Switching Costs Dig Moat for Alliance Data Systems

We believe

Most important, it gives retailers the ability to track their best customers’ purchases and target those customers, a service provided by Alliance’s Epsilon segment. This enables Alliance Data Systems to send highly targeted emails and display ads to a shopper’s mobile device, driving incremental sales. We believe Alliance provides a substantial benefit to its retail partners, which has largely driven its impressive returns and recent growth.

Thanks to demand from retailers, Alliance Data Systems has compounded its receivables at more than 20% over the past five years. In part, we find this growth rate alarming as it may signal the company has loosened credit standards. We expect this to slow to 7%-10% by 2019.

Some of Alliance’s recent growth does appear healthy and caused by an increase in adoption by merchants. That said, when it comes to credit quality, we are seeing mixed signals. The company’s average cardholder does appear to be paying credit balances quickly, and loss rates have stabilized. In 2016, the average balance was $627, so consumers typically have the ability to quickly pay down their balance. In fact, consumers typically choose to pay down their private-label cards first. Loss rates and charge-offs continue to increase. In 2016, provisions were 6.2% of receivables, up from 5.3% in 2015. Management attributes this not to a loosening of credit standards, but rather its impressive growth as newer cardholders typically have higher charge-offs.

The company’s LoyaltyOne segment is driven by Air Miles, a Canadian consumer rewards program that has historically accounted for 15% of operating income. Given management missteps in rolling out changes to its miles redemption program and the resulting scrutiny and regulation from Canadian parliament, we expect slower growth moving forward.

Card Services a Massively Profitable Business In our view, Alliance Data Systems possesses a narrow economic moat. The company's three segments are LoyaltyOne, which administers Canada's largest credit card rewards program; Epsilon, a provider of marketing and data services; and card services, a provider of private-label credit card programs and customer financing for retailers. While each of the company's segments benefits from different sources of moats, card services accounts for 75% of the company's operating income. It is a massively profitable business whose competitive advantage is derived from high switching costs and its dependent relationship with Alliance's marketing and data segment, Epsilon. The smaller LoyaltyOne segment benefits from network effects and efficient scale to a lesser extent, but switching costs at the card services business is the most prominent source of competitive advantage and why we believe the company possesses a narrow moat.

It should not be underestimated how high the switching costs are for retailers using Alliance Data Systems as their private-label card and loyalty program providers. Private-label cards are store-issued credit cards that consumers can use only at the issuing store. When retailers hire Alliance Data Systems to provide their private-label credit card, they are, in effect, outsourcing their entire customer care and much of their digital marketing to Alliance. In fact, Alliance Data Systems will not work with any retailer that does not hand over these functions. This is important because if Alliance’s retail partners want to cancel their agreement, they would have to construct their own customer service and digital marketing apparatus, which could take several years. We believe this encourages retailers to hire Alliance Data Systems to reduce marketing and customer service overhead in the short run while increasing their ability to target their best customers.

Basically, Alliance Data Systems thrives on helping retailers target the 20% of their customers that account for 80% of their sales. When a shopper, normally a woman in her late 30s to early 50s, buys an item at one of the company’s retail partners, she receives an email suggesting a matching accessory or ancillary item. Some of this has changed, as the effectiveness of email marketing has declined as a result of mobile and display ads. Instead of generating automated emails, the company now must automate purchases of banner and display ads on mobile apps and web pages. This pits Alliance Data Systems against the major ad agencies, which in many cases are already working with the company’s biggest customers. In addition, Alliance loses some of the returns to the likes of Google and Facebook, which charge for these ads. This has resulted in some disintermediation as ad agencies go around Alliance’s Epsilon to deal directly with providers of digital display ads. However, because Alliance’s retail partners have already outsourced their customer care and some of their marketing, we believe this puts Alliance in a strong position to influence its clients’ spending on display ads. Despite this pressure, the company has still maintained impressive, albeit slightly lower, returns on capital.

Where Alliance Data Systems does not possess a moat and is arguably at a significant disadvantage is in funding. Normally, this is where many financial institutions develop their moats. The company’s card business funds its receivables mostly through securitizations and brokered deposits, while many of its competitors on the card side are banks with a large source of cheap deposits. Alliance must routinely access capital markets and offer a competitive yield. Thus, it is heavily exposed to a rise in interest rates. In 2016, we estimated Alliance’s cost of total funding at 1.5%. In 2011, it was 3.3%. A rise in interest rates could result in reduced growth in receivables and increased interest rate expense. The company’s structural disadvantage in funding is the biggest threat we see to its narrow moat.

Increase in Cardholder Defaults a Risk The two greatest threats to Alliance Data Systems would be a rise in the number of cardholder defaults and an increase in the cost to fund receivables. The company has been a sizable beneficiary of a healthy U.S. consumer and below-average credit losses. In recent years, low interest rates have provided a significant tailwind to Alliance's receivables growth. In addition, the company has also been a serial acquirer. While the company has made several successful acquisitions, it has paid premiums, which could result in overpaying for future acquisitions. Furthermore, in 2011, the company suffered a large data breach in which thieves were able to steal the names and email addresses of millions of customers. While credit card numbers were not accessed, it is conceivable that they could be targeted in the future. Also, there is always the threat of regulation for Alliance, which could limit its ability to charge card-related fees or gather the personal data of consumers.

On a consolidated basis, Alliance Data Systems is highly leveraged. The company finished 2016 with assets that were more than 15 times its equity, a substantial increase in leverage from 2015 when assets were only 11 times equity. Furthermore, it has negative tangible equity. For a company that must fund receivables in order to grow, we would like to see some tangible equity cushion and hold more cash. Despite this, in 2016, Alliance reduced its share count more than 5.6% while instituting a dividend.

In addition, the company uses variable-rate debt to fund its acquisitions. This could be an expensive proposition if interest rates rise. Finally, the company relies on the securitization market to fund its receivables. Any deterioration in securitization markets could weigh heavily on its ability to fund new receivables.