Alliance Data Systems Corporation ($ADS) is a large publicly traded provider of marketing services and loyalty card programs. ADS has three distinct and eclectic business lines, a private label store credit card business, a data driven marketing company, and a Canadian coalition loyalty program. The company was recently covered on SumZero in an in depth report by Steve Gorelik, the Founder and Lead Portfolio Manager of Firebird's U.S. Value Fund. Prior to founding Firebird, Gorelik earned an MBA from Columbia Business School, where he took part in the Value Investing program.
Several pages into his report he writes that “the fact that it took over 1,300 words to explain all the different parts of ADS and how they fit together is one of the reasons why the company is persistently undervalued by the market”. SumZero sat down with Gorelik to discuss his idea and hear his thoughts on ADS.
Luke Schiefelbein, SumZero: What about Alliance Data Systems (ADS) caught your eye as a value investor? What catalyzed your entrance into the position?
Steve Gorelik, Firebird US Value: One of the screening criteria I use in the investment process is free cash flow yield to equity. Due to the high profitability and low capital intensity of its businesses, Alliance Data Systems has always screened well and was on our radar for years.
In February 2016, ADS shares fell by 20% after weak revenue guidance. The company was transitioning from high to low growth mode, which I find to be a fertile place to look for potential investments. These types of stocks can fall through the cracks when growth investors are abandoning it due to slowing momentum, but traditional value guys have not gotten comfortable with valuation yet. In 2016, ADS went from growing 20%+ per year to 8-10%. After the price drop, free cash flow yield to equity went from 10% to 14%, which I thought was attractive enough given the growth.
Since we invested in the company two years ago, share price stayed at around the same levels, but the intrinsic value increased. The company grew revenues by 20% and EPS by 60%.
Today, I believe ADS represents an even more attractive investment opportunity than it did two years ago. The company has successfully navigated issues in the AirMiles segment, improved profitability in Epsilon, and has grown its credit card franchise. Investor sentiment appears close to an inflection point which should lead to multiple expansion.
Schiefelbein: What catalysts should investors pay attention to as this thesis plays out?
Gorelik: In the last two years, ADS grew revenues and EPS, but has not gotten credit for it from the market due to perceived issues in each segment. As these issues get resolved, multiple should expand. Specifically, we are looking for stabilization in the cost of risk in the credit card division and return to growth in both the number of AirMiles issued and Epsilon revenues.
These are well-known issues, but given the current valuation, I believe the expectations are low, and risk/reward is very much in favor of investors.
Schiefelbein: In your valuation section, you led with: “The fact that it took over 1,300 words to explain all the different parts of ADS and how they fit together is one of the reasons why the company is persistently undervalued by the market.” Why are ADS focused on so many eclectic business verticals? Are these businesses all accretive to each other? Why not spin some out?
Gorelik: The overarching idea of ADS business model is to help enterprises create a meaningful relationship with their customers. Alliance Data Systems has three key divisions – LoyaltyOne, Epsilon, and Credit Cards.
There are synergies between Epsilon and Credit Cards since ADS uses Epsilon’s data marketing services as the key differentiator in bidding for retailer accounts. ADS competes against Synchrony Financial, Citibank and other banks for these relationships. While other players offer interchange fee rebates, lower rates, and other financial incentives, ADS wins relationships through offering retailers ways to increase their sales. Epsilon data helps merchants understand their customers and tailor offers to their specific needs.
The third part, LoyaltyOne, has two divisions that are both market leaders but have little to do with each other and the rest of the company. AirMiles is a Canadian coalition loyalty program with over 10 million active participants - almost 1/3 of country’s population. BrandLoyalty is a European leader in designing short-term incentive programs for grocers. The common thread between the two businesses is that they deal with loyalty programs, but that’s about it since they operate in different geographies. ADS tried to bring BrandLoyalty expertise to North America but so far has had limited success.
Selling or spinning off these businesses would likely reduce complexity and create value for ADS shareholders.
Schiefelbein: What do you make of the 2016 Citron Research report on ADS? It called ADS “more a bank wrapped in the Halloween costume of a business services company”, and claimed that was because business services companies carry higher multiples. What is the flaw in their analysis?
Gorelik: I think Citron puts out high-quality research, but in this case, they failed to appreciate how good of a business Alliance Credit Cards really is. They assumed it should be worth 2x Book Value based on Synchrony Financial multiples but did not take into account that ROE and growth for ADS are both much higher.
At $4.4 billion, they valued the credit card business at 7x P/E at the same time when the S&P Financial Sector was trading at a 15x multiple. Since Citron’s report, net income of the banking subsidiaries has increased by 30% and it paid $700 million of dividends to the mother company.
Schiefelbein: Why do you think that a ~10.5X multiple is appropriate for a company so exposed to retail?
Gorelik: The 10.5x multiple is based on the historical trading range of the company adjusted for leverage of the financial business. Since 2011, the % of overall EBITDA coming from credit cards stayed about the same, and that is why I believe multiple is appropriate.
It is also important to note that ADS operations require little CapX. EBITDA converts to high free cash flow yield and most of that cash go towards dividends and share buybacks.
Schiefelbein: Why is the decline of brick and mortar sales not cannibalizing ADS' store card business? Could a continued retail decline have a negative long-term impact on the business?
Gorelik: ADS partners with mid-size retailers that are trying to figure out how to navigate the changing competitive landscape. They lost some partners, like Bon-Ton, to bankruptcy, but they were replaced by new relationships with build.com and Diamonds International.
I think it is a mistake to paint all retail as a declining industry. ADS partners include growing off-line retailers like Ulta and online players such as Wayfair. The eventual retail landscape will include more than just Amazon and at least some of other participants will likely need help from ADS to understand their customer needs.
Schiefelbein: Do you see any downside risk of new consumer protection laws regarding credit card interest rates? Is a business model predicated on high interest generated from 80% of cards sustainable? Is the exposure to subprime credit?
Gorelik: I do not have a way to predict policy, but it does seem that the United States, at least for the moment, is in a period of decreasing regulation. Regarding specific threats to ADS, their headline interest rates are not much different from other credit card companies. They are no more exposed than Synchrony, Capital One, Discover or any others. The higher effective interest rates and fees come from use pattern (occasional purchases vs. transactional cards) and tendency to forget about payment dates for non-recurring payments.
The company does not target sub-prime borrowers, but store credit is one of the few ways that people with bad credit history can restore their financial standing. As a result, ADS does have a higher percent of sub-prime borrowers than other credit card companies.
Having sub-prime borrowers does not necessarily mean poor credit quality. Both net charge-offs and loans past due by more than 90 days for ADS are lower than those for Synchrony Financial.
Schiefelbein: ADS' marketing platform Epsilon experienced a revenue decline of 10%+ in Q4 2016. Why was this? What has changed since?
Gorelik: The decline of over 10% was in the technology platform part of Epsilon business, which was about 25% of revenues at the time. This particular part of Epsilon is relatively low margin and in Q4 2016 EBITDA for Epsilon was higher than in Q4 2015. Overall revenues for Epsilon declined 1% in Q4 implying that rest of the business grew in mid-single digits.
The technology platform is the nuts and bolts behind brand loyalty initiatives. Epsilon was late to realize that their U.S. based cost structure was no longer appropriate given what competitors were doing in the space and lost customers. They’ve off-shored a large portion of the workforce and were able to return technology platform to growth by the end of last year.
Schiefelbein: Air Miles seems to be massively dependent on their sponsors. What is the risk of a situation like Aeroplan’s where sponsors snowballed out and destroyed the program?
Gorelik: While both Aeroplan and Airmiles were coalition loyalty programs, they are quite different in structure. Aeroplan was similar to airline or hotel rewards program with 85% of Aeroplan miles redeemed for Air Canada flights. When Air Canada withdrew from Aeroplan, it undermined the business model.
AirMiles biggest partner is BMO, but it works with over 120 sponsors in different categories and geographies. Most of the miles are redeemed not at the sponsors, but for items and experiences bought from Air Miles catalogue. In this regard, AirMiles is more similar to Amex Rewards and does not depend on a particular sponsor for survival.
Schiefelbein: Has LoyaltyOne / AirMiles overcome the issues affiliated with their 2016 PR disaster and ensuing lawsuits related to forcing an expiration date of miles in their program? What is the future of the program?
Gorelik: The 2016 expiration policy mishap had a lasting effect on AirMiles causing negative trends in the issuance of miles for most of 2017. Trend improved to only 1% drop in Q1 2018 and management commentary on quarterly call suggests that miles issuance started growing in Q2.
Despite the PR disaster, the value proposition of coalition loyalty program comes from the network effect of having 120 sponsors and 10 million participating members. 2016 was a bad period for AirMiles, but it seems that the main attributes and intrinsic value of the program remained intact.
Schiefelbein: What is the most compelling bear case for ADS? What could go most wrong?
Gorelik: After a number of mishaps in last two years, ADS management does not have a lot of goodwill and trust from market participants. They are projecting return to growth in all key segments by the end of the year. If they fail to hit the targets, there is a good chance that market will lose faith in the company and will discount it even further.
On the macro side, ADS is very much exposed to the health of U.S. economy both in Epsilon and Credit Card segment. The company shares halved in 2008 before recovering all losses by 2010. If we experience a prolonged recession, ADS valuation will likely suffer.
Schiefelbein: Where else do you see value in the market today? Where else do you focus your research?
Gorelik: The technology stocks and the concept of disruption drove the performance of the market in last few years. The flipside of this growth has been an indiscriminate decline in the valuation of the “disrupted” industries, which include retailers and traditional media companies.
I believe that there is some room for coexistence between the new and old technologies and nimble players with valuable assets and customer base can figure out a way to succeed and prosper in the changing world.
Some retailers, like Kohl’s, have shown that they can find a way to extract more profits from their existing store base by changing the assortment and establishing innovative partnerships. The market was late to recognize the change, but shares have now more than doubled since 2017 lows. Despite the increase in price, Kohl’s is still trading at double-digit free cash flow yield to equity.
Another area where the market is overlooking positive changes is in TV content and specifically in local broadcasters. The analysts are focusing on threats from OTT alternatives and upcoming FCC judgment about Sinclair/Tribune merger. At the same time, the market has overlooked the fact that a total number of subscribers and revenues are growing. The expectations and valuation are low, and any change in sentiment should lead to significant positive re-rating of the segment.