- Credit card companies are likely to take a hit, not only due to a decline in retail sales but also an increase in loan losses.
- Alliance Data Systems has a higher-than-normal delinquency rate of 6-7% that is likely to spike with unemployment.
- It has struggled to keep up with the shift away from brick-and-mortar - a shift that is accelerating in today's environment.
- The company has a tangible book value of about zero, so it lacks the financial wherewithal to handle a substantial increase in loan losses.
- While the company appears cheap on a historical basis, its business model is not robust, so its survivability is uncertain.
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Alliance Data Systems (ADS) has taken a significant COVID-19 hit and remains nearly 60% below its March highs. The company provides loyalty credit card services to brick-and-mortar stores, as well as data analytics services. ADS has been struggling for years due to the decline of brick-and-mortar sales, and many fear that COVID-19 will be its final blow. Indeed, the data suggests that this is a possibility.
In 2015, the stock hit a peak price of $300. By January of this year, it had declined to $100 and has fallen 50% more since then. The revenue and assets have been in decline since then, and many analysts are looking for the bottom. Indeed, analysts may see a value opportunity. The stock's valuation is low with a TTM P/E of 12X and a price-to-cash flow of around 2X. The discrepancy can be attributed to loan loss provisions.
If we assume ADS's prospects will not continue to decline, it is clearly undervalued. However, COVID-19, as well as long-term factors, jeopardize its turnaround potential. As you'll see, the company does not have much room to handle a rise in charge-offs.
COVID-19 Measures and Credit Card Risks
COVID-19 has caused brick-and-mortar sales to decline dramatically. Many major retailers are closed or are seeing much lower traffic than normal. The company has made an effort to expand e-commerce operations, but the fact remains that brand loyalty is lower online, so loyalty-based credit cards are less viable.
Additionally, the value to customers of travel rewards is likely greatly diminished, meaning new customer growth will likely be very poor. In fact, credit card applications have already dropped by 40% during the virus, and it seems the trend will continue.
More worrisome is the likelihood of an increase in delinquencies. The company has allowed greater forbearance and is planning for greater charge-offs. Delinquency was already a problem before this crisis, and it is only likely to accelerate in Q2. While an increase in accounts receivable may look like growth, it will not be if people are unable to repay the debt.
It is true that the generous unemployment bonus and stimulus checks will temporarily mitigate this risk. However, state unemployment systems are already running out of funds and are now reliant on loans from the federal government. This means they will likely be increasingly stringent on new jobless applications and are unlikely to continue payments after six months.
Obviously, COVID-19 stay-at-home orders are unlikely to last so long, but I'd bet double-digit unemployment will. Thus, there may be a substantial increase in individual bankruptcies for the rest of 2020.
Can Alliance Data Systems Take the Hit?
By far, ADS's main revenue source is credit card charges. In Q1, it saw $1.2 billion in revenue from charges and only $46 million and $120 million in service and redemption revenue respectively. It may market itself as a technology company, but the fact is that it is a traditional credit card company.
Similarly, the company's major expense is its provision for loan losses, which stood at $655 million last quarter, up from $252 million in Q1 2019 due to expected COVID-19 impacts. At the end of March, ADS had $1.28 billion in delinquent loans, half of which were over 91 days delinquent (see 10-Q pg. 15). With $17.36 billion in total delinquencies and receivables, it has had a delinquency rate of 7.4%, which is far higher than the national average of 2.6%.
Given the $403 million in additional loan loss provisions, it expects this rate to jump to at least 9.6% (likely higher given over half of the delinquencies usually repay).
Quite frankly, I believe ADS is giving a relatively conservative estimate for the spike. The company's book value is only $1.08 billion, so if there are greater charge-offs than expected, then that could easily cause its equity book value to turn negative. Of course, the company has about a billion in intangible assets, so its tangible book value is essentially zero. If the cash stops coming, it will be forced to sell equity to repay creditors.
Bulls argue that the company made it through 2008 without significant hiccups. This is true, as its net income hardly fell and the stock price and gross profit rapidly recovered. See below:
As you can see, ADS made it through the Great Financial Crisis without a financial crisis. That said, the total U.S credit card debt is over 60% higher today. Indeed, mortgage debt remains far below 2006-2007 levels, but total household debt is higher due to a buildup of credit card, auto, student, and other higher-interest forms of debt. Additionally, 80% of workers now live paycheck to paycheck.
In my opinion, ADS is in a bit of a lose-lose situation. If consumers continue to spend, there is a high probability of significant loan losses that jeopardize the company's ability to stay solvent. If they do not continue to spend and use the money to repay debt, loan losses will be less problematic but total receivables and revenue will decline. U.S retail sales have already declined at least 9% (far worse than any period in 2008) and will likely remain depressed for months. If stay-at-home measures are extended (even if slightly lifted), it is likely that both will occur.
In this article, I focused largely on the short-run impacts of COVID-19. It seems clear that the economic fallout of stay-at-home measures will hurt the company significantly on all fronts. Demand for its cards will be much lower, loan losses significantly higher, and its operational efficiency likely lower due to employees working from home.
Of course, these negative factors will likely rebound after the economy is reopened. However, the fact is that many businesses will be permanently closed, and unemployment will likely remain high at least through year-end. Even more, it is possible that the virus has accelerated a permanent shift toward e-commerce, which has been the major long-term factor harming ADS.
Additionally, without an extreme business model transition, the company's long-term prospects are poor due to its dependence on brick-and-mortar. According to ADS's 10-K, its 10 largest clients account for 44% of its revenue, with the struggling-to-survive L Brands (LB) accounting for 11%. While the company is focusing on greater value with data, I have doubts it will be able to successfully manage the change, as witnessed by its declining revenue over recent years.
I do not have a position in the company, but I believe it is headed lower and best avoided at its current price. Yes, its valuation may seem low, but the leverage is extremely high, which leaves little room for a substantial increase in bad debt expenses. If there is a rapid rebound of the real economy, ADS may be a value opportunity. However, such a rebound looks increasingly unlikely, making the company overvalued.
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