ALLIANCE DATA SYSTEMS CORP ADS
August 03, 2019 - 10:29pm EST by
rickey824
2019 2020
Price: 155.00 EPS 20 0
Shares Out. (in M): 53 P/E 8x 0
Market Cap (in $M): 8,153 P/FCF 8x 0
Net Debt (in $M): 3,896 EBIT 0 0
TEV ($): 12,049 TEV/EBIT 0 0

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Description

DISCLAIMER: The author of this posting and related persons or entities ("Author") currently holds a long position in this security. The Author makes no representation that it will continue to hold positions in the securities of the issuer. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The views expressed in this note are the only the opinion of the Author.  The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the below note.

Investment thesis 

Alliance Data Systems Corporation (ADS) is the second largest, pure-play Private Label Credit Card (PLCC) company, focusing on mid-sized consumer-based businesses (mainly retailers) with a focus on creating and managing loyalty programs and marketing campaigns that have proven to drive sales. ADS has a smaller subsidiary called Loyalty One (LO) which represents ~17% of PF operating income and is likely going to be divested soon. The bulk of our thesis and valuation focuses on Card Services (CS), which houses the PLCC and co-brand card business.

With its differentiated capabilities and go-to-market strategy, the company has developed a product that adds tremendous value to their customers. CS pays its customers for a service that usually costs them money (i.e. processing credit card transactions), while also providing customers with best-in-class marketing, loyalty, and analytics programs that drive sales. Our research suggests that no other PLCC/co-brand provider is able to do this as effectively as ADS. That competency, along with the company’s position with mid-sized retailers (which have less negotiating power), has allowed the company to achieve average ROEs of 46% over the last five years at the corporate level and 25% in CS while growing rapidly (we allocate most corporate expenses to CS). 

We believe ADS will continue signing new customers and growing its credit card receivables while maintaining industry-leading economics. The service it offers is increasingly relevant to certain retailers facing competitive pressures in an increasingly digital world. Furthermore, as the retail landscape changes, newer concepts, which are unlikely to have an existing PLCC/co-brand credit card offering, will continue to gain market share opening up a new channel for ADS. 

The company is able to achieve outsized returns on capital because it is able to create more revenue from each dollar of receivable it lends (~25% receivables yield vs ~17% for competitors) by driving increased sales through a combination of its analytical capabilities, resource allocation, a plethora of first-party consumer data, and willingness to underwrite a bit deeper in the credit spectrum (more on this later). The extra sales benefit both the retailer (increased sales growth) and ADS (higher revolve rate on which ADS earns interest) creating a win-win situation. 

A combination of market structure, and competitors’ inability to make money at scale in ADS’ territory, should keep other credit card issuers from encroaching ADS’ niche. ADS’ main PLCC/co-brand competitors, the money center banks (COF, C, AXP, WFC) and Synchrony Financial (SYF), compete in different segments of the market and have a different go-to-market strategy, which has caused them to evolve their product offering differently.

Concerns related to the credit cycle and the current retail environment, along with a lack of former management credibility (caused by missed guidance and other unforced errors), and a sudden CEO change, enables us to buy this business at 8x 2019 P/FCF. We believe the company is well insulated from a credit downturn and that it is likely to emerge stronger relative to competitors. Furthermore, the weak retail environment for ‘legacy’ retailers will have a limited effect on company profitability. Lastly, we think the CEO change is likely a positive for the company. Overall, we see ADS compounding FCF per share in the low to mid-teens through a combination of organic growth in CS, and buybacks.

We believe ADS is worth approximately $337 per share or 117% above current levels. As our base case valuation suggests, we see ADS shares as a great risk/reward around current prices. However, it is important to recognize that there is a higher than average level of uncertainty in this business given management’s unforced errors and changes in the client base. Our diligence gives us a good degree of comfort around those items, but it is important to note that the range of outcomes here is wider, and the position should be sized accordingly. Our valuation is predicated in the following three points:

  1. ADS’ ability to drive a higher revolve rate and pay lower RSAs are the result of a structural competitive advantage over competitors, which will allow ADS to maintain its superior economics.

  2. Continued growth in the PLCC industry, along with ‘tender share’ gains on new signings should facilitate a high-single/low-double digit revenue growth rate for ADS CS.

  3. There is a large cushion in the business’ economics and balance sheet to weather a large credit cycle downturn.

Company description (Note: Some of the below can be found in previous write-ups of ADS. Feel free to skip this section if you are already familiar with the company). 

Card Services (CS) (81% of revenues, 83% of operating income): CS houses the company’s PLCC (80% of receivables) and co-brand credit cards (20% of receivables). This is the company’s crown jewel.  The division handles most of a retailer’s PLCC program, including receivable financing, delinquency risk assumption, new account opening, bill/remittance processing, and customer care. The division also takes an active role in the customer’s marketing strategy and loyalty program. 

Relationships with clients (i.e. retailers) in this business start when a retailer decides to either sell its existing or start a new credit card program. PLCC/co-branding programs are financially and strategically attractive to retailers for a number of reasons that we will touch upon on thesis point 2. A retailer typically enters into 5-15 year contracts with the selected card issuer. ADS’ relationships tend to be quite involved as they look to add value to the client operationally. The industry, and ADS in particular, has high renewal rates given the value added and the disruptive nature of switching providers. ADS’ retention rate was at 99% before 2017, though this figure has fallen recently due to customer bankruptcies, liquidations, acquisitions, and sales.

ADS CS makes money by lending on an unsecured basis to cardholders (the retailer’s customers) and earning fees and/or interest on late payments and unpaid balances. Cardholders benefit from promotions and loyalty benefits they would not receive from a general purpose credit card, which allows ADS to drive further sales. Expenses in this segment include loss provisions, interest expenses, payments to retailers (via revenue/profit share agreements or “RSAs”), and general and administrative expenses. The resulting profit is generally measured against the value of the receivables balance to arrive at an ROA or against the book equity value, which results in an ROE. ADS’ CS ROAs average around 5% (vs SYF below 3%) and ROEs around 25% (vs SYF around 17%). 

PLCC can only be used at the respective retailer. As it is a closed loop system, ADS represents all sides of a transaction and no interchange fees are paid whereas co-brand runs through Visa and MasterCard and can be used anywhere.

Loyalty One (9% of revenues, 17% of operating income): Loyalty One is composed of Air Miles and Brand Loyalty. The company is likely to divest this business in the near term. As the division comprises just ~13% of our current valuation, our price target is not particularly sensitive to the performance of this division. 

  • Air Miles Reward Program is Canada’s biggest full-service outsourced coalition loyalty program with two-thirds of Canadian households actively participating in it. The way the program works is that it has sponsors (usually retailers) that give points to collectors (the retailer’s customers), which can be redeemed from suppliers (such as airlines, consumer electronics, etc) or cash. Air Miles manages the program and gets paid every time points are issued by sponsors and is liable for points redeemed; the difference between the two is ADS’ margin. Network effects are important in this business. There are only two scaled loyalty coalition programs in Canada and Air Miles is the leader. 

  • BrandLoyalty is a European based Loyalty company that has developed a niche in instant loyalty promotions within the grocery vertical. The division manages a program that provides instant rewards to a merchant’s customers based on the amount they spend. The programs last between 12 and 20 months and the division usually gets paid based on its success managing the program, which is measured by the number of customers who get to reward minimums. 

Thesis points

  1. ADS’ ability to drive a higher revolve rate and pay lower RSAs are the result of a structural competitive advantage over competitors, which will allow ADS to maintain its superior economics.

ADS’ ROEs are a clear invitation to competitors. However, our research suggests that a competitor would have to have a willingness to dedicate a lot of resources and probably lose money for some years for the prospect of limited returns. Those prospective limited returns are themselves pretty uncertain given the difficulty to unseat the entrenched incumbent in a relatively small market with high switching costs. 

ADS’ unique expertise driving retailer sales (which is a major driver of profitability) is likely the result of its history. ADS was formed in 1996 through the merger and subsequent carve-out of J.C. Penney's credit card processing unit and The Limited's PLCC operation. On the other hand, its competitor’s businesses were built with the intention of providing a purely financial product largely housed within larger financial services businesses.

ADS has data scientists and marketing people sitting at the retailers customers’ offices whose only job is to help increase sales. These employees work with tools that have been fined tuned for decades. The tools are fed with first and third-party data from a large number of industry participants and ADS is able to test promotions on a much larger sample size than a retailer could. For example, L Brands knows about Jane Smith’s purchasing behavior at L Brands, but ADS knows Jane’s purchasing behavior at L Brands, Ulta, Williams Sonoma, Wayfair, and Century 21 amongst many others. Not only does ADS know her spending habits better than the retailer, but they also know more people with similar spending habits, have done thousands of samples on them and, therefore, know with higher accuracy what drives them to make a purchase decision. This dataset would be extremely difficult to replicate in the verticals where ADS has a strong presence such as apparel, furniture, and jewelry. 

We have seen a number of statistics that illustrate ADS’ superiority when it comes to driving customer sales. For example, we have heard that ADS’ “average cardholder uses her card 8-10 a year whereas the industry average cardholder uses her card twice” and that “what we found over the last 20 years is that an ADS private label cardholder will visit twice as often and spend twice as much as a very comparable bank cardholder”. Most importantly, ADS’ customers buy into its value proposition, and ADS knows how to sell themselves extremely well. 

During the course of our research, we heard from a number of former customers regarding the positive impact that ADS has had on their organization. The below excerpt from Victoria Secret’s former CEO helps illustrate this point. The comment is a response to a question about the company’s Angel Card and loyalty program, which are both managed by ADS.

So I'd say the things that are most effective is when we are really doing consumer relationship marketing. And when we do that, we actually speak to her in a way that resonates, and then she responds. And we're able to build and have shown that we can build loyalty with her. So promotions that really attract her for bras or products that she's already bought from us, we build upon that knowledge. We have a ton of data about who's buying from both stores and online. And we direct messaging, recommendations and products that she'd be interested in. When we offer her that opportunity with varying degrees of brand-accretive moments, she comes in and responds. That's when we're most effective. -- Jan Singer -- Q4 2017 Earnings Call, Mar 01, 2018

ADS’ ability to drive sales is important in helping the company achieve outsized returns on capital because it allows it to achieve a higher revolve rate. ADS’ average revolve rate is an industry-leading 80%. SYF is second at around 50%. For context, the below graph shows the revolving rates for the industry. 

The below table for ADS shows the stability of the yield generated through the cycle measured through its NIM.

The key question is what it would take to replicate ADS’ first-party data, industry-leading marketing/analytics capabilities, and culture focused on helping customers drive sales. We believe that the required investment (both money and time) are not justified compared to the size of the market at ~$35bn (of which ADS is $17bn). 

ADS’ average receivables book is around ~$100mm of receivables. They have around 160 clients and $17bn of receivables, all from small/mid-size retailers. That is a contrast to SYF who has $91bn in receivables with the top 5 retailers representing 44% receivables and yield. It would take SYF 36 new signings a year of $100mm files for SYF’s revenue to increase 5% (assuming $18bn in revenues and 25% yield on receivables). There is nowhere near 36 new available deals of that size in the market in any given year. 

Turning to the economics of getting to a similar offering, ADS has a 5%+ per receivable margin advantage to the competition (the massive yield advantage is somewhat offset by higher delinquencies and funding costs). Part of that excess margin is used to enhance ADS’ non-card capabilities that help drive sales and ROEs. This leads to ADS having higher G&A per receivables than its competitors (hiring high quality marketing and computer science employees). A competitor who wants to copy the offering would have to match that G&A spend for years without seeing a return. We believe that if a competitor wanted to recreate ADS’ analytical/value-add capabilities, it would have to invest 1%-2% per receivable in G&A. Most competitor’s credit card ROAs are right around there, which means they would have to be willing to operate at significantly reduced margins for years. 

Lastly, it is unlikely that ADS’ competitors’ clients, which are the country’s large retailers, would be interested in these unproven capabilities as customer loyalty is already a core competency of a typical large retailer. As a result, that money would be spent to develop a product and go-to-market that is not in sync with the needs of the majority of their existing customers in hope of acquiring a new customer base. 

ADS’ smaller customer base and average cardholder balances are also important contributors to the higher yields and lower RSAs. These are customers and balances that are limited in nature and whom ADS has been nurturing for years. ADS’ average receivable balance is $762 compared to SYF’s $1,000+. Money center banks’ average receivable is typically much larger. We estimate that LB’s file generates 13% mid-cycle ROAs and ~$300 monthly cardholder limits, making it likely the most profitable file in the industry. The smaller the balance the more meaningful the fixed late fee becomes relative to yields and the more likely someone will forget to pay their bill. 

Given ADS’ competitors’ size, they tend to focus on big retailers who mostly focus on economic terms and do not look to their issuer to help them operationally. These banks’ ideal clients are Amazon, Costco, Home Depot, Best Buy, etc. Smaller clients, who value the added services, are a drain on resources for them; RFPs are involved and take months to complete, implementation takes time, and teams need to be built around retailers. 

Given the aforementioned, we are comfortable that ADS CS economic moat is unlikely to be encroached in a meaningful way in the near to medium term. As a result, the company should be able to continue to earn excess returns relative to peers, generating >20% ROEs within the CS division. 

  1. Continued growth in the PLCC industry, along with ‘tender share’ gains on new signings should facilitate a high-single/low-double digit revenue growth rate for ADS CS.

PLCC and co-brand cards present a number of benefits to retailers: it gives them a stream of cash flows through the RSAs at virtually no cost, it saves them the interchange fee that is usually paid to the payments ecosystem, and, if done correctly, helps increase loyalty and sales. 

This attractive value proposition has fueled significant growth for the industry. The two graphs below (while a little dated) show the growth that PLCC/co-brand have enjoyed. That growth has come from both new retailers entering the business as well as increased penetration with pre-existing clients.

cid:image014.png@01D37FC1.2A42E880

Given its value proposition and strong execution, ADS has been growing much faster than the market. From 2011 to 2018, the company grew average receivables at a compounded rate of 18%. This growth has mainly come from new customers and ‘tender share’ gains. According to our estimates, ADS’ current market share hovers around 18% of the market whereas in 2011 it was only 5%. Some of that growth has leveled off and the company is likely to have no revenue growth for the year. The leveling off is a combination of getting rid of legacy retailers that aren’t growing, along with a number of retail bankruptcies, liquidations, and M&A. While there will always be retailers struggling in the current retail environment, the company will exit the year with a significantly improved mix of clients who are only now starting to scale. 

For a new program, once a deal is done and the program implemented, it takes about three years to ramp up, arriving at an average tender share of 33%. This means that we have relatively good visibility into growth for the next two years. The deals signed in 2017 are expected to generate $2bn in excess receivables once fully ramped. 2018 was an unprecedented year for new signings and is expected to generate close to $4bn in receivables. That is a large pipeline of expected receivables for a company with $17bn of receivables. 

Even if we experience headwinds from retailer-specific issues as were experienced in 2018, the company should still grow  due to the impact of the new signings, the tender share gains, and a group of newer clients that are growing fast. New client credit sales (2015-2018 signings) are growing fast and should represent ~50% of total receivables by the end of 2020. Those new files are made up of growing retailers such as Ulta, Wayfair, and Ikea, among others. The portfolio is likely to continue to de-risk over time. On the flip side, the economic characteristic of some of these new files and verticals are not as proven as specialty retail. We gain comfort in the fact that even if the economics of the new files are not as good, they are likely going to be better than SYF’s (given thesis point #1) who already has exposure to a lot of these verticals. Therefore, even if the company is wrong when saying that the new files will have the same ROEs as the previous ones, we think the surprise to the downside still leaves us with high teen ROEs.

  1. There is a large cushion in the business’ economics and balance sheet to weather a large credit cycle downturn.

As a credit business that earns ~25% yields on receivables, understanding the potential impairment risk in a downturn is a primary concern. That job is made difficult by the lack of granular information on the credit characteristics of the portfolio. In addition, today ADS has four times as many receivables as they had in 2008.  Both of these limit our ability to stress the business in a Financial Crisis type scenario. Given those limitations, we focused on understanding the probability of delinquencies being worse in another Financial Crisis, as well as stressing the balance sheet to understand what it would take to impair it. Our analysis suggests that it would be difficult to take a view on how delinquencies will behave in another Financial Crisis, albeit the risk of a significantly worse performance seems unlikely. However, and most importantly, the company should be able to weather higher loss rates than those experienced in the financial crisis.

ADS has higher mid-cycle delinquencies at around 6% than competitors, with SYF around 5% and the money center banks around 4%. Conventional wisdom suggests that difference would widen in a financial crisis. However, ADS’ peak charge-offs in the Financial Crisis were slightly better than the industry’s charge-offs. The below two graphs compare ADS’ World Financial Trust to the rest of the industry. Note that the below graphs use gross numbers for the industry (second graph) and net for ADS (first graph), if we normalize the industry’s assuming 25% recoveries, we see that net charge-offs peaked around 12% for the industry whereas ADS’ peaked below 11%.

cid:image004.png@01D395F8.4A4AA3F0


The large increase in receivables, from $4.5bn in 2008 to $17bn today, means that the majority of current cardholders were not cardholders in the last downturn.  We have identified four areas that can help identify a possible change in the credit quality of the receivables: (a) private label to co-brand mix, (b) the demographic characteristics of the new retailers, (c) underwriting culture/parameters, and (d) the size of the average receivable. As we go through them it will become evident that the growth in receivables is likely neutral-to-positive on the composition of the portfolio. 

  1. Private label/co-brand mix: Co-brand cards have economic characteristics that are more similar to general purpose credit cards than private label cards. Lower ROAs, lower yields, lower charge-offs, and higher balances. All else being equal, it can be expected for net charge-offs on co-brands to be 1%-3% lower than private label. Furthermore, in a credit downturn, co-brand delinquencies peak at similar levels than private label.

 

During the financial crisis, ADS’ co-brand exposure was de minimis, today the mix is 80% PLCC/20% co-brand. The shift in mix is favorable for lower mid-cycle charge-offs (all else equals). Furthermore, because both peak at similar levels, the change in mix is positive through the cycle but neutral in a downturn.   

 

  1. Demographic characteristics of the new retailers: The key to understanding the change in end market characteristics is by discerning the underlying customer demographics of the new retailers. 

 

We already have an idea of how charge-offs would behave for ADS’ pre-financial crisis clients (this assumes that on average the retailers’ demographics have not changed), what we do not know is the effect on new clients. We can estimate the retailer composition of the current book of receivables to separate pre-recession from post-recession customer. Assuming a 6% organic CAGR in receivables from 2009 retailers we get to pre-recession retailers representing ~40% of the expected 2018 book. If we assume half of the 20% co-branded receivables are from post-recession retailers, then we can assume ADS’ exposure to post-recession retailers is around 50% of total receivables.

 

From 2010 to 2016, we found 37 new client signings for ADS. We were able to find the demographic information for the 19 out of those 37 retailers. The information found was for the larger retailers making the analysis more significant. The table below shows the simple average distribution of household income for those retailers. 

 

Average income distribution for retailers signed by ADS between 2010and 2016

As the below shows, the numbers are surprisingly similar to the United States’ household income distribution (note slightly different scale).

 

 

We compare the above numbers to ADS’ two biggest clients during the financial crisis, Victoria’s Secret and Ann Taylor (see table below), who likely represented over 25% of receivables then and are more representative of the average customer pre-crisis. Comparing the below demographics with the new signings suggests a likely improvement in credit quality from new customers. 

 

Average income distribution for Victoria’s Secret and Ann Taylor

 

  1. Underwriting culture/parameters: This aspect is less quantifiable, but we have a few data points that can help us get a sense of directionality. We have had a number of calls with former ADS employees who focused on the underwriting side. From these calls, the overarching message was that the company adheres to the same strict standards. The company’s Chief Risk Officer has been in that seat since before the Financial Crisis, is highly respected within the organization, makes the important underwriting and risk decisions, and has a lot of autonomy and power within the organization. 

 

The above is not sufficient though. As we step back, the company’s livelihood depends on strong underwriting. A strong deterioration would become visible within a couple of years, making it less tempting. Governance for the company is strong; the company’s chairman was the sponsor who created the company. His former private equity partner, and also board member, Bruce Anderson owns $128mm in shares with no real share sales in the last 13 years and no other large public positions. ValueAct is the biggest shareholder and also on the board. On the negative side, CS was led by Ivan Szeftel during the Financial Crisis, who had a reputation of being ultra conservative; today’s Melisa Miller is more client and growth focused. 

 

From what we have gathered there seems to be little change in underwriting culture, no change in underwriting criteria (700+ VantageScore and ~20% of the book is subprime), and there is an incentivized group of people at the top that have an important part of their net worth riding on good underwriting. 

 

  1. Size of the average receivable: This is a headwind. Generally speaking, credit thresholds increase when approving a cardholder that is expected to have a higher average balance. As a result, during periods of economic tranquility, charge-offs from larger accounts are lower than charge-offs from smaller private label accounts. However, in a negative economic environment, charge-offs from bigger balance accounts tend to increase more than smaller. 

 

ADS’ average receivable balance has gone from $356 in 2010 to $762 in 2018. The increase is mainly attributable to an increase in co-branded cards and a higher percentage of clients in the higher ticket segments of jewelry, furniture, and department stores. Furthermore, the increase comes from two credit positive events (higher mix of co-brand and a better retailer demographic), and the overall balance is still relatively small. Therefore this headwind should be limited in nature. 

Our takeaway from the above is that it is unlikely for ADS to have a meaningfully less creditworthy book than it did during the Financial Crisis. 

If we assume a financial crisis suddenly arrives, giving the company no ability to pre-provision, and yields decrease to 24% (they actually increased in the financial crisis), the card services business would be able to sustain a ~12% provision without taking a hit on its tier 1 ratios. Every additional 1% in provisions would be around ~$170mm. Together ADS’ two banks, Comenity Bank and Comenity Capital Bank, have $900mm-$1.1bn of excess tier 1 capital depending on the time of year. That means that all else equals, ADS can sustain 16% in immediate provisions without having to raise equity capital. That is ~50% more than ADS’ highest intra-year charge-off during the Financial Crisis. 

Furthermore, given some recent corporate events (more detail on those below) it is important to point out that the company currently has some HoldCo debt with a leverage covenant at 3.5x EBITDA. A Financial Crisis type scenario would bring EBITDA right around that covenant. It is our view that the company will get rid of the HoldCo debt within the next year or so, which leaves us exposed for some period of time.  That being said, they do have some levers to pull if a crisis emerges between now and then, but something to keep an eye on.

Recent events and short term missteps

Weak performance in Loyalty One

Two years ago LO faced operational issues. The division had an issue with Air Miles in December 2016 in which collectors’ points were set to expire after a 2011 announcement. Little attention was given to the announcement, and when the company reminded collectors that their points would expire soon, there was a public and political backlash which forced Air Miles to reverse the policy. The incident has had an impact on the company’s brand with point issuance and usage being negatively affected.

Despite the issue, LO is still a defensible, and high FCF generating business. It is our expectation (and that of the market) that ADS will divest it. LO is small enough and our assumptions negative enough that its contribution to intrinsic value at 13% doesn’t really affect our thesis. 

Sale of Epsilon

ADS had another division called Epsilon, which was a marketing company of sorts that also provided CS with services. The company sold the division this quarter in a process that was highly mismanaged by (the now former) CEO Ed Heffernan. 

Anyone interested can look at the sequence of events. The outcome of which was that ADS shareholders probably got a lower price than they probably would have received. The price was also lower than what investors were led to expect. 

Despite the above, our estimate of the company’s intrinsic value actually increased on the day of the announcement. Our view was that Epsilon is a challenged asset and that future cash flows from that business were highly uncertain. However, the Company’s handling of the sale caused us to further question Ed’s credibility.

Guidance misses

ADS is, unfortunately, a company that provides guidance. After a long run of beating guidance, starting in 2016 the company began missing consistently. The misses have been small, ‘core EPS’ between 2016 and 2018 was missed by less than 5% in each one of those years. In our view the guidance misses have little to do with the future cash flows of the business and everything to do with management credibility.

Ed stepping down as CEO and CS’ Melisa Miller being promoted

The previous two points highlighted an important issue with management. This point will address it. 

On Friday June 7th 2019, ADS announced the departure of Ed Heffernan as CEO. Card Services’ CEO Melisa Miller was promoted to take Ed’s role. The announcement was sudden and immediate, and therefore brought confusion to the market. We believe Ed’s departure was the result of ADS’ transition to a pure play Private Label and Co-brand card business, and the poorly executed divestiture of Epsilon. 

The elevation of Melisa is a clear vote of confidence from the board. She has been the driving force behind CS’ success over the last eight years. We have done a good amount of work on her and have a positive impression of her ability to drive the business for years to come. 

Ed’s credibility was running really low. In fact, Ed used to be a hold up for us. He sees himself as a capital allocator, a skillset that is not as important for ADS’s CEO than for other businesses given the quality of the board of directors, and, in our opinion, his understanding of the operations was high-level. Melisa is clearly an operator, she is focused, and has a very good track record. We see the change as a positive.  

Valuation

For ADS’ valuation, we project the two businesses’ cash flows out to 2022, assume FCF is mainly used to grow the receivables book and buyback shares at increasing prices, and apply an exit multiple on levered FCF. Below are the main assumptions.

Card Services

  • Receivables growth at 6%-7% from new signings and tender share increases, decreasing to 5% in 2022.

  • Charge-offs to normalize at 6.6% (above management guidance of 6%) leading to 6.7%-7.7% loss provisions. 

  • Unchanged Net Interest Margin and G&A even though there are some fixed costs that the company will leverage as it grows receivables.

  • Around a 2% percentage point deterioration in ROE’s mainly driven by a lower NIM. New files to be funded with 15% equity. 

  • Cash EBIT to compound at 7% under the above assumptions.

Loyalty One

  • Loyalty One: Flat revenue with a little over 1% margin compression leading to slightly negative cash EBIT growth.

Other 

  • FCF to fund receivables growth, NWC usage, and buyback with the small leftover to be received as dividends or in some other form.

  • The above drops down to levered FCF at a 7% CAGR, that turns into 16% with the buybacks, plus another 2% in unallocated excess cash bridges us to a mid-teens + FCF per share growth.

  • We believe the company should be making ~$40 per share by 2023.

  • Exit multiple at 12x discounted back at 10%. 

Other risks and mitigants

  • Irrational competition: In July 2018 SYF lost WMT. There is a lot of excess capital looking for yield. SYF and money center banks have a funding advantage vs ADS that allows them to give more RSA.

    • Mitigant: ADS chooses what deals it gets involved in and they have shown a willingness to walk away. No matter how irrational competitors are, ADS’ yield advantage protects them from competition.

  • Large interest rate increases: ADS charges a floating rate on receivables protecting them from interest rate increases. However, a significant increase in rates will make cardholders averse to revolving. 

    • Mitigant: ADS has been able to keep NIM relatively constant through different rate environments, however, the company was not around in the 1980s when interest rates and inflation were in the teens. This is a risk we monitor and are conscious of dramatic rate increases. 

  • Unexpected increase in delinquencies: We are trusting management with underwriting decisions. We do not know the credit profile of every loan and our knowledge of the composition of the credit pool is limited. 

    • Mitigant: Refer to thesis #3 – we believe the right framework, incentives, and capital cushion is in place.

 

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

Catalyst

Earnings growth. 

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    Description

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    Investment thesis 

    Alliance Data Systems Corporation (ADS) is the second largest, pure-play Private Label Credit Card (PLCC) company, focusing on mid-sized consumer-based businesses (mainly retailers) with a focus on creating and managing loyalty programs and marketing campaigns that have proven to drive sales. ADS has a smaller subsidiary called Loyalty One (LO) which represents ~17% of PF operating income and is likely going to be divested soon. The bulk of our thesis and valuation focuses on Card Services (CS), which houses the PLCC and co-brand card business.

    With its differentiated capabilities and go-to-market strategy, the company has developed a product that adds tremendous value to their customers. CS pays its customers for a service that usually costs them money (i.e. processing credit card transactions), while also providing customers with best-in-class marketing, loyalty, and analytics programs that drive sales. Our research suggests that no other PLCC/co-brand provider is able to do this as effectively as ADS. That competency, along with the company’s position with mid-sized retailers (which have less negotiating power), has allowed the company to achieve average ROEs of 46% over the last five years at the corporate level and 25% in CS while growing rapidly (we allocate most corporate expenses to CS). 

    We believe ADS will continue signing new customers and growing its credit card receivables while maintaining industry-leading economics. The service it offers is increasingly relevant to certain retailers facing competitive pressures in an increasingly digital world. Furthermore, as the retail landscape changes, newer concepts, which are unlikely to have an existing PLCC/co-brand credit card offering, will continue to gain market share opening up a new channel for ADS. 

    The company is able to achieve outsized returns on capital because it is able to create more revenue from each dollar of receivable it lends (~25% receivables yield vs ~17% for competitors) by driving increased sales through a combination of its analytical capabilities, resource allocation, a plethora of first-party consumer data, and willingness to underwrite a bit deeper in the credit spectrum (more on this later). The extra sales benefit both the retailer (increased sales growth) and ADS (higher revolve rate on which ADS earns interest) creating a win-win situation. 

    A combination of market structure, and competitors’ inability to make money at scale in ADS’ territory, should keep other credit card issuers from encroaching ADS’ niche. ADS’ main PLCC/co-brand competitors, the money center banks (COF, C, AXP, WFC) and Synchrony Financial (SYF), compete in different segments of the market and have a different go-to-market strategy, which has caused them to evolve their product offering differently.

    Concerns related to the credit cycle and the current retail environment, along with a lack of former management credibility (caused by missed guidance and other unforced errors), and a sudden CEO change, enables us to buy this business at 8x 2019 P/FCF. We believe the company is well insulated from a credit downturn and that it is likely to emerge stronger relative to competitors. Furthermore, the weak retail environment for ‘legacy’ retailers will have a limited effect on company profitability. Lastly, we think the CEO change is likely a positive for the company. Overall, we see ADS compounding FCF per share in the low to mid-teens through a combination of organic growth in CS, and buybacks.

    We believe ADS is worth approximately $337 per share or 117% above current levels. As our base case valuation suggests, we see ADS shares as a great risk/reward around current prices. However, it is important to recognize that there is a higher than average level of uncertainty in this business given management’s unforced errors and changes in the client base. Our diligence gives us a good degree of comfort around those items, but it is important to note that the range of outcomes here is wider, and the position should be sized accordingly. Our valuation is predicated in the following three points:

    1. ADS’ ability to drive a higher revolve rate and pay lower RSAs are the result of a structural competitive advantage over competitors, which will allow ADS to maintain its superior economics.

    2. Continued growth in the PLCC industry, along with ‘tender share’ gains on new signings should facilitate a high-single/low-double digit revenue growth rate for ADS CS.

    3. There is a large cushion in the business’ economics and balance sheet to weather a large credit cycle downturn.

    Company description (Note: Some of the below can be found in previous write-ups of ADS. Feel free to skip this section if you are already familiar with the company). 

    Card Services (CS) (81% of revenues, 83% of operating income): CS houses the company’s PLCC (80% of receivables) and co-brand credit cards (20% of receivables). This is the company’s crown jewel.  The division handles most of a retailer’s PLCC program, including receivable financing, delinquency risk assumption, new account opening, bill/remittance processing, and customer care. The division also takes an active role in the customer’s marketing strategy and loyalty program. 

    Relationships with clients (i.e. retailers) in this business start when a retailer decides to either sell its existing or start a new credit card program. PLCC/co-branding programs are financially and strategically attractive to retailers for a number of reasons that we will touch upon on thesis point 2. A retailer typically enters into 5-15 year contracts with the selected card issuer. ADS’ relationships tend to be quite involved as they look to add value to the client operationally. The industry, and ADS in particular, has high renewal rates given the value added and the disruptive nature of switching providers. ADS’ retention rate was at 99% before 2017, though this figure has fallen recently due to customer bankruptcies, liquidations, acquisitions, and sales.

    ADS CS makes money by lending on an unsecured basis to cardholders (the retailer’s customers) and earning fees and/or interest on late payments and unpaid balances. Cardholders benefit from promotions and loyalty benefits they would not receive from a general purpose credit card, which allows ADS to drive further sales. Expenses in this segment include loss provisions, interest expenses, payments to retailers (via revenue/profit share agreements or “RSAs”), and general and administrative expenses. The resulting profit is generally measured against the value of the receivables balance to arrive at an ROA or against the book equity value, which results in an ROE. ADS’ CS ROAs average around 5% (vs SYF below 3%) and ROEs around 25% (vs SYF around 17%). 

    PLCC can only be used at the respective retailer. As it is a closed loop system, ADS represents all sides of a transaction and no interchange fees are paid whereas co-brand runs through Visa and MasterCard and can be used anywhere.

    Loyalty One (9% of revenues, 17% of operating income): Loyalty One is composed of Air Miles and Brand Loyalty. The company is likely to divest this business in the near term. As the division comprises just ~13% of our current valuation, our price target is not particularly sensitive to the performance of this division. 

    Thesis points

    1. ADS’ ability to drive a higher revolve rate and pay lower RSAs are the result of a structural competitive advantage over competitors, which will allow ADS to maintain its superior economics.

    ADS’ ROEs are a clear invitation to competitors. However, our research suggests that a competitor would have to have a willingness to dedicate a lot of resources and probably lose money for some years for the prospect of limited returns. Those prospective limited returns are themselves pretty uncertain given the difficulty to unseat the entrenched incumbent in a relatively small market with high switching costs. 

    ADS’ unique expertise driving retailer sales (which is a major driver of profitability) is likely the result of its history. ADS was formed in 1996 through the merger and subsequent carve-out of J.C. Penney's credit card processing unit and The Limited's PLCC operation. On the other hand, its competitor’s businesses were built with the intention of providing a purely financial product largely housed within larger financial services businesses.

    ADS has data scientists and marketing people sitting at the retailers customers’ offices whose only job is to help increase sales. These employees work with tools that have been fined tuned for decades. The tools are fed with first and third-party data from a large number of industry participants and ADS is able to test promotions on a much larger sample size than a retailer could. For example, L Brands knows about Jane Smith’s purchasing behavior at L Brands, but ADS knows Jane’s purchasing behavior at L Brands, Ulta, Williams Sonoma, Wayfair, and Century 21 amongst many others. Not only does ADS know her spending habits better than the retailer, but they also know more people with similar spending habits, have done thousands of samples on them and, therefore, know with higher accuracy what drives them to make a purchase decision. This dataset would be extremely difficult to replicate in the verticals where ADS has a strong presence such as apparel, furniture, and jewelry. 

    We have seen a number of statistics that illustrate ADS’ superiority when it comes to driving customer sales. For example, we have heard that ADS’ “average cardholder uses her card 8-10 a year whereas the industry average cardholder uses her card twice” and that “what we found over the last 20 years is that an ADS private label cardholder will visit twice as often and spend twice as much as a very comparable bank cardholder”. Most importantly, ADS’ customers buy into its value proposition, and ADS knows how to sell themselves extremely well. 

    During the course of our research, we heard from a number of former customers regarding the positive impact that ADS has had on their organization. The below excerpt from Victoria Secret’s former CEO helps illustrate this point. The comment is a response to a question about the company’s Angel Card and loyalty program, which are both managed by ADS.

    So I'd say the things that are most effective is when we are really doing consumer relationship marketing. And when we do that, we actually speak to her in a way that resonates, and then she responds. And we're able to build and have shown that we can build loyalty with her. So promotions that really attract her for bras or products that she's already bought from us, we build upon that knowledge. We have a ton of data about who's buying from both stores and online. And we direct messaging, recommendations and products that she'd be interested in. When we offer her that opportunity with varying degrees of brand-accretive moments, she comes in and responds. That's when we're most effective. -- Jan Singer -- Q4 2017 Earnings Call, Mar 01, 2018

    ADS’ ability to drive sales is important in helping the company achieve outsized returns on capital because it allows it to achieve a higher revolve rate. ADS’ average revolve rate is an industry-leading 80%. SYF is second at around 50%. For context, the below graph shows the revolving rates for the industry. 

    The below table for ADS shows the stability of the yield generated through the cycle measured through its NIM.

    The key question is what it would take to replicate ADS’ first-party data, industry-leading marketing/analytics capabilities, and culture focused on helping customers drive sales. We believe that the required investment (both money and time) are not justified compared to the size of the market at ~$35bn (of which ADS is $17bn). 

    ADS’ average receivables book is around ~$100mm of receivables. They have around 160 clients and $17bn of receivables, all from small/mid-size retailers. That is a contrast to SYF who has $91bn in receivables with the top 5 retailers representing 44% receivables and yield. It would take SYF 36 new signings a year of $100mm files for SYF’s revenue to increase 5% (assuming $18bn in revenues and 25% yield on receivables). There is nowhere near 36 new available deals of that size in the market in any given year. 

    Turning to the economics of getting to a similar offering, ADS has a 5%+ per receivable margin advantage to the competition (the massive yield advantage is somewhat offset by higher delinquencies and funding costs). Part of that excess margin is used to enhance ADS’ non-card capabilities that help drive sales and ROEs. This leads to ADS having higher G&A per receivables than its competitors (hiring high quality marketing and computer science employees). A competitor who wants to copy the offering would have to match that G&A spend for years without seeing a return. We believe that if a competitor wanted to recreate ADS’ analytical/value-add capabilities, it would have to invest 1%-2% per receivable in G&A. Most competitor’s credit card ROAs are right around there, which means they would have to be willing to operate at significantly reduced margins for years. 

    Lastly, it is unlikely that ADS’ competitors’ clients, which are the country’s large retailers, would be interested in these unproven capabilities as customer loyalty is already a core competency of a typical large retailer. As a result, that money would be spent to develop a product and go-to-market that is not in sync with the needs of the majority of their existing customers in hope of acquiring a new customer base. 

    ADS’ smaller customer base and average cardholder balances are also important contributors to the higher yields and lower RSAs. These are customers and balances that are limited in nature and whom ADS has been nurturing for years. ADS’ average receivable balance is $762 compared to SYF’s $1,000+. Money center banks’ average receivable is typically much larger. We estimate that LB’s file generates 13% mid-cycle ROAs and ~$300 monthly cardholder limits, making it likely the most profitable file in the industry. The smaller the balance the more meaningful the fixed late fee becomes relative to yields and the more likely someone will forget to pay their bill. 

    Given ADS’ competitors’ size, they tend to focus on big retailers who mostly focus on economic terms and do not look to their issuer to help them operationally. These banks’ ideal clients are Amazon, Costco, Home Depot, Best Buy, etc. Smaller clients, who value the added services, are a drain on resources for them; RFPs are involved and take months to complete, implementation takes time, and teams need to be built around retailers. 

    Given the aforementioned, we are comfortable that ADS CS economic moat is unlikely to be encroached in a meaningful way in the near to medium term. As a result, the company should be able to continue to earn excess returns relative to peers, generating >20% ROEs within the CS division. 

    1. Continued growth in the PLCC industry, along with ‘tender share’ gains on new signings should facilitate a high-single/low-double digit revenue growth rate for ADS CS.

    PLCC and co-brand cards present a number of benefits to retailers: it gives them a stream of cash flows through the RSAs at virtually no cost, it saves them the interchange fee that is usually paid to the payments ecosystem, and, if done correctly, helps increase loyalty and sales. 

    This attractive value proposition has fueled significant growth for the industry. The two graphs below (while a little dated) show the growth that PLCC/co-brand have enjoyed. That growth has come from both new retailers entering the business as well as increased penetration with pre-existing clients.

    cid:image014.png@01D37FC1.2A42E880

    Given its value proposition and strong execution, ADS has been growing much faster than the market. From 2011 to 2018, the company grew average receivables at a compounded rate of 18%. This growth has mainly come from new customers and ‘tender share’ gains. According to our estimates, ADS’ current market share hovers around 18% of the market whereas in 2011 it was only 5%. Some of that growth has leveled off and the company is likely to have no revenue growth for the year. The leveling off is a combination of getting rid of legacy retailers that aren’t growing, along with a number of retail bankruptcies, liquidations, and M&A. While there will always be retailers struggling in the current retail environment, the company will exit the year with a significantly improved mix of clients who are only now starting to scale. 

    For a new program, once a deal is done and the program implemented, it takes about three years to ramp up, arriving at an average tender share of 33%. This means that we have relatively good visibility into growth for the next two years. The deals signed in 2017 are expected to generate $2bn in excess receivables once fully ramped. 2018 was an unprecedented year for new signings and is expected to generate close to $4bn in receivables. That is a large pipeline of expected receivables for a company with $17bn of receivables. 

    Even if we experience headwinds from retailer-specific issues as were experienced in 2018, the company should still grow  due to the impact of the new signings, the tender share gains, and a group of newer clients that are growing fast. New client credit sales (2015-2018 signings) are growing fast and should represent ~50% of total receivables by the end of 2020. Those new files are made up of growing retailers such as Ulta, Wayfair, and Ikea, among others. The portfolio is likely to continue to de-risk over time. On the flip side, the economic characteristic of some of these new files and verticals are not as proven as specialty retail. We gain comfort in the fact that even if the economics of the new files are not as good, they are likely going to be better than SYF’s (given thesis point #1) who already has exposure to a lot of these verticals. Therefore, even if the company is wrong when saying that the new files will have the same ROEs as the previous ones, we think the surprise to the downside still leaves us with high teen ROEs.

    1. There is a large cushion in the business’ economics and balance sheet to weather a large credit cycle downturn.

    As a credit business that earns ~25% yields on receivables, understanding the potential impairment risk in a downturn is a primary concern. That job is made difficult by the lack of granular information on the credit characteristics of the portfolio. In addition, today ADS has four times as many receivables as they had in 2008.  Both of these limit our ability to stress the business in a Financial Crisis type scenario. Given those limitations, we focused on understanding the probability of delinquencies being worse in another Financial Crisis, as well as stressing the balance sheet to understand what it would take to impair it. Our analysis suggests that it would be difficult to take a view on how delinquencies will behave in another Financial Crisis, albeit the risk of a significantly worse performance seems unlikely. However, and most importantly, the company should be able to weather higher loss rates than those experienced in the financial crisis.

    ADS has higher mid-cycle delinquencies at around 6% than competitors, with SYF around 5% and the money center banks around 4%. Conventional wisdom suggests that difference would widen in a financial crisis. However, ADS’ peak charge-offs in the Financial Crisis were slightly better than the industry’s charge-offs. The below two graphs compare ADS’ World Financial Trust to the rest of the industry. Note that the below graphs use gross numbers for the industry (second graph) and net for ADS (first graph), if we normalize the industry’s assuming 25% recoveries, we see that net charge-offs peaked around 12% for the industry whereas ADS’ peaked below 11%.

    cid:image004.png@01D395F8.4A4AA3F0


    The large increase in receivables, from $4.5bn in 2008 to $17bn today, means that the majority of current cardholders were not cardholders in the last downturn.  We have identified four areas that can help identify a possible change in the credit quality of the receivables: (a) private label to co-brand mix, (b) the demographic characteristics of the new retailers, (c) underwriting culture/parameters, and (d) the size of the average receivable. As we go through them it will become evident that the growth in receivables is likely neutral-to-positive on the composition of the portfolio. 

    1. Private label/co-brand mix: Co-brand cards have economic characteristics that are more similar to general purpose credit cards than private label cards. Lower ROAs, lower yields, lower charge-offs, and higher balances. All else being equal, it can be expected for net charge-offs on co-brands to be 1%-3% lower than private label. Furthermore, in a credit downturn, co-brand delinquencies peak at similar levels than private label.

     

    During the financial crisis, ADS’ co-brand exposure was de minimis, today the mix is 80% PLCC/20% co-brand. The shift in mix is favorable for lower mid-cycle charge-offs (all else equals). Furthermore, because both peak at similar levels, the change in mix is positive through the cycle but neutral in a downturn.   

     

    1. Demographic characteristics of the new retailers: The key to understanding the change in end market characteristics is by discerning the underlying customer demographics of the new retailers. 

     

    We already have an idea of how charge-offs would behave for ADS’ pre-financial crisis clients (this assumes that on average the retailers’ demographics have not changed), what we do not know is the effect on new clients. We can estimate the retailer composition of the current book of receivables to separate pre-recession from post-recession customer. Assuming a 6% organic CAGR in receivables from 2009 retailers we get to pre-recession retailers representing ~40% of the expected 2018 book. If we assume half of the 20% co-branded receivables are from post-recession retailers, then we can assume ADS’ exposure to post-recession retailers is around 50% of total receivables.

     

    From 2010 to 2016, we found 37 new client signings for ADS. We were able to find the demographic information for the 19 out of those 37 retailers. The information found was for the larger retailers making the analysis more significant. The table below shows the simple average distribution of household income for those retailers. 

     

    Average income distribution for retailers signed by ADS between 2010and 2016

    As the below shows, the numbers are surprisingly similar to the United States’ household income distribution (note slightly different scale).

     

     

    We compare the above numbers to ADS’ two biggest clients during the financial crisis, Victoria’s Secret and Ann Taylor (see table below), who likely represented over 25% of receivables then and are more representative of the average customer pre-crisis. Comparing the below demographics with the new signings suggests a likely improvement in credit quality from new customers. 

     

    Average income distribution for Victoria’s Secret and Ann Taylor

     

    1. Underwriting culture/parameters: This aspect is less quantifiable, but we have a few data points that can help us get a sense of directionality. We have had a number of calls with former ADS employees who focused on the underwriting side. From these calls, the overarching message was that the company adheres to the same strict standards. The company’s Chief Risk Officer has been in that seat since before the Financial Crisis, is highly respected within the organization, makes the important underwriting and risk decisions, and has a lot of autonomy and power within the organization. 

     

    The above is not sufficient though. As we step back, the company’s livelihood depends on strong underwriting. A strong deterioration would become visible within a couple of years, making it less tempting. Governance for the company is strong; the company’s chairman was the sponsor who created the company. His former private equity partner, and also board member, Bruce Anderson owns $128mm in shares with no real share sales in the last 13 years and no other large public positions. ValueAct is the biggest shareholder and also on the board. On the negative side, CS was led by Ivan Szeftel during the Financial Crisis, who had a reputation of being ultra conservative; today’s Melisa Miller is more client and growth focused. 

     

    From what we have gathered there seems to be little change in underwriting culture, no change in underwriting criteria (700+ VantageScore and ~20% of the book is subprime), and there is an incentivized group of people at the top that have an important part of their net worth riding on good underwriting. 

     

    1. Size of the average receivable: This is a headwind. Generally speaking, credit thresholds increase when approving a cardholder that is expected to have a higher average balance. As a result, during periods of economic tranquility, charge-offs from larger accounts are lower than charge-offs from smaller private label accounts. However, in a negative economic environment, charge-offs from bigger balance accounts tend to increase more than smaller. 

     

    ADS’ average receivable balance has gone from $356 in 2010 to $762 in 2018. The increase is mainly attributable to an increase in co-branded cards and a higher percentage of clients in the higher ticket segments of jewelry, furniture, and department stores. Furthermore, the increase comes from two credit positive events (higher mix of co-brand and a better retailer demographic), and the overall balance is still relatively small. Therefore this headwind should be limited in nature. 

    Our takeaway from the above is that it is unlikely for ADS to have a meaningfully less creditworthy book than it did during the Financial Crisis. 

    If we assume a financial crisis suddenly arrives, giving the company no ability to pre-provision, and yields decrease to 24% (they actually increased in the financial crisis), the card services business would be able to sustain a ~12% provision without taking a hit on its tier 1 ratios. Every additional 1% in provisions would be around ~$170mm. Together ADS’ two banks, Comenity Bank and Comenity Capital Bank, have $900mm-$1.1bn of excess tier 1 capital depending on the time of year. That means that all else equals, ADS can sustain 16% in immediate provisions without having to raise equity capital. That is ~50% more than ADS’ highest intra-year charge-off during the Financial Crisis. 

    Furthermore, given some recent corporate events (more detail on those below) it is important to point out that the company currently has some HoldCo debt with a leverage covenant at 3.5x EBITDA. A Financial Crisis type scenario would bring EBITDA right around that covenant. It is our view that the company will get rid of the HoldCo debt within the next year or so, which leaves us exposed for some period of time.  That being said, they do have some levers to pull if a crisis emerges between now and then, but something to keep an eye on.

    Recent events and short term missteps

    Weak performance in Loyalty One

    Two years ago LO faced operational issues. The division had an issue with Air Miles in December 2016 in which collectors’ points were set to expire after a 2011 announcement. Little attention was given to the announcement, and when the company reminded collectors that their points would expire soon, there was a public and political backlash which forced Air Miles to reverse the policy. The incident has had an impact on the company’s brand with point issuance and usage being negatively affected.

    Despite the issue, LO is still a defensible, and high FCF generating business. It is our expectation (and that of the market) that ADS will divest it. LO is small enough and our assumptions negative enough that its contribution to intrinsic value at 13% doesn’t really affect our thesis. 

    Sale of Epsilon

    ADS had another division called Epsilon, which was a marketing company of sorts that also provided CS with services. The company sold the division this quarter in a process that was highly mismanaged by (the now former) CEO Ed Heffernan. 

    Anyone interested can look at the sequence of events. The outcome of which was that ADS shareholders probably got a lower price than they probably would have received. The price was also lower than what investors were led to expect. 

    Despite the above, our estimate of the company’s intrinsic value actually increased on the day of the announcement. Our view was that Epsilon is a challenged asset and that future cash flows from that business were highly uncertain. However, the Company’s handling of the sale caused us to further question Ed’s credibility.

    Guidance misses

    ADS is, unfortunately, a company that provides guidance. After a long run of beating guidance, starting in 2016 the company began missing consistently. The misses have been small, ‘core EPS’ between 2016 and 2018 was missed by less than 5% in each one of those years. In our view the guidance misses have little to do with the future cash flows of the business and everything to do with management credibility.

    Ed stepping down as CEO and CS’ Melisa Miller being promoted

    The previous two points highlighted an important issue with management. This point will address it. 

    On Friday June 7th 2019, ADS announced the departure of Ed Heffernan as CEO. Card Services’ CEO Melisa Miller was promoted to take Ed’s role. The announcement was sudden and immediate, and therefore brought confusion to the market. We believe Ed’s departure was the result of ADS’ transition to a pure play Private Label and Co-brand card business, and the poorly executed divestiture of Epsilon. 

    The elevation of Melisa is a clear vote of confidence from the board. She has been the driving force behind CS’ success over the last eight years. We have done a good amount of work on her and have a positive impression of her ability to drive the business for years to come. 

    Ed’s credibility was running really low. In fact, Ed used to be a hold up for us. He sees himself as a capital allocator, a skillset that is not as important for ADS’s CEO than for other businesses given the quality of the board of directors, and, in our opinion, his understanding of the operations was high-level. Melisa is clearly an operator, she is focused, and has a very good track record. We see the change as a positive.  

    Valuation

    For ADS’ valuation, we project the two businesses’ cash flows out to 2022, assume FCF is mainly used to grow the receivables book and buyback shares at increasing prices, and apply an exit multiple on levered FCF. Below are the main assumptions.

    Card Services

    Loyalty One

    Other 

    Other risks and mitigants

     

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

    Catalyst

    Earnings growth. 

    Messages


    SubjectDeclining ROAs
    Entry08/05/2019 09:32 AM
    Memberthistle933

    Hi Rickey, we had a very similar thesis a couple years ago. A few things we got wrong:

    1) ROAs are declining significantly at legacy clients. You can see this in "servicing fees, net" (difference between finance chanrges and total CS revenue), which is the same thing as SYF retailer share arrangement expense except it is a new contra revenue item for ADS CS. Last 12 months servicing fees have been an incremental -$150MM expense (and increasing) whereas historically this was $0.

    2) ADS PLCC is an almost fully penetrated product and clients signed over past several years (and new clients) are likely to be much smaller portfolios than company saying and at significantly lower ROAs. This is because new files are typically larger balances where people are less willing to pay a 26% APR on larger balances (and therefore use cheaper forms of credit instead of PLCC) and late fees are a smaller % of larger balance so gross yields probably 5% smaller. Also, there is more competition than we thought, it is a much better credit environment so competitors willing to earn less, and there are more consultants helping retailers negotiate contracts, all of which result in lower ROAs for ADS CS.

    We think this results in receivables growth in low to mid single digits but earnings likely decline significantly because we think pretax ROAs drift from 9% to 4-5% over next 5 years.


    SubjectRe: any thoughts post tender?
    Entry08/20/2019 04:09 PM
    MemberDO EM GO

    I thought the PR telling market how much was tendered beyond the 148 price was awful.  They basically told market that 15M are for sale below 162.  Not sure why they did that.  Seems with that high amount that ValueAct had to have tendered some as well as Arlington maybe?  Not sure how indexes play these tenders if at all?  Do they tender some knowing shares outstanding will fall?  

     

    Either way seems like an opportunity on a bungle by company and technical selling 


    SubjectRe: Re: any thoughts post tender?
    Entry08/20/2019 10:29 PM
    MemberValue1929

    DO EM GO,  I agree this was a botched tender, but I wonder if letting the market know how many shares were put up (~3x the offer size) was deliberate?  Mgmt. kept $350mn in dry powder to purchase opportunistically, likely before year end. At these depressed levels any additional buybacks become very accretive to EPS. On top of this, with the potential sale of loyalty one, it seems quite clear (to me at least) that the card biz will be for sale. Think of the consolidation benefits for someone like Synchrony, funding costs would go down materially overnight and there is substantial operational overlap between these two businesses, the synergies savings would be massive between these two businesses. 

    That being said, I started buying this thing $10 handles higher after the botched DT.


    SubjectRe: Re: Re: any thoughts post tender?
    Entry08/21/2019 06:56 AM
    MemberDO EM GO

    I fully agree regarding the SYF synergies but I don’t think ValueAct or you and I would take a 30% premium here paid mostly through SYF stock.  

    I have been traveling so not in front of my Bloomberg but I was told 2.1MM reverse conversions were put on so Arbs bought to tender.  Given the stock traded above $150 throughout tender it seems they tendered at prices above $150 and took a bath as they didn’t get any shares off.  They are no doubt blasting it out now without really regard to price, especially since they started selling right out of gate on Friday.  The DB downgrade only added to the maelstrom here.  I will be adding. In my view, mgmt mis steps have created a wonderful opportunity to buy a defensible business. Although I do feel future business won’t be as profitable as past.  This is more than priced in.  

    I am thinking that they are buying back at maximum 25% of past 4 week ADV in the last couple of days. 

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