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Discover, Synchrony likely to benefit more from tax reform than rivals


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Discover, Synchrony likely to benefit more from tax reform than rivals

A pair of consumer finance companies could find significant relief from a tax reform package that looks likely to pass through the U.S. Congress.

Tax reform moved closer to the finish line Dec. 15 as House and Senate Republicans released a finalized bill. Two days earlier, Credit Suisse Securities (USA) LLC analyst Moshe Orenbuch said he believes consumer finance companies stand to be among the biggest beneficiaries of reduced taxes.

He said some investors had been concerned about a deterioration of credit quality negatively impacting specialty finance companies. But if tax reform can help improve consumer income, some of those worries could be alleviated. Orenbuch said a positive change in the consumer outlook is especially beneficial for Discover Financial Services and Synchrony Financial.

"They happen to be the ones who suffer the most from credit concerns," he said.

He added that Synchrony and Discover should find themselves in a position to return capital to shareholders because they are not among the companies facing the prospect of a large write-down on deferred tax assets as result of the legislation. Others in the space such as Capital One Financial Corp. and American Express Co. will likely record significant deferred tax asset write-downs.

Orenbuch estimated that Capital One could see a $1.95 billion deferred tax asset write-down while American Express could see one of $1.09 billion, according to a Dec. 12 report. In those scenarios, it would take American Express 1.2 years and Capital One 2.6 years to replenish their book values from the write-downs, Orenbuch estimated in the report.

Synchrony and Discover also stand to see more of a benefit than Capital One and American Express from a reduction in the corporate tax rate. Lawmakers are looking to reduce the federal corporate tax to 21% from 35%. Due to state and local taxes, among other things, Synchrony and Discover at times saw their effective tax rates exceed 35%.

For the nine months ended Sept. 30, Discover recorded an effective income tax rate of 35.1%, and Synchrony had an effective income tax rate of 36.7%, according to each of the companies' most recent Form 10-Q SEC filings. During the same period, Capital One reported a 28.8% effective income tax rate from continuing operations, while American Express' effective tax rate was 29.7%.

Compared to Discover and Synchrony, American Express tends to have a lower tax rate because a greater portion of its business comes from outside the U.S. Capital One's more favorable tax rate is thanks to its higher use of tax-exempt investments, Orenbuch said.

If tax reform does bring increased earnings, Discover CFO R. Mark Graf said his company would explore a number of possibilities to use the increased capital. He said Discover could make investments in capabilities and infrastructure or increase returns to shareholders. "Any number of different things you can think about," he said, according to a transcript of remarks made at a Dec. 5 investor conference.

Higher earnings from reduced taxes will not last forever, according to Sandler O'Neill & Partners LP analyst Christopher Donat. He said that economic theory suggests that competition tends to erode the increased earnings.

"Industry returns will normalize over time," he said in an interview.

Companies could use the higher earnings from tax reform to better position themselves by reinvesting the capital instead of returning it to shareholders, said Compass Point Research & Trading LLC analyst William Ryan. One area he would like to see the consumer finance companies invest is in digital offerings, such as mobile products.

What Ryan does not want to see is tax reform leading to an invigorated rewards war; it is possible card companies could use the higher earnings to increase customer perks such as higher cash-back rewards.

"It would be great for the consumer, but you would rather see the companies pile it back into the business development side," he said in an interview.