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Morningstar | Alliance Data Systems Feels the Sting of Retailer Bankruptcies and Higher Credit Losses. See Updated Analyst Note from 19 Jul 2018

Narrow-moat Alliance Data Systems is starting to exhibit the struggles we highlighted last quarter when we predicted higher credit card losses and slower growth lies ahead for the company. This quarter’s results and commentary seem to suggest we are on the right track. We’ll be maintaining our fair value estimate at $240 per share. For the second quarter, Alliance Data Systems grew receivables by 1% sequentially. In comparison, receivables grew 3.6% during last year’s second quarter. This is a meaningful deceleration that we think will continue. On the call, management mentioned that it is still targeting “a 15% growth rate in the file for the next several years.” Though that may be possible for customers it retains, we doubt Alliance Data Systems can grow its entire portfolio by similar rates. Alliance’s retail partners will continue to go bankrupt, which will be a significant headwind to growth. In the second quarter, total credit sales on Alliance credit cards grew only 1% from the previous year. While credit sales resulting from active programs was 11%. This 10-point gap is significant and directly highlights Alliance's current issues.

We are encouraged that new partners seem to be growing faster than they have historically. During the call, management said, “If you go back eight, nine years ago…a new private label program would go from 0 to 50 million receivables over a three-year period. We now are adding private label programs that are going from 0 to 200 million plus in receivables over a three-year window.” This speed makes us wonder if Alliance is willing to accept lower credit quality and what margin new partnerships will generate. We’ll also like to point out that average receivables are growing at faster rates than total credit sales. This suggests to us that customers are paying off their balances at slower rates, which is why we believe credit losses will continue to be a headwind for Alliance.

In addition, delinquencies were 5.5%, 40 basis points higher than a year ago. It’s puzzling to us that the company still blames higher delinquencies on hurricanes that happened more than nine months ago. We also have to wonder what impact Bon Ton’s bankruptcy had on delinquencies. Once a retailer goes bankrupt or begins closing locations, customers will stop using the card and are at higher risk of not paying off existing balances. We have to think that provided some pressure to Alliance’s credit quality. In addition, during the call, management said that in order to achieve returns on equity exceeding 30%, the company will see a normalized loss rate of about 6%. This is a departure from management’s previous comments. In April of 2016, CEO Ed Heffernan said, “Great Recession, our normalized loss rate was 6.5%. We are saying it is 5.5% now.” Here at Morningstar, we have always stuck with the 6.5% normalized loss rate and believe recent credit performance is better than what investors should expect long term. For 2017, we still expect provisions will be about 7.25% of total receivables and eventually improve to 6.5%.

Finally, LoyaltyOne appears to be getting back on the right track. Air Miles burn rate (miles redeemed dividend by miles earned) is settling around 74% which should boost Alliance’s cash flow. The company will say this business was hurt by Parliament enacting legislation, but it really was management’s fault by overplaying its hand by instituting an expiration data on redemption miles. In addition, LoyaltyOne’s margins improvement significantly during the quarter. Though some of this may be related to the adoption of ASC 606, LoyaltyOne’s operating expenses were $203 million. It would appear that the company has taken out over $90 million in quarterly expenses over the last two years.