Alliance Data Systems (NYSE:ADS) provides private label credit cards along with marketing services and loyalty programs for over 145 brands with 43 million active cardholders. It's been a difficult operating environment for the company given the ongoing structural weakness in the retail industry considering declining brick and mortar traffic and ongoing store closures among a number of major clients. Weak growth and a decline in earnings have sent shares in ADS 44% lower over the past year. That being said, there are some encouraging signs of a turnaround with management offering a positive outlook for the year ahead. We think ADS represents value at the current level and the market is simply too bearish. This article recaps recent developments and our view on where the stock is headed next.
The company last reported Q3 earnings in October with non-GAAP EPS of $5.05 and GAAP EPS of $2.41 which both missed expectations. Revenue on the quarter at $1.44 billion increased by 1.4% year over year. Despite the significant decline in the stock price, the company remains profitable and free cash flow positive. The market has focused on its weak growth, lower card receivables, loan balance quality, and lower gross yield which have combined for earnings headwinds.
(Source: Company IR)
The card services segment which represents 83% of revenues and 89% of the operating income in the last quarter appeared to show some stability with management highlighting a 6% y/y increase in credit sales as the first positive quarter of 2019 for the metric. Favorably, the segment's operating expense as a percent of revenue fell by 100 basis points to 8.7% from 9.7% in Q3 2018. Another positive this past quarter was the principal loss rate that fell 30 basis points to 5.6% from 5.9% in the period last year.
The company maintains a bullish outlook on market fundamentals seeing the core private label credit card business with robust growth with a forecast of industry outstanding balances to grow by 6% per year through 2022. The trend has been more "omni-channel" shopping by consumers shifting from brick and mortar to online while ADS sees opportunity to grow with the changes in the market including mobile. The company sees a market opportunity of $50 billion per year as an addressable market.
(Source: Company IR)
Management is guiding for full year 2019 revenues at $5.6 billion, flat from 2018. The reported EPS target in a range between $16.75 and $17.00 if confirmed would be down by about 14% from $19.49 in 2018. Going forward, the company has a more positive outlook with an expectation to return to earnings growth in 2020 driven by reducing its cost structure and streamlining its operating model. Current guidance sees 2020 revenue growth up to the "low-single digits" and core pro-forma EPS growth in the "mid to high 20%" range.
(Source: Company IR)
It's important to recognize that ADS has some of the highest delinquency and charge-off rates among major credit card companies. With data for October 2019, ADS's delinquency rate reached 5.9% and the charge-off rate reached 6.6%, each above the industry average.
(Source: Seeking Alpha)
The relatively high numbers here compared to traditional credit card companies like Capital One Financial Corp. (COF) or American Express (AXP) reflect ADS's focus on retail store-branded credit cards which are simply a higher-risk lending segment typically attracting lower-credit rated consumers. The figures here are also higher than Synchrony Financial (NYSE:SYF) with a 'core delinquency' rate of 4.5% and 'adjusted charge-off' rate of 5.1%, as the closest comparable considering both companies focus on private-label credit cards with a high exposure to retail.
The other side is that these cards are often issued with higher interest rates and represent the earnings opportunity for the underlying ADS business. ADS highlights how its business is able to generate industry-leading ROE which has averaged 40% over the past five years. The company believes it is positioned for long term, sustainable growth.
(Source: Company IR)
What we like about ADS is that it trades at a deep discount to industry peers reflecting the weaker growth this year and lower-quality balance sheet credit exposure and overall bearish sentiment more recently. ADS's forward P/E multiple at 6.2x compares to an average forward P/E of 8.9x for Synchrony Financial, Capital One Financial Corp., and Discover Financial Services (DFS). ADS's price to free cash flow at 2.6x is at a 7% discount to SYF and 14% discount to COF.
The higher delinquency and charge-off rates in recent months for ADS are concerning but from a macro perspective, there are indications the environment could be improving or at least will stabilize. Going back to the first half of 2019, a concern in the market was that the U.S. economy was decelerating towards a recession which would negatively impact credit services companies leveraged to trends in consumer spending.
Investors here simply need to reconcile what has been a more recent wave of enthusiasm towards a recovery to economic growth expectations in the United States. The global macro outlook has also become less uncertain with a growing consensus of a U.S.-China trade deal or preliminary agreement that has pressured global risk sentiment. The S&P 500 (SPY) trading at a new all-time high suggests the market is gaining confidence that the economic cycle will be extended.
Considering the most recent November jobs report with a stronger than expected non-farm payrolls result, the sense is that trends like a firm labor market and accelerating wage growth will be positive for consumer credit. The setup here is that ADS is well-positioned to benefit over the next year at the margin.
Even for investors that aren't buying the narrative of a potential economic growth renaissance, which is understandable, a middle ground of moderate economic growth with stable consumer dynamics should also be positive for ADS. The company can realize its operational and financial recovery in 2020 based on management guidance under different market scenarios.
It's been a difficult year for ADS with disappointing results. We believe the core business has value and the company has a path to regain growth. The company recently hired a new CEO which may be the fresh start and new perspective it needs to move forward. We like the stock on valuation and see upside with a potential stabilization of operating metrics in the year ahead.
The main risk will be the cyclical outlook and consumer credit conditions. A deterioration in the labor market and spike in credit card delinquencies could likely lead to a reassessment of the company's earnings outlook. Given the company's market segment exposure to retail, we expect volatility to continue. Overall, we view risks as tilted to the upside and rate shares of ADS as a buy.
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Disclosure: I am/we are long ADS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Investing includes risks, including loss of principal.