Description

ADS is a financial company with exposure to retailers, a combination that the market wants nothing to do with. However, for the patient value investor ADS trades at 3x normalized earnings and I believe the stock could be a double in 2-3 years.

ADS has been written up several times on VIC, so please refer to those detailed write-ups for longer descriptions of the business. Note ADS has exited the Epsilon business, which is referred to in previous write-ups. Currently 85-90% of ADS’s pre-corporate earnings come from its private label credit card (PLCC) business with a smaller contribution from its LoyaltyOne segment. 

The PLCC business is the 3rd largest private label card issuer (behind SYF and C). ADS’s primary earnings driver is credit cards, so it is notable that ADS’s stock has lagged other credit card company stocks by ~30% YTD as ADS is down -55% YTD vs SYF -21%, DFS -24% and COF -23%. Consumer finance stocks have done better than bank stocks (-31% YTD) as consumer credit has been holding up surprisingly well this recession. The resilient consumer finance environment can be explained by the following factors: 1) consumers entered this recession with much healthier balance sheets; 2) the bulk of job losses in this recession have been in lower-wage consumers who are not heavy users of credit card debt; 3) government stimulus and lender forbearance programs have helped consumers build savings. (Note: Enright’s recent DFS write-up gives some helpful charts and context on the consumer finance environment.) Of course, the market is skeptical that this good credit performance will last but the consumer continues to hold up well - JPM CFO said today that she doesn’t expect credit card losses to meaningfully increase until 2H 2021. The longer credit losses stay relatively low, the more capital these companies will generate to offset future losses.

ADS’s credit stats have held up well reasonably well due to the factors above. In Aug 2020, NCOs were 6.45% which is up 76bps from Aug 2019 and 66bps from Aug 2018. Relative to other credit card companies, ADS’s loss experience is higher than average, but shows smaller increases in recessions. I believe this is due to relatively high credit scores combined with relatively low balances. See below for ADS’s NCO experience vs peers in the last recession:

I believe ADS is using more conservative economic assumptions than peers. Credit card peers are assuming unemployment rates have already peaked and continue to improve to 8-9% by 2021. Given the 7.9% Sep unemployment rate, these assumptions could be conservative but are also prudent given the high level of macro uncertainty. ADS appears to be incorporating more uncertainty in its reserves as they are assuming a double-dip recession with unemployment going back up to 13% and a 10% decrease in GDP in 2021.

As a result, ADS’s reserve rates are also the highest amongst the credit card companies. Under CECL accounting, banks reserve for expected life of loan losses. Assuming 1.5 year average duration for credit card loans, ADS’s 13.3% reserve/loan ratio implies annual losses of 8.8% which are 90% of last recession’s peak NCOs (8.8% / 9.8%). Doing a similar calculation for peers results in ratio of 78% for SYF, 74% for COF, 69% for DFS, and 52% for AXP

Another concern is ADS’s troubled retailer clients. ADS had 50-60% of its credit card book from mall-based retailers in 2025, but today that mix has been reduced to ~25%. It’s also notable that ~40% of ADS’s card spend is occurring online (was ~30% pre-pandemic). ADS has said that 8-9% of its card portfolio is from retailers currently in bankruptcy. However, when a retailer goes bankrupt, ADS doesn’t have credit risk with the retailer but rather the credit risk is with the individual card holder. When a retailer ceases to operate, the cardholder is still responsible for repaying the credit card balance and ADS sales and marketing expenses go down. Of course, since the card has no utility for customer, the balances tend to roll off (~50% in 6 months and 90% in 24 months) presenting a revenue (but not credit) headwind for ADS.

In Feb 2020, ADS appointed Ralph Andretta as CEO. He was formerly head of US Cards at Citi and previously worked at the card division of BAC and AXP. Andretta’s card operations-focused background stands in sharp contrast to the prior deal-driven management team. I believe the PLCC business has been mis-managed by the prior management team and the recent announcement $250m of non-volume related cost savings is evidence of the operational improvements being made. The previous management team was focused on growing EPS through acquisitions of non-card businesses and was aggressive with stock buybacks. For a while, this worked as prior management pitched ADS as more of a tech/services company than a credit card company, and investors awarded ADS with a ~20x P/E 2013-2015. However, this acquisition-driven led to some poor acquisitions and a painful reversal of the prior strategy. ADS sold its Epsilon marketing division in mid-2019 leaving the ADS with the PLCC and LoyaltyOne businesses - and a 5x forward P/E on consensus estimates. Andretta has not spent much time with investors since he joined ADS but given his background I would not be surprised if he chooses to eventually sell LoyaltyOne and focus on running the PLCC business. If the LoyaltyOne business is sold, I think ADS could pay down almost all its holding company debt and leave ADS pure-play credit card company that will be easier to compare to peers.

Since the main earnings driver is PLCC, I will touch on the LoyaltyOne business briefly. This segment generated average pre-tax profits of ~$160m/yr from 2017-2019. Earnings are taking a hit this year, but I do not think earnings here are impaired and will return to prior levels in 2-3 years. The LoyaltyOne business is a GDPish grower with decent low 20s EBITDA margins and low capex (~4% revenues). Valuing this at 8x EBITDA / 10x EBITDA-Capex / 12x after-tax cash flow results in a value of ~$2bn. 

ADS’s capital structure has also been a source of confusion so I will offer a few quick notes. ADS’s PLCC business is operated through 2 regulated bank subsidiaries. On a combined basis these banks have tangible equity / tangible assets of 12.6% and CET1 capital ratio of 18.3% (after the ~13% reserves on the loans). In 2018-2019 these bank subs paid $1.4bn ($700m/yr) in dividends to the parent company. In 2020, I would expect dividends to parent to be much lower - the $75m paid in Q1 may be all for this year. However, the banks also pay out ~$150m of cash to parent company from an intercompany servicing contract. LoyaltyOne will likely kick up ~$150m of cash to the parent company. This results in total cash flow to the parent company of ~$300m/yr without any dividends from the bank subsidiaries. This is plenty to cover corporate expense (including holding company debt interest) of ~$140m/yr. Note the holding company has no debt maturities until it’s credit facility is due in Dec 2022 and the holding company currently has $1.1bn in liquidity ($775m in cash plus $350m in unused revolver).

I think ADS’s normalized earnings per share is ~$16 (note this is on GAAP basis, ADS “adjusted” EPS adds back amortization equating to additional ~$2/sh of earnings). My key assumptions are: 1) PLCC generates pre-provision profits of ~13% of average loans (vs ~13.5% 2017-2019); 2) loan book shrinks to $15.5bn (vs $18.9bn in 2019); 3) Normalized loan loss provisions are 6.5% of loans (vs average / high / low of 6.4% / 9.3% / 4.2% 2001-2019). This results in PLCC pre-tax earnings of ~$1.0bn (vs $1.1bn 2017-2019). LoyaltyOne pre-tax of $160m is largely offset by corporate expense of $140m. Using 25% tax rate results in ~$750m net income which equates to $16 EPS on 47.7m shares. In “normal” times credit card companies like SYF and DFS trade at ~10x P/E but to be conservative I am using a 6-8x target P/E which results in a 2-3 year target price of $96-128 (90%-153% upside).

Catalyst

ADS’s credit card reserves end up being conservative and ADS gets back to ~$16/sh in normalized earnings

ADS's new management team continues to run PLCC better than prior management team

Eventual sale of LoyaltyOne business resuts in pure play credit card company that is easier to compare to peers