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Morningstar | Given Partners' Headwinds, We Are Downgrading Synchrony's Moat to None From Narrow

After reviewing Synchrony Financial's competitive position as a result of the company’s loss of its Walmart partnership, we are lowering our economic moat and trend ratings to none and negative from narrow and stable. As a result of this decrease in moat rating, we have also lowered our fair value estimate to $28.50 per share from $32, given that we use a shorter period for a no-moat company's returns to fade to the cost of capital. Though we no longer award Synchrony a moat, we do believe the company’s issues are fixable and anticipate returns on equity will only modestly fall to levels in the midteens from the upper teens to mid-20s over the medium term. Given time, Synchrony should be able to improve its technology and data capabilities to adequate levels to retain and win new customers. However, we don’t believe it will ever be able to match the technology offering of its main rival, Capital One. Should Synchrony fix these issues, we believe it’s possible the company could regain its narrow moat rating.

After losing Walmart, we did a deep dive into the company’s business and operations to determine what caused the defection and if additional partners would follow Walmart’s lead. We encourage readers to read our report, "Capital One: A Moat in Tech That Vikings Can't Surmount." During our research, we became increasingly worried about the extent to which Synchrony’s technology lagged Capital One's. We’ve always known Capital One has emphasized technology investment but were unsure what, if any, advantage that afforded the bank. However, it became apparent that retailers increasingly focused on selling through digital channels need partners that can deploy applications and software updates more quickly and more frequently. In addition, it appeared to us that Synchrony has a culture that doesn’t greatly value technology. We suspect this is partly attributable to being constrained while operating within General Electric.

We stress that we do not believe Synchrony will see a significant exodus of its current partners. The company just re-signed Lowe’s and will start its partnership with PayPal this year. However, Synchrony will be affected by the declining financial health of its remaining partners. Eventually, this will provide another headwind. When a partner goes bankrupt, the credit card balances do not disappear but enter a slow runoff period lasting for years. This slow process gives Synchrony time to fix these issues.

We anticipate and hope that Synchrony will spend more to improve its technology and data offering, which will result in declining margins. We forecast Synchrony’s efficiency ratio (operating expenses as a percentage of net revenue) will worsen to approximately 50% in 2022 from 44% in 2017, largely due to increased technology spending. If Synchrony doesn’t invest more in technology, we worry it will see additional deceleration in growth, further complicating its efforts and ability to improve its technology.

Finally, we think the company’s issues are cultural and will say that Synchrony is not the only bank facing these problems. Capital One’s superior tech capabilities are largely a result of a culture that values having the best developers and building the most advanced technology infrastructure. For years, banks did not have to worry about tech capabilities, as they were primarily focused on building scale through acquisitions, making good loans, and managing relationships. In our opinion, banks need to be increasingly focused on deriving value from the data they’re collecting while facilitating the technology capabilities of customers. To us, this could mark a paradigm shift for banks.