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Morningstar | Alliance Data Systems Management Waffles on Its Ability and Intention to Sell Epsilon

Narrow-moat Alliance Data Systems’ fourth quarter and guidance were about what we expected--not very good. For the quarter, pro forma revenue came in at $2.1 billion, only slightly higher than last year. ADS finished 2018 with net credit card receivables of $16.8 billion, about a 4% decline from the previous year while reclassifying $1.9 billion receivables as held for sale. Combined, receivables grew just 1.3%, a far cry from the midteens portfolio growth management to which management forecast a year ago. For the quarter, ADS earned $5.25 per share, year-over-year growth of 8%. Though we place very little value in management’s optimistic commentary and guidance, we do like the new partnerships they’ve signed, specifically Ikea, Wyndham, and Penn Gaming. While we’ve voiced concerns about ADS in the past, currently, the stock trades at about 9 times trailing earnings. To us, this is cheap and the stock should eventually return to growth, though we caution it will take some time. Again as we have stated before, investors should totally ignore the company’s non-GAAP “core EPS,” which for 2018 was about 30% higher than the GAAP earnings. For now, we’ll be maintaining our fair value estimate of $210.

Regarding the potential sale of Epsilon, we think management’s comments during the call represent a change in tone for the possible sale. Just this past December at the Goldman Sachs conference, CEO Ed Heffernan said, “Additionally, given that the Epsilon transaction has now moved into execution phase, or in other words, we've moved from thinking about it to doing it …” In contrast, this quarter, he said, “The process is moving smoothly. And I have to say, if consummated, the use of proceeds will be focused on a combo of further debt reduction as well as significant share repurchases.” This is the first time we can recall management using the phrase, “if consummated.” In our mind, management portrayed this divestiture as a done deal. As we have said, we’ve always viewed Epsilon as intertwined with the company’s credit card business, so it will be hard to extract this business without affecting the ongoing services of ADS’ card operation.

Finally, we think it’s worth pointing out that ADS’ largest shareholder, ValueAct, which has board representation, is selling shares. Management maintains that ValueAct is selling shares so that it falls below the 10% threshold that requires additional reporting requirements and limits the fund's ability to sell. We don’t know why ValueAct is selling, but we think it is worth noting.