio. Banks are required to hold a certain amount of capital or liquidity to support outstanding loans after estimating the need to cover net charge-offs. The company expects to use the approximately $2.5 billion to repurchase shares. Reducing the outstanding share count combined with the cost savings associated with selling the portfolio is expected to neutralize the EPS impact of losing the program.

The second option is to retain the Walmart portfolio and convert qualifying accounts to general purpose co-brand cards, or GPCCs, beginning in the first quarter of 2019. Cards that are not converted would remain Walmart cards to be used in-brand for up to three years. This approach allows Synchrony to earn royalties on the Walmart cards for three years post contract expiration. Similar to option one, the company anticipates that retaining the cards and converting them to GPCCs would fully replace EPS generated by the program.

It is hard to determine which of the two options is better for shareholders. Both have positives and negatives. The outcome of option one, selling the portfolio, seems clearer. Using a majority of the $2.5 billion of freed up capital to repurchase shares will undoubtedly help performance as the company's earnings would be divided among fewer shares. However, Synchrony states in its filing that retaining the portfolio and converting to a GPCC would fully replace the EPS generated by the current program. We would not have assumed this to be the case. If this is achievable, option two may be the better choice due to the associated portfolio diversification reducing the reliance on other partners.

Portfolio

Synchrony made significant changes to its portfolio recently as highlighted in its second-quarter presentation. It completed the acquisition of the U.S. PayPal (PYPL) credit financing program as well as e-gifting platform Loop Commerce. Synchrony will be PayPal's exclusive issuing bank for the PayPal Credit point-of-sale financing program for the next 10 years. Synchrony also added a host of new partnerships including Furniture Row, Ashley HomeStore, and LasikPlus. Synchrony now partners with 28 national and regional retailers per the recent 10-Q filing.

Growth rates in the second quarter were respectable for the company's three platforms: Retail Card, Payment Solutions, and CareCredit. Retail card loan receivables grew by a modest 3% compared to the second quarter of 2017. Payment Solutions loan receivables increased to $16.9 billion, or about 8%, from 2Q of 2017. Growth for this segment was pushed higher by loan receivable growth in home furnishings and auto. Finally, CareCredit loan receivables also increased by 8% compared to the same quarter of last year reaching $9.1 billion led by dental and veterinary. The segment accounting for by far the greatest portion (73%) of interest and fee income, Retail Card, had the slowest growth rate. Payment Solutions and CareCredit contributed almost an identical amount accounting for 14% and 13%, respectively, of interest and fee income.

One risk to consider for the portfolio is other retailers taking a cue from Walmart and negotiating for better deals and possibly not renewing their agreements. The Walmart relationship had lasted over 18 years and it was willing to make the switch anyway. On a positive note, the retail card partners are fairly diverse including mass merchandisers, specialty retailers, department stores, e-retailers, and oil and gas retailers. The retail market breakup image below is from the most recent 10-K and still includes Walmart. One should also note that many of the current partners have programs that do not expire for years. Sixty-five percent of total retail card interest and fees are associated with programs that have expiration dates going into 2021 including some that do not expire until after 2024.

Source: 10-K filed on Feb 22, 2018

There was a slight drop of two percent in retailer share arrangements in the last quarter largely as a result of the Toys "R" Us bankruptcy. Net charge-offs have remained fairly stable recently but did increase to 5.97% compared to 5.42% last year. On the Q2 call, Synchrony also announced that it is raising its annual dividend from $0.15 to $0.21, an increase of 40% for a yield of 1.79%.

Diversification

Synchrony has diversification in its partners and the retail markets associated with its loan portfolio. The partners were discussed briefly in the previous section so next we want to consider the loans made by the Payment Solutions segment. Synchrony has many partners in this segment with several having an over five-year long relationship with the company. The biggest proportion of the loans is associated with the home furnishings market, but other substantial percentages belong to the electronics/appliances, automotive and home specialty segments. No single payment solutions program accounts for more than 1.2% of the total interest and fees on loans. The image below shows the complete breakup by retail market:

Source: Annual Report

CareCredit provides financing to consumers for health and personal care procedures, products, or services. It accounted for $2 billion or 12% of total interest and fees on loans in 2017. The biggest portion of the loans is related to dental care followed by veterinary. A full breakup of CareCredit interest and fees on loans by specialty is provided below:

Source: Annual Report

There is still plenty of room for improvement in terms of diversification. At the end of 2017, the five largest customers accounted for 53% of Synchrony's total interest and fees on loans. The five largest customers at the time were Gap (GPS), J.C. Penney (JCP), Lowe's (LOW), Sam's Club, and Walmart. We have recently seen a clear example of the risks of concentration with Walmart which accounted for more than 10% of total interest and fees on loans in 2017.

Industry Outlook

The industry is extremely competitive and that is not going to change. Some of Synchrony's main competitors include Alliance Data Systems (ADS), American Express (AXP), JPMorgan Chase (JPM), Citibank (C), and Wells Fargo (WFC), and of course the new Walmart partner Capital One (COF). Luckily, the credit card market is one of United States' largest consumer financial markets per the Consumer Credit Card Market Report from the Consumer Financial Protection Bureau, or CFPB. The report states that every year hundreds of millions of credit cards are used to spend trillions of dollars and revolve hundreds of billions of dollars of debt. While the addressable market size is enormous, the total amount of consumer credit card debt has now risen to prerecession levels.

The CFPB report notes that the rates of credit card delinquency and charge-offs have declined sharply since they peaked during the recession and remain lower than they were in the years prior to the recession. However, slight increases were noted in both indicators. According to the report, as of Q2 of 2017, 18% of the U.S. population had a credit score rating of subprime or deep subprime per the table provided below. The proportion comprising the three lower credit score tiers has been declining for the last several years.

Source: CFPB Consumer Credit Card Market Report

One thing to keep an eye on is the outstanding consumer credit which has risen to prerecession levels. This is probably not a good sign, but one should also consider that purchase volumes increased at a much greater rate over the same period. Low unemployment figures have kept delinquency rates from rising substantially, for now.

Source: CFPB Consumer Credit Card Market Report

A positive trend for the industry is that credit card purchase volumes have risen steadily over the last 16 years. The fact that growth in purchase volumes has exceeded growth in outstanding credit card debt indicates that credit cards are being used for purchases that would have been previously made with cash. As this trend continues, credit card companies will realize some benefit as they see an increase in the amount of fees charged to merchants. Of course, this will always need to be considered with an eye on delinquency rates which had an uptick recently as is seen in the image below showing the share of balances that are 60 or more days delinquent.

Source: CFPB Consumer Credit Card Market Report

Valuation

Synchrony meets the basic criteria for a conservative investment with positive net income and free cash flow since 2011. For data going back further than this, one would need to reference filings from GE (GE) before the company was spun off from GE Capital in 2014. Return on equity and return on investment also show impressive performance coming in at 13.5% and 24.2%, respectively, for the trailing twelve months. The current PE ratio is an extremely low 10.45, and the forward PE indicates even more value standing at 6.98 compared to the current S&P 500 PE ratio of 24.34. The reasons have been discussed above. When you lose the biggest retailer in the world as a customer, an overreaction to the downside is to be expected. The stock is down over 20% for the year.

We will consider a discounted free cash flow model that uses the EPS of the trailing twelve months, $2.84. This will result in a much more conservative model compared to one that uses the average analyst EPS forecast for next year, which is $4.25 according to Finviz. The average annual EPS growth rate forecast for the next five years is 17.17% according to Reuters and 15.13% according to Finviz. Both estimates seem optimistic and we would rather use the low end of the analyst annual EPS growth estimates, which is 5%. The DCF model will also use a 10% discount rate and a PE ratio of 15 at the end of year five. Using these inputs the model shows us that Synchrony is currently trading at 82% of fair value even when using a low expected EPS growth rate. While the model did use a much higher future PE, 15, compared to the current PE of 10.45, it is still below the industry average. Even if we use a PE in year five of 13, the model shows that Synchrony is trading at a discount albeit a smaller one of about 7%. We should also note the model did not assume any share repurchases and assumed that dividends would only grow at the same slow rate as earnings 5%.

We think the model is conservative due to the low growth rate used and the fact that Synchrony has been repurchasing shares recently. The number of outstanding shares has dropped by slightly over 10% in the last three years. Additionally, Synchrony just increased the dividend by 40% raising it by much more than our model assumes it will grow going forward.

SYF Shares Outstanding data by YCharts

The company also has plenty of room to grow its dividend with the current yield standing at 2.02%. The payout ratio stands at a very comfortable 23.9%. Further evidence of room for dividend increases and additional buybacks can be seen by looking at the retained earnings balance over time. The retained earnings balance has been increasing consistently growing by 531% since 2015. Retained earnings are the money the company has left over after paying its operating expenses, interest payments, and paying out dividends.

SYF Retained Earnings (Annual) data by YCharts

Options

If investors are interested in using options, we recommend employing a buy-write strategy for Synchrony Financial. The covered call options are fairly attractive for sellers given that even options that are over 17% out of the money and expire in less than five months provide an annualized yield of over one percent. The covered call we will consider here is the one expiring on December 21st with a strike price of $34. The current bid on this option is $0.45 and the option is 14.52% out of the money. A seller of this option would receive an annualized yield of well over 3% even after accounting for standard brokerage fees. The seller would only lose his or her shares if the stock goes up over 14% in about four and a half months given the current share price of $29.69.

Final Thoughts

Despite the loss of likely its most important customer, we think there was an overreaction to the downside in Synchrony shares. This presents an opportunity for value investors searching for a stable company that generates reliable cash flow. The company trades at a huge discount to the S&P 500 and the financial sector. The consumer financial services company also offers an attractive dividend yield that we expect to grow over time. We also like the fact that investors can get a yield boost in their Synchrony shares by selling covered calls that allow for participation in substantial appreciation from current price levels. We think that now is a great opportunity for new investors to initiate a position in the 2014 spin off of GE Capital, and we rate the stock a buy. Finally, it would be remiss of us not to mention that investors that buy Synchrony are following the steps of the greatest investor of all time, the Oracle of Omaha, Warren Buffett.

Analyst’s Disclosure: I am/we are long SYF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.