Alliance Data Systems Corporation (NYSE:ADS): If You Don’t Like The Answer, Just Change The Question! by Citron Research
This month Citron Research celebrates its 15th year of publication — exposing, for lack of a better term, “market inefficiencies”.
This neutral-sounding moniker is occasionally an accident … but rarely. Most often it exploits the shallowness of Wall Street’s “insight” with management’s intentional hype, misdirection or just plain fraud. It has become too profitable taking advantage of a bullish market environment to ever let the truth get in the way of a good story.
And then comes Citron Research
In the Case of Alliance Data Systems (NYSE:ADS), Wall Street is just now waking up to the misrepresentations that have been promulgated by ADS management. At best, this is a mis-categorized company which should immediately be priced 40% lower. At worst management is covering up a business that has an entirely different risk profile … and is one big credit event from derailing into a devastating downward spiral.
What makes this story timely is that it is not just Citron but Wall Street analysts who are finally catching up to the story, as reflected in this weeks’ note from Credit Suisse, which states:
Alliance Data Closer To a Card Lender Than A Tech Company says Credit Suisse
Alliance Data Systems Corporation (NYSE: ADS) is being increasingly viewed as a lender, and its shares should trade in-line with other credit card lenders. The market would eventually recognize Alliance Data as a lender….
The operations of the company’s card services business, which contributes the lion’s share of earnings, is at two bank subsidiaries. These two entities are limited by regulatory and capital requirements, which limits the parent company’s use of the cash generated by them.
— Credit Suisse Analyst Paul Condra August 18, 2016
Citron could not have said it better. However, although Credit Suisse DID acknowledge the elephant in the room, they stopped short of driving their verdict to its inevitable valuation conclusion.
“Increasingly Viewed As A Lender”
Let’s begin with the background for those who are not familiar with Alliance Data Systems. This is what management CLAIMS they do in their most recent 10-K:
“We are a leading global provider of data-driven marketing and loyalty solutions serving large, consumer-based businesses in a variety of industries. We offer a comprehensive portfolio of integrated outsourced marketing solutions, including customer loyalty programs, database marketing services, end-to-end marketing services, analytics and creative services, direct marketing services and private label and co-brand retail credit card programs.” — ADS 10-K Dec 31, 201
This would lead most investors, and importantly, indexers, to categorize ADS as a business services company, which deservedly trades on earnings rather than book value, and be assigned a higher multiple than a bank.
But as Credit Suisse noted, the lion’s share of earnings do in fact come from the banks they operate. The myth of ADS being a business services company has been widely accepted because the company is in the S&P 500 Information Technology Sector Index but not the S&P 500 Financial Sector Index. Alliance Data Systems has no incentive to correct this obvious mis-categorization; management prefers the higher valuations that are associated with tech companies.
Three divisions of ADS must be considered separately when valuing the company:
So while LoyaltyOne and Epsilon can fairly be valued as members of the Business Services (IT) cohort, ADS is more and more a bank wrapped in the Halloween costume of a business services company.
The Obvious Next Question: What’s the Breakdown?
As we can see, ‘Card Services’ are more often than not discussed last, but is by far the most important division of Alliance Data Systems. The bank-like portion of the business, is almost 2/3rds of the business. From the chart below you can see why ADS would rather be considered a tech services firm than a bank:
There aren’t too many tech companies out there that report zero Research and Development costs … but it gets even more obvious than that.
What does Alliance Data Systems Really Do? Numbers Don’t Lie!
The majority of its income being generated from its banks, ADS is clearly not primarily a technology company. As the operator of Comenity Bank, ADS issues credit cards from Victoria Secret, JCrew, Ulta, and a list of other retailers.
* For those who defend the company claiming it should trade at a premium because their might be synergies between the two business …this is simply UNTRUE. Citron’s investigation makes clear that the crossover between clients is statistically insignificant; instances can be counted on one hand. The only ones of note are Express and New York & Co.
Engagement Promoted This Description
“In terms of the businesses, and what we worry about, what we’re looking at, probably the thing that’s important here is free cash flow. I am old school, believe very big in the generation of free cash.” –Ed Heffernan, ADS CEO Jun 14, 2016 at (William Blair & Company Growth Stock Conference
Meanwhile, the company stopped reporting free cash flow in its Q2 2016 investor presentation (the last time it was not disclosed was Q4 2014).
Generation of free cash is NOT what a bank should be focused on.
More importantly the company is categorized into the Info Tech part of the S&P Index.
Worse, ADS is explicitly in the “S&P 500 Ex-Financials” Index.
Yet, until now analyst have still been complacent spouting off free cash flow when discussing the financial health. Almost like having a conference call about how fast Usain Bolt can swim: WHO REALLY CARES…?
“strong free cash flow generation is used to repurchase stock to support EPS growth and the stock price.” — RBC Aug 15, 2016
“During the quarter, free cash flow was $421 million, with operating cash flow of $474 million and capex of $53 million. — Raymond James Jul 21, 2016
“However, we suspect that ValueAct is looking at free cash per share guidance in excess of Core EPS and is interested in two key potential avenues: first, the implementation of a dividend and second, a long-term commitment to prioritizing capital returns over M&A.” — JMP Jul 11, 2016
Plain and Simple:
ADS sells the investment community on cash flows, not Return on Equity or Return on Assets, metrics that a bank would be valued on. Instead they refer to financial metrics that are akin to a technology company.
The Only Intellectually Honest Way To Value ADS
While Credit Suisse got the ball rolling …. Citron now completes and publishes the obviously needed analysis. Because of its two completely different business units, the only way to value ADS is a complete sum of the parts analysis — looking at the bank and the tech operation separately.
To be fair, we assign the non-bank business a fair multiple of 10x EBIDTA, which is widely accepted for this type of business. This is right in line with Amiya (AIM in Toronto), the largest of all customer loyalty data driven companies.
We will add that to the value of the banks, assigning them a 2x book value, which is the same as Synchrony Financial, the gold standard of private label credit cards.
*NOTE: The corporate debt must be assigned to the loyalty business. Due to Section 23 of the Federal Reserve Banking Regs, banks cannot hold corporate debt. They certainly can’t raise debt to buy back shares. This concern is acknowledged in the GS research report on ADS.
Because its more than half a bank, not a tech firm, the valuation models of Alliance are miles from reality!
See the full PDF below.