Undervalued and Still Growing: Synchrony Financial and AerCap Holdings

Whatever happens or will happen in the stock market, it is nice to find companies that are growing and are still undervalued. Both Synchrony Financial and AerCap Holdings are interesting as they continue to have good prospects of progress. The best investments offer both growth and value by employing large amounts of new capital at a high return on invested capital.


Synchrony Financial

Synchrony Financial (NYSE: SYF) is one of the nation’s premier consumer financial services companies, roots back to 1932. The company is the largest provider of private label credit cards in the United States based on purchase volume and receivables. Synchrony Financial provides consumer financial products services to the diverse group of national and regional retailers, local merchants, manufacturers, buying groups, industry associations and healthcare service providers.

The key to understanding SYF and the PLCC (Private Label Credit Cards) industry is the business model. We can argue how much SYF is financial company and how much a marketing firm or technology-enabled business service provider. Its real customers are retailers (such as Walmart, Amazon and Lowe’s) and all that bank stuff is just a by-product of its true business. The key question is why is SYF so much more profitable than most of its competitors? Notice that SYF does not charge the merchants at all. In fact, it gives them a share of its revenue. SYF charges the consumer side of the market in the form of interest payments. The company also offers a significant value proposition for retailers because it can collect data on customers’ purchases. So this is a very different business model for instance to Amex, Mastercard or Visa.

Synchrony Financial has one of the strongest balance sheets in the financial sector. The company’s total liquidity (liquid assets and undrawn credit facilities) is $21 billion, or 22% of total assets. SYF has a Common Equity Tier 1 ratio under Basel III of 15.8%, well in excess of the Basel III 7.0% requirement to qualify as a well capitalized bank. SYF’s balance sheet is sensitive to interest rate levels. Increase in interest rates will increase net interest income.

Synchrony Financial is also very profitable with a net interest margin of 15.65% at the end of the 2017. Although company’s net earnings decreased 14.0% from the year 2016, primarily driven by increases in provision for loan losses and other expense, as well as the impact related to the Tax Act enacted in December 2017. Loan receivables increased 7.3% and net interest income increased 11.0% during the year 2017. SYF has been strong direct deposit growth from $19.7 billion at the end of 2014 to $42.7 billion at the end of 2017. Management is also looking to return some of the company’s large cash balance to shareholders by paying increasing dividends and buying back its outstanding (undervalued!) common stocks.

The valuation of Synchrony Financial is moderate. The company’s P/E is 15, P/B is 2 and EV/EBIT 11. Particularly noteworthy is strong free cash flow, P/FCF is only 3.3. Strong cash flow ensures constantly increasing dividends. Estimated future EPS for years 2018 and 2019 are somewhere between $3.50 and $4.30.  By average P/E ratio 13-15 it would give the range of price from $45 to over $60. This means a significant upside potential.

Are there any risks? Customer concentration is one. SYF’s five largest partners accounted over 50% of its total interest and fees on loans and loan receivables. Long standing co-operation agreements would certainly offset single adversities. Investors can also worry about rising write-offs and higher consumer defaults. The company expects the trend of increases in its net charge-off rates, delinquencies and allowance coverage to continue in 2018, but at a more modest rate as compared to what we experienced in 2017. This may be just part of the cycle, but you should monitor that the growth of charge-offs etc. does not exceed the growth in net sales and earnings. Last but not least, there is always risk of Economic downturn. Even though SYF is strong and conservatively financed, stock price will certainly react to possible stock market crash. Surely, the company is well placed to ride out these problems and recovery would probably be faster than average.

Whether growth and profitability will continue in the future is an important issue for an investor. At least continuing improvement in the U.S. economy and employment rates will contribute to an increase in consumer credit spending. SYF has taken a highly profitable position in a niche market with high barriers to entry. Main purpose is organic growth, but program acquisitions such as acquiring PayPal’s US consumer credit receivables portfolio last year are also possible.

Synchrony Financial’s investment case has not changed much over the past few months, even though company’s stock price has risen somewhat from the bottom price of 2017. The business is still a highly profitable, the company is well-capitalized, undervalued and focused on investor returns. Synchrony Financial’s bull case just keeps getting stronger. Although you should never blind follow guru investors, it isn’t too bad that both Warren Buffett and Seth Klarman have noteworthy positions in the company.


AerCap Holdings

AerCap Holdings (NYSE: AER) provides aircraft leasing and aviation finance services. Its activities also include aircraft asset management, corporate services, remarketing of aircraft, collecting rental, maintenance payments and monitoring aircraft maintenance. AerCap is the global leader in aircraft leasing with over 1,500 owned, managed or on order aircraft in its portfolio. AerCap serves approximately 200 customers in approximately 80 countries. The company is headquartered in Dublin, Ireland.

Generally, historically airlines have generated the worst return on capital of any industry. But there is another way to act if you have dreamed of owning an airplane. There is a way to own hundreds of them and generate a respectable return. You can go into the aircraft leasing business.

The air leasing industry has witnessed bullish momentum as airline companies increasingly prefer leasing over ownership of aircraft. Today, 40% of the global airline fleet is leased. There has been huge increase from 2% in 1980. Especially the future of overall industry outlook is positive considering strong leasing activity from emerging Asia, Latin America and Africa among others.

AerCap buys planes and then leases them out to carriers. Due to the company’s size, it will enable to borrow at low rates, negotiate the best deals from manufacturers and offer customers the best deals. This means that AerCap can mainly do this in a more cost-effective way than the airlines themselves. The company has expanded to become the most significant player in the sector.

As of December 31, 2017, average age of owned fleet was 6.8 years and average remaining lease term was 6.9 years. Fleet utilization rate for the full year 2017 was 99.1%. With the company’s strategy of selling older aircraft and with steady pipeline of new aircraft, the average age of the fleet will decline and newer aircraft generally command longer lease term. Aircraft fleet of AerCap is growing year by year. With a strong pipeline of new aircraft in the next two to three years, revenue growth along with cash flow is likely to be robust. This will boost sustained upside for the stock.

Growth in the leasing industry is largely backed by leverage and therefore the balance sheet aspect is important. As long as average remaining lease term will remain about at the current level of 6.9 years, most of the debt matures at the earliest 2027 and average cost of debt is 3.9%, this is likely to ensure steady cash inflow and debt should not be a concern. Liquidity position of AerCap is also strong. The company’s total liquidity buffer is $9.6 billion for this year. Estimated total available liquidity plus operating cash flow are $12.8 billion and debt maturities plus capex are $9.3 billion, which leaves $3.5 billion excess coverage.

After the stock price dropped from the year peak price of $55.67 under $50, valuation is again attractive. The company’s P/E is 7.4 (earnings growth 16.5%), P/B is 0.95 (ROE 13.8%) and P/S is 1.66 (net margin 22.8%). And now we are speaking about the company which revenue growth rate was 11.50% per year and earnings per share growth rate was 15.10% per year during the past 10 years. We should not forget either that AerCap is domiciled in Ireland, so the tax rate is low 13.3% for the full year 2017 (14.5% for the full year 2016). There is no reason to believe AerCap’s flight path will change anytime soon. The company should continue to report a healthy interest spread (net spread about 9%) and see high demand for its planes. All of this is good news for shareholders.

The company’s management and CEO Aengus Kelly runs the business disciplined and shareholder‐friendly way. The company do not overpay for new aircraft and it routinely sells older aircraft, which are more sensitive to cyclical downturns and technological obsolescence. Most importantly the company has repurchased aggressively its undervalued stocks. There’s also a new share repurchase program authorizing total repurchases of up to $200 million of AerCap ordinary shares through June 30, 2018.

No business activity is risk-free. AerCap bears credit risk and residual value risk. As the company is reliant on leasing income to pay off its interest income, the company is exposed to credit risk. AerCap manages credit risk by aggressively monitoring customer creditworthiness and diversifying its customer base. Losses have been low. Because around 80% of the defaulted planes were repossessed and then re‐leased or sold. To mitigate residual value risk AerCap focuses its portfolio on the most widely used current‐generation aircraft, especially narrow‐bodies. While these aircraft provide lower up‐front rental yields, they have held their value better over time and through cycles. We can well say that the chance of a total loss is slim.

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