Double “Oracle” Endorsement
Following the lead of two highly successful investing gurus dubbed “oracles” by Wall Street, we have just added Synchrony Financial (NYSE: SYF) to our portfolio. Both the Oracle of Omaha, Warren Buffett, and the Oracle of Boston, Seth Klarman, hold large stakes in the company. Buffett’s Berkshire Hathaway (NYSE: BRK.B) owns 17.5 million SYF shares while Klarman’s Baupost Group owns 29.3 million. Berkshire’s stake is new while Baupost upped its stake by 65 percent in the second quarter. Both “oracles” appear to like Synchrony as a value play, as the stock trades at less than 11 times projected forward-twelve-month earnings, well below the current S&P 500’s valuation.
Spun off from General Electric (NYSE: GE) in 2015, Synchrony is the largest provider of private label credit cards in the U.S. It specializes in co-branded credit cards. Synchrony provides a range of credit products through programs established with a diverse group of regional and local merchants totaling more than 365,000 locations across the U.S. and Canada.
For example, if you have a Sam’s Club member’s card or a BP gas card, you are using a Synchrony card. The businesses that offer these cards typically offer perks for shopping in their stores (whether in the physical store or online). These cards benefit the retailers because they avoid the fees general credit cards charge and the rewards tend to help increase customer “stickiness.” These specialty cards can also be use whenever Synchrony’s network is accepted.
In general, consumers are trending toward cashless transactions, and use of these private-label cards are growing faster than general cards. For instance, in 2016, U.S. retail sales grew about 4 percent, but spending on Synchrony cards surged 9 percent. As of the latest reported 2017 quarter, the same metric shows 6 percent year-over-year growth, including an 18 percent growth in online and mobile purchases.
Synchrony also makes loans to consumers to help them purchase big-ticket items. In fact, the company makes most of its money on the interest on outstanding loan balances. In the second quarter, loans receivable grew 11 percent to $75 billion.
The company on average charges a higher interest rate than traditional credit card companies because its customers tend to have worse credit. Of course, the other side of the coin is that these customers have a higher risk of default. Thus, we will monitor very closely for signs of economic weakness, as a recession would have an outsized impact on the less affluent, who will have a tough time paying off their debt. This in turn would have adverse financial consequences for Synchrony.
In the second quarter, the credit quality did show some deterioration as loans 30 or more days past due increased to 4.25 percent of loan receivables from 3.79 percent one year ago, net charge-offs grew to 5.42 percent from 4.51 percent, and reserves set asside to cover potential loan losses increased to 6.63 percent from 5.70 percent.
The decline in the loan portfolio quality was expected, and it explains why the stock only trades at about 10-times expected forward-twelve-month earnings. Synchrony management expects the third quarter metrics to rebound a bit and it forecasts losses to trend higher in the first half of 2018 and then level off in the second half. Thus, on the one hand Synchrony is enjoying increasing demand while on the other loan losses have been on an uptrend lately. Hence, we reiterate that SYF shareholders should pay close attention to economic trends. And of course, we will keep you up to date.
Given the market’s low expectations, if Synchrony’s loan portfolio quality improves in the upcoming quarters to sooth the market’s concerns, we could see an uptick in the earnings multiple, which would provide an extra boost to the stock price. The company is expected to earn $2.59 a share this year and $3.20 next year.
We suggest an initial buy up to price of $34.