ADS - Alliance Data Systems

[dbuch]

People value financials at P/B because most the assets and liabilities are marked to market and it is an easy short hand to get to a comparable value across the industry. It is less meaningful for companies where book value is not marked to current values and companies that don't rely on much capital. MSFT doesn't need much capital and generates substantial earnings on both tangible and intangible assets so P/B will be very high and the number isn't very comparable across the industry. Banks are mostly tangible assets which are market to market and they tend to generate similar ROEs so P/B can be a way to compare one bank to another. You can get to the same valuations using P/E or a DDM.
 
If a no growth finance company earns its cost of capital they are worth no more than their equity.  P/B = (ROE - g) / (r-g). So 10% ROE divided by 10% cost of capital = 1x P/B. If a better bank like JPM is expected to grow 3% a year has a lower cost of capital say 8% and generates 12% ROEs it should trade at 1.8x P/B.

The formula is more complicated for a two state high growth firm but in general you should be willing to pay up the higher the growth and the higher the ROE. If you assume ADS can grow earnings 15% a year for 5 years then 3% thereafter while generating 30% ROEs the P/B should be 5.8x. P/E multiples will get you similar results as will DDMs if you use similar assumptions.

Aswath Damodaran has the rationale here:

http://people.stern.nyu.edu/adamodar/New_Home_Page/lectures/pbv.html

Banks make money with leverage so ROE's drop the lower the leverage. If i have $1 of equity levered 10x and earn 1% on assets, i earn 10% ROE, If i drop the leverage to 5x my ROE drops to 5%. So financials can make more money the more levered they are but they are constrained by regulation and the risk of default.

[chompsterama]

People value financials at P/B because most the assets and liabilities are marked to market and it is an easy short hand to get to a comparable value across the industry. It is less meaningful for companies where book value is not marked to current values and companies that don't rely on much capital. MSFT doesn't need much capital and generates substantial earnings on both tangible and intangible assets so P/B will be very high and the number isn't very comparable across the industry. Banks are mostly tangible assets which are market to market and they tend to generate similar ROEs so P/B can be a way to compare one bank to another. You can get to the same valuations using P/E or a DDM.
 
If a no growth finance company earns its cost of capital they are worth no more than their equity.  P/B = (ROE - g) / (r-g). So 10% ROE divided by 10% cost of capital = 1x P/B. If a better bank like JPM is expected to grow 3% a year has a lower cost of capital say 8% and generates 12% ROEs it should trade at 1.8x P/B.

The formula is more complicated for a two state high growth firm but in general you should be willing to pay up the higher the growth and the higher the ROE. If you assume ADS can grow earnings 15% a year for 5 years then 3% thereafter while generating 30% ROEs the P/B should be 5.8x. P/E multiples will get you similar results as will DDMs if you use similar assumptions.

Aswath Damodaran has the rationale here:

http://people.stern.nyu.edu/adamodar/New_Home_Page/lectures/pbv.html

Banks make money with leverage so ROE's drop the lower the leverage. If i have $1 of equity levered 10x and earn 1% on assets, i earn 10% ROE, If i drop the leverage to 5x my ROE drops to 5%. So financials can make more money the more levered they are but they are constrained by regulation and the risk of default.

Thank you very much for this:
 
"If a no growth finance company earns its cost of capital they are worth no more than their equity.  P/B = (ROE - g) / (r-g). So 10% ROE divided by 10% cost of capital = 1x P/B. If a better bank like JPM is expected to grow 3% a year has a lower cost of capital say 8% and generates 12% ROEs it should trade at 1.8x P/B.

The formula is more complicated for a two state high growth firm but in general you should be willing to pay up the higher the growth and the higher the ROE. If you assume ADS can grow earnings 15% a year for 5 years then 3% thereafter while generating 30% ROEs the P/B should be 5.8x. P/E multiples will get you similar results as will DDMs if you use similar assumptions."

Best explanation I've ever seen on the subject.  Should be kept in mind more often

[dbuch]

People value financials at P/B because most the assets and liabilities are marked to market and it is an easy short hand to get to a comparable value across the industry. It is less meaningful for companies where book value is not marked to current values and companies that don't rely on much capital. MSFT doesn't need much capital and generates substantial earnings on both tangible and intangible assets so P/B will be very high and the number isn't very comparable across the industry. Banks are mostly tangible assets which are market to market and they tend to generate similar ROEs so P/B can be a way to compare one bank to another. You can get to the same valuations using P/E or a DDM.
 
If a no growth finance company earns its cost of capital they are worth no more than their equity.  P/B = (ROE - g) / (r-g). So 10% ROE divided by 10% cost of capital = 1x P/B. If a better bank like JPM is expected to grow 3% a year has a lower cost of capital say 8% and generates 12% ROEs it should trade at 1.8x P/B.

The formula is more complicated for a two state high growth firm but in general you should be willing to pay up the higher the growth and the higher the ROE. If you assume ADS can grow earnings 15% a year for 5 years then 3% thereafter while generating 30% ROEs the P/B should be 5.8x. P/E multiples will get you similar results as will DDMs if you use similar assumptions.

Aswath Damodaran has the rationale here:

http://people.stern.nyu.edu/adamodar/New_Home_Page/lectures/pbv.html

Banks make money with leverage so ROE's drop the lower the leverage. If i have $1 of equity levered 10x and earn 1% on assets, i earn 10% ROE, If i drop the leverage to 5x my ROE drops to 5%. So financials can make more money the more levered they are but they are constrained by regulation and the risk of default.

Thank you very much for this:
 
"If a no growth finance company earns its cost of capital they are worth no more than their equity.  P/B = (ROE - g) / (r-g). So 10% ROE divided by 10% cost of capital = 1x P/B. If a better bank like JPM is expected to grow 3% a year has a lower cost of capital say 8% and generates 12% ROEs it should trade at 1.8x P/B.

The formula is more complicated for a two state high growth firm but in general you should be willing to pay up the higher the growth and the higher the ROE. If you assume ADS can grow earnings 15% a year for 5 years then 3% thereafter while generating 30% ROEs the P/B should be 5.8x. P/E multiples will get you similar results as will DDMs if you use similar assumptions."

Best explanation I've ever seen on the subject.  Should be kept in mind more often

no problem 

[chompsterama]

Meaning, if one thought ADS could grow at 7%, have ROE's of 20% and has a 10% cost of capital then the P/B ought to be 4.3x.  So for ADS to trade at 2x book (as suggested by a recent poster), the business has to deteriorate pretty significantly. 

[chompsterama]

what is the main catalyst for ADS to be recognized by Mr Market?  Is it more bookings (more customers)? Revenue? or just normal bottom line growth?

I would argue that ADS right now is recognized by Mr Market correctly. Mr Market has stripped off the premium from phony cash earnings and values the company based on GAAP earnings, just like its peers.

FWIW, peers have traded at average multiples since IPO or 10+ years (whichever is longer) on their diluted GAAP EPS of:
COF: 14.1
SYF: 11.9
DFS: 10.2

After the repurchase and interest savings from debt paydown, ADS should make about $17/share diluted GAAP. 

[adhital]

Meaning, if one thought ADS could grow at 7%, have ROE's of 20% and has a 10% cost of capital then the P/B ought to be 4.3x.  So for ADS to trade at 2x book (as suggested by a recent poster), the business has to deteriorate pretty significantly. 

The way I’m looking at ADS, it’s valuation all comes down to the receivable growth.

If the card business earns $16 cash/share this year than the question remains if they can plow back this cash towards receivable growth?  Historically, they reinvest, I think around 50% of earnings to support 15% receivable growth by keeping financial leverage at around 13. However, I think, the easy receivables days are gone. 2019 earning is likely to go back to buyback or debt reduction and not much to support the portfolio growth.  Les say, 2019 EOY BV is $50 and net leverage multiple compress by 30%. 

Starting 2020:
case 1) let’s say, receivable starts to pick up with ~7-10% earning, 25% ROE and 20% BV CAGR for the next 5 years. 50% earning goes towards portfolio growth by maintaining existing leverage ratio.  what’s the value for this model? I think, at 12% earning yield today (or 2.7 times EOY BV), I expect to get 15 to 17% IRR just with the card business alone.  Expected share price = $280 to $300 within the next 2 to 5 years (12 PE multiple or 2.5x BV).

Case 2) However, if the receivable slows or drops and the company decides to liquidate in 2021, what’s the liquidation value? I think $16Billion receivable should ask for a 30% premium i.e. ~100 cash/share (It’s just my guess estimate based on 25% yield, 7% default on 10Q receivable data matrix). With 2019 EOY BV around $50, I think the current share price is less than this future card business liquidation value. However, market is likely to push this to 2 times BV if receivable shows sign of weakness.

[Spekulatius]

Meaning, if one thought ADS could grow at 7%, have ROE's of 20% and has a 10% cost of capital then the P/B ought to be 4.3x.  So for ADS to trade at 2x book (as suggested by a recent poster), the business has to deteriorate pretty significantly. 

The way I’m looking at ADS, it’s valuation all comes down to the receivable growth.

If the card business earns $16 cash/share this year than the question remains if they can plow back this cash towards receivable growth?  Historically, they reinvest, I think around 50% of earnings to support 15% receivable growth by keeping financial leverage at around 13. However, I think, the easy receivables days are gone. 2019 earning is likely to go back to buyback or debt reduction and not much to support the portfolio growth.  Les say, 2019 EOY BV is $50 and net leverage multiple compress by 30%. 

Starting 2020:
case 1) let’s say, receivable starts to pick up with ~7-10% earning, 25% ROE and 20% BV CAGR for the next 5 years. 50% earning goes towards portfolio growth by maintaining existing leverage ratio.  what’s the value for this model? I think, at 12% earning yield today (or 2.7 times EOY BV), I expect to get 15 to 17% IRR just with the card business alone.  Expected share price = $280 to $300 within the next 2 to 5 years (12 PE multiple or 2.5x BV).

Case 2) However, if the receivable slows or drops and the company decides to liquidate in 2021, what’s the liquidation value? I think $16Billion receivable should ask for a 30% premium i.e. ~100 cash/share (It’s just my guess estimate based on 25% yield, 7% default on 10Q receivable data matrix). With 2019 EOY BV around $50, I think the current share price is less than this future card business liquidation value. However, market is likely to push this to 2 times BV if receivable shows sign of weakness.

Yes, receivables are the key growth metric and delinquencies the key profit metric. Receivables are flatfish as the runoff from failing retailers now is counter the growth from new customer wins. Delinquencies are flatfish to rising, but at a measured pace. ROE isn’t really all that relevant until they can invest new capital in growing receivables.

Overall, I see the valuation getting quite attractive. Now if we get a market correction and we really could get in an interesting setup.

[abitofvalue]

What can ADS do that SYF can't? The notion that ADS has better data scientists or more 'marketing' edge seems dubious to me, especially with Epsilon gone.. I suspect SYF would also disagree that it doesnt have marketing / loyalty expertise.. what do ppl think the 1000s of ppl SYF employs do? Its not like SYF is run by dumb ppl.. in fact i think most investors would prefer Ms Keane to Ed to run a card business. 

In terms of models i think SYF's profit share model is a superior mousetrap to ADS' signing bonus + royalty model. I am willing to bet that if you were to properly account for ALL expenses / costs at the card segment, the profitability would not be materially (+5% more) than a SYF/AXP/DFS (i.e. other closed loop models). This management team has proved to be over optimistic every step along the way and yet ppl seem to take at face value their claims of being this superior return business because others dont want to compete for small accounts.. 

ADS points to recent wins but accounting for all their programs, their receivables are not growing anywhere near 10%. Yes Yes their 'active' receivables growth is bigger but at this point i think the market has clearly rejected that metric (rightly imo). The notion that they are a 'prime' lender is belied by their higher than GPCC loss rates. Their recession performance which ppl keep pointing too was helped by strong receivable growth and more importantly, their recent wins are in categories that prob wont have similar loss outcomes - ahem, signet ahem.

Is it cheap - maybe. But DFS' at 8x, COF at 7.5x and SYF at 7x 2020 EPS, ADS seems to be in-line...

[vince]

Meaning, if one thought ADS could grow at 7%, have ROE's of 20% and has a 10% cost of capital then the P/B ought to be 4.3x.  So for ADS to trade at 2x book (as suggested by a recent poster), the business has to deteriorate pretty significantly. 

The way I’m looking at ADS, it’s valuation all comes down to the receivable growth.

If the card business earns $16 cash/share this year than the question remains if they can plow back this cash towards receivable growth?  Historically, they reinvest, I think around 50% of earnings to support 15% receivable growth by keeping financial leverage at around 13. However, I think, the easy receivables days are gone. 2019 earning is likely to go back to buyback or debt reduction and not much to support the portfolio growth.  Les say, 2019 EOY BV is $50 and net leverage multiple compress by 30%. 

Starting 2020:
case 1) let’s say, receivable starts to pick up with ~7-10% earning, 25% ROE and 20% BV CAGR for the next 5 years. 50% earning goes towards portfolio growth by maintaining existing leverage ratio.  what’s the value for this model? I think, at 12% earning yield today (or 2.7 times EOY BV), I expect to get 15 to 17% IRR just with the card business alone.  Expected share price = $280 to $300 within the next 2 to 5 years (12 PE multiple or 2.5x BV).

Case 2) However, if the receivable slows or drops and the company decides to liquidate in 2021, what’s the liquidation value? I think $16Billion receivable should ask for a 30% premium i.e. ~100 cash/share (It’s just my guess estimate based on 25% yield, 7% default on 10Q receivable data matrix). With 2019 EOY BV around $50, I think the current share price is less than this future card business liquidation value. However, market is likely to push this to 2 times BV if receivable shows sign of weakness.

Yes, receivables are the key growth metric and delinquencies the key profit metric. Receivables are flatfish as the runoff from failing retailers now is counter the growth from new customer wins. Delinquencies are flatfish to rising, but at a measured pace. ROE isn’t really all that relevant until they can invest new capital in growing receivables.

Overall, I see the valuation getting quite attractive. Now if we get a market correction and we really could get in an interesting setup.

Is it just me or are people missing the fact that there is future growth in receivables just based on new signings of the last couple years.  I haven't actually sat down and figured out what the potential growth rate may be but it seems pretty certain that there is some growth coming based on newer signings in the pipe that spool up over time.  At the very least I think we can assume no lasting shrinkage in receivables which could still work out quite well.

[adhital]

What can ADS do that SYF can't? The notion that ADS has better data scientists or more 'marketing' edge seems dubious to me, especially with Epsilon gone.. I suspect SYF would also disagree that it doesnt have marketing / loyalty expertise.. what do ppl think the 1000s of ppl SYF employs do? Its not like SYF is run by dumb ppl.. in fact i think most investors would prefer Ms Keane to Ed to run a card business. 

In terms of models i think SYF's profit share model is a superior mousetrap to ADS' signing bonus + royalty model. I am willing to bet that if you were to properly account for ALL expenses / costs at the card segment, the profitability would not be materially (+5% more) than a SYF/AXP/DFS (i.e. other closed loop models). This management team has proved to be over optimistic every step along the way and yet ppl seem to take at face value their claims of being this superior return business because others dont want to compete for small accounts.. 

ADS points to recent wins but accounting for all their programs, their receivables are not growing anywhere near 10%. Yes Yes their 'active' receivables growth is bigger but at this point i think the market has clearly rejected that metric (rightly imo). The notion that they are a 'prime' lender is belied by their higher than GPCC loss rates. Their recession performance which ppl keep pointing too was helped by strong receivable growth and more importantly, their recent wins are in categories that prob wont have similar loss outcomes - ahem, signet ahem.

Is it cheap - maybe. But DFS' at 8x, COF at 7.5x and SYF at 7x 2020 EPS, ADS seems to be in-line...

Yes, I think about this too and have asked about this..but  looking at the historical data, there may be a reason why ADS deserve higher multiple?

          2007 BV/share   2018 BV/share   CAGR
COF        $65.16                 $100.90        4%
ADS        $15.20                 $43.67        9%
         
         2007 EPS     2018 EPS          CAGR
COF          $6.55        $11.86           5%
ADS          $3.75       $22.72        16%
         
         
GFC EPS              2007 EPS   2009 EPS   CAGR
COF                       $6.55               $0.98   -47%
ADS                       $3.75               $5.21   12%


SYF with $80+B, COF with $100+B and ADS with just under $17B receivable, there may be a very little reason why SYF, COF and others find worthwhile to compete against ADS on those niche merchandise where ADS thrive?