This article is excerpted from a letter authored by Samer Hakoura, principal at Alphyn Capital Management, based in New York.

ADS has two segments, the Card services division (85% of operating profit) and LoyaltyOne (air miles in Canada, 15% of operating profits). Card Services operates Private Label Credit Cards, which are store-issued cards that consumers can use only at the issuing store. While ADS manages its customers’ card operations, such as receivable financing, bill processing, and delinquency management, its real strength is in driving customers’ sales through targeted loyalty programs and marketing campaigns. It does this by signing long-term (5-15 year) contracts and integrating with and managing its clients’ customer care and digital marketing activities, providing trained call center staff and data scientists who build detailed individual customer profiles to track shoppers’ buying habit and preferences.

With its deep roots in the retail industry, ADS was formed in December 1996 through the merger of J.C. Penney’s credit card processing unit and The Limited’s credit card bank operation, the company has a large proprietary data set of consumer behavior, and is thus able to target highly relevant digital ads that drive additional consumer purchases. For example, when a consumer buys an item at a retail partner, they receive an email or are exposed to targeted display advertising suggesting a matching accessory or related item. This requires both SKU-level detailed data, and purchase behavior across different retailers. It would be financially prohibitive and operationally complex for customers to replicate these marketing activities, and few competitors possess equivalent data at the same level of granularity. ADS has a demonstrated ability to increase customer sales by 20-30%,[1] and a very sticky business (a “high switching cost” moat), as evidenced by retention rates of approximately 99% (excluding customer bankruptcies and sales), and multi-year Returns on Equity in the 30%+ range.

Card Services earns money like most other credit card companies, through interest and fees on credit card balances and late payments. A difference between it and general card companies is ADS is on a closed loop system, with no interchange fees to be paid by the customer (as charged by Visa and MasterCard). In fact ADS pays retailers a proportion of sales through a through a Revenue Share Agreement.

Sentiment on the company is currently quite negative for a plethora of reasons, most of it beginning in early 2016 when overall market sentiment turned against all things bricks and mortar, from traditional retailers to mall operators. ADS went from being a 20%+ per year growth story to a more pedestrian 8-10% as large legacy files were liquidated, such as Bon-Ton (liquidation, ~4.5% of receivables), Gander Mountain (bankruptcy), and Virgin America (bought by Alaska Air).[2] A series of own goals did not help, including repeatedly missing earnings guidance, and a poorly managed plan in 2016 to let LoyaltyOne’s air miles points expire that caused public outcry in Canada.[3]

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