Alliance Data Systems Should Survive - Upside Is Huge
Summary
- Alliance Data Systems stock has been severely beaten down.
- Investors are afraid that large charge-offs will wipe out the company's equity.
- A look at past history and the level of reserves build-up suggest that the company will survive this downturn. If so, the upside is huge.
Alliance Data Systems Corporation (ADS) was founded in 1996 and is headquartered in Columbus, Ohio. Alliance Data was formed from the December 1996 merger of J.C. Penney's (JCP) credit card processing unit and The Limited's credit card bank operation. In August 1998, Alliance Data acquired Loyalty Group for $250 million. The deal gave Alliance Data two valuable business enhancements, Canada's Air Miles Rewards Program and the company behind the popular Air Miles program, LoyaltyOne. It also had a digital marketing segment called Epsilon which it divested in 2019 for about $3.5 Billion or (10 X EBITDA).
Alliance Data Systems Corporation operates through two segments, LoyaltyOne and Card Services. The LoyaltyOne segment offers the AIR MILES reward program in Canada; short-term loyalty program; and loyalty services, which include loyalty consulting, customer analytics, creative services, and mobile solutions.
The Card Services segment provides receivable financing services comprising underwriting and risk management; processing services, such as new account processing, bill processing, remittance processing, and customer care; and marketing services to private label and co-brand retail credit card programs. Segment Revenue and Adjusted EBITDA are as follows:
Years Ended December 31, | % Change | ||||
2019 | 2018 | 2017 | to 2018 | to 2017 | |
| Revenue: | (in millions, except percentages) | ||||
LoyaltyOne | $ 1,033.10 | $ 1,068.40 | $ 1,303.50 | -3% | -18% |
Card Services | 4,547.80 | 4,597.60 | 4,170.60 | (1) | 10 |
Corporate/Other | 0.40 | 0.60 | 0.60 | nm * | nm * |
Total | $ 5,581.30 | $ 5,666.60 | $ 5,474.70 | -2% | 4% |
Adjusted EBITDA, net: | |||||
LoyaltyOne | $ 244.50 | $ 254.20 | $ 256.70 | -4% | -1% |
Card Services | 1,119.70 | 1,496.00 | 1,344.90 | (25) | 11 |
Corporate/Other | (92.90) | (140.80) | (136.20) | (34) | 3 |
Total | $ 1,271.30 | $ 1,609.40 | $ 1,465.40 | -21% | 10% |
The Card Services segment is now the major profit driver of the company.
Card Services
ADS Card Services is basically a private-label credit card issuer. Private-label credit cards are issued in partnership with retailers and differ from general-purpose cards in that they can only be used at the issuing retailer. The company also issues co-branded cards with retailers in partnership with Visa (V) or Mastercard (MA) that can be used at any retailer. It mainly targets customers with prime credit ratings.
The card issuers, consumers, and retailers form a symbiotic relationship. The issuer earns a net interest margin and the retailers get the benefit of a loyalty relationship, personalized market intelligence, and avoidance of interchange fees charged by general-purpose card issuers. The consumers get the benefit of special discounts, loyalty rewards as well as customized terms (i.e., extended credit terms).
The company captures and analyzes data created during each customer interaction, leveraging the insight derived from that data to enable clients to identify and acquire new customers and to enhance customer loyalty. It serves clients across various end-markets, including financial services, specialty retail, grocery and drugstore chains, petroleum retail, home furnishing and hardware, beauty and jewelry, hospitality and travel, and telecommunications.
The stock came out of the depth of the financial crisis of 2009 like gangbusters when it bought back 30% of its shares outstanding with excess funds released from its loan loss reserves. The stock reached its peak in 2015. After that, as the retail apocalypse meme took hold, it has been on a downwards trajectory. With the recent COVID-19 downturn, it has really broken down. With the current downturn, investors, obviously, fear that people will stop paying their credit card bills and defaults will increase.
So, basically, we have a situation here where not only net income has declined but the multiples investors are willing to pay for the shares have also imploded. One big issue is that after the financial crisis, the market was valuing the company like a technology company and giving it high P/E multiples (in the mid-20s to mid-30s.) This issue was picked upon by short-sellers who shorted the stock and made a lot of money. Over time, motivated by the shorts, the market realized its error that ADS is more and more a finance/credit company rather than a tech/industrial company, and P/E multiples started to re-rate the shares to much lower multiple. In fact, ADS financial reporting is still stuck in the past, i.e., its reports are structured like that of a tech company and not like an ordinary finance company. The end result is investor confusion, skepticism, and low valuation.
I believe investors have overreacted to the fear of charge-offs. The company does not appear to be going out of business. ADS has built up its Allowance for Loan Loss (ALL) reserves rapidly. As of March 31, the company had ALL reserves of 2,150.80 million vs. credit card loan receivables of 17,731.9 million. This is adequate for the absorption of a 12.1% charge-offs vs. receivables without dipping into equity. In 2010, a ratio of 10% provision proved adequate to weather the last recession. This is also comparable to the ratio put forward to Synchrony Financial (SYF) in their presentation (below).
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Private Label Credit Card - Charge offs 2009 to 2019 - from Synchrony Financial |
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ALLL Reserves - ADS - Source: Mergent |
Commenting on first-quarter results, Ralph Andretta, president and chief executive officer of Alliance Data said:
Using the last recession as a guidepost, we believe our credit card portfolio is more diversified and better positioned from a risk standpoint than it was in 2009, and we are in a stronger financial position, with significant liquidity and additional borrowing capacity.
At the end of the first quarter, we had over $1 billion of immediate liquidity between cash on hand and our revolver at the parent level. Our FDIC-insured banks had $2.5 billion of equity capital and total risk-based capital of approximately 17%.
Andretta added that:
While it is difficult to predict how the economy will evolve, Alliance Data is projected to remain EBT and cash flow positive with sufficient liquidity through an assumed period of very significant stress.
Thus, unless the current crisis is much worse than the great recession, ADS's reserves should be adequate to absorb peak recession charge-offs without affecting equity. Capital at the bank level is quite healthy at about 17% (regulatory minimum is 4%).
It should be noted that ADS owns two state-regulated industrial/credit-card bank subsidiaries in Delaware and Utah, respectively (Comenity Bank or Comenity Capital Bank). These banks take FDIC insured deposits such as Money Market and CDs and issue the credit cards. ADS's receivables are funded through a combination of bank deposits and securitization of receivables. The company has total liabilities of 23.1 Billion (6.3 Billion are securitized and non-recourse).
ADS has compounded book value at about 20% per annum over the last 10 years and bought back a lot of stock. Unfortunately, the stock has fallen quite a bit and the money has not ended up in shareholder's pocket.
Valuation Discussion
If push comes to shove, ADS can sell its loyalty segment. It could likely get $1.12 billion for that segment (I am assuming ~5x EBITDA; last year, it could have got 10x for it based on similar deals in the loyalty space, but such is life and this is now.) Synchrony Financial is its closest but much larger competitor with revenues of $16 billion, valued at around $10 billion market cap (P/S of 0.63). This would imply that the ADS's card services segment with an estimated 2020 revenues of $4 billion should be valued at about 2.5 billion. This would imply a sum of parts value of $3.6 billion vs. a current market cap of 2.1 billion as compared to peers. This is a 42% margin of safety, at a low point in the business cycle.
The loyalty segment should be separated from the card division. With the sale of Epsilon, ADS is really a credit card bank. I believe it is just a matter of time before this happens.
This is, of course, just the start of the downturn and the situation will continue for the next year. In Q1, receivables were already down -9%. I think we can easily expect that receivables will plummet rapidly (I am estimating -20% to -30%) in the quarters ahead from a year ago. While this reduces risk, it will have a negative effect on earnings potential. Understandably, the company is not able to provide guidance. The company has also cut its dividend by 2/3rd. The huge economic uncertainty has driven the stock price to a low level.
The following table gives ADS income from continuing operations. As you can see, it's quite variable with 2018 being the peak.
2019 | 2018 | 2017 | 2016 | 2015 | 2014 | 2013 | 2012 | 2011 | 2010 | |
Income from continuing operations | 572.6 | 945.5 | 769.2 | 480.2 | 544.3 | 516.1 | 496.17 | 422.26 | 315.29 | 195.64 |
Note: The company has included depreciation and amortization expenses in the above numbers which are not really that relevant for a mostly finance company as there are little assets to wear out. I have left them in, but, if anything, the true profitability is understated.
Assuming that ADS can get earnings back to the 2019 level after the recession, the company's current market capitalization is only 2.2 billion. This is less than 5 times normalized core earnings. Assuming normalized P/E to be about 10, this would represent a 100% upside. The Price to Sales ratio is at the lowest level in its history. If the company manages to survive this downturn (and odds suggest that it will), the upside on the other side should be very good.
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Price to Sales Ratio |
Multiple insiders have bought the stock recently which is encouraging.
This article was written by
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.