Description

Alliance Data Systems

Thesis

·         The market doesn’t understand the franchise value and long-term earnings power of Alliance Data Systems (“ADS”)

·         ADS’s primary business creates high utility loyalty programs to subscale retailers that are delivered through private label credit cards. The cards have an APR consistent with subprime lending (prime rate + 21.74%), but loans are to prime borrowers with small balances and therefore small credit losses (6%)

·         Unlike other private label credit card issuers that are primarily used for off-balance sheet financing, ADS shares very little of the card economics with their retail partners due to differentiated loyalty program services, which results in high returns on assets (6%) and a franchise value

·         Investors believe increases in net charge-offs are indication of declining credit quality, but we believe they reflect normalization after 2008/09 charge-offs, which accelerated default by weakest cardholders, depressing net charge-offs in recent years

·         Quality of recent customers wins (Williams-Sonoma, Wayfair, Signet’s prime portfolio) and organic growth in credit balances indicates room for 10-15% earnings growth

·         At the current price of $250, shares of ADS trade at 10x 2018E earnings power and it appears that no price is being paid for the significant earnings growth potential of the company

Card Services (56% of revenues and 66% of EBITDA)

·         Summary

o   Card services business is a leading provider of tailored marketing and loyalty solutions, delivered through private label credit programs that drive more profitable relationships between ADS brand partners and their cardholders

o   ADS loyalty programs have high utility as they are critical to their brand partners’ success/profitability, but are a small component of costs at approximately 60bps of retailer sales. The utility of their programs is also increasing due to competitive response to Amazon, which designs similar programs internally

o   Private label credit programs allow ADS to capture customer name, address, and email, which is then augmented by SKU-level transaction data provided by retail partners and external demographic/psychographic (married, kids, etc.) data. This unique data then allows ADS to design targeted loyalty programs to individuals

o   ADS manages approximately 160 private label credit programs for U.S. retailers with highly-recognized brands. Segment focuses on long tail of smaller retailers that lack the economies of scale and core competencies necessary to handle the logistics of their own database and loyalty programs. ADS allows these smaller retailers to do expensive loyalty programs that Epsilon does, but shifts the majority of the expense to the consumer through private label credit programs

o   42.5mm active accounts and 25.5mm with small revolving average balance of $625. Cardholder base consists of middle- to upper-income individuals, in particular women (approx. 93%), who use the card to access the retailer’s loyalty program and to get discounts on purchases, which has better value proposition than a general purpose card

o   70% of balances and 80% of credit sales are from retail partners’ most profitable/loyal customers that are +2 years old, therefore growth not through churning (+80% of tender share growth is from cardholders that are +3 years old). Spending from cardholders is 2-3x spending from non-cardholders

o   26% APR on balances appears high, but cardholders get approximately 5% off everyday purchases and 5-30% off during promotions, which avoids yield price discovery (regulatory scrutiny) and the net APR similar to general purpose credit card like AXP

§  ADS has a higher revolve rate of 80-85% vs 40-50% at peers. ADS also has 8-10 purchases per year vs Synchrony (“SYF”) at 2-3 purchases per year

o   Also, with small balances, the consumer looks at using a private label credit card as an installment plan and a tax on purchase payment

·         Industry Structure

o   Card services segment operates in a consolidated industry structure where top 3 private label credit card issuers have 85% share and long-term, 5-10 year contracts with retail partners

o   SYF and Citi Retail Services (which together are 70% of market) focus on large private label credit programs (Walmart, Lowe’s, etc) and do not focus on smaller merchants where ADS plays (ADS average file is $100MM). High entry barriers result in rational competitive behavior as competitors have segmented market amongst themselves

o   SYF and Citi earn 2.5-3% ROA, which prevents new entry as they are not overearning and new entrants would earn less due to scale economies and discounting needed to incent retail partner switching. Large retail partners do not switch private label card issuers often (SYF has avg. relationship length of 17 years with retail partners) due to cost/disruption from integrating into new networks and issuing new cards

o   ADS has competitive edge over SYF, Citi, and other players due to marketing capabilities. ADS gets SKU-level data for loyalty programs whereas large retailers do not provide this data to their private label credit card issuers (large retailers have the scale to analyze SKU data and develop loyalty programs in house or hire 3^rd party marketing firm to analyze) and primarily use them for off-balance sheet financing. SYF and Citi are also limited in developing their marketing and data analytic capabilities, either organically or inorganically, due to S&L holding company and bank holding company regulations

§  This is evidenced by lower retailer share agreements (ADS retail share agreements are approximately 2% of receivables vs SYF retail share agreements at 6% of receivables) and higher ROA economics (6% for ADS vs 2.5-3% for SYF)

o   ADS has a cost and scale competitive advantage over 3^rd party marketing agencies as cost of loyalty programs shifted to consumer and ADS owns Epsilon, which is the #1 CRM/direct marketing agency in the U.S. and world and #1 largest agency from all disciplines according to Ad Age. In addition, the high utility of a loyalty program relative to its small cost (60bps of retailer sales) translates into contracts that are less about extracting best price from issuer than growing sales for retail partners

o   ADS retail partners have high switching costs as they would lose ADS marketing analysis of their most loyal/profitable customers

§  For example, if a competitor offers a -50% reduced loyalty program cost (30bps instead of 60bps, which is equivalent to 4% RSA vs ADS 2% RSA) the retailer would increase operating profits by 3% assuming 10% average operating margin. But, if the utility of the competitor’s loyalty program is less than ADS loyalty program and results in 20% lower private label credit sales, the operating profit of the retailer would decline by -30% (assuming contribution margin of 50%)

§  This high cost of failure creates large switching costs for retailers and has resulted in 99% annual retention rate for ADS

o   Due to industry structure, switching costs, and high utility product relative to cost, ADS franchise is highly defensible and sustainable

·         Penetration

o   ADS has an estimated 30% penetration of addressable market that could use their card services. The addressable market for ADS, which excludes major department stores, Amazon, and large mass chains, consists of approximately $360B sales. Approximately 33% of sales go on their cards and 50% have balances, which results in $50B balances vs ADS current $16B balances

o   ADS penetration of private label credit sales is approximately 30% of existing retailer client’s sales. The company’s most mature stores have 50% penetration, which suggests continued tender share gains for ADS

·         Credit Analysis

o   Normalization of credit: in the aftermath of credit crisis, charge-offs were effectively pulled forward resulting in several years of sub-normalized credit losses as those who were going to default did so during the crisis

o   As credit begins to normalize from historically low levels, the resulting provision building has been a headwind to ADS earnings, but this should end in 2018 as reserves reach 10 year average of 6%

o   ADS believes they have a higher quality customer on average now and reserves should be sub 6% long-term

§  Federal Reserve data shows revolving credit approximately 25% less per capita in real terms than pre 2008

§  ADS has higher % of 800-plus FICOs in portfolio and 20% of average receivables are co-brand today vs 0% pre-recession

§  ADS net charges offs increased 350bps during the GFC vs 600bps for general purpose cards. Private label credit cards have singular utility and lower limits vs general purpose cards

o   As of September 30, 2017, Comenity Bank’s Common Equity Tier 1 capital ratio 15.6% (vs minimum 4.5% plus a mandatory conservation buffer of 2.5%, which will be fully phased in by January 1, 2019), Tier 1 Capital Ratio 15.6% (vs min 6% plus a phased-in mandatory conservation buffer of 2.5%), total capital ratio 16.9% (vs min 8% plus a phased-in mandatory conservation buffer of 2.5%), and leverage ratio 14.4% (min 4%)

Epsilon (27% of revenues and 21% of EBITDA)

·         Epsilon provides marketing services that use rich data and analytics to help clients acquire, retain and grow relationships with their customers through direct marketing

·         Epsilon competes with a variety of niche providers as well as large media/digital agencies who either lack full spectrum of data-driven marketing services used for traditional/online advertising and promotional/loyalty marketing programs or the internal integration of offerings to deliver a seamless “one stop shop” solution

·         For targeted direct marketing services offerings, their 25 year history of analyzing SKU-level transaction data from the largest clients in the world provides them with scale advantages that are difficult for competitors to replicate

·         Epsilon has ~1,400 clients, operating primarily in the financial services, insurance, media and entertainment, automotive, consumer packaged goods, retail, travel and hospitality, pharma, and telco industries

·         Ad Age ranks Epsilon the #1 CRM/direct marketing agency in the U.S. and world and #1 largest agency from all disciplines in the U.S.

LoyaltyOne (16% of revenues and 13% of EBITDA)

·         Air Mile reward program is an outsourced loyalty program used by 170 sponsors including Shell Canada, Bank of Montreal, Amex Canada

·         Sponsors tend to be exclusive to their market category, enabling them to realize incremental sales and increase market share as a result of their participation

·         ADS uses the information gathered through loyalty programs to help clients design and implement marketing programs

·         Approximately 70% of households in Canada carry the AIR MILES card

Risks

·         Current and proposed legislation relating to card services segment could limit business activities, product offerings and fees charged and may have an impact on profitability. In particular, now that Comenity Bank has +$10B of assets, their prime regulator is Consumer Financial Protection Bureau

·         Increases in net charge-offs, due to general economic factors, such as the rate of inflation, unemployment levels and interest rates, or other factors, could impact capital and net income

·         If the company is unable to securitize their credit card receivables due to changes in the market, they may not be able to fund new credit card receivables, which could have a negative impact on their operations and profitability

·         In the card services segment, the 10 largest clients represent approximately 60% of revenue with L Brands and Ascena Retail Group representing 16% and 13% of revenue, respectively. The loss of any of these clients could materially impact revenue and profitability. Contract with L Brands expires in 2019

·         ADS may not be able to successfully grow its receivables portfolio due to full penetration of existing clients tender share or addressable market for its card services

Valuation

·         At the current price of $250, ADS trades at 10x 2018E earnings power of $25. Capital needed to grow card services business is 15% of receivables portfolio. This translates into a free cash flow yield of 8% that should grow +10% annually over the next several years due to continued organic share gains, new customer wins, and portfolio acquisitions

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Catalyst

Large activist shareholder could spin/sell LoyaltyOne and Epsilon segments