No-moat Alliance Data Systems reported second-quarter earnings that benefited from the strong industrywide credit results. Recorded EPS of $4.07 comfortably beat FactSet consensus of $3.68. Earnings were supported by a $14 million loan-loss benefit, as a net charge-off rate of 5.1%, below normal for ADS, allowed the bank to release more than $200 million in reserves. ADS still has a reserve rate of 10.4%, leaving a little more room for reserve releases, though the majority should be behind us now. With a 30-day-plus delinquency rate of 3.3%, ADS will likely enjoy low charge-off rates until at least 2022. After incorporating these results into our model, we are increasing our fair value estimate for ADS to $84 from $79 as a result of lower projected net charge-offs in 2021 and 2022.

Like its peers, ADS has seen abnormally high repayment rates on its credit cards as a financially strong U.S. consumer has become less likely to maintain an ongoing balance. We expect repayment rates to normalize over time, but in the meantime credit cards should see low default rates. High credit card repayment rates are a double-edged sword, and while ADS has benefited from strong credit results, the company has also struggled to restart receivable growth. Period-end receivables fell 1% year over year to $15.7 billion despite an impressive 54% increase in spending on ADS’ credit cards from the year prior period and a 22% increase sequentially. As a result, companywide revenue increased a relatively modest 3% year over year.

ADS is still planning to spin off its LoyaltyOne assets in a bid to focus the company on its credit-services segment and reduce its debt load. We like the idea, but key details remain missing to form an evaluation. ADS holds a considerable amount of its debt at the parent company level and it remains to be seen how much debt reduction the company can enable with the spin-off given how little growth LoyaltyOne has seen in recent years.

With the sale of Epsilon in 2019, Alliance Data Systems' private label credit card business is now responsible for more than 80% of its revenue. However, ADS’ retail credit card business is under pressure. The company has historically targeted midsized retailers for its partnerships. This strategy has led to a partnership base that is weighted toward mall-based retailers, which are in decline due to increased online shopping. Many of ADS’ retail partners have already filed for bankruptcy, including the Ascena Retail Group in July 2020 and Forever 21 in 2019. ADS has also suffered defections, losing Wayfair and Meijer to Citi in 2020. These issues are magnified by ADS' high concentration risk. The company's 10 largest partners account for more than 40% of its revenue. Any additional bankruptcies or defections among them will further increase the pressure on ADS.

ADS must also now contend with rising competitive threats from buy now pay later firms, which are targeting the U.S. retail market and seek to sign agreements with ADS' partners. These firms are still a small part of U.S. retail, but ADS takes the threat seriously. The company’s acquisition of Bread, a buy now pay later company, was done with the intent of accelerating the deployment of its own competing offering. In the future, ADS will need to contend with this new threat in addition to the economic struggles of its retail partners.

ADS still retains some good assets, like its partnership deals with some healthy retailers, such as Ikea and Sephora. The company has also seen little in the way of credit consequences to the pandemic. Credit deterioration was forestalled by industrywide forbearance programs and fiscal stimulus and while unemployment remains high, the company has enjoyed lower than normal net charge-offs in 2021. Credit conditions should normalize over time but ADS’ credit card portfolios are well capitalized and should be able to handle any deterioration in credit costs.

In our view, Alliance Data Systems does not have an economic moat as the lack of a competitive advantage in its core credit card business overwhelms the network benefits of its Air Miles program. Alliance Data Systems is the third largest issuer of private label credit cards in the U.S. by outstanding receivables, and while the company does offer co-branded general-purpose cards as well, it is a small player in the overall credit card market. The private label credit card market currently sees limited participation from major credit card issuers, with the notable exception of Citi, limiting the amount of competitive pressure that Alliance Data Systems has historically faced. Furthermore, the company has focused on partnering with small to midsized retailers, such as apparel and mall-focused brands, that typically generate even less interest among major credit card issuers, leaving more room for Alliance Data Systems. However, this strategy means that Alliance Data Systems’ fortunes are tied to the sales performance of the retailers most exposed to the shift toward online shopping. This problem is further compounded by the high levels of leverage that the firm uses in its business strategy, leaving it with little room for error.

Alliance Data Systems’ partners are under significant pressure both from the long-term trend of increased online purchasing and the impact of the pandemic. Alliance Data Systems has historically had heavy exposure to mall-centric partners and apparel retailers. After a strategic rethink in 2015, the firm has attempted to move toward beauty, jewelry, and digital retailers. While initial receivable growth was strong, more recent results have been mixed with receivables balances stagnating since the end of 2017. The company has also struggled to acquire and maintain partnerships with digital retailers, losing Wayfair to Citi in 2020. The company is in the difficult position of needing to replace atrophying partnerships with healthier ones while simultaneously maintaining healthy enough margins to make its high-leverage strategy a success. This is made even more difficult by the disadvantages Alliance Data Systems faces when directly bidding against larger credit card issuers for new partnership agreements.

The loss of Wayfair to Citi highlights Alliance Data Systems’ position as a distant third place in the private label credit card market and its lack of a competitive advantage. At the end of 2020, Alliance Data Systems had $16.8 billion in gross receivables, a fraction of those of Citi and Synchrony. Alliance Data Systems operates with a higher cost of funding than its larger competitors. In 2019 Alliance Data Systems' overall cost of funding was 3.29% compared with 2.70% for Synchrony, giving it a cost disadvantage. Additionally, Alliance Data Systems’ small scale prevents it from submitting serious bids for large anchor clients as the receivable volumes these programs generate are too large for the company to reliably finance.

With large premium partnerships out of reach, Alliance Data Systems has historically found success targeting smaller brands that do not capture the same level of competitive attention. Here Alliance Data Systems can offer retailers a compelling value proposition by combining consumer financing and loyalty rewards with the company’s in-house data analytics and digital marketing. For many smaller brands, signing a partnership agreement with Alliance Data Systems is a way to outsource their data analytic and digital marketing. This does create switching costs for Alliance Data Systems’ partners since canceling their agreement would mean finding a new provider for these services or rebuilding these capabilities in house. However, Alliance Data Systems has already monetized much of its data analytic and digital marketing operations. First, with the sale of Epsilon, its digital marketing business, in 2019 for $4.4 billion. This was followed by the much smaller sale of the data analytic business, Precima, to Nielsen in 2020. Alliance Data Systems has stated that it has rebuilt much of the capabilities held at those businesses and that the services provided to its partners will not be impacted by the asset sales. But we believe that these sales reflect lower switching costs and that its digital marketing has become a more commoditized product. This is supported by the performance of Epsilon when it was held by ADS. Revenue grew 1.75% from 2015 to 2018 while margins declined.

Even prior to the sale of Epsilon, the shift toward digital purchases has eroded the value added by the data collection opportunity of Alliance Data Services’ credit cards. When a consumer makes an online account with a retailer, they are providing that retailer with contact information that can be tied to the consumer’s purchases. The availability of alternative data sources decreases reliance on Alliance Data Systems’ cards and increases the negotiating power of the retailers.

Alliance Data Systems has historically managed to generate a ROIC between 20%-30%, well above its cost of capital. However, with an asset to equity ratio of roughly 15, well above its peers, we see these returns as being driven more by Alliance Data Systems’ high degree of leverage than an identifiable economic moat. Alliance Data Systems avoids bank capital restrictions by structuring itself as a parent company and keeping its LoyaltyOne assets and $2.8 billion of its debt above the two banks that it owns, Comenity Bank and Comenity Capital. The two banks themselves are well capitalized. At the end of 2020 there was $2.6 billion in equity at the bank level and the two banks combined had a common equity Tier 1 capital ratio of 18.4%. However, the parent company is far more leveraged, with $2.8 billion in debt and $245 million in IBID from LoyaltyOne in 2019 the parent company as a stand-alone business has a debt/EBITDA ratio of 11.4. LoyaltyOne generates enough operating income to cover the parent company’s interest payments, but there is limited prospect of principal reduction without continued distributions from the two underlying banks, especially considering LoyaltyOne’s lack of growth.

The sale of Alliance Data Systems’ Epsilon has placed even more pressure on this business structure as it depleted the asset base at the parent level and left Card Services as the dominant source of income for the firm. With the well-timed influx of $4.4 billion in additional cash from the sale of Epsilon, $2.4 billion of which was used for debt reduction, we do not foresee any immediate credit issues. However, heightened risk remains and any deterioration in Alliance Data System’s business model will be magnified by the firm’s leverage.

While we do not believe that the Card Services segment has an economic moat, there are signs that Alliance Data Systems enjoys the benefits of network effects in its Air Miles program. Air Miles is the largest airline miles reward program in Canada. The program has over 100 sponsors in Canada and roughly two thirds of Canadian households. With market penetration this deep there is little room for competing programs, and the business is protected by strong network effects. However, Air Miles is a small part of Alliance Data Systems. In our opinion, the network effects associated with the Air Miles program are insufficient to outweigh the lack of a moat in the rest of Alliance Data Systems.

Our fair value estimate for Alliance Data Systems is $84, or roughly 7.6 times our projected 2022 earnings. Our estimate is highly sensitive to potential credit losses on the credit card portfolio, credit card receivable growth, and the company’s ability to maintain its high level of leverage at the parent company.

We anticipate that net charge-offs will rise in 2021 as repayment rates normalize after the impact from fiscal stimulus programs fades. As these programs have ended and unemployment remains elevated, future net charge-offs will be an important determinant of ADS’ value.

We expect ADS’ credit card receivables to begin to recover after a sharp drop in 2020. However, we expect the growth of digital retail to continue to pressure ADS’ partners leading to low levels of credit card receivable growth after the 2020 trough. A number of ADS’ partners have already declared bankruptcy, and the credit card portfolios tied to those programs will likely atrophy over time, creating a significant headwind to the company’s receivables balance.

With the impressive cost saving the company has achieved in 2020, ADS has demonstrated that it is capable of effectively scaling its cost structure with the size of the firm. However, the acquisition of Bread will add incremental costs going forward as ADS works to develop its new product offerings. The firm itself does not expect the acquisition to be earnings accretive for some time, and we project a slight deterioration in the firm's efficiency ratio as a result. Most of ADS’ credit cards charge variable rates and the company is reliant on broker deposits for funding. We expect the company’s net interest margins to remain broadly stable as changes in interest rates impact both the company's interest expense and interest income.

Alliance Data Systems has a very high uncertainty rating. ADS is heavily exposed to the economic cycle, as it is affected by changes in credit quality, interest rates, and retail sales. ADS’ ability to generate revenue and grow depends on the business performance of its retail partners. ADS’ partnership base is weighted toward brick-and-mortar retailers that are under tremendous pressure from the shift toward online shopping. As a result of this pressure, many of ADS’ partners have already gone bankrupt and it is uncertain how many will fully recover from the COVID-19 pandemic. When a retail partner goes bankrupt or consolidates its store count, downward pressure is placed on ADS’ credit card receivables, which are already well below their peak. Credit card portfolios from shuttered retailers also typically see elevated charge-off rates as the accounts run off, making bankruptcy a credit risk for ADS, as well.

These risks are magnified by the amount of leverage the firm uses. While the two banks that ADS operates are well capitalized, the parent company above them is heavily leveraged and faces high borrowing costs. This debt is supported by the company’s LoyaltyOne assets that generate sufficient cash flow to cover the interest payments but not the principal. The ability of the firm to support the debt held at the parent level could depend on additional cash flow from the banks. The company is planning to spin off its Loyalty One assets as part of a debt-reduction plan. While we like the idea, the value of this action will depend on how much of its debt the company can eliminate with this method.

ADS does carry some environmental, social, and governance risk, though it is incorporated in the very high risk rating. Credit cards carry inherent product risk as their high interest rates can trap consumers in a cycle of debt. ADS relies heavily on interest income for revenue, and any regulatory action or consumer trends away from credit cards would have a severe impact.

We assess the stewardship of Alliance Data Systems as poor. ADS has a weak balance sheet when viewed as a consolidated firm, and while the firm has an appropriate shareholder return policy, its investment history has been mixed.

ADS ended June 2021 with nearly $2.8 billion in debt at the parent level, while its LoyaltyOne business had only $245 million in EBITDA before the pandemic in 2019. While the company's banks are well capitalized as stand-alone firms, they will likely need to support the parent company's debt. The extent of the burden will depend on the specifics of ADS' planned spin-off, but ADS has far less room for error or economic uncertainty than its peers.

Historically, the investments ADS made into its Epsilon business ended up generating little in returns, as the company saw limited growth in the asset and was eventually forced to sell it. On the other hand, ADS has made good use of its acquisition of Bread, the buy-now, pay-later firm, even though we might have preferred the funds been used to reduce debt. The company's shareholder return policies have also generally been decent. The decision to cut its dividend by two thirds early in the pandemic was prudent even if the feared credit losses ended up not occurring. Despite this, ADS' weak balance sheet remains a key concern for the company. Once the firm spins off its LoyaltyOne assets, we will reassess its capital allocation rating based on the specifics of what the company can achieve.

Alliance Data Systems has seen rapid turnover in the CEO position. The surprise departure of Melisa Miller after only five months is a concern, though Ralph Andretta is well qualified for the position. Before joining ADS Andretta led Citi’s U.S. card business, giving him strong credentials for his role at ADS. Under Ed Heffernan, who was CEO until June 2019, ADS pursued a high-growth strategy, supported by acquisitions. This led to the deployment of capital in investments that ultimately produced poor results and led to disappointing business performance.

With Heffernan’s exit the company’s goals have become more modest, with sharp cuts to its growth targets. The company also reduced its scope by selling Epsilon in 2019 after concluding it could not invest the capital the business needed to succeed. We are also encouraged by the proactive decision to preserve capital in the first half of 2020 by eliminating share buybacks and reducing the dividend, particularly considering the company’s heavy debt load.

Despite these changes, we still give ADS a poor rating due to its poor stewardship history, high executive turnover, and weak balance sheet. While we can understand the strategic logic, the acquisition of Bread is a risky use of capital given the company’s leverage, the potential for elevated levels of charge-offs in the future, and the high interest rates the company faces. After years of disappointing results and muddled strategy, Andretta will need to restore confidence in ADS’ direction and discipline.