Credit Card Net Charge-Offs Will Rise, but We Still See Opportunity Among the Card Issuers

Many of the credit card-focused firms under our coverage have developed deep discounts to our fair value estimates as concerns about rising credit costs have been aggravated by recent turmoil in the banking sector following the failure of Silicon Valley Bank. While the market has gone too far in discounting many of these names, the concern is not entirely unwarranted. Rising interest rates, debt levels, and shelter costs have increased financial pressure on consumers as a larger portion of their income becomes tied up in servicing financial obligations, and we expect this pressure to continue to build in the near term.

The risk of higher net charge-offs is a common consideration for credit card issuers, as it is what most distinguishes this business from other forms of lending. Credit card receivables are highly lucrative, with interest rates on credit card debt ranging from the midteens to as high as 30%, allowing firms in this part of the banking industry to enjoy net interest margins and returns on equity far above their peers’. However, these higher margins are balanced by higher and more volatile credit costs, with periods of elevated charge-offs leading to diminished profitability. We think we are entering one of these periods and project net charge-offs to increase in both 2023 and 2024.

However, when looking at valuations on a full-cycle basis, we think the market has gone too far in pricing in future credit losses that are too high, given reasonable expectations for future defaults. We see an opportunity in the sector, with Discover DFS and Capital One COF our preferred names as they trade at steep discounts to our fair value estimates but lack the weaker credit profile and increased macroeconomic exposure of private-label card issuers Synchrony SYF and Bread BFH. American Express AXP is the least affected by higher credit costs, as it is a payment-focused firm and benefits from a wide economic moat, but it lacks the steep discount to our fair value estimate of the others.