Here's Why Synchrony Financial Could Be a Great Stock for 2018

Synchrony Financial (SYF 0.59%) might just be the biggest credit card company you've never heard of. With a growing business and extremely profitable products, Industry Focus: Financials host Michael Douglass and Fool.com contributor Matt Frankel break down why they're fans of the company.

A full transcript follows the video.

This video was recorded on Jan. 8, 2018.

Michael Douglass: Matt, why don't you lead us off with Synchrony Financial?

Matt Frankel: Synchrony. I tend to refer to it in articles as the biggest credit card company you've probably never heard of. If you have any store credit cards, you might already be a customer of theirs. To name a couple of the big ones, they issue Wal-Mart store credit cards, Gap, Dick's Sporting Goods. I have a Rooms to Go credit card that's issued by Synchrony. And Amazon's store card, the one that doesn't have the Visa logo on it, is a Synchrony product. They also do the CareCredit product, which allows people to finance medical expenses at 0% interest. It's accepted at a ton of doctor's offices nationwide. We use it to finance our vet bills, actually, because we have one dog that gets sick a lot. But, that's kind of an overview of what Synchrony does, in 30 seconds.

Douglass: Synchrony's ticker symbol, by the way, folks, is SYF. I'll note, as well, it's interesting, because when you look up Synchrony, it functions a lot like a bank. It takes in deposits, usually on, as far as I can tell, just on interest-bearing accounts. We're talking money markets and CDs. And if that reminds you of Bank of the Internet a little bit, it probably should. Then, as you noted, Matt, it's very heavily into credit cards.

Frankel: Yeah, they're becoming more of a deposit-based business model over the past couple of years. Their deposit growth was actually very impressive in 2017. Right now, on Synchrony's website, they have a 12-month CD advertised at 2% interest, which, if you've shopped around for a CD recently, that's pretty much unheard of. They have longer CDs up to 2.4% right now. So their business model is similar to BofI, which we talked about, and some of these other online-based banks, like Goldman Sachs' Marcus Bank, where, because they don't have the cost of making any brick-and-mortar banking branches, can offer higher, more competitive interest rates to attract deposits. And it looks like it's working, at least in their case.

Douglass: Yeah. It's interesting, because you think about it, the financial hacker crowd in particular, the folks who are like, "Let me find how to get an APR that's just a little bit better than my money market account, or a little bit better than my CDs," those are the kind of people that tend to be really attracted to companies like Synchrony Financial and their products on the deposits side. And frankly, those are the sort of really financially savvy people that a bank tends to want to have as their customers, because they're the sort of folks who they can hopefully cross-sell to later on.

Frankel: Definitely. On the surface, if you think of how much they're paying out in interest, and the fact that store cards tend to have a higher default rate than general credit cards, right now, Synchrony's is just under 5%, which means for every $1,000 in purchases that people make on Synchrony, $50 of that is not going to get paid back. Which may sound like a very risky business model. But the flip side of that is, store credit cards tend to have higher interest rates than standard credit cards. I think the standard, Visa, Mastercard, American Express, has about a 16% interest rate these days. And store credit cards tend to be in the upper 20s. So the difference in interest rates actually makes an interesting business dynamic. It more than makes up for the higher cost of deposits, and the higher default rates.

So Synchrony's profit margins are actually pretty sky high. To give you a little bit of context, Synchrony's net interest margin is almost 17% right now. That's more than the average credit card charges in interest, period, before you factor in things like cost of capital and default rates. So it's a huge profit margin that we're talking about.

Douglass: Yeah. Of course, on the flip side is this issue that there's going to be more volatility in a business like this, because they're in not just a riskier pool in general, which is credit cards, but kind of on the riskier end of the credit card pool. And one of the things that's a caution for me, at least, when looking at this company, is that Synchrony hasn't been public for very long. Their IPO was in 2014. So we don't have that much historical data, and we don't really have a clear sense of how bad things got during the Great Recession. And that's something I tend to like to look at when I'm considering a fundamentally loan-based operation like Synchrony. But I have to say, certainly, when times are good, it looks pretty darn good.

Frankel: Definitely. A couple of things worth pointing out. First of all, before the IPO that you just mentioned, Synchrony was a part of General Electric , the GE Capital division. They keep enough in reserves to cover if 7% of their loans wind up defaulting. So they actually have more in reserves than their current charge-off right by about a 2% margin. So even if things got a little bit worse, they could have some cushion to where it could get a lot worse than it is right now, and they would still have enough in reserves to more than cover their losses.

Douglass: And one of the other things that I'll add to that, on the flip side, another green light, if you will, is that it's an incredibly efficient business. When we talk about efficiency ratios, we want to see an efficiency ratio under 60%, generally speaking. Synchrony's is 30.4%.

Frankel: Right. That means for every $1 in revenue they're generating, they're only spending $0.30 to get it. That's a remarkably low efficiency ratio for a bank. The industry standard for return on assets for a bank is 1%. Synchrony's is 2.4%. So this is a very profitable and very efficient business right now. Like you said, I wish I could see what they were doing during the Great Recession, or have some kind of context in an environment where things weren't going great. But for the time being, and in good markets, they're very efficient and very profitable.

Douglass: One of the other things we should touch on here is some of those partnerships. Of course, you mentioned a number of partnerships that they already have. They've also been adding some new ones lately.

Frankel: Yeah. Zulily as one of their newest ones, and they just recently expanded their partnership with PayPal as well. That's becoming one of their bigger ones. The CareCredit medical financing that I mentioned earlier -- they just recently added, I'm not exactly sure what they're calling it, but it's a Visa card as well, so you can use it at places other than doctors' offices, which could be a big deal, because it's becoming a very popular product for people financing their medical expenses with no interest. So there's a bunch of different growth avenues, and I wouldn't be surprised to see them add a few more stores, especially some online retailers to add to their Amazon in the coming years. I think their portfolio is going to get a lot bigger.

Douglass: Yeah, it's a very interesting business. I will say, again, it's definitely only appropriate for the more risk-tolerant investor. But for all of that, it is a very interesting company, and one that certainly has a lot of growth opportunity. The hope is, with those low-cost deposits -- which, again, they're still paying out more than anybody else on them, at least anyone that we're aware of offhand -- but their cost basis is just so darn low that they can afford to do that. You have to think that's a pretty good opportunity for the business' growth long-term.

Frankel: Definitely. It's also worth pointing out that interest rates could be a big catalyst over the next couple of years. Things like mortgages and auto loans are not directly tied to Federal Reserve rate hikes, but credit cards are. If you look at your credit card cardholder agreements, they'll generally say something like prime rate plus a certain percentage. So if the Fed raises rates six or seven more times over the next three years, like they're planning to do, this could really raise Synchrony's profit margins. Generally, their deposit payout rates don't rise at the same speed as the Fed rate hikes, so this could expand their already impressive margin even further.

Douglass: Yeah. I think there's a lot to like there.