August 19, 2016

Alliance Data Systems: If You Dont Like the

Answer ... Just Change the Question.
Citron Target on Alliance Data Systems Corp is
50% Near-Term Downside
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 miscategorized 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.

A Software
Company that
Owns a Bank

A Bank that
Owns a Software
Company

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:
Citron Unmasks ADS

August 19, 2016

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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 companys card services business, which contributes the lions
share of earnings, is at two bank subsidiaries. These two entities are limited by regulatory
and capital requirements, which limits the parent companys use of the cash generated by
them.
-- Credit Suisse Analyst Paul Condra
August 18, 2016
http://www.benzinga.com/analyst-ratings/analyst-color/16/08/8361854/alliance-data-closer-to-a-card-lender-than-tech-company-

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, 2015

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.

Citron Unmasks ADS

August 19, 2016

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Three divisions of ADS must be considered separately when valuing the company:
1
2
3

LoyaltyOne
(Tech)
Epsilon
(Tech)
Card Services
(Bank)

Runs loyalty programs and leverages the data collected to help design
and implement marketing programs.
A comprehensive suite of targeted and data-driven marketing services. A
majority of clients do not currently use the full suite of services.
Provides a variety of funding and processing services for private label and
co-branded credit card programs; leverages the transaction level data to
drive multi-channel marketing activities.

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: Whats 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:
Valuation
Disparity
Financial Sector
Price / Earnings
Price / Book Value
EV / EBIT
EV / EBITDA

14.73
1.35
13.04
10.76

S&P 2015A
Tech Sector

Tech > Fin

19.16
4.13
14.35
10.97

30.1%
205.9%
10.0%
2.0%

There arent 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.

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August 19, 2016

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ADS | Business Segment Split 2015

LoyaltyOne
Revenue
% of total revenue
Adjusted EBITDA, net
% of total EBITDA, net

$1,353
21%
$271
16%

Epsilon
$2,141
33%
$508
29%

Card
Services
$2,974
46%
$1,069
62%

Corporate
($28)
(0%)
($119)
(7%)

Total
$6,440
$1,728

* 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.

Management Has Promoted This Deception

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.
https://en.wikipedia.org/wiki/Global_Industry_Classification_Standard

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...?

Citron Unmasks ADS

August 19, 2016

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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!

Citron Unmasks ADS

August 19, 2016

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P/E Analysis
ADS | Valuation by P/E
Non-Financials Business EBITDA (2015A)
EV / EBITDA
Implied Non-Financial Business Value
Less: Net
Debt
Implied Non-Financial Business Value (less debt)
Implied Non-Financial Business Value (less debt) - per share

$779
10.0x
$7,789

Earnings from bank (2015A)

Price /
Earnings
Implied Value of Banks (per share)

$10.50

Implied Market Capitalization

Shares outstanding

$6,483
$1,306
$22.32

10.0x
$105.00
$7,452
58.5

Implied Share Price

Current Share Price

$127.32

Downside

(37.5%)

$203.71

Price to Book Analysis:

ADS | Valuation
Non-Financials Business EBITDA (2015A)
EV / EBITDA
Implied Non-Financial Business Value
Less: Net Debt
Implied Non-Financial Business Value (less debt)

$779
10.0x
$7,789
$6,483
$1,306

Comenity Bank
Comenity Capital Bank
Book Value of Banks
P / Book
Implied Value of Banks

$1,497
$707
$2,204
2.0x
$4,408

Implied Market Capitalization

Shares outstanding

$5,714
58.5

$97.63

Implied Share Price

Current Share Price

$203.71

(52.1%)

Downside

Citron Unmasks ADS

August 19, 2016

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Realigning Perceptions and Reality

In a best-case scenario, ADS should trade at $100 per share -- $125 tops -- which is more than
fair. Worst case scenario, it could go much lower with a credit event. While this story does
need to explain what could happen, investors would be foolish not to pay attention to a lender
with more red flags than the Beijing Olympics..ALL WHICH COULD TRIGGER A CREDIT EVENT
AND SEND THE STOCK LOWER THAN OUR PROJECTIONS

The Single Most Disturbing Data Point about ADS:

ADS DOES NOT disclose FICO scores of their borrowers. They are
the only credit company in the S&P 500 that does not this is beyond disturbing,
because they intentionally cater to a lower than prime client. See the "Shopping
Cart Trick" below.

And the other Red Flags:

Many of ADS private label credit cards purposely do not offer an auto pay
feature, which enables them to earn a higher ROE from late fees charged. This
has already been the target of the FDIC and could go to the CFPB.
Comenity bank already has history of run-ins with regulators, and has been
fined. CFPB is always a threat. http://www.creditcards.com/credit-card-news/comenity-bankfdic-fine-refund-1282.php

ADS is possibly the only bank on the S&P 500 that does not disclose Return
on Equity or Return on Assets.
ADS is the rare financial institution on the S&P 500 that has > $5 billion of
debt and no credit rating.
The sub-prime book is becoming more apparent -- you can see the
connection to Lending Club of page 9 of their most recent 10-K.

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August 19, 2016

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Charge-offs are growing:

Lastly, and the Biggest Red Flag of them All, is Comenity's

Prominent Use of the Shopping Cart Trick
Citron believes that a big part of the online credit card business of Comenity is based on a
widely known trick amongst the subprime community which allows consumers to get credit,
especially high fee retail-branded credit cards, without a credit request ever getting put on
your credit records or lowering your FICO score. Comenity is well aware of this credit
loophole; you will be amazed of how popular it has become with the subprime community.
Below are just 3 but there are literally hundreds of sites and videos dedicated to this Comenity
loophole". Folks this is the Holy Grail of subprime lending:

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August 19, 2016

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How to Perform the Shopping Cart Trick

1. Go online to the stores website for the card you want.
2. Register for their website or loyalty program. You will want to provide your
personal information. Providing your address is a must because it allows them
to send promotions to your address.
3. Add a couple of items to your shopping cart.
4. Continue the check-out process until you reach the final page. If you have not
received an offer, then you will have try again or try another website. Again,
you do not have to purchase anything. The process of going to the final
checkout page increases your chance of an offer to pop up.
5. Accept the offer and complete the application.

Note: Be sure to enter the same information that is on your credit

report when youre applying for the credit card. If they cannot verify
your identity, then you will not be eligible for the card.

http://www.bankcheckingsavings.com/shopping-cart-trick/

Other links documenting the same nonsensical sleight-of-hand -- an engraved invitation to subprime customers:

http://shoppingcarttrick.net
http://theshoppingcarttrick.com

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August 19, 2016

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So Why Do Investors Own ADS???

Simple: Investors buy ADS as a yield name as it boasts 10% free cash flow yields.
Yet, using this metric for a bank instead of its price to book is like asking Ryan
Lochte how his night was. You'll get an answer; it's just that reality might be a
different story.
The company has said numerous times in SEC filings that in 2015 they generated
$1.3 billion in free cash flow. This is not only misleading in our opinion this is
borderline fraudulent.
In a time where we all increasingly struggle to understand or delineate GAAP vs. non-GAAP
figures, the SEC has attempted to add clarity with Regulation G. This regulation forces
companies to show their homework when disclosing any non-GAAP financial measures, in this
case when disclosing cash flows Alliance Data Systems should show investors how they were
calculated. They should provide a reconciliation of Free Cash Flow to provided GAAP figures (as
free cash flow is a non-GAAP figure). But Alliance Data Systems does not do this.

Worse- they have changed their own definition of free cash flows.
Q1 2013 Earnings Call
Edward Heffernan (CEO): One of the
key things is free cash flow everyone
seems to define free cash flow
differently. I keep it real simple, which
is how much is left in the bank account
at the end of the year, which means
how much after you pay for CapEx and
interest and taxes and working capital
and bank capital and everything else.
(source)

Q4 2014 Earnings Call

Edward Heffernan (CEO): Then finally,
free cash flow, if we are going to do
around $1.8 billion or so of net EBITDA,
if you take out CapEx and cash interest
and cash taxes, we will probably be
around $1.3 billion of free cash flow
(source)

Research done by numerous accountant and industry experts has

concluded that the actual free cash flow of ADS is less than HALF of
what is disclosed, just $539 million and here is the homework.

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August 19, 2016

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2015 Free Cash Flow Reconciliation

GAAP Net Income

$605

Stock Based Compensation

Depreciation & Amortization
Non-cash interest expense and derivative MTM Gain
Non-Cash Items

$91
$492
$24
$607

Capex (non-card services only)

Change in net working capital
Cash items not captured in net income
Adjusted EBITDA
Interest expense on deposits
Securitization funding costs
Regulatory settlement
Stock based compensation
Taxes
Remove card services impact to GAAP net income

($156)
($53)
($209)
($1,219)
$54
$97
$65
$15
$354
($634)

Dividends
Infusions
Free cash flow from banks (CB and CCB)

$225
($55)
$170

Free cash flow available to shareholders

$539

While ADS wants investors to believe that free cash flow = EBITDA less taxes,
capex, interest in reality and in their own former calculation it is Net dividends
from the two banks to the parent plus the free cash flow of the non bank
businesses.
DUH!!! Everyone knows that EBITDA is the most useless metric when looking at a
bank ... Everyone except maybe ADS.

Conclusion
Citron has attempted to present this story as simply as possible. Goldman Sachs already
understands the mispricing of ADS, and reports even its Sum of The Parts analysis is significantly
lower than the stock's current lofty levels. Now Credit Suisse is on board. Pretty soon, all of
Wall Street will wake up and understand that AT BEST- Alliance Data Systems is a $100 stock.
And if we see a recession or other threat to consumer credit default rates, the floor becomes
the ceiling ... overnight.

Cautious Investing to All

Citron Unmasks ADS

August 19, 2016

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