form10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
     
 
FORM 10-Q

(Mark One)
 
R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the quarterly period ended September 30, 2012
   
OR
 
£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the transition period from          to          

Commission File Number: 001-15749
 
     
 
ALLIANCE DATA SYSTEMS CORPORATION
(Exact name of registrant as specified in its charter)

Delaware
31-1429215
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)

7500 Dallas Parkway, Suite 700
Plano, Texas 75024
(Address of principal executive office, including zip code)

(214) 494-3000
(Registrant’s telephone number, including area code)
 
     
 
 

 
Indicate by check mark whether the registrant: (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes R     No  £
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes R     No  £

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 
Large accelerated filer R     
Accelerated filer  £     
 
Non-accelerated filer £ (Do not check if a smaller reporting company)
Smaller reporting company £

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes £     No R

As of October 31, 2012, 49,855,700 shares of common stock were outstanding.
 


 
 
 
 
 
ALLIANCE DATA SYSTEMS CORPORATION
 
INDEX
 
 
 
 
 
Page
Number
Part I:  FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited)
 
 
3
 
4
 
5
 
6
 
7
Item 2.
28
Item 3.
42
Item 4.
42
Part II:  OTHER INFORMATION
 
Item 1.
44
Item 1A.
44
Item 2.
44
Item 3.
44
Item 4.
44
Item 5.
44
Item 6.
45
46
 
 
2


PART I
 
Item 1.
Financial Statements.
  
ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
 
       
   
September 30,
2012
   
December 31,
2011
 
   
(In thousands, except per share amounts)
 
ASSETS
           
Cash and cash equivalents
  $ 766,317     $ 216,213  
Trade receivables, less allowance for doubtful accounts ($4,583 and $2,406 at September 30, 2012 and December 31, 2011, respectively)
    287,643       300,895  
Credit card receivables:
               
Credit card receivables – restricted for securitization investors
    5,838,099       4,886,168  
Other credit card receivables
    741,216       779,843  
Total credit card receivables
    6,579,315       5,666,011  
Allowance for loan loss
    (448,542 )     (468,321 )
Credit card receivables, net
    6,130,773       5,197,690  
Deferred tax asset, net
    183,319       252,303  
Other current assets
    155,854       121,589  
Redemption settlement assets, restricted
    495,699       515,838  
Assets of discontinued operations
          2,439  
Total current assets
    8,019,605       6,606,967  
Property and equipment, net
    224,018       195,397  
Deferred tax asset, net
    79,315       43,408  
Cash collateral, restricted
    62,205       158,727  
Intangible assets, net
    403,100       383,646  
Goodwill
    1,458,700       1,449,363  
Other non-current assets
    165,361       142,741  
Total assets
  $ 10,412,304     $ 8,980,249  
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Accounts payable
  $ 236,891     $ 149,812  
Accrued expenses
    238,489       206,621  
Deposits
    984,798       642,567  
Asset-backed securities debt – owed to securitization investors
    1,420,866       1,694,198  
Current debt
    782,706       19,834  
Other current liabilities
    104,666       105,888  
Deferred revenue
    1,031,836       1,036,251  
Total current liabilities
    4,800,252       3,855,171  
Deferred revenue
    202,254       190,185  
Deferred tax liability, net
    191,036       151,746  
Deposits
    850,854       711,208  
Asset-backed securities debt – owed to securitization investors
    2,094,250       1,566,089  
Long-term and other debt
    1,660,739       2,163,640  
Other liabilities
    120,433       166,244  
Total liabilities
    9,919,818       8,804,283  
Commitments and contingencies
               
Stockholders’ equity:
               
Common stock, $0.01 par value; authorized, 200,000 shares; issued, 94,832 shares and 94,141 shares at September 30, 2012 and December 31, 2011, respectively
    948       941  
Additional paid-in capital
    1,429,936       1,387,773  
Treasury stock, at cost, 44,847 shares and 44,311 shares at September 30, 2012 and December 31, 2011, respectively
    (2,386,054 )     (2,320,696 )
Retained earnings
    1,469,599       1,131,004  
Accumulated other comprehensive loss
    (21,943 )     (23,056 )
Total stockholders’ equity
    492,486       175,966  
Total liabilities and stockholders’ equity
  $ 10,412,304     $ 8,980,249  
 
See accompanying notes to unaudited condensed consolidated financial statements.

 
3


ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME
 
   
Three Months Ended
September 30,
 
Nine Months Ended
 September 30,
   
2012
 
2011
 
2012
 
2011
   
(In thousands, except per share amounts)
Revenues
                   
Transaction
 
$
74,904
 
$
74,712
 
$
235,150
 
$
221,352
Redemption
   
144,144
   
141,152
   
491,795
   
424,254
Finance charges, net
   
434,824
   
365,925
   
1,188,933
   
1,040,339
Database marketing fees and direct marketing services
   
225,303
   
230,350
   
658,429
   
565,324
Other revenue
   
32,317
   
32,705
   
95,239
   
74,469
Total revenue
   
911,492
   
844,844
   
2,669,546
   
2,325,738
Operating expenses
               
Cost of operations (exclusive of depreciation and amortization disclosed separately below)
   
499,455
   
476,993
   
1,532,815
   
1,312,768
Provision for loan loss
   
81,250
   
70,697
   
183,129
   
198,739
General and administrative
   
24,584
   
26,242
   
76,115
   
68,202
Depreciation and other amortization
   
18,745
   
20,304
   
54,845
   
53,908
Amortization of purchased intangibles
   
22,987
   
22,929
   
65,009
   
60,743
Total operating expenses
   
647,021
   
617,165
   
1,911,913
   
1,694,360
Operating income
   
264,471
   
227,679
   
757,633
   
631,378
Interest expense
           
Securitization funding costs
   
23,296
   
30,233
   
68,143
   
96,281
Interest expense on deposits
   
6,753
   
5,645
   
18,719
   
16,832
Interest expense on long-term and other debt, net
   
44,316
   
38,478
   
126,222
   
111,496
Total interest expense, net
   
74,365
   
74,356
   
213,084
   
224,609
Income before income tax
 
$
190,106
 
$
153,323
 
$
544,549
 
$
406,769
Provision for income taxes
   
70,561
   
59,342
   
205,954
   
157,389
Net income
 
$
119,545
 
$
93,981
 
$
338,595
 
$
249,380
                         
Basic income per share
 
$
2.39
 
$
1.86
 
$
6.76
 
$
4.89
Diluted income per share
 
$
1.84
 
$
1.60
 
$
5.33
 
$
4.35
                         
Weighted average shares
           
Basic
   
49,939
   
50,644
   
50,086
   
50,948
Diluted
   
65,038
   
58,579
   
63,539
   
57,377
                         
 
See accompanying notes to unaudited condensed consolidated financial statements.

 
4


ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
   
2012
 
2011
 
2012
 
2011
   
(In thousands)
                     
Net income
 
$
119,545
 
$
93,981
 
$
338,595
 
$
249,380
Other comprehensive income, net of tax
                       
Net unrealized gain on securities available-for-sale, net of tax expense of $142, tax expense of $111 and tax expense of $26, tax expense of $261 for the three and nine months ended September 30, 2012 and 2011, respectively
   
3,044
   
13,989
   
4,880
   
13,045
Foreign currency translation adjustments
   
(2,107
 
7,281
   
(3,767
 
3,750
Total comprehensive income, net of tax
 
$
120,482
 
$
115,251
 
$
339,708
 
$
266,175
                         
 
See accompanying notes to unaudited condensed consolidated financial statements.

 
5


ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
   
Nine Months Ended
September 30,
 
   
2012
   
2011
 
   
(In thousands)
 
CASH FLOWS FROM OPERATING ACTIVITIES:
 
Net income                                                                                                                      
 
$
338,595
   
$
249,380
 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
Depreciation and amortization                                                                                                                   
   
119,854
     
114,651
 
Deferred income taxes                                                                                                                   
   
76,356
     
(221
Provision for loan loss                                                                                                                   
   
183,129
     
198,739
 
Non-cash stock compensation                                                                                                                   
   
37,605
     
32,471
 
Fair value gain on interest-rate derivatives                                                                                                                   
   
(22,672
)
   
(23,146
)
Amortization of discount on convertible senior notes                                                                                                                   
   
60,915
     
54,574
 
Change in operating assets and liabilities, net of acquisitions:
 
Change in trade accounts receivable                                                                                                                   
   
(9,595
   
1,188
 
Change in other assets                                                                                                                   
   
20,317
     
43,402
 
Change in accounts payable and accrued expenses                                                                                                                   
   
134,848
     
44,739
 
Change in deferred revenue                                                                                                                   
   
(36,364
   
15,869
 
Change in other liabilities                                                                                                                   
   
(25,479
)
   
37,411
 
Excess tax benefits from stock-based compensation                                                                                                                      
   
(15,237
)
   
(12,103
)
Other                                                                                                                      
   
(211
)
   
5,546
 
Net cash provided by operating activities
   
862,061
     
762,500
 
   
CASH FLOWS FROM INVESTING ACTIVITIES:
 
Change in redemption settlement assets                                                                                                                      
   
41,885
     
4,353
 
Change in restricted cash                                                                                                                      
   
(43,892
)
   
98,408
 
Change in credit card receivables                                                                                                                      
   
(418,514
)
   
160,592
 
Purchase of credit card portfolios                                                                                                                      
   
(780,153
)
   
(42,696
)
Change in cash collateral, restricted                                                                                                                      
   
101,536
     
(468,690
)
Payments for acquired businesses, net of cash                                                                                                                      
   
     
(359,076
)
Capital expenditures                                                                                                                      
   
(77,340
)
   
(48,536
)
Investments in marketable securities, net                                                                                                                      
   
(1,492
   
(68,191
)
Investments in the stock of investees                                                                                                                      
   
(921
)
   
(17,974
)
Other                                                                                                                      
   
(9,666
)
   
 
Net cash used in investing activities
   
(1,188,557
)
   
(741,810
)
   
CASH FLOWS FROM FINANCING ACTIVITIES:
 
Borrowings under debt agreements                                                                                                                      
   
699,500
     
2,858,500
 
Repayments of borrowings                                                                                                                      
   
(500,428
)
   
(2,524,729
)
Issuances of deposits                                                                                                                      
   
1,185,049
     
842,505
 
Repayments of deposits                                                                                                                      
   
(703,173
)
   
(332,600
)
Borrowings from asset-backed securities                                                                                                                      
   
1,672,962
     
1,126,921
 
Repayments/maturities of asset-backed securities                                                                                                                      
   
(1,418,133
)
   
(1,703,776
)
Payment of capital lease obligations                                                                                                                      
   
(16
)
   
(3,920
)
Payment of deferred financing costs                                                                                                                      
   
(30,930
)
   
(27,366
)
Excess tax benefits from stock-based compensation                                                                                                                      
   
15,237
     
12,103
 
Proceeds from issuance of common stock                                                                                                                      
   
15,119
     
22,942
 
Purchase of treasury shares                                                                                                                      
   
(65,358
)
   
(186,320
)
Net cash provided by financing activities
   
869,829
     
84,260
 
   
Effect of exchange rate changes on cash and cash equivalents
   
6,771
     
(4,494
)
Change in cash and cash equivalents
   
550,104
     
100,456
 
Cash and cash equivalent at beginning of period
   
216,213
     
139,114
 
Cash and cash equivalents at end of period                                                                                                                
 
$
766,317
   
$
239,570
 
   
SUPPLEMENTAL CASH FLOW INFORMATION:
 
Interest paid                                                                                                                      
 
$
149,076
   
$
177,301
 
Income taxes paid, net                                                                                                                      
 
$
91,055
   
$
87,185
 
 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
6

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation
 
The unaudited condensed consolidated financial statements included herein have been prepared by Alliance Data Systems Corporation (“ADSC” or, including its wholly owned subsidiaries and its consolidated variable interest entities, the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report filed on Form 10-K for the year ended December 31, 2011, filed with the SEC on February 27, 2012.
 
The unaudited condensed consolidated financial statements included herein reflect all adjustments (consisting of normal, recurring adjustments) which are, in the opinion of management, necessary to state fairly the results for the interim periods presented. The results of operations for the interim periods presented are not necessarily indicative of the operating results to be expected for any subsequent interim period or for the fiscal year.
 
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect (1) the reported amounts of assets; (2) liabilities and disclosure of contingent assets and liabilities at the date of the financial statements; and (3) the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
 
Effective October 1, 2012, the Company’s subsidiaries World Financial Network Bank and World Financial Capital Bank changed their names to Comenity Bank and Comenity Capital Bank, respectively. These name changes have been reflected in the Notes to the Unaudited Condensed Consolidated Financial Statements.
 
Recently Issued Accounting Standards
 
In July 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2012-02, “Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment,” which amends Accounting Standards Codification (“ASC”) 350, “Intangibles – Goodwill and Other.” ASU 2012-02 provides an option to first perform a qualitative assessment in testing an indefinite-lived intangible asset for impairment. If based on the qualitative assessment, the carrying value of the asset is more likely than not greater than the fair value, then the current quantitative impairment test must be performed. ASU 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. ASU 2012-02 only impacts the process of testing indefinite-lived intangible assets, other than goodwill, for impairment. Accordingly, the adoption of the standard in 2013 will have no impact on the Company’s financial condition, results of operations or cash flows.
 
 
7

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
2. SHARES USED IN COMPUTING NET INCOME PER SHARE
 
The following table sets forth the computation of basic and diluted net income per share for the periods indicated:
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
2012
 
2011
 
2012
 
2011
 
       
(In thousands, except per share amounts)
     
Numerator:
                     
Net Income
 
$
119,545
 
$
93,981
 
$
338,595
 
$
249,380
 
Denominator:
                 
Weighted average shares, basic
   
49,939
   
50,644
   
50,086
   
50,948
 
Weighted average effect of dilutive securities:
             
Shares from assumed conversion of convertible senior notes
   
9,033
   
5,138
   
8,378
   
4,195
 
Shares from assumed conversion of convertible note warrants
   
5,263
   
1,750
   
4,317
   
1,306
 
Net effect of dilutive stock options and unvested restricted stock
   
803
   
1,047
   
758
   
928
 
Denominator for diluted calculations
   
65,038
   
58,579
   
63,539
   
57,377
 
                           
Basic net income per share
 
$
2.39
 
$
1.86
 
$
6.76
 
$
4.89
 
Diluted net income per share
 
$
1.84
 
$
1.60
 
$
5.33
 
$
4.35
 
 
The Company calculates the effect of its convertible senior notes, consisting of $805.0 million aggregate principal amount of convertible senior notes due 2013 (the “Convertible Senior Notes 2013”) and $345.0 million aggregate principal amount of convertible senior notes due 2014 (the “Convertible Senior Notes 2014”), which can be settled in cash or shares of common stock, on diluted net income per share as if they will be settled in cash as the Company has the intent to settle the convertible senior notes for cash.
 
Concurrently with the issuance of the Convertible Senior Notes 2013 and the Convertible Senior Notes 2014, the Company entered into hedge transactions that are generally expected to offset the potential dilution of the shares from assumed conversion of convertible senior notes.
 
The Company is also party to prepaid forward contracts to purchase 1,857,400 shares of its common stock that are to be delivered over a settlement period in 2014. The number of shares to be delivered under the prepaid forward contracts is used to reduce weighted-average basic and diluted shares outstanding.
 
For the three and nine months ended September 30, 2011, the Company excluded 10.3 million warrants, respectively, from the calculation of net income per share as the effect was anti-dilutive.
 
3. CREDIT CARD RECEIVABLES
 
The Company’s credit card receivables are the only portfolio segment or class of financing receivables. Quantitative information about the components of total credit card receivables is presented in the table below:
 
   
September 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Principal receivables
 
$
6,260,239
   
$
5,408,862
 
Billed and accrued finance charges
   
264,106
     
221,357
 
Other receivables
   
54,970
     
35,792
 
Total credit card receivables
   
6,579,315
     
5,666,011
 
Less credit card receivables – restricted for securitization investors
   
5,838,099
     
4,886,168
 
Other credit card receivables
 
$
741,216
   
$
779,843
 
 
 
8

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Allowance for Loan Loss
 
The Company maintains an allowance for loan loss at a level that is appropriate to absorb probable losses inherent in credit card receivables. The allowance for loan loss covers forecasted uncollectable principal as well as unpaid interest and fees. The allowance for loan loss is evaluated monthly for adequacy.
 
In estimating the allowance for principal loan losses, management utilizes a migration analysis of delinquent and current credit card receivables. Migration analysis is a technique used to estimate the likelihood that a credit card receivable will progress through the various stages of delinquency and to charge-off. The allowance is maintained through an adjustment to the provision for loan losses. Charge-offs of principal amounts, net of recoveries are deducted from the allowance.
 
Net charge-offs include the principal amount of losses from credit cardholders unwilling or unable to pay their account balances, as well as bankrupt and deceased credit cardholders, less recoveries and exclude charged-off interest, fees and fraud losses. Charged-off interest and fees reduce finance charges, net while fraud losses are recorded as an expense. Credit card receivables, including unpaid interest and fees, are charged-off at the end of the month during which an account becomes 180 days contractually past due, except in the case of customer bankruptcies or death. Credit card receivables, including unpaid interest and fees, associated with customer bankruptcies or death are charged-off at the end of each month subsequent to 60 days after the receipt of notification of the bankruptcy or death, but in any case, not later than the 180-day contractual time frame.
 
The Company records the actual charge-offs for unpaid interest and fees as a reduction to finance charges, net. Actual charge-offs for unpaid interest and fees were $44.3 million and $43.3 million for the three months ended September 30, 2012 and 2011, respectively, and $137.5 million and $147.8 million for the nine months ended September 30, 2012 and 2011, respectively. In estimating the allowance for uncollectable unpaid interest and fees, the Company utilizes historical charge-off trends, analyzing actual charge-offs for the prior three months. The allowance is maintained through an adjustment to finance charges, net.
 
In evaluating the allowance for loan loss for both principal and unpaid interest and fees, management also considers factors that may impact loan loss experience, including seasoning, loan volume and amounts, payment rates and forecasting uncertainties. The following table presents the Company’s allowance for loan loss for the periods indicated:
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands)
 
Balance at beginning of period
 
$
432,521
   
$
461,015
   
$
468,321
   
$
518,069
 
Provision for loan loss
   
81,250
     
70,697
     
183,129
     
198,739
 
Change in estimate for uncollectible unpaid interest and fees
   
     
(5,000
           
(5,000
Recoveries
   
22,088
     
20,858
     
74,802
     
68,600
 
Principal charge-offs
   
(87,309
)
   
(93,905
)
   
(277,702
)
   
(326,743
)
Other
   
(8
)
   
(5,000
)
   
(8
)
   
(5,000
Balance at end of period
 
$
448,542
   
$
448,665
   
$
448,542
   
$
448,665
 
 
Delinquencies
 
A credit card account is contractually delinquent if the Company does not receive the minimum payment by the specified due date on the cardholder’s statement. It is the Company’s policy to continue to accrue interest and fee income on all credit card accounts beyond 90 days, except in limited circumstances, until the credit card account balance and all related interest and other fees are paid or charged off, typically at 180 days delinquent. When an account becomes delinquent, a message is printed on the credit cardholder’s billing statement requesting payment. After an account becomes 30 days past due, a proprietary collection scoring algorithm automatically scores the risk of the account becoming further delinquent. The collection system then recommends a collection strategy for the past due account based on the collection score and account balance and dictates the contact schedule and collections priority for the account. If the Company is unable to make a collection after exhausting all in-house collection efforts, the Company may engage collection agencies and outside attorneys to continue those efforts.
 
 
9

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The following table presents the delinquency trends of the Company’s credit card portfolio:
 
   
September 30,
2012
   
% of
Total
   
December 31,
2011
   
% of
Total
 
           
(In thousands, except percentages)
         
Receivables outstanding – principal
 
$
6,260,239
     
100
%
 
$
5,408,862
     
100
%
Principal receivables balances contractually delinquent:
                               
31 to 60 days
   
96,159
     
1.5
%
   
78,272
     
1.4
%
61 to 90 days
   
58,626
     
0.9
     
51,709
     
1.0
 
91 or more days
   
109,602
     
1.8
     
105,626
     
2.0
 
Total
 
$
264,387
     
4.2
%
 
$
235,607
     
4.4
%
 
Modified Credit Card Receivables
 
The Company holds certain credit card receivables for which the terms have been modified. The Company’s modified credit card receivables include credit card receivables for which temporary hardship concessions have been granted and credit card receivables in permanent workout programs. These modified credit card receivables include concessions consisting primarily of a reduced minimum payment and an interest rate reduction. The temporary programs’ concessions remain in place for a period no longer than twelve months, while the permanent programs remain in place through the payoff of the credit card receivables if the credit cardholder complies with the terms of the program. These concessions do not include the forgiveness of unpaid principal, but may involve the reversal of certain unpaid interest or fee assessments. In the case of the temporary programs, at the end of the concession period, credit card receivable terms revert to standard rates. These arrangements are automatically terminated if the customer fails to make payments in accordance with the terms of the program, at which time their account reverts back to its original terms.
 
Credit card receivables for which temporary hardship and permanent concessions were granted are collectively evaluated for impairment. Modified credit card receivables are evaluated at their present value with impairment measured as the difference between the credit card receivable balance and the discounted present value of cash flows expected to be collected. Consistent with the Company’s measurement of impairment of modified credit card receivables on a pooled basis, the discount rate used for credit card receivables is the average current annual percentage rate the Company applies to non-impaired credit card receivables, which approximates what would have been applied to the pool of modified credit card receivables prior to impairment. In assessing the appropriate allowance for loan loss, these modified credit card receivables are included in the general pool of credit cards with the allowance determined under the contingent loss model of ASC 450-20, “Loss Contingencies.” If the Company applied accounting under ASC 310-40, “Troubled Debt Restructurings by Creditors,” to the modified credit card receivables in these programs, there would not be a material difference in the allowance for loan loss.
 
The Company had $113.5 million and $122.2 million, respectively, as a recorded investment in impaired credit card receivables with an associated allowance for loan loss of $41.8 million and $45.3 million, respectively, as of September 30, 2012 and December 31, 2011. These modified credit card receivables represented less than 3% of the Company’s total credit card receivables as of September 30, 2012 and December 31, 2011, respectively.
 
The average recorded investment in the impaired credit card receivables was $111.7 million and $129.0 million for the three months ended September 30, 2012 and 2011, respectively, and $114.3 million and $133.2 million for the nine months ended September 30, 2012 and 2011, respectively.
 
Interest income on these modified credit card receivables is accounted for in the same manner as other accruing credit card receivables. Cash collections on these modified credit card receivables are allocated according to the same payment hierarchy methodology applied to credit card receivables that are not in such programs. The Company recognized $3.0 million and $3.4 million for the three months ended September 30, 2012 and 2011, respectively, and $9.1 million and $10.5 million for the nine months ended September 30, 2012 and 2011, respectively, in interest income associated with modified credit card receivables during the period that such credit card receivables were impaired.
 
 
10

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The following tables provide information on credit card receivables that entered into a modification program during the specified periods:
 
   
Three Months Ended September 30, 2012
   
Nine Months Ended September 30, 2012
 
   
Number of Restructurings
   
Pre-modification Outstanding Principal Balance
   
Post-modification
Outstanding Principal Balance
   
Number of Restructurings
   
Pre-modification Outstanding Principal Balance
   
Post-modification
Outstanding Principal Balance
 
     
(Dollars in thousands)
 
Troubled debt restructurings – credit card receivables
   
35,000
   
$
31,267
   
$
31,248
     
95,039
   
$
85,422
   
$
85,316
 
                                                 
 
   
Three Months Ended September 30, 2011
   
Nine Months Ended September 30, 2011
 
   
Number of Restructurings
   
Pre-modification Outstanding Principal Balance
   
Post-modification
Outstanding Principal Balance
   
Number of Restructurings
   
Pre-modification Outstanding Principal Balance
   
Post-modification
Outstanding Principal Balance
 
     
(Dollars in thousands)
 
Troubled debt restructurings – credit card receivables
   
36,576
   
$
32,665
   
$
32,655
     
119,614
   
$
104,483
   
$
102,419
 
                                                 
 
The tables below summarize troubled debt restructurings that have defaulted in the specified periods where the default occurred within 12 months of their modification date:
 
   
Three Months Ended
September 30, 2012
   
Nine Months Ended
September 30, 2012
 
   
Number of Restructurings
   
Outstanding Balance
   
Number of Restructurings
   
Outstanding Balance
 
   
(Dollars in thousands)
 
Troubled debt restructurings, defaulted – credit card receivables
   
12,764
   
$
12,363
     
41,971
   
$
40,524
 
                                 
 
   
Three Months Ended
September 30, 2011
   
Nine Months Ended
September 30, 2011
 
   
Number of Restructurings
   
Outstanding Balance
   
Number of Restructurings
   
Outstanding Balance
 
   
(Dollars in thousands)
 
Troubled debt restructurings, defaulted – credit card receivables
   
18,538
   
$
17,850
     
56,933
   
$
56,267
 
                                 
 
 
11

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Age of Credit Card Receivables
 
The following table sets forth, as of September 30, 2012, the number of active credit card accounts with balances and the related principal balances outstanding, based upon the age of the active credit card accounts from origination:
 
Age Since Origination
 
Number of
Active Accounts
with Balances
   
Percentage of
Active Accounts
with Balances
   
Principal
Receivables
Outstanding
   
Percentage of Receivables
Outstanding
 
   
(In thousands, except percentages)
 
0-12 Months
   
3,838
     
25.7
%
 
$
1,388,049
     
22.2
%
13-24 Months
   
1,944
     
13.0
     
733,807
     
11.7
 
25-36 Months
   
1,424
     
9.5
     
621,926
     
9.9
 
37-48 Months
   
1,139
     
7.6
     
565,294
     
9.0
 
49-60 Months
   
944
     
6.3
     
436,518
     
7.0
 
Over 60 Months
   
5,668
     
37.9
     
2,514,645
     
40.2
 
Total
   
14,957
     
100.0
%
 
$
6,260,239
     
100.0
%
 
Credit Quality
 
The Company uses proprietary scoring models developed specifically for the purpose of monitoring the Company’s obligor credit quality. The proprietary scoring models are used as a tool in the underwriting process and for making credit decisions. The proprietary scoring models are based on historical data and require various assumptions about future performance. Information regarding customer performance is factored into these proprietary scoring models to determine the probability of an account becoming 90 or more days past due at any time within the next 12 months. Obligor credit quality is monitored at least monthly during the life of an account. The following table reflects composition of the Company’s credit card receivables by obligor credit quality as of September 30, 2012:
 
Probability of an Account Becoming 90 or More Days Past Due or Becoming Charged-off (within the next 12 months)
 
Total Principal
Receivables Outstanding
   
Percentage of Principal
Receivables Outstanding
 
   
(In thousands, except percentages)
 
No Score(1) 
 
$
290,008
     
4.6
%
27.1% and higher
   
257,032
     
4.1
 
17.1% - 27.0%
   
545,755
     
8.7
 
12.6% - 17.0%
   
625,436
     
10.0
 
3.7% - 12.5%
   
2,521,231
     
40.3
 
1.9% - 3.6%
   
1,322,943
     
21.1
 
Lower than 1.9%
   
697,834
     
11.2
 
Total
 
$
6,260,239
     
100.0
%
                     
 
 (1)
Included in the No Score information is The Talbots, Inc. credit card portfolio, whose accounts have yet to be converted to the Company’s credit card processing system. The conversion is expected to be completed in the first quarter of 2013.
 
Credit Card Portfolio Acquisitions
 
During the nine months ended September 30, 2012, the Company acquired the following credit card portfolios:
 
 
• 
March 2012 – Pier 1 Imports, for a total purchase price of $97.7 million, which consisted of $96.2 million of credit card receivables and $1.5 million of intangible assets;
 
 
• 
May 2012 – Premier Designs, Inc., for a total purchase price of $24.3 million, which consisted of $22.9 million of credit card receivables and $1.4 million of intangible assets;
 
 
• 
July 2012 – The Bon-Ton Stores, Inc., for a preliminary total purchase price of $494.6 million, which remains subject to customary purchase price adjustments and consists of $444.9 million of credit card receivables and $49.7 million of intangible assets; and
 
 
• 
August 2012 – The Talbots, Inc., for a preliminary total purchase price of $163.6 million, which remains subject to customary purchase price adjustments and consists of $136.5 million of credit card receivables and $27.1 million of intangible assets.
 
The credit card receivables and intangible assets associated with these portfolios are included in the September 30, 2012 unaudited condensed consolidated balance sheet.
 
 
12

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Securitized Credit Card Receivables
 
The Company regularly securitizes its credit card receivables through its credit card securitization trusts, consisting of World Financial Network Credit Card Master Trust, World Financial Network Credit Card Master Note Trust, World Financial Network Credit Card Master Note Trust II and World Financial Network Credit Card Master Trust III (collectively, the “WFN Trusts”), and World Financial Capital Credit Card Master Note Trust (the “WFC Trust”). The Company continues to own and service the accounts that generate credit card receivables held by the WFN Trusts and the WFC Trust. In its capacity as a servicer, each of the respective banks earns a fee from the WFN Trusts and the WFC Trust to service and administer the credit card receivables, collect payments, and charge-off uncollectable receivables. These fees are eliminated and therefore are not reflected in the unaudited condensed consolidated statements of income for the three and nine months ended September 30, 2012 and 2011.
 
The WFN Trusts and the WFC Trust are variable interest entities (“VIEs”) and the assets of these consolidated VIEs include certain credit card receivables that are restricted to settle the obligations of those entities and are not expected to be available to the Company or its creditors. The liabilities of the consolidated VIEs include asset-backed secured borrowings and other liabilities for which creditors or beneficial interest holders do not have recourse to the general credit of the Company.
 
The tables below present quantitative information about the components of total securitized credit card receivables, delinquencies and net charge-offs:
 
   
September 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Total credit card receivables – restricted for securitization investors
 
$
5,838,099
   
$
4,886,168
 
Principal amount of credit card receivables – restricted for securitization investors, 90 days or more past due
 
$
102,194
   
$
94,981
 
 
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
2012
   
2011
 
2012
   
2011
 
   
(In thousands)
 
Net charge-offs of securitized principal
 
$
61,441
   
$
65,993
 
$
184,886
   
$
231,919
 
                               
 
4. REDEMPTION SETTLEMENT ASSETS
 
Redemption settlement assets consist of cash and cash equivalents and securities available-for-sale and are designated for settling redemptions by collectors of the AIR MILES® Reward Program in Canada under certain contractual relationships with sponsors of the AIR MILES Reward Program. These assets are primarily denominated in Canadian dollars. Realized gains and losses from the sale of investment securities were not material. The principal components of redemption settlement assets, which are carried at fair value, are as follows:
 
   
September 30, 2012
   
December 31, 2011
 
   
Cost
   
Unrealized
Gains
   
Unrealized
Losses
   
Fair Value
   
Cost
   
Unrealized
Gains
   
Unrealized
Losses
   
Fair Value
 
   
(In thousands)
 
Cash and cash equivalents
 
$
14,420
   
$
   
$
   
$
14,420
   
$
35,465
   
$
   
$
   
$
35,465
 
Government bonds
   
5,166
     
82
     
     
5,248
     
4,948
     
152
     
     
5,100
 
Corporate bonds
   
464,745
     
11,337
     
(51
)
   
476,031
     
468,894
     
7,416
     
(1,037
)
   
475,273
 
Total
 
$
484,331
   
$
11,419
   
$
(51
)
 
$
495,699
   
$
509,307
   
$
7,568
   
$
(1,037
)
 
$
515,838
 
 
 
13

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The following tables show the gross unrealized losses and fair value for those investments that were in an unrealized loss position as of September 30, 2012 and December 31, 2011, aggregated by investment category and the length of time that individual securities have been in a continuous loss position:
 
   
Less than 12 months
   
September 30, 2012
12 Months or Greater
   
Total
 
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
 
   
(In thousands)
 
Corporate bonds
 
$
   
$
   
$
5,039
   
$
(51
)
 
$
5,039
   
$
(51
)
Total
 
$
   
$
   
$
5,039
   
$
(51
)
 
$
5,039
   
$
(51
)
 
 
   
Less than 12 months
   
December 31, 2011
12 Months or Greater
   
Total
 
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
 
   
(In thousands)
 
Corporate bonds
 
$
65,043
   
$
(444
)
 
$
18,124
   
$
(593
)
 
$
83,167
   
$
(1,037
)
Total
 
$
65,043
   
$
(444
)
 
$
18,124
   
$
(593
)
 
$
83,167
   
$
(1,037
)
 
Market values were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the security’s issuer, and the Company’s intent to sell the security and whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis. The Company typically invests in highly-rated securities with low probabilities of default and has the ability to hold the investments until maturity. As of September 30, 2012, the Company does not consider the investments to be other-than-temporarily impaired.
 
The net carrying value and estimated fair value of the securities at September 30, 2012 by contractual maturity are as follows:
 
   
Amortized
Cost
   
Estimated
Fair Value
 
   
(In thousands)
 
Due in one year or less
 
$
91,602
   
$
91,935
 
Due after one year through five years
   
392,729
     
403,764
 
Total
 
$
484,331
   
$
495,699
 
 
 
14

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
5. INTANGIBLE ASSETS AND GOODWILL
 
Intangible Assets
 
Intangible assets consist of the following:
 
   
September 30, 2012
   
   
Gross
Assets
   
Accumulated
Amortization
   
Net
 
Amortization Life and Method
   
(In thousands)
   
Finite Lived Assets
                   
Customer contracts and lists
 
$
289,500
   
$
(140,589
)
 
$
148,911
 
3 - 12 years—straight line
Premium on purchased credit card portfolios
   
234,894
     
(98,574
)
   
136,320
 
5 - 10 years—straight line, accelerated
Customer database
   
161,700
     
(97,825
)
   
63,875
 
4 - 10 years—straight line
Collector database
   
71,153
     
(64,253
)
   
6,900
 
30 years—15% declining balance
Tradenames
   
37,644
     
(9,148
)
   
28,496
 
5 - 15 years—straight line
Purchased data lists
   
21,643
     
(15,395
)
   
6,248
 
1 - 5 years—straight line, accelerated
Noncompete agreements
   
     
     
 
2 years—straight line
   
$
816,534
   
$
(425,784
)
 
$
390,750
   
Indefinite Lived Assets
                         
Tradenames
   
12,350
     
     
12,350
 
Indefinite life
Total intangible assets
 
$
828,884
   
$
(425,784
)
 
$
403,100
   
 
 
   
December 31, 2011
   
   
Gross
Assets
   
Accumulated
Amortization
   
Net
 
Amortization Life and Method
   
(In thousands)
   
Finite Lived Assets
                   
Customer contracts and lists
 
$
314,245
   
$
(140,622
)
 
$
173,623
 
3 - 12 years—straight line
Premium on purchased credit card portfolios
   
156,203
     
(82,988
)
   
73,215
 
5 - 10 years—straight line, accelerated
Customer database
   
175,377
     
(96,363
)
   
79,014
 
4 - 10 years—straight line
Collector database
   
68,652
     
(61,091
)
   
7,561
 
30 years—15% declining balance
Tradenames
   
38,155
     
(7,411
)
   
30,744
 
5 - 15 years—straight line
Purchased data lists
   
23,776
     
(16,712
)
   
7,064
 
1 - 5 years—straight line, accelerated
Noncompete agreements
   
1,045
     
(970
)
   
75
 
2 years—straight line
   
$
777,453
   
$
(406,157
)
 
$
371,296
   
Indefinite Lived Assets
                         
Tradenames
   
12,350
     
     
12,350
 
Indefinite life
Total intangible assets
 
$
789,803
   
$
(406,157
)
 
$
383,646
   
 
With the credit card portfolio acquisitions made during the nine months ended September 30, 2012, the Company acquired $79.7 million of intangible assets consisting of $42.4 million of customer relationships being amortized over a weighted average life of 5.0 years and $37.3 million of marketing relationships being amortized over a weighted average life of 6.6 years. See Note 3, “Credit Card Receivables,” of the Notes to Unaudited Condensed Consolidated Financial Statements for additional information related to the credit card portfolio acquisitions.
 
Goodwill
 
The changes in the carrying amount of goodwill for the nine months ended September 30, 2012 are as follows:
 
   
LoyaltyOne®
   
Epsilon®
   
Private Label
Services and
Credit
   
Corporate/
Other
   
Total
 
   
(In thousands)
 
December 31, 2011
 
$
241,697
   
$
945,934
   
$
261,732
   
$
   
$
1,449,363
 
Effects of foreign currency translation
   
8,394
     
943
     
     
     
9,337
 
September 30, 2012
 
$
250,091
   
$
946,877
   
$
261,732
   
$
   
$
1,458,700
 
 
 
15

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
6. DEBT
 
Debt consists of the following:
 
Description
 
September 30,
2012
   
December 31,
2011
 
Maturity
 
Interest Rate
   
(Dollars in thousands)
       
Deposits:
                     
Certificates of deposit
 
$
1,690,623
   
$
1,353,775
 
Various - October 2012 – September 2019
 
0.20% to 5.25%
Money market deposits
   
145,029
     
 
On demand
 
0.01% to 0.23%
Total deposits
   
1,835,652
     
1,353,775
       
Less: current portion
   
(984,798
)
   
(642,567
)
     
Long-term portion
 
$
850,854
   
$
711,208
       
                   
Asset-backed securities debt – owed to securitization investors:
                     
Fixed rate asset-backed term note securities
 
$
2,069,515
   
$
1,562,815
 
Various - October 2012 – March 2019
 
1.68% to 7.00%
Floating rate asset-backed term note securities
   
588,150
     
703,500
 
Various - October 2012 – April 2013
 
(1)
Conduit asset-backed securities
   
857,451
     
993,972
 
Various - May 2013 – March 2014
 
1.23% to 1.76%
Total asset-backed securities – owed to securitization investors
   
3,515,116
     
3,260,287
       
Less: current portion
   
(1,420,866
)
   
(1,694,198
)
     
Long-term portion
 
$
2,094,250
   
$
1,566,089
       
                   
Long-term and other debt:
                 
2011 credit facility
 
$
   
$
410,000
 
May 2016
 
—%
2011 term loan
   
891,666
     
782,594
 
May 2016 or May 2017
 
(2)
Senior notes due 2020
   
500,000
     
 
April 2020
 
6.38%
Convertible senior notes due 2013
   
753,999
     
711,480
 
August 2013
 
1.75%
Convertible senior notes due 2014
   
297,761
     
279,365
 
May 2014
 
4.75%
Capital lease obligations
   
19
     
35
 
July 2013
 
7.10%
Total long-term and other debt
   
2,443,445
     
2,183,474
       
Less: current portion
   
(782,706
)
   
(19,834
)
     
Long-term portion
 
$
1,660,739
   
$
2,163,640
       
                         
 
(1)
Interest rates include those for certain of the Company’s asset-backed securities – owed to securitization investors where floating rate debt is fixed through interest rate swap agreements. The interest rate for the floating rate debt is equal to the London Interbank Offered Rate plus a margin of 0.1% to 2.5%, each as defined in the respective agreements. The weighted average interest rate of the fixed rate achieved through interest rate swap agreements is 5.64% at September 30, 2012.
 
(2)
At September 30, 2012, the weighted average interest rate for the 2011 Term Loan was 2.22%.
 
At September 30, 2012, the Company was in compliance with its covenants.
 
Deposits
 
Beginning January 1, 2012, Comenity Bank and Comenity Capital Bank, subsidiaries of the Company, offered a demand deposit program through contractual arrangements with securities brokerage firms. As of September 30, 2012, Comenity Bank and Comenity Capital Bank had issued $145.0 million in money market deposits. Money market deposits are redeemable on demand by the customer and, as such, have no scheduled maturity date.
 
Credit Agreement
 
The Company, as borrower, and ADS Alliance Data Systems, Inc., ADS Foreign Holdings, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Marketing Services, LLC, Epsilon Data Management LLC, Comenity LLC and Alliance Data FHC, Inc., as guarantors, are party to a credit agreement that originally provided for a $792.5 million term loan (the “2011 Term Loan”) and a $792.5 million revolving line of credit (the “2011 Credit Facility”).
 
In March 2012, the Company entered into a second amendment (the “Second Amendment”) to its credit agreement, dated May 24, 2011 (the “Credit Agreement”), through which the Company increased its 2011 Credit Facility by $125.0 million to $917.5 million. In addition, in March 2012, the Company borrowed additional term loans in the aggregate principal amount of $125.5 million, increasing the 2011 Term Loan to $903.1 million.
 
 
16

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The Second Amendment, among other things, (i) extends the maturity date of certain term loans under the Credit Agreement from May 24, 2016 to May 24, 2017, (ii) creates a mechanism by which in the future non-extending term loan lenders may extend their term loans to May 24, 2017, (iii) reflects the additional term loans and the increase in the revolving credit commitments and (iv) provides for aggregate principal payments equal to 5% of the extended term loan amount in the additional year of the extended term loans, payable in equal quarterly installments. Total availability under the 2011 Credit Facility at September 30, 2012 was $917.5 million.
 
Senior Notes Due 2020
 
In March 2012, the Company issued and sold $500 million aggregate principal amount of 6.375% senior notes due April 1, 2020 (the “Senior Notes due 2020”). The Senior Notes due 2020 accrue interest on the principal amount at the rate of 6.375% per annum from March 29, 2012, payable semiannually in arrears, on April 1 and October 1 of each year, beginning on October 1, 2012.
 
The payment obligations under the Senior Notes due 2020 are governed by an indenture dated March 29, 2012 with Wells Fargo Bank, N.A., as trustee. The Senior Notes due 2020 are unsecured and are guaranteed on a senior unsecured basis by certain of the Company’s existing and future domestic subsidiaries that guarantee its Credit Agreement, initially ADS Alliance Data Systems, Inc., ADS Foreign Holdings, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Marketing Services, LLC, Epsilon Data Management LLC, Comenity LLC and Alliance Data FHC, Inc. The indenture includes usual and customary negative covenants and events of default for transactions of this type.
 
Convertible Senior Notes
 
The Company has outstanding $1.15 billion of convertible senior notes, consisting of $805.0 million scheduled to mature on August 1, 2013 and $345.0 million scheduled to mature on May 15, 2014. The table below summarizes the carrying value of the components of the convertible senior notes:
 
   
September 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Carrying amount of equity component
 
$
368,678
   
$
368,678
 
                 
Principal amount of liability component
 
$
1,150,000
   
$
1,150,000
 
Unamortized discount
   
(98,240
)
   
(159,155
)
Net carrying value of liability component
 
$
1,051,760
   
$
990,845
 
                 
If-converted value of common stock
 
$
2,485,284
   
$
1,818,048
 
 
The discount on the liability component will be amortized as interest expense over the remaining life of the convertible senior notes which, at September 30, 2012, is a weighted average period of 1.1 years.
 
Interest expense on the convertible senior notes recognized in the Company’s unaudited condensed consolidated statements of income for the three and nine months ended September 30, 2012 and 2011 is as follows:
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
2012
   
2011
 
2012
   
2011
 
   
(In thousands, except percentages)
 
Interest expense calculated on contractual interest rate
 
$
7,619
   
$
7,619
 
$
22,856
   
$
22,856
 
Amortization of discount on liability component
   
20,865
     
18,692
   
60,915
     
54,574
 
Total interest expense on convertible senior notes
 
$
28,484
   
$
26,311
 
$
83,771
   
$
77,430
 
                               
Effective interest rate (annualized)
   
11.0
%
   
11.0
%
 
11.0
%
   
11.0
%
 
In the third quarter of 2012, the convertible senior notes were convertible at the option of the holder based on the condition that the common stock trading price exceeded 130% of the applicable conversion price. During the third quarter, a de minimis amount were surrendered for conversion and, in each case, either have been or will be settled in cash following the completion of the applicable cash settlement averaging period.
 
 
17

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Asset-backed Securities – Owed to Securitization Investors
 
Asset-backed Term Notes
 
In April 2012, World Financial Network Credit Card Master Note Trust issued $550.0 million of term asset-backed securities to investors. The offering consisted of $412.5 million of Class A Series 2012-A asset-backed term notes that have a fixed interest rate of 3.14% per year and mature in March 2019. In addition, the Company retained an aggregate of $137.5 million of subordinated classes of the term asset-backed notes which have been eliminated from the Company’s unaudited condensed consolidated financial statements.
 
In July 2012, $395.0 million of Class A Series 2009-B asset-backed term notes with a fixed interest rate of 3.79% matured.
 
In July 2012, World Financial Network Credit Card Master Note Trust issued $433.3 million of term asset-backed securities to investors. The offering consisted of $325.0 million of Class A Series 2012-B asset-backed term notes that have a fixed interest rate of 1.76% per year and mature in July 2017. In addition, the Company retained an aggregate of $108.3 million of subordinated classes of the term asset-backed notes which have been eliminated from the Company’s unaudited condensed consolidated financial statements.
 
In July 2012, World Financial Network Credit Card Master Note Trust issued $266.7 million of term asset-backed securities to investors, which will mature in October 2018. The offering consisted of the following:
 
 
$200.0 million of Class A Series 2012-C asset-backed notes with a fixed interest rate of 2.23% per year;
 
 
$10.0 million of Class M Series 2012-C asset-backed notes with a fixed interest rate of 3.32% per year;
 
 
$12.7 million of Class B Series 2012-C asset-backed notes with a fixed interest rate of 3.57% per year;
 
 
$33.3 million of Class C Series 2012-C asset-backed notes with a fixed interest rate of 4.55% per year; and
 
 
$10.7 million of Class D Series 2012-C asset-backed notes which were retained by the Company and have been eliminated from the Company’s unaudited condensed consolidated financial statements.
 
Conduit Facilities
 
In June 2012, the Company renewed its $1.2 billion 2009-VFN conduit facility under World Financial Network Credit Card Master Note Trust, extending its maturity to March 5, 2014. Also, in June 2012, the Company renewed its 2009-VFN conduit facility under World Financial Capital Master Note Trust, extending the maturity to May 31, 2013 and increasing the total capacity from $275.0 million to $375.0 million.
 
In September 2012, the Company renewed its $330.0 million 2009-VFC1 conduit facility under World Financial Network Credit Card Master Note Trust III, extending its maturity to September 27, 2013.
 
Derivative Financial Instruments
 
As part of its interest rate risk management program, the Company may enter into derivative financial instruments with institutions that are established dealers to manage its exposure to changes in interest rates for certain obligations.
 
The credit card securitization trusts enter into derivative financial instruments, which include both interest rate swaps and an interest rate cap, to mitigate their interest rate risk on a related financial instrument or to lock the interest rate on a portion of their variable asset-backed securities debt.
 
These interest rate contracts involve the receipt of variable rate amounts from counterparties in exchange for the Company making fixed rate payments over the life of the agreement without the exchange of the underlying notional amount. These interest rate contracts are not designated as hedges. Such contracts are not speculative and are used to manage interest rate risk, but do not meet the specific hedge accounting requirements of ASC 815, “Derivatives and Hedging.”
 
 
18

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The following tables identify the notional amount, fair value and classification of the Company’s outstanding interest rate contracts at September 30, 2012 and December 31, 2011 in the unaudited condensed consolidated balance sheets:
 
   
September 30, 2012
    December 31, 2011  
   
Notional Amount
   
Weighted Average Years to Maturity
    Notional Amount    
Weighted Average Years to Maturity
 
   
(Dollars in thousands)
Interest rate contracts not designated as hedging instruments
 
$
588,150
    0.72  
$
703,500
    1.37  
                               
 
   
September 30, 2012
    December 31, 2011  
   
Balance Sheet
Location
   
Fair Value
 
  Balance Sheet
Location
   
Fair Value
 
   
(In thousands)
Interest rate contracts not designated as hedging instruments
 
Other assets
   
$
5
 
Other assets
   
$
 
Interest rate contracts not designated as hedging instruments
 
Other current liabilities
   
$
15,436
 
Other current liabilities
   
$
4,739
 
Interest rate contracts not designated as hedging instruments
 
Other liabilities
   
$
 
Other liabilities
   
$
33,364
 
                               
 
The following table summarizes activity related to and identifies the location of the Company’s outstanding interest rate contracts for the three and nine months ended September 30, 2012 and 2011 recognized in the unaudited condensed consolidated statements of income:
 
   
2012
  2011  
For the three months ended September 30,
 
Income Statement
Location
   
Gain on Derivative Contracts
 
Income Statement
Location
   
Gain on Derivative Contracts
 
   
(In thousands)
 
Interest rate contracts not designated as hedging instruments
 
Securitization
funding costs
   
$
7,488
 
Securitization
funding costs
   
$
8,543
 
                               
For the nine months ended September 30,
                             
Interest rate contracts not designated as hedging instruments
 
Securitization
funding costs
   
$
22,672
 
Securitization
funding costs
   
$
23,146
 
                               
 
The Company limits its exposure on derivatives by entering into contracts with institutions that are established dealers who maintain certain minimum credit criteria established by the Company. At September 30, 2012, the Company does not maintain any derivative contracts subject to master agreements that would require the Company to post collateral or that contain any credit-risk related contingent features. The Company has provisions in certain of the master agreements that require counterparties to post collateral to the Company when their credit ratings fall below certain thresholds. At September 30, 2012, these thresholds were not breached and no amounts were held as collateral by the Company.
 
 
19

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
7. DEFERRED REVENUE
 
Because management has determined that the earnings process is not complete at the time an AIR MILES reward mile is issued, the recognition of revenue on all fees received at issuance is deferred. The Company allocates the proceeds from the issuance of AIR MILES reward miles into two components as follows:
 
 
• 
Redemption element. The redemption element is the larger of the two components. Revenue related to the redemption element is based on the estimated fair value. For this component, revenue is recognized at the time an AIR MILES reward mile is redeemed, or for those AIR MILES reward miles that are estimated to go unredeemed by the collector base, known as “breakage,” over the estimated life of an AIR MILES reward mile, or a period of 42 months. The Company’s estimate of breakage is 28%.
 
 
• 
Service element. The service element consists of marketing and administrative services. Revenue related to the service element is determined in accordance with ASU 2009-13, “Multiple Deliverable Revenue Arrangements.” It is initially deferred and then amortized pro rata over the estimated life of an AIR MILES reward mile. With the adoption of ASU 2009-13, the residual method will no longer be utilized for new sponsor agreements entered into on or after January 1, 2011 or existing sponsor agreements that are materially modified subsequent to that date; for these agreements, the Company will measure the service element at its estimated selling price.
 
Under certain of the Company’s contracts, a portion of the proceeds is paid to the Company upon the issuance of an AIR MILES reward mile and a portion is paid at the time of redemption and therefore, the Company does not have a redemption obligation related to these contracts. Revenue is recognized at the time of redemption and is not reflected in the reconciliation of the redemption obligation detailed below. Under such contracts, the proceeds received at issuance are initially deferred as service revenue and revenue is recognized pro rata over the estimated life of an AIR MILES reward mile. Amounts for revenue related to the redemption element and service element are recorded in redemption revenue and transaction revenue, respectively, in the unaudited condensed consolidated statements of income.
 
A reconciliation of deferred revenue for the AIR MILES Reward Program is as follows:
 
   
Deferred Revenue
 
   
Service
   
Redemption
   
Total
 
   
(In thousands)
 
December 31, 2011
 
$
358,973
   
$
867,463
   
$
1,226,436
 
Cash proceeds
   
168,367
     
404,743
     
573,110
 
Revenue recognized
   
(151,492
)
   
(458,324
)
   
(609,816
)
Other
   
     
366
     
366
 
Effects of foreign currency translation
   
13,393
     
30,601
     
43,994
 
September 30, 2012
 
$
389,241
   
$
844,849
   
$
1,234,090
 
Amounts recognized in the unaudited condensed consolidated balance sheets:
                       
Current liabilities
 
$
186,987
   
$
844,849
   
$
1,031,836
 
Non-current liabilities
 
$
202,254
   
$
   
$
202,254
 
 
Effective from December 31, 2011, LoyaltyOne implemented an expiry policy, with all existing and future AIR MILES reward miles having an expiry of five years.
 
In December 2011, LoyaltyOne introduced a new program option, AIR MILES Cash, to which collectors, beginning in the first quarter of 2012, can allocate some or all of their future AIR MILES reward miles collected. Effective March 2012, AIR MILES Cash enabled collectors to instantly redeem their AIR MILES reward miles collected in this new program in-store towards purchases at participating sponsors. The implementation of AIR MILES Cash did not have a material impact to the Company.
 
 
20

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
8. STOCKHOLDERS’ EQUITY
 
Stock Repurchase Program
 
On December 13, 2011, the Company’s Board of Directors authorized a stock repurchase program to acquire up to $400.0 million of the Company’s outstanding common stock from January 1, 2012 through December 31, 2012, subject to any restrictions pursuant to the terms of the Company’s credit agreements or otherwise.
 
For the nine months ended September 30, 2012, the Company acquired a total of 536,241 shares of its common stock for $65.4 million. As of September 30, 2012, the Company has $334.6 million available under the stock repurchase program.
 
Stock Compensation Expense
 
Total stock-based compensation expense recognized in the Company’s unaudited condensed consolidated statements of income for the three and nine months ended September 30, 2012 and 2011 is as follows:
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
2012
   
2011
 
2012
   
2011
 
   
(In thousands)
 
Cost of operations
 
$
8,343
   
$
7,762
 
$
23,864
   
$
19,672
 
General and administrative
   
4,076
     
4,519
   
13,741
     
12,799
 
Total
 
$
12,419
   
$
12,281
 
$
37,605
   
$
32,471
 
 
During the nine months ended September 30, 2012, the Company awarded 328,759 performance-based restricted stock units with a weighted average grant date fair value per share of $120.00 as determined on the date of grant. The performance restriction on the awards will lapse upon determination by the Board of Directors or the Compensation Committee of the Board of Directors that the Company’s earnings before taxes for the period from January 1, 2012 to December 31, 2012 met certain pre-defined vesting criteria that permit a range from 50% to 150% of such performance-based restricted stock units to vest. Upon such determination, the restrictions will lapse with respect to 33% of the award on February 21, 2013, an additional 33% of the award on February 21, 2014 and the final 34% of the award on February 23, 2015, provided that the participant is employed by the Company on each such vesting date.
 
During the nine months ended September 30, 2012, the Company awarded 108,418 service-based restricted stock units with a weighted average grant date fair value per share of $122.10 as determined on the date of grant. Service-based restricted stock units typically vest ratably over three years provided that the participant is employed by the Company on each such vesting date.
 
9. FINANCIAL INSTRUMENTS
 
In accordance with ASC 825, “Financial Instruments,” the Company is required to disclose the fair value of financial instruments for which it is practical to estimate fair value. To obtain fair values, observable market prices are used if available. In some instances, observable market prices are not readily available and fair value is determined using present value or other techniques appropriate for a particular financial instrument. These techniques involve judgment and as a result are not necessarily indicative of the amounts the Company would realize in a current market exchange. The use of different assumptions or estimation techniques may have a material effect on the estimated fair value amounts.
 
 
21

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Fair Value of Financial Instruments  The estimated fair values of the Company’s financial instruments are as follows:
 
   
September 30, 2012
   
December 31, 2011
 
   
Carrying
Amount
   
Fair
Value
   
Carrying
Amount
   
Fair
Value
 
   
(In thousands)
 
Financial assets
                       
Cash and cash equivalents
 
$
766,317
   
$
766,317
   
$
216,213
   
$
216,213
 
Trade receivables, net
   
287,643
     
287,643
     
300,895
     
300,895
 
Credit card receivables, net
   
6,130,773
     
6,130,773
     
5,197,690
     
5,197,690
 
Redemption settlement assets, restricted
   
495,699
     
495,699
     
515,838
     
515,838
 
Cash collateral, restricted
   
62,205
     
62,205
     
158,727
     
158,727
 
Other investment securities
   
72,185
     
72,185
     
26,772
     
26,772
 
Derivative financial instruments
   
5
     
5