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Alliance Data Systems Corporation (NYSE:ADS)

Q2 2014 Earnings Conference Call

July 17, 2014 8:30 a.m. ET

Executives

Julie Prozeller - Investor Relations, FTI Consulting

Ed Heffernan - President and Chief Executive Officer

Charles Horn - Executive VP & CFO

Bryan Kennedy - Executive VP & President, Epsilon

Analysts

Sanjay Sakhrani - KBW

Darrin Peller – Barclays

Dan Perlin - RBC Capital Markets

Tulu Yunus - Nomura

Ashish Sabadra - Deutsche Bank

Andrew Jeffrey – SunTrust

Operator

Good morning, and welcome to the Alliance Data Second Quarter 2014 Earnings Conference Call. At this time, all parties have been placed on a listen-only mode. Following today’s presentation, the floor will be opened for your questions. (Operator Instructions) In order to view the company’s presentation on their website, please remember to turn off the pop-up blocker on your computer.

It is now my pleasure to introduce your host, Ms. Julie Prozeller of FTI Consulting. Ma’am, the floor is yours.

Julie Prozeller

Thank you, operator. By now, you should have received a copy of the company’s second quarter 2014 earnings release. If you haven’t, please call FTI Consulting at 212-850-5721. On the call today, we have Ed Heffernan, President and Chief Executive Officer and Charles Horn, Chief Financial Officer of Alliance Data; and Bryan Kennedy, Executive Vice President and President of Epsilon and Alliance Data Company.

Before we begin, let me remind you that some of the comments made on today’s call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and the uncertainties described in the company’s earnings release and other filings with the SEC. Alliance Data has no obligation to update the information presented on the call.

Also on today’s call, our speakers will reference certain non-GAAP financial measures, which we believe will provide useful information for investors. Reconciliation of those measures to GAAP will be posted on the Investor Relations website at www.alliancedata.com.

With that, I’d like to turn the call over to Ed Heffernan. Ed?

Ed Heffernan

Great. Thanks, Julie and good morning everyone. Joining me today is our always colourful CFO Charles Horn and Bryan Kennedy, our President of Epsilon. Charles is going to go first and talk about our operating results; Bryan will talk about Epsilon and in particular, the results of our new product Harmony and then I will wrap up with a discussion of our raised guidance and outlook for 2014 and how we see our jump-off for ’15. So Charles, take it away.

Charles Horn

Thanks, Ed. During the first quarter earnings call, we discussed an expectation of growth acceleration as 2014 progressed. During the second quarter, we delivered on that expectation with over 20% growth in both revenue and core EPS. That is the trend we were talking about and that is the trend we expect to see continue during the remainder of 2014.

For the second quarter of 2014 revenue increased 23% to $1.27 billion driven by double-digit organic growth and strong contribution from BrandLoyalty, which added 13% to revenue growth.

Adjusted EBITDA, net increased 8% to $332 million with solid expense leveraging in both Epsilon and Private Label. However the growth rate was dampened our reserve build to Private Label due to the significant increase in credit card receivables. The related provision expense increased $39 million or 67% from the second quarter of 2013 despite a 20 basis point improvement in principal loss rates.

EPS and core EPS increased 28% and 20% respectively, aided by an 8% decrease in diluted shares outstanding which dropped with the maturity of the convertible notes in May. There were still 2.7 million phantom shares in the diluted share count for the second quarter due to the average calculation. Starting in the third quarter, that impact will be gone and the diluted share count should be about 60 million shares.

Let’s flip over to the next page and talk about LoyaltyOne. LoyaltyOne’s revenue increased 62% to $356 million for the second quarter of 2014, driven primarily by BrandLoyalty, which added $136 million to the top line. AIR MILES business continues to be hampered by weak Canadian currency which reduced its revenue by $14 million compared to the second quarter of 2013. On a constant currency basis, AIR MILES had a robust second quarter with revenue up 6% compared to the previous year.

Adjusted EBITDA increased 32% to $87 million for the second quarter. BrandLoyalty contributed $26 million gross or $60 million net of non-controlling interest to the quarter. Its adjusted EBITDA margin was 19%, up 600 basis points from the first quarter, reflecting BrandLoyalty’s largely fixed operating cost structure and its ability to leverage revenue growth.

Adjusted EBITDA for AIR MILES decreased 6% compared to the second quarter of 2013 but was flat on a constant currency basis. We expect improvement in adjusted EBITDA margin for AIR MILEs as the year progresses.

AIR MILES issued were flat compared to the second quarter of 2013 as the growth rate was primarily dampened by two items: Number one, the SoBe’s purchase of Safeway negatively impacted issuance as numerous Safeway stores were closed in order to comply with government regulations. As legacy SoBe stores rolled into the AIR MILES program, we expect to see this pressure abate. And two, new regulations in one Canadian province limiting the awarding of the incentives for prescription drug purchases. For the year we still expect issuance growth in the 3% to 4% range, driven by increased promotional activity by our sponsors and new initiatives [indiscernible] reward program such as the new e-voucher program which is delivered via email and could be used to gift redemptions.

AIR MILES redeemed increased 11% compared to the second quarter of 2013 primarily due to increasing popularity of the instant reward program. We expect year-over-year increases in AIR MILES redeemed for the remainder of 2014.

Batch [ph] BrandLoyalty had exceeded expectations in the second quarter with over 20% organic revenue growth driven by growth in core markets as well as success in developing ones. With the majority of programs already [indiscernible] for 2014, we have a clear sight of line into the second half and expect this momentum to continue.

In addition, BrandLoyalty provides a platform to generate opportunities for growth in other areas as LoyaltyOne, what Ed and I refer to as revenue synergies. Precima, a consulting analytics firm specializing in shopper insights is now leveraging BrandLoyalty’s grocery relationships to grow its top line. While currently a small of LoyaltyOne, Precima is rapidly growing by signing multiyear contracts with major Canadian and overseas grocers.

Turning to Dotz for a quick update. The Brazilian-based business added another half million collectors in the second quarter bringing the total number of enrolled collectors to 12.5 million, 18 [ph] ahead of our year-end target of 13 million. In addition, the program expanded into a 10th market during the second quarter with plans to expand to 13 markets by year end.

With that, I will turn it over to Mr. Kennedy to discuss Epsilon.

Bryan Kennedy

Okay. Thanks, Charles. For Epsilon, revenue increased 8% to $357 million for the second quarter of 2014, which is really driven by growth in our technology offerings.

Technology revenue increased a very robust 14% year-over-year, which was really primarily due to the conversion of a number of earlier pipeline wins that rolled into revenue and began to contribute. Importantly, Harmony also made a nice contribution with email volumes up double-digit for the second quarter of 2014 which compares to a double-digit decrease last year for the same quarter.

The success of the launch of Harmony has really effectively carved attrition. As Harmony’s cloud-based micro segment and multichannel market capabilities are beginning to get a great traction in the market. Reception has been extremely strong, and we’re pleased that with such I a short time in the market, Harmony can make such a nice impact on the results with our email volumes for the quarter.

Looking forward we expect continued growth of Harmony in the back half of the year as we’ve got about a dozen clients on board today and a dozen that are actively in the process and a very nice pipeline ahead of us. So a tremendous progress on the harmony front.

Turning to the agency. Revenue slowed just a bit during the second quarter of 2014, up 6% versus last year compared to a first quarter increase of 9% versus last year. We expect the on-boarding of new clients, including the announced relationship with FordDirect will aid the agency’s growth rates as the year progresses.

Lastly, our data offering fell back just a bit during the second quarter, after a nice strong first quarter where data revenue increased 5% compared to the prior year. It dropped about 2% in the second quarter of 2014, which was due primarily to circulation cuts that negatively impacted our Avoca’s [ph] catalog offerings as well as a bit of a lowering of demand which was primarily due to one client in our off-line data offering.

However what’s encouraging for me is that as the distribution of our data goes up and that data gets used in more digital channels, value and importance of our data offering continues to increase as part of Epsilon’s overall offering.

Turning to profit. Adjusted EBITDA, net increased 6% to $68 million compared to the second quarter of 2013 while margins remain essentially consistent with the prior year. Double-digit growth in our high-margin technology business helped to mitigate a $2.5 million expense drag associated with the onboarding of new clients such as FordDirect. As the current backlog of [inaudible] rolls out margin pressure should begin to abate as new client revenue starts to flow to the bottom line.

So lastly, what we’re seen in the marketplace is that trends continue to move steadily towards data enabled targeted marketing and a more clear understanding of who the customer is. As a result of that, our clients focus is evolving towards engagement - that is how to market to a consumer by one, leveraging the most effective touch points or channels, and two, using insight-driven creative messaging to truly enhance the brand experience. I believe Epsilon is superbly positioned to meet these needs by offering a full-service end-to-end targeted marketing solution. And that service positioning element really differentiates us in the marketplace.

All right. Now let me turn back over to Charles for Private Label.

Charles Horn

Thanks, Bryan. Private Label's revenue increased 16% to $557 million for the second quarter of 2014, representing the 10th consecutive quarter in double-digit revenue growth. Revenue growth was driven by a 17% increase in average card receivables, the majority of which was organic.

Adjusted EBITDA, net increased 5% to $210 million for the second quarter of 2014. As expected, we saw operating expense leveraging during the second quarter. While revenue increased 16%, operating expenses increased a lesser 15% compared to the second quarter of 2013. This leveraging reversed the trend whereby expenses were growing at faster rate than revenue due to the need to add infrastructure and advance a substantial receivable growth expected in the back of 2014. We beefed-up [ph] staffing levels largely already in place, we expect continued expense leveraging as 2014 progresses.

Conversely, the provision for loan loss expense increased 39 million or 67% compared to the second quarter of 2013. This increase is driven by receivables growth, not deteriorating credit quality. As you can see on the next page, credit quality actually improved during the second quarter of 2014. The bottom line is as long as card receivables are in high growth mode, the provision for loan loss expense will lead revenue growth, just have a dampening effect to adjusted EBITDA net.

Turning to funding costs. We continued to see improvements as we replaced maturing tranches of debt with new less expensive funding. Our funding rate for the second quarter of 2014 was 1.5%, 30 basis points better than last year.

Let’s go to the next page and look at some of the stats for Private Label. Total gross yields for the quarter compressed 30 basis points compared to the prior year as new programs continued to affect yields. We would expect some continued compression throughout 2014 as we onboard a record number of new programs. As it relates to the new programs, it takes about three years what we refer to as a vintage period to really reach our desired yield levels. Growth continues to be strong across the board - credit sales up 22%, average card receivables up 17% and ending card receivables up 18% all compared to the second quarter of 2013. Importantly this growth is balanced.

Credit sales were record programs, meaning we’ve had them at least three years, increased 11% during the second quarter or roughly more than doubled the sales growth rate of our brand partners. This is [indiscernible] pickup of over 100 basis points. The other 50% of our growth has been driven by the newer programs which are being actively supported by the new brand partners and being [ph] and resonating with our clients.

Lastly credit stats continue to look good with no indication of future upward pressures. Normalized principal loss rates decreased 30 basis points to 4.5% for the second quarter of 2014, helped by strong receivable growth rates and a higher mix of co-brand receivables. The related allowance for loan loss reserve remained strong at June 30, 2014with approximately 15 months of forward coverage.

Delinquency rates increased moderately to 4%, up 10 basis points compared to the previous year. Based upon current trends, we expect stable principal loss rates for the remainder of 2014.

Let’s go to the next page and give you an update on liquidity. Liquidity at the corporate level remains very good at 700 million at June 30, 2014. Year-to-date we spent about 500 million on the BrandLoyalty acquisition and the share buyback program. We will likely look to bolster our liquidity via new debt during the third quarter of the year.

I'm happy to say the convertible notes are now gone. The notes were settled in cash 345 million from ADS and about 1.5 billion from our counterparties in May of this year. With the call option settled, the phantom shares dropped from our diluted share count. The warrants we owed to the counterparties are currently being settled with an August 11 end date.

As you probably noticed in the June 8-K, we paid a small fee to our counterparties to shorten the settlement period end date from November to August. The shortened period reduced the dilution risk if our share price runs up later in the year.

Liquidity at our banks remains strong at 2.7 billion. We continue to take advantage of the receptive debt market to not only lower our current funding rates but also lock in longer-term fixed rate money. Approximately 75% of our bank borrowings are fixed rate with an average maturity of about 25 months.

Lastly, the buyback program kicked in, in the second quarter as we saw an opportunity to buy during the temporary fall back in our share price. Year to date we spent 202 million of our 400 million board authorized program.

I will now turn it over to Ed.

Ed Heffernan

Great, thanks, Charles. Thanks Bryan. I think if we could move to the page on 2014 updated guidance, I will give you a little color on where we’re seeing things. Obviously Q2 I think across-the-board came in a bit better than we had anticipated, which is good news. I think the quality of [inaudible] the earnings is very strong. Specifically you know you're dealing with a reserve build which is an expense in Q2 of this year where last year we actually had a reserve release. So not only were the results from a growth perspective very strong but it was against the tough comp from that perspective, also against a tough Canadian dollar comp as well.

So overall I think very, very high quality earnings results and better across-the-board from what we had anticipated. So that gives us comfort as we move through the rest of the year. I know there were some rumblings or concerns when we posted Q1 and gave guidance for the rest of the year. Three months ago that it looked like there was some spec [ph] there, there was some risk in the back half, hopefully folks now see that things are going out quite nicely and in fact, things have moved up a bit and we’re seeing better results earlier than we had anticipated. So we feel very good about the year.

I think it's comfortable that we've moved the guidance from its original 12.20 to 12.25 to now 12.35 a share which will give us a topline growth of 23% and core EPS growth of 23% as well. That also reflects a hit of roughly $0.17 from the Canadian dollar. So overall 20.20 is what we’re looking for. Within that you'll see the little note on the side of plus 9% organic, that’s our base. I think we'll probably do plus 10, plus 11 on the organic side or comfortably running 3X GDP growth rate which is our goal.

Let's go ahead and turn to laying out to the quarters which we usually don't do except for the fact that I think it's important that everyone is comfortable with how things will flow. You'll see that the growth rates by quarter on the face of it looked like oh, my gosh, there looks like – there is a big Q4, Hail Mary pass in there when in fact that's not the case. You saw growth rates now have accelerated from 9% in Q1 to 20% in Q2. We look for about that same type of growth rate in Q3 and then in Q4 sort of the difference between going from the low 20s up to the 40% you're talking probably about $30 million in terms of what we’re looking for, and two thirds of that is pure seasonality out of BrandLoyalty.

Q4 is BrandLoyalty’s strongest quarter and it is significantly stronger than Q3. So two thirds of that bump between Q3 and Q4 is just seasonality within BrandLoyalty and then additionally at Epsilon, we expect the other third as the Ford deals truly spulls [ph] up and we get the type of growth that we want. So I get the message here is I think hopefully Q3 looks pretty reasonable compared to Q2, 20% to 22% and then as you move into Q4, that bump up there is almost exclusively seasonality from BrandLoyalty which hasn't been introduced until this year. So I guess the net result is there is no spec in the back half.

The guidance we’re giving is stuff clients that have been signed, contracts that have been signed and therefore as we look at the rest of the year this is solid and we’re beginning to look at the jump off for 2015. So we feel very good about that.

Let's move along and get a little bit of color on rest of the ‘14 outlook. Starting with LoyaltyOne, we talked about the seasonality at BrandLoyalty with Q4 being by the far the heaviest quarter but overall I would say that AIR MILES we think when you factor out the Canadian dollar, it’s going to do plus 3, plus 3 top and bottom which is sort of a bit below where we like it to be long-term. We think it's more of a plus 5 top, plus six EBITDA type growth business where we should get back to that in ’15, but plus 3, plus 3 is about where we’re looking at now. The Canadian dollar drag is lessening as the year goes on. So we’ve got probably two thirds of it behind us with another one third to go in the second half.

BrandLoyalty, very very pleased with how that is playing out. They are running for sure 20% plus organic top and bottom for the year and the growth is coming both from their core countries as well as emerging markets as well. So these things got some legs to it.

And then finally, even though it’s not in the gnomes, because we only own 37% for Brazil, we’re on track to grow revenue of about 40% and again this is a land grab in terms of we’re trying to grow as fast as we can in terms of memberships. We started with less than 2 million in ’11, we now expect 2014 to be north of 13 million members. So this continues to spool up, it’s I guess you could view it as a very valuable asset that is not in our financials.

At Epsilon, as Bryan talked about, we’re looking at high single-digit revs and mid to high single digit on EBITDA growth. Where we’re getting sort of the best traction this year as Bryan talked about is in the technology side, which are the big loyalty platforms that we’re building. There's a huge amount of interest coming from not just sort of the core verticals and big, big multinational clients that we’re used to servicing, but we’re getting into newer verticals where we didn't see that much interest in prior years, beginning to see everyone is getting more and more excited about, hey, I need something that will give me some insights into who my customer is and that requires some type of loyalty application. So we’re seeing a lot of movement in the retail vertical as well as the food segments, both QSR and casual dining. And then we’re also seeing sort of the mid tier or mid market firms that traditionally couldn't pony up the type of dollars that are needed to have one of these solutions. They are making the decision to that this is too important not to have. And so we’re seeing a lot of movement on the midmarket side of dollars switching over and making the big investment in this type of program.

So it bodes extremely well going forward and I would say our biggest challenge at Epsilon right now is making sure that we have the growth in the sort of hot skilled personnel that we need to bring this all to fruition but very pleased there.

And then the second thing is our new digital platform Harmony that Bryan talked about is off, we can finally call up [indiscernible] Epsilon and say green light on Harmony, we boarded a dozen clients of which one is a very very large client, maybe as much as 10% of all of our permission-based email volume up and running, no issues. So we think this will be an industry-leading solution and very happy about that.

So I think Epsilon – you know it cycles right, you’re going to have in some years its data leading the charge, other years it’s the agency, other years it’s database loyalty, email leading the way, this year looks like technology is going to be the – get the gold star.

Finally, if you turn to the card business, we continue to see very, very strong growth and again you have a backdrop of a card industry that’s barely growing maybe 1% to 2% a year. We expect our credit sales to be north of 20% for the year. We expect our average file to actually be higher than the sort of 15% we were thinking about, we expected to actually grow more of 20% for the year and that will be accelerating as the year unfolds. So we did about a 15% file growth in Q1, 17% in Q2, 20% in Q3 and we will exit the year at a 25% growth rate, which will be extremely positive as we go into ’15.

Again we always get the question of how come – how does this work, why is this working so well in an overall environment where consumer spend is modest at best, consumer revolving debt is growing a couple of points and that’s it? And the answer I think Charles talked about earlier is a lot of it has to do with what's happening in our core client base. When you're seeing the pressure that on our retail base and you see that their same-store sales are growing 2% to 3%, maybe 3% plus and yet we’re looking at double-digit sales growth at the same retailers, something is working. And that has captured the attention of a lot of other folks and that is I think a big reason why they are signing up for the Alliance solution because again whether it’s at Epsilon, whether it’s at LoyaltyOne or whether it's in our card group, across the board the interest in understanding who the customer is, which requires a data-driven analytical approach has never been stronger. And so the trends are friend, we expect to keep riding it for many years and so far so good.

Again I'm looking frankly more at ‘15 at this point and that means that I need to focus on how is the vintage, how is the sign-ups doing this year, has it dropped off or not? The answer is no. We’re probably somewhere around 1.3 billion, 1.4 billion that we signed up in terms of vintage. For this year we expect to have another 2 billion -- we expect to have a 2 billion vintage for all of this year, which means three years from now there is another 2 billion of growth added to the file. So pipeline remains strong. You should see a bunch of good announcements coming out the door.

In summary, not much more to add. Revenue and core EPS up 23% respectively, the organic growth rate is running about three times GDP. All the segments are growing. I would say our fastest-growing segments would be BrandLoyalty for sure, followed by the card group, followed by Epsilon, followed by AIR MILES. So I think that we’ve got a nice portfolio of growth engines and I guess I probably should say that Brazil is probably edging out even BrandLoyalty but that's not in our numbers.

So -- and hopefully everyone feels comfortable now with how we laid out the back half of the year. I think doing 20% growth on earnings in this quarter does a lot to assuage people's concerns about the back half. So the seasonality of BrandLoyalty, getting past the Ford ramp up should give us very good visibility as we go into the back half of the year.

So I am going to leave it there, other than to say that if you look at the way things are playing out for ‘14 and the fact that there is no back in our gnomes for the back half of the year. What I am probably most pleased with is we had a couple of big question marks this year. Probably our largest was the very significant investment we made in our all-digital platform, Harmony which Bryan can talk about, and needless to say we were positive about it but until you flip the switch and get things up and running and actually jam through huge volumes you just don't know. And so we feel very good about the net results there.

Probably another area that we wanted to make sure played through was the fact that hey, this huge run in our current business with these massive vintages that we’re signing, is this a one and done or is this thing for real? I think at this point, we jumped from signing of 400 million vintage three years ago to a billion 2, years ago to 2 billion last year and another 2 billion this year. So this is for real. We expect it to continue for some time. The BrandLoyalty was probably the third area where I wanted to make sure that we didn't have issues there as a lot of folks have with acquisitions. And frankly it's performing much better than even we had anticipated.

So i think probably those are the three areas where they say kept us up at night little bit. And I think we can check the box on all three for now, and now it’s a function of what their jump off for ’15.

So that’s it. Why don’t we turn it over to Q&A and we will open it up.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Sanjay Sakhrani with KBW.

Sanjay Sakhrani - KBW

Thank you for all the numbers -- the color on the numbers. I guess stepping back and thinking about next year and I know you guys saved that for the next call. It seems to me like the EPS growth rate we’re seeing this year as very achievable if not beatable as we look out. Is that a fair statement? And I guess secondly, just thinking about free cash, you guys have repurchased I think $200 million worth of stock and there is still fair amount of free cash that’s been generated or will be generated throughout the year, how should we think about that excess over the remainder of the year?

Ed Heffernan

Well, you know we want people to show up for the Q3 call, Sanjay. So I probably won't go too far out on a limb for the earnings growth rate. But I think clearly people can see the trends, we would expect ‘15 to be a strong year and just bear with us until we get to Q3,when we give official guidance in terms of free cash flow. Charles?

Charles Horn

You can see we’ve been fairly active this year, Sanjay, again with the buyback program of about $200 million, with the BrandLoyalty 60% acquisition of about 300 million. I think you'll see us continue to support the buyback program as necessary over the course of the year. Obviously we are more active when we have pull back in our share price, which allows us to continue to look for acquisition opportunities whether it be aboard in Europe, something to flush out the Epsilon model little bit further. or even in the US I think some opportunities are coming to our attention that could make sense. But you know what, we like to deploy our free cash flow, we will find a way to do so during the course of the year. And so just expect us to continue to look at our main competencies which is buyback, M&A we will have a little bit of cash to support the growth of Private Label from a regulatory standpoint, and those would be the three usage.

Sanjay Sakhrani - KBW

I guess – there is a question on Harmony -- on Epsilon, in terms of Harmony, could you just talk about how much of a contribution you're expecting from the remainder of the year from the rollout and then how beneficial it could be next year?

Bryan Kennedy

Sure, Sanjay. I think as we grow through the back half of the year it’s obviously going to ramp. So if you think about Q2 Harmony contributed in the low single digits in terms of volume that we would push out the door by the time we get to the end of the year. That should be into the double-digit range and then as we roll into ‘15 you’d see I think better than 50% of our volume next year would come from Harmony and I think the natural follow-on question to that would be how much of that is clients that you're converting from old platform to new platform, how much of that is new clients? And the interesting thing that we’re seeing right now is the majority of the Harmony activity is coming from new clients, and that's a bit because our existing clients have been, just as Ed said until they saw us in production and in market [inaudible] excited about what Harmony brings to the cable but they have been slower to come versus new clients. So we should see some nice acceleration as we move out of this year and into next year as they jump on board.

Operator

Your next question comes from the line of Darrin Peller with Barclays.

Darrin Peller – Barclays

Well, just to be clear, I mean the ramp up through the year into the fourth quarter, you did a good job I think laying out but really BrandLoyalty is the majority of that. But it also seems like I mean Ford is rolling out in a big way, Harmony as you mentioned multiple times it’s rolling up in a big way. So what kind of organic growth should we be looking at from an Epsilon standpoint? When you think about -- right now it’s growing, you’re saying high single digits but when we factor in Ford and Harmony, I mean for next year and the exit run rate we’re going to see in fourth quarter, is that the right way to look at this business to the growth rhythm? And secondly to that, just a little more on Harmony, just one [ph], I mean I think the overall opportunity for new clients, can you – Bryan, just give us a little more color on what this actually means for the business after the expenses you built out, what kind of is actually good for growth?

Charles Horn

Darrin, I will take the first one. You do have a valid premise, for Q4 you could see low double-digit organic revenue growth as some of the ramp comes through that you talked about, going into ’15 we will keep it pretty conservative high single-digit organic revenue growth, that’s kind of the target we have for Epsilon. If you think about data enabled market in the US growing 6% to 7% which is the bulk of Epsilon, digital growing 20% per year which is a piece of Epsilon, that gets you more to the high single-digit number run rate number and that’s what we will look for in ’15.

Bryan Kennedy

Yes, I think just to chime in on that, Darrin, we've had a bit of an ankle wave that we’ve been dragging around for the last couple of years in terms of our existing email business, which has been healthy but not contributing to the growth. So – and I think of the Epsilon offering to the portfolio and they are going to cycle which is the point Ed made earlier. We've had one major engine which is the email engine which hasn’t really been contributing. Now you’ve got something back in the portfolio that has nice growth ahead of it, which kind of insulates us against risk as some of the other offerings will bounce around in terms of their growth rate. So what that can do long-term obviously we’re going to push hard and heavy. But I think more broadly if you think about Harmony, it's less about what can that one offering do for us from a revenue perspective and for us it’s more about how it becomes a part of these large enterprise relationships that we’re pushing for, which cover multiple channels, multiple offerings, which are on everything from data to database to our strategy and analytics and creative and then distribution. And in this case distribution is email. And so we see it as a good cross-sell, up-sell engine that should help to reinforce some of those enterprise relationships.

Ed Heffernan

Yeah, the final piece I’d throw in there is – look, we've had a heck of a good run on the agency side with the auto vertical, huge wins, lots of big new auto platforms being built and with new car sales ripping along in the US the last few years, all helpful, I would say, Darrin, quite frankly the number that Charles gave you is sort of a hedge against sort of the auto sector of the business kind of slowing down a bit. So we would expect the digital – pure our digital side to pick up the slack there. If auto doesn’t slow then, sure you’ve got a little kiss to those numbers.

Darrin Peller – Barclays

Yeah, now that’s helpful. I mean it just seems like between the strength you’ve seen in agency is now picking the email business from what was meeting on the headwind but a slower growth through a normalized growth rate environment, the rest [ph] are better, it seems like that business should set to accelerate beyond the even high single digits but that’s a fair point. Just one follow up and I will turn it back to the queue. On the Private Label side, I mean you guys mentioned ending the year at 25% growth, I guess end of your receivables growth, we imagine there's a fair number of deals coming down the pipe in terms of portfolio acquisitions that have to flow into that, can you give us a sense of the profile of these deals in terms of -- are they co-branding, or are they as profitable to the other one’s credit profile, and we look at sustainability of that kind of the growth rate for the receivables side of the business, then it has to get 18% organically the last couple of months, layering on these deals, I mean is this the kind of new growth for this business we should see for a while?

Bryan Kennedy

Well, again that’s a big -- the big question we thought when we signed the billion dollar vintage that boy, that was pretty exciting and maybe it was one and done, and we doubled it to 2 billion, this year it would be 2 billion. I think as you look into Q4, yeah inherent in those numbers are probably three very modest sized files, 100 million to $200 million type files that are pretty standard for us. So there is no big file that’s in that year-end number that we have. So think of it as you know – and includes probably three modest sized files that are out there and should be good growth and it’s on a go forward basis. It's going to be a combo of both Private Label and co-brand depending on what the clients want. But I would say going forward that if we could sustain a mid-teens file growth rate for years to come that would be very exciting for us, because then you're talking double-digit type financial return.

So I think that would be our goal and right now based on the vintages obviously it's going better than that. But I would assume that most of the clients that you’re signing are going to be clients who have abandoned the program because it didn’t work in the past or clients who are brand-new to the scene and let’s about some major -- let's hope for big portfolio acquisition, we’re not really counting on that.

Operator

Your next question comes from the line of Dan Perlin with RBC Capital Markets.

Dan Perlin - RBC Capital Markets

Just got a couple. One, Charles, can you maybe tell us what you’re forecasting for the full year, that you have to absorb before the Ford switching cost [inaudible] in this quarter but my sense was it was somewhere 7 million, 8 million for the year and that obviously will be a duplicative expense, what will be the next? Can you just give us what that number would be?

Charles Horn

That would be right. Yes, that’s a good range. It’s around 8 now.

Dan Perlin - RBC Capital Markets

Okay and then the margin profile of BrandLoyalty in the current quarter was a lot better than I would have anticipated given kind of the investment and the growth rate. Is that kind of the right run rate or with the hockey stick in the fourth quarter a bit, is there significant investment pool that needs to go into there and therefore the margin comes in a little bit or is this kind of where we should be thinking about going forward?

Charles Horn

Think of this way, Dan, as this is the high fixed cost business, so it leverages the revenue growth very well. So if you look at Q1, revenue was little bit lower, ramped up in Q2, good expansion, now I expect it to pull back on revenue a little bit in Q3 and then ramp up in Q4. So for the year around 18-ish in terms of EBITDA margins, probably a little bit of a pullback in the margin in Q3, good expansion in Q4. So in Q4 it’s likely you could see EBITDA margins in the 20% range, so for the year expect it around 18 with fixed cost structure.

Bryan Kennedy

Yeah, if you look at overall LoyaltyOne, which consists of sort of the international business, there is the Canadian AIR MILES program, BrandLoyalty which is primarily Europe as well as some Asia, and the Brazilian coalition program, you’ve got Brazil which is running 40 plus percent topline but very little earnings at this point, because it’s in pure growth mode. You got BrandLoyalty which is running 20 plus organic top and bottom but that still means the margin as Charles said in the sort of high teens. And then you’ve got the traditional AIR MILES program which is growing 3%, 4% has mid to high 20s, high EBITDA margin. So you squish it altogether, to use the financial term, and what you’ve got there is a very nice double digits organic top line growth and double-digit organic bottom. So that’s sort of where we are after.

Dan Perlin - RBC Capital Markets

And I think Charles, you mentioned the tender share growth was a hundred basis points, is that a function of this built-out of this multi-tender database, or is this up and different?

Charles Horn

This is just basically the basic blocking and tackling we’ve been doing. The multi-tender database really is still under development, something we’re looking to get closely done by the end of the year. That is an opportunity maybe in ’15 going forward but really will not be a contributor to ’14.

Dan Perlin - RBC Capital Markets

And then lastly as I was kind of looking back to some of my notes and we are thinking about vintages going into ’15 to get some line of sight, am I right to assume that you got about $500 million file that was from ‘13 vintage that you’re going to roll in, it looks like in the ’15, maybe back half of ’15, that’s not even in ‘14 numbers.

Charles Horn

That’s correct.

Operator

Your next question comes from the line of Tulu Yunus with Nomura.

Tulu Yunus - Nomura

Just one question on clarifying the guidance for a second. So I think for the quarter you guys beat your published guidance by about $0.20 actually, and you’re raising the full year by 10, you know just trying to reconcile that it doesn't seem like there's anything in the report that suggests you’re actually lowering your back half view? Was it just that there’s just some conservatism baked in as sort of -- as your style or is there something else that we should be thinking about?

Charles Horn

That's always the piece of it, Tulu but also you don’t always exactly know how things will sequence between quarters, going to back to what Ed said before, we had a little bit more coming to Q2 than we originally expected, which is just about Q3, Q4. But I’d say it's a combination of both. We always like to try to keep little conservatism in there, so we like to do the beating rates but sometimes you can’t exactly sequence your quarters exactly -- exactly right.

Tulu Yunus - Nomura

And then just on the credit trajectory, actually just a question there, so I think last quarter your outlook really was that the loss rate should be sort of flattish to down from those levels, looks like the DQ rates have done really quite well, beating seasonality and so forth. Can you just give us an update on your outlook for the charge-off rate?

Charles Horn

We’re still expecting improvement in the loss rates, last year it was a 4.7% charge-off rate. This year we’re trending more toward a 4.5% loss rate and I think that pretty much stays on track.

Ed Heffernan

I think for modeling purposes we've been saying this for the last year or so, I mean the good news or the bad news of declining charge-off rate and declining funding cost, we don't factor that in as we look into ‘15 and ’16. We assume this thing has straight bottom which is probably a good assumption in that the growth that we’re expecting is going to be coming purely out of just driving very large increases in the file from all the signings that we have in the tender share pickups from the core.

Tulu Yunus - Nomura

And then just lastly on Brazil, you know obviously tracking very nicely, I guess what is the – but your ownership kind of remains where it was, just what it is that you kind of need to see before you can sort of -- perhaps take that in and invest a little bit more into that business, I guess what type of collector counter you really are looking for – basically that’s it.

Ed Heffernan

Yeah, it’s a fair question, I think it's a classic dilemma right of you know, would you like to own a majority of something that you hope will work well or a large minority piece where the owners are also the operators and have a huge incentive obviously for themselves and the associates to grow this thing profitably and quickly. And frankly I would prefer to own 37% of something where the ownership is as highly motivated as possible to make this the most valuable asset that they can, and if that means at some point down the road they would like a liquidity event we’d be more than happy to offer that but we are not aggressively pursuing that. We would prefer to build up the asset to be as valuable as it possibly can, and if that means we pay a little bit more down the road I think that's a good -- a good play.

Operator

Your next question comes from the line of Ashish Sabadra with Deutsche Bank.

Ashish Sabadra - Deutsche Bank

Solid quarter, just had a couple of quick questions. The receivables growth of 20% in the third quarter, does that include a Coldwater creek receivables, are you planning to migrate those over and convert those over?

Charles Horn

Yes, yes.

Ashish Sabadra - Deutsche Bank

Can you just help us size how big that is remaining?

Charles Horn

I’d say it’s still in the 250 million plus range, we will look to do obviously try to covert the cardholders into other programs and retain utility of those cardholders.

Ashish Sabadra - Deutsche Bank

That's great, and so there's definitely an opportunity for you to convert those over to other programs, then that should help grow your receivables further, is that the right way to think about it?

Charles Horn

That is correct.

Ed Heffernan

Yeah I mean 20 would be sort of our base, hopefully there will be little better news coming up on that.

Ashish Sabadra - Deutsche Bank

Definitely, and then the second question on the reserve build, so in this quarter, the provisions were higher than the charge-offs, and I believe the reserve build is associated with receivables growing so fast. So how should we think about the reserve built through the rest of the year, just wondering if you can just comment on the provisions for the rest of the year?

Charles Horn

Let me look at my cheat sheet, I think you're basically going to be in a situation where you are on a solid reserve build Q3 and Q4 just based up on the growth rates we’re experiencing. So even though the loss rates aren’t expected to move, we said that’d be he stable for the remainder of 2014 with the sheer amount of growth we’re expecting to see you will be in a reserve build situation.

Ed Heffernan

Yeah, it’s kind of like -- sometimes people ask could we flow through more, is there chance for margin expansion? The answer is it's a real simple thing, if we slow our growth you will see a flood of earnings coming through because your reserve build always front runs the earnings coming from the file. So it is one of those things where the reserve builds that we’re going through certainly dampen current period earnings but at the same time we would expect that -- the goal here is sort of long-term earnings generation and so we expect that the builds are good sign going forward but you’re just not going to see any margin till we start slowing.

Ashish Sabadra - Deutsche Bank

And just quickly on the M&A pipeline usually you tend to do one or two tuck-in acquisition every year, I was just wondering when you look at the M&A pipeline both on the portfolio acquisition front as well as maybe some tuck in acquisitions, how do you look at the pipeline, and if you just could comment on your plans?

Ed Heffernan

Yeah I mean on the M&A side, obviously in the card business we’re not – we don’t do a lot of it, we will do as we talked about some pretty modest size files that there's out there, 100 million, 200 million, we have one in ‘15 that’s coming on board, that’s about 500 million. So we’re not assuming that there's going to be a lot of M&A there which sort of leaves the other two large segments from an M&A perspective and clearly I certainly wanted to make sure our European adventure via BrandLoyalty was successful before we dip our toe any deeper into the water and needless to say we are more than happy with how that's going. So that gives us more confidence that maybe we beef up Europe a little bit more, at the same time that our clients are asking for a larger footprint in Europe as well as in Asia because these are global clients. So we need to be aware of that. At the same time it's always the question – do we build or buy in terms of beefing up digital assets. If prices are crazy we’re certainly not going to get involved in that, we prefer to build it. If there are opportunities where there are reasonable valuations and that means accretive to us, then we will buy. So that's about as close as I can get.

Ashish Sabadra - Deutsche Bank

That’s a great segue into my last question, just on the synergies between BrandLoyalty and Epsilon business, can you talk about your plans fixed [ph] and Epsilon in Europe and Asia and maybe bring BrandLoyalty in the US, if you could just provide some color on that front?

Ed Heffernan

Yeah, there is no question – I will take the first piece, Bryan can take the second -- there is no question that BrandLoyalty which exclusively is with the big supermarkets hypermarkets what everyone call them over in, primarily in Europe as well as some in Asia, we are already getting traction in Canada first, which would make sense, given our presence up there, as well as beginning to look at opportunities in the US. As part of this deal, we certainly wanted to use our relationships in North America to help the footprint of BrandLoyalty. I think what you'll find is that in Canada will be their first jump off and that will be sooner rather than later and in the US would be next.

Bryan Kennedy

I think from an Epsilon perspective just to give you some color, Epsilon today already has a nice healthy footprint across Europe and APAC but as a percent of revenue, that’s a fairly small piece of our business. We have been growing that -- originally many of those relationships were centered around our email offering, and as our multinational clients grow – we are growing with them by adding personnel and adding services in all of those locations which enables us to broaden what we do internationally beyond email to database and data etc. So that’s something that’s going to be critical for Epsilon going forward is to continue strengthening those international offices so we can grow with our global clients.

Operator

Your final question comes from the line of Andrew Jeffrey with SunTrust.

Andrew Jeffrey – SunTrust

Hey Ed, I think your comments on Epsilon are particularly telling vis-a-vis the strategic positioning of business, Harmony from a long-term sort of cross sell synergy perspective, this is clearly critical. Could you elaborate a little bit on a competitive basis when you look at the broadening of the revenue base from whom do you think Epsilon is taking share and who do you see in the market as your primary competition?

Ed Heffernan

Yeah I will take a stab at it but I won’t do a justice of – I will let Bryan finish up. But there is a large chunk of the growth in Epsilon that is coming from not dissimilar to what we talked about in the card business as well, it is coming from a shift of dollars away from your much more traditional channels of marketing, your brand advertising everything else, when we’re looking at especially in the midmarket space which we've never really had much traction, because this stuff is expensive. But what we’re finding is people are going to pony up the bucks to get a solution that will provide them with using all types of data to get good insights into their customer base, they are taking money out of those traditional channels. So I would say Andrew, to answer your question it’s less about against whom we compete, it’s more about a shift that’s taking place out of traditional spend and into data-driven sort of targeted marketing and loyalty, that’s the biggest. But now I will let Bryan hit the –

Bryan Kennedy

Yes I think Ed is right. I mean so we see a little bit more in the category of market expansion than stealing market share. I mean indirectly for sure if you’ve got for example Ed talked earlier about the food vertical, quick serve and casual dining and retail, I mean you are seeing in those clients a shift in spend which is basically away from general advertising into these data-driven forms of marketing and in that regard I guess you’re indirectly stealing share from traditional advertising agencies, you would have supporting those channels. But really it's we think of it more as new spend in these data-driven categories and in particular loyalty which Ed emphasized earlier which is a lot of runway to it, and it’s a big driver of the growth in our technology business. And beyond that you see competitors in the categories that we cover, which would range from data companies to database, marketing services companies to agencies and Epsilon’s emphasis and our market position is about integrating all those services together in one end to end platform. We think that's a winning formula because our clients are looking for somebody who can insulate them from all the complexity in the marketplace and we believe we’re one if not the only one of the companies that has the broadest reach across all of those channels and categories. So it's a good position for us to take, and that’s helping to drive growth.

Andrew Jeffrey – SunTrust

The Precima business is a relatively new business, I haven't heard you talk a lot about that. Can you talk about the opportunities for growth sort of on that I guess more of a bespoke or one off or closed loop kind of offering, is that something we’re going to be hearing more of in terms of loyalty’s long term growth?

Ed Heffernan

Yeah, I think it is the natural growth -- outgrowth of the AIR MILES business itself, in the sense of what Precima does is it gets a lot deeper into the behaviors and spending patterns of the existing clients. And so you're really getting down into for example at a grocer, the individual SKUs and trying to figure out how we should do product placement, to who we should be offering the big promotions to, how we should be tearing those promotions. Again think of it as adding another level of detail for those clients enough clients can either be a part of the coalition or outside of the coalition itself. So some clients don't want that level of detail, those who do Precima is the solution. So yeah i would say given the trend in the amount of information people want I would say Precima is a legitimate new growth vehicle for the LoyaltyOne segment.

Andrew Jeffrey – SunTrust

Great, thank you very much.

Ed Heffernan

Thank you everyone. Bye.

Operator

Thank you ladies and gentlemen. This concludes today’s Alliance Data second quarter 2014 earnings conference call. You may now disconnect.

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Source: Alliance Data Systems' (ADS) CEO Ed Heffernan on Q2 2014 Results - Earnings Call Transcript
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