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Dilantha De Silva
Dilantha De Silva
Articles (9) 

Synchrony Financial: A Warren Buffett Holding Trading at a Discount

The guru's lesser-known holding yields 2.7%

Investment thesis

Warren Buffett (Trades, Portfolio), the investment wizard, is known for making unpopular bets that deliver stellar investment returns in the long term. Since the financial crisis, he has invested in many banks and financial institutions. Today, his portfolio is overweight financial services stocks.

Source: GuruFocus data.

Buffett’s portfolio includes some of the most popular banks and financial institutions, including Bank of America (NYSE:BAC), US Bancorp (NYSE:USB), Wells Fargo (NYSE:WFC) and American Express (NYSE:AXP). A lesser-known name is Synchrony Financial (NYSE:SYF), which is one of the largest providers of private-label credit cards in the U.S.

Shares were trading around $32 on Monday with a yield of 2.7% and a discount of 15% to its intrinsic value. The risk-reward profile is also attractive, making Synchrony a strong buy option.

Company overview and business strategy

Synchrony Financial is a consumer financial services company offering private-label credit cards, dual cards, co-branded credit cards and installment loans. Initially, the company was a part of General Electric (GE), which it spun off from in mid-2014.

The company operates under three business segments: retail cards, payment solutions and CareCredit.

The retail cards segment is responsible for the issuance of private-label and co-branded cards in partnership with Mastercard (NYSE:MA) and Visa (V). The payment solutions segment is comparatively small and provides consumer financing for retail purchases, whereas CareCredit is a financier for elective health procedures. The company has partnered with renowned names to roll out each of these products and solutions.

Source: Second-quarter investor presentation.

One of Synchrony's primary business strategies is to maintain a healthy relationship with its partners, as this is important to maintain or grow revenue. As highlighted in the second-quarter earnings call, a particular emphasis is placed on improving the technological aspects of the company as well. This is mainly due to the continued growth of e-commerce and other data-driven trends.

Finally, the company is continuing to focus on honoring its commitments to shareholders by distributing wealth to investors.

Industry outlook

According to Packaged Facts, the private-label credit card industry has grown at a compounded annual rate of 3% from 2016 to 2018 and is currently valued at $210 billion. In its research study titled "Private Label Credit Cards in the U.S.," it was revealed that Synchrony Financial accounted for half of the industry’s revenue in this period.

The industry is expected to grow in the next five years based on a few tailwinds, which are discussed below.

Store-branded cards help retailers to build loyalty programs around these products, which is seen as an essential initiative to avoid customer loss to Amazon (NASDAQ:AMZN) and other e-commerce stores. Demand for private-label cards will grow steadily as the competition from such online shopping giants intensifies.

Another positive development for Synchrony is the shift from cash payments to card payments. A study by Harvard Business Review revealed that cash represented only 30% of total transactions completed in the U.S. in 2017. Furthermore, the number of households with a credit card has increased from 63.8% in 2015 to 68.7% in 2018, which is an indication of the strong preference to use non-cash payment solutions. Another study by the Federal Reserve confirms that U.S. adults are increasingly using non-cash transaction methods.

Source: The Federal Reserve and The Financial Brand.

Under these circumstances, retailers will be inclined to partner with consumer finance companies to issue store-branded and private-label credit cards to embrace the new payment trends.

The primary risk for the growth of the private-label card industry is the eventual failure of one or a few retail giants, which would be a reality if economic growth slows down considerably.

Overall, the industry dynamics are positive, and as the leader of the private-label credit card industry in the U.S., Synchrony is in an excellent position to drive revenue and earnings higher with this favorable outlook.

Financial performance

Synchrony’s strong partnerships with its customers and the growth of the economy have helped the company nearly double its net interest income from $8.2 billion in 2011 to $16.1 billion in 2018. Total revenue has also grown steadily over the same period.

Source: Company filings.

The company has generated a return an equity of over 15% since the financial crisis. As we know, Buffett is a fan of investing in companies that can earn a high return on equity consistently for an extended period, and Synchrony satisfies this characteristic.

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One risk from a revenue perspective is the high concentration on the five largest card partners, which is evident from the 50% contribution from these partners to the company’s revenue in the second quarter. However, the average relationship with these companies is over 18 years, as confirmed by the management, which suggests that the bond between the two parties is strong enough to continue for many more years to come.

The risk-adjusted yield of a card issuer provides insightful information regarding the profitability of the company over time. As the graph below illustrates, Synchrony has historically earned higher yields than general-purpose card issuers, which makes the company a unique player in the credit card industry.

Source: Investor presentation.

The financial performance of Synchrony’s partners matters to the company as well, since an eventual bankruptcy or a failure of one of its leading clients could dampen earnings. Therefore, it’s imperative to determine whether customers are in a safe position from a financial health perspective.

According to the second-quarter investor presentation, 76% of loan receivables have a FICO score of over 660, which is generally an indication of high credit quality. This is also a sign that the company will not have any issue in earning its dues from partners for the next few years.

The Direct Deposit Program is also a success, and the company grew its deposits by $6.6 billion in the second quarter. This is a healthy trend for the company as the cost of these deposits is significantly lower than other funding methods, as confirmed by the management. Because of this characteristic, the net interest margin of Synchrony will expand as deposits grow.

The retail cards segment is the leading contributor to company revenue, but both the other segments (payment solutions and CareCredit) grew at higher rates in the second quarter. This is a positive sign from two fronts. First, growth opportunities will open up for Synchrony from its two non-core business operations. Second, revenue diversification will help the company perform better when retailers are under pressure from macroeconomic developments.

Source: Company filings.

Synchrony has assets amounting to 7 times equity, which is below the industry average. This is an indication that the company has comparatively lower leverage than its peers, even though it is the leader of the industry.

A low level of leverage positions the company better to earn stable revenue in economic downturns.

Outlook

Retailers benefit from private-label credit cards for a couple of reasons. First, the information that can be collected about customers is invaluable as this enables companies to conduct targeted promotions and advertising that yield better results. Second, Synchrony has a program in which some of the collected fees are passed on to the partners, which is an essential source of additional income to these retailers. This incentivizes retailers to promote private0-label credit cards to their customers.

The below illustration depicts how Synchrony funnels revenue to its partnering companies. This is a critical aspect of the business operations that help keep these customers loyal to the company.

Source: Investor presentation.

An important development over the last decade has been the growth of direct deposits with Synchrony, which now accounts for the bulk of the funding. For instance, in the second quarter, deposits accounted for 75% of the available funding sources. The use of securitized debt and unsecured debt contributed 14% and 11%, respectively. This lowers the cost of funding for Synchrony.

There are switching costs for customers as well, which helps Synchrony build an economic moat around its business operations. For instance, when Costco (COST) ditched American Express for Citigroup (NYSE:C) in 2016, there were millions of complaints from customers who were not aware of this transition and tried to purchase items from the retailer using their private-label credit cards. The Motley Fool reported that Citigroup received a staggering 1.5 million customer calls related to the Costco card in the span of three days. These switching costs will likely help Synchrony retain its most significant and most important customers as it’s a burden for these retailers to switch over to a new provider.

Synchrony’s partnership with PayPal (NASDAQ:PYPL) is proving to be value accretive as well. For instance, in the second quarter, retail cards segment revenue grew 2% on a year-over-year basis. The management attributed this growth primarily to the acquisition of PayPal’s credit program in 2018. Also, this continued partnership will help Synchrony approach other online payment solutions providers to collaborate with.

The rise of e-commerce and the increasing importance of data has pushed Synchrony to invest in improving its digital offerings to ensure its products work seamlessly across online and physical channels preferred by customers. These ongoing investments will be a catalyst for the company’s growth in the future. So far, the company has introduced Digital Apply, Digital Services and Synchrony Plug-In services to help customers manage and use their payments digitally.

Synchrony is planning to accelerate investments in improving its data analytics capabilities as well, which is aimed at helping partnering companies better leverage data to drive their business operations. In the second-quarter earnings call, the management confirmed that the ongoing investments would run for two to three years until the digital requirements of customers and partners are adequately addressed.

Colin Plunkett, the Morningstar analyst covering Synchrony, estimates that around 70% of its costs are variable costs. Low fixed costs will help the company if a slowdown in economic growth occurs in the next few years and retailer profits decline.

In July, Walmart (NYSE:WMT) ditched Synchrony and opted to work with Capital One (COF) to issue private-label cards, which was, at that time, considered a headwind for Synchrony. However, during the second-quarter earnings call, management confirmed its belief that profit margins will be positively affected by this decision as it was a low-margin business for Synchrony. Even though the company is positive about this move, there could be repercussions as well. For example, other partners of Synchrony might request better terms knowing the company is not in a position to lose another one of its valuable customers, which would be an adverse development.

Dividends and buybacks

Synchrony Financial is focused on increasing the wealth of shareholders through dividend distributions and share buybacks, which is synonymous with the management characteristics Buffett looks for when investing in a company.

Since initiating its dividend policy at 13 cents per share in 2016, the company has grown its quarterly dividend per share to 22 cents. In the second quarter, the company announced its new capital plan, in which $4 billion was authorized for share buybacks. Both buybacks and dividends will continue to improve shareholder returns in the future.

From a cash flow perspective, Synchrony’s dividend is safe, and the company generates more than sufficient cash to honor dividend distributions and share buybacks.

Source: Company filings.

From a cash flow perspective, Synchrony still has room to grow its dividend payments and buybacks.

Valuation

Assuming that Synchrony Financial will grow at a stable rate and the fact that dividend investors are likely to invest in the company, a dividend discount model was used to calculate the fair value for shares. However, rather than using the reported dividend per share amounts, a hypothetical adjusted dividend per share was used in the calculation. The idea behind using this model is that Synchrony will eventually distribute all of its excess returns to shareholders at some point in time.

According to data from Reuters Eikon, Synchrony has made a net income of $3.414 billion in the last 12 months, and the total dividend payout was $602 million in this period. Hence, the excess retained earnings were $2.812 billion for the 12 months ended June 30.

The midpoint of the adjusted dividend per share is $4.35.

Source: Author’s calculations and estimates.

A cost of capital assumption of 12% and a terminal growth rate of 2% results in an intrinsic value of $45.73 per share, which represents an upside of 40% from $32.64, the closing price of Synchrony shares on Friday.

A sensitivity analysis of the terminal growth rate reveals that shares are trading below the intrinsic value, even under a no-growth scenario.

Source: Author’s calculations.

Conclusion

Synchrony Financial is a lesser-known holding of Buffett's that is trading at a discount to its intrinsic value. At a yield of 2.7%, shares are attractive for dividend investors as well. The initiatives taken by the management team to secure long-term growth, which were discussed earlier, will help Synchrony earn economic profits for an extended period.

Disclosure: I do not own any stocks mentioned in this article.

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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I'm a CFA level 2 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). During my free time, I enjoy reading.

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