I wrote up this idea back in September. The price has recovered considerably since then but I still believe there is a lot of upside and this is a good long-term holding so I decided to post it. I have not updated any of the numbers in my analysis, but the thesis is unaffected by this.
Synchrony Financial (SYF) has the highest net interest margin in the credit card industry (SYF 16.1% vs. DFS 10%, AXP 9.6%, and COF 6.8%), the lowest efficiency ratio in the banking industry (31% for SYF vs. 50-60% for peers), and once it returns its excess capital to shareholders it could easily have the highest ROE in the banking industry as well (SYF pre-IPO 38.6% vs. AXP 26.0%, DFS 20.41%, and COF 7.51%).
Why is SYF so much more profitable than its competitors? And why hasn’t its advantage been competed away in the hyper competitive banking industry? The key difference is that SYF’s customer is the retailer, not the cardholder. SYF primary job is to increase client sales using credit products. That dynamic opens the door to higher interest rates and lower expenses. And whether by design, providence, or just plain luck, SYF’s competitors face considerable barriers to entry in Private Label Credit Card (NASDAQ:PLCC) market.
As you read this, don’t think of SYF as a bank. Think of it as a marketing firm. Yeah, it accepts deposits. Yeah, it makes loans. But its real customer is the retailer, and all that bank stuff is just a by-product of its true business – creating marketing strategies for its clients.
SYF is the largest issuer of PLCCs in the U.S. The company is a former subsidiary of GE Capital Corporation that was spun off in 2014. SYF has 29 retail partners with over 365,000 retail locations, including Lowe’s, Walmart, and Amazon, and is the clear market leader with 40% market share. The company conducts operations through a single business segment with three sales platforms: Retail Card (74% of rev.), Payment Solutions (13%), and CareCredit (13%). SYF has a wholly-owned direct-to-consumer bank subsidiary called SYF Bank. Through its bank subsidiary SYF offers a range of deposit products such as CoDs, IRAs, MMAs, and savings accounts. SYF’s primary competitors are Citi (29% market share) and ADS (10%).
SYF has carved out a highly profitable position in a niche market with a strong economic moat. The company’s stock price is down 18.6% from its all-time high as a result of higher net charge-offs (NCOs) due to industry-wide credit normalization, creating a buying opportunity for investors looking to own a high quality business with growing earnings power. SYF also holds excess capital equal to 34.6% of its market capitalization and has begun a capital return program that is underestimated by financial markets, has upside potential from a rise in interest rates, and has considerable equity vesting for its management in the near term.
1) Highly Profitable, Niche Market: PLCCs utilize a unique business model where they perform the role of marketing consultant rather than traditional credit card company. While PLCC’s primary source of income is undoubtedly from financing charges on credit card loans, it competes based on its ability to increase client sales through effective credit card offers.
1A) Basis of Competition: The basis of competition is more favorable for PLCCs than General Purpose Credit Cards (GPCCs). GPCCs are offered directly to consumers and compete on interest rates, rewards, and credit standards, all commodity-like provisions that stimulate competition and reduce industry profits. But PLCCs are offered through retail partners, such as Walmart and Lowe’s, which use them as a marketing tool to increase sales. Retail partners choose a PLCC provider based primarily its ability to grow its partner’s business through effective credit card programs. Commodity features like interest rates are a secondary consideration. Consider these quotes from some of SYF’s retail partners:
- “Our credit card is a proven sales driver as our cardholders are our most frequent visitors.” CFO, Stein Mart.
- “The Belk Rewards credit program has been instrumental in increasing our store and online traffic. We value Synchrony Financial’s industry expertise, commitment to innovation and knowledgeable insights that provide added value to our customers.” CEO, Belk.
- “We look forward to benefiting from Synchrony Financial’s vast retail experience and insights as we continue to offer services and convenience designed to attract new customers, deepen our relationship with our loyal customers and grow our business.” CFO, At Home.
Cardholders are also less sensitive to interest rates, often being enticed by special financing sponsored by the retailer or viewing PLCCs as a lender of last resort.
1B) High Interest Rates: Because retail partners and cardholders aren’t as interest rate sensitive as GPCC users, it opens the door to higher interest rates. In fact, PLCCs charge 1.5x-2.0x higher interest rates than GPCCs. Interest rates on funding sources remain unchanged so PLCCs are able to capture most of the higher yield as pure profit. The higher interest rates on PLCC loans are justified by higher loan losses, which have NCO rates roughly double that of GPCCs (An average of 4.65% for PLCCs vs. 2.35% for GPCCs in 2016). PLCCs generally underwrite lower quality loans than GPCCs to avoid loan application rejections at point-of-sale in order to satisfy retail partners. Part of a PLCCs appeal to retailers is that financing drives sales by enabling transactions which otherwise wouldn’t occur due to insufficient funds. That said, SYF’s average FICO score is 717, 72.6% of its Retail Card loans have a FICO score greater than 660 (in line with peers), and Retailer Share Agreements are in place to ensure a minimum level of profitability.
2) Barriers to Entry: SYF operates in an industry that benefits from a number of barriers to entry. These barriers keep the number of industry players low, competitive dynamics stable, and profits high.
2A) Small Market Size: The PLCC market represents only 6.9% of all payment transactions in the U.S., according to a Federal Reserve study of the payments industry. Although the industry grew at a 17.1% CAGR from 2009-2012, the relatively small size of the PLCC market helps insulate it from competition by large GPCC companies because PLCCs would comprise a small portion of their overall loan portfolio. For example, although Citi has a 29% market share in the PLCC industry, its PLCC business represents only 14.5% of its entire consumer loan portfolio. And when new players enter the PLCC market their loans initially comprise an insignificant part of their total loan portfolio, as evidenced by Wells Fargo with a single PLCC account that contributes less than 1% to its total revenue and TD Bank which acquired the Nordstrom’s portfolio that accounts for less than 1.3% of its total interest earning assets.
2B) Customer Stickiness: Industry incumbents have extremely sticky customer relationships, with long-term contracts, profit sharing arrangements, decade long partnerships, and high customer switching costs.
2C) Long Sales Cycle: The PLCC business requires a slower, direct selling model, as opposed to the consumer mass marketing typically seen in the GPCC industry. This model requires a well-trained sales force that sometimes quite literally goes door-to-door to create profitable new product offerings such as SYF’s CareCredit product or ADS’s Air Miles program.
2D) Cannibalization: PLCCs do not charge interchange fees, which are a significant source of revenue for GPCC companies (DFS 14% of rev. and COF 10% vs. SYF 3.8%). Publicly traded GPCC companies are unlikely to cannibalize a profitable revenue stream by entering the PLCC market, which is too small to generate enough revenue to replace lost interchange fees.
3) Growth Opportunities: SYF has many organic and acquisitive growth opportunities available. Of the top 100 retailers in the U.S. in 2014 only 36 offered credit card programs. SYF can also grow by penetrating existing retail partners deeper, expanding the use of dual-purpose credit cards, creating new programs such as Synchrony Car Care, purchasing loan portfolios from competitors, and partnering with online payment platforms such as PayPal, Apple Pay, and Samsung Pay.
4) Capital Returns: SYF created a huge capital position to receive approval of its application to the Federal Reserve Board and build credibility with regulators as a newly independent, publicly traded company. SYF has a CET1 ratio of 17.4%, well in excess of the Basel III 7.0% requirement to qualify as a “well capitalized” bank. SYF holds excess capital of $8.1 billion, or 34.6% of its market capitalization. Now that SYF has received approval for its capital plan from the Federal Reserve Board and successfully split from GE it plans to aggressively return capital to shareholders. It announced a quarterly dividend of $0.15 per share (21% payout ratio) and a $1.64 billion share repurchase program. In reality, its unlikely SYF will lower its CET1 ratio to 7.0%, but management has indicated they want SYF’s CET1 ratio to be more in line with peers, which have an average CET1 ratio of 11.9%. Even at an 11.9% CET1 ratio, SYF holds excess capital of $4.1 billion, or 17.5% of its market capitalization. To lower capital ratios SYF would also have to distribute net income of $2-3 billion per year. I anticipate buybacks of at least $10.6 billion over the next 2-3 years, or 45% upside, plus a dividend yield of 0.52% for the final quarter of 2017 increasing to 3.12% in 2019, to bring capital ratios in line with peers.
5) Interest Rate Sensitivity: Synchrony’s balance sheet is sensitive to interest rate levels. Every 100 basis point increase in interest rates will increase net interest income by $113 million per year, or $0.12 per share after retailer share arrangements, a 4.3% increase over 2016 EPS. The Fed has already started increasing interest rates and indicated future rate hikes in 2018.
6) Management Incentives: In conjunction with the IPO, management received Founder’s Grants of $20.3 million split 70/30 between RSUs and stock options with a $24 strike price and four-year cliff vesting period. Current executive compensation levels include ~77% performance based compensation with a 3 year vesting period, going as high as 90% performance based for the CEO. Management has a considerable amount of equity in the company that will start vesting for the first time in 2018-2019, providing a powerful incentive to increase Synchrony’s share price in that time frame.
7) Notable Investor Base: SYF counts the two most famous value investors in the world amongst its top 10 holders. Buffet and Klarmen both established sizeable positions in SYF in 2017 (2.66% and 3.74%, respectively), and value fund Boston Partners also has a stake (1.65%). This lends credence to the thesis that SYF is a good value play with a strong economic moat, and should give investors that last drop of confidence needed to initiate a large position.
SYF currently trades at a P/E Ratio of 11.07x. SYF’s valuation took a hit in 1H 2017 when it announced higher than expected credit losses as a result of loan seasoning. Credit card companies experienced abnormally low credit losses from 2012-2015 after tightening credit standards during the financial crises, but now underwriting standards are returning to normal and NCO rates are rising to historical mid-cycle levels. As loan losses normalize and the market buys into SYF’s growth story over the next 1-2 years I expect an uptick in the company’s P/E ratio. SYF’s benchmark companies are COF and DFS, which have traded at P/E ratios between 8.4x-13.4x over the last 5 years. I believe SYF deserves to trade at the high end of that valuation range because the company is extremely well positioned in a favorable market with rising interest rates and numerous growth opportunities. The currently depressed stock price represents an excellent buying opportunity with significant upside potential for investors. I'm projecting EPS of $3.82 in 2019, with multiple expansion to 13.4x in 2019. This results in a price target of $51.25 in 2019 and upside of 83.5% as of 9/25/17.
- Customer Concentration: SYF’s five largest partners accounted for 54% of its total interest and fees on loans and 50% of loan receivables in 2016. SYF has had relationships with these customers for over a decade and switching costs are high, so they are unlikely to switch to a competitor or terminate the program. No major customer contracts are up for renewal until 2019.
- Online Retailers: Brick and mortar retailers, historically SYF’s biggest partners, are experiencing secular decline as consumer shopping habits move online. Customer financial statements show that the decline is slow and gradual, so short-term fears are overblown, but it is still present. In the short-term this trend actually benefits SYF, as retailers turn to SYF’s credit card programs to boost sales. In the long-term SYF is positioning itself to capture online shopping with products such as its Amazon and PayPal cards.
- Economic Downturn: An economic downturn would negatively impact SYF’s results. However, SYF is conservatively financed and historically experiences an increase in deposits from a “flight to safety” effect during recessions. Additionally, macroeconomic indicators such as consumer confidence and debt-to-discretionary income do not indicate a downturn.
Disclosure: I am/we are long SYF.