ALLIANCE DATA SYSTEMS CORP ADS
February 10, 2016 - 2:25pm EST by
Bluegrass
2016 2017
Price: 180.00 EPS 17 19
Shares Out. (in M): 62 P/E 10.6 9.5
Market Cap (in M): 11,100 P/FCF 9 8
Net Debt (in M): 3,900 EBIT 1,575 1,725
TEV: 15,000 TEV/EBIT 9.5 8.7

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  • High ROIC
  • Payment services
  • credit card
 

Description

Alliance Data Systems
Investment Thesis
February 2016
 
Summary: ADS is a growing, capital light, high ROIC, well managed loyalty program operator, yet priced like a general credit card issuer
standing in front of a consumer default wave. The company is on the right side of numerous trends, has experienced and incentivized
management, and has created a very sticky yet rewarding mouse trap for its customers. Assuming continued growth in revenues, and
FCFs are reinvested thoughtfully, the forward 11x earnings multiple materially undervalues the company.
 
Industry and company are growing, capital structure is efficient, operations generate ample free cash flow
 
As an outsourced provider of consumer loyalty and marketing programs, ADS benefits from growing, secular trends in the retail
and payments industries that should continue indefinitely into the future. Targeted marketing driven by data and analytics is
taking share from generalmarketing spend, the spend on both isvery large and increasing, and the function is vitalto the health
of those companies purchasing it. Retailers are increasingly acceptant of and dependent on customer loyalty programs to cost
efficiently drive sales. Private label credit cards are taking share from general purpose cards due to lack of interchange fees
(these savings essentially redirected to fund retailers’ loyalty programs), increased tracking ability of consumer spending
patterns, and the rise of digital wallets driving broader acceptance by consumers
• The company’s revenues and FCF have tracked these trends, growing at CAGRs of 16% and 19%, respectively from 2006 to
2015, and management has guided to continued growth through 2017
The company is conservatively financed and has ample liquidity; gross leverage = ~2.75x, and the company has 10% of its
market cap in cash
Existing management is tenured and have been excellent allocators of capital
Value disparity: the market is overly focused on potential consumer credit deterioration in the US generally, and confused by
management’s guidance for increased charge offs in 2016 / 2017 specifically (due to expected seasoning of credit portfolios
which started life 2-3 years ago, not worsening credit losses)
 
Inexpensive valuation
 
Contrarian viewpoint: Despite 64% of LTM EBIT coming from the private label card segment (including internal processing
operation), the company should be primarily valued as an outsourced loyalty program operator and data / analytics provider
with a small credit component attached as opposed to primarily as a credit card issuer
Consistent high returns on invested capital support this viewpoint; after tax ROIC averaged 28% from 2006 - 2015
At ~11x / 9x 2016 earnings / free cash flow, ADS is currently valued at or lower than multiples analogous to general purpose
card comps AXP, DFS and COF, despite ADS’ focus on prime borrowers (700 FICO and above) only and low average balances
(~$500 vs ~$5,000 for general purpose cards) in its credit book. Assuming credit portfolio loss rates of 700bps in 2017 (vs
management guide of 550bps, and compared to 10% in 2009) and assuming no related expense structure offsets, 2017 cash
earnings would be reduced by 11% to $17 / share, for an implied multiple of 11x 2017 earnings.
ADS has historically traded at 18-20x forward earnings, in line with a peer group of asset light, transaction processing and
business process outsourcing firms such as proxy peers FISV, FIS, EXPN.L, GPN, DNB, and ACXM
• Hidden value: Dotz’ (Brazil coalition loyalty program described below) 37% ownership not reflected in financial reporting,
potentially worth $0.60-$0.70 in earnings per share
 
ADS owns a collection of high quality businesses
 
Card services 46% of revenue / 64% of EBIT / 34% EBIT margin for 2015
 
Operates 140 private label card programs for retail channel customers with >30 million card holders; total universe of potential
clients = ~400 per management; gained ~10 clients / year over past 5 years; account holder base consists primarily of middle
to upper income individuals, in particular women who use cards primarily as brand affinity tools
Provides a comprehensive marketing mechanism at a more cost effective measure for small to mid size retailers, where most
of program’s cost is borne by the cardholder herself; per CEO: “What we found over the last 20 years is that a private label
cardholder will visit twice as often and spend twice as much as a very comparable bank cardholder.”
Bundled services provided to the retailer include: 1) credit to the consumer 2) payment processing 3) customer care / call center
4) direct marketing based on purchase history and payment statistics
In contrast to general card providers, ADS (due to its contractual relationship with the retailer) can marry consumer purchase
behavior with SKU level information, providing a large informational advantage for the company’s targeted marketing activities 
Closed loop network charges no / limited interchange fees to the retailer, freeing up incremental capital that retailer can spend
on further targeted marketing initiatives; thus retailer strongly favors private label card spending versus general cards
At program maturity, card revenues equate to 40% or greater of overall revenues for retail customers
Due to the embedded nature of its service and high value add at a cost efficient manner (ie high, measurable ROI), the company
has a 99% customer retention rate
• Per CFO: “Right now, we run low 40% return on equity [in cards]. During the worst of the great recession, mid-2009, we were
still generating over a 30% ROE and that was at the very worst of the economic cycle.”
 
LoyaltyOne 21% of revenue / 14% of EBIT / 16% EBIT margin for 2015
 
Operator of three coalition loyalty programs, where numerous vendors participate in a joint consumer rewards program issuing
points that are redeemable across the network of participants; typically involves one or two major retail vendors per category
(eg one national bank, one national grocery chain, one airline, one drug store chain, one gas station chain, etc)
As the manager of the program, ADS receives float from the timing disconnect of when points are issued versus when points
are redeemed (can extend out 3-4 years); programs are self funding, require almost no capital to operate, and generate
enormous float (negative working capital from deferred revenue) in the ramp stage
Air Miles Primary, national program in Canada used by ~70% (25 million members) of the population (36 million); has over
200 participating retail issuers
BrandLoyalty 70% current ownership; success based (consumer has to earn x amounts of points before rewards become
available) program operator for grocery channel in Europe; seeking to replicate a similar program in the US in 2016
Dotz: 37% current ownership; similar to Air Miles but in Brazil; from a standing start in 2009, the program had 6 million members
by 2012, and 18 million at year end 2015; management thinks a 25 million (versus Brazil population of 205 million) member
target by 2018 is achievable, equating to $600 million of revenues and $100 million of EBITDA for the entity
Coalition loyalty programs are rare assets and not many exist at scale; outside of ADS, other programs include Aeroplan in
Canada, Nectar in Europe, Club Premier in Mexico (all three owned by Aimia), Avios in the UK, Multiplus in Brazil, Plenti in the
US (launched by AXP in Spring of 2015) and Payback in Europe (acquired by AXP in 2011)
 
Epsilon 33% of revenue / 22% of EBIT / 17% EBIT margin for 2015
 
Operates outsourced (but non credit extending) loyalty programs and other targeted marketing activity for large consumer
focused companies; key clients include Kraft, Dell, Unilever, Ford, Toyota, AT&T, Dunkin Donuts, Citi, Wells Fargo, US Bank;
has >1,000 existing customers
A portion of segment revenue = general agency related services, which tend to be project based and drive lumpy revenues
Acquired digital ad placement and tracking firm Conversant (~40% of Epsilon segment EBITDA in 2015) in 2014 for 10x EBITDA;
>30% legacy EBITDA margins have been compressed under ADS’ ownership as management aggressively spends on new
customer growth, including headcount additions for awarded, but not yet revenue generative, contracts
The segment requires nominal working capital to operate
 
Value proposition of the company’s services summarized by the CEO: “The interesting thing about loyalty programs is that the more
challenging the environment, the more the client is willing to pour into these loyalty programs. And that's true in Europe, it's true in the
U.S. If you look at just your traditional retailers in the U.S., it's no different than in Europe that pricing power is short. There is no pricing
power. And as a result, these retailers need to make do with less, which means again getting back to how they're spending their marketing
dollars. They can't spend it. Everyone gets 20% off, come on in. That doesn't work effectively anymore. You're just going to crush your
margins. What has to happen is you need to segment your customer base into those customers who are enticed by being notified of the
latest goods have just arrived, come on in for a special viewing or whatever to 5% off up to 25% off. And if you do it that way, you're
basically optimizing the marketing spend of the retailer and the retailer can maintain some of their margin.”
 
Management team and Board are experienced and well regarded
 
•Board includes multiple partners of private equity firm Welsh Carson (ADS was formed in 1996 via Welsh Carson’s merging two
portfolio companies, JC Penney’s transaction services unit and The Limited’s credit card unit) and also include former VPs and
CFOs from FDC, ADP and AXP
CEO, 53, has been with the company since its founding, was previously the CFO from 2000 2009, and led the 2001 IPO
CFO, 55, has been CFO since 2009
Each of the three division heads has been with the company for at least 10 years
 
Management has a strong track record of capital allocation, clearly articulates their capital allocation priorities, and the company has
ample reinvestment opportunities at high incremental ROIC
 
Balanced current capital allocation with descending priorities of 1) investing in existing business 2) M&A 3) share repurchases
4) larger ownership of current JVs
Successful history of both acquisitions and organic reinvestment; management has not overpaid for acquisitions
Completed well timed, large share repurchases, including retiring 40% of the then shares outstanding during 2008/2009; has
repurchased a cumulative 25% of the shares outstanding since 2006 (offset = issuing shares for acquisitions and management
options)
Current organic investments include building out the support function (headcount, systems) for credit card portfolios started from
scratch or acquired within the last 1-2 years (maturity and scale usually achieved by year 3 or 4), recreating BrandLoyalty’s
grocery coalition loyalty program in the US, and cross selling Epsilon’s digital marketing services to existing retail card channel
customers
 
Catalysts for value creation and market recognition include:
 
Earnings multiple re rating as credit portfolio losses trend in line with management guidance
• Eventual consolidation of dotz JV onto company’s reported financial statements
Increasing ownership %s in existing, growing JVs
Future M&A
Ongoing share shrink
Potential acquisition target for larger players in digital marketing, loyalty or card services; specifically: AXP
 
Share ownership: management is aligned with shareholders
 
Insiders collectively own 2.5% of the shares outstanding, or ~$300 million
CEO has exposure to $45 million of shares
Short interest is low (4% of shares outstanding)
However, no notable 13F portfolios include a material position in ADS (both a pro and a con)
 
Contra thesis
 
The company’s operations are complex and can be confusing to both sell side analysts and investors
 
High returns on capital across all three business units may be overshadowed in favor of comping ADS primarily against the
lowest common denominator of its peer group, general purpose and co-brand credit card providers (65% of EBIT derived from
private label card segment)
Card company peers (SYF, COF, AXP, DFS) trade for low multiples (~10-12x EPS), and ADS may not re-rate to its former
multiple of 18-20x
Each of the three individual business units has its own growth, margin, working capital and funding profile, many of which move
in different directions from one another
•Formerly off balance sheet securitizations (which provide funding for the company’s managed credit portfolios) were brought
back onto the GAAP balance sheet in 2010; although non recourse to the company, may create challenges for the company’s
capital structure in the future and confusion around current enterprise value
 
ADS has been highly acquisitive since inception, making run rate FCFs, organic vs acquired revenues, etc hard to determine
 
Focusing on and digesting material acquisitions may distract management from their existing responsibilities
• Management’s preferred earnings metric = “Cash EPS,” which adds back both stock based compensation and amortization of
acquired intangibles; short sellers have repeatedly challenged this metric, and an additional accounting critique combined with
a weakening credit outlook could hurt company perception / valuation
Half ($175 million / 62 million shares = $2.80 / share) of the $350 million in LTM amortization relates to acquired credit card
portfolios (excess paid by ADS above book value of seller); ADS has been a serial acquiror of these portfolios
 
The company has material US consumer credit exposure, and the US credit cycle is beginning to weaken after a long expansion
 
From a high of 10% in 2009 / 2010 to a recent low of <4% in mid 2015, management projects credit portfolio loss rates to rise
in 2016 / 2017 to 5% / 5.5%
Each 10 bps move in loss rates = ~$0.14 of EPS (assuming no corresponding expense offset); assuming credit performance
weakened to the half way point between 2009 and 2015 (ie to 700bps vs 550bps for 2017), EPS would decline by ~$2 / share,
impairing projected 2017 EPS by 11%
 
Card industry competition is accelerating, and many of the company’s peers have larger capital and customer bases
 
• SYF, ADS’ only direct private label peer, recently spun out of GE where it was likely mismanaged; SYF management is now
incentivized, has their own currency, and competes at the margin for mid scale private label card portfolios
• AXP, a general purpose card operator, but also a manager of various loyalty programs (eg AXP’s Plenti coalition loyalty
program), has had rapid deterioration in its primary business and may disrupt overall card industry economics and relationships
as it searches for a panacea
 
ADS’ targeted end markets are cyclical, and the company has both customer and industry concentration risk
 
10 largest clients = ~30% of total revenues
Largest client (L Brands) = ~9% of credit card loan receivables
Auto sector = largest end market exposure for Epsilon (pre Conversant acquisition)
 
Company has material exposure to foreign currency movements, which have notably impaired revenue and earnings growth
 
Impact = $0.46 / share in 2015 (vs $15 reported EPS)
Primarily Canadian dollar related to Air Miles program and Euro related to BrandLoyalty program
Does not hedge currency
 
Financial performance summary:
 
Financial performance summary
 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

 Earnings multiple re rating as credit portfolio losses trend in line with management guidance
• Eventual consolidation of dotz JV onto company’s reported financial statements
 Increasing ownership %s in existing, growing JVs
 Future M&A
 Ongoing share shrink
 Potential acquisition target for larger players in digital marketing, loyalty or card services; specifically: AXP
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    Description

    Alliance Data Systems
    Investment Thesis
    February 2016
     
    Summary: ADS is a growing, capital light, high ROIC, well managed loyalty program operator, yet priced like a general credit card issuer
    standing in front of a consumer default wave. The company is on the right side of numerous trends, has experienced and incentivized
    management, and has created a very sticky yet rewarding mouse trap for its customers. Assuming continued growth in revenues, and
    FCFs are reinvested thoughtfully, the forward 11x earnings multiple materially undervalues the company.
     
    Industry and company are growing, capital structure is efficient, operations generate ample free cash flow
     
    As an outsourced provider of consumer loyalty and marketing programs, ADS benefits from growing, secular trends in the retail
    and payments industries that should continue indefinitely into the future. Targeted marketing driven by data and analytics is
    taking share from generalmarketing spend, the spend on both isvery large and increasing, and the function is vitalto the health
    of those companies purchasing it. Retailers are increasingly acceptant of and dependent on customer loyalty programs to cost
    efficiently drive sales. Private label credit cards are taking share from general purpose cards due to lack of interchange fees
    (these savings essentially redirected to fund retailers’ loyalty programs), increased tracking ability of consumer spending
    patterns, and the rise of digital wallets driving broader acceptance by consumers
    • The company’s revenues and FCF have tracked these trends, growing at CAGRs of 16% and 19%, respectively from 2006 to
    2015, and management has guided to continued growth through 2017
    The company is conservatively financed and has ample liquidity; gross leverage = ~2.75x, and the company has 10% of its
    market cap in cash
    Existing management is tenured and have been excellent allocators of capital
    Value disparity: the market is overly focused on potential consumer credit deterioration in the US generally, and confused by
    management’s guidance for increased charge offs in 2016 / 2017 specifically (due to expected seasoning of credit portfolios
    which started life 2-3 years ago, not worsening credit losses)
     
    Inexpensive valuation
     
    Contrarian viewpoint: Despite 64% of LTM EBIT coming from the private label card segment (including internal processing
    operation), the company should be primarily valued as an outsourced loyalty program operator and data / analytics provider
    with a small credit component attached as opposed to primarily as a credit card issuer
    Consistent high returns on invested capital support this viewpoint; after tax ROIC averaged 28% from 2006 - 2015
    At ~11x / 9x 2016 earnings / free cash flow, ADS is currently valued at or lower than multiples analogous to general purpose
    card comps AXP, DFS and COF, despite ADS’ focus on prime borrowers (700 FICO and above) only and low average balances
    (~$500 vs ~$5,000 for general purpose cards) in its credit book. Assuming credit portfolio loss rates of 700bps in 2017 (vs
    management guide of 550bps, and compared to 10% in 2009) and assuming no related expense structure offsets, 2017 cash
    earnings would be reduced by 11% to $17 / share, for an implied multiple of 11x 2017 earnings.
    ADS has historically traded at 18-20x forward earnings, in line with a peer group of asset light, transaction processing and
    business process outsourcing firms such as proxy peers FISV, FIS, EXPN.L, GPN, DNB, and ACXM
    • Hidden value: Dotz’ (Brazil coalition loyalty program described below) 37% ownership not reflected in financial reporting,
    potentially worth $0.60-$0.70 in earnings per share
     
    ADS owns a collection of high quality businesses
     
    Card services 46% of revenue / 64% of EBIT / 34% EBIT margin for 2015
     
    Operates 140 private label card programs for retail channel customers with >30 million card holders; total universe of potential
    clients = ~400 per management; gained ~10 clients / year over past 5 years; account holder base consists primarily of middle
    to upper income individuals, in particular women who use cards primarily as brand affinity tools
    Provides a comprehensive marketing mechanism at a more cost effective measure for small to mid size retailers, where most
    of program’s cost is borne by the cardholder herself; per CEO: “What we found over the last 20 years is that a private label
    cardholder will visit twice as often and spend twice as much as a very comparable bank cardholder.”
    Bundled services provided to the retailer include: 1) credit to the consumer 2) payment processing 3) customer care / call center
    4) direct marketing based on purchase history and payment statistics
    In contrast to general card providers, ADS (due to its contractual relationship with the retailer) can marry consumer purchase
    behavior with SKU level information, providing a large informational advantage for the company’s targeted marketing activities 
    Closed loop network charges no / limited interchange fees to the retailer, freeing up incremental capital that retailer can spend
    on further targeted marketing initiatives; thus retailer strongly favors private label card spending versus general cards
    At program maturity, card revenues equate to 40% or greater of overall revenues for retail customers
    Due to the embedded nature of its service and high value add at a cost efficient manner (ie high, measurable ROI), the company
    has a 99% customer retention rate
    • Per CFO: “Right now, we run low 40% return on equity [in cards]. During the worst of the great recession, mid-2009, we were
    still generating over a 30% ROE and that was at the very worst of the economic cycle.”
     
    LoyaltyOne 21% of revenue / 14% of EBIT / 16% EBIT margin for 2015
     
    Operator of three coalition loyalty programs, where numerous vendors participate in a joint consumer rewards program issuing
    points that are redeemable across the network of participants; typically involves one or two major retail vendors per category
    (eg one national bank, one national grocery chain, one airline, one drug store chain, one gas station chain, etc)
    As the manager of the program, ADS receives float from the timing disconnect of when points are issued versus when points
    are redeemed (can extend out 3-4 years); programs are self funding, require almost no capital to operate, and generate
    enormous float (negative working capital from deferred revenue) in the ramp stage
    Air Miles Primary, national program in Canada used by ~70% (25 million members) of the population (36 million); has over
    200 participating retail issuers
    BrandLoyalty 70% current ownership; success based (consumer has to earn x amounts of points before rewards become
    available) program operator for grocery channel in Europe; seeking to replicate a similar program in the US in 2016
    Dotz: 37% current ownership; similar to Air Miles but in Brazil; from a standing start in 2009, the program had 6 million members
    by 2012, and 18 million at year end 2015; management thinks a 25 million (versus Brazil population of 205 million) member
    target by 2018 is achievable, equating to $600 million of revenues and $100 million of EBITDA for the entity
    Coalition loyalty programs are rare assets and not many exist at scale; outside of ADS, other programs include Aeroplan in
    Canada, Nectar in Europe, Club Premier in Mexico (all three owned by Aimia), Avios in the UK, Multiplus in Brazil, Plenti in the
    US (launched by AXP in Spring of 2015) and Payback in Europe (acquired by AXP in 2011)
     
    Epsilon 33% of revenue / 22% of EBIT / 17% EBIT margin for 2015
     
    Operates outsourced (but non credit extending) loyalty programs and other targeted marketing activity for large consumer
    focused companies; key clients include Kraft, Dell, Unilever, Ford, Toyota, AT&T, Dunkin Donuts, Citi, Wells Fargo, US Bank;
    has >1,000 existing customers
    A portion of segment revenue = general agency related services, which tend to be project based and drive lumpy revenues
    Acquired digital ad placement and tracking firm Conversant (~40% of Epsilon segment EBITDA in 2015) in 2014 for 10x EBITDA;
    >30% legacy EBITDA margins have been compressed under ADS’ ownership as management aggressively spends on new
    customer growth, including headcount additions for awarded, but not yet revenue generative, contracts
    The segment requires nominal working capital to operate
     
    Value proposition of the company’s services summarized by the CEO: “The interesting thing about loyalty programs is that the more
    challenging the environment, the more the client is willing to pour into these loyalty programs. And that's true in Europe, it's true in the
    U.S. If you look at just your traditional retailers in the U.S., it's no different than in Europe that pricing power is short. There is no pricing
    power. And as a result, these retailers need to make do with less, which means again getting back to how they're spending their marketing
    dollars. They can't spend it. Everyone gets 20% off, come on in. That doesn't work effectively anymore. You're just going to crush your
    margins. What has to happen is you need to segment your customer base into those customers who are enticed by being notified of the
    latest goods have just arrived, come on in for a special viewing or whatever to 5% off up to 25% off. And if you do it that way, you're
    basically optimizing the marketing spend of the retailer and the retailer can maintain some of their margin.”
     
    Management team and Board are experienced and well regarded
     
    •Board includes multiple partners of private equity firm Welsh Carson (ADS was formed in 1996 via Welsh Carson’s merging two
    portfolio companies, JC Penney’s transaction services unit and The Limited’s credit card unit) and also include former VPs and
    CFOs from FDC, ADP and AXP
    CEO, 53, has been with the company since its founding, was previously the CFO from 2000 2009, and led the 2001 IPO
    CFO, 55, has been CFO since 2009
    Each of the three division heads has been with the company for at least 10 years
     
    Management has a strong track record of capital allocation, clearly articulates their capital allocation priorities, and the company has
    ample reinvestment opportunities at high incremental ROIC
     
    Balanced current capital allocation with descending priorities of 1) investing in existing business 2) M&A 3) share repurchases
    4) larger ownership of current JVs
    Successful history of both acquisitions and organic reinvestment; management has not overpaid for acquisitions
    Completed well timed, large share repurchases, including retiring 40% of the then shares outstanding during 2008/2009; has
    repurchased a cumulative 25% of the shares outstanding since 2006 (offset = issuing shares for acquisitions and management
    options)
    Current organic investments include building out the support function (headcount, systems) for credit card portfolios started from
    scratch or acquired within the last 1-2 years (maturity and scale usually achieved by year 3 or 4), recreating BrandLoyalty’s
    grocery coalition loyalty program in the US, and cross selling Epsilon’s digital marketing services to existing retail card channel
    customers
     
    Catalysts for value creation and market recognition include:
     
    Earnings multiple re rating as credit portfolio losses trend in line with management guidance
    • Eventual consolidation of dotz JV onto company’s reported financial statements
    Increasing ownership %s in existing, growing JVs
    Future M&A
    Ongoing share shrink
    Potential acquisition target for larger players in digital marketing, loyalty or card services; specifically: AXP
     
    Share ownership: management is aligned with shareholders
     
    Insiders collectively own 2.5% of the shares outstanding, or ~$300 million
    CEO has exposure to $45 million of shares
    Short interest is low (4% of shares outstanding)
    However, no notable 13F portfolios include a material position in ADS (both a pro and a con)
     
    Contra thesis
     
    The company’s operations are complex and can be confusing to both sell side analysts and investors
     
    High returns on capital across all three business units may be overshadowed in favor of comping ADS primarily against the
    lowest common denominator of its peer group, general purpose and co-brand credit card providers (65% of EBIT derived from
    private label card segment)
    Card company peers (SYF, COF, AXP, DFS) trade for low multiples (~10-12x EPS), and ADS may not re-rate to its former
    multiple of 18-20x
    Each of the three individual business units has its own growth, margin, working capital and funding profile, many of which move
    in different directions from one another
    •Formerly off balance sheet securitizations (which provide funding for the company’s managed credit portfolios) were brought
    back onto the GAAP balance sheet in 2010; although non recourse to the company, may create challenges for the company’s
    capital structure in the future and confusion around current enterprise value
     
    ADS has been highly acquisitive since inception, making run rate FCFs, organic vs acquired revenues, etc hard to determine
     
    Focusing on and digesting material acquisitions may distract management from their existing responsibilities
    • Management’s preferred earnings metric = “Cash EPS,” which adds back both stock based compensation and amortization of
    acquired intangibles; short sellers have repeatedly challenged this metric, and an additional accounting critique combined with
    a weakening credit outlook could hurt company perception / valuation
    Half ($175 million / 62 million shares = $2.80 / share) of the $350 million in LTM amortization relates to acquired credit card
    portfolios (excess paid by ADS above book value of seller); ADS has been a serial acquiror of these portfolios
     
    The company has material US consumer credit exposure, and the US credit cycle is beginning to weaken after a long expansion
     
    From a high of 10% in 2009 / 2010 to a recent low of <4% in mid 2015, management projects credit portfolio loss rates to rise
    in 2016 / 2017 to 5% / 5.5%
    Each 10 bps move in loss rates = ~$0.14 of EPS (assuming no corresponding expense offset); assuming credit performance
    weakened to the half way point between 2009 and 2015 (ie to 700bps vs 550bps for 2017), EPS would decline by ~$2 / share,
    impairing projected 2017 EPS by 11%
     
    Card industry competition is accelerating, and many of the company’s peers have larger capital and customer bases
     
    • SYF, ADS’ only direct private label peer, recently spun out of GE where it was likely mismanaged; SYF management is now
    incentivized, has their own currency, and competes at the margin for mid scale private label card portfolios
    • AXP, a general purpose card operator, but also a manager of various loyalty programs (eg AXP’s Plenti coalition loyalty
    program), has had rapid deterioration in its primary business and may disrupt overall card industry economics and relationships
    as it searches for a panacea
     
    ADS’ targeted end markets are cyclical, and the company has both customer and industry concentration risk
     
    10 largest clients = ~30% of total revenues
    Largest client (L Brands) = ~9% of credit card loan receivables
    Auto sector = largest end market exposure for Epsilon (pre Conversant acquisition)
     
    Company has material exposure to foreign currency movements, which have notably impaired revenue and earnings growth
     
    Impact = $0.46 / share in 2015 (vs $15 reported EPS)
    Primarily Canadian dollar related to Air Miles program and Euro related to BrandLoyalty program
    Does not hedge currency
     
    Financial performance summary:
     
    Financial performance summary
     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise do not hold a material investment in the issuer's securities.

    Catalyst

     Earnings multiple re rating as credit portfolio losses trend in line with management guidance
    • Eventual consolidation of dotz JV onto company’s reported financial statements
     Increasing ownership %s in existing, growing JVs
     Future M&A
     Ongoing share shrink
     Potential acquisition target for larger players in digital marketing, loyalty or card services; specifically: AXP

    Messages


    SubjectRe: Epsilon
    Entry02/10/2016 09:24 PM
    MemberBluegrass

    My sense: Epsilon approaches their target customer base in a more tailored manner than ACXM and EXPN, seeking to provide a fully outsourced marketing service that is primarily loyalty driven, rather than providing a scrubbed data set that the customer then utilizes to drive their own marketing effort (that customer then manages themselves). So Epsilon has the same data aggregation and analysis focus as the others, but they attempt to monetize it via a recurring service program to the customer.

    I think the Ford and Toyota relationships for Epsilon are good case studies. A large portion of an auto dealer's revenue (and even larger % of gross profit) comes from maintenance work of cars still under OEM warranty. Ford and Toyota outsourced the marketing and customer relationship function for its dealers here, with Epsilon managing a consumer loyalty program aimed at keeping car owners' maintenance business in house and on a scheduled, recurring basis. So Epsilon is utilizing all of the online and offline data it has in its standalone database on the dealer's specific customers to target them with direct marketing to get them into the dealership for an oil change...but it then also gets proprietary data from the customer's visits to the dealership. Due to agreements w the OEM, third parties dont have access to this flow of transaction data, so Epsilon can keep iterating its marketing to this captured consumer with more recent and actionable data than competitors.

    AXCM suffered through a lot of poor M&A and management turnover over the past few years, trying to transition from being a commodity type data provider to something more valuable and differentiated (I think). Weak recent M&A experience could also be argued for Epsilon, and the unit has certainly been the weakest leg of ADS' stool. But Epsilon has benefitted from cross selling existing Card or LoyaltyOne customers, and this is where management's focus is at the moment.


    SubjectRe: Re: Epsilon
    Entry02/10/2016 11:09 PM
    Memberstraw1023

    As bluegrass says, Epsilon offers the full integrated consulting. They purchase datasets from Acxiom and Experian as part of that analysis. So Epsilon will work wth a customer to tell them exactly what offers and what catalogs to send to a particular customer. 

     

    The others are data providers. I have been baffled for years as to why Acxiom could never figure out how to leverage its dataset into a better business. It seems like they hold a key piece of the equation but it never works out that way for them.


    SubjectLoyalty will become payments' killer app
    Entry02/13/2016 01:59 PM
    MemberBluegrass

    "Data – and the creative use of that data — has the ability to... inspire the frequency of use that builds preference, engagement and loyalty. Loyalty programs alone can’t deliver that since there’s no ability to close the loop. And payments platforms alone are limited in their ability to deliver that since there’s no incentive, outside of acceptance, to build a base. But together they can change the consumer dynamic for their mutual benefit.

     

    Loyalty can become the killer app for digital payments in much the same way that points were the killer app for card acquisition back in the day. Creatively integrating loyalty capabilities into payments apps can help retailers get what they want — data on consumer behavior in their stores and a way to communicate with them – and consumers what they want – a benefit for being a loyal customer – and payments apps players what they want – adoption of their payments method online without violating consumer privacy or data security."

     

    http://www.pymnts.com/news/mobile-commerce/2016/the-six-things-that-will-define-payments-in-2016/

    Related to point #1 in that article, the CEO speaking at a conference in Sep 2014:

     

    "But little known fact to a lot of folks is that almost a third of our sales in the stores are without a card today. In other words, most people, or a big chunk of people, walk into Ann Taylor, for example, and just say, oh, heck, I forgot my card, flash their license, and I'm pretty sure people are going to need to carry their license or scan it in, and we just look it up and that's how we get your card."

     

    Related to point #4, from the Q4 2015 earnings call:

     

    "40% of our credit sales were online for the fourth quarter of 2015"


    SubjectHow mobile payment acceleration aids private label card adoption / value prop
    Entry02/13/2016 02:15 PM
    MemberBluegrass

    from Sep 2015 DB Tech conference:

    <Q - Ashish Sabadra>: Okay. That's helpful. Question on mobile payments, can you just talk about how the private label fits in with the whole Apple Pay and the Android Pay, Samsung Pay that we are hearing and also merchants-owned mobile payment strategy?

    <A - Charles L. Horn>: We personally believe [merchants will] look for individual solutions and the individual application that can be used to drive their loyalty program, an individual app that could be used to apply for credit, an individual app that can drop a virtual card, so when you walk in the store, it geo-fences you, you walk up to pay and that's your default card at your point of sale. We believe those are really the key advantages. 

    So, retailers are always trying to get to know more about you. They'll ask you for your phone number. They're asking you for your email address. They're always wanting to know more about you. If they went in the purest form of tokenization, they could lose insight as to who you are. Now, we have some clients over on the Epsilon side, they still work around it, and you may have run into this before, where if you go up and you want to do your Apple Pay at the point of sale, they still make you to scan your loyalty card or put in your phone number. That way, they can still capture who you are, know you're in the store and basically allocate what you bought to you as a client.

    So, from a convenience standpoint, it's not any more convenient than pulling out your card except for it provides card not present. Card not present is really not too big of a deal these days; probably about 35%, 40% of our spend right now is card not present. You have the ability to go into a store. We're tied into the POS. You can do a POS lookup, show your driver's license, make a spend. You can do it in-app. You can do it online. So, really, card not present is becoming less of an issue. So that's why I gave you a long-winded answer of saying we don't really know. It's going to come down to our clients wanting it and we believe our own clients will look for individual solutions versus a more generic solution.

    <A - Tiffany Louder>: Yeah. And just real quick, a trend that we're seeing on the Card Services side is 10 of our top 20 clients have asked us to design apps for them. So that just shows that we're seeing they want to get close to their customers to really build their brand affinity that way rather than going to a wallet of some sort.

    <Q - Ashish Sabadra>: That's very helpful. And then quickly on the mobile, how is that help you on the activation side? You can just talk about the activation and how that's helped you create new users?

    <A - Charles L. Horn>: It's actually quite effective. Think of it this way. If you were a little bit worried that your FICO equivalent would be good enough, historically, you would have had to go up to the point of sale to apply for credit. If you were at the point of sale and you have a number of people stacked up behind you and you get basically rejected for whatever reason, that could be a little bit of an embarrassment factor. Or it could be a case, it's the holiday season, you get a sales clerk up there. You got customers stacked up 12 deep. They really don't want to ask if you want to apply for the card today, because it will slow down the process.

    So, the ability for us to do it now where you can sign up for it online or with the mobile app; you could be the store, it could be a clothing store, you walk in to the dressing room and secure our code on the wall, scan your smart device. Within 30 seconds, you know if you're approved. And importantly, you know what your credit limit is.

     

    If you know what your credit limit is while you're still shopping, what does a consumer do? He or she buys more. So, the average initial ticket when you apply for a credit online is about 20% higher than it is if you've done it at the point of sale. So, we do think it facilitates, obviously, efficiency within the retailer and it drives a higher ticket for us, which is very advantageous.


    Subjectre: RSAs
    Entry04/17/2016 02:59 PM
    MemberBluegrass

    Nails - thank you for continued interest. Find my analysis below. I *think* you highlighted a competitive advantage that supports ADS having some sort of moat, rather than discovering a source of potentially eroding economics. Based on your conversations with the company, please share management’s feedback (and yours) on related strategy in this thread, especially if contra.

     

    Surface logic supports a card co having a retailer share arrangement with its retail partners: the more interest and fee revenue the card company makes, the more cash is funneled back to the retailer, confirming that partnering with said card company was a good idea, motivating retailer to seek more credit related sales, driving more fees to card co, etc etc spin the flywheel. In this relationship, the retailer believes the card co’s primary value proposition = credit extension to its customer base, monetized via finance charges and transaction fees, and the retailer wants its fair share of the honey pot.

     

    ADS pitches a different value proposition to retailers, and they monetize it via a service bundle (which always helps obscure relative pricing from the client’s POV). ADS targets what the client really values: higher SSS. Instead of paying out a revenue share, ADS reinvests money they would have paid out to the retailer into ADS’ own internal operating expense, supporting the marketing and loyalty programs they manage for the client. When an RSA relationship is present, funds received by the retailer from RSA payments may or may not be channeled back into card promotions. In contrast, ADS determines their own expense levels and what constitutes a fair ROI on their spend, versus having a third party in the kitchen impacting how marketing dollars are spent, or whether they are spent at all.

     

    From an economic standpoint, a retailer share arrangement disincentivizes the card provider from achieving the best outcome for the retailer, assuming there is usually a threshold that must be achieved before the retailer gets its split, as is the case for SYF (1). If the card provider receives 100% of (n), but only 80% of the >(n) cohort, theoretically they wont be working as hard for the marginal dollar of revenue above threshold. Conversely, if higher overall sales are the retailer’s primary goal, then the services ADS provides are 100% economically aligned with the retailer, especially when considering how ADS goes to market (ie credit agnostic, providing customers w outsourced loyalty programs with no credit component if a better fit for customer's goals).

     

    From a competitive standpoint, if the card company doesn’t have to give up a revenue share to its win / maintain client relationships, it wont. Another sign of relative weakness in the customer relationship / value proposition could be how terms of the RSA are determined; again see SYF for an example (2). Viewed through the lens of SYF’s increasing payout of its net interest income (17% paid out to retailers in 2011 vs 23% in 2015), the composition of its largest customers (Walmart, Lowes), and recent customer wins (Amazon), its easy to pick one private label credit card revenue model over the other, given the choice.

     

    Some related questions are a) how much more runway does ADS have with existing and new SME customers whose internal marketing and loyalty capabilities are inferior to ADS’ ? b) what is the customer size tipping point for ADS increasingly overlapping with larger card only comps eg SYF, and are we already there on a new customer basis? c) will ADS feel pressure to accept economically inferior retailer customer relationships going forward, and eventually disintermediate their own service bundle in the name of growth? I don’t view any of these as material threats over the next few years, but also don’t have concrete data to defend my view.

     

    1 “Most of our Retail Card program agreements and certain other program agreements contain retailer share arrangements that provide for payments to our partners if the economic performance of the program exceeds a contractually defined threshold. These arrangements are designed to align our interests and provide an additional incentive to our partners to promote our credit products. Although the share arrangements vary by partner, these arrangements are generally structured to measure the economic performance of the program, based typically on agreed upon program revenues (including interest income and certain other income) less agreed upon program expenses (including interest expense, provision for loan losses, retailer payments and operating expenses), and share portions of this amount above a negotiated threshold.”

     

    2 “The threshold and economic performance of a program that are used to calculate payments to our partners may be based on, among other things, agreed upon measures of program expenses rather than our actual expenses, and therefore increases in our actual expenses (such as funding costs or operating expenses) may not necessarily result in reduced payments under our retailer share arrangements.”


    SubjectRe: SYF readthru
    Entry06/19/2016 05:45 PM
    MemberBluegrass

    I think this is SYF's management transitioning into becoming a public company management team. After bouncing around cycle lows during 2H 2015, the slight credit deterioration trends were present in Q1 for SYF, sparking many related analyst questions / comments. ADS mgmt communicated a slight rise (1) in forward loss rate expectations during its Q4 call, before it became apparent in the data. SYF mgmt did the opposite. 

    I dont see any weakness in ADS' card division at the moment. Would appreciate others' thoughts.  

    (1) Not driven by weakened consumer credit, but from maturing of older portfolios and mix shift in overall credit book


    SubjectZales
    Entry06/19/2016 06:42 PM
    MemberBluegrass

    ADS signed an agreement to takeover Zales' private label card offering in 2013, with a targeted go live date of Oct 2015 (post prior financing partner contract expiration). In the interim, Signet Jewelers acquired Zales. Signet provides in house customer financing to its non Zales brands (72% of revenue = non Zales). The Zales brands utilize third party credit programs provided by Comenity (ADS) in the US and TD Bank in Canada.

    Using data from Signet's 10K on its own customer financing programs, and specifics provided for the Zales portfolio, I estimate Zales US sales = $1.5b, Zales US credit sales = $620m, and Zales US credit receivables balance = $475m. Weighed against ADS' May 2016 card receivables balance of $13.5b, Zales could account for as much as ~3.5% of ADS' run rate cards business, or ~1.6% of ADS total company revenue.

    The receivables transfer did not occur until January 2016. Loss rates for Signet's in house credit portfolio have averaged ~100% higher (ie 9-10% vs 4-5% for ADS) over the past 2 years. With recent scrutiny around Signet, and materially weaker credit performance at their in house financing operation,  I assume ADS' mgmt was cautious when evaluating and purchasing this legacy portfolio. FWIW, ADS' average card receivables balance increased by $384m from Dec to Jan (vs my estimate of $475m above related to Zales).

    Some related commentary is here https://thecapitolforum.com/wp-content/uploads/2013/12/Signet-2016.02.24.pdf , which suggests Signet's in house finance arm may become a larger portion of Zales' customer financing going forward as ADS installs tighter underwriting. 


    SubjectRe: Re: Zales
    Entry06/22/2016 08:23 PM
    MemberBluegrass

    No real value add from me here. Sorry.


    SubjectValueAct files 13D
    Entry07/11/2016 11:57 AM
    MemberBluegrass

    Discloses 6.8% ownership

    Reporting Person          Trade Date             Shares          Price/Share
    ----------------          ----------          ------------       -----------
    ValueAct Master Fund      06/15/2016              35,300           $200.99
                              06/15/2016             137,000           $200.87
                              06/15/2016             210,000           $200.12
                              06/15/2016              63,000           $200.80
                              06/15/2016              15,580           $200.70
                              06/15/2016              75,000           $200.89
                              06/21/2016              80,000           $197.78
                              06/21/2016             120,000           $198.26
                              06/22/2016             125,000           $200.07
                              06/23/2016              63,000           $200.94
                              06/24/2016             100,000           $194.92
                              06/24/2016             112,000           $195.43
                              06/27/2016             150,000           $188.36
                              06/27/2016             150,000           $187.25
                              06/27/2016             112,560           $186.66
                              06/28/2016              50,000           $187.18
                              06/28/2016              50,000           $188.24
                              06/28/2016             100,000           $187.55
                              06/29/2016              50,000           $190.11
                              06/29/2016             155,000           $192.59
                              06/30/2016              75,000           $192.51
                              06/30/2016              16,000           $194.22
                              07/01/2016             100,000           $195.63
                              07/01/2016              50,000           $195.31
                              07/05/2016             150,000           $193.40
                              07/05/2016             100,000           $193.30
    ValueAct Master Fund      07/06/2016              12,090           $193.89
    (cont.)                   07/06/2016             100,000           $194.97
                              07/07/2016             200,000           $198.00

    SubjectCitron short thesis
    Entry08/19/2016 11:19 AM
    MemberBluegrass

    http://www.citronresearch.com/wp-content/uploads/2016/08/ADS-final_a.pdf

     


    SubjectRe: Re: Citron short thesis
    Entry08/22/2016 11:58 AM
    MemberBluegrass

    Always appreciate shorts making their work public. This specific analysis was light on substance, sloppy in form, and primarily a re hash. But it did bring up two themes worth evaluting: 1) what is the correct industry classification? 2) for a co with off balance sheet leverage, what is the correct way to evaluate FCF and capitalize it in valuation?

    Citron argues ADS is a bank, not a technology company, and should be valued as such. Ive argued for a hybrid, and implicit to that is an argument for earnings multiple expansion (and/or mean reversion). It would be much easier to claim ADS is a technology co if it were 2005, or 2010 (based on relative industry perceptions, not a negative change at ADS). And despite 40% of ADS' end credit sales coming via online channel, their customer base = brick & mortar retailers, which also doesnt inspire a technology multiple. Based on ADS' returns on capital through the cycle, customer retention and ongoing diversification away from PL cards, I think the co deserves a multiple higher than a TBTF bank or a general issuer credit card. However, with the recent (albeit small, telegraphed and explained by management) rise in credit delinquencies, the market is focused on credit risk, and "credit risk" sounds like "bank." 

    Citron argues that management overstates actual FCF generation, and conveniently changes the way they communicate the calculation when it suits their goals. Ive never seen or heard this from management, and think the FCF is straightforward. But their FCF does benefit greatly from the relationship w Comenity, and despite protections in place walling off capital light ADS from its capital intense cousin, there will always be some overhang on the stock from fear of a cascading credit event and potential putback liabilities. Add in the other, non card businesses (Epsilon, Loyalty One) to the mix, and ADS remains a complicated, confusing story that takes a lot of work to understand.

    Summary: The long thesis is driven by multiple expansion to a greater degree than I initially realized, and the event path of complexity > less complexity > little complexity has not yet materialized. ValueAct putting a stamp on future capital allocation and explaining the investment thesis to investors should help, as should continued benign credit conditions. ADS performed well in Q2 despite poor macro ex US, and management has ramped up their capital return to shareholders, which worked out well the last time credit risk was an issue for the market.

     

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