Alliance Data Systems ADS
December 30, 2008 - 10:10am EST by
lindsay790
2008 2009
Price: 45.24 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 2,986 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

 
Investment Overview
-Largest and most comprehensive provider of transaction-based marketing and loyalty solutions
-Data-intensive approach to marketing directly tied to ROI makes programs very “sticky” with customers and recession   resistant
-30+% cash earnings CAGR since 2003
-2008E earnings growth of 13% despite credit headwinds and loss of a major customer (Lane Bryant); company targeting 17+% growth in 2009
-Trading at credit card company multiple of 10.3x 2008e P/E and 8.8x 2009e P/E despite credit being only 30% of business
2009e FCF yield of ~10%
-Low leverage at 1.7x net debt/EBITDA
-Strong liquidity profile with $150 million credit facility from Wachovia in June 2008, $805 convertible notes ($78.50 conversion price) priced in July 2008 and $1.4 billion securitization in October 2008 ($380 million in cash at 9/30/08)
-Announced $1.8 billion of stock repurchase programs (35-40% of market cap) of which only $870 million have been completed
 
Company Stats

Market Cap $2.99bn

Enterprise Value $4.21bn

Revenue (2008e) $2.05bn

Adjusted EBITDA (2008e) $654.0mn

Cash EPS (2008e) $4.40
 
2008E Valuation Multiples

P/E 10.3x

EV/EBITDA 6.4x

 
Share Stats

Shares Out 66mn (9/30/08)

Float 64.4mn

Avg Daily Volume (3 mo.) 1.6mn shares

% Short 14.0% (11/24/08)

52 week range $34.76-$75.13
 

Company Overview

Alliance Data Systems was formed in 1996 as the result of Welsh Carson Anderson & Stowe’s merging two of its portfolio companies, JC Penney’s transaction services business and The Limited’s credit card bank operation, World Financial Network National Bank. The company issued public shares in 2001.

 

The Company operates in 4 distinct segments:

 

Loyalty Services (~33% revenue, 31% EBITDA)
- Provide all marketing, customer service and rewards and redemption management services for AIR MILES Reward Program, the largest coalition loyalty program in Canada with over 120 participating sponsors;
70% of Canadians belong to the program; benefit from network effect and pricing power
- No connection to airlines; primary sponsors include pharmacies, banks, grocery stores and gas stations (non-discretionary high frequency spending)
- Long-term contracts with very high renewal rates
- Looking to leverage capabilities to expand internationally
 
Epsilon Marketing (~19% revenue, 15% EBITDA)
- Provide ROI-based integrated direct marketing solutions that combine:
           - Marketing strategy,
           - Database management,
           - Proprietary data services,
           - Analytical services, and
           - Distribution (35+ billion permission-based emails sent annually)
- Coalition programs such as Citi ThankYou Network (reduces attrition by 50%)
- Individual programs such as Hilton HHonors and Barnes & Noble
 
Private Label Services (~16% revenue, 17% EBITDA)
- Assist clients in extending their brand with a loyalty-driven private label or co-branded credit card
- Provide marketing programs, high-end customer care, and transaction processing
- Key clients have long tenure and high renewal rate
- Generally sign 4 to 5 major clients per year (10 to be signed in 2008)
- Intercompany revenue derived from Private Label Credit based on market rates
 
Private Label Credit (~31% revenue, 37% EBITDA)
- 11 million households
- 85% female, mid-to-high income, 700 average FICO, low average balance ($350)
- Customer views as loyalty program, not extension of credit
- Target high-end and luxury retailers

 

In May 2007 Alliance Data Systems entered into an Agreement and Plan of Merger with Aladdin Solutions, an affiliate of The Blackstone Group, pursuant to which the Company was to be acquired for $81.75 per share. In January 2008 Aladdin sent the Company written notice that it did not believe that the Office of the Comptroller of the Currency would give necessary approvals to the transaction. As a result the Company filed a suit against Aladdin and Blackstone seeking a $170 million (~$2.50/share) Business Interruption Fee as defined in the Agreement.

 

Industry Overview

- Loyalty services competes somewhat with Aeroplan coalition loyalty program (though Aeroplan focuses on business customers rather than consumers) and individual company loyalty plans in Canada; dominant market position
- Epsilon marketing competes with traditional and online marketers as well as internal teams of potential clients; unique in blending of traditional marketing services with highly targeted data–driven programs
- Private label services highly competitive space with several players; differentiates with “white glove service” aimed at high end retailers
- Private label credit competes with financial institutions that issue credit cards, especially those that offer co-branded platforms; loyalty focus differentiates 
 

Investment Thesis

- Market values company based on private label credit despite being less than 1/3 of cash flow currently (and even less in subsequent periods)
             - Believe credit business to be free at current trading levels
             - Credit trends should be better than most other card issuers
- Loyalty services, Epsilon Marketing and Private Label Services provide steady stream of growing cash flows via long-term contracts
             - Businesses very resilient during recession earlier this decade
- Expect mid-teen growth in operating cash flow over the next 5 years
- Micro-segmenting based on managing transaction data growing secular trend; digital advertising hanging on much better than traditional advertising
- Top tier management team that has met or exceeded guidance every quarter since IPO
- Potential for large settlement payment from Blackstone
- Share buyback should help put a floor on the stock if markets are choppy
- Upside to 2009 estimates as funding costs (i.e. LIBOR) normalize (projected $25 million headwind in 2009)

 

Risks

- Economic slowdown could slow signing of new clients to programs
- Manage $3.9 billion of credit card receivables ($3.2 billion of which are securitized) with increasing delinquencies and charge-offs (both up 100bps from 2007 to 2008) – 50bps is $20 million in pre-tax earnings
             - Could hedge 25-30% of position with DFS or COF if bearish on credit card receivables
             - Plenty of liquidity for a massive increase in charge-offs
- Customer concentration could lead to slowing growth if a customer is not renewed (10 largest clients account for 41% of 2007 revenues)
- Currency risk associated with translating Canadian Dollar profits into US Dollars (benefit in first half of 2008, but expected to be a $20 million drag on pre-tax earnings in 2009)
- Own an industrial bank subject to regulation by the Office of the Comptroller of Currency, the entity which derailed the Blackstone transaction
 

Historical Financial Performance:

(From ADS 3Q ’08 Presentation)


  • Consistent strong profit growth
 

2003 2004 2005 2006 2007       2008e       2009e      CAGR
Adjusted EBITDA 189 215 321 498 632 660 680 24%
Cash EPS $1.00 $1.54 $1.99 $3.14 $3.88 $4.40 $5.15 31%
         
           
           
           
  • Business emphasis has shifted away from credit
 
 
Operating EBITDA




2005
2009e
Loyalty
24%
33%
Epsilon
9%
20%
Private Label Services 23%
17%
Private Label Credit 44%
30%
       
         
         
 

Valuation

Blended target of $67.00 based on Comparables and Discounted Cash Flow Analysis

 

Comparables Analysis
Getting Private Label Credit for free at current stock price

Sum of the Parts




        Multiple   Value
Loyalty Services2

14.4x
 $    20.96
Epsilon Marketing2

14.4x
 $    14.94
Private Label Services3
10.6x
 $      8.83
Private Label Credit4
9.6x
 $    17.67







     
Total
 $    62.40
1) Based on percentage of operating profits before corporate expenses and JMP Securities EPS projection.
2) Comps include DRIV, GOOG, IPG, MCHX, NCMI and YHOO at consensus estimates.
3) Comps include EEFT, GPN, HPY and TSS at consensus estimates.


4) Comps include AXP, COF and DFS at consensus estimates.


         
           
           
           

Discounted Cash Flow Analysis

 

- Assume continued credit headwinds (i.e. increased net charge- offs to 10.5% from 6.5% in 2008) and compromised growth through 2010 as experienced in 2008
- Beginning 2011, assume a return to 10% growth (below company target of mid-teens growth) for 3 years and then 6% for 5 years

 


WACC


10.0% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0%
Terminal Growth Rate 1.0% $94 $82 $72 $64 $57 $52 $47
2.0% $102 $88 $76 $67 $60 $54 $48
3.0% $111 $94 $82 $71 $63 $56 $50
4.0% $124 $103 $88 $76 $66 $59 $52
5.0% $142 $115 $96 $82 $71 $62 $55
         
           
           
           

 

Catalyst

1. Improvement in y-o-y earnings growth after anniversary of losing Lane Bryant business
2. Achievement of 2009 profitability targets (management assumptions for funding costs and currency headwinds now look extremely conservative)
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