It’s been a while since I wrote about Synchrony Financial (NYSE: SYF), so a little review of operations is in order before explaining why the company’s valuation of 6.2 times earnings is good value and not a value trap. Synchrony is a consumer lender through credit cards and installment loans in a diverse set of industries ranging from home improvement and auto repair to medical, dental and veterinary care, and sports equipment to name a few.
Synchrony partners with retailers and suppliers in these industries to offer credit cards and financing programs. The company thus obtains higher interest rates compared to general purpose credit cards, but is also subject to higher costs due to loyalty programs and shareholding agreements with retailers. These loans are also subject to a higher risk of default than general purpose credit cards, but Synchrony has historically earned attractive returns even after these costs and charges. Synchrony has diversified its portfolio with around 1/4 of loan receivables now on dual or co-branded cards that can be used anywhere. Yet the majority of the loan portfolio is based on traditional store credit accounts.
The market still seems to have a reason to value Synchrony at a mid-single-digit P/E despite safe and stable activity. During the pandemic, there were concerns about widespread customer defaults, which were quickly proven to be unfounded thanks to government stimulus programs. Second, the stimulus programs themselves have created concerns that consumers are paying their cards and buying new purchases with cash rather than credit. Now there are worries about inflation or a coming recession hampering consumer spending. Through it all, the market was also worried about the loss of key account partners like Walmart (WMT) and Gap (GPS) despite the company forming new partnerships with Verizon (VZ) and PayPal (PYPL).
While the value of loan receivables has been up and down over the past few years, the consumer has been more resilient than expected. Synchrony has been able to return money to shareholders through dividends, but more importantly through massive buyouts. The number of shares has grown from around 800 million shares in 2017 to just over 500 million today to around 450 by mid-2023 based on the current repurchase authorization. This increases EPS and book value per share even without strong growth in net income. Based on the company’s guidance on the Q1 2022 earnings call and presentation, my estimate of Synchrony’s 2022 EPS is $6.40 per share, making the stock a buy at a P/E of only 6.2 times.
Concerns are unfounded
The credit quality of Synchrony’s loans was a concern that never materialized. Looking at the chart below, the Q1 2020 delinquency and write-off metrics are fairly typical of the bank’s pre-pandemic lending. At that time, everyone was worried about consumers not paying their bills, causing the bank to dramatically increase its provision for credit losses. As government stimulus programs rolled out, consumers not only paid their bills on time, but many paid them back in full. As a result, Synchrony released a large amount of loan loss reserves in 2021 and now the reserves are stable around 10% to 11% of loan receivables.
While chargebacks and charges may have bottomed out in mid-2021, the slow rise since then leaves them well below pre-pandemic levels. Synchrony now expects write-offs to average 3.5% of loans this year and not reach their mid-cycle expectation of 5.5% until mid-2024. This outlook is based on macroeconomic assumptions of maintaining a low unemployment rate. Inflation does not seem to have a negative impact on the consumer due to their higher level of savings approaching this period. On the contrary, inflation increases the volume of purchases in certain categories such as gasoline and clothing.
The client really starts at a point of strength. They absolutely have excess liquidity, and we have demonstrated or at least indicated this with higher savings rates. Our credit default and how it sits today, average balances, all are in great shape when they have it, and you have low unemployment. So we’re looking at the client today. When you look at the buying behavior pattern, we see small evidence of inflation inside our book, but not really significant.
Source: Brian Wenzel, CEO, Synchrony 1Q 2022 Earnings Call
One of the downsides of a stronger consumer for Synchrony is that they tend to pay off their cards sooner, leading to lower outstanding loan balances. This was a problem in 2021 as I wrote about in some of my previous articles. However, since March 2022, customers are finally starting to pay less of their balance compared to last year. The growing balance of loans receivable contributes to the net interest margin even if the rates on deposits and loans increase in parallel. The higher percentage of loans to cash in interest-earning assets simply makes a significant difference.
The turnover of some of Synchrony’s major partnerships has also been a cause for concern over the past few years, starting with the loss of the Walmart card in 2019. Currently, the bank also has two major card wallets for sale expected to be off the balance sheet by year-end: Gap and BP (BP), totaling approximately $4 billion in loan receivables. I don’t see this as a big downside, as it means Synchrony is disciplined not to renew partnerships when the costs of retailer sharing agreements and loyalty programs get too high. Synchrony has signed many new business partners, two of the biggest being Verizon and PayPal. The recently launched PayPal Card, and in addition to the loan wallet it provides, also gives Synchrony more experience in building the app-based interface desired by young consumers.
With purchase volumes growing thanks to continued consumer strength and new card partnerships, Synchrony expects to grow loan receivables by 10% this year. Given modest increases in charges and operating costs, Synchrony is expected to be able to return $3.05 billion of capital through buyouts by Q2 2023, as reported in the earnings release. That’s enough to withdraw about 77 million shares, or about 15% of the shares currently outstanding. This would be after already withdrawing around 75 million shares in the past 4 quarters.
For those who like dividend growth, it has been more modest and only increases by $0.01 per share to $0.23 per quarter from Q3 2022. This represents a dividend yield of about 2.3%.
Assemble the numbers
Those who have read my previous articles on Synchrony know my financial model for the company. Starting with the balance sheet, I assume Synchrony can grow loan receivables by 10% in 2021, not including assets held for sale. The bank will remain well capitalized with equity/assets at 13.3%, in line with current levels. Equity increases with retained earnings, which is net income minus dividends, and redemptions this year are $1.83 billion, or 60% of the $3.05 billion projected by September. Q2 2023. The resulting book value per share decreases from $24.52 at the end of Q1 2022 to $27.64. /share at the end of 2022. Return on assets and return on common equity are still attractive at 3.3% and 24.2% by the end of 2022, but down from current levels, as loan loss provisions are returning to a more normal operating rate. Excluding changes in reserves, ROA and ROCE would improve compared to 2021 levels.
On the income statement, I use the company’s advice of 15.25% to 15.50% net interest margin on loan receivables mentioned above. The bank also provided guidance of 5.25% to 5.50% retail stock arrangement costs and 3.5% write-offs as a percentage of loans, and $1.05 billion a quarter of Operating Expenses. Buybacks are as described above, resulting in an average share count of 480.5 million for 2022 and EPS of $6.40. This figure is lower than in 2021 due to more normal loan loss provisions this year compared to the large reserve releases last year. Excluding reserves, EPS would be up 37%.
SYF stock price is down about 23% from its October 2021 highs, likely due to concerns about rising interest rates and inflation impacting consumer spending . In the Q1 2022 earnings release, we see that the consumer is still paying their bills better on time than they were before the pandemic, even as they buy more and start carrying a higher balance. This actually helps Synchrony’s net interest margins. This organic growth in loan receivables combined with new programs like the PayPal card more than offset the loss of interest income from loan portfolios for sale this year. Inflation does not yet seem to have an impact on the consumer either, as they had a savings cushion as they approached this period, allowing them to spend more and have a higher balance.
Growth in loans receivable is the primary driver of earnings, allowing Synchrony to continue to repurchase large amounts of stock, which contributes to EPS and book value per share. The bank is expected to earn $6.40 per share this year, which puts the P/E at an extremely cheap 6.2 times 2022 earnings. While the market still seems to be worried about the stock, a return to 2021 highs of around $52 seems warranted, which would represent a P/E of 8.1, more in line with the average of the past 3 years. After noting that SYF was near 2021 highs in June, I now consider it a buy.