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Morningstar | ADS' Epsilon Divestiture a Mild Positive; Investors Should View Sell-Off as an Opportunity

Narrow-moat Alliance Data Systems has followed through on the much-anticipated divestiture of its Epsilon marketing business to Publicis. In total, Publicis will pay $4.4 billion for Epsilon, which translates to 9.3 times the segment’s 2018 adjusted EBITDA and nearly 30 times 2018 GAAP operating income. Given the stock’s negative reaction, it appears the market was expecting a higher deal price. In Epsilon, Publicis is buying a segment whose revenue declined more than 4% in 2018, partly driven by the struggles of Conversant, which ADS acquired in 2014 for nearly $2.5 billion. In 2014, ADS issued more than 4.6 million shares at prices exceeding $250 (a greater than 50% premium to today’s price) to acquire Conversant, which saddled the business with significant amounts of purchase amortization. Given the struggles of Conversant, we always believed it was appropriate to value Epsilon based on GAAP operating income instead of EBITDA. That’s why we believed it was possible, if not likely, that a deal would disappoint investors. Nevertheless, we believe the April 15 sell-off is somewhat unwarranted and still think Alliance Data Systems is cheap. Currently, ADS trades at a price/fair value of 75%. Overall, we view this divestiture as a mild positive for the company. For now, we’ll maintain our fair value estimate at $220 per share until we can get more clarity on ADS’ use of the cash proceeds.

There’s still a lot we need to learn about the deal. Specifically, ADS says it will have $3.5 billion available for share repurchases and to pay down debt. At the parent level, ADS holds more than $5.5 billion in debt. This parent company structure with bank subsidiaries has enabled ADS to be significantly more leveraged than any of its bank rivals, allowing it to return more cash to shareholders. Without Epsilon, we wonder if it will be more challenging for ADS to structure its balance sheet like a marketing company. Our fair value estimate partly depends on how much the company will be able to repurchase. If the company cannot maintain its high leverage, returns on equity will suffer.

Management says the divestiture will be highly accretive on a GAAP basis. Though we have been skeptical of management in the past, here we are in absolute agreement. Selling Epsilon helps ADS remove a weight on profitability. We have always believed it was more appropriate to value ADS on a GAAP basis, given the weak performance of Conversant. As a result, we are incrementally more optimistic for ADS’ prospects. That said, ADS still faces a struggling retail customer base, which will provide some headwind for growth in the medium term.