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Morningstar | Ugly 2Q for Alliance Data Systems, but Still Immensely Profitable

Narrow-moat Alliance Data Systems has entered a new chapter in its leadership, as Melisa Miller and Tim King have assumed the roles of CEO and CFO, respectively. During the second quarter, the company earned $2.71 per diluted share from continuing operations. This was a more than 30% decline from the previous year as ADS' receivables portfolio declined by 2% and the company no longer includes its divested Epsilon segment in its results. While this was ugly, it was not unexpected by us or the market. That said, the company has yet to start repurchasing shares, which should offset most of the dilution that resulted from the Epsilon divestiture. In early July, ADS announced a $1.1 billion repurchase plan, and based on the current share price the firm could buy back as much as 13% of its outstanding shares if it put this plan to full effect. We are maintaining our $220 per share fair value estimate.

Overall, we think ADS is beginning to regain its footing and based on the limited statements we've heard from management, we are modestly optimistic regarding stewardship. Management signaled their intention to be more candid, implying to us that they would likely be less focused on providing guidance. Overall, Miller’s tone differed substantially from previous leadership. Management did, however, reiterate ADS' previous forecast to end 2019 with more than $20 billion in receivables--a target we had expected the new team to walk back. And during the second quarter, ADS signed $900 million in new receivables including children's clothing brand Carter's, bringing ADS’ period-ending active receivables to $17.6 billion. Though the company is likely to continue to face headwinds, investors should note that ADS earned an annualized GAAP ROE of 24.5% during the quarter, so while ADS may be an ugly business going through a difficult period, it is still immensely profitable.

As we mentioned above, we were pleasantly surprised that ADS reiterated its intention to hit $20 billion in receivables by the end of the year. While we had previously been skeptical of this guidance, the $900 million addition of Carter's receivables during the second quarter brought ADS' period-ending active receivables to $17.6 billion--further narrowing the gap to $20 billion. For ADS to hit its end-of-year target, it will need annualized receivables growth of 13.5% through the end of 2019. In 2016 and 2017, ADS produced receivables growth of 18.3% and 14.0% in the back half of the year, so (barring a recession) it is possible.

ADS' comparatively weaker funding base continues to be a headwind, and we don’t expect this to change in the near to medium term. This past quarter, funding costs consumed 9.6% of card services revenue. In comparison, just two years ago, funding costs accounted for only 6.5% of card services revenue. While lower rates would benefit ADS, should rates continue to rise steadily it would pose a significant headwind (leading to lower margins). We believe that the next big challenge for ADS is building a sustainable source of cheaper deposits. During the quarter, the company launched its consumer deposit program, attracting $1 billion in deposits. It’s not apparent to us yet whether this effort will lower its funding costs, but if it does it would allow ADS to lower its reliance on higher-yield debt. However, continued use of CDs for funding leaves ADS with a somewhat more expensive funding profile than many of its peers.