Thursday, November 26

Conservatively Reserved, Synchrony Financial Is A Buy

On Tuesday, Synchrony Financial (SYF) reported financial results that should alleviate investor concern about its ability to withstand the current economic downturn; in fact, shares finished 1% higher. As one of the nation’s leading credit card lenders, SYF is directly exposed to consumer credit, particularly given its focus on low-prime and subprime borrowers. Undoubtedly, the company will see a rise in defaults and delinquencies due to the recession and increased joblessness. However, thanks to federal stimulus efforts, it may not be as bad as feared, and shares remain attractive, in my view.

In the company’s second quarter, SYF managed to eke out a small profit despite increasing reserves against future credit losses substantially. The company’s non-GAAP EPS of $0.69 was $0.49 ahead of consensus. GAAP EPS was $0.06. There was an accounting policy change known as the Current Expected Loss Methodology, or CECL. In essence, this forces banks to immediately reserve against some losses when making loans rather than waiting for loans to go sour, which should increase reserves during strong economic periods. Banks can adjust to CECL on their existing loan book over two years, which SYF has chosen to do, hence the GAAP vs. non-GAAP differential.

Given the economic carnage and likely impending loan losses, I was impressed that Synchrony was able to manage a profit. Critically, this profit did not come from the company short-changing its reserves. If anything, its reserves appear overly conservative. Provisions for credit losses increased $475 million, or about 40%. As a consequence, SYF has now set aside $9.8 billion in reserves. That is four times the $2.4 billion in loans delinquent over 30 days, leaving ample room for deterioration.

Indeed, SYF has now reserved against 12.5% of its loan book, meaning we could see a tremendous wave of defaults, and SYF would not need to allocate any more funds to cover bad loans. During the financial crisis, credit card delinquencies (and not every delinquency becomes a default) never passed 7%, so SYF has prepared its balance sheet for a truly severe shock.

(Source: St. Louis Federal Reserve)

On the company’s earnings call, management stated they have reserved assuming unemployment finishes 2020 at 11.5%, 2021 at 9.3%, and 2022 at 6.4%. This is an extremely conservative forecast, actually assuming unemployment rises this year from its current 11.1% level. Relative to other banks, SYF is also cautious. JPMorgan Chase (JPM) assumes unemployment will be 7.7% at end 2021 (1.6% below SYF). The Federal Reserve has unemployment ending 2021 at 6.5%, which SYF doesn’t foresee for an additional 12 months.

None of us know who will be right; the future is never certain. But SYF has reserved against a really severe outcome. This means the company’s balance sheet and book value will not be impaired if the economy develops quite a bit worse than consensus. Instead, if the economy proves to play out closer to the consensus, SYF will have over-reserved and could release back potentially $2 billion (bringing reserves back below 10% of loans), creating room for larger buybacks or dividends. In particular, I would highlight that personal income is running higher than last year due to stimulus checks and enhanced unemployment benefits. Should these policies continue in some fashion, those who lose their job will not suffer historic levels of lower income, which may serve to further limit delinquencies and credit losses.

With SYF more than adequately reserved, we can feel comfortable that it will not have to further impair assets or reduce its $11.165 billion in common equity, which is about $19.11 per share. At Tuesday’s $22.64 closing price, SYF shares are trading 1.18x book value, which I view as an attractive entry point.

Now, the company’s credit card volumes will remain lower for some time until retail activity improves, though its partnerships with Amazon (AMZN) and PayPal (PYPL) help to insulate the company from brick-and-mortar stores. Still, loan receivables declined by 4% to $78.3 billion, which will lower net interest income in the future until spending fully rebounds and stabilizes loan balances. Assuming a 5% drop in net interest income from the $3.396 billion in Q2, that there are no more COVID-19 related reserves, and that SYF recoups half of the lost transaction volumes as its new run rate, the company should have $0.70-0.75 in quarterly earnings power, or about $2.80-3.00 over the next year.

Given its highly cyclical business, I expect shares will struggle to trade more than 10x forward earnings, or $28-30. This assumes SYF’s reserves play out as expected, which assume a cautious economic recovery. A swifter recovery like the Fed forecasts could lead to $1-2 billion in reserve releases, though this reserve release likely would be a late-2021 and 2022 event as lower unemployment is realized. This provides another $2-3 per share in upside. I see 26% upside with further 5-10% if the economy strengths more quickly over the next 12 months and would buy shares here.

Disclosure: I am/we are long SYF, JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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