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Edward Heffernan - President and CEO

Analysts

Alliance Data Systems Corporation (ADS) 2012 Citi Financial Technology Conference Transcript November 7, 2012 3:00 PM ET

Unidentified Analyst

And so it's been a great story over the last few years and the one area where I want to start the segment that you admittedly gave the gold start to for the last couple of years is the private label segment.

And can you just provide an update on, you guys have won some deals competitively, you continue to sign new retail private label programs? Can you give your perspective as to why ADS is winning in the marketplace and why you should continue to win going forward?

Edward Heffernan

Sure. In private label, essentially again, we view it is one of three platforms on the loyalty, being that we have at Alliance in general. From a win perspective, obviously, those of you who track the card spending and balances know that essentially this was going up to a $1 trillion a few years ago and then fell off a cliff during the recession, and it’s only been stabilized at $800 billion over the last few quarters, that’s consumer revolving debt. So the big card companies obviously are going to have big challenges growing.

From our perspective we play in a very different sandbox. We play in the sandbox where we grow through the sale of our existing retailers, plus signing up new retailers and also taking away additional programs from some other folks out there.

Traditionally, we try to grow organically about 10% a year and we have done so for the last 15 years, which is the amount of time I have been there. This year we are actually looking at roughly 25% on portfolio and 30% on sales.

I would say that is roughly half-and-half between sort of core client and new client signings or organic growth and then half from programs that we've taken from others which would be Pier 1, Bon-Tons and Talbots for example this year. So it's been a record year. Yeah, the growth in consumer revolving debt is essentially zero and we are doing 25%, I would say that means, we are doing something right.

As we look into ‘13 and ’14, I get the question a lot of, well, has this exhausted the pipeline? The answer is no. I expect ‘13 to be another very strong year. The pipeline continues to be quite robust.

We expect a significant number of signings, there will be a couple announced already of them already in January that we’ve signed, we’ll wait till after the holiday season to announce them. And so, could we grow the file another 15%, 20%? Absolutely on the low side of 15%, probably more like 20%, ‘13 is shaping up to be a very strong year in private label.

There is probably two things going on that are relatively new and different from what you will traditionally hear from us. One is some of the takeaways of existing programs from the large banks has been a direct result of our clients feel, how the CEO is felt, during the recession itself and how they were treated.

Essentially there is a number of them who were not pleased at the retrenchment that went on, whereas at Alliance we continue to grow through the recession. So they're looking for someone where this is a core part of their business and that's helping us win some deals.

The second thing which is really new to a lot of folks which never thought it was that new. But, the fact that, you no longer having these discussions with CFO’s, you are having the discussions with CMO’s and the reason for that is that, as you all know everyone talking about data these days, private label is about the only two out there. We didn’t get SKU level information and attach the SKU level information to the individual person. You can't do that in the general purpose bank card market, you can’t do it in most other data collection areas.

In private label if a third of the sales come through. You have a closed loop network where you are connecting the actual customers with what she buys down to the SKU level. That type of information in gold mine for the CMO today and that's why more and more of the wins that we are getting involve the CMO and less CFO. So I think those two trends should help us have over performance versus our traditional growth rates for the next two, three years. That was a very long-winded answer.

Unidentified Analyst

Okay. And so, in terms of the wins that you think you could get, I mean, you alluded to it several times throughout the year, sounds like timing of announcements could be some factor that holding it back for next year.

But as we think about the magnitude of what you could add over the next couple of years, should we look at 2012 as a barometer for that or do you think the opportunities even larger than that?

Edward Heffernan

I don’t think it’s larger, I think in, 25% growth pretty good. I’d be happy at 10%, which I think is the long-term growth rate. If I can do 10% in the market that's not growing, that would be great, because it is growing where we play, especially in an environment where you have 2%, 2.5% GDP, if you can do Forex that the GDP rate, that to me is a significant growth company.

So, no, I wouldn't think that it could be bigger. Do I think it could be north of 10% over the next year? Absolutely, I would say somewhere between 10% and 20% growth rates for the next two years and the file would be, what we would be shooting for.

Unidentified Analyst

Including new win.

Edward Heffernan

Yeah.

Unidentified Analyst

Okay. And as you think about private label from a strategic perspective, you pointed out that a lot of retailers are focused on this, which makes sense given that it’s probably the lowest cost transaction, but also they get a lot of data.

Edward Heffernan

Yeah.

Unidentified Analyst

I mean, have your discussions with your existing clients change significantly in the last couple of years, where they are putting a lot more resources towards growing these program significantly, and how are you helping out in that regard?

Edward Heffernan

Sure. Yeah. I mean, part of the growth that you saw these year, you saw actually, if a programs moves up over three years to about a third of sales and let say that client is growing normal sales at -- total sales at 5%, 6%, our private label sales growth is more like 8% or 9% for that client this year, which means more dollars are being put on the card that has come from exactly what you said. This is now viewed by CMO's as a more and more important tool to attract and drive incremental sales from their best clients, as well as driving new clients, sorry, new customers.

And that’s very different from where it was years ago, where it was sort of got to have one, looks good, very interesting, data is cool, but whatever, now its, this is a critical piece of communicating with their customers.

And in the day -- in these days where it’s a lot harder to come by a sale in low GDP type environment, having that core customer base. Having a personalized relationship with that core customer base is more and more and important.

Unidentified Analyst

Okay. On the cost of the private label business, it’s been one of your main areas, one of the main drivers of your earnings growth has been the credit improvement in kind of financing cost reduction over the last several years. Do you that peaked out and you’ve guided the higher losses next year, is that just a reversion to the mean or are you seeing something that would guide you towards that?

And then, as you think about 10% to 20%, growth, is there any scale in that business or are the costs kind of in line with the revenue growth strategy?

Edward Heffernan

That had about 18 parts, Stuart, but I will try to do the best I can. Yeah. I mean, as far as I’m concern when we are doing our planning, we do not feel there anyone should bake anything more in for improvements and funding cost or improvement in credit quality.

We’re already a good hundred basis points below our historical norm as it relates to credit quality and that's fine. But what we are focusing on is we are focusing on bringing on the new clients and getting the, what I call, the old school growth from the file itself.

And so, regardless of where funding rates go or where credit quality goes, it’s not going to be enough to move the needle one way or other away from our, let’s call it 10% to 20% overall growth rates for the next two, three years because that's coming from real growth in the file itself.

The other thing to remember is that, those things that can’t change such as funding costs, we have traded off short-term funding benefits of borrowing at 50 basis point to go out and lock down seven-year fixed-rate money on the asset-backed market size. So we have traded off significant earnings upside with short-term rates to lock down long-term visibility and we will do that all day long.

And on the credit quality side, again, for other players that are out there where there is no room, their earnings are increasing by reserve releases. We do not do, we haven’t done any reserve releases. We are reserving at 6.5% rate using end of year. And our loss rate is more like 5.1%.

So we are reserving at, what we believe is the long-term normalized loss rate for the portfolio. So even if it’s starts creeping up to that rate, it doesn't really matter because the reserves are already there. So there is no P&L hit that’s going to be coming from that and that gives us a good feeling about our visibility for the next two or three years.

Analyst

The final question of -- we guided to a little bit higher on the loss rate for 2013. Are we seeing anything? No. So maybe, we don’t. Okay. Shifting segments, I want to talk about LoyaltyOne. Okay. You guys have a couple significant partners coming up for contract renewal and any update on that. Can that impact the accounting of the business and others but some accounting changes in that business and will those renewals affect that, any thoughts there?

Edward Heffernan

I have some thoughts on the former and none on the latter. But the former, yeah, we have very significant renewals coming up with Bank of Montreal, which is our largest client in American Express, which is also a very large client. The way things are going right now should be, hopefully relatively straightforward. They seem to straight forward. They’ve been with us for 20 years, so I don’t see any issues there.

In terms of any benefit from new accounting or so, that hasn't been reflected in the guidance. I'm not sure exactly, what it is. I do believe some of it has to do with accelerating the recognition a little bit sooner as opposed to later. But I don't think we are comfortable enough at this point to take that in.

Edward Heffernan

Okay. And then on the Brazil JV in that segment, they guys have made good progress. Any update on what the main milestones investors should be looking at, as we think about next year? And then, how do you think about your ability to increase your ownership of that business? From my understanding, in the past you’ve increased our ownership in that business with nearly cash. If it's turning towards profitability, does that take away some of that opportunity?

Edward Heffernan

Yeah. And we are talking about the model down there. It’s no different from the Canadian model in the sense of, it doesn't need cash. It was cash flow positive, over a year go. If you think of it, the program in Brazil, the loyalty program you are essentially earning points buying the escrows through our own pharmacy et cetera, et cetera and we get paid by those clients.

Every time, a point is issued, so the cash pours in the door. We are not using any type of trust account to cover up the liabilities. So we have all that as use of working capital. So the business itself is cash flow positive, very nicely today. But because of the way the accounting works, we are not allowed to recognize all of that immediately. We need to spread it over the life of the programs, so we have a unique deal just like in Canada where your free cash flow far outstrips your P&L.

So while we are going to book a $12 million or $14 million loss on our share of the venture of this year, the cash flow is probably just the opposite. When does that reverse? It will reverse as 2013 comes to a close and once you hit the inflection point, things really start to take off. So there is no need for any incremental capital or cash down there.

Does that make things more difficult, when it comes to taking a majority position there? I don't know. We have two big hurdles to overcome in 2013, and it’s very simple. We are hoping to get about 4 million active collector's folks will basically who use the card. This year, we’ve now past 5 million. So it's moving quite a bit faster than we had thought. I would like to see that at 10 million by the end of next year.

And to put in perspective, all of Canada with that 10 million, up to 20 years. So it's a big market. If we can get to 10 million, two big things have to happen. We need to roll into Rio and São Paulo. We’ve rolled into five or six areas already. We've got the two big ones to go. One those two big ones are done, this thing is basically going to be on our upper goal and should take care of itself after that. At that point, we will start having discussions about liquidity events for the majority owner. So long list down there.

Analyst

Okay. Going to the last segment, Epsilon, it’s an areas of the business where growth is underperforming to some degree this year.

Edward Heffernan

Yeah.

Analyst

Can you provide an update there? You’ve been building out the products out of these units over the last couple of years through acquisitions. It seem like on the earnings call, you alluded to perhaps even additional acquisitions. So perhaps you can layout, how you think about this business for next year, but also how you view it longer-term in terms of what additional services you need to add.

Edward Heffernan

Sure. There is basically two scenarios for Epsilon, I think from our mind. Epsilon, we believe long-term has organic growth rate of roughly 7% or 8% topline. So again, 3x and they go little bit higher, the GDP growth rate and about 10% on cash flow or EBITDA, how you want to define it.

So that 7%, 8% and 10% is what we look for. This year we are right on the money in terms of the 10% earnings growth rate. We were as you correctly pointed out did a very poor job on top line in terms of organic growth. Epsilon itself would post top and bottom of like 13, 13 but excluding an acquisition it’s going to be more like 3 and 10.

So topline was light. The concern was do we have a real problem going forward here or is this more of an air pocket. And the way we’re comfortable that we’re going to return nicely to the 7 or 8 in Q1 of ‘13 as you look at the pipe. And the pipeline in our world is the real pipeline of either signed contracts or verbal not from the client which means we’re going to contract. The first five months of this year, we were actually behind where we were last year.

And that’s what gave us some pause. As of last week, we were up nicely double digits over where we were at this point last year. That will translate directly when we move into Q1 and that’s why I think you’re going to have Epsilon returning to its historical growth rate, 7, 8 top and above 10 on EBITDA.

Regarding longer term, do I think that’s a comfortable growth rate? Yeah. What’s the unknown right now, the unknown right now is if Epsilon is successful with restructuring that we did. In other words, all we did is we move from selling products to selling by vertical.

So now the head of our digital agency walk in the door, let say, the financial services vertical at one of the large banks and sit there and say let us do all the creative work and agency work that a digital agency will do. And then okay you don't want to know how the sausage is made, you just want to see the results.

Well, then I’ll take care of all those other pieces as well, which would be providing the demographic and psychographic information on all the individuals, the database, the analytics, the distribution channel that’s spend from direct mail to POS, commission-based e-mail, social mobile targeted display, all that stuff is going to be wrapped together in what we call the sausage.

The CMOs of today don't want to know where it comes from. They just know that they’ve got 30 analyst, who need to analyze the output of all the campaigns and the ROIs and everything else. Whereas five years ago, it was all about the technology and how cool it is and the discussions with the CIO, today it’s with the CMO.

And so long story short is that if the Madison Avenue-type digital agencies, once they’ve been gobbling up are absolutely in they’re as competitors to us today, which is very different from five years ago. They offer very good level of service and then they will go to others to fill in all the other pieces.

We’re banking on having not only that digital agency fees but also having all the other pieces in house. And so we can offer the Chief Marketing Officer everything she needs when it comes to very sophisticated targeted marketing across all channels, including all-digital channels as well so where not only the content like the old days of Disney versus the cable companies, but we’re the pipes as well.

And that something if we can move to a model where we are selling through our entire vertical channel, you’re going to accelerate their growth rate of Epsilon dramatically, and we won't know that happens into probably late ‘13 or ’14.

So those cases you stick to your seven or eight topline and 10 EBITDA. And then if we start selling the whole package with a single throat to choke, so to speak, you’re going to see that move up dramatically. And that’s what we’re seeing from the CMOs as they want that single throat to just wrap their hands on and choke and but also expertise across all the different channels themselves.

Unidentified Analyst

And other additional acquisitions, they need to be made to make that happen?

Edward Heffernan

We’ve got critical math now on everything. So Epsilon is about $1 billion or so topline. If I had my wish, I would try to have an even stronger presence in the CMO's office up front, which would be more on the digital agency type assets. So that would be something that if we could bolster that, I think would make the case even stronger than it is now.

Question-and-Answer Session

Unidentified Analyst

Okay. At this point, I want to open it up for question in the audience. There should be a mike going around, if you want to raise your hand. I can keep going.

What are the topics that we’ve talked about in most sessions today is mobile?

Edward Heffernan

And shocking.

Unidentified Analyst

Yeah. I was surprised. If you think about mobile, there obviously could be different aspects depending on which business technique, you’re talking about. You’re talking about ADS. Just wondering how you would frame it by segment as we think about the impact of mobility over the course of the next three to five years.

Edward Heffernan

Yeah. We don't find it nearly as sexy as I think most people. I think they’re quite frankly that there's an awful lot of smoke when it comes to mobile. That’s just me. I could be completely wrong, which is unheard of for sure.

I view you mobile as a very important distribution channel. I did not view mobile as the end-all and be-all because it’s not going to be. Specifically, if I want to communicate with a consumer, it is more important to identify the correct channel by which to communicate than to just assume everyone does mobile because everyone in the room here has the smart phone.

If you want to talk to, for example, my dad going to mobile device which he doesn't have, it doesn't do you much good. Having a very specific direct mail piece maybe in fact the way to reach that type of consumer. So it’s more important in our mind to figure out -- should I communicate to this person through direct mail, point-of-sale, permission-based e-mail, mobile, social, or targeted display.

That is much more important than just saying, I'm in mobile. So from that perspective it's one of many channels that we think will be utilized to contact the consumer, but it may not be the right channel. For me, it's not the right channel. Permission-based e-mail, you get me.

As you skew usually towards the more happening crowd, I guess, mobile is probably it. And we have to be aware of that. All of the data and analysis that we do is not just messaging but figuring out the channel as well.

So long story short, mobile is important as a channel. What I think people need to be very aware of is there’s an awful lot of noise about who wants the data with mobile. The people who have mobile in the wallets and all other stuff do not own the data. They can’t use the data. The merchant owns the data. The merchant’s not going to sign over the data.

So at the end of the day, the ownership of the data, the use of the data doesn’t change for us. We are partnered with the merchant, the mobile device allows to capture but it still goes down the same pipes for everything else and so I think there is a lot of confusion on who actually can use that information and except for a few large programs like Home Depot or something that data is going to reside with the merchant. And so that’s fine by us because that’s how we make our money.

The final thing is that where mobile actually has worked for us? Sure. Are we going to have location-based marketing? Absolutely. Have we rolled out SMS, MMS all that stuff? Absolutely. But with actually work for us where we actually can make money, which is what we focus on is really kind of interesting, it’s in our Private Label division.

We’ve rolled out mobile to the private label retailers that skew very heavily towards the younger crew and rather than getting a card when you are checking out he can walk into a store like tobacco or something like and apply using your phone. We get it score to one of the big agencies, he comes back and so when you have a virtual card right there and they're shopping and then they can go up and use that for checkout.

Well, so what we’ve actually found is, new applications were up 10% using that avenue of the mobile phone. So mobile phone for us is actually driving incremental application volume right there in the store itself. If you ask me why, I have no idea, I know is it works. So, we will keep it open as a channel to drive incremental application.

So, it sounds rather boring, I’m sure and not too sexy. But the fact of the matter is that’s what drives our business. If we can drive incremental customers that means we have incremental sales for our client, which is a good thing. And whether or not we're going to be doing a lot of work with you are walking in the mall and all the sudden your phone vibrate and it’s says, hey, these are your friends at Pottery Barn or Ann Taylor or Victoria's Secret, 10 yards down, bang in right, come on in, you get 5% off.

Yeah, we get involved in that how we make money on it. I have no idea. So, that’s the some total on mobile, do you lot of that targeted offers today for your partners and it is just part of the service that you provide and have you benefit economically, if you're not getting paid to just a higher spending on the card. I don't know how we benefit.

I don't think anyone knows and mobile how they benefit. So, I think we are all working through it. I think there's a thought process that I mean new applications going up 10%. I know exactly, how we benefit because there is spending and there is card growth and everything else. SMS, MMS, location based all other stuff is so new, that it's really hard to say whether that's driving incremental sales for our client or not, or whether it just going to wind up, irritating a bunch of folks who don't really want all that noise.

So, the one thing we have done is no MMS, SMS or location based unless we get permission from the mobile phone user, so that’s one of the things we are making sure takes place. Right now, I can't tell you, it’s too early

Unidentified Analyst

Okay. If there is any questions, let me know.

In terms of your cash flow and generate pretty strong cash flow, you have the few opportunities it seems like a 2013 to use that you have the converts coming up. I guess there is an opportunity for you to settle some of those and cash you obviously bought back stock as well, you don’t currently have dividend perhaps. Can you talk about what your priorities are in terms of use of cash?

Edward Heffernan

Yeah. I mean again if I went back we were originally in LBO back in 98. So, I'm kind of use to be and levered up six to one. So, being two to one is a little bit new for me, I think that the company itself will throw off somewhere between $650 million and $700 million of pure free cash flow in '13 growing double-digits every year, very low CapEx needs.

So, you are not going to have that’s actually after CapEx. So it's pure free cash, if we did nothing, you are going to bring your leverage ratio down about one times and that’s not what we shooting for. So, I would say is there a large transformational deal out there that could add a fourth leg to the company. I’ve looked for the past 15 months and have not seen anything, where we could match the 7%, 8% sort of organic growth rate of Alliance itself.

So, I don't see why we would spend the money for something less than that just to get big, so we won't be. So, that really leaves and a couple of other avenues, we are pretty good at tuck-ins. And so, if there's a tuck-in acquisition out there and that will be something up to $400 million, $500 million. Those are pretty straightforward, probably in one of our core businesses, most likely the Loyalty or Epsilon segments that would make sense.

Also, we tend to be shareholder friendly and we do believe that growth looks very good over the next couple of years. So, most likely you'll see activity on the buyback front of some size and what form it takes, I don’t really know, I don’t really care as long as we can takeout shares.

And then you absolutely right that we have a $800 million converts that’s coming do, we’ve all settle that in of course and then that will rid of these goofy things called phantom shares that, I'd rather not explain ever again. So that will take our share count down into the low 60s or $60 million by the end of the year. So, that’s what we working for. So our leverage were most likely go down from like two times today it will go down a little bit, you are probably see tuck-in and you will probably see some activity on the stock buyback front.

Unidentified Analyst

Okay. I think we are just about out of time. Thanks, Ed. Pleasure to seeing you.

Edward Heffernan

My pleasure. Thank you.

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