Synchrony Financial: The Search for 20% Annual Returns

Sometimes, it is helpful to start an analysis with the converse inquiry: “What stock am I familiar with today, don’t own, but think has a fair chance of being one of those omitted regrets ten to fifteen years from now?”

When framed like that, I come back regularly Synchrony Financial (SYF), the spun-off consumer lending arm of General Electric back in 2014 that is 2.6% owned by Berkshire Hathaway.

It did not really gain much attention in the investor’s eye during its inception because spun-off companies take a year or two for their standalone operational results to become clear, and, prior to 2016, Synchrony did not pay out a dividend. Even then, the initial dividend payout was de minimis, well below 1%.

But, of course, those are information asymmetry and evolving capital allocation issues. Those do not address the merits of whether Synchrony is a great investment.

As you may recall, Synchrony is in the business of handling private label credit cards. If you have ever gone to a physical brick and mortar location, be it retail, gas station, or a restaurant, and asked if you wanted to obtain a store credit card, there is a fair chance that Synchrony had its hand somewhere in the back of that transaction, as it controls about two-thirds of America’s private-label credit card industry.

The company, which earned $2.65 per share in profits in 2015 during its first full year as a standalone publicly traded corporation, is expected to earn $3.85 per share in profits this year, which is a growth rate of 13.26% annualized. And those profits are going to be somewhere north of $2.5 billion in 2018–for a size comparison, Coca-Cola earns a little over $9 billion in annual profits, making Synchrony so massive that it is one-fourth the size of the corporation that brings the world 3.5% of its consumable beverage supply. People don’t think of it as a blue-chip that reaps the stability benefits that come from massive size, yet there it is.

And, boy, is there retained cash being retained to shareholders. Because it didn’t pay a dividend from 2014-2016, it had $7 billion roll in as retained profits that is only now getting deployed. And even with the initiation of a dividend in 2016, it only amounted to a payout ratio of 20% so Synchrony has retained another $5 billion in profits over that time, too.

But recently, we have seen some allocation decision. In order to shift away from its heavy reliance on brick-and-mortar private label cards, Synchrony paid $7 billion for $7.6 billion for Paypal’s credit receivables from online business debt that has accrued. This makes Synchrony an incredibly asset light business model–it basically has enormous sums of debt that are outstanding and need to get repaid in its favor, often from so-so borrowers that incur massive fees, late penalties, and interest in paying Synchrony back. It earns a 17.5% return on equity, suggesting a very high possibility of double-digit price appreciation ahead.

Synchrony just raised its $0.60 annual dividend to $0.84, which amounts to a 40% hike. Even after that hike, Synchrony is still only paying one-fourth of its profits out to shareholders as dividends.

In light of its high cash position, and still low dividend payout ratio, Synchrony’s Board recently authorized itself to repurchase $2.2 billion in stock between this past summer and June 30, 2019. At the current price of $31 per share, if those repurchases manifest, Synchrony will retire 9.5% of its shares outstanding and will deliver single-year earnings per share growth that matches the historical returns of the U.S. stock market just from the buybacks alone.

Another element that catches my attention is the valuation. If you analyze Visa or Mastercard or Paypal, you have to figure out whether the earnings per share growth rate will continue to be high enough to deliver satisfactory returns in light of a 30x or 40x earnings valuation. Synchrony is a way to invest in the high-growth, asset-light credit card industry without the wildly high valuations that are found elsewhere. The P/E ratio of 8, which is a bona fide evaluation of true profits rather than an earnings gimmick, is eye-catching.

I do not like to, and I cannot, predict short-term movements in stocks, but Synchrony is growing organic profits at about 8%, just picked up at Paypal consumer credit portfolio that might increase organic earnings to 11%, and could theoretically repurchase 9.5% of its outstanding stock in the next year if prices hold. In other words, 20% short-term earnings per share growth is viably in the picture as a possibility. If that happens, I would be inclined to believe that the $31 share price would rise at least somewhat proportionately.

The list of stocks that have a fair possibility of five-year, 20% annual returns are few and far between. And yet, Synchrony has a spot on that list. Its P/E valuation could rise substantially. It is generating almost double-digit organic profit per share growth, and with expected repurchases, the earnings per share growth has a very high possibility of being in the double-digit growth rate. I personally think the stock is worth $50 right now, and should trade somewhere between $80-$100 within the next five to seven years, to the point where I consider Synchrony financial to be the financial sector stock that will have the best five-year performance ahead.

N.B.: This is an archived article of ancient vintage and should be analyzed as such.


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