Description

I recommend shorting Alliance Data Systems, ADS, because it is an expensive, overleveraged company with sizeable nonprime credit card exposure, aggressive accounting and poor corporate governance.  ADS operates 4 segments: Loyalty Services, Epsilon Marketing Services, Private Label Services, and Private Label Credit.  Despite management claims to being a transaction processing and loyalty marketing company, it is really more appropriate to analyze the company as a credit card company with considerable subprime exposure with some ancillary marketing segments. 

ADS is also aggressively growing its receivables portfolio right now.  2009 will probably prove to be the worst possible time in decades for a company to increase its exposure to unsecured consumer credit because of the impact that the recession has had on credit quality.  Although ADS is bucking the industry trend by growing receivables through this recession, it is experiencing dramatically worse credit losses, along with the rest of the industry.  Even with any potential improvement in the economy, there is reason to believe that ADS's existing portfolio of receivables will continue to experience heavy losses, and that the additions to the portfolio in 2009 will be problematic.

The regulatory and legislative environment is also not favorable for ADS.  The Credit Card Accountability act will hurt the yield on ADS's portfolio because it will dramatically reduce the fees ADS can charge.  1Q'10 will also be the first quarter that ADS reports after adopting SFAS 166 and 167, which requires that qualified special purpose entities (QSPE) and receivables that are currently off balance sheet will have to be repatriated on to the balance sheet, which, among other things, will probably cause capital shortfalls in the future.

ADS's accounting is aggressive on many fronts.  Most importantly, its private label services segment basically only exists to handle the transaction processing of the credit card segment.  Most credit card companies do this internally without breaking it out, so it should be analyzed along with the credit card segment.  When analyzed from this perspective, about 1/2 of ADS's EBITDA is from credit cards, although historically it has been much higher.  Accounting is also aggressive in the loyalty business, whose main product is called AIR MILES, which is a rewards program.  It appears that ADS has been overstating its earnings by estimating lower pay outs of awards than is actually happening.  

They also focus on a "cash" EPS metric, which is misleading because it adds back the amortization of intangibles, but acquiring credit card portfolios at premiums is an ongoing cost of business for ADS.  Cash EPS also does not include stock compensation expense, but most of its peers do not back this out.  Also, non cash gain on sale revenue is included in "cash" EPS, even though they are aggressive in excluding non cash expenses.

Furthermore, corporate governance is weak, as management is incentivized to grow "cash" EPS, a metric that management invented and which does not provide an accurate assessment of operating performance.  Stock grants are supposed to vest over 3 years, but if management hits certain growth targets this is accelerated, which leads to poor capital allocation and reckless decisions.  For instance, it is buying back stock and increasing leverage, while there is a potential capital shortfall situation, and they are growing their credit card receivables in the midst of a recession when poor credit quality was pervasive. 

Company segments

ADS has four segments:

Loyalty Services business offers rewards programs, mainly AIR MILES.  The company uses the information gathered through its loyalty programs to help clients design and implement marketing programs.  AIR MILES is a Canadian reward program that allows consumers to earn miles when they shop with participating retailers.

In 2009 revenue fell 5.4% to $715.1M, mainly due to change in foreign exchange rates, which negatively impacted revenue by $46.7M.   This was partially offset by increases in redemption and issuance revenue in AIR MILES.  Adjusted EBITDA fell 2% versus 2008 to $200.7M, which was also impacted by changing foreign exchange rates, but received some benefit from cost cutting.

Epsilon Marketing Services engages in providing integrated direct marketing solutions that combine database marketing technology and analytics with a broad range of direct marketing services.  These programs help clients target and acquire customers, and enable them to measure their return on marketing investments.

2009 revenue was up 4.7% in this segment to $514.3M as new client signings grew and there were expanded commitments from existing clients.  Adjusted EBITDA increased 1.3% yoy to $128.3M, with margins falling as a result of the recession.

Private Label Services provides transaction processing, customer care, and collections services for the company's private label card programs.  I will argue later why this segment should not be broken out independently, but rather should be analyzed as a part of Private Label Credit.

Private label services reported $396.7M, up 3.7% on increases in servicing revenues.  Adjusted EBITDA rose 4.1% to $120.8M.

Private Label Credit provides risk management solutions, account origination and funding services for its private label and other retail card programs.  This segment is the real value driver for the company, so it is worthwhile to focus on the details here.  ADS specializes in private label credit cards, which can only be used at one specific retailer.  The retailer offers the cards in an effort to ensure a good customer experience, and in doing so the retailer hopes to build brand loyalty.  In comparison to general credit cards, private label cards tend to have worse credit metrics.  Retailers often offer credit cards to a broader (read: lower end) spectrum of consumers because the end goal is to drive sales, as opposed to general purpose credit card companies that focus more heavily on credit worthiness.  Private label cards also have higher interest rates, in general, so it is logical to assume that people that revolve credit on these cards have lower credit scores and few alternatives.  Private label card bills also tend to be paid off after general purpose cards, presumably because of their more limited utility to consumers.  Inactive accounts are much more common here, as well, as many retailers use discounts to incentivize customers to apply for a card, but once the initial purchase is made the card often goes unused.

In 2009 ADS reported revenue of $693.2M, a 7.6% decline, due to a decrease in securitization income and finance charges, and higher credit costs, which was partially offset by positive portfolio growth of 11.3%.  Adjusted EBITDA was $194.4M, down 23.5% due to higher credit losses yoy.  Managed charge-offs were 9.3%, up from 7.3% in 2008.

4Q'09 was generally soft and in line with the rest of 2009, but ADS did make a large portfolio acquisition in the quarter.  Charming Shoppes, CHRS, sold their receivables portfolio to ADS.  In subsequent months via the monthly credit updates, more data became available about the quality of these receivables.  It seems like management overpaid since CHRS overall sales are not doing that well and the credit quality is quite poor, and worse than ADS's own portfolio.  Furthermore, ADS recognized a $21M gain on the acquisition, so it is possible that they are being aggressive in accounting for the purchase.

Credit quality has remained stable, but at elevated levels for the past several quarters.  In the 2/10 monthly update, ADS reported that 30-day plus delinquencies in its master trust fell 9bps to 5.85% and credit losses fell 78bps to 9.8% from 10.6% in the previous month.  Excluding some accounting changes, which I will address later, credit quality was fairly consistent through out the past two quarters.

Portfolio growth continues at a breakneck pace.  In the latest monthly update, ADS announced that total average managed receivables were $5.2B, an increase of 22% yoy.  In 10/09 ADS closed the acquisition of the Charming Shoppes credit portfolio, which contributed about half of that increase.  Without this acquisition, organic portfolio growth was still approximately 11%, which is more or less about the rate they have been running at over the last few months.  When taking its charge-off rates of 9% or higher into consideration, it means that real or gross portfolio growth is closer to 20%. 

There are several important implications to consider regarding the growth rate.  Industry wide revolving credit fell 13% in 2/10, so there is nearly a 20 point spread between ADS and the rest of the pack, which is quite a delta.  Bulls would likely trumpet this as market share gains, but I would caution that there is a reason that the rest of the industry is pulling back.  Credit quality is much worse and I think there is some degree of adverse selection happening with respect to ADS's increase in receivables, as ADS might be the lender of last resort to some consumers.  Newer accounts also tend to have better credit quality, which deteriorates as they age, so the recent portfolio growth is probably unsustainably suppressing credit losses.

Other potential warning signs include the re-aging of receivables and uncollected fees. There are indications that ADS's cardholders are under more strain than the loss rates would imply because the principal payment rate was at or near historical lows (below 13%) for most of 2009, which in turn implies that ADS might be re-aging a significant portion of its receivables.  Accrued but uncollected fees of 3.5% are also near historical highs and suggest high levels of stress.

Regulation

The Credit Card Accountability, Responsibility and Disclosure Act of 2009 (CCA) will have a deleterious impact on ADS's ability to generate fees, lowering its yield on its portfolios.  The CCA went into effect 2/22/10 and its goal is mainly to hinder credit card companies' ability to charge excessive fees, so it will probably impact results in 2Q'10.  The CCA states that fees for violations like late payments or being over the limit must be reasonable.   ADS's yield on its revolving balances in its trusts are in the low 20s and have been as high as the mid 20s in more normal economic times, which is considerably higher than other card companies. The CCA also states that card issuers can not charge interest on those fees any longer. 

Incidentally, ADS recently announced that it would be adding a $1 fee for sending paper statements.  This will probably end up being a big mistake as it seems to defy the letter of the law, but it might be an early warning sign that ADS is willing to push the envelope to generate fees because its ability to do so elsewhere are being reined in.  Nonetheless, regulators will probably not be happy about this, not to mention the retail clients who are trying to create a good customer experience.

The CCA will also outlaw double cycle billing.  This occurs when a cardholder is billed for interest on debt that has been repaid already.  ADS charges interest from the date of purchase, so it will have to change this policy further reducing fees and yield.

ADS also has to contend with some new rules from FASB.  In 6/09 FASB issued guidance concerning the consolidation of variable interest entities, so ADS will begin consolidating its trusts this quarter, under SFAS 166 and 167.  The US Treasury has also suggested that the holding companies of credit card banks should become bank holding companies, which would subject ADS to much stricter capital requirements.  An integral part of ADS's business model is its ability to originate receivables at its subsidiary banks, World Financial Network National Bank and World Financial Credit Bank, which it then securitizes into trusts, which are QSPE's to ADS's subsidiary banks.  This practice is common in the industry, as it enhances liquidity and lowers borrowing costs, but the impending change could be more onerous on ADS than other industry players.  Consolidating these will have a significant impact on its financial statements and there is a good chance that it will have to meet more responsible capital standards, in which case repatriating these securitizations to the balance sheet will leave the bank undercapitalized and it will have to build reserves, which would be dilutive.  Initially, management indicated that, although the change would cause a 1500bps drop in capital levels, ADS would remain officially well capitalized.  By 3/10 management decided to inject $50M of capital into WFNNB, which might not be the last time they have to downstream capital to the subsidiary banks.  It is also a possibility that at some point its I/O strip will be meaningfully impaired under consolidation, which would also hurt its capital level.  These changes could also impact ADS's ability to refinance the asset backed notes associated with the trusts, which could be very disruptive because a substantial portion of them have relatively short maturities.  Anything that hurts ADS's ability to securitize receivables would have a very detrimental impact on the company.  Management has provided a pro forma look at 2009, had they already consolidated all of the off balance sheet vehicles and receivables.

PRIVATE LABEL SERVICES AND CREDIT

PRO FORMA 2009 (Unaudited)

Accounting

ADS is aggressive in its accounting; in how it defines it business segments, how it recognizes revenue and income, in its presentation of pro forma results, and in changing the presentation of its accounting to boost results.

As I mentioned earlier there should not be a separation between Private Label Services and Credit.  97% of private label services revenues are from intersegment transfers with Private Label Credit, so this is for all intents and purposes one segment.  Processing and general servicing are activities that credit card companies generally provide as a part of the normal course of business operations, so for the sake of consistency it makes sense to analyze Private Label Services and Credit as one.  However, processing companies are viewed in a more favorable light than nonprime consumer credit companies because they generally generate steadier and higher profitability, and consequently receive higher valuations (not to mention, they get covered by business services analysts and not financial services analysts).  Management also has a lot of discretion about how to allocate profitability.  Service revenues are recognized on a cost plus basis.  The margin is based on their estimates of prevailing market rates for these services among its peers.  If you combined these two divisions approximately half of its EBITDA is from credit, although several years ago these two segments accounted for over 80% of EBITDA.

Management prefers that investors focus on "cash" EPS, which does not reflect economic reality.  First, they add back stock based compensation.  While there is clearly an economic cost to this, it is a fairly common practice in some industries, although not in ADS's peer group.  It is worth noting that management is particularly generous to themselves in terms of equity compensation.  Beyond that, there are positive feedback loops in compensation because management is incentivized to hit "cash" EPS targets.  The more stock they grant rather than paying in cash, the higher the "cash" EPS, so compensation goes higher, and when these targets are met, vesting accelerates, making compensation more cash-like after all.  The next item is amortization of purchased intangibles, which is almost entirely related to acquired credit card portfolios and customer lists.  ADS's business model is predicated on purchasing portfolios of receivables and customer lists.  This is an ongoing part of its business.  If it did not purchase these, it would have to increase its sales and marketing expenses in order to acquire accounts and customers organically.  Non-cash interest expense is also added back, which includes debt amortization costs and imputed interest expense, both of which have real economic consequences and are normal parts of financing operations, so I would argue they should not be added back either.  The final questionable aspect of "cash" EPS is the fact that management historically has added back non-cash expenses, but naturally they have recognized non-cash revenue in the form of gain on sale associated with the securitization of receivables (generally I am not a fan of gain on sale accounting because of the heavy reliance on long term assumptions and the non-cash aspects of it, but it is a generally accepted practice and there is no reason to believe there is anything improper in their treatment of it), although ADS might not use gain on sale accounting following the adoption of SFAS 166 and 167.  Then there are the assorted gains and one time benefits that often find their way into "cash" EPS, like the 3Q'09 21c tax benefit from the reversal of accrued interest that management included.  I am somewhat mystified by management's emphasis of "cash" EPS, while they completely ignore the cash flow statement and the lack of cash flowing there.

ADS has changed its disclosure and an accounting assumption, which have resulted in better credit metrics.  In the 11/09 Private Label Credit update that ADS "refined" its bankruptcy processing from 30 days to 60 days.  60 days is still within industry standards, albeit at the high end, but this change did result in a one time benefit to the reported loss numbers.  Excluding this change, losses would have been 9%.  This provided a small EPS boost to 4Q'09 and consequently we saw a pick up in the delinquency rate in the 1/09 master trust update of 211bps.  Earlier in 2009, ADS switched from showing its master trust data to managed receivables, which includes more new accounts that have yet to be offloaded into trusts.  Since newer accounts have fewer losses, this treatment should give the appearance of better credit quality.  However, comparing total and trust receivable data shows similar credit quality, which indicates that the newer on balance sheet receivables might be experiencing worse credit trends earlier than the legacy receivables.  Now in 2010 it appears that there is some kind of accounting maneuvering happening within the CHRS portfolio to make it appear that delinquencies are better this quarter, which is odd because the first quarter is usually the seasonally weakest in terms of credit quality, and CHRS's portfolio is somewhat low quality to begin with.

Let's not forget about Loyalty Programs here.  ADS primarily collects fees from clients based on the number of AIR MILES issued.  These fees are deferred and recognized over time because the earnings process is not complete at the time of issuance.  Proceeds from the issuance of miles are allocated into two components: the redemption element, which recognizes revenue at the time an AIR MILES reward is redeemed, and the service element, which represents marketing and administrative services that are recognized pro rata over the estimated life of a reward mile, which is 42 months.  Management uses a "breakage" assumption of 28% for AIR MILES that it estimates will not be redeemed.  Ostensibly, deferring revenue recognition seems like the prudent thing to do, but management's estimates are questionable and could prove aggressive.  AIR MILES never expire, so the estimated life is somewhat arbitrary.  Also, AIR MILES' biggest competitor, Groupe Aeroplan (AER CN), estimates a breakage rate of 17%.  Disclosure is insufficient because the filings do not delineate how the actual miles redeemed relates to their accounting estimates, but I expect that "breakage" is lower than they estimate and at some point in the future they will have to revise their assumptions, generating a substantial loss in the process.  Furthermore, it seems that ADS is recognizing more revenue for every mile redeemed than it has in the past, thereby boosting revenue and adjusted EBITDA.  However, this pattern will not be sustainable, especially if the redemption of miles continues to pick up as it did in 4Q'09.

Corporate Governance

Corporate governance at ADS is lacking.  Management incentives encourage excessive risk taking, an overemphasis on short term results, and poor capital allocation.

As mentioned previously, management incentives are not aligned with shareholders.  By compensating based on "cash" EPS and by allowing accelerated vesting of stock grants, the board has encouraged management to pursue reckless policies, specifically a focus on short term results, and a lack of emphasis on a rational capital structure and return on invested capital.

Earlier this year the board extended ADS's $1.8B buyback plan that still had about $275M remaining on it.  This substantial size of this buyback has resulted in inflating "cash" EPS.  Too often share buybacks are authorized under the guise of shareholder value creation.  However, at this valuation I think it is an extremely poor decision, especially when it is accomplished by levering the company at an inadvisable time.  Furthermore, the company is aggressively growing its credit portfolio during a recession when credit quality of the new receivables will likely turn out to be very poor.  In this environment ADS needs more of a capital cushion, not less, especially with the potential for more stringent reserve requirements that will accompany the consolidation of its QSPE's.  The true impact of these actions on shareholders will become evident over time, but they are immediate positives for management compensation.

The result of leveraging up the balance sheet to repurchase stock is plainly evident.

To top it all off, after deciding to engage in an enormous buyback that serves to increase their compensation, insiders have sold 1,873,197 shares in the past year.  I might be overreaching here, but I tend to think management agrees with me.

It should also be noted that the Chief Accounting Officer resigned in 2/10.  This after the CEO and COO, among others, departed in 2009.

Valuation

How does one value a stock like this?  There are several unrelated businesses.  The company's accounting is questionable.  And the company has never generated meaningful free cash flow.  On the balance sheet side of things, there is virtually no net asset value and the adoption of SFAS 166 and 167 will result in a dramatically different presentation than previously reported.  Valuing ADS requires a bit more subjectivity than the average stock.

Currently, ADS has 52.6M shares outstanding with 2.5M options, striking at $36.50, $213.4M of cash, $1,782.4M of debt, and $1,466M of certificates of deposit, resulting in an enterprise value of $6,691M.  I believe the adoption of SFAS 166 and 167 will add about $3.7B of debt to ADS's balance sheet once it is repatriated.  Management increased guidance this quarter for 2010 based on the new accounting treatment, and is now expecting revenues of $2.8B and EBITDA OF $792M, which translates into EV/Revenues of 3.8x and EV/EBITDA of 13x, as well as a P/B of 13.4x, which is less meaningful as a result of the aggressive share buybacks.

Let's say you want to give management the benefit of the doubt and assume that the reported numbers are not dramatically overstated and that ADS is really a marketing/business services company, and compare them to ADS's peers.  Marketing services companies (ALOY, ARB, AER CN, HHS, IPG, MDZ CN, OMC) are trading below 1x EV/revenue and at approximately 7.5x EV/EBITDA on 2010 estimates.  Data processing peers (ADP, FIS, DST, CVG, TSS, HPY) are trading at 1.7x 2010 revenue and 9.2x 2010 EBITDA.  Comparing the credit card business to peers is more difficult since there is virtually no book value, negative tangible book value, and negative free cash flow, so it is difficult to quantify just how expensive ADS is.  Whether you think ADS is a marketing company, a processing company, or a credit card company, or some kind of blend, you can ascribe whatever multiples you feel appropriate based on the segment information I provided.  Any way you slice it, ADS looks pretty expensive.  If any or all of the negative operational, accounting, or governance issues come to light, the impact could be catastrophic, so I think the risk-reward is very attractive as far as shorts go, since it is expensive even in an optimistic scenario, but also has huge potential downside.  The bottom line is that I think the stock could decline in excess of 50%.

To put this into perspective, operational results have dramatically deteriorated, the regulatory environment has gotten tougher, and the balance sheet has gotten a lot weaker, yet the stock is now trading at the same levels as where its failed LBO was announced in 2007.

Risks

Shorting in general is inherently risky and shorting already heavily shorted stocks can be hair-raising at times.  According to Bloomberg, on a float of 50.8M shares, 15.4M are short.  While this is fairly high and could result in some short squeezes, I do not necessarily view this as a risk.  It can cause volatility in the stock, but does not affect my judgment of the fundamentals or the valuation in any way.  The volatility can also create opportunities.  In these types of situations I like to size my position accordingly so that in the event of a spike I do not get squeezed out and I have some dry powder to improve my average.  Despite the high short interest, the sell side still likes the story.  Of 21 analysts covering the stock, there are 15 buys.

The only real risk I see is that the economy ends up being much stronger than expected, which causes a steep decline in credit losses, so if you think we are in the midst of a sharp V-shaped recovery this idea might not be for you.  However, the stock already appears to be pricing in quite a bit of improvement in credit, so at this valuation I'm comfortable with that risk.  I also think that even in the event that the economy strengthens considerably that the issues I raised about Private Label Credit will cause credit losses to stay near current levels or worsen.

Catalyst

SFAS 166 and 167 and CCA