Synchrony Spreads Its Wings as It Flies Solo

Investor misunderstanding of Synchrony centers on the attractive nature of the firm's closed-loop model, particularly its retail sharing agreements, funding picture, and growth prospects. Retail sharing agreements with Synchrony offer more detailed information on consumer behavior and lower interchange fees. For cardholders, Synchrony offers unique discounts and rewards on future purchases. Given this attractive proposition, Synchrony's receivables growth has been double that of general-purpose cards over the past few years, and we expect these growth trends and market share gains to continue. Credit losses in the 4%-5% range are easily offset by significantly higher net interest margins, and we believe the market overestimates future credit risk.

We believe Synchrony is undervalued and poised to outperform as consumer spending on private label continues to thrive. As Synchrony has yet to show up on many investors' radar screens given its short life as a public company, we expect its dividend announcement via the Comprehensive Capital Analysis and Review later this month to attract attention, and the indiscriminate recent selling off of bank stocks following the Federal Reserve's increased reluctance to increase interest rates in 2016--as well as overreaction to Synchrony's higher charge-offs--offers an opportunity to purchase a unique private-label card franchise at a 50% discount to what we think it's worth.

Market Underappreciates Breadth and Depth of Synchrony's Business Model

Synchrony Financial was previously GE Capital's consumer credit division, with roots tracing back to 1932. Until August 2014,

Synchrony provides an array of credit products through programs established with a diverse group of national and regional retailers, local merchants, manufacturers, industry associations, and healthcare providers, which it refers to as partners. These credit products are sold through three sales platforms for Synchrony: retail card (private-label credit cards where Synchrony has 41% market share), payment solutions (consumer financing for major purchases), and CareCredit (financing for elective healthcare procedures). Through all of these platforms, Synchrony offers credit through its partners' cumulative 350,000 locations in the U.S. and Canada, their websites, and their mobile applications.

The business model for Synchrony is still not well understood by the market, in our view--specifically, the value Synchrony brings to retailers and customers, as well as the benefits of operating a closed-loop system versus the open-loop system used by

In terms of payment systems, private-label card issuers like Synchrony operate in a closed-loop network system (similar to

Market Underappreciates Merchant Switching Costs We think Synchrony has a narrow moat as it has built strong switching costs around its ecosystem of partners, helping the company earn high yields and margins in its three business platforms. First, private-label cards generally result in higher repeat business, with an average of 12 card uses annually for over 50 million accounts in 2013. Second, the ability to migrate away from Synchrony to another private-label issuer is onerous, given the intertwined data systems of Synchrony and the retailer receiving Synchrony customer purchase data. Third, the waiving of interchange fees for cardholder transactions and the incentive and opportunity to generate cash back from Synchrony through the retail share agreements makes it particularly difficult for other competitors.

The primary way that the retail card partners stick with Synchrony is through the aforementioned retail sharing agreements, or RSAs. These are designed to encourage both the retailer and cardholder to promote and use the credit lines offered by Synchrony. With higher average percentage rates on private-label cards, Synchrony structures the RSAs with its partners to market new accounts and promote the use of cards, which is beneficial for all parties while offering value to the cardholder. These arrangements provide payments to retailers from Synchrony once economic performance levels of the program exceed a contractually defined threshold. These shared economics enhance partners' engagement with Synchrony and provides an incentive for the retailers to support the program through store discounts. Synchrony individually negotiates with its partners the terms of the RSAs. Synchrony's RSAs dictate the terms for payment back to the retailer if the economic performance of the program exceeds contractually defined performance thresholds and align both parties' economic interests. If the program underperforms, Synchrony shares less with the retailer. It is the RSAs that determine the support each party will provide to the program, including the elimination of interchange fees that are normally borne by the retailer for open-loop network payments. In addition, the retailer can be paid fees by Synchrony based on the success of the individual RSA. While the retail partner agrees to support and promote the program to its customers, Synchrony retains control of the underwriting and issuance of credit to the customers of the partner. The typical agreement has contract terms ranging from 5 to 10 years with most agreements possessing an automatic renewal clause until it is terminated by either Synchrony or the retail partner. In most circumstances, Synchrony will seek to renew the RSAs well in advance of termination dates. This general formula appears to have worked well, given that the average length of relationship with its ongoing retail card partners is 17 years.

Furthermore, over 90% of retail card revenue is with retailers that have contracts beyond 2019. Generally, Synchrony tries to stay ahead of expiring RSAs well before they come due with a greater proportion of partner contracts more than two years away from expiration. With only one contract coming due in 2017 and four in 2018, we think it is highly likely that all of these retailers will be renewed well before expiration. Given the attractive economics, including the waiver of interchange fees for retailers, we do not believe Synchrony is subject to the same pressures that American Express faced renewing its agreement with Costco, which it eventually lost.

Adding to switching costs, Synchrony has developed and implemented technology with its partners' systems, enabling it to provide customized credit products at the point of sale across multiple channels including in-store, online, or on a mobile device. Synchrony maintains deeply integrated technology with its partners' systems and processes, enabling it to provide customized credit products and solutions to its partners' customers at the point of sale.

Plus, Synchrony's online and mobile technologies are capable of being integrated into its partners' systems with little difficulty and enabling customers to check available credit, manage their account, access customer service, and participate in partner loyalty programs. This entrenchment of technology into its partners' data systems would make it difficult for other private-label issuers to easily and seamlessly replace Synchrony as a private-label issuer.

Synchrony continues to develop its digital capabilities to help drive an improved mobile and online experience for cardholders. Synchrony has designed its mobile applications to deliver customized features, including rewards, retail offers, and alerts. Other areas include expanding use of its credit cards reaching various mobile wallets, enhancing the user experience for its customers. In 2015, as well as enabling its Dual Card products for use in mobile wallets, Synchrony provided the capability to offer private-label cards through Apple Pay and enabled the use of payment solutions and CareCredit cards in Samsung Pay.

Market Underappreciates Synchrony's Value to Cardholders and Retailers We see private-label cards as offering value to cardholders in three ways: ability to offer immediate credit, ability to offer in-store discounts, and ability to compartmentalize large purchases for customers. Synchrony, much like American Express and Discover, operates as the owner of the payment network for its private-label cards in its closed-loop system. As a result, one of the benefits to retail partners is the waiver of cardholders' interchange fees, which are normally associated with general-purpose credit cards and other payment transactions. This is one way retailers are motivated to encourage enrollment and future use of private-label cards, given the 2%-3% retention of revenue that would otherwise be paid to parties in an open-loop network.

Synchrony is also in the position to access individual customer purchase information, which can be used by the retailer for targeted marketing efforts and expanding the business quickly. Through its data analytics teams, Synchrony is able to track cardholder responsiveness to marketing programs to target marketing messages and promotional offers to cardholders based on their individual characteristics, such as length of relationship and spending pattern. For example, if a cardholder responds positively to a coupon sent by text message, future marketing messages will be tailored so that they are delivered by text message. These extensive marketing activities targeted to existing customers have yielded high levels of reuse across both the payment solutions and CareCredit sales platforms. Over the last year, approximately 27% and 50% of purchase volume across the payment solutions platform and CareCredit network, respectively, resulted from repeat use.

In addition, Synchrony offers instant access to credit at the point of sale for its payment solutions and CareCredit platforms. The main difference is that Synchrony typically does not pay fees to its payment solutions partners pursuant to any RSA, unlike the retail card platform. However, in some cases, Synchrony will pay a sign-up fee to a partner or provide volume-based rebates on the merchant discount paid by the partner. Generally, customers in these other platforms will typically benefit from promotional financing such as interest-free periods on purchases, which are typically not available with general card use. The average length of Synchrony's relationship with its top 10 payment solutions retailers is 11 years. For CareCredit customers, the ability for qualified customers to pay for elective health procedures or services that are typically not covered by insurance is particularly valuable.

Synchrony's Funding Is Not Low-Cost, but Feeds the Model Profitably A key element of Synchrony's model is its funding structure, but we do not consider the firm to have a cost advantage. Synchrony benefits from its direct banking model, which means its efficiency ratio is well below 50% because it does not need to support expensive branches, yet its funding costs and credit costs are much higher than peers. Further, with a product portfolio focused on private-label credit cards, where switching costs are relatively low from a consumer standpoint, we don't think Synchrony serves as the main banking relationship for consumers, limiting its ability to keep deposit costs low and forcing the firm to rely on brokered deposits more heavily than peers. However, we also believe Synchrony is more than willing to pay up to acquire deposits, as its extremely high net interest margins provide ample room to pay higher deposits rates and still earn excess returns. As a result, we don't believe Synchrony enjoys a cost advantage, but it is willing to pay the rates that are needed to support its overall receivables growth.

We expect the direct banking operations to continue to grow strongly. According to 2014 and 2015 American Bankers Association surveys, the percentage of customers who prefer to do their banking via direct channels (Internet, mail, phone, and mobile) increased from 54% to 56% between 2014 and 2015, while those who prefer branch banking declined from 21% to 17% over the same period. To attract new deposits and retain existing ones, Synchrony plans to introduce new deposit products and enhancements to its existing products, including checking accounts, overdraft protection lines of credit, bill payment, and Synchrony-branded debit cards. As a growing part of its funding, Synchrony offers depositors a range of FDIC-insured deposit products. At year-end 2015, Synchrony had $43.4 billion in deposits, $29.7 billion of which were direct deposits and $13.7 billion of brokered, higher-cost deposits, which were almost entirely retail accounts. To date, deposit funding has grown from 48% of Synchrony's funding at year-end 2013 to approximately 65% at year-end 2015, which we expect to be maintained.

As with most online banks, the direct bank platform is highly scalable, allowing expansion without having to rely on a traditional brick-and-mortar branch network. With this direct banking/branchless model, the relative costs for Synchrony are much better than traditional banks with branch networks. Typical brick-and-mortar banks operate with an efficiency ratio of 60%-65%. Any U.S. bank operating below 60% is generally considered to be well run with little room for potential cost savings. Depending upon the treatment of the RSA payments to retailers (Synchrony subtracts RSA payments from its net interest income while we account for it as an expense and use the higher net interest income number), Synchrony operates very favorably with those benchmarks, well below 50%.

Market Underappreciates Private-Label Growth Prospects We believe three major trends will drive developments over the next five years that are favorable for Synchrony's business model. First is the end-to-end facilitation of commerce. Consumers once found out about products on TV or at the water cooler, shopped at the mall, and paid with cash or checks. Today, Synchrony is inserting itself into the entire shopping process, and retailers are using technology to create closer ties with customers. Second, retailer scale and regulation are strengthening the hands of merchants relative to the banks and general-purpose cards that have long dominated the payment industry. Third, technologies are increasing the number of options consumers have for storing funds, obtaining credit, and making payments, further diminishing the importance of traditional banks. All of these trends will be positive for Synchrony's business model, in our opinion.

Private-label programs allow retailers to sidestep transaction fees while also getting access to the valuable data on customers' purchasing habits. As a result, Synchrony has gained 12% market share since 2004 (to 41%), and its loan portfolio is projected to grow nearly 8% this year. The average Synchrony cardholder has been with the firm for 7.7 years. As Synchrony adds partners and the private-label industry grows, we expect the company to continue to add to its overall share of the market, and we project market share of around 45% in 2020.

The U.S. market presents an extremely favorable environment for private-label card growth. Card receivables for all private-label credit cards have grown faster than general-purpose cards, 9.1% versus 4.2% during 2014, and we estimate similar growth in 2015 and for 2016-20 as we expect the value proposition for retailers and cardholders to persist. As a result, private-label balances have returned to precrisis levels while general-purpose card receivables have not yet attained precrisis peak levels. Based on the comparative growth for each type of card, these results are not surprising. We expect 6%-8% growth to occur as we see few trends that would disrupt the private-label business model with Synchrony as the prime benefactor.

The value propositions and integration between Synchrony and its retail partners have resulted in purchase volume growth in excess of market norms across all types of retailers. We like the growth prospects for private label and Synchrony because of incentives for retailers to serve as a strong value proposition for its customers--along with the pressures upon general-purpose card issuers--particularly on interchange fees. Overall, we expect Synchrony's receivables growth to continue outpacing general-purpose receivables.

Market Underappreciates Synchrony's Relative Value and Overestimates Credit Risks Our $40 fair value estimate represents a multiple of 13.4 times our 2017 earnings estimate and 2.5 times estimated book value for 2017. In terms of capital return, Synchrony is not yet paying dividends or repurchasing common shares. However, the company is expected to seek assent from the Federal Reserve for modest capital returns during 2016. While Synchrony has not specifically stated its request, we estimate that total returns will approximate 30% of annual net income, leading to an annual dividend of $0.83 and a yield of 3.2% based on current pricing.

One of the worries for Synchrony investors is the potential impact of future credit losses into the latter stages of a credit cycle. At year-end 2015, approximately 27% of Synchrony's receivables were from cardholders with credit FICO scores of 660 or lower, generally considered subprime; this was slightly lower than 2014. However, we think Synchrony prices its very granular loan portfolio appropriately, with an average yield over 21% for the past three years. With this level of interest income, Synchrony has had sufficient cushion for potential loan losses. With the exception of the post-financial-crisis period, Synchrony has set aside a greater amount of loan-loss provisions as a percentage of net charge-offs, which we expect to continue. During the financial crisis, Synchrony did not incur a loss despite reaching a net charge-off level of 11.3% in 2009 compared with long-term net charge-off levels of 4.5%-5.0% over a business cycle.

Furthermore, our analysis shows that credit card net charge-offs are highly correlated to the unemployment rate, going back to available data from 2001. In our opinion, low unemployment levels portend strong returns on equity for Synchrony.

Given the sensitivity to unemployment, our fair value uncertainty rating is high. That said, over time, we project generally healthy results for Synchrony, thanks to the stickiness of its partner relationships and the yields it is able to extract from cardholders. We project net interest margin to remain fairly stable and consistent with the last two years' results at 19.0% for 2016-20. In addition, we anticipate total net charge-offs for credit cards will equal 4.75%, which is also consistent with recent history and long-term averages. Last, we project that the equity/assets ratio will remain high but decline slowly to 12.0% by 2018 from 17% in 2014 and remain at that level. We typically see similar capital ratios in other credit card companies under our coverage, such as 14.2% at

We see Synchrony's net interest margin, along with credit card loan growth and charge-off levels, as the primary driver of future valuation. In our downside scenario, we assume that net interest margins, as we calculate them, compress to 16.0% by 2020 due to higher funding costs, which is below 2011 performance, the lowest margin in the past five years. In our bull scenario, we assume net interest margins increase to 19% over the projected period if Synchrony attracts more lower-cost funding through deposits, which is similar to 2013, the highest margin in the past six years.

A second variable affecting our fair value estimate is net charge-offs in credit card receivables. In our bear scenario, we assume net charge-offs increase to 5.5% over 2016-20 if unemployment begins to increase significantly. For our bull scenario, we assume net charge-offs decrease to 3.5% because of a stronger consumer and continued low unemployment in the U.S. economy.

The growth in credit card receivables is the last variable that has an impact on our fair value estimate. In our bear scenario, we assume card receivables will grow only 5% annually as consumers cut back on taking more debt. In our bull scenario, we assume credit card receivables will increase to 12% as a stronger, more confident consumer emerges.

If we were to change each variable statically, net charge-offs have the biggest impact on the bear scenario compared with the other variable metrics, leading to a low fair value estimate of $22. In our bull scenario, our fair value estimate would be $67, or 4.2 times our estimated book value for 2017. Given these overall results, we would be the most worried about higher net charge-offs having an impact on our long-term fair value estimate. While stronger loan growth and net charge-offs have a positive impact on the bull case, we would look for better net interest margins to be the catalyst for outperformance.