Synchrony's on Its Own

We like Synchrony's overall business and believe it is undervalued relative to our fair value estimate of $37 per share. Synchrony does not currently pay a dividend. However, it will submit a capital return plan under the Federal Reserve's Comprehensive Capital Analysis and Review in anticipation of returning capital to shareholders during 2016. Our initial estimate is that Synchrony would meet little resistance in returning 30% of net income to shareholders.

Most Revenue From Retail Card Segment Synchrony provides a range of credit products through programs established with a diverse group of national and regional retailers, local merchants, manufacturers, industry associations, and healthcare providers, which the company refers to as its partners. There are three credit sales platforms provided through these partners: retail card, payment solutions, and CareCredit.

With a pullback by many banks in unsecured consumer credit since the financial crisis, Synchrony has been able to fill the need for credit through its retail card platform, its largest segment with 68% of revenue for 2013 and 2014. The retail card platform is a leading provider of private-label credit cards offered primarily through national and regional retailers. Synchrony performs the underwriting for the partners and retains the receivables while paying out rewards to retailers through retailer share arrangements across all of its platforms. For the retailers, these partnership agreements include the elimination of interchange and exchange fees for in-store purchases, with costs assumed by Synchrony that would otherwise be paid by the retailers. We believe that as the U.S. consumer comes back and stops deleveraging, Synchrony will be positioned to offer immediate credit to qualifying consumers with satisfactory credit scores.

Synchrony also offers financing for retailers of large-ticket items, primarily furniture and electronics/appliances in payment solutions, as well as for elective healthcare procedures or services such as dental, veterinary, cosmetic, vision or audiology through its CareCredit division.

As a result of high card yields, interchange fees through its dual-use cards, and durable partner relationships, Synchrony is able to generate high returns on equity with high-yield cards while retailer partners have incentives to bring with them valuable relationships with consumers holding Synchrony cards that help garner profitable deals for both Synchrony and its retailer partners.

Switching Costs Enforce Moat We think Synchrony has a narrow economic moat as it has built strong switching costs around its ecosystem of partners and, as a result, earns high yields and high margins in its credit card business. The retail card platform is a leading provider of private-label credit cards offered primarily through national and regional retailers. The retail card segment accounted for $6.9 billion of revenue in 2014, or 68% of total revenue. We think the stickiness of the partner relationship is demonstrated by the average length of Synchrony's relationship with all of its retail card partners, which is 15 years comprising 33,000 retail locations collectively.

The primary way that the retail card partners stick with Synchrony is through the retailer share arrangements. These arrangements provide payments to retailers once the economic performance of the program exceeds a contractually defined threshold. These shared economics enhance partners' engagement with Synchrony and provide an incentive for the retailers to support the program. Last year, Synchrony paid out a total of $2.6 billion for retailer share arrangements. For the retailers, these partnerships reduce costs by eliminating interchange and exchange fees for in-store purchases that would otherwise be paid with general-purpose cards or debit cards. As a result, Synchrony is able to generate high returns because credit card yields are naturally high.

Additionally, the retailers are encouraged to bring with them valuable relationships that help garner profitable deals. Synchrony has agreements with partners having an expiration date of 2016 and beyond accounting for 95.3% of the revenue realized during 2013 with those long-term partners. Most recently, Synchrony entered into an agreement with an additional partner, BP. As of year-end 2014, nearly 90% of retail card loan receivables were contractually locked up to 2018 and beyond.

Consolidating Industry Could Bring More Assets In a consolidating industry like financial services with excess capital, Synchrony is in prime position to pick up additional assets or card portfolios. The prospect of increased regulation could weaken the economic moat of Synchrony, but we see no immediate threats on the horizon.

Synchrony has attracted more deposits through its direct banking operations, increasing this source of stable lower-cost funding. Currently, Synchrony's deposit funding consists largely of high-cost brokered deposits. If Synchrony were able to attract more lower-cost funding through its direct bank, we think this would add to the firm's economic advantage by reducing its cost of funding, which is the primary moat source for U.S. banks.

At this point, Synchrony performs the underwriting for the credit for the partners. In terms of total payment cards issued (which includes debit cards), private-label cards constitute approximately 40% of all cards issued. Synchrony remains the largest issuer of private-label cards in the U.S., with a market share of approximately 34% of total private label.

Technology and Regulation Pose Risks We think there are a few things that could detract from Synchrony's moat. First, as payments made from mobile devices become more common, the credit card business will be affected. As people can make payments directly from their accounts, using mobile devices without the use of a credit card will have a negative impact on firms like Synchrony by taking them out of the payments system. We think this will affect the stickiness of customers to their credit card accounts and ultimately the partner relationship with Synchrony. However, Synchrony is taking steps to build its mobile capabilities, including reaching an agreement with Apple to include Synchrony's dual-purpose cards in Apple Pay.

Second, the consumer protection regulation from the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 may have an impact on Synchrony's infrastructure, recordkeeping, and revenue should the Consumer Financial Protection Bureau impose its will as the lead regulator of consumer financial products and services. This bureau is tasked with "promoting fairness and transparency for mortgages, credit cards, and other consumer financial products and services," according to the U.S. Treasury Department. We have already seen limitations on bank interchange fees through the Durbin Amendment as a result of this legislation.

We think Synchrony is in good financial health, as demonstrated by its strong capital position following the initial public offering as well as improved credit quality. Capital remains solid with a tangible common equity ratio at 12.5% as of year-end 2014. While net charge-offs are between 4.5% and 5%, we think the high yields generated by Synchrony in its receivables portfolios help to mitigate its higher loss rates relative to other credit card competitors such as Discover Financial DFS and Capital One COF. In addition, we think the granularity of the portfolio prevents big swings in net charge-offs compared with commercial banks. Synchrony never incurred a net loss even in the financial crisis. Despite its higher risk profile compared with other credit card companies and commercial banks, we think Synchrony has managed and priced that risk into its product offerings, which has cushioned it from significant financial health problems.