Company Overview
Synchrony is one of the nation’s premier consumer financial services companies. Their roots in consumer finance trace back to 1932, and today they are the largest provider of private label credit cards in the United States based on payment volume and loans receivable. Synchrony was spun off from GE’s capital division a few years ago and now operates as a standalone company.
For those that don’t know, private label credit cards are store-branded cards that offer specific rewards and loyalty programs for consumers when used to purchase the retailer’s products. Synchrony partners with several large retailers to offer these cards and finances the credit that consumers use when paying with the private label cards. Some of Synchrony’s most significant partners include Lowe’s, Sam’s Club, GAP, Amazon, and Pay Pal, with the latter two having potential to generate strong growth in loan balances for Synchrony in the future.
Credit Card Industry
Trends show that our society is moving towards more ways to pay without cash, whether that be with cards or digitally, using tools like Apple Pay for mobile payment. In 2016, a USA Today article reported that the dollar amount of payments made using cards topped cash for the first time worldwide. Digital banking and other forms of payment, like Venmo, are non-cash methods people are using to exchange money. The rise of online commerce also supports continued use and adoption of card payment in the future.
All of this has resulted in large profits for the companies with the strongest payment processing networks, like Visa and Mastercard, who charge retailers interchange fees for each transaction they process on their network of banks and merchants. These two behemoths essentially make up a duopoly and share one of the most lucrative positions in business today, evidenced by their 30%+ net profit margins. These profits are at the expense of the retailers’ margins. That’s why you may see some retailers prefer you pay in cash or don’t use a card for small transaction amounts. They want to avoid the hefty interchange fees.
To no surprise, these payment processing companies sell at rich valuations, and deservedly so, as a lot of people want ownership of such outstanding assets. However, there are other niches of the payment space that have similar secular tailwinds and a strong competitive position but provide much more value for your dollar.
Synchrony in the Private Label Credit Card Space
The business model of private label credit card issuers, like Synchrony, has a very intriguing value proposition for both retailers and consumers. What they do is pretty simple. We will use Lowe’s as a partner example. Synchony enters into an agreement with Lowe’s to issue the Lowe’s-branded private label credit card to Lowe’s customers. As mentioned before, Synchrony will provide all of the credit to the Lowe’s customers. This is very profitable; they lend at high credit card interest rates but the funds they use to lend out are low cost deposits from their digital bank, producing an attractive net interest spread of over 16%.
The deal maker is that Synchrony doesn’t charge its partners an interchange fee like they would be charged from Visa or Mastercard. This is because Synchrony has a closed loop payment network, meaning they are the sole bank financing the retailers customers and there are only two parties in the payment network; contrarily, on an open loop network, the general card companies are facilitating transactions between many different bank accounts and the retailers. And, of course, the network owners want to be paid for it. Because of the fact Lowe’s will profit more on sales when their customers use their private label card, with no interchange fee, Lowe’s has very strong incentive to promote adoption and usage of Synchrony’s card. This is demonstrated in the excessive marketing of the retailer’s private label card, which I have witnessed first hand at Sam’s Club. This can come in the form of signs and banners displaying the cash back perks, or even the checkout cashier will ask customers if they would like to apply for the card. This is great marketing for the growth of Synchrony’s credit card loan balances.
Back to our example, Lowe’s will give its credit card users strong discounts or cash back to promote usage of the private label card so Lowe’s can avoid interchange fees. Giving the cash back is more profitable for Lowe’s than paying the fees from general credit cards, and the cash back is also a strong incentive for their customers to use the card to buy more in order to save money with rewards. In turn, Lowe’s sees sales increase, their customers are more loyal, and Synchrony’s loan balances grow. This is a very attractive cycle to be in the middle of. The stronger the customer loyalty, the stronger sales will grow and the more rewards can be given back to the customers, which creates more loyalty and sales growth… you get the point. At the end of the day more money is being lent out at great spreads because all parties are benefiting.
If you aren’t convinced private label cards are unique enough to be a big deal, just look at the numbers. A 2016 U.S. consumer payment study of a diverse group of 1,000 individuals by TSYS found this: “While many things change with payment offerings and features, consumers still rank rewards as the most attractive feature and a key influencer for using one card over another. This year, the percentage of respondents who selected rewards as the most attractive feature was nearly 60 percent.”
Because of the nature of the loyalty rewards cycle, Synchrony has been steadily increasing its penetration of their existing partners’ customer base and can consistently grow in just this way, by taking payment market share from the general card companies. Synchrony is the leading player that benefits from this “loophole” that helps merchants avoid getting killed on interchange fees. They are the retailer’s best friend.
In the past, a big barrier to adoption of private labels cards was that people didn’t want to have dozens of credit cards fattening up their wallet. Today, with growth of digital wallets and digital payments, it is much more convenient to digitally store and use several different card options that apply to stores frequently shopped at. This may also make more retailers interested in offering a private label card that they previously didn’t expect enough adoption from. These would be more partnerships that Synchrony could secure going forward.
Competitive Position
The partnerships, which are the driver of Synchrony’s revenues, in the private label card industry tend to be very sticky. The lack of turnover is a result of high switching costs and the build-up of expertise that companies like Synchrony provide to their partners.
Synchrony’s average relationship with its partners spans around two decades with their longest being an over 30 year partnership. This is a testament to the consistency of the partnerships. When Synchrony works with their partner, they give the retailer access to all the payment data on their customers to strategically target promotions and rewards to drive sales growth. Synchrony provides much of the data analytics expertise to assist their partner with the structure of loyalty campaigns, and I have even read that Synchony’s employees will work in the partner’s marketing department to maximize the effectiveness of the two firms’ resources. Altogether, there is a long history of shared data and knowledge about the retailer’s customer base, along with working relationships developed between staff at the two companies. If a partner were to take its business to a different private label issuer, they would likely have to adjust their marketing and loyalty campaigns, lose the specific data analytics expertise that has been accumulated for years, if not decades, and start from zero with new staff relationships between the retailer and issuer. Not only this, but they will have to issue their customers new credit cards and likely have their loan balances transferred to the new issuer, which can result in annoyed and confused card holders, not to mention the extra dollar costs to administer the switch.
From a retailer’s perspective, we can see that Synchrony is a very attractive candidate to work with. They are one of few company’s that are entirely focused on the private label business. Many other players, like large banks, derive a small portion of their business from private label cards and are unable to focus on enhancing the partnership value proposition as much as Synchrony can. Additionally, Synchrony has a very strong and large balance sheet to support the loan balances required to finance the customers of their large retail partners. This is a scale advantage that partners look for, as they won’t work with someone who doesn’t have access to enough capital to support the program.
And, finally, Synchrony is a low cost operator. They focus on technological processes to reduce overhead expense in areas of the business, like their digital bank, which allows them to achieve a five-star efficiency ratio in the low 30% range. The efficiency ratio is non-interest expense divided by total revenue and shows how tightly run the operation is. Most banks run their ratio at 50-70%. Another financial services company I have recommended as a buy, Bank of Internet, also runs an efficiency ratio below 40% as a result of their branch-less banking model. It is clear that this model has become a profitability advantage for the companies that have adopted it.
With a combination of great interest spreads and low costs, Synchrony’s Return on Assets (ROA) are top notch and vary in the 2.5-3% range. For comparison, most banks are considered to be well-run with ROA over 1%. While Synchrony isn’t just a bank, the general essence of the way they make income is the same as the banking model. This translates to a high teens Return on Equity, because they only have to maintain a fraction of their total assets in equity capital, like all banks. These metrics are highly attractive considering Synchrony has ample opportunity to reinvest capital at high rates to support loan balance growth.
Why SYF is a Cheap
There has been some pessimism surrounding the stock for a few reasons. First, the credit cycle began normalization after the post-recession years that had uniquely low loan losses because most losses happened in the recession. Recently, this has increased Syncrony’s loan loss expenses and pressured earnings. On top of that, Synchrony recently lost one of its top partners, Wal-Mart, to Capital One. The partnership made up a large portion of Synchrony’s loans and revenues. Lastly, Synchrony’s revenue base is cyclical and not very diverse because of its concentrated partnerships. This causes investors to assign earnings a lower multiple than the market average.
Breaking all this down, I found that loan loss trends have started to decelerate from the past couple years and management expects losses to begin to stabilize in the next year. That means the company is likely close to mid-cycle earnings power, which is probably the best way to evaluate long term earnings power.
As for Wal-Mart, management said that they could not reach an agreement that would make economic sense for Synchony’s shareholders, so they let the business go to Capital One. They mentioned that Wal-Mart works in unique ways. I feel it is likely that Wal-Mart was asking Synchrony to give up a lot of the loan profits and take on a lot of the risk, based on Wal-Mart’s history of cutthroat negotiating. Synchrony’s new plans for the existing Wal-Mart loan portfolio are expected to leave the company in a better position than had they renewed the partnership, with potential for a gain on sale, freed up capital, and better average credit risk metrics without the loans to Wal-Mart customers. All of this news sent the stock down 10% in a day as investors now fear that Wal-Mart is the first of many partners to not renew upcoming agreements with Synchrony. I think the full picture actually makes me more confident to invest in the company because management has demonstrated that they will only take on profitable business and not simply expand the corporate empire for the sake of size. Also, Lowe’s just renewed their partnership, so I think we will need to see more losses than just Wal-Mart before we jump to the conclusion that Syncrony’s revenue base is at risk.
On the topic of management, they have adopted a unique method to reduce the cyclical nature of earnings, which the market may not be giving enough respect. Synchrony uses a Retailer Share Agreement (RSA) with their partners which is a profit share between the parties. Basically, Synchrony pays their partners well when the loans are performing well, and then reduces their payment to partners when the loans perform below a certain threshold. The RSA is reported as an expense for Synchrony; so, when loan losses rise, the RSA expense goes down and partially offsets the negative impact to earnings. All in all, this creates smoother earnings power throughout the credit cycle and deserves a higher earnings multiple than fully cycle-exposed financial companies.
Management also tightened up their lending standards when the credit cycle began to normalize. This has led to improving average FICO scores across the loans receivable and likely reduced the negative impacts of today’s higher loan loss rates. Overall, I am very impressed with Synchrony’s profitability-focused management, business model, and strategy.
Valuation
Historically, Synchrony has been able to grow their loans receivable pretty steadily, in the 6-10% range. Management has iterated that they expect these past growth rates to continue once they lap recent years of tightening credit standards that put a cap on growth. Additionally, the company could see margin expansion once current overhead costs related to the Pay Pal loans acquisition are lapped, resulting in a lower efficiency ratio.
Without these impacts, and with the credit cycle likely normalized, Synchrony has current earnings power of around $3.20 per share. This results in a PE ratio of under 10, one of the lowest since Synchrony’s IPO, against the $30 stock price. This is on the low end of where most consumer finance companies tend to trade at, which is 10-13 times earnings depending on the quality of the business. Because Synchrony is conservatively managed and has sticky long-term partnership deals that mitigate the cyclical nature of earnings, I think their quality deserves to trade at the high end of this range. That would put fair value at $41.60 per share ($3.20 times 13). While that looks good, that’s not all.
Synchrony has more capital than they are required to hold because the SEC is strict on financial companies returning capital, especially following an IPO. Their equity to risky weighted assets stands around 17%, while similar companies tend to only hold 10-12% equity capital against their assets. If Synchrony were to reduce their capital ratio to peer level, which management has said they plan to work towards, this would free up around $4.5 billion, or $6 per share, that could be returned to shareholders. This unique balance sheet situation is similar to Apple’s in years past. Both companies have cash that makes up a large portion of their market price, yet they continue to generate strong cash flow that builds the cash pile. It’s a great problem to have. Synchrony has just recently been cleared to return cash to shareholders through dividends and buybacks, which they used to return almost $2 billion, or $2.60 a share, last year alone. This is an 8.6% capital return on the $30 stock today.
Even after such massive capital returns, Synchrony still has a boat load of capital to shed. It will take huge amounts of buybacks and dividends to reduce the excess because the company continues to generate a lot of cash. Taking this into our valuation, we will deduct the $6 of excess capital per share from the stock price to find what the actual business operation is selling for. Now we have a net price of $24 for $3.20 of earnings, which is a mouthwatering 7.5 PE ratio and 13.3% earnings yield.
To purchase a well-managed company that holds a leading competitive position, with a niche inside a strong secular trend, and at a 13.3% earnings yield is a good deal. Synchrony is very capable of growing at 6-10% for the foreseeable future, and an investor at current prices is likely to see a very attractive yield on cost within five years. Additionally, it is likely that investors will receive lucrative dividends and well-timed buybacks over the next few years as management reduces their capital ratio to industry norms. This is a great opportunity with a strong margin of safety.
I hold a material position in SYF, initiated at prices below $30.
Bryce Dooley
BD Capital 