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Morningstar | It Will Take Time for Alliance Data Systems to Regroup and Return to Its Recent Growth Trajectory

Narrow-moat Alliance Data Systems provided some more clarity on its $4.4 billion divestiture of Epsilon after reporting first-quarter earnings. During the quarter, the company generated sales from continuing operations of $1.3 billion, down 3% from the previous year while GAAP EPS from continuing operations increased 3%. What’s interesting is Alliance reported GAAP earnings from continuing operations of $3.28 per share but consolidated EPS of $2.80. This means Epsilon produced after-tax losses of more than $25 million this quarter. This is, at least, partly attributable to non-recurring expenses related to the divestiture, but it does show the weight Epsilon was on the company’s profitability. For 2019, management now expects revenue from continuing operations of $5.8 billion, about what we were expecting excluding Epsilon. For now, we’ll be maintaining our fair value estimate of $220 per share. We do believe the Epsilon deal was accretive, however, we’re becoming more cautious with Alliance and have increased our cost of equity assumption to 11%, which has mostly offset any accretion attributable to the sale.

Currently, Alliance trades at about 11 times our 2021 estimate. We still believe it takes a margin hit as retailers demand more from credit card partners and higher funding costs. Though we view Alliance as cheap, we firmly believe it is going to take some time for the company to regroup and return to steady growth. We’re no longer forecasting goodwill impairment for Conversant as if the company had remained on Alliance's balance sheet. Moreover, the problems with Alliance's remaining card partners aren’t behind the company. Mall retailers are still facing significant headwinds, but Alliance does have promising new partnerships. It will take time for partners like Ikea to build card balances that will eventually return the company to growth realized the past few years.

While we did get a better idea of the company's earnings potential once the deal closes, we didn’t get much clarity on how the relationship between Epsilon and Alliance’s card services business will work going forward. Specifically, we are still trying to figure out how data will be shared and who ultimately controls the data. During Publicis’ recent call announcing the transaction, the company touted Epsilon’s access to transaction data and the ability to build unique consumer ID’s while highlighting the importance of data privacy. However, our impression has always been that private label card data isn’t owned by Alliance but the retail partner. These are tough subjects that we are still investigating. However, Allinace's management did mention a long-term servicing arrangement that should ensure Alliance won’t have to worry about increasing costs from Epsilon.

We were modestly encouraged by management’s commentary around credit quality. Based on our review of recent Alliance vintages, we do believe credit quality within its existing portfolio should be stable, if not improve. Upon review of Allinace's securitization trusts, the company’s 2017 and 2018 vintages had noticeably better credit quality metrics than in previous years. In addition, we liked that management is focusing more on deposits. As interest rates rise, the difference in cost between deposits and securitizations should widen. Depending on how successful management is in gathering deposits, we may become less bearish on the company’s margins.