Sometimes, a small drift in closely watched measurements can shed light on powerful trends in a business. During the fourth quarter of 2017, Synchrony Financial (NYSE:SYF) reported slight but significant declines in its credit-quality metrics. Net charge-offs reached 5.78% of total loan receivables, an increase of 113 basis points over the fourth quarter of 2016. The company bumped its allowance for loan losses as a percentage of total receivables to 6.8%, a rise of roughly 1 percentage point against the prior-year quarter. And customers took more time to make payments on their accounts: Loans 30-plus days past due at period-end ticked up slightly to 4.67%, versus 4.32% in Q4 2016.
All of the changes above can be traced to "credit normalization," which management has discussed in detail in recent earnings conference calls. As revolving credit becomes more easily available to consumers in the current economic cycle, default risk is ticking up.
Accordingly, Synchrony has shored up its resources to manage risk. While net interest income after retailer share agreements has increased 29% over the last two years, the company's annual provision for loan losses, which increases balance sheet reserves against bad debts, has ballooned by nearly 80%. This provisioning has trimmed Synchrony's overall profitability, and it's the primary factor behind a drop in net earnings of roughly 13% between 2015 and 2017. The trend of higher provisions against expected losses is easier to see in the table below:
|Net interest income, after retailer share arrangements||$12,079||$10,628||$9,355|
|Provision for loan losses||$5,296||$3,986||$2,952|
|Net interest income||$6,783||$6,642||$6,403|
The credit-quality metrics, described above, affect the provision for loan losses. It's important to note that a company's loss provision reflects both current trends in customer credit quality and the forecast for delinquencies and charge-offs 12 months after a balance sheet date. In other words, the provision is a forward-looking adjustment on the income statement to make sure balance sheet reserves are robust.
I've highlighted the 2016 and 2017 provisions to illustrate the burgeoning trend. These higher adjustments to absorb risk cause earnings pain in the present, but they signal better margins ahead. And to some extent, the widening of loss provisions can be traced to two important initiatives that should directly impact Synchrony's already-impressive profitability.
The first trend is a general improvement in underwriting quality. Synchrony is seeking to lend to customers with higher credit quality within its three primary businesses -- retail card partnerships, retailer big-ticket "payment solutions," and healthcare-oriented "care credit." The following chart, from the company's most recent earnings presentation, displays Synchrony's rising tendency to lend to consumers with upper-tier credit scores:
As the company gradually shifts to a more credit-worthy customer, it will winnow out some of its highest-risk accounts. This generates some losses on a portion of Synchrony's credit portfolio, as marginal accounts are written off and replaced with those pegged to low-risk borrowers.
The second initiative driving bigger loss provisions is Synchrony's expansion of its credit receivables. This portfolio of loans to credit card customers is characterized as an asset on the company's balance sheet. Growth in loan receivables automatically results in a higher provisioning -- size is one variable that will always increase the provision, even when credit quality doesn't change.
Investors should welcome adjustments generated by growing receivables balances, because additional receivables provide higher net interest income. Synchrony has expanded its loan receivables balance at a compound annual growth rate of 9.4% over the past four years.
The company has achieved this rate primarily through striking up partnerships with retailers. But executives have also demonstrated an appetite for significant bolt-on transactions. A case in point is Synchrony's pending $6.8 billion purchase of PayPal's (NASDAQ:PYPL) consumer credit receivables portfolio (slated to close in the third quarter of this year).
Through this mammoth transaction, which extends an existing partnership, Synchrony becomes the exclusive issuer of PayPal's online consumer financing program, PayPal Credit. U.S. consumer credit represents roughly 2% of PayPal's annual total payments volume, or TPV, a measure of transaction volume facilitated on PayPal's platform.
Interestingly, PayPal has increased its TPV at a torrid rate in recent years -- it improved this metric by 24% last year. Thus, Synchrony isn't just purchasing a book of receivables; it's buying a portfolio that will expand largely through PayPal's efforts, and at a double-digit rate at that, for the foreseeable future.
To sum up, while Synchrony's loss provisioning has accelerated in recent years, it's not completely the result of credit normalization. The growth initiatives of higher credit quality and receivables expansion are pushing loss reserves higher in the near term, but these two synchronous objectives should pad profits for years to come.