INSTITUTIONAL PERSPECTIVES June 2016

Taking Charge: Card Issuers Growing in Uncertain Rate Setting

Key Takeaways  Growing digitization of  Credit quality remains  We remain positive on payments and e-commerce high although portfolio the card issuer segment are increasing credit seasoning is resulting in given solid fundamentals card utilization among some modest increases and low valuations. consumers, benefiting in delinquencies and These companies should card issuers and charge-offs. We expect generate attractive returns payment networks. charge-offs to remain for shareholders until below normal if economic there is a change in the  Payment networks don’t face credit risk like card growth continues and economic outlook. issuers but trade at unemployment remains low. 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. Concerns about Brexit and dollar strength, combined with recent deceleration in job growth, have further reduced the probability of rate hikes. 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. TAKING CHARGE: CARD ISSUERS GROWING IN UNCERTAIN RATE SETTING

Exhibit 1: U.S. Household Consumer Debt Service Ratio driving up issuers’ rewards costs. For example, this year Citi 8% launched its new 4-3-2-1 Costco rewards card with different 7% cash back rewards based on purchase type; Chase launched 6% a new 1.5% cash back card; Discover continues to offer new 5% customers double rewards; while 4% Synchrony and Walmart have launched a new 3-2-1 rewards 3% card. These new products are helping issuers attract new 2% customers and leading to increased card usage. Consumers 1% are more willing to borrow as credit card balances are showing 0% their largest year-over-year Dec. 2000 Dec. 2003 Dec. 2006 Dec. 2009 Dec. 2012 Dec. 2015 increases since 2008. Consumer Source: Bloomberg based on U.S. Federal Reserve data as of March 31, 2016. debt service ratios have risen moderately, but with low unemployment, they don’t seem The Great Recession and new regulations in the U.S. have to signal deterioration in credit. resulted in significant improvements in the quality of most card issuers’ portfolios. The Credit Card Accountability, Despite still attractive fundamentals and low valuations, Responsibility and Disclosure Act of 2009 has resulted card issuers’ shares have underperformed those of many in more conservative underwriting by the card industry, banks so far this year. We believe the recent weakness in contributing to charge-off rates falling to all-time lows. card stocks is largely attributable to concerns about the Card issuer selectivity contrasts with auto lenders and risk of eventual credit deterioration. Earlier this month, some marketplace lenders that have been loosening shares of Synchrony Financial declined more than 15% standards to win more business. Borrowers have also after the private label card issuer updated its loss forecast maintained stronger balance sheets as reflected by lower for 2016, gave loss guidance for the first half of 2017 and debt service ratios (Exhibit 1). indicated it expects to increase its loss reserves in the second quarter to reflect a slight increase in expected Competition has increased in other areas however. Card charge-offs over the next 12 months. Despite this news, issuers have become aggressive in targeting consumers we believe that, given still positive GDP growth and low with richer rewards and better service. Enhanced rewards unemployment, credit conditions will remain very good for are lowering the cost of customer acquisitions and, with at least the next year and that card issuers stand to benefit. improved service, are reducing customer attrition. Both improve profitability. But more generous rewards are Through the first quarter, the credit quality of U.S. consumer lenders was high with credit card charge-offs

Exhibit 2: Monthly Credit Card Charge-Off Rate

10 9 8 7 6 off off Rate (%)

- 5 4 3

Net Charge Net 2 1 0 Mar. 2006 Mar. 2008 Mar. 2010 Mar. 2012 Mar. 2014 Mar. 2016 Source: Bloomberg based on U.S. Federal Reserve data as of March 31, 2016. 2 INSTITUTIONAL PERSPECTIVES June 2016

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

General Purpose Credit Cards Private Label Credit Cards Payment Networks � American Express � Alliance Data Systems � American Express � Bank of America � Capital One � China Union Pay � Capital One � Citi � Discover � Chase � Synchrony � JCB � Citi � Wells Fargo � Mastercard � Discover � Visa � U.S. Bank � Wells Fargo

Source: ClearBridge Investments. Data as of June 21, 2016. well below normal at close to 2% (Exhibit 2). Households card issuer/regional bank Capital One Financial, which has have cleaned up their balance sheets post the financial more sub-prime exposure than other issuers and has been crisis and are now benefiting from lower debt service growing faster as well. expenses. Consistent job growth, signs of wage growth, Card issuers are executing well and seem likely to continue low interest rates, low fuel costs and rising home values to do so even if interest rates rise. Higher rates should be are also helping consumers’ financial conditions, lowering reflective of an improved economy which should benefit the likelihood of delinquencies and defaults. Charge-offs lenders, including card issuers. Even in the event of some will eventually rise as accounts season – charge-offs tend economic weakness, card issuers may outperform many to peak 24 to 36 months after prime credit is issued and other lenders. Card issuers are less exposed to the rate after 12 to 18 months for sub-prime credit. Although a risk faced by banks, which today is manifesting itself as significant rise in issuer and industry charge-offs seems pressure on net interest margins. Card issuers also benefit unlikely until there is an increase in unemployment, from fewer irrational direct competitors. Eight banks Synchrony’s recently revised guidance has clearly made comprise the bulk of the general purpose card business some investors nervous. We do not believe its forecast 20 while five companies control most private label credit card to 30 basis point increase in charge-offs is indicative of issuance. Global payment networks, led by MasterCard and portfolio credit deterioration or a broader rise in industry Visa, also face less competition and are less fragmented charge-offs. Nevertheless, concern that Synchrony may be than other financial businesses (Exhibit 3). There are more indicative of deterioration in industry trends is hurting the than 5,000 banks competing for commercial lending valuation of other companies including general purpose business. While card issuers compete primarily on rewards and customer service, most Exhibit 4: Card Issuer Valuations Look Attractive other banks compete principally on loan pricing/rates and terms. 18 The concentration that exists in 16 card issuance reflects the scale and expertise necessary for 14 success in this business. Large diversified banks JPMorgan 12 Chase and Citigroup, which 10 benefit from strong capabilities in both underwriting and 8 lending, have identified their P/E Ratios credit card businesses as among 6 their most attractive lines of 4 business. For large banks, credit cards enable them to develop 2 more relationships with their customers, strengthening those 0 relationships and increasing Jun. 2010 Jun. 2012 Jun. 2014 Jun. 2016 overall profitability. As a result,

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 3 TAKING CHARGE: CARD ISSUERS GROWING IN UNCERTAIN RATE SETTING both companies are making significant investments in economic strength and higher inflation. While card issuers their card businesses. General purpose issuers benefit represent a value opportunity, investors concerned about by enabling consumers to spend more at a merchant’s issuers’ exposure to credit risk can still participate in the point of sale than if they only paid with cash. Private label robust growth of electronic payments through pure-play issuers, such as Synchrony and Alliance Data Systems, payment networks Visa and MasterCard. These companies lower retailers’ transaction costs, help them develop better generate 100% of their earnings from transactions, but relationships with their customers and generate more sales trade at higher valuations, with P/E multiples above 20. through the use of targeted promotions and offers. For consumers, using a credit card is a convenient way to From a fundamental standpoint, card issuers look borrow when making a purchase. To win more business, attractive. The group was already trading at the lower card issuers are offering better rewards for a payment end of its historical valuation range (Exhibit 4) and the type whose usage continues to expand. And for investors, Synchrony news has reduced valuations further to 8 credit card issuers are benefiting from the current healthy to 11x next year’s earnings estimates. The risk of rising credit environment and have business models that should charge-offs has kept P/Es in check, but as stated earlier, continue to thrive in a period of rising interest rates. 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

About the Author David Hochstim, CFA Director, Senior Research Analyst for Financials • 30 years of investment industry experience • Joined ClearBridge in 2015 • MBA from the UCLA Anderson School of Management • AB in Urban Studies from Brown University

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