Last month, Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) reported a small (small by Berkshire standards) $512 million holding in credit company Synchrony Financial (SYF, Financial) following highly acclaimed value investor Seth Klarman (Trades, Portfolio) into the stock.
When the Berkshire position was revealed, I took a look at Synchrony and concluded that the company –Â with a 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, and a return on tangible common equity of 15.9% for the first half of the year –Â looked to be a “premium business” trading at a discount valuation.
But a recent interview with Gator Capital’s Derek Pilecki in the Aug. 30 issue of Value Investor Insight has led me to reconsider my position on the company.
Financial expert
Gator Capital invests mainly in financial companies, and it's not bad at this. Since inception in 2008, the long/short fund has returned 24.9% per annum compared to 9.9% for the Standard & Poor's 500. When asked about Synchrony in the interview, Pilecki replied:
“We think this is a strong company in the private-label credit-card business, which has had to build its credit reserves beyond what the market expected after a period of growth. This is one where I’d like to see a bit more stability in the numbers before considering a larger position. Having had similar experiences with Capital One, there is a fairly good chance the reserve building won’t just be a one-quarter experience.”
At the end of the first quarter, Synchrony reported that it was increasing loan loss provisions to $1.3 billion, up 45% year on year. 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%. When these numbers were revealed, the market marked down the value of Synchrony’s shares by around one-fifth. It’s interesting that Pilecki expects further charge-offs from the company.
Synchrony isn’t the only company facing rising write-offs. Both Capital One Financial Corp. (COF, Financial) and Discover Financial Services (DFS, Financial) reported rising losses for the first quarter of this year, with Capital One’s write-off rate rising to 5.02%, the highest rate in six years. Capital One’s provisions for losses in the credit-card unit jumped 29% to $1.7 billion in the first quarter from the preceding three-month period. Discover’s net charge-off rate for credit cards climbed to 2.84%, the highest level since at least the fourth quarter of 2014. Discover’s provisions for credit losses increased 1.4% to $586 million.
These figures indicate that rising write-offs may not be a one-off for Synchrony and the company could be facing more pain ahead – especially with interest rates rising. Zerohedge reported figures from the S&P/Experian Bankcard Default Index at the end of the first quarter showing that the percentage of disposable income required to service consumer credit debt is 5.58%, up from its recent low of 4.92% in 2012 but lower than the 6.01% peak seen shortly before the financial crisis. Based on these figures it’s no surprise that the bank card default rate reported in the study was 3.31%, a 45-month high.
Reason to worry?
For card issuers like Synchrony, these figures certainly aren't anything to celebrate, and it could be just the start of a longer term trend. That said, defaults have been artificially depressed for almost a decade now, and rising write-offs may be just part of the cycle – something issuers will have to absorb as the rate cycle normalizes.
The question is, will this hurt Synchrony? Maybe, but the damage will be muted. The firm’s strong capital ratio, coupled with existing cash generation, should soften the blow. Meanwhile, the group’s retail bank provides around 70% of its funding, so the risk of the company suffering a liquidity event if it’s cut out of capital markets is slim.
Overall, yes, the company may have to deal with high write-offs, but it should be able to manage the costs.
Disclosure: The author owns shares in Synchrony Financial.
