|Shares Out. (in M):||55||P/E||10||9|
|Market Cap (in $M):||13,000||P/FCF||10||9|
|Net Debt (in $M):||0||EBIT||0||0|
There have been a couple previous write-ups on ADS which I think provide a good overview of the company so I refer you to those write-ups to learn about more of the details of the company and I’ll keep it higher level.
ADS creates loyalty programs and runs marketing campaigns on behalf of predominantly medium-sized retailers. The company creates private label (>80%) and co-branded (<20%) credit cards on the retailer’s behalf. These cards allow consumers to obtain financing to purchase goods while simultaneously providing ADS with SKU-level data to develop targeted marketing programs.
The company’s competitive advantage is its vertical integration, size and focus. It is the one-stop shop for medium sized retailers. These retailers have access to ADS’ marketing scale and data analytics capabilities and can leverage the company’s balance sheet. This allows retailers to focus on their core retailing capabilities instead of underwriting financial risk or losing margin by hiring a large marketing division. Additionally, when consumers use one of ADS’ private label cards, retailers don’t pay interchange fees.
For ADS, the benefit is to underwrite a high quality customer at an attractive interest rate. The average balance on the credit card is ~$700 or $60 of spend per month. Even though these are prime consumers, the APR’s can be over 25%. According to ADS’ 10-K: “We focus our sales efforts on prime borrowers and do not target sub-prime borrowers”. Consumers don’t mind paying these rates because 1) the payback period is short and 2) when combined with discounts on the product offered by the retailer (up to 30%), the consumer still views the deal positively. ADS can then use the data it collects from consumers to provide more targeted marketing programs that allow the retailer to increase sales by an incremental 20%. This process provides value to the consumer, the retailer, and ADS.
ADS is less risky to traditional credit card companies. Traditional credit card balances are approximately $6,400 versus ADS’ $700 average annual balance. During the financial crisis, 90+ day delinquencies on credit cards increased from 9.5% to 13.5% between 2007 and at peak in 2010 according to the Federal Reserve. But for ADS, charge-offs only peaked at 9.3% in 2009 from its 6.5% targeted rate and it remained profitable during the financial crisis unlike most banks. Finally, credit card companies like Capital One have a mix of prime (â ) and subprime customers (â ), while ADS focuses on prime customers. And ADS’ margins are much higher than traditional credit card companies, which insulate it from similar losses during downturns.
Often, investors will quickly group ADS into the traditional credit card bucket (even though it’s also growing loan balances much faster - low-mid teens rate), which can often be misleading when valuing the business.
Competitive Landscape / ADS’ Niche
Within the retail card business, there are a handful of players. But contrary to common perception, few of them focus on ADS’ niche. ADS’ focus on marketing services and private label credit cards among smaller and medium sized clients is unique, less competitive, and therefore a more profitable niche.
The handful of players in the retail card business include Synchrony Financial, Capital One, Citi, American Express, etc. Most of these players have enormous loan books across a wide variety of asset classes including credit cards, auto loans, and many more. Therefore, to move the needle, these large banks focus on winning mega-accounts. This has led to competition at the mega-account end of the market. For example, Capital One took the Wal-Mart business from Synchrony Financial, Citi won Costco from American Express, American Express took the Hilton Honors portfolio from Citi, etc.
Among banks, these mega-accounts compose a large percentage of their retail card business. In Citi’s 10-K, they note that “Citi retail services partners directly with more than 20 retailers and dealers to offer private-label and co-branded consumer and commercial cards.” So ~20 retailers make up its $50bn book. For Synchrony, 5 mega-accounts contribute over 50% of revenues: “Our five largest programs are with Retail Card partners: Gap, JCPenney, Lowe’s, Sam’s Club and Walmart. These programs accounted in aggregate for 53% of our total interest and fees on loans for the year ended December 31, 2017, and 49% of loan receivables at December 31, 2017.” The banks are all fighting to win business from these mega-accounts which are being auctioned, and competition in that segment is stiff.
Furthermore, many of these banks focus on building their co-branded portfolio. For example, when Capital One bought Cabela’s, it was partially because that was a co-branded deal. Conversely, ADS’ core focus is on private label credit cards- over 80% of its business which is a very different business model. Putting size in context, L Brands, ADS’ largest customer, only represents 10% or $1.7bn in receivables for the company, which is still relatively small compared to the mega-accounts that Synchrony, Citi, Capital One and Amex alikes are fighting for ($2bn+). This has allowed ADS to maintain a retention rate of ~99% and the company is diversified across 160 accounts.
The Setup: A Perfect Storm
Since Ed Heffernan took over the company in 2009, ADS is in the top 1% of companies in terms of shareholder return, so the company has been exceptionally well run during his tenure. But starting in 2016, a series of events led to a perfect storm for the company. As investors started losing faith ADS’ business, its multiple contracted to 10x earnings. We believe these issues are temporary and the company is approaching an inflection point, which allows one to buy the business at an attractive price.
In order to understand what happened, it’s important to describe ADS’ three segments.
LoyaltyOne ($1.15bn LTM revenues - 17% of revenues, 11% of EBITDA)
LoyaltyOne is composed of two subsegments: Canada Air Miles and BrandLoyalty.
Canada Air Miles
Description: Canada Air Miles is a loyalty program that over 70% of Canada’s population participates in. The program is structured so that when consumers buy goods at gas stations, retailers, or use their credit cards, etc they earn points that they can redeem for rewards. The retailers, or sponsors (roughly 200 of them), pay ADS a fee when miles are issued at their locations. Part of this fee revenue is then paid to the rewards suppliers (roughly 400) for the goods they ship to consumers. ADS’ profit is the spread between these payments.
Disruption: In 2016, Parliament decided to change the way the program was structured. Initially, air miles would expire after 5 years of inactivity. This meant that ADS would get paid for points issued by sponsors, but would not need to pay rewards suppliers for goods because the points were never redeemed, leading to high margins. Eventually, Parliament ruled that air miles would never expire, which caused major disruption to the program and a significant decline in LoyaltyOne’s 2016 EBITDA.
Relief: ADS was forced to completely re-tool the entire program. This took all of 2017 and the first half of 2018. Below is chart of the % growth in air miles issued and redeemed.
Specifically, ADS described what they did on a presentation on May 15th, 2018:
What is the status of the [indiscernible] expiration? And does it not expire on an ongoing way? And are you able to price compensate for that in some way?
Edward J. Heffernan
Yes. It's a great question. The question had to do with the expiration in our Canadian program and what do we do to change it. The answer is that we had to get rid of the ability to expire after 5 years. So you can expire some with -- if they're inactive, after a certain -- like 24 months or something like that, but it's a very small piece. Because we made the bulk of our money on the breakage. The fact that people didn't redeem points, what -- the only way to fix it is you move to a markup on the rewards themselves. And so before, we know it charged to markup when you redeemed your points. Now as part of the points, if it was 100 points before, it may be 115 points today when you redeem it. So it's -- that's essentially how you compensate for loss of breakage, and that's what got the margin back.
One can see that Air Miles are starting to stabilize and rebound.
BrandLoyalty is a loyalty program for grocers in Europe, Canada and Asia. BrandLoyalty creates over 200 programs per year and will do ~600mm EUR in 2018 or a bit over half of LoyaltyOne’s revenue. This business is expected to grow in the low double digits over the medium term, albeit at a chunky pace. The company just signed Kroger, the largest grocer in the US earlier this year, which will be a nice lift to sales over the coming few years.
Per the 9/12/2018 DB conference:
Okay, and that's helpful. Maybe jumping over to the other 2 businesses AIR MILES and BrandLoyalty. So BrandLoyalty had a really solid quarter in the second quarter, looks like you're getting some good traction with the Disney products, World Cup has definitely been a good tailwind. You also had a new win in the U.S. market. Maybe you can just talk about how should we think about BrandLoyalty going forward, not just recovering in the European market, but also growth opportunity in the U.S. market?
Edward J. Heffernan
Sure. So BrandLoyalty will do a bit under EUR 600 million and our goal is to get it to about EUR 1 billion. It traditionally grows somewhere around 10% to 12% organically each year. The problem from, I guess, an outsider's perspective is that it's chunky. So I'll have 3 years of 15% or 18% growth and I'll have 1 year where everyone pulls back and waits to run big loyalty programs until the World Cup comes around and I'll actually go backwards. And so that chunkiness can certainly cause some angst out there. But over the long term, you're running low double-digits organically this year. We're back to, as you mentioned in Q2. And the rest of the year, we're going to be running that business in the double-digits as well. So the growth looks good. We're probably most excited about the opportunities in APAC, Eastern Europe and South America, especially Brazil. And we think a lot of the growth is going to come out of those areas. And again, we run about 220 of these programs, which are shorter-term loyalty programs that essentially when you're shopping at the grocery store, you got certain incentives to buy and to have a certain basket size, a bit higher than it was traditionally. And so we have lift in the spend at the market.
That's great. Can you also talk about the U.S. The Kroger relationship in the U.S.? How is that progressing?
Edward J. Heffernan
Yes. We announced a relationship there. We have a couple of irons in the fire in the U.S. We've had more progress in Canada, because of the relationship with our other program AIR MILES up there and as well as in South America than we have in the U.S. So we'll probably hear something on the U.S. side probably in the next 4 to 6 months.
Epsilon (29% of revenues, 19% of EBITDA)
Description: Epsilon is one of the largest ad agencies in the US with over 1,600 clients. Epsilon develops targeted marketing programs on behalf of its customers to grow their sales. The business works with the majority the top 10 banks, majority of top 10 retailers, top 10 pharmaceutical companies, and the majority of the top auto manufacturers. The services it offers include consulting, predictive modeling, omnichannel marketing, etc.
Half of Epsilon’s revenue is derived from its Conversant business. Conversant is the digital media practice within Epsilon.
Disruption: In the first half of 2018, Epsilon’s revenues fell by 4.5%. The agency side of the business was down by 20% due to consolidation and budget cuts in the CPG sector (P&G, Unilever who are the top 2 largest spenders on advertising all cut their ad budgets in 2017).
Relief: While the industry is temporarily in transition, the long-term outlook remains positive. US ad spending is expected to grow 4-7% depending on the forecaster over the next 5 years. Digital spend is expected to grow in the high teens / low 20% range. Even though certain customers in CPG have cut their budgets, we believe this will eventually stabilize and grow over the longer-term. As the CPG sector becomes a smaller portion of Epsilon’s revenues, other verticals are making up to help grow the business:
Q2 2018 Earnings Call:
“Epsilon, as we've guided to, we knew the first half would be soft. Revenue was down in the first half. But again, as Charles mentioned, this is primarily passed through a low-margin agency business. Frankly, we're deemphasizing those types of areas. And as a result, you saw the softness there. The adjusted EBITDA, however, we held for the first half, up 4%, and tracking to sort of that mid-single-digit guidance that we want for the year. We are using some additional dollars from the tax windfall, as we mentioned last year, for additional development in our various digital channels.
Second half, we do have decent visibility on mid-single-digit revenue and adjusted EBITDA growth. Both are probably big growth engines. The Auto and the Conversant CRM revenue are tracking to double-digit growth, and that's approximately half of Epsilon. And the other businesses are relatively stable or flat, and that's where we get our mid-single digits. And so we'll be talking more in Q3 as Epsilon begins to contribute, along with the other 2 businesses.”
Card Services (54% of revenues, 70% of EBITDA)
Description: The company had $18bn in credit card receivables on behalf of 160 client consumers.
Disruption: In the past year, card services faced three simultaneous headwinds:
Hurricanes Harvey and Irma hit a large number of customers which forced ADS to put them in a special bucket and temporarily increased charge-offs
The company brought all its collections in-house and so the company’s recovery rates were in transition
A series of liquidations (Gander Mountain, Bon-Ton and Virgin Atlantic’s acquisition by Alaska Airlines) in the credit portfolio caused receivables growth to be slower than expected
After a temporary spike in charge-offs, ADS’ charge-offs are now tracking in line with expectations. The company has anniversaried the impact of the Hurricanes which should no longer impact charge-offs.
The company has finished successfully ramping up its collections team:
9/12/2018 DB Conference Presentation:
Edward J. Heffernan
We're not hearing any stress or strain from our collectors who are out there from the consumer, which is a very good sign. In terms of recoveries, which we bought in house, to bore you with the details, if your gross charge-offs are 7.5%, you try to recover 1.5% from recoveries, get to about a 6% loss rate, that was a 50 basis point headwind in the first quarter, it's going to be a 50 basis point tailwind in the last quarter as our internal recovery efforts have brought us above 20% level -- 20% of gross charge-off.
Okay. That's very helpful. You also talked about a nice jump up. So should we expect the recovery at 20% to sustain going into the next year?
Edward J. Heffernan
3) The consecutively large # of liquidations shouldn't continue. While undoubtedly retailers will continue going bankrupt, the shear number of large, consecutive liquidations ADS faced this year shouldn't continue. Additionally, the receivables book is continuing to diversify away from traditional clothing retailers and towards other industry verticals like travel and leisure (Carnival Cruise Lines, Red Roof), Beauty (Ulta), Furniture (IKEA), e-commerce (Blue Nile, Wayfair, Overstock, Build.com). 40% of the company’s credit sales now come from online. ADS now believes it can continue growing receivables at a mid-double digit rate as it churns through legacy retailers by focusing on 1) new growing retailers in adjacent verticals in North America and 2) expanding internationally in Europe and Asia.
Putting it All Together
The combined weakness in LoyaltyOne in 2016, Epsilon in 2016-2018, and Card Services in 2018 all caused a contraction in the company’s multiple as investors became fatigued with the company’s poor performance. In 2018, the company also spent a fair amount of cash flow delevering the balance sheet, instead of using it on share repurchases as it has historically. The company will now end the year at the low end of its debt / EBITDA range (low 2’s versus comfortable under 3x).
We see the light at the end of the tunnel in an unfortunate series of short-term problems the company faced all at the same time. LoyatyOne is beginning to inflect. Epsilon is still in transition, but starting to show signs of growth in the second half of 2018. It is replacing low margin agency business with higher margin business lines through Conversant and auto. Card Services has overcome all 3 of its headwinds as well in the back half of this year. The company will once again begin actively repurchasing stock in next year since it will finish delevering by the end of 2018. We believe that as this execution occurs, EPS will continue to grow at a double digit rate and ADS’ multiple will re-rate moving forward.
As investors start to recognize that the disruption in ADS’ three segments are due to temporary reasons as opposed to structural headwinds, we believe ADS’ P/E multiple will re-rate. As this transition proves itself out over the next several years, we believe ADS will continue repurchasing shares at an attractive price, boosting EPS over the long-term. When ADS’ two capital light businesses (LoyaltyOne and Epsilon) show signs of progress, this will contribute to the premium valuation ADS deserves relative to other financial services companies. We believe ADS can grow its receivables portfolio at mid-double digits, but even if it comes lower than that (low double digits due to higher retail bankruptcies than expected), there is still a large margin of safety at today’s price. A company that grows it's loan book at even 10% a year should not trade at 10x earnings.
We believe that ADS can grow EPS at double digits with share buybacks over the next three years. As the short-term headwinds from this perfect storm disappear, ADS should trade a 14x P/E. This will generate over a 20% IRR for investors.
EBITDA from segments start growing again
Break-up of company
|Subject||Possible bear cases?|
|Entry||10/18/2018 08:12 PM|
I think the crux of this debate is "does ADS card services have a data advantage and thus should earn returns greater than that of COF and SYF"? Talking to former employees thus far, I'm leaning towards no. If that's the case, then the sources of higher return has to come down to risk pool. Lower quality customers = higher yield. This is interesting because former employees have said there are a lot of <650 subprime customers in the receivables pool (directly in contrast with the CEO's claim that they don't lend to subprime. There should be no gray area when it comes to this...).
In terms of growth in new accounts: Conceptually, e-commerce economics should actually be worse for a private label CC issuer relative to B&M e-commerce. Your typical shopper is more affluent (thus isuers get lower yield) and e-commerce shopping is much more fragmented and competitive (and thus you're using your card less). As ADS shifts more to faster growing e-commerce, faster growth should see pressure on yields (but improvement on losses).
What are people's thoughts on the bull case? Say they sell Epsilon and/or loyalty at 8-10x EBITDA. You're left with a pure play credit card issuer that optically grows low to mid teens receivables but might have longer term credit issues (competitive bidding forces ADS to reach more into lower quality customers. Provision/NCO ratio has remained flat since 2014 despite pool of customers potentially getting worse in terms of credit quality) and lower yields (lower yielding e-commerce customers). Maybe you get 10% earnings growth. Is the growth of the pure-play enough to re-rate this?
What are people's thoughts on the holdco leverage given some of the cash has to be held at the bank subsidiary level and cash flow excl. card services minus share repurchases has been negative (see CS House of Cards note)? How much cash can actually be dividend out? Tier 1 ratio at 15% currently, similar to SYF (and SYF has a much better sticky deposit funding source vs. ADS)
I'd love to hear feedback from the community.
|Subject||ValueAct - Strategic Alternatives|
|Entry||10/19/2018 11:12 AM|
Rearden - what's your estimate for the value of the business on a sum of the parts basis? Similarly, what do you think is the likelihood that ADS breaks itself up into 2 or 3 pieces and sells them off? What multiples could the pieces get in a sale?