Bread Financial Faces Challenges as Credit Costs Continue To Rise

Equity Analyst

Michael Miller

After the sale of Epsilon in 2019 and spinoff of LoyaltyOne in 2021, Bread Financial is now solely a consumer credit company, with its private-label credit cards and buy now/pay later businesses its only two product lines. However, Bread’s retail credit card business is under pressure as it continues to lose major partners, losing Wayfair and Meijer to Citi in 2020 and BJ's Wholesale Club to Capital One at the start of 2022. We see retail partner loss as an ongoing threat to Bread as the firm does not have a competitive advantage that would give it an edge in retaining partnerships during contract renewal negotiations. 

Bread must also contend with competitive threats from buy now/pay later firms, which are targeting the U.S. retail market and seek to sign agreements with Bread's partners. These firms are still a relatively small part of U.S. retail, but Bread takes the threat seriously. The company’s acquisition of the original Bread, a buy now/pay later company, as well its decision to adopt its name as its own, was done with the intent of accelerating the deployment of its own competing offering. 

As part of the spinoff of LoyaltyOne, Bread used the proceeds from the transaction to reduce its considerable debt load. Since then, Bread has continued to focus on deleveraging, using a $500 million distribution from its subsidiary banks to further reduce its debt in 2023. We view this strategy favorably as Bread is heavily leveraged, especially when considering the low credit quality of its receivable portfolio, which has historically seen net charge-offs well above industry averages. We still think more needs to be done to put Bread in a good financial position, but the spinoff and subsequent debt reduction have materially improved Bread's balance sheet, with the company in the best financial position it has seen in years.

Additionally, the company has found considerable success in expanding its retail deposit base, which now makes up more than one fourth of its total funding. This trend gives the firm a material tailwind for its net interest margin, already one of the best in our coverage, and reduces its reliance on external funding.

Business Strategy & Outlook

In our view, Bread Financial does not have an economic moat as it lacks a competitive advantage in its core credit card business. Bread Financial is the third-largest issuer of private label credit cards in the U.S. by outstanding receivables, and while the company does offer cobranded general-purpose cards as well, it is a small player in the overall credit card market. The private label credit card market has historically seen limited participation from major credit card issuers, with the notable exception of Citi, limiting the amount of competitive pressure that Bread Financial has typically faced. Furthermore, the company has focused on partnering with small to midsize retailers, such as apparel and mall-focused brands, that typically generate even less interest among major credit card issuers, leaving more room for Bread Financial. However, this strategy means that Bread Financial’s fortunes are tied to the sales performance of the retailers most exposed to the shift toward online shopping. This problem is further compounded by the high levels of leverage that the firm uses in its business strategy, leaving it with little room for error. 

Many of Bread Financial’s partners are under significant pressure both from the long-term trend of increased online purchasing and the impact of the pandemic. Bread Financial has historically had heavy exposure to mall-centric partners and apparel retailers. After a strategic rethink in 2015, the firm has attempted to move toward beauty, jewelry, and digital retailers. While initial receivable growth was strong, more recent results have been mixed, with receivables balances stagnating since the end of 2017. The company has also struggled to acquire and maintain partnerships with digital retailers, losing Wayfair to Citi in 2020. The company is in the difficult position of needing to replace atrophying partnerships with healthier ones while simultaneously maintaining healthy enough margins to make its high-leverage strategy a success. This is made even more difficult by the disadvantages Bread Financial faces when directly bidding against larger credit card issuers for new partnership agreements.

The loss of Wayfair to Citi in 2020 and BJ’s Wholesale Club to Capital One in 2022 highlights Bread Financial’s position as a distant third place in the private label credit card market and its lack of a competitive advantage. At the end of 2021, Bread Financial had $17.4 billion in gross receivables, a fraction of those of Citi and Synchrony. Bread Financial operates with a higher cost of funding than its larger competitors. In 2019 Bread Financial's overall cost of funding was 2.21% compared with 1.37% for Synchrony, giving it a cost disadvantage. Additionally, Bread Financial’s small scale prevents it from submitting serious bids for large anchor clients as the receivable volumes these programs generate are too large for the company to reliably finance. 

With large premium partnerships out of reach, Bread Financial has historically found success targeting smaller brands that do not capture the same level of competitive attention. Here Bread Financial can offer retailers a compelling value proposition by combining consumer financing and loyalty rewards with the company’s in-house data analytics and digital marketing. For many smaller brands, signing a partnership agreement with Bread Financial is a way to outsource their data analytic and digital marketing. This does create switching costs for Bread Financial’s partners since canceling their agreement would mean finding a new provider for these services or rebuilding these capabilities in house. However, Bread Financial has already monetized much of its data analytic and digital marketing operations. First, with the sale of Epsilon, its digital marketing business, in 2019 for $4.4 billion. This was followed by the much smaller sale of the data analytic business, Precima, to Nielsen in 2020. Bread Financial has stated that it has rebuilt much of the capabilities held at those businesses and that the services provided to its partners will not be affected by the asset sales. But we believe that these sales reflect lower switching costs and that its digital marketing has become a more commoditized product. This is supported by the performance of Epsilon when it was held by Bread Financial. Revenue grew 1.75% from 2015 to 2018 while margins declined. 

Even prior to the sale of Epsilon, the shift toward digital purchases has eroded the value added by the data collection opportunity of Bread Financial’s credit cards. When a consumer makes an online account with a retailer, they are providing that retailer with contact information that can be tied to the consumer’s purchases. The availability of alternative data sources decreases reliance on Bread Financial’s cards and increases the negotiating power of the retailers.

Bread Financial has historically managed to generate a return on invested capital between 20% and 30%, well above its cost of capital. However, with an asset/equity ratio of roughly 15, well above its peers, we see these returns as being driven more by Bread Financial’s high degree of leverage than an identifiable economic moat. Bread Financial avoids bank capital restrictions by structuring itself as a parent company and keeping much of its debt above the two banks that it owns, Comenity Bank and Comenity Capital. The two banks themselves are well capitalized. At the end of 2020 there was $2.6 billion in equity at the bank level and the two banks combined had a common equity Tier 1 capital ratio of 18.4%. However, the parent company cannot finance itself without distributions from these two banks, with $2.8 billion in debt and no revenue generating assets. As the parent company requires ongoing cash flow from its subsidiaries, we believe that the Bread Financial should be viewed as a single consolidated entity, and a heavily leveraged one at that. 

The sale of Bread Financial’s Epsilon and the spinoff of LoyaltyOne have alleviated some of the leverage issues the firm faces as much of the proceeds were used for debt reduction, but heightened risk remains and any deterioration in Bread Financial’s business model will be magnified by the firm’s leverage.

None

Economic Moat

Bread Financial Holdings Inc

Bread Financial Holdings, Inc. engages in the provision of data-driven and transaction-based marketing, customer loyalty and payment solutions. Its products and services include credit cards, loan financing, processing, and servicing, marketing, data and analytics, and digital offerings. The company was founded in 1996 and is headquartered in Columbus, OH.

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Bread Financial Holdings, Inc. engages in the provision of payment, lending, and saving solutions. The firm also offers private label and co-brand credit cards and buy now, pay later products such as installment loans and split-pay offerings. The company was founded in 1996 and is headquartered in Columbus, OH.

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