How Many General Electric Shares Should You Exchange For Synchrony Financial?

The reason why stock split-offs are generally unpopular with investors is that it requires the measurement of figuring out how much of a company you’re familiar with (the parent company) to exchange for a company that is relatively unknown. And because stock split-offs usually occur in prosperous economies, you tend to receive a misleading set of figures–the truly long-term investors want to know how a company performs in the worst of times, and that information is not usually available at the time you have to make your decision.

But unfortunately, life isn’t so simple that you can adopt the rule that split-off companies should always be ignored. In fact, the academic studies show quite the contrary. In Dr. Jeremy Siegel’s work “Stocks for the Long Run”, he studied the performance of corporate spin-offs by comparing their performance to the original parent company for the subsequent ten years after the spinoff date. In 82% of the cases, the freshly minted spinoff company outperformed the former parent.

And the outperformance was more than a rounding error: the difference between 10.8 annual returns and 9.2 percent annual returns. A $10,000 investment in a typical parent company historically has grown to $25,005 a decade later. The same amount invested into a typical spinoff company grew to $29,304. After ten years, you get almost a 15% higher cumulative net worth due to your holding off the stock that got spunoff.

A caveat: Dr. Siegel’s research noted that this average performance differential didn’t form in a neat cluster. He explains it better than I do, but the distribution contained a wide variance–the spinoffs that went on to become successful really made it (often delivering 14%, 15%, or even 18% annual returns for the next decade.) And this was mixed with a collection of poor-performing spinoffs that only generated 2%, 3%, or 4% subsequent returns.

Even though the blind statistics state that you should own a spinoff, you should keep in mind that the performance in instances in which the spinoffs don’t outperform is usually quite poor–when spinoffs subsequently underperform the parent company, they tend to underperform by quite a lot.

This brings us to Synchrony Financial, a company that had almost 16% of its outstanding shares become publicly available on July 31, 2014 when GE raised $2.8 billion in capital to debut the shares at $23.00 apiece on the New York Stock Exchange. The company hasn’t gotten a whole lot of attention from the financial press, only being mentioned in afterthought when the financial media documents General Electric’s process of shedding nearly every aspect of GE Capital.

But when you study Synchrony in its own right, there is a lot to like. It has a loan portfolio of private label credit cards that have experienced portfolio growth of 5% over the past ten years. Given that this period included the great reset of the financial crisis, the general trudge forward is commendable.

But loan growth is not impressive if it means that the quality of the portfolio is sacrificed. I would classify the quality of Synchrony Financial as mid-tier. It is not going to have the loan quality of Visa or Mastercard, and certainly not American Express (although American Express has quietly been dumbing itself down in terms of credit quality in recent years so Visa may eventually become the best in breed because of its superior diversification of resources.) But it’s better than Discover Card, and it does have a strong presence in middle-class suburban markets.

In fact, it thoroughly dominates the private label credit card market. It is the largest player, with over 42% market share. It runs the Amazon card program. It runs the Wal-Mart card program. It runs the Lowe’s card program. It runs Gap Clothing cards, and it runs BP gas cards. Its major growth initiative is the CareCredit card administered through Synchrony Bank in which people with unexpected dental, vision, cosmetic, audial, or even vet bills can sign up and negotiate a monthly payment.

I view the CareCredit program as the greatest risk, highest growth part of the bank. This seems to be a case where risk and reward stand in symmetry. If things go well at CareCredit, this could be something that helps take Synchrony Shareholders from receiving returns in the 8% to 12% range to the 15%+ range for the next ten years. If it goes poorly, it could become one of those toxic assets that explains why GE wanted to spin off this former GE Capital Retail Finance business in the first place. Right now, you need to prove the capacity to pay in order to receive a $5,000+ upfront credit through CareCredit. I would pay attention to the standards governing this program. If the standards get too loose, I would consider exiting the position immediately as the risk of capital loss entering a deep recession could be great.

As of now, it is well capitalized. The Tier 1 Common Capital Ratio at Synchrony is 14.9%. That is excellent. That can ride out storms. By comparison, Citigroup found itself in trouble during the financial crisis because its Tier 1 ratio slipped below 5%. The New Basel requirements demand 9-10% Tier 1 common ratios, depending on the institution. For now, the bank seems to have taken great heed of the lessons from the financial crisis, and is highly well capitalized. But if you see this figure dip below 11%, it should be a cause for concern (and if the price was holding up decently at that point, I would sell it immediately and move on. The tricky question would be if the stock price fell by a good amount at the same time the credit quality and Tier 1 capital was also depleting.)

But still, holders of General Electric stock are facing a dilemma between now and November 16th. How many shares, if any, of the parent GE corporation should you exchange for shares of Synchrony Financial? Like I illustrated earlier, the consequences can be extreme. If you took some Patriot Coal shares, you would have experienced a near 100% wipeout. On the other hand, if you had picked up a decent block of Chipotle stock during the McDonald’s exchange, you would be on easy street. Someone that exchanged $68,750 worth of McDonald’s shares for Chipotle on January 26, 2006 would have over $1,000,000 just nine years later. The Chipotle stock went on to compound at 31.5% for a decade.

The greatest argument against Synchrony stock is that it’s probably not the kind of company a blue-chip investor would normally seek out. Blue-chip investors tend to like the best-in-industry operators. As far as credit cards are concerned, that would imply loading up on shares of Visa and Mastercard. Also, it does carry see default rates approach 10% in bad times (that’s the average for mid-tier quality credit assets), and that almost certainly means this would be a terrible asset to own in the event of another Great Depression. If it’s not something that you would buy independent of this GE corporate action, why would you look at it now?

The best argument in favor of Synchrony stock is that it benefits from three tailwinds. The first is valuation. It makes $2.60 per share in profits and only trades at $30 per share. That’s a P/E ratio of 11. It makes $2.1 billion in profits. That is solid. It is trading cheap because of its unclear trading history and the lack of a dividend payout currently. It could easily pay $1.30 in dividends, and suddenly you’re collecting 4.3% in dividend income. The initiation of a dividend would likely propel the stock price forward.

Secondly, it stands to benefit from an increase in interest rates. When interest rates are higher, it is able to charge customers more that fall behind on their credit bills, and this will increase the net income. That is why Warren Buffett bought Wells Fargo, Bank of America, M&T Bank, and U.S. Bancorp–these financial institutions will see sharply earnings increases when interest rates climb by three percentage points. Synchrony Bank will also benefit if the general expectation that rates will rise begins to materialize in the coming years.

And thirdly, it does excel at its core job: running credit cards at places where people shop. Places like Amazon and Lowe’s don’t want to deal with the hassle of setting up its own network and dealing with delinquent payers, and it is unlikely that the task at Synchrony will ever be administered in-house. Retail card purchase volume at Synchrony increased 18% in the past year. That could bode well for good returns to come.

I think the wisest course of action is to acquire enough Synchrony that you can benefit if it proves successful, but don’t acquire so much that you could be in trouble if it fails. To me, that means trading in 25 out of every 100 shares of GE that you own for shares of Synchrony stock. You get the benefit of some free money, as every $100 worth of GE turns into $107.53 of Synchrony stock. The stock seems like a good five-to-ten year hold, as the P/E ratio could increase significantly (look at Visa and Mastercard around 30x earnings!) if it initiates a dividend, develops a solid track record consistent with current performance, and sees net income rise alongside interest rate hikes.

The reason why I find 25 the right amount, rather than say 50, is two-fold: (1) first, it is a hedge against another financial crisis. Financial crises tend to come every 25+ years or so, but if one comes sooner than scheduled, this is not a company where you want to have a lot of your money, and (2) secondly, this is a compliment to the General Electric parent company. The industrial divisions at GE is possibly one of the top three dozen companies in the entire world, and it offers a 3% dividend yield plus long-term earnings per share growth in the 8% range. I’m not sure you to enthusiastically part with an asset of that caliber, but the combination of undervaluation plus net interest income growth (fueled by rising interest rates) make Synchrony Financial worthy of dipping your leg into the pool.