EUR 850.00 For Business Accounts Only

Morningstar | Alliance Data Systems Signals It May Divest Some of Its Non-Card Assets

The significance of narrow-moat Alliance Data Systems’ second-quarter earnings announcement had less to do with the company’s operating performance and more to do with the strategic changes the company expects to announce in next several weeks. It should not come as a surprise the company said it would divest credit card portfolios of retailers that are being liquidated or acquired. What we do find surprising is that Alliance clearly signaled it would divest some of its non-card assets, such as LoyaltyOne or Epsilon. Specifically, CEO Ed Heffernan said, “We are evaluating what assets could thrive under a different steward while also unlocking the value for shareholders.” Beyond that, Alliance's performance in the second quarter was modestly below our expectations. The company’s marketing business Epsilon continues to struggle, while slowing growth in Card Services was partly offset by improving credit costs. For now, we'll be maintaining our fair value estimate at $240 per share. Currently, we view the shares as fairly valued.

If the firm is going to sell one of its non-card businesses, we’d speculate the company is referring to LoyaltyOne, the cash cow rewards business. We view selling Epsilon, the company’s other non-card segment, as more challenging, since the business is struggling and it’s more intertwined with the company’s card business. Given where private equity multiples sit today, we’ll guess LoyaltyOne could attract a fair price that would unlock some value for shareholders. Over the past four quarters, Alliance's LoyaltyOne segment has generated $267.1 million in EBITDA. If we assume a high-single-digit EV/EBITDA transaction multiple, the sale could generate in the ballpark of $2.4 billion, roughly 20% of the company’s current market cap. Keep in mind that LoyaltyOne only accounts for about 10% of Alliance's total operating income. If the company can divest this asset at a premium, it probably makes a lot of sense for shareholders.

For the third quarter, Alliance managed to grow pro-forma revenue by 5% to $2 billion while GAAP EPS climbed 28% from the previous year. Much of this earnings growth is attributable to a decline in the rate of credit provisions as well as growth in average receivables of 10.2%. For the third quarter, the company’s provisions were 4.5%, a sequential decline of 260 basis points and year-over-year decline of approximately 60 basis points. Management attributed this to higher recoveries resulting from its decision to do collections in house. We’ll need to examine the company’s 10-Q before we make a judgment on the sustainability of lower credit losses.

If it weren’t for management’s teasing it’d be selling a noncore asset at a good price, we likely would have modestly lowered our fair value estimate after this quarter’s results. Epsilon continues to underperform our expectations. Year to date, revenue is down 5%. Just last quarter, management forecast Epsilon would grow revenue by a mid-single-digit percentage in the second half of 2018. This quarter, Epsilon revenue was down 3.8% from the previous year. Despite the decline in revenue, Alliance has managed to maintain the segment’s EBITDA at levels comparable to the previous year. Without a rebound in sales, this can’t continue. Management specifically said, “The biggest areas of challenge right now are the agency and site-based display, the old ValueClick platforms, and we had a number of client bankruptcies that during the year.” Management’s comments seem to support our thesis that at least some of the more than $1.6 billion in goodwill associated with the Conversant acquisition is impaired. Given management’s adjusted earnings exclude depreciation and amortization from Conversant, which we consider a declining asset, we continue to believe GAAP earnings are a better proxy for performance.