FORM 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

(Mark One)

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

     For the quarterly period ended September 30, 2010

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  þ    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  þ    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  þ

   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 Act).    Yes  ¨    No  þ

As of November 3, 2010, 51,995,538 shares of common stock were outstanding.

 

 

 


Table of Contents

 

ALLIANCE DATA SYSTEMS CORPORATION

INDEX

 

         Page
Number
 
Part I: FINANCIAL INFORMATION   
Item 1.  

Financial Statements (unaudited)

     3   
 

Condensed Consolidated Balance Sheets as of September 30, 2010 and December 31, 2009

     3   
 

Condensed Consolidated Statements of Income for the three and nine months ended September  30, 2010 and 2009

     4   
 

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009

     5   
 

Notes to Condensed Consolidated Financial Statements

     6   
Item 2.  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     30   
Item 3.  

Quantitative and Qualitative Disclosures About Market Risk

     50   
Item 4.  

Controls and Procedures

     50   
Part II: OTHER INFORMATION   
Item 1.  

Legal Proceedings

     52   
Item 1A.  

Risk Factors

     52   
Item 2.  

Unregistered Sales of Equity Securities and Use of Proceeds

     52   
Item 3.  

Defaults Upon Senior Securities

     52   
Item 4.  

(Removed and Reserved)

     52   
Item 5.  

Other Information

     52   
Item 6.  

Exhibits

     53   
SIGNATURES      55   

 

2


Table of Contents

 

PART I

 

Item 1. Financial Statements.

ALLIANCE DATA SYSTEMS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

 

     September 30,
2010
    December 31,
2009
 
     (In thousands)  
ASSETS     

Cash and cash equivalents

   $ 391,226      $ 213,378   

Trade receivables, less allowance for doubtful accounts ($5,256 and $6,736 at September 30, 2010 and December 31, 2009, respectively)

     234,570        225,212   

Seller’s interest

     —          297,108   

Credit card receivables:

    

Credit card receivables—restricted for securitization investors

     4,406,664        —     

Other credit card receivables

     539,227        671,182   
                

Total credit card receivables

     4,945,891        671,182   

Allowance for loan loss

     (514,296     (54,884
                

Credit card receivables, net

     4,431,595        616,298   

Deferred tax asset, net

     340,208        197,455   

Other current assets

     112,437        201,427   

Redemption settlement assets, restricted

     495,499        574,004   

Assets of discontinued operations

     18,028        34,623   
                

Total current assets

     6,023,563        2,359,505   

Property and equipment, net

     162,758        165,012   

Due from securitizations

     —          775,570   

Cash collateral, restricted

     205,359        216,953   

Intangible assets, net

     332,033        316,597   

Goodwill

     1,214,569        1,166,275   

Other non-current assets

     192,214        225,755   
                

Total assets

   $ 8,130,496      $ 5,225,667   
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Accounts payable

   $ 124,040      $ 103,891   

Accrued expenses

     132,105        128,012   

Certificates of deposit

     452,400        772,500   

Asset-backed securities debt—owed to securitization investors

     885,509        —     

Current debt

     262,751        51,963   

Other current liabilities

     92,345        88,716   

Deferred revenue

     1,013,116        984,930   
                

Total current liabilities

     2,962,266        2,130,012   

Deferred revenue

     167,733        161,216   

Deferred tax liability, net

     106,804        140,712   

Certificates of deposit

     514,400        692,500   

Asset-backed securities debt—owed to securitization investors

     2,476,315        —     

Long-term and other debt

     1,666,881        1,730,389   

Other liabilities

     190,330        98,062   
                

Total liabilities

     8,084,729        4,952,891   

Stockholders’ equity:

    

Common stock, $0.01 par value; authorized 200,000 shares; issued 92,746 shares and 91,121 shares at September 30, 2010 and December 31, 2009, respectively

     927        911   

Additional paid-in capital

     1,302,604        1,235,669   

Treasury stock, at cost (40,277 and 38,922 shares at September 30, 2010 and December 31, 2009, respectively)

     (2,007,844     (1,931,102

Retained earnings

     769,014        1,033,039   

Accumulated other comprehensive loss

     (18,934     (65,741
                

Total stockholders’ equity

     45,767        272,776   
                

Total liabilities and stockholders’ equity

   $ 8,130,496      $ 5,225,667   
                

See accompanying notes to unaudited condensed consolidated financial statements.

 

3


Table of Contents

 

ALLIANCE DATA SYSTEMS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME

 

    Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
    2010     2009     2010     2009  
    (In thousands, except per share amounts)  

Revenues

       

Transaction

  $ 68,150      $ 90,505      $ 214,092      $ 279,638   

Redemption

    120,424        120,779        386,810        346,935   

Securitization income

    —          98,723        —          315,345   

Finance charges, net

    327,677        16,268        953,303        45,278   

Database marketing fees and direct marketing services

    167,083        129,317        427,246        364,605   

Other revenue

    19,109        25,839        54,247        66,620   
                               

Total revenue

    702,443        481,431        2,035,698        1,418,421   

Operating expenses

       

Cost of operations

    384,301        326,578        1,102,128        974,438   

General and administrative

    19,767        30,143        63,440        77,176   

Provision for loan loss

    90,459        —          275,044        —     

Depreciation and other amortization

    17,196        15,364        50,101        45,715   

Amortization of purchased intangibles

    20,711        15,770        56,398        45,833   

Merger costs (reimbursements)

    —          30        —          (486
                               

Total operating expenses

    532,434        387,885        1,547,111        1,142,676   
                               

Operating income

    170,009        93,546        488,587        275,745   

Interest expense:

       

Securitization funding costs

    43,026        —          128,251        —     

Interest expense on certificates of deposit

    7,317        6,616        23,519        19,800   

Interest expense on long-term and other debt, net

    33,776        31,947        98,903        84,157   
                               

Total interest expense, net

    84,119        38,563        250,673        103,957   
                               

Income from continuing operations before income taxes

    85,890        54,983        237,914        171,788   

Provision for income taxes

    32,831        9,666        90,881        55,035   
                               

Income from continuing operations

    53,059        45,317        147,033        116,753   

Income (loss) from discontinued operations, net of taxes

    —          479        —          (13,666
                               

Net income

  $ 53,059      $ 45,796      $ 147,033      $ 103,087   
                               

Basic income (loss) per share:

       

Income from continuing operations

  $ 1.01      $ 0.86      $ 2.79      $ 2.05   

Income (loss) from discontinued operations

    —          0.01        —          (0.24
                               

Net income per share

  $ 1.01      $ 0.87      $ 2.79      $ 1.81   
                               

Diluted income (loss) per share:

       

Income from continuing operations

  $ 0.96      $ 0.82      $ 2.63      $ 2.01   

Income (loss) from discontinued operations

    —          0.01        —          (0.23
                               

Net income per share

  $ 0.96      $ 0.83      $ 2.63      $ 1.78   
                               

Weighted average shares:

       

Basic

    52,584        52,841        52,743        56,946   
                               

Diluted

    55,218        55,136        55,820        57,959   
                               

See accompanying notes to unaudited condensed consolidated financial statements.

 

4


Table of Contents

 

ALLIANCE DATA SYSTEMS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

    Nine Months Ended
September 30,
 
    2010     2009  
    (In thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES:

   

Net income

  $ 147,033      $ 103,087   

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

   

Depreciation and amortization

    106,499        91,649   

Deferred income taxes

    24,044        48,168   

Provision for loan loss

    275,044        44,252   

Non-cash stock compensation

    33,996        43,353   

Fair value loss on interest-only strip

    —          2,207   

Fair value loss on interest rate derivatives

    5,443        —     

Amortization of discount on convertible senior notes

    48,914        37,243   

Loss on the sale of assets

    —          18,018   

Change in operating assets and liabilities, net of acquisitions:

   

Change in trade accounts receivable

    (20,927     13,231   

Change in merchant settlement activity

    —          (18,907

Change in other assets

    36,975        (22,683

Change in accounts payable and accrued expenses

    33,220        (68,583

Change in deferred revenue

    9,079        (2,731

Change in other liabilities

    13,551        (20,526

Proceeds from the sale of credit card receivable portfolios to the securitization trusts

    —          53,240   

Excess tax benefits from stock-based compensation

    (12,713     (7,425

Other

    (6,654     (7,471
               

Net cash provided by operating activities

    693,504        306,122   

CASH FLOWS FROM INVESTING ACTIVITIES:

   

Change in redemption settlement assets

    21,964        29,744   

Change in seller’s interest

    —          (21,337

Change in credit card receivables

    273,925        (221,473

Change in cash collateral, restricted

    12,530        85,068   

Change in restricted cash

    24,064        (64,810

Change in due from securitizations

    —          (158,823

Capital expenditures

    (48,296     (39,706

Payments for acquired businesses, net of cash

    (117,000     —     

Proceeds from the sale of assets

    —          8,013   

Other

    (3,032     4,399   
               

Net cash provided by (used in) investing activities

    164,155        (378,925

CASH FLOWS FROM FINANCING ACTIVITIES:

   

Borrowings under debt agreements

    1,205,000        2,396,000   

Repayment of borrowings

    (1,089,549     (2,327,926

Proceeds from issuance of convertible senior notes due 2014

    —          345,000   

Issuances of certificates of deposit

    94,000        1,100,400   

Repayments of certificates of deposit

    (592,200     (609,400

Proceeds from asset-backed securities

    833,126        —     

Maturities of asset-backed securities

    (1,157,235     —     

Payment of capital lease obligations

    (17,272     (15,718

Payment of deferred financing costs

    (3,025     (21,407

Excess tax benefits from stock-based compensation

    12,713        7,425   

Proceeds from issuance of common stock

    31,848        23,780   

Proceeds from issuance of warrants

    —          30,050   

Payments for convertible note hedges

    —          (80,765

Payments for prepaid forward contracts

    —          (74,872

Purchase of treasury shares

    (76,742     (417,774
               

Net cash (used in) provided by financing activities

    (759,336     354,793   
               

Effect of exchange rate changes on cash and cash equivalents

    (2,028     10,720   
               

Change in cash and cash equivalents

    96,295        292,710   

Cash effect on adoption of ASC 860 and ASC 810

    81,553        —     

Cash and cash equivalents at beginning of period

    213,378        156,911   
               

Cash and cash equivalents at end of period

  $ 391,226      $ 449,621   
               

SUPPLEMENTAL CASH FLOW INFORMATION:

   

Interest paid

  $ 176,335      $ 58,579   
               

Income taxes paid, net

  $ 26,497      $ 53,890   
               

See accompanying notes to unaudited condensed consolidated financial statements.

 

5


Table of Contents

 

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. 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, 2009, filed with the SEC on March 1, 2010.

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. For purposes of comparability, certain prior period amounts have been reclassified to conform to the current year presentation. See Note 2, “Change in Accounting Principle,” for information on the adoption of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 860, “Transfers and Servicing,” and ASC 810, “Consolidation.”

In the first quarter of 2010, the Company reorganized its segments with Private Label Services and Private Label Credit reflected as one segment. All prior year segment information has been restated to conform to the current presentation. In addition, the Company renamed its other two segments from Epsilon Marketing Services and Loyalty Services to “Epsilon” and “LoyaltyOne,” respectively.

In February 2009, the Company sold the remainder of its utility services division, which was reflected as a discontinued operation. In November 2009, the Company terminated operations of its credit program for web and catalog retailer VENUE. Prior period information has been restated to reflect the termination of VENUE as a discontinued operation.

2. CHANGE IN ACCOUNTING PRINCIPLE

In June 2009, the FASB issued guidance codified in ASC 860 related to accounting for transfers of financial assets and ASC 810 related to the consolidation of variable interest entities (“VIEs”). ASC 860 removed the concept of qualifying special purpose entity (“QSPE”) and eliminated the consolidation exemption that was then available for QSPEs. ASC 810 requires an initial evaluation as well as an ongoing assessment of the Company’s involvement in the activities of World Financial Network Credit Card Master Trust (“Master Trust”), World Financial Network Credit Card Master Note Trust (“Master Trust I”), World Financial Network Credit Card Master Note Trust II (“Master Trust II”) and World Financial Network Credit Card Master Trust III (“Master Trust III”) (collectively, the “WFN Trusts”), and World Financial Capital Credit Card Master Note Trust (the “WFC Trust”) and the Company’s rights or obligations to receive benefits or absorb losses of the trusts that could be potentially significant in order to determine whether those VIEs are required to be consolidated on the balance

 

6


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

sheets of World Financial Network National Bank (“WFNNB”), World Financial Capital Bank (“WFCB”) or their affiliates, including ADSC.

On January 1, 2010, the Company adopted ASC 860 and ASC 810 on a prospective basis, resulting in the consolidation of the WFN Trusts and the WFC Trust. Based on the carrying amounts of the WFN Trusts’ and the WFC Trust’s assets and liabilities as prescribed by ASC 810, the Company recorded an increase in assets of approximately $3.4 billion, including $0.5 billion to loan loss reserves, an increase in liabilities of approximately $3.7 billion and a $0.4 billion decrease in stockholders’ equity.

After adoption, the Company’s consolidated statements of income no longer reflect securitization income, but instead reflect finance charges and certain other income associated with the securitized credit card receivables. Net charge-offs associated with credit card receivables impact the Company’s provision for loan loss reflected in the Company’s total operating expenses. Interest expense associated with debt issued from the WFN Trusts and the WFC Trust to third-party investors is reported in securitization funding costs. Additionally, the Company no longer records initial gains on new securitization activity since securitized credit card loans no longer receive sale accounting treatment, nor are there any gains or losses on the revaluation of the interest-only strip receivable, as that asset is not recognized in a transaction accounted for as a secured borrowing. Since the Company’s securitization transactions are accounted for under the new accounting rules as secured borrowings rather than asset sales, the cash flows from these transactions are presented as cash flows from financing activities rather than cash flows from operating or investing activities.

The assets of the consolidated VIEs include certain credit card receivables, which 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.

3. RECENT ACCOUNTING PRONOUNCEMENTS

In October 2009, the FASB issued Accounting Standards Update (“ASU”) 2009-13, “Multiple-Deliverable Revenue Arrangements,” which supersedes certain guidance in ASC 605-25, “Revenue Recognition — Multiple-Element Arrangements,” and requires an entity to allocate arrangement consideration at the inception of an arrangement to all of its deliverables based on their relative selling prices (the relative-selling-price method). ASU 2009-13 eliminates the use of the residual method of allocation in which the undelivered element is measured at its estimated selling price and the delivered element is measured as the residual of the arrangement consideration, and requires the relative-selling-price method in all circumstances in which an entity recognizes revenue for an arrangement with multiple deliverables subject to ASU 2009-13. ASU 2009-13 will be effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption is permitted. If the Company elects early adoption and the adoption is during an interim period, the Company will be required to apply this ASU retrospectively from the beginning of the Company’s fiscal year. The Company can also elect to apply this ASU retrospectively for all periods presented. The Company is currently evaluating the impact that the adoption of ASU 2009-13 will have on its consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures,” which amends ASC 820, “Fair Value Measurements and Disclosures,” to add separate disclosures about purchases, sales, issuances and settlements related to Level 3 measurements. The requirement to provide the Level 3 disclosures about purchases, sales, issuances and settlements will be effective for interim and annual periods beginning after December 15, 2010. The adoption of ASU 2010-06 for the separate Level 3 disclosures will only impact disclosures and will not have a material impact on the Company’s consolidated financial statements.

 

7


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

In July 2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses,” which amends ASC 310, “Receivables,” to require further disaggregated disclosures that improve financial statement users’ understanding of (1) the nature of an entity’s credit risk associated with its financing receivables and (2) the entity’s assessment of that risk in estimating its allowance for credit losses as well as changes in the allowance and the reasons for those changes. The new and amended disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The adoption of ASU 2010-20 will only impact disclosures and will not have a material impact on the Company’s consolidated financial statements.

4. 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,
 
     2010      2009      2010      2009  
     (In thousands, except per share amounts)  

Numerator

           

Income from continuing operations

   $ 53,059       $ 45,317       $ 147,033       $ 116,753   

Income (loss) from discontinued operations, net of taxes

     —           479         —           (13,666
                                   

Net income

   $ 53,059       $ 45,796       $ 147,033       $ 103,087   
                                   

Denominator

           

Weighted average shares, basic

     52,584         52,841         52,743         56,946   

Weighted average effect of dilutive securities:

           

Shares from assumed conversion of convertible senior notes

     1,454         788         1,785         —     

Net effect of dilutive stock options and unvested restricted stock

     1,180         1,507         1,292         1,013   
                                   

Denominator for diluted calculation

     55,218         55,136         55,820         57,959   
                                   

Basic

           

Income from continuing operations per share

   $ 1.01       $ 0.86       $ 2.79       $ 2.05   

Income (loss) from discontinued operations per share

     —           0.01         —           (0.24
                                   

Net income per share

   $ 1.01       $ 0.87       $ 2.79       $ 1.81   
                                   

Diluted

           

Income from continuing operations per share

   $ 0.96       $ 0.82       $ 2.63       $ 2.01   

Income (loss) from discontinued operations per share

     —           0.01         —           (0.23
                                   

Net income per share

   $ 0.96       $ 0.83       $ 2.63       $ 1.78   
                                   

The Company calculates the effect of its convertible senior notes, 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 in cash. For the three and nine months ended September 30, 2010 and 2009, the Company excluded, in each case, 17.5 million warrants from the calculation of net income per share as the effect was anti-dilutive.

During the second quarter of 2009, the Company entered into prepaid forward contracts to purchase 1,857,400 shares of its common stock for $74.9 million 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.

 

8


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

5. ACQUISITION

On July 1, 2010, the acquisition date, the Company completed the acquisition of the Direct Marketing Services and Database Marketing divisions of Equifax, Inc., (collectively, “DMS”). The total purchase price was $117.0 million. DMS provides proprietary data-driven, integrated marketing solutions through two complementary offers: database marketing and hosting, and data services, including U.S. consumer demographic information.

The results of operations for DMS have been included since the date of acquisition and are reflected in the Company’s Epsilon segment. The goodwill resulting from the acquisition will be deductible for tax purposes.

The following table summarizes the fair values of the assets acquired and liabilities assumed in the DMS acquisition as of the date of purchase:

 

     As of July 1,
2010
 
     (In thousands)  

Other current assets

   $ 893   

Property and equipment

     2,290   

Capitalized software

     4,800   

Identifiable intangible assets

     67,600   

Goodwill

     43,874   

Non-current assets

     165   
        

Total assets acquired

     119,622   
        

Current liabilities

     2,622   
        

Total liabilities assumed

     2,622   
        

Net assets acquired

   $ 117,000   
        

6. CREDIT CARD RECEIVABLES

Beginning January 1, 2010, the Company’s credit card securitization trusts, the WFN Trusts and the WFC Trust, were consolidated on the balance sheets of WFNNB, WFCB or their affiliates, including ADSC, under ASC 860 and ASC 810. The WFN Trusts’ and the WFC Trust’s credit card receivables are reported in credit card receivables — restricted for securitization investors.

The tables below present quantitative information about the components of total credit card receivables and delinquencies:

 

     September 30,
2010
     December 31,
2009
 
     (In millions)  

Principal receivables

   $ 4,705.4       $ 5,332.8   

Billed and accrued finance charges

     203.0         155.7   

Other receivables

     37.5         21.0   
                 

Total credit card receivables

     4,945.9         5,509.5   

Less credit card receivables—restricted for securitization investors

     4,406.7         4,838.3   
                 

Other credit card receivables

   $ 539.2       $ 671.2   
                 

Principal amount of credit card receivables 90 days or more past due

   $ 130.5       $ 157.4   
                 

 

9


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

Allowance for Loan Loss

The Company maintains an allowance for loan losses at a level that is adequate to absorb probable losses inherent in credit card receivables. In estimating the inherent loan losses for the credit card portfolio, 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 migration analysis considers uncollectible principal, interest and fees reflected in credit card receivables. In determining the proper level of the allowance for loan loss, management also considers factors that may impact loan loss experience, including seasoning, loan volume and amounts, payment rates and forecasting uncertainties.

The allowance for loan loss is evaluated monthly for adequacy and is maintained through an adjustment to the provision for loan loss. Additions to the allowance are made through charges to the provision for loan loss or when reserves are acquired as part of a business or portfolio acquisition. When credit card receivables are charged off, principal amounts of credit card receivables outstanding are deducted from the allowance and subsequent recoveries of such amounts increase the allowance. The Company considers uncollectible interest and fees in assessing the adequacy of the allowance for loan loss; however, unpaid interest and fees are reversed against finance charges, net.

Changes in the allowance for loan loss on credit card receivables for the nine months ended September 30, 2010 and the year ended December 31, 2009 were as follows:

 

     September 30,
2010
    December 31,
2009
 
     (In thousands)  

Balance at beginning of period

   $ 54,884      $ 38,124   

Adoption of ASC 860 and ASC 810

     523,950        —     

Provision for loan loss

     272,259        52,259   

Principal charge-offs, net of recoveries

     (336,797     (35,499
                

Balance at end of period

   $ 514,296      $ 54,884   
                

The provision for loan loss expense was $90.5 million and $275.0 million for the three and nine months ended September 30, 2010, respectively, which includes $0.9 million and $2.8 million of credit card fraud losses, respectively. The provision for loan loss expense was $16.4 million and $35.9 million for the three and nine months ended September 30, 2009, respectively, for the Company’s on-balance sheet credit card receivables. These amounts were netted against securitization income in 2009.

Net charge-offs of principal receivables were $102.1 million and $99.6 million for the three months ended September 30, 2010 and 2009, respectively, and $336.8 million and $297.2 million for the nine months ended September 30, 2010 and 2009, respectively.

Securitized Credit Card Receivables

The Company regularly securitizes its credit card receivables to the WFN Trusts and 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 receivables, collect payments, and charge-off uncollectible receivables.

 

10


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

The tables below present quantitative information about the components of total securitized credit card receivables, delinquencies and net charge-offs:

 

     September 30,
2010
     December 31,
2009
 
     (In millions)  

Total credit card receivables—restricted for securitization investors

   $ 4,406.7       $ 4,838.3   
                 

Principal amount of credit card receivables—restricted for securitization investors, 90 days or more past due

   $ 117.6       $ 148.2   
                 

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2010      2009      2010      2009  
     (In millions)  

Net charge-offs of securitized principal

   $ 91.5       $ 89.9       $ 297.5       $ 270.8   

During the initial phase of a securitization reinvestment period, the Company generally retains principal collections in exchange for the transfer of additional credit card receivables into the securitized pool of assets. During the amortization or accumulation period of a securitization, the investors’ share of principal collections (in certain cases, up to a maximum specified amount each month) is either distributed to the investors or held in an account until it accumulates to the total amount due, at which time it is paid to the investors in a lump sum.

The table below summarizes certain cash flows received from and paid to the securitization trusts when transfers of credit card receivables to the securitization trusts were treated as sales prior to the adoption of ASC 860 and ASC 810:

 

     Three Months Ended
September 30, 2009
     Nine Months Ended
September 30, 2009
 
     (In millions)  

Proceeds from collections reinvested in previous credit card securitizations

   $ 849.2       $ 3,133.4   

Proceeds from new securitizations

     1,081.4         2,150.0   

Proceeds from collections reinvested in revolving period transfers

     1,491.6         4,672.2   

Servicing fees received(1)

     17.3         53.6   

 

(1)

Upon adoption of ASC 860, these fees were eliminated with the consolidation of the WFN Trusts and the WFC Trust, and therefore not reflected in the unaudited condensed consolidated statements of income as of September 30, 2010.

 

11


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

7. 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, 2010      December 31, 2009  
     Cost      Unrealized
Gains
     Unrealized
Losses
    Fair Value      Cost      Unrealized
Gains
     Unrealized
Losses
    Fair Value  
     (In thousands)  

Cash and cash equivalents

   $ 34,502       $ —         $ —        $ 34,502       $ 71,641       $ —         $ —        $ 71,641   

Government bonds

     35,084         1,016         (7     36,093         41,026         1,205         —          42,231   

Corporate bonds(1)

     417,740         7,545         (381     424,904         453,447         8,473         (1,788     460,132   
                                                                     

Total

   $ 487,326       $ 8,561       $ (388   $ 495,499       $ 566,114       $ 9,678       $ (1,788   $ 574,004   
                                                                     

 

(1)

Included in corporate bonds at December 31, 2009 is an investment in retained interests in the WFN Trusts with a fair value of $73.9 million. Upon adoption of ASC 860, these amounts were eliminated with the consolidation of the WFN Trusts, and therefore not reflected in the unaudited condensed consolidated balance sheet as of September 30, 2010.

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, 2010 and December 31, 2009, 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, 2010
12 Months or Greater
     Total  
     Fair
Value
     Unrealized
Losses
    Fair Value      Unrealized
Losses
     Fair Value      Unrealized
Losses
 
     (In thousands)  

Government bonds

   $ 9,780       $ (7   $ —         $ —         $ 9,780       $ (7

Corporate bonds

     53,792         (381     —           —           53,792         (381
                                                    

Total

   $ 63,572       $ (388   $ —         $ —         $ 63,572       $ (388
                                                    

 

     Less than 12 months     December 31, 2009
12 Months or Greater
    Total  
     Fair
Value
     Unrealized
Losses
    Fair Value      Unrealized
Losses
    Fair Value      Unrealized
Losses
 
     (In thousands)  

Corporate bonds

   $ 98,448       $ (1,646   $ 7,705       $ (142   $ 106,153       $ (1,788
                                                   

Total

   $ 98,448       $ (1,646   $ 7,705       $ (142   $ 106,153       $ (1,788
                                                   

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

 

12


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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, 2010, 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, 2010 by contractual maturity are as follows:

 

     Amortized
Cost
     Estimated
Fair Value
 
     (In thousands)  

Due in one year or less

   $ 160,888       $ 161,738   

Due after one year through five years

     326,438         333,761   
                 

Total

   $ 487,326       $ 495,499   
                 

8. INTANGIBLE ASSETS AND GOODWILL

Intangible Assets

Intangible assets consist of the following:

 

     September 30, 2010      Amortization Life and Method  
     Gross
Assets
     Accumulated
Amortization
    Net     
     (In thousands)         

Finite Lived Assets

          

Customer contracts and lists

   $ 236,228       $ (142,022   $ 94,206         5-10 years—straight line   

Premium on purchased credit card portfolios

     151,431         (58,162     93,269         3-10 years—straight line, accelerated   

Collector database

     68,024         (58,809     9,215         30 years—15% declining balance   

Customer database

     175,430         (70,930     104,500         4-10 years—straight line   

Noncompete agreements

     2,839         (2,351     488         2-5 years—straight line   

Tradenames

     14,156         (4,711     9,445         4-10 years—straight line   

Purchased data lists

     19,824         (11,264     8,560         1-5 years—straight line, accelerated   
                            
   $ 667,932       $ (348,249   $ 319,683      

Indefinite Lived Assets

          

Tradenames

     12,350         —          12,350         Indefinite life   
                            

Total intangible assets

   $ 680,282       $ (348,249   $ 332,033      
                            

 

13


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     December 31, 2009      Amortization Life and Method  
     Gross
Assets
     Accumulated
Amortization
    Net     
     (In thousands)         

Finite Lived Assets

          

Customer contracts and lists

   $ 186,428       $ (121,540   $ 64,888         5-10 years—straight line   

Premium on purchased credit card portfolios

     155,227         (46,936     108,291         3-10 years—straight line, accelerated   

Collector database

     66,541         (56,316     10,225         30 years—15% declining balance   

Customer database

     160,564         (57,043     103,521         4-10 years—straight line   

Noncompete agreements

     2,522         (1,986     536         3-5 years—straight line   

Tradenames

     11,658         (3,674     7,984         4-10 years—straight line   

Purchased data lists

     17,178         (8,376     8,802         1-5 years—straight line, accelerated   
                            
   $ 600,118       $ (295,871   $ 304,247      

Indefinite Lived Assets

          

Tradenames

     12,350         —          12,350         Indefinite life   
                            

Total intangible assets

   $ 612,468       $ (295,871   $ 316,597      
                            

With the acquisition of DMS, the Company acquired $67.6 million of intangible assets. These assets included $49.8 million of customer relationships, $15.0 million of customer databases, $2.5 million of trade names and $0.3 million for noncompete agreements. These assets are being amortized over a weighted average life of 7.7 years, 4.0 years, 10.0 years and 2.0 years, respectively. See Note 5, “Acquisition,” for more information on DMS.

Goodwill

The changes in the carrying amount of goodwill for the nine months ended September 30, 2010 are as follows:

 

     LoyaltyOne      Epsilon     Private Label
Services and
Credit
     Corporate/
Other
     Total  
     (In thousands)  

December 31, 2009

   $ 234,613       $ 669,930      $ 261,732       $ —         $ 1,166,275   

Effects of foreign currency translation

     4,979         (559     —           —           4,420   

Goodwill acquired during the year

     —           43,874        —           —           43,874   
                                           

September 30, 2010

   $ 239,592       $ 713,245      $ 261,732       $ —         $ 1,214,569   
                                           

 

14


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

9. DEBT

Debt consists of the following:

 

Description

  September 30,
2010
    December 31,
2009
    Maturity         Interest Rate      
    (In thousands)

Long-term and other debt:

       

Credit facility

  $ 370,000      $ 487,000      March 2012   (1)

Senior notes

    250,000        250,000      May 2011   6.14%

2009 Term loan

    161,000        161,000      March 2012   (2)

2010 Term loan

    236,000        —        March 2012   (3)

Convertible senior notes due 2013

    647,111        612,058      August 2013   1.75%

Convertible senior notes due 2014

    252,730        238,869      May 2014   4.75%

Capital lease obligations and other debt

    12,791        33,425      Various – Oct 2010 –Jul 2013(4)   5.20% to 8.10%(4)
                   
    1,929,632        1,782,352       

Less: current portion

    (262,751     (51,963    
                   

Long-term portion

  $ 1,666,881      $ 1,730,389       
                   

Certificates of deposit:

       

Certificates of deposit

  $ 966,800      $ 1,465,000      One year to five years   0.50% to 5.25%

Less: current portion

    (452,400     (772,500    
                   

Long-term portion

  $ 514,400      $ 692,500       
                   

Asset-backed securities debt—owed to securitization investors:(5)

       

Fixed rate asset-backed term note securities

  $ 1,772,815      $ —        Various –Nov 2011 – Jun 2015   3.79% to 7.00%

Floating rate asset-backed term note securities

    1,153,500        —        Various – Sept 2011 – Apr 2013   0.39% to 2.76%(6)

Conduit asset-backed securities

    435,509        —        Various – Jun 2011 – Sept 2011   1.85% to 2.66%
                   

Total asset-backed securities—owed to securitization investors

    3,361,824        —         

Less: current portion

    (885,509     —         
                   

Long-term portion

  $ 2,476,315      $ —         
                   

 

(1)

The Company maintains a $750.0 million unsecured revolving credit facility (the “Credit Facility,”) where advances are in the form of either base rate loans or Eurodollar loans and may be denominated in Canadian dollars, subject to a sublimit, or U.S. dollars. The interest rate for base loans is the higher of (a) the Bank of Montreal’s prime rate, (b) the Federal funds rate plus 0.5%, and (c) the quoted London Interbank Offered Rate (“LIBOR”) as defined in the credit agreement plus 1.0%. The interest rate for Eurodollar loans denominated in U.S. or Canadian dollars fluctuates based on the rate at which deposits of U.S. dollars or Canadian dollars, respectively, in the London interbank market are quoted plus a margin of 0.4% to 0.8% based upon the Company’s senior leverage ratio as defined in the Credit Facility. Total availability under the Credit Facility at September 30, 2010 was $380.0 million. At September 30, 2010, the weighted average interest rate was 0.76%.

(2)

Advances under the term loan agreement, dated May 15, 2009 (the “2009 Term Loan”), are in the form of either base rate loans or Eurodollar loans. The interest rate for base rate loans fluctuates and is equal to the highest of (a) Bank of Montreal’s prime rate; (b) the Federal funds rate plus 0.5%; and (c) the quoted

 

15


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

LIBOR as defined in the 2009 Term Loan agreement plus 1.0%, in each case plus a margin of 2.0% to 3.0% based upon the Company’s senior leverage ratio as defined in the 2009 Term Loan agreement. The interest rate of Eurodollar loans fluctuates based on the rate at which deposits of U.S. dollars in the London interbank market are quoted plus a margin of 3.0% to 4.0% based on the Company’s senior leverage ratio as defined in the 2009 Term Loan. At September 30, 2010, the weighted average interest rate was 3.26%.

(3)

Advances under the term loan agreement, dated August 6, 2010 (the “2010 Term Loan”), are in the form of either base rate loans or Eurodollar loans. The interest rate for base rate loans fluctuates and is equal to the highest of (a) Bank of Montreal’s prime rate; (b) the Federal funds rate plus 0.5%; and (c) the quoted LIBOR as defined in the 2010 Term Loan agreement plus 1.0%, in each case plus a margin of 1.5% to 2.5% based upon the Company’s senior leverage ratio as defined in the 2010 Term Loan agreement. The interest rate of Eurodollar loans fluctuates based on the rate at which deposits of U.S. dollars in the London interbank market are quoted plus a margin of 2.5% to 3.5% based on the Company’s senior leverage ratio as defined in the 2010 Term Loan. At September 30, 2010, the weighted average interest rate was 2.76%.

(4)

The Company has other minor borrowings, primarily capital leases, with varying interest rates and maturities.

(5)

Upon adoption of ASC 860 and ASC 810, the Company consolidated the WFN Trusts and the WFC Trust and the related asset-backed securities debt. See Note 2, “Change in Accounting Principle,” for more information on the adoption of ASC 860 and ASC 810.

(6)

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 weighted average interest rate of the fixed rate achieved through interest rate swap agreements is 4.45% at September 30, 2010.

As of September 30, 2010, the Company was in compliance with its financial covenants.

Credit Facility

In June 2010, the Company amended its Credit Facility to clarify the application of ASC 860 and ASC 810 with respect to the calculation of covenant compliance.

2009 Term Loan

In June 2010, the Company amended its 2009 Term Loan to clarify the application of ASC 860 and ASC 810 with respect to the calculation of covenant compliance. In addition, the amendment removed the prepayments that were required beginning June 30, 2010 and now provides that principal payments be paid at maturity, March 30, 2012.

2010 Term Loan

On August 6, 2010, the Company, as borrower, and ADS Alliance Data Systems, Inc., ADS Foreign Holdings, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Marketing Services, LLC and Epsilon Data Management, LLC, as guarantors, entered into a term loan agreement with Bank of Montreal, as administrative agent, and various other agents and banks. The 2010 Term Loan is unsecured. Amounts borrowed under the 2010 Term Loan are scheduled to mature on March 30, 2012.

The 2010 Term Loan contains usual and customary negative covenants, which are subject to certain specified exceptions. The 2010 Term Loan also requires the Company to satisfy certain financial covenants, including maximum ratios of total leverage and senior leverage and a minimum ratio of consolidated operating EBITDA to consolidated interest expense, each as determined in accordance with the 2010 Term Loan.

As of September 30, 2010, total borrowings under the 2010 Term Loan were $236.0 million.

 

16


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

Convertible Senior Notes

The table below summarizes the carrying value of the components of the convertible senior notes:

 

     September 30,
2010
    December 31,
2009
 
     (In thousands)  

Carrying amount of equity component

   $ 368,678      $ 368,678   
                

Principal amount of liability component

   $ 1,150,000      $ 1,150,000   

Unamortized discount

     (250,159     (299,073
                

Net carrying value of liability component

   $ 899,841      $ 850,927   
                

If-converted value of common stock

   $ 1,142,583      $ 1,130,852   
                

The discount on the liability component will be amortized as interest expense over the remaining life of the convertible senior notes which is a weighted average period of 3.1 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, 2010 and 2009 is as follows:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  
     (In thousands)  

Interest expense calculated on contractual interest rate

   $ 7,619      $ 7,619      $ 22,856      $ 15,937   

Amortization of discount on liability component

     16,752        15,019        48,914        37,243   
                                

Total interest expense on convertible senior notes

   $ 24,371      $ 22,638      $ 71,770      $ 53,180   
                                

Effective interest rate (annualized)

     11.0 %     11.0 %     11.0 %     11.0 %

Asset-backed Securities—Owed to Securitization Investors

An asset-backed security is a security whose value and income payments are derived from and collateralized (or “backed”) by a specified pool of underlying assets. The sale of the pool of underlying assets to general investors is accomplished through a securitization process.

The Company regularly sells its credit card receivables to its securitization trusts, the WFN Trusts and the WFC Trust. Beginning January 1, 2010, the WFN Trusts and the WFC Trust were consolidated on the balance sheets of the Company, under ASC 860 and ASC 810. See Note 2, “Change in Accounting Principle,” for more information on the adoption of ASC 860 and ASC 810. The liabilities of the consolidated VIEs include asset-backed securities for which creditors or beneficial interest holders do not have recourse to the general credit of the Company.

Asset-backed Term Notes

In March 2010, Master Trust II issued $100.8 million of term asset-backed securities to investors. The offering consisted of $65.0 million of Class A Series 2010-1 asset-backed notes that have a fixed interest rate of 4.2% per year, $9.8 million of Class M Series 2010-1 asset-backed notes that have a fixed interest rate of

 

17


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

5.3% per year, $6.6 million of Class B Series 2010-1 asset-backed notes that have a fixed interest rate of 6.3% per year, $11.6 million of Class C Series 2010-1 asset-backed notes that have a fixed interest rate of 7.0% per year and $7.8 million of Class D Series 2010-1 zero-coupon notes which were retained by the Company. The Class A notes will mature in November 2012, the Class M notes will mature in December 2012, the Class B notes will mature in January 2013, the Class C notes will mature in February 2013 and the Class D notes will mature in March 2013. With the consolidation of the WFN Trusts, the Class D Series 2010-1 notes are eliminated from the unaudited condensed consolidated financial statements.

On July 8, 2010, Master Trust I issued $450.0 million of term asset-backed securities to investors in a public offering. The offering consisted of $355.5 million of Class A Series 2010-A asset-backed notes that have a fixed interest rate of 3.96% per year, $16.9 million of Class M Series 2010-A asset-backed notes that have a fixed interest rate of 5.2% per year, $21.4 million of Class B Series 2010-A asset-backed notes that have a fixed interest rate of 6.75% per year and $56.2 million of Class C Series 2010-A asset-backed notes that have a fixed interest rate of 5.0% per year. The Class A, Class M, Class B and Class C notes will all mature in June 2015. The Class C Series 2010-A notes were retained by the Company. With the consolidation of the WFN Trusts, the Class C Series 2010-A notes are eliminated from the unaudited condensed consolidated financial statements.

Conduit Facilities

During the first quarter of 2010, the Company renewed its $550.0 million 2009-VFC1 conduit facility under Master Trust III, extending the maturity to September 30, 2011.

During the second quarter of 2010, the Company renewed its $1.2 billion 2009-VFN conduit facility under Master Trust I, extending the maturity to June 23, 2011, and its $275.0 million 2009-VFN conduit facility under the WFC Trust, extending the maturity to June 3, 2011.

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 and manage its exposure to changes in fair value of certain obligations attributable to changes in LIBOR.

The credit card securitization trusts have entered 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.

Effective January 1, 2010, the derivative financial instruments of the credit card securitization trusts were consolidated on the Company’s balance sheets under ASC 860 and ASC 810. These interest rate contracts involve the receipt of fixed rate amounts from counterparties in exchange for the Company making variable 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.”

The following tables identify the notional amount, fair value and classification of the Company’s outstanding interest rate contracts at September 30, 2010 in the unaudited condensed consolidated balance sheets:

 

     Notional Amount
(in thousands)
     Weighted
Average Years
to Maturity
 

Interest rate contracts not designated as hedging instruments

   $ 1,153,500         1.98   

 

18


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

     Balance Sheet Location    Fair Value
(in thousands)
 

Interest rate contracts not designated as hedging instruments

   Other current liabilities    $ 6,624   

Interest rate contracts not designated as hedging instruments

   Other liabilities    $ 77,375   

The following tables identify the classification of the Company’s outstanding interest rate contracts for the three and nine months ended September 30, 2010 in the unaudited condensed consolidated statements of income:

 

For the three months ended September 30, 2010

   Income Statement Location      Loss  on
Derivative
Contracts

(in thousands)
 

Interest rate contracts not designated as hedging instruments

     Securitization funding costs       $ 59   

For the nine months ended September 30, 2010

   Income Statement Location      Loss on
Derivative
Contracts

(in thousands)
 

Interest rate contracts not designated as hedging instruments

     Securitization funding costs       $ 5,443   

The Company limits its exposure on derivatives by entering into contracts with institutions that are established dealers and maintain certain minimum credit criteria established by the Company. At September 30, 2010, 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, 2010, these thresholds were not breached and no amounts were held as collateral by the Company.

10. 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.

 

   

Service element. The service element consists of marketing and administrative services provided to sponsors. Revenue related to the service element is determined using the residual method in accordance with ASC 605-25. It is initially deferred and then amortized pro rata over the estimated life of an AIR MILES reward mile.

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.

 

19


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

A reconciliation of deferred revenue for the AIR MILES Reward Program is as follows:

 

     Deferred Revenue  
     Service     Redemption     Total  
     (In thousands)  

December 31, 2009

   $ 306,336      $ 839,810      $ 1,146,146   

Cash proceeds

     136,088        359,749        495,837   

Revenue recognized

     (126,637     (364,684     (491,321

Other

     —          4,564        4,564   

Effects of foreign currency translation

     6,898        18,725        25,623   
                        

September 30, 2010

   $ 322,685      $ 858,164      $ 1,180,849   
                        

Amounts recognized in the unaudited condensed consolidated balance sheets:

      

Current liabilities

   $ 154,952      $ 858,164      $ 1,013,116   
                        

Non-current liabilities

   $ 167,733      $ —        $ 167,733   
                        

11. STOCKHOLDERS’ EQUITY

Stock Repurchase Programs

On January 27, 2010, the Company’s Board of Directors authorized a stock repurchase program (“Prior Repurchase Program”) to acquire up to $275.1 million of the Company’s common stock through December 31, 2010. On September 13, 2010, the Company’s Board of Directors authorized a new stock repurchase program, replacing the Prior Repurchase Program, to acquire up to $400.0 million of the Company’s common stock through December 31, 2011, subject to any restrictions pursuant to the terms of the Company’s credit agreements or otherwise.

For the three and nine months ended September 30, 2010, the Company acquired a total of 897,986 shares and 1,354,486 shares, respectively, of its common stock for $50.9 million and $76.7 million, respectively. All shares were acquired prior to September 13, 2010 and under the Prior Repurchase Program.

Stock Compensation Plans

On March 31, 2005, the Company’s Board of Directors adopted the 2005 long-term incentive plan, which was subsequently approved by the Company’s stockholders on June 7, 2005 and became effective July 1, 2005. This plan reserved 4,750,000 shares of common stock for grants of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, restricted stock units and other performance-based awards to selected officers, employees, non-employee directors and consultants performing services for the Company or its affiliates. On September 24, 2009, the Company’s Board of Directors amended the 2005 long term incentive plan to provide that, in addition to settlement in shares of the Company’s common stock or other securities, equity awards may be settled in cash. No more grants may be made from the 2005 long-term incentive plan, which expired on June 30, 2010.

On March 25, 2010, the Company’s Board of Directors adopted the 2010 Omnibus Incentive Plan, which was subsequently approved by the Company’s stockholders on June 8, 2010, became effective July 1, 2010 and expires on June 30, 2015. This plan reserves 3,000,000 shares of common stock for grants of nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, restricted stock units, performance share awards, cash incentive awards, deferred stock units, and other stock-based and cash-based awards to

 

20


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

selected officers, employees, non-employee directors and consultants performing services for the Company or its affiliates, with only employees being eligible to receive incentive stock options.

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, 2010 and 2009 is as follows:

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2010      2009      2010      2009  
     (In thousands)  

Cost of operations

   $ 6,598       $ 7,315       $ 18,801       $ 23,466   

General and administrative

     4,377         7,293         15,195         19,799   
                                   

Total

   $ 10,975       $ 14,608       $ 33,996       $ 43,265   
                                   

There was no stock-based compensation expense related to discontinued operations for the three and nine months ended September 30, 2010 and for the three months ended September 30, 2009. For the nine months ended September 30, 2009, stock-based compensation expense for the Company’s discontinued operations was approximately $0.1 million. This amount is included in the loss from discontinued operations in the unaudited condensed consolidated statements of income.

During the nine months ended September 30, 2010, the Company awarded 477,329 performance-based restricted stock units with a weighted average grant date fair value per share of $57.15 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 core earnings per share growth for the period from January 1, 2010 to December 31, 2010 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 22, 2011, an additional 33% of the award on February 22, 2012 and the final 34% of the award on February 22, 2013, provided that the participant is employed by the Company on each such vesting date.

During the nine months ended September 30, 2010, the Company awarded 201,639 service-based restricted stock units with a weighted average grant date fair value per share of $60.37 as determined on the date of grant. Service-based restricted stock units typically vest ratably over three years provided that the participant meets the service condition on each such vesting date.

In March 2009, the Company determined that it was no longer probable that the specified performance measures associated with certain performance-based restricted stock units would be achieved. As a result, 1,242,098 performance-based restricted stock units granted during 2008 and in January 2009, having a weighted-average grant date fair value of $56.43 per share, are not expected to vest. The Company has not recognized stock-based compensation expense related to those awards no longer expected to vest.

 

21


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

12. COMPREHENSIVE INCOME

The components of comprehensive income, net of tax effect, are as follows:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  
     (In thousands)  

Net income

   $ 53,059      $ 45,796      $ 147,033      $ 103,087   

Adoption of ASC 860 and ASC 810(1)

     —          —          55,881        —     

Unrealized loss on securities available-for-sale

     (1,535     (5,678     (3,283     (35,126

Foreign currency translation adjustments(2)

     (3,909     (2,908     (5,791     6,217   
                                

Total comprehensive income, net of tax

   $ 47,615      $ 37,210      $ 193,840      $ 74,178   
                                

 

(1)

These amounts related to unrealized losses associated with retained interests in the WFN Trusts and the WFC Trust, which were classified as available-for-sale. These amounts were previously reflected in accumulated other comprehensive income. Effective January 1, 2010, upon the adoption of ASC 860 and ASC 810, these interests and related accumulated other comprehensive income have been reclassified, derecognized or eliminated upon consolidation of the WFN Trusts and the WFC Trust.

(2)

Primarily related to the impact of changes in the Canadian currency exchange rate.

13. 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.

Fair Value of Financial InstrumentsThe estimated fair values of the Company’s financial instruments are as follows:

 

     September 30, 2010      December 31, 2009  
     Carrying
Amount
     Fair Value      Carrying
Amount
     Fair Value  
     (In thousands)  

Financial assets

           

Cash and cash equivalents

   $ 391,226       $ 391,226       $ 213,378       $ 213,378   

Trade receivables, net

     234,570         234,570         225,212         225,212   

Seller’s interest

     —           —           297,108         297,108   

Credit card receivables, net

     4,431,595         4,431,595         616,298         616,298   

Redemption settlement assets, restricted

     495,499         495,499         574,004         574,004   

Due from securitizations

     —           —           775,570         775,570   

Cash collateral, restricted

     205,359         205,359         216,953         216,953   

Financial liabilities

           

Accounts payable

     124,040         124,040         103,891         103,891   

Asset-backed securities debt—owed to securitization investors

     3,361,824         3,427,074         —           —     

Debt, including certificates of deposit

     2,896,432         3,073,214         3,247,352         3,408,039   

Derivative financial instruments

     83,999         83,999         —           —     

 

22


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

Fair Value of Assets and Liabilities Held at September 30, 2010

The following techniques and assumptions were used by the Company in estimating fair values of financial instruments as disclosed herein:

Cash and cash equivalents, trade receivables, net and accounts payable—The carrying amount approximates fair value due to the short maturity.

Credit card receivables, net—The carrying amount of credit card receivables, net approximates fair value due to the short maturity, and the average interest rates approximate current market origination rates.

Redemption settlement assets, restricted—Fair value for securities is based on quoted market prices for the same or similar securities.

Cash collateral, restricted—The spread deposits are recorded at their fair value based on discounted cash flow models. The carrying amount of excess funding deposits approximates its fair value due to the relatively short maturity period and average interest rates, which approximate current market rates.

Asset-backed securities debt—owed to securitization investors—The fair value is estimated based on the current rates available to the Company for similar debt instruments with similar remaining maturities.

Debt, including certificates of deposit—The fair value is estimated based on the current rates available to the Company for similar debt instruments with similar remaining maturities.

Derivative financial instruments—The valuation of these instruments is determined using a discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and option volatility.

Fair Value of Assets and Liabilities Held at December 31, 2009

The following techniques and assumptions were used by the Company in estimating fair values of financial instruments which were subsequently reclassified, derecognized or eliminated upon consolidation of the WFN Trusts and the WFC Trust as a result of the adoption of ASC 860 and ASC 810 as disclosed herein:

Seller’s interest—Seller’s interest was carried at an allocated carrying amount based on their fair value. The Company determined the fair value of its seller’s interest through discounted cash flow models. The estimated cash flows used included assumptions related to rates of payments and defaults, which reflected economic and other relevant conditions. The discount rate used was based on an interest rate curve that was observable in the market place plus an unobservable credit spread. With the consolidation of the WFN Trusts and the WFC Trust on January 1, 2010, seller’s interest has been eliminated.

Due from securitizations—The retained interest and interest-only strips were recorded at their fair value. The Company used a valuation model that calculated the present value of estimated future cash flows for each asset which incorporated the Company’s own estimates of assumptions market participants used in determining fair value, including estimates of payment rates, defaults, net charge-offs, discount rates and contractual interest and fees. With the consolidation of the WFN Trusts and the WFC Trust on January 1, 2010, due from securitizations has been derecognized or eliminated.

Assets and Liabilities Measured on a Recurring Basis

ASC 825 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include:

 

   

Level 1, defined as observable inputs such as quoted prices in active markets;

 

23


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

   

Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and

 

   

Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial instruments also include those for which the determination of fair value requires significant management judgment or estimation. The use of different techniques to determine fair value of these financial instruments could result in different estimates of fair value at the reporting date.

The following tables provide the assets carried at fair value measured on a recurring basis as of September 30, 2010 and December 31, 2009:

 

     Balance at
September 30, 2010
     Fair Value Measurements at
September 30, 2010 Using
 
        Level 1      Level 2      Level 3  
     (In thousands)  

Government bonds(1)

   $ 36,093       $ —         $ 36,093       $ —     

Corporate bonds(1)

     424,904         210,367         214,537         —     

Other available-for-sale securities(2)

     83,758         64,746         19,012         —     

Cash collateral, restricted

     205,359         —           37,530         167,829   
                                   

Total assets measured at fair value

   $ 750,114       $ 275,113       $ 307,172       $ 167,829   
                                   

Derivative financial instruments(3)

   $ 83,999       $ —         $ 83,999       $ —     
                                   

Total liabilities measured at fair value

   $ 83,999       $ —         $ 83,999       $ —     
                                   
     Balance at
December 31, 2009
     Fair Value Measurements at
December 31, 2009 Using
 
        Level 1      Level 2      Level 3  
     (In thousands)  

Government bonds(1)

   $ 42,231       $ 16,676       $ 25,555       $ —     

Corporate bonds(1)

     460,132         308,668         77,598         73,866   

Other available-for-sale securities(2)

     105,064         95,300         9,764         —     

Seller’s interest

     297,108         —           —           297,108   

Due from securitizations

     775,570         —           —           775,570   

Cash collateral, restricted

     216,953         —           10,275         206,678   
                                   

Total assets measured at fair value

   $ 1,897,058       $ 420,644       $ 123,192       $ 1,353,222   
                                   

 

(1)

Amounts are included in redemption settlement assets in the unaudited condensed consolidated balance sheets.

(2)

Amounts are included in other current and non-current assets in the unaudited condensed consolidated balance sheets.

(3)

Amounts are included in other current liabilities and other liabilities in the unaudited condensed consolidated balance sheets.

 

24


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

The following tables summarize the changes in fair value of the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as defined in ASC 825 as of September 30, 2010 and 2009:

 

     Corporate
Bonds
    Seller’s
Interest
    Due from
Securitizations
    Cash
Collateral,
Restricted
 
     (In thousands)  

June 30, 2010

   $ —        $ —        $ —        $ 171,790   

Total gains (realized or unrealized)

        

Included in earnings

     —          —          —          473   

Included in other comprehensive income

     —          —          —          —     

Purchases, sales, issuances and settlements

     —          —          —          (4,434

Transfers in or out of Level 3

     —          —          —          —     
                                

September 30, 2010

   $ —        $ —        $ —        $ 167,829   
                                

Gains for the period included in earnings attributable to the change in unrealized gains or losses related to assets still held at September 30, 2010

   $ —        $ —        $ —        $ 473   
                                
     Corporate
Bonds
    Seller’s
Interest
    Due from
Securitizations
    Cash
Collateral,
Restricted
 
     (In thousands)  

December 31, 2009

   $ 73,866      $ 297,108      $ 775,570      $ 206,678   

Adoption of ASC 860 and ASC 810

     (73,866     (297,108     (775,570     —     

Total gains (realized or unrealized)

        

Included in earnings

     —          —          —          143   

Included in other comprehensive income

     —          —          —          —     

Purchases, sales, issuances and settlements

     —          —          —          (38,992

Transfers in or out of Level 3

     —          —          —          —     
                                

September 30, 2010

   $ —        $ —        $ —        $ 167,829   
                                

Gains for the period included in earnings attributable to the change in unrealized gains or losses related to assets still held at September 30, 2010

   $ —        $ —        $ —        $ 143   
                                
     Corporate
Bonds
    Seller’s
Interest
    Due from
Securitizations
    Cash
Collateral,
Restricted
 
     (In thousands)  

June 30, 2009

   $ 83,559      $ 183,673      $ 531,386      $ 189,668   

Total (losses) gains (realized or unrealized)

        

Included in earnings

     —          (816     1,427        85   

Included in other comprehensive income

     14,129        —          (23,838     —     

Purchases, sales, issuances and settlements

     —          28,635        23,553        (4,222

Transfers in or out of Level 3

     —          —          —          —     
                                

September 30, 2009

   $ 97,688      $ 211,492      $ 532,528      $ 185,531   
                                

Losses for the period included in earnings attributable to the change in unrealized gains or losses related to assets still held at September 30, 2009

   $ —        $ —        $ (3,578   $ —     
                                

 

25


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     Corporate
Bonds
     Seller’s
Interest
     Due from
Securitizations
    Cash
Collateral,
Restricted
 
     (In thousands)  

December 31, 2008

   $ 28,625       $ 182,428       $ 428,853      $ 175,384   

Total (losses) gains (realized or unrealized)

          

Included in earnings

     —           7,727         (9,149     556   

Included in other comprehensive income

     4,506         —           (54,125     —     

Purchases, sales, issuances and settlements

     64,557         21,337         166,949        9,591   

Transfers in or out of Level 3

     —           —           —          —     
                                  

September 30, 2009

   $ 97,688       $ 211,492       $ 532,528      $ 185,531   
                                  

Losses for the period included in earnings attributable to the change in unrealized gains or losses related to assets still held at September 30, 2009

   $ —         $ —         $ (8,868   $ —     
                                  

For the three and nine months ended September 30, 2010 and 2009, gains included in earnings attributable to cash collateral, restricted were included in revenue under finance charges, net in the unaudited condensed consolidated statements of income. For the three and nine months ended September 30, 2009, gains and losses included in earnings for seller’s interest and due from securitizations were included in securitization income in the unaudited condensed consolidated statements of income.

Assets and Liabilities Measured on a Non-Recurring Basis

The Company also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets include those associated with acquired businesses, including goodwill and other intangible assets. For these assets, measurement at fair value in periods subsequent to their initial recognition is applicable if one or more is determined to be impaired. During the three and nine months ended September 30, 2010, the Company had no impairments related to these assets.

14. INCOME TAXES

For the three and nine months ended September 30, 2010, the Company utilized an effective tax rate of 38.2% to calculate its provision for income taxes. In accordance with ASC 740-270, “Income taxes—Interim Reporting,” the Company’s expected annual effective tax rate for calendar year 2010 based on all known variables is 38.2%.

For the three and nine months ended September 30, 2009, the Company’s effective tax rate was 17.6% and 32.0%, respectively. During the third quarter of 2009, the Company recognized an $11.7 million tax benefit related to previously established tax reserves to cover various uncertain tax positions, which were no longer necessary due to a United States Tax Court decision, statute of limitations expirations and other factors. The Company’s 2009 effective tax rate without regard to the $11.7 million tax benefit remained 38.8%.

On January 1, 2010, the Company’s deferred tax asset increased by approximately $197.2 million as a result of the adoption of ASC 860 and ASC 810.

 

26


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

15. SEGMENT INFORMATION

In the first quarter of 2010, the Company reorganized its segments with Private Label Services and Private Label Credit reflected as one segment. All prior year segment information has been restated to conform to the current presentation. In addition, the Company renamed its other two segments from Epsilon Marketing Services and Loyalty Services to “Epsilon” and “LoyaltyOne,” respectively.

The Company operates in three reportable segments: LoyaltyOne, Epsilon and Private Label Services and Credit.

 

   

LoyaltyOne includes the Company’s Canadian AIR MILES Reward Program;

 

   

Epsilon provides integrated direct marketing solutions that combine database marketing technology and analytics with a broad range of direct marketing services; and

 

   

Private Label Services and Credit provides risk management solutions, account origination, funding, transaction processing, customer care and collections services for the Company’s private label retail credit card programs.

Additionally, corporate and all other immaterial businesses are reported collectively as an “all other” category labeled “Corporate/Other.” Total interest expense, net and income taxes are not allocated to the segments in the computation of segment operating profit for internal evaluation purposes and have also been included in “Corporate/Other.” Total assets are not allocated to the segments. The Company’s utility services business and a terminated credit program have been classified as discontinued operations. See Note 16, “Discontinued Operations,” for additional information.

 

Three Months Ended September 30, 2010

   LoyaltyOne      Epsilon      Private Label
Services and
Credit
     Corporate/
Other
    Eliminations     Total  
     (In thousands)  

Revenues

   $ 184,411       $ 170,468       $ 349,642       $ 357      $ (2,435   $ 702,443   

Adjusted EBITDA(1)

     46,478         44,091         143,894         (13,988     (1,584     218,891   

Depreciation and amortization

     5,827         21,473         8,892         1,715        —          37,907   

Stock compensation expense

     2,514         2,305         1,779         4,377        —          10,975   

Operating income (loss)

     38,137         20,313         133,223         (20,080     (1,584     170,009   

Interest expense, net

     —           —           —           84,119        —          84,119   

Income (loss) from continuing operations before income taxes

     38,137         20,313         133,223         (104,199     (1,584     85,890   

 

Three Months Ended September 30, 2009

   LoyaltyOne      Epsilon      Private Label
Services and
Credit
     Corporate/
Other
    Eliminations      Total  
     (In thousands)  

Revenues

   $ 177,008       $ 131,926       $ 166,982       $ 5,515      $ —         $ 481,431   

Adjusted EBITDA(1)

     53,186         35,196         67,845         (16,061     —           140,166   

Depreciation and amortization

     5,966         18,003         5,809         1,356        —           31,134   

Stock compensation expense

     3,847         1,705         1,763         7,293        —           14,608   

Merger and other costs(2)

     —           —           —           878        —           878   

Operating income (loss)

     43,373         15,488         60,273         (25,588     —           93,546   

Interest expense, net

     —           —           —           38,563        —           38,563   

Income (loss) from continuing operations before income taxes

     43,373         15,488         60,273         (64,151     —           54,983   

 

27


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

Nine Months Ended September 30, 2010

  LoyaltyOne     Epsilon     Private Label
Services and
Credit
    Corporate/
Other
    Eliminations     Total  
    (In thousands)  

Revenues

  $ 575,612      $ 433,799      $ 1,032,106      $ 1,510      $ (7,329   $ 2,035,698   

Adjusted EBITDA(1)

    158,731        102,654        416,878        (44,171     (5,010     629,082   

Depreciation and amortization

    18,111        57,565        25,913        4,910        —          106,499   

Stock compensation expense

    7,042        6,441        5,318        15,195        —          33,996   

Operating income (loss)

    133,578        38,648        385,647        (64,276     (5,010     488,587   

Interest expense, net

    —          —          —          250,673        —          250,673   

Income (loss) from continuing operations before income taxes

    133,578        38,648        385,647        (314,949     (5,010     237,914   

 

Nine Months Ended September 30, 2009

  LoyaltyOne     Epsilon     Private Label
Services and
Credit
    Corporate/
Other
    Eliminations     Total  
    (In thousands)  

Revenues

  $ 504,985      $ 372,495      $ 512,960      $ 27,981      $ —        $ 1,418,421   

Adjusted EBITDA(1)

    146,419        87,717        216,314        (36,002     —          414,448   

Depreciation and amortization

    15,877        51,835        17,740        6,096        —          91,548   

Stock compensation expense

    10,128        6,930        6,394        19,813        —          43,265   

Merger and other costs(2)

    —          —          —          3,890        —          3,890   

Operating income (loss)

    120,414        28,952        192,180        (65,801     —          275,745   

Interest expense, net

    —          —          —          103,957        —          103,957   

Income (loss) from continuing operations before income taxes

    120,414        28,952        192,180        (169,758     —          171,788   

 

(1)

Adjusted EBITDA is a non-GAAP financial measure equal to income from continuing operations, the most directly comparable GAAP financial measure, plus stock compensation expense, provision for income taxes, interest expense, net, depreciation and amortization, merger and other costs. Adjusted EBITDA is presented in accordance with ASC 280, “Segment Reporting,” as it is the primary performance metric by which senior management is evaluated.

(2)

Merger and other costs are not allocated to the segments in the computation of segment operating profit for internal evaluation purposes. Merger costs represent investment banking, legal and accounting costs directly associated with the proposed merger with an affiliate of The Blackstone Group. Other costs represent compensation charges related to the departure of certain employees resulting from cost saving initiatives and other non-routine costs associated with the disposition of certain businesses.

 

28


Table of Contents

ALLIANCE DATA SYSTEMS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

16. DISCONTINUED OPERATIONS

In February 2009, the Company completed the sale of the remainder of its utility services business, including the termination of a services agreement and the resolution of certain contractual disputes, to a former utility client. In November 2009, the Company terminated operations of its credit program for web and catalog retailer VENUE. These have been treated as discontinued operations under ASC 205-20, “Presentation of Financial Statements — Discontinued Operations.” The underlying assets of the discontinued operations for the periods presented in the unaudited condensed consolidated balance sheets are as follows:

 

     September 30,
2010
     December 31,
2009
 
     (In thousands)  

Assets:

     

Credit card receivables, net

   $ 18,028       $ 34,623   
                 

Assets of discontinued operations

   $ 18,028       $ 34,623   
                 

The following table summarizes the operating results of the discontinued operations:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010      2009     2010      2009  
     (In thousands)  

Revenue

   $     —         $ 1,755      $     —         $ 10,089   
                                  

Income (loss) before provision for income taxes

     —           744        —           (20,898

(Provision) benefit from income taxes

     —           (265     —           7,232   
                                  

Income (loss) from discontinued operations

   $ —         $ 479      $ —         $ (13,666
                                  

17. REGULATORY MATTERS

On July 15, 2010, the Office of the Comptroller of the Currency (“OCC”) approved an application filed by the Company’s credit card services bank subsidiary, WFNNB, to change the location of the bank to Wilmington, Delaware through the merger of the bank with an interim banking association organized under the laws of the United States and located in Wilmington, Delaware. WFNNB is a national banking association and a limited purpose credit card bank and is regulated, supervised, and examined by the OCC, its primary regulator. WFNNB is also subject to regulation by the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation. Neither the name of the bank nor any of its assets, liabilities or contemplated business purposes will change as a result of the merger. The merger was completed in August 2010.

18. NON-CASH FINANCING AND INVESTING ACTIVITIES

On January 1, 2010, the Company adopted ASC 860 and ASC 810 resulting in the consolidation of the WFN Trusts and the WFC Trust. Based on the carrying amounts of the WFN Trusts’ and the WFC Trust’s assets and liabilities as prescribed by ASC 810, the consolidation of the trusts had the following non-cash impact to the financing and investing activities for the nine months ended September 30, 2010 as follows:

 

   

elimination of $74 million in redemption settlement assets for those interests retained in the WFN Trusts,

 

   

elimination of $775 million in retained interests classified in due from securitizations,

 

   

consolidation of $4.1 billion in credit card receivables, and

 

   

consolidation of $3.7 billion in asset-backed securities.

 

29


Table of Contents

 

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and related notes thereto presented in this quarterly report and the consolidated financial statements and related notes thereto included in our Annual Report filed on Form 10-K for the year ended December 31, 2009, filed with the Securities and Exchange Commission, or SEC, on March 1, 2010.

In the first quarter of 2010, we reorganized our segments with Private Label Services and Private Label Credit reflected as one segment. All prior year segment information has been restated to conform to the current presentation. In addition, we renamed our other two segments from Epsilon Marketing Services and Loyalty Services to “Epsilon” and “LoyaltyOne,” respectively.

Year in Review Highlights

Our results for the first nine months of 2010 included the following new and renewed agreements:

 

   

In January 2010, we announced the signing of a multi-year expansion agreement with New York & Company, a specialty retail apparel chain, to provide a comprehensive database marketing solution that includes customer data management, campaign management, reporting and strategic consulting and analytics services.

 

   

In February 2010, we announced the signing of multi-year agreements with Kraft Foods Inc. to provide a comprehensive direct-to-consumer marketing solution, including database and data management, consumer data integration, permission-based email marketing services, multi-channel campaign management and interactive web services.

 

   

In February 2010, we announced that Budgetcar, Inc., a subsidiary of Avis Budget Group, Inc. and an AIR MILES® Reward Program sponsor and rewards supplier since 2007, had signed a multi-year renewal agreement.

 

   

In February 2010, we announced the signing of a new multi-year agreement with Dallas-based La Quinta to provide permission-based email marketing services. In addition, La Quinta also renewed its existing agreement for Epsilon’s ongoing support and management of La Quinta’s frequent guest program.

 

   

In March 2010, we announced that Vision Electronics, an AIR MILES Reward Program sponsor since 2007, had signed a multi-year renewal agreement.

 

   

In March 2010, our private label credit card banking subsidiary, World Financial Network National Bank, or WFNNB, issued $100.8 million of asset-backed securities to investors.

 

   

In March 2010, WFNNB completed the renewal of its $550.0 million conduit facility.

 

   

In April 2010, we announced the signing of a new 5-year contract with the Liquor Control Board of Ontario, a top-10 AIR MILES Reward Program sponsor and a sponsor since 1998.

 

   

In May 2010, we announced that Pharmasave Atlantic, an Atlantic Canadian pharmacy retailer and an AIR MILES Reward Program sponsor since 1995, signed a multi-year renewal agreement.

 

   

In May 2010, we announced the signing of a multi-year agreement with Whirlpool Canada LP, one of Canada’s leading marketers and supplier of home appliances, as a sponsor in our AIR MILES Reward Program.

 

   

In June 2010, we announced that Washington, D.C.-based AARP has signed a multi-year renewal agreement to provide data and database marketing services in support of AARP’s member acquisition program.

 

30


Table of Contents

 

   

In June 2010, we announced a new sponsor agreement coinciding with an innovative energy conversation campaign with the Ontario Power Authority, representing an expansion of the AIR MILES Reward Program in the energy sector.

 

   

In June 2010, WFNNB completed the renewal of its $1.2 billion conduit facility, and our industrial bank subsidiary, World Financial Capital Bank, or WFCB, completed the renewal of its $275.0 million conduit facility, resulting in an increase of $175.0 million in overall conduit capacity.

 

   

In July 2010, we completed the acquisition of the Direct Marketing Services and Database Marketing divisions of Equifax, Inc., collectively DMS. DMS provides proprietary data-driven, integrated marketing solutions and has been integrated in our Epsilon segment.

 

   

In July 2010, we announced the signing of a multi-year renewal agreement with New York, N.Y.-based JPMorgan Chase, providing digital marketing services in support of JPMorgan Chase’s Credit Card Services group.

 

   

In July 2010, WFNNB issued $450.0 million of asset-backed securities to investors.

 

   

In July 2010, we announced that Dell Inc. signed a multi-year expansion agreement, supporting its strategic email marketing program.

 

   

In August 2010, we announced that the Manitoba Liquor Control Commission, an AIR MILES Reward Program sponsor since 1998, signed a multi-year renewal agreement.

 

   

In August 2010, we entered into a new term loan agreement with Bank of Montreal and various other agents. At closing, we borrowed $221.0 million. In September 2010, we exercised the option to increase and borrowed an additional $15.0 million.

 

   

In August 2010, WFNNB completed its charter relocation from Columbus, Ohio to Wilmington, Delaware, providing additional flexibility in the management of our credit card programs going forward.

 

   

In August 2010, we announced the signing of a multi-year expansion agreement with Unilever, a large consumer products company, to provide database management and multichannel marketing services.

 

   

In August 2010, we announced the signing of a multi-year agreement with David’s Bridal, Inc., parent company of Priscilla of Boston and a leading retailer of bridal and special occasion attire, to provide private label credit card services.

 

   

In September 2010, we announced the signing of a new agreement with AAA Northern California Nevada and Utah, the second-largest club in the national AAA federation, to provide marketing services.

 

   

In September 2010, we announced the signing of a new multi-year agreement with MyPoints.com, an online loyalty marketing service, to provide co-brand credit card services.

 

   

In September 2010, our Board of Directors approved a new stock repurchase program to acquire up to $400.0 million of our outstanding common stock through December 31, 2011, subject to any restrictions pursuant to the terms of our credit agreements or otherwise.

 

   

In September 2010, we announced the signing of an expansion agreement with leading specialty retailer Chico’s to provide data overlay services.

Critical Accounting Policies and Estimates

There have been no material changes, other than those noted below with the adoption of Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, 860, “Transfers and Servicing,” and ASC 810, “Consolidation,” to our critical accounting policies and estimates from the information provided in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included in our 10-K for the fiscal year ended December 31, 2009.

 

31


Table of Contents

 

Effective January 1, 2010, our seller’s interest, interest-only strips and retained interest, which were recorded at estimated fair value, have been reclassified, derecognized or eliminated upon adoption of ASC 860 and ASC 810. Additionally, with the consolidation of World Financial Network Credit Card Master Trust, or Master Trust, World Financial Network Credit Card Master Note Trust, or Master Trust I, World Financial Network Credit Card Master Note Trust II, or Master Trust II, and World Financial Network Credit Card Master Trust III, or Master Trust III, or collectively, the WFN Trusts, and the World Financial Capital Credit Card Master Note Trust, or the WFC Trust, the estimate for the allowance for loan loss has become a critical accounting estimate.

Management evaluates its allowance for loan loss monthly for adequacy. The allowance is maintained through an adjustment to the provision for loan loss. In estimating the inherent loan losses in the credit card portfolio, we utilize 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 migration analysis considers uncollectible principal, interest and fees reflected in credit card receivables. In determining the proper level of the allowance for loan loss, management also considers factors that may impact loan loss experience, including seasoning, loan volume and amounts, payment rates and forecasting uncertainties.

Recent Accounting Pronouncements

In October 2009, the FASB issued Accounting Standards Update, or ASU, 2009-13, “Multiple-Deliverable Revenue Arrangements,” which supersedes certain guidance in ASC 605-25, “Revenue Recognition — Multiple-Element Arrangements,” and requires an entity to allocate arrangement consideration at the inception of an arrangement to all of its deliverables based on their relative selling prices (the relative-selling-price method). ASU 2009-13 eliminates the use of the residual method of allocation in which the undelivered element is measured at its estimated selling price and the delivered element is measured as the residual of the arrangement consideration, and requires the relative-selling-price method in all circumstances in which an entity recognizes revenue for an arrangement with multiple deliverables subject to ASU 2009-13. ASU 2009-13 will be effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Early adoption is permitted. If we elect early adoption and the adoption is during an interim period, we will be required to apply this ASU retrospectively from the beginning of our fiscal year. We can also elect to apply this ASU retrospectively for all periods presented. We are currently evaluating the impact that the adoption of ASU 2009-13 will have on our consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures,” which amends ASC 820, “Fair Value Measurements and Disclosures,” to add separate disclosures about purchases, sales, issuances and settlements related to Level 3 measurements. The requirement to provide the Level 3 disclosures about purchases, sales, issuances and settlements will be effective for interim and annual periods beginning after December 15, 2010. The adoption of ASU 2010-06 for the separate Level 3 disclosures will only impact disclosures and will not have a material impact on our consolidated financial statements.

In July 2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses,” which amends ASC 310, “Receivables,” to require further disaggregated disclosures that improve financial statement users’ understanding of (1) the nature of an entity’s credit risk associated with its financing receivables and (2) the entity’s assessment of that risk in estimating its allowance for credit losses as well as changes in the allowance and the reasons for those changes. The new and amended disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The adoption of ASU 2010-20 will only impact disclosures and will not have a material impact on our consolidated financial statements.

 

32


Table of Contents

 

Accounting Treatment for Securitizations

We have consolidated the credit card securitization trusts used in our securitization transactions, as the WFN Trusts and the WFC Trust were no longer exempt from consolidation effective January 1, 2010, upon our adoption of ASC 860 and ASC 810.

At adoption, we added approximately $3.4 billion of assets, including a $0.5 billion addition to loan loss reserves, and approximately $3.7 billion of liabilities to our unaudited condensed consolidated balance sheets. The impact of the new accounting is a reduction to stockholders’ equity of $0.4 billion. The adoption required a full consolidation of the securitization trusts in accordance with accounting principles generally accepted in the United States of America, or GAAP.

Subsequent to January 1, 2010, our unaudited condensed consolidated statements of income no longer reflect securitization income, but instead reflect finance charges and certain other income associated with the securitized credit card receivables. Net charge-offs associated with credit card receivables impact our provision for loan loss reflected in our total operating expenses. Interest expense associated with debt issued from the trusts to third-party investors is reported in securitization funding costs. Additionally, we no longer record initial gains on new securitization activity since securitized credit card loans no longer receive sale accounting treatment, nor are there any gains or losses on the revaluation of the interest-only strip receivable, as that asset is not recognized in a transaction accounted for as a secured borrowing. Since our securitization transactions are accounted for under the new accounting rules as secured borrowings rather than asset sales, the cash flows from these transactions are presented as cash flows from financing activities rather than cash flows from operating or investing activities.

Regulatory Matters

The new Federal Reserve Board guidelines on late fees that can be charged by financial institutions became effective on August 22, 2010. In anticipation of the late fee guidelines, we modified cardholder terms to offset the impact of any decline in average late fees charged. The final guidelines had less impact than initially expected as they provide for: (1) a $25 maximum late fee compared to our original expectation of $20, and (2) late fees to be charged in excess of the $25 maximum for repeat offenses within a six month period. In response to the final guidelines, we have changed minimum payments and modified late fee structures effective for billing cycles beginning in November 2010.

On July 15, 2010, the Office of the Comptroller of the Currency, or OCC, approved an application filed by our credit card services bank subsidiary, WFNNB, to change the location of the bank to Wilmington, Delaware through the merger of the bank with an interim banking association organized under the laws of the United States and located in Wilmington, Delaware. WFNNB is a national banking association and a limited purpose credit card bank and is regulated, supervised and examined by the OCC, its primary regulator. WFNNB is also subject to regulation by the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation. Neither the name of the bank nor any of its assets, liabilities or contemplated business purposes will change as a result of the merger. The merger was completed in August 2010.

On September 27, 2010, the Board of the Federal Deposit Insurance Corporation adopted new safe harbors relating to the treatment of securitizations in receivership or conservatorship. The new safe harbor rules include a grandfathering provision that we believe will allow the credit card securitization trusts used in our securitization program to continue to benefit from the protections under the safe harbor to the same extent as prior securitizations issued by those trusts. Therefore we do not expect the adoption of the new rule to adversely affect our ability to securitize our receivables. However, because the new safe harbors were recently adopted, participants in the securitization market, including investors in asset-backed securities and the rating agencies that rate our asset-backed securities, are continuing to evaluate the effect of the new safe harbors.

 

33


Table of Contents

 

Outlook

We expect double-digit growth in both consolidated revenue and consolidated adjusted EBITDA for the fourth quarter. Private Label Services and Credit and Epsilon are expected to provide positive revenue growth and adjusted EBITDA growth, while LoyaltyOne is expected to provide positive revenue growth but a decline in adjusted EBITDA.

LoyaltyOne

LoyaltyOne is expected to report a decline in adjusted EBITDA primarily due to the run-off of deferred revenue related to the conversion of a certain split fee to non-split fee program that began in May 2008. In conjunction with this conversion, we changed our estimate of breakage from one-third to 28%. The change in estimate had no impact on the total redemption liability, but reduced the amount of deferred breakage within the redemption liability that is expected to be recognized over the expected life of the mile.

The deferred revenue associated with the conversion of a split fee sponsor to a non-split fee sponsor was recognized as AIR MILES reward miles were redeemed and was fully amortized in the third quarter of 2010. Comparatively, revenue associated with breakage is recognized ratably over the estimated life of a mile. Although our deferred breakage element continues to build, the growth rate has been impacted by weak AIR MILES reward miles issuance in the later part of 2009 and 2010. We believe this will negatively impact our redemption revenue. Based on AIR MILES reward miles issuance forecasts, the negative impact of this timing issue should moderate by mid-2011.

While we believe that the AIR MILES Reward Program tends to be resilient during economic swings, macroeconomic factors, such as the overall health of the Canadian economy, may impact collector behavior. Therefore, we could experience an impact to our sponsor mix resulting in lower-priced miles being issued, which could impact our operating margins. In the latter part of 2008 and 2009, we started to see a shift in the sponsor mix, and given the deferred nature of our revenue recognition, this impact is expected to be reflected in our results of operations for the second half of 2010. In 2010, we have seen a slight positive shift in sponsor mix.

AIR MILES reward miles issued during the third quarter of 2010 decreased 3.9% compared to the third quarter of 2009 due to reduced promotional activity in the grocer sector and generally flat consumer credit card spending compared to the prior corresponding quarter. Growth in credit card spending was sluggish as a result of less buoyant consumer spending brought on by the slowing the economic recovery in Canada.

LoyaltyOne also has a partnership interest in an entity operating a Brazilian coalition loyalty program. The initial phase is currently in progress and a further planned investment of up to $15.0 million in the initiative is dependent on the success of the initial phase and the timing of the phased program rollout. The program is in the process of securing long-term agreements with select major sponsors, while preparing for a national rollout with them in early 2011.

Epsilon

We believe that the outlook for Epsilon’s business remains strong as the major offerings continue to demonstrate positive momentum, with expected growth of 20% in revenue and adjusted EBITDA in the fourth quarter of 2010 as compared to the fourth quarter of 2009. Specifically, the database/digital businesses continue to benefit from strong new client wins, producing a solid implementation stream throughout 2010. We also believe that Abacus’ continued growth demonstrates a return to stability in retail and catalog marketing budgets. This trend suggests a positive economic outlook from these key verticals, which we expect will reinforce the value of data-driven ROI-based marketing strategies in the overall marketing mix.

Finally, the DMS acquisition has been integrated into our Epsilon segment. DMS provides proprietary data-driven, integrated marketing solutions through two complementary offerings: database marketing and hosting,

 

34


Table of Contents

and data services, including U.S. consumer demographic information. The DMS acquisition is not expected to materially benefit earnings in 2010, but is expected to be accretive to earnings in 2011.

Private Label Services and Credit

For the third quarter of 2010, credit trends were positive with principal charge-offs at 8.3% of average total receivables, improving from 9.4% for the third quarter of 2009. Charge-off rates continue to trend lower as, due to the length of severity of the economic downturn, there is no longer a direct correlation between loan loss rates and unemployment levels. Delinquency rates, a good predictor of future losses, improved slightly to 6.1% of principal receivables at September 30, 2010 from 6.2% at September 30, 2009. Delinquency rates continue to trend downward on a seasonally adjusted basis. However, the September 2010 delinquency rate was 10 to 20 basis points higher than predicted by normal seasonality. We believe that the changes incorporated in cardholder terms during 2010, including raising annual percentage rates in March and increasing minimum payments from $10 to $20 in June, have resulted in two small increases that are working their way through the delinquency rate. Finally, cardholder spending has slowed from the first half of 2010. For the third quarter of 2010, credit sales increased 7.2%, driven primarily by new credit card portfolios.

For the fourth quarter of 2010, average receivable balances are expected to be flat year-over-year as new programs anniversary. The provision for loan loss will increase during the fourth quarter from the third quarter of 2010 due to the seasonal buildup in credit card receivables and will exceed actual loan loss charge-offs.

Use of Non-GAAP Financial Measures

Adjusted EBITDA is a non-GAAP financial measure equal to income from continuing operations, the most directly comparable GAAP financial measure, plus stock compensation expense, provision for income taxes, interest expense, net, merger and other costs, depreciation and other amortization and amortization of purchased intangibles.

We use adjusted EBITDA as an integral part of our internal reporting to measure the performance of our reportable segments and to evaluate the performance of our senior management. Adjusted EBITDA is considered an important indicator of the operational strength of our businesses. Adjusted EBITDA eliminates the uneven effect across all business segments of considerable amounts of non-cash depreciation of tangible assets and amortization of certain intangible assets that were recognized in business combinations. A limitation of this measure, however, is that it does not reflect the periodic costs of certain capitalized tangible and intangible assets used in generating revenues in our businesses. Management evaluates the costs of such tangible and intangible assets, the impact of related impairments, as well as asset sales through other financial measures, such as capital expenditures, investment spending and return on capital and therefore the effects are excluded from adjusted EBITDA. Adjusted EBITDA also eliminates the non-cash effect of stock compensation expense. Stock compensation expense is not included in the measurement of segment adjusted EBITDA provided to the chief operating decision maker for purposes of assessing segment performance and decision making with respect to resource allocations. Therefore, we believe that adjusted EBITDA provides useful information to our investors regarding our performance and overall results of operations. Adjusted EBITDA is not intended to be a performance measure that should be regarded as an alternative to, or more meaningful than, either operating income or net income as an indicator of operating performance or to cash flows from operating activities as a measure of liquidity. In addition, adjusted EBITDA is not intended to represent funds available for dividends, reinvestment or other discretionary uses, and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with GAAP.

 

35


Table of Contents

 

The adjusted EBITDA measures presented in this Quarterly Report on Form 10-Q may not be comparable to similarly titled measures presented by other companies, and may not be identical to corresponding measures used in our various agreements.

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2010      2009      2010      2009  
     (In thousands)  

Income from continuing operations

   $ 53,059       $ 45,317       $ 147,033       $ 116,753   

Stock compensation expense

     10,975         14,608         33,996         43,265   

Provision for income taxes

     32,831         9,666         90,881         55,035   

Interest expense, net

     84,119         38,563         250,673         103,957   

Merger and other costs(1)

     —           878         —           3,890   

Depreciation and other amortization

     17,196         15,364         50,101         45,715   

Amortization of purchased intangibles

     20,711         15,770         56,398         45,833   
                                   

Adjusted EBITDA

   $ 218,891       $ 140,166       $ 629,082       $ 414,448   
                                   

 

(1)

Represents investment banking, legal and accounting costs directly associated with the proposed merger with an affiliate of The Blackstone Group. Other costs represent compensation charges related to the departure of certain employees resulting from cost saving initiatives and other non-routine costs associated with the disposition of certain businesses.

 

36


Table of Contents

 

Results of Continuing Operations

Three months ended September 30, 2010 compared to the three months ended September 30, 2009

 

     Three Months Ended
September 30,
    Change  
     2010     2009     $     %  
     (In thousands, except percentages)  

Revenue:

        

LoyaltyOne

   $ 184,411      $ 177,008      $ 7,403        4.2

Epsilon

     170,468        131,926        38,542        29.2   

Private Label Services and Credit

     349,642        166,982        182,660        109.4   

Corporate/Other

     357        5,515        (5,158     (93.5

Eliminations

     (2,435     —          (2,435     NM
                                

Total

   $ 702,443      $ 481,431      $ 221,012        45.9
                                

Adjusted EBITDA(1):

        

LoyaltyOne

   $ 46,478      $ 53,186      $ (6,708     (12.6 )% 

Epsilon

     44,091        35,196        8,895        25.3   

Private Label Services and Credit

     143,894        67,845        76,049        112.1   

Corporate/Other

     (13,988     (16,061     2,073        (12.9

Eliminations

     (1,584     —          (1,584     NM
                                

Total

   $ 218,891      $ 140,166      $ 78,725        56.2
                                

Stock compensation expense:

        

LoyaltyOne

   $ 2,514      $ 3,847      $ (1,333     (34.7 )% 

Epsilon

     2,305        1,705        600        35.2   

Private Label Services and Credit

     1,779        1,763        16        0.9   

Corporate/Other

     4,377        7,293        (2,916     (40.0
                                

Total

   $ 10,975      $ 14,608      $ (3,633     (24.9 )% 
                                

Depreciation and amortization:

        

LoyaltyOne

   $ 5,827      $ 5,966      $ (139     (2.3 )% 

Epsilon

     21,473        18,003        3,470        19.3   

Private Label Services and Credit

     8,892        5,809        3,083        53.1   

Corporate/Other

     1,715        1,356        359        26.5   
                                

Total

   $ 37,907      $ 31,134      $ 6,773        21.8
                                

Operating income from continuing operations:

        

LoyaltyOne

   $ 38,137      $ 43,373      $ (5,236     (12.1 )% 

Epsilon

     20,313        15,488        4,825        31.2   

Private Label Services and Credit

     133,223        60,273        72,950        121.0   

Corporate/Other

     (20,080     (25,588     5,508        (21.5

Eliminations

     (1,584     —          (1,584     NM
                                

Total

   $ 170,009      $ 93,546      $ 76,463        81.7
                                

Adjusted EBITDA margin(2):

        

LoyaltyOne

     25.2     30.0     (4.8 )%   

Epsilon

     25.9        26.7        (0.8  

Private Label Services and Credit

     41.2        40.6        0.6     
                          

Total

     31.2     29.1     2.1  
                          

Segment operating data:

        

Private Label statements generated

     34,827        31,064        3,763        12.1

Credit sales

   $ 2,046,490      $ 1,909,165      $ 137,325        7.2

Average credit card receivables

   $ 4,909,977      $ 4,217,159      $ 692,818        16.4

AIR MILES reward miles issued

     1,124,363        1,169,492        (45,129     (3.9 )% 

AIR MILES reward miles redeemed

     844,509        777,422        67,087        8.6

 

(1)

Adjusted EBITDA is equal to income from continuing operations, plus stock compensation expense, provision for income taxes, interest expense, net, merger and other costs, depreciation and amortization. For a reconciliation of adjusted EBITDA to income from continuing operations, the most directly comparable GAAP financial measure, see “Use of Non-GAAP Financial Measures” included in this report.

(2)

Adjusted EBITDA margin is adjusted EBITDA divided by revenue. Management uses adjusted EBITDA margin to analyze the operating performance of the segments and the impact revenue growth has on operating expenses.

* Not Meaningful

 

37


Table of Contents

 

Consolidated Operating Results:

Revenue. Total revenue increased $221.0 million, or 45.9%, to $702.4 million for the three months ended September 30, 2010 from $481.4 million for the comparable period in 2009. The increase was due to the following:

 

   

Transaction. Revenue decreased $22.4 million, or 24.7%, to $68.2 million for the three months ended September 30, 2010 due to several factors:

 

   

elimination of servicing fees of $17.3 million from the credit card securitization trusts, as a result of the adoption of ASC 860 and ASC 810. In its capacity as a servicer, each of our respective banks earns a fee from the credit card securitization trusts to service and administer its receivables, collect payments, and charge-off uncollectible receivables. Upon consolidation of the credit card securitization trusts, this fee was eliminated; and

 

   

a decline in merchant fees, which are transaction fees charged to the retailer, of $15.5 million attributable to increases in royalty payments to our retail clients, as well as a decline in fees earned from our deferred programs.

These declines were offset in part by increased AIR MILES reward miles issuance fees of $5.4 million due in part to a favorable foreign currency exchange rate. The average foreign currency exchange rate for the current year period increased to $0.96 as compared to $0.91 in the prior year period. Issuance fees in local currency (Canadian dollars) increased CAD $3.5 million due to growth in the number of AIR MILES reward miles issued in the prior periods. Our issuance fees, which consist of fees for marketing and administrative services provided to sponsors, are recognized pro rata over the estimated life of an AIR MILES reward mile. Additionally, debt cancellation premiums paid by our credit card holders increased $5.4 million due to higher volumes.

 

   

Redemption. Revenue decreased $0.4 million, or 0.3%, to $120.4 million for the three months ended September 30, 2010. Redemption revenue in local currency (Canadian dollars) decreased approximately CAD $7.4 million. Redemption revenue was negatively impacted by a decline in the run-off of deferred revenue related to the conversion of a certain split-fee to non-split fee program of CAD $18.4 million. This decrease was offset by an increase in redemption revenue of CAD $11.0 million, consistent with the increase in AIR MILES reward miles redeemed of 8.6%.

 

   

Securitization income. Securitization income decreased $98.7 million. Upon adoption of ASC 860 and ASC 810 and the consolidation of the credit card securitization trusts, securitization income is no longer reflected. Amounts that were previously included in this financial statement line item are now reflected in finance charges, net in our unaudited condensed consolidated statements of income.

 

   

Finance charges, net. Revenue increased $311.4 million to $327.7 million for the three months ended September 30, 2010. On a conformed presentation, adjusting 2009 securitization income for securitization funding costs and credit losses, revenue increased $78.2 million. The increase was a result of continued positive trends in average receivable balances of 16.4% and an increase in our gross yield of approximately 200 basis points from the comparable period.

 

   

Database marketing fees and direct marketing. Revenue increased $37.8 million, or 29.2%, to $167.1 million for the three months ended September 30, 2010. The database/digital businesses continue to build from recent client signings and expansion of services to existing clients, increasing 23.3% for the three months ended September 30, 2010. The positive trends in our catalog business are continuing as our large catalog coalition database, Abacus, achieved solid revenue growth of 10.7% during the third quarter of 2010 as the data sector continued to show positive momentum. Additionally, the recent DMS acquisition added $12.6 million in revenue.

 

   

Other revenue. Revenue decreased $6.7 million, or 26.0%, to $19.1 million for the three months ended September 30, 2010. Included in the third quarter of 2009 was revenue from the sale of certain licenses in conjunction with an outsourcing agreement. Additionally, investment revenue of $1.6 million from

 

38


Table of Contents
 

investments held by LoyaltyOne in the credit card securitization trusts was eliminated due to their consolidation in 2010 upon adoption of ASC 860 and ASC 810. These decreases were offset in part by additional consulting revenue at LoyaltyOne.

Cost of operations. Cost of operations increased $57.7 million, or 17.7%, to $384.3 million for the three months ended September 30, 2010. The increase was driven by the following:

 

   

higher payroll and benefit costs at Epsilon of $16.2 million and Private Label Services and Credit of $6.7 million, respectively, due to the DMS acquisition, the addition of a customer call center with the Charming Shoppes acquisition, and to support overall growth;

 

   

increased data processing costs at Epsilon of $5.8 million from new database builds coming online and the assumption of expenses related to the DMS acquisition;

 

   

increases in the cost of redemptions for the AIR MILES Reward Program of $6.4 million, driven by the increase in average foreign currency exchange rates. The cost of redemptions for the AIR MILES Reward Program in local currency increased CAD $1.6 million, in part from increased redemptions; and

 

   

credit card related expenses such as marketing, stationary and supplies and postage rose $8.2 million in the current period as compared to the prior year period due to higher volumes and changes in cardholder terms.

General and administrative. General and administrative expenses decreased $10.4 million, or 34.4%, to $19.8 million for the three months ended September 30, 2010. The decrease was driven by costs associated with the sale of certain licenses incurred in the third quarter of 2009 along with a decrease in medical and benefit costs.

Provision for loan loss. Provision for loan loss was $90.5 million for the three months ended September 30, 2010. In 2009, net losses were netted against securitization income. On a conformed presentation, provision for loan loss decreased $9.1 million as compared to the prior year period net losses of $99.6 million. The decrease was a result of continued declines in the loss rate.

Depreciation and other amortization. Depreciation and other amortization increased $1.8 million, or 11.9%, to $17.2 million for the three months ended September 30, 2010 due to additional capital expenditures placed in service.

Amortization of purchased intangibles. Amortization of purchased intangibles increased $4.9 million, or 31.3%, to $20.7 million for the three months ended September 30, 2010. The increase was primarily related to the amortization of $2.1 million associated with the intangible assets acquired in the Charming Shoppes acquisition in October 2009 and $2.7 million associated with the intangible assets acquired in the DMS acquisition in July 2010.

Interest expense. Total interest expense, net increased $45.5 million, or 118.1%, to $84.1 million for the three months ended September 30, 2010 from $38.6 million for the comparable period in 2009. The increase was due to the following:

 

   

Securitization funding costs. Securitization funding costs were $43.0 million for the three months ended September 30, 2010. In 2009, these costs were netted against securitization income and totaled $34.9 million. In 2010, with the consolidation of the WFN Trusts and the WFC Trust, amounts are now reflected as an expense. The increase in these costs from 2009 relates to increased borrowings due to the growth in the portfolio and the amortization of securitization fees.

 

   

Interest expense on certificates of deposit. Interest expense on certificates of deposit increased $0.7 million to $7.3 million for the three months ended September 30, 2010 from $6.6 million for the comparable period in 2009 due to an increase in the average balance offset by a decline in the interest rate.

 

39


Table of Contents

 

   

Interest expense on long-term and other debt, net. Interest expense on long-term and other debt, net increased $1.9 million, to $33.8 million for the three months ended September 30, 2010 from $31.9 million for the comparable period in 2009. The increase in interest expense is related to an increase in the amortization of the discount associated with our convertible senior notes.

Merger costs (reimbursements). In 2010, there were no merger costs or reimbursements. During the three months ended September 30, 2009, we incurred minimal legal costs associated with our proposed merger with an affiliate of The Blackstone Group. We do not expect any future costs associated with the proposed merger.

Taxes. Income tax expense increased $23.1 million to $32.8 million for the three months ended September 30, 2010 from $9.7 million for the comparable period in 2009. In 2009, we recognized an $11.7 million tax benefit related to previously established tax reserves to cover various uncertain tax positions, which were no longer necessary during the period ended September 30, 2009. The remaining increase was due in part to an increase in taxable income, offset by a decline in our effective tax rate to 38.2% as compared to 38.8%, exclusive of the tax benefit recognized.

Income (loss) from discontinued operations. In 2010, there were no gains or losses associated with discontinued operations. Income from discontinued operations, net of taxes, of $0.5 million in the three months ended September 30, 2009 related to the terminated operations of our credit program for web and catalog retailer VENUE.

Segment Revenue and Adjusted EBITDA:

Revenue. Total revenue increased $221.0 million, or 45.9%, to $702.4 million for the three months ended September 30, 2010 from $481.4 million for the comparable period in 2009. The increase was due to the following:

 

   

LoyaltyOne. Revenue increased $7.4 million, or 4.2%, to $184.4 million for the three months ended September 30, 2010 due to a favorable foreign currency exchange rate. In local currency (Canadian), revenue declined CAD $4.6 million, as increases in issuance revenue of CAD $3.5 million were offset by declines in redemption revenue of CAD $7.4 million. Although redemptions increased 8.6%, increasing redemption revenue by CAD $11.0 million in total, redemption revenue decreased as a result of a decline in the run-off of deferred revenue of CAD $18.4 million related to the conversion of a certain split-fee to non-split fee program.

 

   

Epsilon. Revenue increased $38.5 million, or 29.2%, to $170.5 million for the three months ended September 30, 2010. The database/digital businesses continued their trend of double-digit revenue growth increasing 23.3%. These businesses have benefited from the number of signings in 2009 which has continued into 2010. The remaining portion of Epsilon consists primarily of its data business, which includes the large catalog coalition database, Abacus. Abacus achieved solid revenue growth of 10.7% during the third quarter of 2010 continuing the positive trend from the first half of 2010. Additionally, the data business was enhanced by the DMS acquisition, as it added $12.6 million in revenue.

 

   

Private Label Services and Credit. Revenue increased $182.7 million, or 109.4%, to $349.6 million for the three months ended September 30, 2010. On a conformed presentation, adjusting 2009 revenue for securitization funding costs and credit losses, revenue increased $48.1 million, or 16.0% due to growth in our average receivable balances which increased 16.4%, and an increase in gross yield of approximately 200 basis points. This was offset in part by a reduction in transaction revenue, attributable to increases in royalty payments to our retail clients, as well as a decline in fees earned from our deferred programs.

 

   

Corporate/Other. Revenue decreased $5.2 million to $0.4 million for the three months ended September 30, 2010 resulting primarily from the third quarter 2009 sale of certain licenses in conjunction with an outsourcing agreement.

 

40


Table of Contents

 

Adjusted EBITDA. For purposes of the discussion below, adjusted EBITDA is equal to income from continuing operations plus stock compensation expense, provision for income taxes, interest expense, net, merger and other costs, depreciation and amortization. Adjusted EBITDA increased $78.7 million, or 56.2%, to $218.9 million for the three months ended September 30, 2010 from $140.2 million for the comparable period in 2009. The increase was due to the following:

 

   

LoyaltyOne. Adjusted EBITDA decreased $6.7 million, or 12.6%, to $46.5 million and adjusted EBITDA margin decreased to 25.2% for the three months ended September 30, 2010 compared to 30.0% in the same period in 2009. The decrease in 2010 was primarily due to the run-off of deferred revenue associated with the conversion of a split-fee sponsor to a non-split fee sponsor which was offset in part by increased margins on cost of AIR MILES reward miles redeemed.

 

   

Epsilon. Adjusted EBITDA increased $8.9 million, or 25.3%, to $44.1 million, but adjusted EBITDA margin decreased to 25.9% for the three months ended September 30, 2010 compared to 26.7% in the same period in 2009. This was driven by double digit revenue growth offset by increases in payroll costs to support this growth, as well as expenses assumed with the DMS acquisition.

 

   

Private Label Services and Credit. Adjusted EBITDA increased $76.0 million, or 112.1%, to $143.9 million for the three months ended September 30, 2010 while adjusted EBITDA margin increased to 41.2% for the three months ended September 30, 2010 compared to 40.6% in the same period in 2009. On a conformed presentation, adjusting 2009 for securitization funding costs, adjusted EBITDA increased $41.1 million, or 40.0%, and adjusted EBITDA margin increased to 41.2% from 34.1%. Adjusted EBITDA and adjusted EBITDA margin were positively impacted due to growth in our average receivable balances which increased 16.4% from 2009, improvement in our gross yield, and an improvement in credit losses as compared to the prior year.

 

   

Corporate/Other. Adjusted EBITDA increased $2.1 million to a loss of $14.0 million for the three months ended September 30, 2010, primarily related to a decline in payroll and benefits and a general reduction of overall expenses.

 

41


Table of Contents

 

Results of Continuing Operations

Nine months ended September 30, 2010 compared to the nine months ended September 30, 2009

 

     Nine Months Ended
September 30,
    Change  
     2010     2009     $     %  
     (In thousands, except percentages)  

Revenue:

        

LoyaltyOne

   $ 575,612      $ 504,985      $ 70,627        14.0

Epsilon

     433,799        372,495        61,304        16.5   

Private Label Services and Credit

     1,032,106        512,960        519,146        101.2   

Corporate/Other

     1,510        27,981        (26,471     (94.6

Eliminations

     (7,329     —          (7,329     NM
                                

Total

   $ 2,035,698      $ 1,418,421      $ 617,277        43.5
                                

Adjusted EBITDA(1):

        

LoyaltyOne

   $ 158,731      $ 146,419      $ 12,312        8.4

Epsilon

     102,654        87,717        14,937        17.0   

Private Label Services and Credit

     416,878        216,314        200,564        92.7   

Corporate/Other

     (44,171     (36,002     (8,169     22.7   

Eliminations

     (5,010     —          (5,010     NM
                                

Total

   $ 629,082      $ 414,448      $ 214,634        51.8
                                

Stock compensation expense:

        

LoyaltyOne

   $ 7,042      $ 10,128      $ (3,086     (30.5 )% 

Epsilon

     6,441        6,930        (489     (7.1

Private Label Services and Credit

     5,318        6,394        (1,076     (16.8

Corporate/Other

     15,195        19,813        (4,618     (23.3
                                

Total

   $ 33,996      $ 43,265      $ (9,269     (21.4 )% 
                                

Depreciation and amortization:

        

LoyaltyOne

   $ 18,111      $ 15,877      $ 2,234        14.1

Epsilon

     57,565        51,835        5,730        11.1   

Private Label Services and Credit

     25,913        17,740        8,173        46.1   

Corporate/Other

     4,910        6,096        (1,186     (19.5
                                

Total

   $ 106,499      $ 91,548      $ 14,951        16.3
                                

Operating income from continuing operations:

        

LoyaltyOne

   $ 133,578      $ 120,414      $ 13,164        10.9

Epsilon

     38,648        28,952        9,696        33.5   

Private Label Services and Credit

     385,647        192,180        193,467        100.7   

Corporate/Other

     (64,276     (65,801     1,525        (2.3

Eliminations

     (5,010     —          (5,010     NM
                                

Total

   $ 488,587      $ 275,745      $ 212,842        77.2
                                

Adjusted EBITDA margin(2):

        

LoyaltyOne

     27.6     29.0     (1.4 )%   

Epsilon

     23.7        23.5        0.2     

Private Label Services and Credit

     40.4        42.2        (1.8  
                          

Total

     30.9     29.2     1.7  
                          

Segment operating data:

        

Private Label statements generated

     106,627        94,086        12,541        13.3

Credit sales

   $ 6,119,733      $ 5,401,527      $ 718,206        13.3

Average credit card receivables

   $ 5,029,052      $ 4,197,426      $ 831,626        19.8

AIR MILES reward miles issued

     3,327,131        3,278,290        48,841        1.5

AIR MILES reward miles redeemed

     2,538,773        2,321,387        217,386        9.4

 

(1)

Adjusted EBITDA is equal to income from continuing operations, plus stock compensation expense, provision for income taxes, interest expense, net, merger and other costs, depreciation and amortization. For a reconciliation of adjusted EBITDA to income from continuing operations, the most directly comparable GAAP financial measure, see “Use of Non-GAAP Financial Measures” included in this report.

(2)

Adjusted EBITDA margin is adjusted EBITDA divided by revenue. Management uses adjusted EBITDA margin to analyze the operating performance of the segments and the impact revenue growth has on operating expenses.

* Not Meaningful

 

42


Table of Contents

 

Consolidated Operating Results:

Revenue. Total revenue increased $617.3 million, or 43.5%, to $2.04 billion for the nine months ended September 30, 2010 from $1.42 billion for the comparable period in 2009. The increase was due to the following:

 

   

Transaction. Revenue decreased $65.5 million, or 23.4%, to $214.1 million for the nine months ended September 30, 2010 due to the following factors: