If you follow the research we have done over the years, check the tutorials at the knowledge center, you will know that one important emphasis in our value strategies is to invest in companies with predictable revenue and earnings growth. We have since ranked the predictability of all companies in our database, and developed strategies that invest in the undervalued predictable companies and wide-moat, low-debt companies that young Warren Buffett and Charlie Munger would like. Our backtesting and model portfolios have found these companies can deliver returns that far exceed the market average.
It is not surprising that those companies can deliver above average returns. The companies have consistently grown their revenue and earnings at predictable rates. If the companies can control their debt levels and maintain their profit margins while growing, “the stock prices will follow,”, as pointed out by Warren Buffett.
In this series of articles we will highlight the stocks that have high predictability rank, using the tools we offer to analyze the quality of businesses, the valuation and the potential risks of investing in the stocks. The first company here we discuss is Alliance Data Systems (NYSE:ADS).
Alliance Data Systems Corporation is a provider of transaction services, credit services and marketing services to retail companies in North America. Alliance Data Systems has a market cap of $4.28 billion; its shares were traded around $83.61 with a P/E ratio of 15.4 and P/S ratio of 1.5. Alliance Data Systems had an annual average earnings growth of 27.3% over the past 10 years. GuruFocus rated Alliance Data Systems the business predictability rank of 5-star.
If you look at the growth in the revenue and earnings of Alliance Data Systems, you will understand why we rank it 5-star. Please see the chart below for the 10-year history of the revenue and earnings growth.
Over the past 10 years Alliance Data Systems has consistently grown its revenue. Per-share revenue grew from $10.58 in 2001 to $53.68 in 2010. The revenue growth is about 20% a year. Its earnings growth is even faster. The 10-year average growth rate is 27% per annum, with EBITDA growing from $1.75 to $14.85. In addition to the good predictability, Alliance Data Systems seems to have another one of the most important traits of a good business: moat. The company can not only maintain but expand its profit margin while growing business. This is clearly shown in the operating margin of Alliance:
Intrinsic Value and Historical Valuations
DCF Calculation can give quite reasonable estimates of the intrinsic values for companies with predictable business. Trading at all-time high of around $85 a share, the stock doesn’t look cheap. When we assume an aggressive 20% of growth rate for the next 10 years, 4% of terminal growth rate, and 12% of discount rate, the stock looks fair valued.
If we look at the 10-year historical valuation of Alliance, the stock is traded at the lower end of historical price/sales and P/E ratio.
It is interesting here to point out that Alliance has declined shareholder equity over the past 10 years. The book value of the book is on its way to negative. Therefore its price/book ratio cannot be used in the valuation.
The Risks of Investing in Alliance Data Systems
While Alliance does have good business growth and reasonable valuations, a deeper look spots something that is worth further research, which is the debt. While growing its business, Alliance’s debt-to-revenue ratio grew from 30% five years ago to more than 100% in the last two years! See the chart below:
To understand more about the dramatic increase of debt, a look at the company’s 10-K is necessary. This is what the company wrote in its 10-K about its debt: “We have a high level of indebtedness, which requires a high level of interest and principal payments. Subject to the limits contained in our credit facility, our note purchase agreement, our indenture governing the convertible senior notes and our other debt instruments, we may be able to incur substantial additional indebtedness from time to time to finance working capital, capital expenditures, investments or acquisitions, or for other purposes. If we do so, the risks related to our level of indebtedness could intensify. Our level of indebtedness increases the possibility that we may be unable to generate cash sufficient to pay, when due, the principal of, interest on or other amounts due in respect of our indebtedness.”
10-K also indicates that the company has a much higher Allowance for loan loss for 2010. Considering the debt level, the much higher possibility for loan loss, and the valuation of the company stock, we would pass Alliance Data System at this point.
On the surface, Alliance Data System is a great business. The company grew its revenue consistently, while expanding its profit margins. The stock is about fair valued. The biggest risk with the business seems to be the continuous increase of the leverage in the business operating. While leverage helps the business grew faster, it also increases the risk.
This might be one of the reasons why Alliance Data Systems is of the stocks with the strongest short interest. The short interest is about 37% of the float.
Check out GuruFocus list of undervalued predictable companies for the companies that have high business predictability rank and are undervalued.