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Robert Abbott
Robert Abbott
Articles (383)  | Author's Website |

Has Alliance Data Systems Regained Its Composure?

The company took a dip from credit card losses in 2016. Is it now back in the good graces of value investors?

March 08, 2018 | About:

If you use a credit card or loyalty card, the odds are good that Alliance Data Systems Corp. (NYSE:ADS) knows about you and your spending habits—at least in the aggregate with people who share your consumption preferences.

The Plano, Texas-based company operates in three segments: credit cards, a marketing agency and a loyalty card services provider. Across these segments, ADS uses big data to help its clients better understand their customers. It is an intermediary between consumers and the financial industry.

As this three-year chart shows, Alliance Data declined in July 2015, then followed up the following November with a real plunge in its share price--and just as quickly in what must have been terrifying ride for its shareholders.

Alliance Data price chart

Share prices had peaked at more than $307 dollars before losing nearly half of their value in February 2016, when the price bottomed out at $177. The current price (after close on March 6) stands at $235.10, after much volatility over the past two years.

An article at Zacks from Jan. 29, 2016 attributes the previous day’s 19% slump to earnings:

“This slump shouldn’t be too much of a surprise to investors, as the financial transaction services provider has seen 2 negative revisions in the past few weeks and its current year earnings consensus has moved lower over the last 30 days. This suggests there may be more trouble down the road. So make sure to keep an eye on this stock going forward to see if this recent slump will continue, as the earnings picture definitely suggests that this might be the case.”

Ironically, the article goes on to recommend Equifax (NYSE:EFX) as a better choice in the same sector, not knowing of course that about a year and a half in the future, Equifax would experience an even deeper plunge of its own, in the wake of being hacked and management’s weak response.

Great company?

Is it safe to go back in the water? On the positive side, Alliance Data is now rated as an undervalued predictable stock, even though its share price is choppy.

To try to answer that question, we will use what I call the Macpherson model, which is the set of metrics used by guru Thomas Macpherson to do an initial scan of stocks. For more information, see Macpherson’s article, "The Search for Compounding Machines," and my article here.

His criteria for a great company is a combination of:

  • A competitive moat.
  • Financial strength.
  • Profitability.

For the competitive moat, Macpherson uses two financial measures: A competitive moat, which is defined as at least a 15% median return on capital over the preceding 10 years and a minimum 15% median return on tangible equity, again over 10 years. GuruFocus provides ROC and return on invested capital data and tangible book value, which is what we use in place of return on tangible equity.

Alliance Data fails on the first test, ROC, with 9.64%.

Tangible book value for the company is negative (-$51.14 at the end of calendar 2016), and so will not be applied.

Instead, we note an August 2017 analysis of Alliance at Morningstar argues the company has a deep moat for its private-label credit cards and loyalty programs. The article says: "It should not be underestimated how high the switching costs are" and private-label credit card services essentially outsource their complete customer care and much of their digital market to Alliance. However, the analysis also notes the company has no moat on the funding side of the business, unlike the banks with which it competes, making it vulnerable if interest rates rise.

For the competitive moat criterion, Alliance Data therefore receives a fail.

Looking at financial strength, Macpherson sets a threshold of:

  • Cash-to-debt, minimum value of 100.
  • Financial strength, minimum value of 9.

The GuruFocus dashboard for Alliance Data shows a fail on both counts:

Alliance Data financial strength

As we see, cash-to-debt is less than 1.0 and the financial strength rating is just 4.

The profitability factor is the third element in assessing whether a company should get “great” status. It also comes from the GuruFocus Dashboard:

Alliance Data profitability

Alliance Data gets a pass on this criterion with a 9, which equals the required rating.

Summing up, the numbers point to a fail based on the results of a competitive moat rating, financial strength and profitability.

Great price?

To answer this question, the Macpherson model uses these three types of discounted cash flow analysis (although not all may be necessarily relevant):

  • DCF-free cash flow-based.
  • DCF-earnings-based.
  • DCF-projected-free cash flow-based.

The DCF-free cash flow calculation shows an extreme discrepancy: the current price (end of day on March 7) is $235.38, while the DCF-free cash flow valuation is $1,215.48. If we take this valuation seriously, then Alliance Data is wildly undervalued (I would recommend further research).

For earnings-based DCF, the numbers indicate undervaluation again, at $235.38 versus $318.94.

Projected free cash flow, for the record, is $424.59, but not relevant since its cash flow metrics are relatively consistent.

Overall, the results show Alliance Data to be undervalued, so it receives a pass on valuation.

Other thoughts

Twelve of the GuruFocus gurus hold positions in Alliance Data Systems. The biggest holding is that of Jeff Ubben (Trades, Portfolio)'s ValueAct Partners, with 5.9 million shares. Glenn Greenberg (TradesPortfolio) has 1.7 million shares, and Steven Cohen (Trades, Portfolio) holds 429,000.

Elsewhere among the professionals, the six analysts who follow Alliance Data and are watched by NASDAQ.com have a bullish perspective:

Alliance Data analysts opinion

Conclusion

Based on the criteria in the Macpherson model, Alliance Data Systems is not yet ready to become a value investor choice.

  • Competitive moat: It does have a moat of sorts, but at 9.64%, it is a relatively weak one. That's backed by a Morningstar opinion that sees a strong moat in two spaces, and a vulnerability in a third.
  • Financial strength: Below par, with a poor cash-to-debt ratio and a GuruFocus rating of 4 of 10. The copious amount of red ink on this section of the dashboard is a warning flag for investors.
  • Profitability: A pass since it receives a GuruFocus rating of 9.
  • Price: Of the two DCF tests that are relevant, both signal undervalued status.

Alliance Data has some favorable aspects, notably its profitability and price as well as inclusion on the undervalued predictable screener and demand from gurus. Value investors, however, will give more weight to its weak financial strength rating and its relatively weak competitive moat.

Disclosure: I do not own shares in any of the stocks listed, and do not expect to buy any in the next 72 hours.

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995, and in 2010 added options, mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the Unseen Revolution. In Big Macs & Our Pensions: Who Gets McDonald's Profits?, he looks at the ownership of McDonald’s and what that means for middle class retirement income.

Visit Robert Abbott's Website


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