Institutional Perspectives

Key Takeaways

• Growing digitization of payments and e-commerce are increasing credit card utilization among consumers, benefiting card issuers and payment networks.
• Credit quality remains high although portfolio seasoning is resulting in some modest increases in delinquencies and charge-offs. We expect charge-offs to remain below normal if economic growth is at least modest and unemployment remains low.
• We remain positive on the card issuer segment as given their strong fundamentals and low valuations, these companies should generate attractive returns for shareholders until there is a change in the economic outlook.
• Payment networks don’t face credit risk like card issuers but trade at higher valuations.

Financial stocks have endured a volatile stretch as the outlook for interest rates has changed. At the end of December, the Fed projected four rate increases in 2016. By late February, in the aftermath of a global stock correction and deflation fears, Janet Yellen and company eased off the accelerator, telegraphing fewer rate moves during the year. Recent deceleration in job growth could push out the next rate hike further. Most financial companies benefit from higher short-term interest rates, which year-to-date has led to general underperformance. Card issuers are different as these companies are less tied to rates and more dependent on a generally healthy economy and borrowers’ credit performance. Card companies take more credit risk and less interest rate risk than most banks. In addition, card issuers as well as global card payment networks, benefit from the secular growth of electronic payments as more consumers globally shift spending from cash and checks to debit and credit cards. Despite a rapid transition to electronic payments in the U.S., roughly 85% of payments globally are still made with cash or checks. The continued growth of e-commerce, which typically requires an electronic payment to complete a transaction, is also contributing to increased credit card utilization.

The Great Recession and new regulations in the U.S. have resulted in significant improvements in the quality of most card issuers’ portfolios.  The Credit Card Accountability, Responsibility and Disclosure Act of 2009 has resulted in more conservative underwriting by the card industry, contributing to charge-off rates falling to all-time lows. Card issuer selectivity contrasts with auto lenders and some marketplace lenders that have been loosening standards to win more business. Borrowers have also maintained stronger balance sheets as reflected by reasonable debt service ratios (Exhibit 1).

 

Exhibit 1: U.S. Household Consumer Debt Service Ratio

Source: Bloomberg based on U.S. Federal Reserve data as of March 31, 2016.

Competition has increased in other areas however. Card issuers have become aggressive in targeting consumers with richer rewards and better service. Enhanced rewards are lowering the cost of customer acquisitions and improved service is reducing customer attrition. Both improve profitability. But more generous rewards are driving up issuers’ rewards costs. For example, this year Citi launched its new 4-3-2-1 Costco rewards card with different cash back rewards based on purchase type; Chase launched a new 1.5% cash back card; Discover continues to offer new customers double rewards; while Synchrony and Walmart have launched a new 3-2-1 rewards card. These new products are helping issuers attract new customers and leading to increased card usage. Consumers are more willing to borrow as credit card balances are showing their largest year-over-year increases since 2008. Consumer debt service ratios have risen moderately, but with low unemployment, they don’t seem to signal deterioration in credit.

Despite still attractive fundamentals and low valuations, card issuers’ shares have underperformed those of some banks so far this year. We believe the recent weakness in card stocks is largely attributable to concerns about the risk of eventual credit deterioration. Earlier this month, shares of Synchrony Financial declined more than 10% after the private label card issuer updated its loss forecast for 2016, gave loss guidance for the first half of 2017 and indicated it expects to increase its loss reserves in the second quarter to reflect a slight increase in expected charge-offs over the next 12 months. Despite this news, we believe that, given still positive GDP growth and low unemployment, credit conditions will remain very good for at least the next year and that card issuers stand to benefit.

Through the first quarter, the credit quality of U.S. consumer lenders was high with credit card charge-offs well below normal at close to 2% (Exhibit 2). Households have cleaned up their balance sheets post the financial crisis and are now benefiting from lower debt service expenses. Consistent job growth, signs of wage growth, low interest rates, low fuel costs and rising home values are also helping consumers’ financial conditions, lowering the likelihood of delinquencies and defaults. Charge-offs will eventually rise as accounts season – charge-offs tend to peak 24 to 36 months after prime credit is issued and 12 to 18 months for sub-prime credit. Although a significant rise in issuer and industry charge-offs seems unlikely until there is an increase in unemployment, Synchrony’s recently revised guidance has clearly made some investors nervous. We do not believe its forecast 20 to 30 basis point increase in charge-offs is indicative of portfolio credit deterioration or a broader rise in industry charge-offs any time soon. Nevertheless, concern that Synchrony may be indicative of deterioration in industry trends is hurting the valuation of other companies including general purpose card issuer/regional bank Capital One Financial, which has more sub-prime exposure than other issuers and has been growing faster as well.

 

Exhibit 2: Monthly Credit Card Charge-Off Rate

Source: Bloomberg based on U.S. Federal Reserve data as of March 31, 2016.

Card issuers are executing well and seem likely to continue to do so even if interest rates rise. Higher rates should be reflective of an improved economy which should benefit lenders, including card issuers. Even in the event of some economic weakness, card issuers may outperform many other lenders. Card issuers are less exposed to the rate risk faced by banks, which today is manifesting itself as pressure on net interest margins. Card issuers also benefit from fewer irrational direct competitors. Eight banks comprise the bulk of the general purpose card business while five companies control most private label credit card issuance. Global payment networks, led by MasterCard and Visa, also face less competition and are less fragmented than other financial businesses (Exhibit 3). There are more than 6,000 banks competing for commercial lending business. While card issuers compete primarily on rewards and customer service, most other banks compete principally on loan price/rates and terms.

Exhibit 3: A Limited Number of Companies Dominate Card Issuance and Payments

Source: ClearBridge Investments. Data as of June 21, 2016.

The concentration that exists in card issuance reflects the scale and expertise necessary for success in this business. Large diversified banks JPMorgan Chase and Citigroup, which benefit from strong capabilities in both underwriting and lending, have identified their credit card businesses as among their most attractive lines of business. For large banks, credit cards enable them to develop more relationships with their customers, strengthening those relationships and increasing overall profitability. As a result, both companies are making significant investments in their card businesses to grow market share. General purpose issuers benefit by enabling consumers to spend more at a merchant’s point of sale than if they only paid with cash. Private label issuers, such as Synchrony and Alliance Data Systems, lower retailers’ transaction costs, help them develop better relationships with their customers and generate more sales through the use of targeted promotions and offers.

From a fundamental standpoint, card issuers look compelling. The group was already trading at the lower end of its historical valuation range (Exhibit 4) and the Synchrony news has reduced valuations further to 8 to 11x next year’s earnings estimates. The risk of rising charge-offs has kept P/Es in check, but as stated earlier, we don’t expect much change in credit trends - until there is some change in unemployment. Defaults should remain low even if rates rise, as higher rates likely indicate economic strength and higher inflation. While card issuers represent a value opportunity, investors concerned about issuers’ exposure to credit risk can still participate in the robust growth of electronic payments through pure-play payment networks Visa and MasterCard. These companies generate 100% of their earnings from transaction, but trade at higher valuations with P/E multiples above 20.

Exhibit 4: Card Issuer Valuations Look Attractive

Source: Bloomberg North American Card Lenders Valuation Index based on forward P/E of American Express, Capital One, Discover Financial, Alliance. Data Systems and Synchrony Financial

For consumers, using a credit card is a convenient way to borrow when making a purchase. To win more business, card issuers are offering better rewards for a payment type whose usage continues to expand. And for investors, credit card issuers are benefiting from the current healthy credit environment and have business models that should continue to thrive in a period of rising interest rates.