I recently wrote about Seth Klarman (Trades, Portfolio)’s interest in Synchrony Financial (SYF, Financial), the financial services company that has seen its share price suffer this year thanks to higher reported loan impairments.
Klarman initiated his position at the end of 2016, but then reduced the holding by 14.5% during the first quarter. Surprisingly, he then increased his holding by 66% during the second quarter according to the firm’s 13F. The additional buying means Synchrony is now Baupost’s second-largest holding after Cheniere Energy (LNG, Financial).
Yesterday, Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) released its quarterly report of its U.S.-listed stock holdings. And it seems Synchrony has also attracted the attention of Buffett and his investing lieutenants, Ted Weschler and Todd Combs. Berkshire built a position worth roughly $521 million in the private label credit card issuer during the second quarter. Due to the size of the holding, it is likely the position was initiated by either Weschler or Combs rather than Buffett himself, but this does not mean the Omaha, Nebraska-based conglomerate’s interest in the business should be ignored.
Time to consider Synchrony?
Now that both Buffett and Klarman own Synchrony, the shares certainly warrant a closer look. It is clear these two investing legends see value in the business, but it is also clear the market is wary of Synchrony and its prospects.
As I covered previously, shares of Synchrony have plunged by around 15% year to date after the company reported a 14% decline in net profit year over year for the first quarter as loan losses increased markedly. Net charge-offs grew to roughly 5.3% of loans on an annualized basis, up from about 4.7% last year, while loans more than 30 days past due rose to 4.25%, up from 3.85%. Off the back of these figures, the company recorded $1.3 billion of loan loss provisions, up 45% year over year.
Known for their long-term nature, it seems Klarman and Berkshire view this poor first-quarter performance as a one-off in the grand scheme of things. Synchrony is a credit business, but is also a play on the strong U.S. consumer market and Amazon (AMZN, Financial). One of Synchrony’s key private label cards is with Amazon. Even though some rivals to this business have appeared over the past 12 months, such as the co-branded Visa credit card by Amazon and JPMorgan Chase (JPM, Financial), the company remains a sizeable force in this space with an estimated 40% market share.
Not only is Synchrony the largest player in the space, it also has an enormous competitive advantage in the form of data.
Synchrony offers a significant value proposition for retailers because it can collect data on customers’ purchases. Collection, aggregation and interpretation of this data is another avenue of revenue growth for the business. By compiling customer spending patterns, the company can help clients create advertising campaigns and promotions that drive more store traffic and purchase volumes.
But what about those charge-offs?
Strong balance sheet
The main criticism against Synchrony this year has been the rising level of charge offs.
Analysts have interpreted this trend as being a result of wider retail industry woes. Rising defaults among subprime auto borrowers have only added fuel to the fire. However, Synchrony has one of the strongest balance sheets in the financial sector with an estimated Common Equity Tier 1 ratio under Basel III rules of 17.4% and total liquidity of $22 billion, or 24% of assets at the end of the fiscal second quarter. What’s more, at the end of the second quarter, the company reported deposits of $53 billion, comprising 72% of funding. All in all, Synchrony is a well-capitalized business that can weather the downturn in the consumer credit market.
The company is also extremely profitable with a net interest margin of 16.2% at the end of the second quarter and return on tangible common equity of 15.9% for the first half of the year. Management is looking to return some of the company’s enormous cash balance to shareholders. At the end of the second quarter, Synchrony announced a new $1.6 billion share repurchase program (6.6% of market value) and increased the quarterly dividend to 15 cents per share, for an annualized yield of 2%. Considering the company’s already strong balance sheet and higher return on equity, I would not rule out additional cash returns in the future.
What Berkshire and Klarman love
Looking at all of the above, it is clear Synchrony is a premium business. While the company may face headwinds in the form of higher consumer defaults, it is well placed to ride out these problems. When it comes to valuation, the stock is cheap, trading at a forward price-earnings (P/E) multiple of 9.8 does not seem to take into account the high return on equity and efforts by management to return cash to investors. For some comparison, the industry median of the financial sector is 14.8.
All in all, this is not a complete, in-depth rundown of Synchrony’s financial prospects. Regardless, a quick look at the company’s figures reveals why it has attracted the attention of Berkshire and Klarman.
Disclosure: The author owns no stock mentioned.
