Alliance Data Systems Q4: Growth Amid the Wreckage, but Mysteries Galore in the Details

Alliance Data Systems reported increases in revenue and net income today. The news suggests that while the rest of the business suffers, there’s still money to be made in the most boring part of advertising: loyalty programs and direct marketing to shoppers.

ADS reported revenues for full year 2008 at $2 billion, up from $1.9 billion; and profits of $217 million, up from $164 million. The company believes revenues will rise still further to $2.1 billion in 2009.

It’s not all sunshine and rainbows in ADS-land, however. The earnings statement contains some eyebrow-raising factoids:

While the overall size of the business and its profitability were healthy, ADS showed a loss of $109 million on the cashflow statement. That’s not a concern in a business of ADS’ size, but there was a $3.8 billion expenditure on borrowing repayments; that was only $2.1 billion the year before.

There are two other types of expenditure that are rising fast at ADS: database marketing fees and long-term debt. The fees went up from $347 million in 2006 to $526 million last year. The company’s total liabilities rose from $2.9 billion to $3.9 billion, versus assets that were relatively flat at $4.3 billion. The long-term debt portion of that more than doubled to $1.4 billion.

So this is a company that seems to be enjoying today but may have to get serious about cutting some costs tomorrow.

There’s also some headscratching language in the “risks” section to do with its credit card receivables. (ADS manages store credit cards and associated data.) The company reported that in September 2008 it started a “securitization program for the credit card receivables,” and this effort is affected by “conditions in the securities markets in general and the asset backed securitization market in particular.”

Here’s my interpretation of what this means (email me if you think I’m wrong):

ADS is selling the money customers owe on their credit cards to investors who pay a discount on the balances due but are willing to wait to collect the full amount later. ADS gets cash up front, and the investors get a larger amount of cash later. The bundled credit card debts can then be sold like any other kind of bond or security.

This, of course, comes with problems. First, it looks a lot like the bundled mortgage market, which went belly up after investors discovered their mortgage-backed securities were filled with subprime loans. There’s no reason to believe that in a recession bundled credit card loans — particularly retail cards! — are any better quality than mortgages.

Second, it means ADS isn’t living off its own business, it’s living off its ability to finance its future business. Should the value of that future business decline (say, if investors get nervous about the ability of unemployed people to pay off their cards) then ADS will find itself with assets it can’t sell.

Third it turns a relatively simple business — loyalty cards and retail credit — that keeps the company in direct contact with its customers into a complicated derivative activity.

But I’m sure new CEO Ed Heffernan knows what he’s doing. In fact, he said as much to the Dallas Morning News:

So ADS touches both finance and retail, two industries that have been hit harder than almost any other in America over the last several months. And yet, Heffernan still expects ADS to grow in 2009, and double in size over the next five years.

To beef up this notion that ADS will be magically untouched by recession, ADS also filed a slightly defensive investor presentation in the form of a myth-busting Q&A. Here’s a sample section:

• “Q4 was flat. Pressure on marketing budgets will cause big declines in 2009 performance.”
• Not true.
• Majority of business (database, analytics, digital) tied to massive multi-year loyalty programs - very stable - double digit growth.

Heffernan also told the DMN that ADS’ $170 million lawsuit against The Blackstone Group, for backing out of a buyout agreement, was not a distraction for the company:

Heffernan said the Blackstone deal never was much of a distraction for Alliance’s business operations, and the company has moved on.

But the SEC filing is a little more cautious:

We cannot predict with certainty the outcome of the proceedings, but the costs and time expended for such litigation could have a material negative impact on our results of operations and financial condition…

Caution ought to be the watchword here. ADS has a good thing going — its customers are essentially built-in to its services. All it needs to do now is control its costs and resist the temptation to turn itself into some sort of quasi-investment bank.