Value Investors Club / ALLIANCE DATA SYSTEMS CORP (ADS)

Description

Alliance Data Systems

Investment Thesis

February 2016

Summary: ADS is a growing, capital light, high ROIC, well managed loyalty program operator, yet priced like a general credit card issuer

standing in front of a consumer default wave. The company is on the right side of numerous trends, has experienced and incentivized

management, and has created a very sticky yet rewarding mouse trap for its customers. Assuming continued growth in revenues, and

FCFs are reinvested thoughtfully, the forward 11x earnings multiple materially undervalues the company.

Industry and company are growing, capital structure is efficient, operations generate ample free cash flow

• As an outsourced provider of consumer loyalty and marketing programs, ADS benefits from growing, secular trends in the retail

and payments industries that should continue indefinitely into the future. Targeted marketing driven by data and analytics is

taking share from generalmarketing spend, the spend on both isvery large and increasing, and the function is vitalto the health

of those companies purchasing it. Retailers are increasingly acceptant of and dependent on customer loyalty programs to cost

efficiently drive sales. Private label credit cards are taking share from general purpose cards due to lack of interchange fees

(these savings essentially redirected to fund retailers’ loyalty programs), increased tracking ability of consumer spending

patterns, and the rise of digital wallets driving broader acceptance by consumers

• The company’s revenues and FCF have tracked these trends, growing at CAGRs of 16% and 19%, respectively from 2006 to

2015, and management has guided to continued growth through 2017

• The company is conservatively financed and has ample liquidity; gross leverage = ~2.75x, and the company has 10% of its

market cap in cash

• Existing management is tenured and have been excellent allocators of capital

• Value disparity: the market is overly focused on potential consumer credit deterioration in the US generally, and confused by

management’s guidance for increased charge offs in 2016 / 2017 specifically (due to expected seasoning of credit portfolios

which started life 2-3 years ago, not worsening credit losses)

Inexpensive valuation

• Contrarian viewpoint: Despite 64% of LTM EBIT coming from the private label card segment (including internal processing

operation), the company should be primarily valued as an outsourced loyalty program operator and data / analytics provider

with a small credit component attached as opposed to primarily as a credit card issuer

• Consistent high returns on invested capital support this viewpoint; after tax ROIC averaged 28% from 2006 - 2015

• At ~11x / 9x 2016 earnings / free cash flow, ADS is currently valued at or lower than multiples analogous to general purpose

card comps AXP, DFS and COF, despite ADS’ focus on prime borrowers (700 FICO and above) only and low average balances

(~$500 vs ~$5,000 for general purpose cards) in its credit book. Assuming credit portfolio loss rates of 700bps in 2017 (vs

management guide of 550bps, and compared to 10% in 2009) and assuming no related expense structure offsets, 2017 cash

earnings would be reduced by 11% to $17 / share, for an implied multiple of 11x 2017 earnings.

• ADS has historically traded at 18-20x forward earnings, in line with a peer group of asset light, transaction processing and

business process outsourcing firms such as proxy peers FISV, FIS, EXPN.L, GPN, DNB, and ACXM

• Hidden value: Dotz’ (Brazil coalition loyalty program described below) 37% ownership not reflected in financial reporting,

potentially worth $0.60-$0.70 in earnings per share

ADS owns a collection of high quality businesses

Card services – 46% of revenue / 64% of EBIT / 34% EBIT margin for 2015

• Operates 140 private label card programs for retail channel customers with >30 million card holders; total universe of potential

clients = ~400 per management; gained ~10 clients / year over past 5 years; account holder base consists primarily of middle

to upper income individuals, in particular women who use cards primarily as brand affinity tools

• Provides a comprehensive marketing mechanism at a more cost effective measure for small to mid size retailers, where most

of program’s cost is borne by the cardholder herself; per CEO: “What we found over the last 20 years is that a private label

cardholder will visit twice as often and spend twice as much as a very comparable bank cardholder.”

• Bundled services provided to the retailer include: 1) credit to the consumer 2) payment processing 3) customer care / call center

4) direct marketing based on purchase history and payment statistics

• In contrast to general card providers, ADS (due to its contractual relationship with the retailer) can marry consumer purchase

behavior with SKU level information, providing a large informational advantage for the company’s targeted marketing activities

• Closed loop network charges no / limited interchange fees to the retailer, freeing up incremental capital that retailer can spend

on further targeted marketing initiatives; thus retailer strongly favors private label card spending versus general cards

• At program maturity, card revenues equate to 40% or greater of overall revenues for retail customers

• Due to the embedded nature of its service and high value add at a cost efficient manner (ie high, measurable ROI), the company

has a 99% customer retention rate

• Per CFO: “Right now, we run low 40% return on equity [in cards]. During the worst of the great recession, mid-2009, we were

still generating over a 30% ROE and that was at the very worst of the economic cycle.”

LoyaltyOne – 21% of revenue / 14% of EBIT / 16% EBIT margin for 2015

• Operator of three coalition loyalty programs, where numerous vendors participate in a joint consumer rewards program issuing

points that are redeemable across the network of participants; typically involves one or two major retail vendors per category

(eg one national bank, one national grocery chain, one airline, one drug store chain, one gas station chain, etc)

• As the manager of the program, ADS receives float from the timing disconnect of when points are issued versus when points

are redeemed (can extend out 3-4 years); programs are self funding, require almost no capital to operate, and generate

enormous float (negative working capital from deferred revenue) in the ramp stage

• Air Miles – Primary, national program in Canada used by ~70% (25 million members) of the population (36 million); has over

200 participating retail issuers

• BrandLoyalty – 70% current ownership; success based (consumer has to earn x amounts of points before rewards become

available) program operator for grocery channel in Europe; seeking to replicate a similar program in the US in 2016

• Dotz: 37% current ownership; similar to Air Miles but in Brazil; from a standing start in 2009, the program had 6 million members

by 2012, and 18 million at year end 2015; management thinks a 25 million (versus Brazil population of 205 million) member

target by 2018 is achievable, equating to $600 million of revenues and $100 million of EBITDA for the entity

• Coalition loyalty programs are rare assets and not many exist at scale; outside of ADS, other programs include Aeroplan in

Canada, Nectar in Europe, Club Premier in Mexico (all three owned by Aimia), Avios in the UK, Multiplus in Brazil, Plenti in the

US (launched by AXP in Spring of 2015) and Payback in Europe (acquired by AXP in 2011)

Epsilon – 33% of revenue / 22% of EBIT / 17% EBIT margin for 2015

• Operates outsourced (but non credit extending) loyalty programs and other targeted marketing activity for large consumer

focused companies; key clients include Kraft, Dell, Unilever, Ford, Toyota, AT&T, Dunkin Donuts, Citi, Wells Fargo, US Bank;

has >1,000 existing customers

• A portion of segment revenue = general agency related services, which tend to be project based and drive lumpy revenues

• Acquired digital ad placement and tracking firm Conversant (~40% of Epsilon segment EBITDA in 2015) in 2014 for 10x EBITDA;

>30% legacy EBITDA margins have been compressed under ADS’ ownership as management aggressively spends on new

customer growth, including headcount additions for awarded, but not yet revenue generative, contracts

• The segment requires nominal working capital to operate

Value proposition of the company’s services summarized by the CEO: “The interesting thing about loyalty programs is that the more

challenging the environment, the more the client is willing to pour into these loyalty programs. And that's true in Europe, it's true in the

U.S. If you look at just your traditional retailers in the U.S., it's no different than in Europe that pricing power is short. There is no pricing

power. And as a result, these retailers need to make do with less, which means again getting back to how they're spending their marketing

dollars. They can't spend it. Everyone gets 20% off, come on in. That doesn't work effectively anymore. You're just going to crush your

margins. What has to happen is you need to segment your customer base into those customers who are enticed by being notified of the

latest goods have just arrived, come on in for a special viewing or whatever to 5% off up to 25% off. And if you do it that way, you're

basically optimizing the marketing spend of the retailer and the retailer can maintain some of their margin.”

Management team and Board are experienced and well regarded

•Board includes multiple partners of private equity firm Welsh Carson (ADS was formed in 1996 via Welsh Carson’s merging two

portfolio companies, JC Penney’s transaction services unit and The Limited’s credit card unit) and also include former VPs and

CFOs from FDC, ADP and AXP

• CEO, 53, has been with the company since its founding, was previously the CFO from 2000 – 2009, and led the 2001 IPO

• CFO, 55, has been CFO since 2009

• Each of the three division heads has been with the company for at least 10 years

Management has a strong track record of capital allocation, clearly articulates their capital allocation priorities, and the company has

ample reinvestment opportunities at high incremental ROIC

• Balanced current capital allocation with descending priorities of 1) investing in existing business 2) M&A 3) share repurchases

4) larger ownership of current JVs

• Successful history of both acquisitions and organic reinvestment; management has not overpaid for acquisitions

• Completed well timed, large share repurchases, including retiring 40% of the then shares outstanding during 2008/2009; has

repurchased a cumulative 25% of the shares outstanding since 2006 (offset = issuing shares for acquisitions and management

options)

• Current organic investments include building out the support function (headcount, systems) for credit card portfolios started from

scratch or acquired within the last 1-2 years (maturity and scale usually achieved by year 3 or 4), recreating BrandLoyalty’s

grocery coalition loyalty program in the US, and cross selling Epsilon’s digital marketing services to existing retail card channel

customers

Catalysts for value creation and market recognition include:

• Earnings multiple re rating as credit portfolio losses trend in line with management guidance

• Eventual consolidation of dotz JV onto company’s reported financial statements

• Increasing ownership %s in existing, growing JVs

• Future M&A

• Ongoing share shrink

• Potential acquisition target for larger players in digital marketing, loyalty or card services; specifically: AXP

Share ownership: management is aligned with shareholders

• Insiders collectively own 2.5% of the shares outstanding, or ~$300 million

• CEO has exposure to $45 million of shares

• Short interest is low (4% of shares outstanding)

• However, no notable 13F portfolios include a material position in ADS (both a pro and a con)

Contra thesis

The company’s operations are complex and can be confusing to both sell side analysts and investors

• High returns on capital across all three business units may be overshadowed in favor of comping ADS primarily against the

lowest common denominator of its peer group, general purpose and co-brand credit card providers (65% of EBIT derived from

private label card segment)

• Card company peers (SYF, COF, AXP, DFS) trade for low multiples (~10-12x EPS), and ADS may not re-rate to its former

multiple of 18-20x

• Each of the three individual business units has its own growth, margin, working capital and funding profile, many of which move

in different directions from one another

•Formerly off balance sheet securitizations (which provide funding for the company’s managed credit portfolios) were brought

back onto the GAAP balance sheet in 2010; although non recourse to the company, may create challenges for the company’s

capital structure in the future and confusion around current enterprise value

ADS has been highly acquisitive since inception, making run rate FCFs, organic vs acquired revenues, etc hard to determine

• Focusing on and digesting material acquisitions may distract management from their existing responsibilities

• Management’s preferred earnings metric = “Cash EPS,” which adds back both stock based compensation and amortization of

acquired intangibles; short sellers have repeatedly challenged this metric, and an additional accounting critique combined with

a weakening credit outlook could hurt company perception / valuation

• Half ($175 million / 62 million shares = $2.80 / share) of the $350 million in LTM amortization relates to acquired credit card

portfolios (excess paid by ADS above book value of seller); ADS has been a serial acquiror of these portfolios

The company has material US consumer credit exposure, and the US credit cycle is beginning to weaken after a long expansion

• From a high of 10% in 2009 / 2010 to a recent low of <4% in mid 2015, management projects credit portfolio loss rates to rise

in 2016 / 2017 to 5% / 5.5%

• Each 10 bps move in loss rates = ~$0.14 of EPS (assuming no corresponding expense offset); assuming credit performance

weakened to the half way point between 2009 and 2015 (ie to 700bps vs 550bps for 2017), EPS would decline by ~$2 / share,

impairing projected 2017 EPS by 11%

Card industry competition is accelerating, and many of the company’s peers have larger capital and customer bases

• SYF, ADS’ only direct private label peer, recently spun out of GE where it was likely mismanaged; SYF management is now

incentivized, has their own currency, and competes at the margin for mid scale private label card portfolios

• AXP, a general purpose card operator, but also a manager of various loyalty programs (eg AXP’s Plenti coalition loyalty

program), has had rapid deterioration in its primary business and may disrupt overall card industry economics and relationships

as it searches for a panacea

ADS’ targeted end markets are cyclical, and the company has both customer and industry concentration risk

• 10 largest clients = ~30% of total revenues

• Largest client (L Brands) = ~9% of credit card loan receivables

• Auto sector = largest end market exposure for Epsilon (pre Conversant acquisition)

Company has material exposure to foreign currency movements, which have notably impaired revenue and earnings growth

• Impact = $0.46 / share in 2015 (vs $15 reported EPS)

• Primarily Canadian dollar related to Air Miles program and Euro related to BrandLoyalty program

• Does not hedge currency

Financial performance summary:

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

Catalyst