Stock Strategist

Synchrony Sell-Off Offers Opportunity

Colin Plunkett, CFA

 Synchrony Financial (SYF) provides the store-branded credit cards of many of the country’s largest retailers, including Amazon, Walmart, Gap, and JCPenney, and benefits from these long-term mutually beneficial relationships. Since 2008, Synchrony has routinely generated returns on equity exceeding 15%, partly as a result of high switching costs. In the coming years, we believe Synchrony will be able to increase returns on equity as a result of higher leverage while returning a substantial amount of cash to shareholders. We believe it can increase balance sheet leverage without putting shareholder returns at risk.

Private-label card providers are enjoying some favorable tailwinds. Retailers have become increasingly pressured by the likes of Amazon, which has encouraged merchants to pursue additional revenue streams while necessitating the collection of shopper data to offer tailored marketing programs. Synchrony has been a valuable partner for many retailers. Despite this, we expect a moderation in performance from the supernormal returns achieved by Synchrony and other private-label credit card providers since 2008 as a result of rising competition for new receivables. Retailers have been able to negotiate increasingly favorable terms, which we expect will damp Synchrony’s margins. In addition, Synchrony can only prosper as long as its partners remain in business. In 2017, Synchrony saw partner HH Gregg file for bankruptcy. Our biggest concern is that Synchrony’s performance will improve as pain increases for retailers, which could give a skewed picture of the company’s prospects. Once retailers file for bankruptcy, it will provide a significant headwind to Synchrony’s growth.

We also believe that charge-offs will increase. Nevertheless, we don’t believe this is a huge cause for concern and is only reflective of the company’s impressive growth. Charge-offs on credit cards typically peak in the second year after a card is issued. Once this growth slows, Synchrony should see significant benefits to its bottom line through lower credit provisions and reversals of allowances for loan losses.

Switching Costs Result in Narrow Moat
Formerly a unit of General Electric, Synchrony Financial is the nation’s largest provider of private-label credit cards via its retail card segment. Private-label credit cards are issued in partnership with retailers and differ from general-purpose cards in that they can only be used at the issuing retailer. In 2016, 74% of Synchrony’s interest and fee income came from its retail card segment. Synchrony has two smaller segments: payment solutions, which provides consumer financing for major retail purchases, and CareCredit, which provides financing for elective health procedures. While we expect these smaller segments to contribute to the bottom line, we do not believe they possess any sustainable competitive advantages.

We believe the company has constructed a narrow economic moat through onerous switching costs around its private-label retail card segment. Retailers benefit in three ways by offering a private-label card. First and foremost, this enables retailers to track the customers’ purchase information. This yields valuable data that retailers are able to use to offer highly targeted sales promotions, which helps drive incremental sales. Second, retailers generate additional income through sharing agreements with Synchrony. Once certain agreed-on economic performance hurdles are met, Synchrony shares additional revenue with the retailer. In 2016, Synchrony’s retail card segment paid $2.9 billion in retailer share arrangements. This motivates retailers to encourage customers to use their private-label card. Third, private-label cards operate in a closed-loop network, allowing retailers to bypass interchange fees on purchases. The main switching costs are a feature of Synchrony’s data collection and analytics. Retailers that switch private-label card providers are at great risk of compromising the quality of their customer data, which could disrupt the purchase behavior of a retailer’s best customers. In addition, retailers build interlocking data collection systems, strengthening Synchrony’s hold on its customer base.

Furthermore, Synchrony’s narrow moat has resulted in long and dependent relationships with its retail partners. The company’s five largest retail programs are Gap, JCPenney, Lowe’s, Sam’s Club, and Walmart. Combined, these relationships account for 54% of total interest and fees. While we think customer concentration limits some of Synchrony’s returns, the average length of these relationships is 17 years. We believe this supports our thesis that the company enjoys a narrow, but not wide, economic moat. Typically, agreements last 5-10 years. Through the end of 2019, none of Synchrony’s major partnerships is up for renewal, limiting the risk of customer defection. One of the key long-term risks to Synchrony’s business is the ability for retailers to collect their own data through some alternative means. As a result of increases in point-of-sale technology linked to smartphones, it has become easier for retailers to collect data from their customers and offer highly targeted marketing plans. Should this trend gain momentum, retailers may not need private-label cards to gather data on their customers. While we do not expect this to materialize in the near future, it is something we view as a long-term threat.

Also limiting Synchrony’s returns is the competition to acquire new private-label credit card receivables. For example, in October 2015, TD Bank acquired $2.2 billion of Nordstrom’s credit card receivables and about $325 million in associated debt for $2.2 billion from the retailer. We calculate a premium of at least 17% to book value. In comparison, in 2012, TD Bank purchased $5.9 billion of Target’s receivables at what we calculate was approximately a 7% premium to book value. Going forward, we believe it will be challenging for card companies to maintain returns while increasing earnings through portfolio acquisitions. In May 2015, Synchrony acquired the credit card portfolio of BP. While details were few, we believe that returns on this acquisition will remain above the cost of capital but lower than previous deals. Given the increasing premiums card providers are willing to pay for receivables, we have to conclude that the terms are improving for retailers. As a result, we suspect the returns on card portfolios are likely to moderate as a result of a gradual decrease in growth, albeit still remain healthy and above the cost of capital. This bolsters our view that while recent supernormal performance may suggest Synchrony possesses a wide moat, it more likely only has a narrow moat.

In addition, we have observed that some retailers appear to be more focused on providing financing to customers rather than just selling them goods. We believe that many retailers struggling with rising competition have preferred the quick income gains from interest and late fees provided by retailer share agreements rather than addressing the problems with their business models. Without income from share agreements, the performance of many of Synchrony’s partners would look a lot weaker. In the short run, this bodes well for receivables growth, as beleaguered retailers continue to drive customers to private-label cards, increasing dependence on Synchrony. In the long run, this is worrisome because Synchrony obviously needs its retail partners to remain in business.

We believe the bank is making strides to achieve a cheaper, more stable form of deposits, but it has a long way to go. In 2012, Synchrony stopped securitizing newly issued cardholder receivables in favor of brokered deposits. Previously, it relied on securitizations and could be limited by the securitization market’s appetite to fund new receivables. While Synchrony increased deposits from $11.6 billion in 2009 to more than $52 billion in 2016, most of these deposits are CDs or brokered deposits. When interest rates rise, Synchrony will have to pay up for funding. Thus, the bank’s funding capabilities have only modestly improved.

Good Financial Health, but Technology Poses a Risk
Synchrony is subject to regulation by the U.S. Consumer Financial Protection Bureau. Given the agency’s broad mandate, it could limit credit card providers’ ability to charge late fees. Given that Synchrony’s cardholders often carry only minimal balances, it should not be underestimated how important late fees are to private-label credit card providers. Apparel retailer Gap offers a private-label credit card through Synchrony with an APR that exceeds 25% and charges a late fee usually totaling $25 for a small balance. In some situations, this can send the average yield on Gap’s credit card receivables to more than 50%. Synchrony does not break out late fees, but at its closest competitors, these fees account for about one third of total interest and fee income.

The greatest long-term risk we see to Synchrony’s business is that through advances in technology, it has become easier for retailers to collect data on their customers through alternative means. Today, shoppers frequently punch in their phone numbers at checkout, purchase coffee through their Starbucks app, or buy goods online. These are all forms of alternative data collection that retailers could use, making private-label credit cards unnecessary. In addition, Synchrony’s retail partners are often large retailers that have the scale necessary to implement these programs.

At the end of 2017, the bank had assets totaling only 6.7 times equity. This suggests to us that it is significantly underleveraged. We do not believe there has been a material deterioration in credit quality. However, we do project an increase in charge-offs. Typically, charge-offs have been 4.5%-5% of receivables. We believe Synchrony will not see substantially lower charge-offs until 2019. Since 2008, credit card portfolios have been tilted toward high-quality cardholders who were issued cards more than five years ago. Given this long and seasoned relationship, card providers were able to reasonably predict low losses. Now, card providers are seeing growth from newer customers, often with shorter credit histories. The performance of newer cardholders is harder to project, and they have a much higher probability of defaulting. Provided this risk is priced properly, it shouldn’t represent a significant threat to Synchrony’s financial health.

We think it’s a great idea to transition away from securitizations in favor of brokered deposits and CDs. Throughout 2016, securitizations amounted to only 18% of Synchrony’s total interest-bearing liabilities. In comparison, in 2012 when Synchrony stopped assigning new receivables to its securitization trust, this figure was 36%. While brokered deposits can be expensive and be subject to competitive pressures, they are less vulnerable to shocks in funding markets. We anticipate the company will continue to invest in alternative and more durable sources of funding. The next step will be converting CD and brokered deposits to checking accounts.

We support the company’s decision to introduce a dividend and share-repurchase plan. In 2017’s second quarter, the company took advantage of a share price decline to accelerate its repurchases of what we believe is an undervalued stock. Our only regret is that Synchrony didn’t buy back more. Should the market get spooked by volatile credit provisions, we hope management will use it as an opportunity for further repurchases.

Colin Plunkett, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.