Last week Consumer Lenders started reporting Q1 2017 earnings, which showed above average loan growth and better margins. But, in spite of the improving revenue trends, a surge in credit costs hurt results and stocks in the space sold off hard. It was Déjà vu for investors who have seen this twice in the past three quarters from the credit card issuers (COF, and SYF in particular raised their loss rate forecast).
Entering 2017, investors in the Consumer Lending/Credit Card sector were assuming those companies would face less pressure from new regulations, top line growth would come from increased consumer spending (animal spirits), and would realize higher margins on lending from rising rates. All of which, so far, has come true. What nobody counted on was the drastic increase in credit costs.
“We believe that our loss rate will continue to trend higher into 2018…We expect the net charge-off rate to be in the low- to mid-5% range for 2018. Given that expectation as well as continued strong growth, the reserve builds for the next couple of quarters are likely to be in a similar range on a dollar basis to what we saw this quarter.” – Brian D. Doubles, CFO of Synchrony Financial on 4/28/17 (Q1 Call)
Industry Delinquency Rates
The uptick in charge-offs is a problem for obvious reasons – it is indicating a change in trend. Since the “Great Recession” both consumer and corporate balance sheets have drastically improved, and are in substantially better shape than they were in 2008. Corporate cash balances are at record highs and household debt service as a percentage of disposable income has fallen, as you can see from the chart below.
On the other hand, the Transaction Processors (Paypal, JKHY, GPN, Western Union, Visa, MA, etc) which are reliant on transaction volume (picking up as you can see in the chart below), had good quarters. The driver of growth for these companies is the shift from cash to plastic. Any kind of plastic – debit, credit, online, offline, whatever. Cash and check usage everywhere is declining, and electronic payments are rising. It’s a 30-yr trend that isn’t going to stop.
Transaction Growth
Transaction Processors are tech companies, not financial service companies. They don’t lend money. They process payments, have huge economies of scale (tech costs fall as transaction volume rises), and produce very high returns on assets and free cash flow.
Consumer lenders, on the other hand – credit card companies, auto lenders, mortgage lenders – take credit risk. They lend money, hoping to recover it plus some interest. Discover and American Express are not payment processors, they are lenders. And their credit costs (bad loans) are now rising for first time in years. Meanwhile, tech companies like PYPL continue to exceed most of their relevant measurement metrics.
So, one industry is showing early signs of peaking while the other is still early cycle. Dispersion abounds, which correlates directly to investment opportunities, both long and short. Stock performance in the group is starting to price in the turn in credit risk versus the transaction toll takers, presenting clear winners and losers in a choppy market.
