Bread Financial Holdings, Inc. (BFH) Q4 2012 Earnings Report, Transcript and Summary

Good morning, and welcome to the Alliance Data Fourth Quarter and Full Year 2012 Earnings Conference Call. [Operator Instructions] It is now my pleasure to introduce your host, Ms. Julie Prozeller of FTI Consulting. Ma'am, the floor is yours.

Thank you, operator. By now you should have received a copy of the company's fourth quarter and full year 2012 earnings release. If you haven't, please call FTI Consulting at (212) 850-5721. On the call today we have Ed Heffernan, President and Chief Executive Officer; and Charles Horn, Chief Financial Officer of Alliance Data. Before we begin, I would like to remind you that some of the comments made on today's call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and the uncertainties described in the company's earnings release and other filings with the SEC. Alliance Data has no obligation to update the information presented on the call. Also on today's call, our speakers will reference certain non-GAAP financial measures, which we believe will provide useful information for investors. Reconciliation of those measures to GAAP will be posted on the Investor Relations website at www.alliancedata.com. With that, I'd like to turn the call over to Ed Heffernan. Ed?

Great. Thank you, Julie, and everyone, welcome to the early-morning edition of Alliance's Q4 Earnings Call. And joining me today, of course, is Charles Horn, our always insightful CFO. And Charles is going to talk about our segment and consolidated results, and I'll wrap up with a financial scorecard and our 2013 outlook. Also, I know a lot of folks are in the middle of earnings season right now, but will, I think, most likely go back and look at the transcripts or listen to the call. So at the very end, I am going to give a few minutes discussion just in terms of where we see the company from a longer-term perspective, give a little bit of a strategic view of looking at where we want to be as we move through '13 into '14 and into '15. So that being said, Charles, your show.

Thanks, Ed. 2012 was another tremendous year with double-digit revenue, adjusted EBITDA and net of funding costs and core EPS growth. The growth was balanced, as all 3 segments contributed 9% or better to top line and bottom line growth to the year. Organically, revenue grew 9% in 2012 driven by 9% growth in LoyaltyOne and 12% growth at Private Label. Epsilon had a somewhat off year with organic growth of 4%. However, importantly, after negative organic revenue growth in Q3 2012, Epsilon returned to 3% growth in Q4 2012, as it played through the air ball created by the lack of new wins early in 2012. Our Q4 results, aside from the increase in diluted share count, closely mirror full year 2012, revenue up 15% to $972 million, adjusted EBITDA, net of funding costs up 26% to $245 million and core EPS up 8% to $1.84 or 14% to $2.15 on an economic basis, which excludes phantom shares. The acquisition of Hyper Marketing completed on November 30, 2012, added approximately $0.04 to Q4 and full year 2012. Our share count continued to move against us, as diluted shares for Q4 increased 6.9 million shares driven by a 3.5 million increase in phantom shares and a 3.7 million increase in warrants associated with our convertible debt, both driven by higher ADS average share price as partially offset by share repurchases we made. Looking forward, approximately 4.6 million of the phantom shares at year end disappear August 1, 2013, as the first tranche of convertible debt matures. Let's turn to the next slide and talk about LoyaltyOne. LoyaltyOne had a strong fourth quarter, with the revenue up 1% and adjusted EBITDA up a notable 24%. Excluding the benefit of favorable foreign exchange translation rates, revenue decreased 2%, while adjusted EBITDA increased…

Good. Thanks, Charles. Let's turn to the Slide 2012 Wrap-up. Obviously, Charles has covered everything in depth, but again, stepping away and looking at what are the key messages that we take away from 2012. Obviously, the financial performance, always important. What we note is very, very strong double-digit growth across all of our key metrics. And I would say moving on to probably one of the key highlights is the second bullet point, which is 9% of this is organic growth. And in this environment of new, new and even assuming yesterday's GDP with a bit of a timing issue, if you're looking at 2%, 2.5% real GDP growth and you're doing organic growth of 8%, 9%, quite frankly, we think that is a very, very attractive model. And that's why we will continue to focus very, very intently on the organic growth rate of our businesses. That being said, having incremental M&A activity and share buyback round out what we call the three-pronged strategy that we have. What was also nice in 2012 was the growth was nicely balanced across all 3 of our engines. For those of you who have been around for a dozen years and have followed us, you'll notice that sometimes we have years in which we have one just blow the doors off and another segment is a little bit soft, and that also works with the model. But 2012 was notable because all 3 of the engines contributed nicely to the record results. Same with -- on the EBITDA or free cash flow side, again, ranging from anywhere of just under 10% to 20% in the range. As you look at the individual businesses, Private Label obviously was the primary engine of overperformance during 2012 where you had record portfolio growth of…

[Operator Instructions] Your first question comes from the line of Sanjay Sakhrani with KBW. Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division: It seems like in Epsilon, you guys have a pretty nice setup given the acquisition, some of the new relationships and some of the restructuring efforts you've taken. Can you just talk about how much of that's kind of incorporated in your guidance? It seems like there's a fair amount of tailwind? And then also just how much the restructuring charges were for the quarter? And then just on Loyalty, I was hoping you could just talk about the reduction in the breakage rate and your comfort moving forward that any impacts are manageable to the overall economics of that segment.

On Epsilon, Sanjay, in terms of the expense we took this year realigning the restructuring was about $5 million for the fourth quarter, about $11 million for the entire year. It is not something we've adjusted out of core EPS. That is a reported number that's been decremented for those items. I think on a go-forward basis what it's going to do is help us get back on Epsilon to drive close to high single-digit organic revenue growth again. In fact, I'm looking for mid-single-digit, at least, organic growth in the first quarter of '13 and maintain double-digit organic EBITDA growth in '13. And I think that's the key focus, and then what we ladder on top from Hyper Marketing is just kind of a plus. In terms of the breakage reset, we did change it from 28% in 2012 to 27% in 2013. The key takeaways I'd want to make on that is, one, we do think it is an effect from the announcement of the expiry, meaning we triggered a run on the bank, and we had a few people we'd expected not would ever redeem redeemed, so we adjusted. What that means is we true up our balance sheet, which has not created an immediate P&L hit. What it means is we're reducing the amount of deferred revenue at 12/31/2012 that we would amortize into revenue over multi-year standpoint. So what that means is, in any 1 year, it's not overly material. And then three, the other point I would make is since it's a prospective adjustment, as with any coalition program, you've got multiple levers you can pull. So as we look forward, we know what the impact will be over the next 2, 2.5 years, so we can adjust our pricing mechanism in such a way so we can offset it with basically gross margin on the product. So I think from that standpoint, we don't see any impact to earnings for LoyaltyOne in 2013 nor do we anticipate it will affect our guidance for ADS in 2013. Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division: Okay. Just one more on Epsilon, just the restructuring. I mean, you mentioned the revenue side of it but just on the operating margin side on legacy basis, I mean, do you expect that to be accretive to the operating margin?

I do. So if I look at the base business -- and again, you have to overlay in Hyper Marketing. Before Hyper Marketing, I'm looking for at least a 50-basis-point expansion in EBITDA margins for Epsilon. And then, of course, then you ladder in Hyper Marketing being a digital agency is going to have a little bit lower EBITDA margin. But for the base business, I'm looking for at least 50 basis points of improvement in EBITDA margins.

Your next question comes from the line of Bob Napoli with William Blair. Robert P. Napoli - William Blair & Company L.L.C., Research Division: Question on the guidance. Is the buyback in the guidance and is your intention to essentially buy back the warrants from the convert when it matures? Or will you do -- be buying out during the year?

Yes, there is no -- there is nothing in guidance related to buyback activity, so one could view that as, obviously, a potential plus. Obviously, we don't want to tip our hand too much. But what we like to do with the buyback, obviously, if you went back in our history, we tend to be extremely active at certain times and less active at other times. I guess when corporate America bought back the least, which was Q4 of '08 through the first half of 2010, is when we backed the truck up and loaded up. So we tend to do things a little bit differently here. Obviously, we think the price is still attractive. We have a lot of liquidity, but we're not going to be silly and just go out there and back up the truck. If it looks like we have a good opportunity, we absolutely will be there, and we will be there in size. Otherwise, most likely we'll be picking away at it throughout the year. And whether we do it through just purchasing throughout the year or taking up the warrants, we haven't really decided at this point, so... Robert P. Napoli - William Blair & Company L.L.C., Research Division: Okay. And just on the Private Label business, are you seeing, Ed, an increased interest in Private Label cards by retailers? I mean, it seems like their -- like the Target REDcard and it just seems like to us that there's more interest than retailers using Private Label cards as loyalty programs incrementally than what there has been in the past.

There is no doubt. And as we talked about earlier, the big driver behind it, right, and all you hear out in the marketplace today is data this and digital that and all the other fancy stuff. This is what we do for a living, and what the benefit of Private Label has for our clients is quite simply the fact that you have a closed-loop network. And with the closed-loop network and Alliance being a marketing company, you're capturing a level of data that is much richer than what really any other source can capture. You're down to the category level, the SKU level. And as a result, you can take that richness of the data, and now it's then worthwhile to talk about the various distribution channels, this whole omni-channel approach. Whereas before, we could put in very sophisticated, fancy, personalized messaging in the statements or inserts or at the point of sale. Well, now we're talking about using the digital channels as well, whether it's permission-based email, whether it's SMS, MMS, things like that. When you have the richness of the data, you have the analytics to segment that information, and then you have the omni-channel distribution system across, not only old school but the new digital channels. I got to tell you. It's getting people's interest. And when you then filter in the demographics, psychographic data that we have over at Epsilon to overlay the transactional data, it's a pretty fancy machine we got here. Robert P. Napoli - William Blair & Company L.L.C., Research Division: Last question. Just on your guidance for '13, what are your -- the yield that you saw in this quarter on Private Label, is that a reasonable run rate yield? Or is there more pressure on that yield? And what do you have in there from a credit loss perspective?

Bob, from that standpoint, the yield always fluctuates during the course of the year with Q4 generally being the lowest because of what, I call, the denominator effect. You have a big ramp-up in the NAD and AR [ph] that's not income producing yet. So looking into 2013, what I would expect, obviously dependent on any onboarding in the new programs, is a gross yield roughly consistent between years.

Yes. I'd also say that you have obviously seasonality in the yield itself where Q1, you will tend to have your highest yield because essentially, right, people hopefully shop till they drop in Q4. And in Q1, they go, "Oops, we need to figure out how to pay that off." So folks tend to either miss or a little bit late in January or they roll the balance during Q1. And then also in Q3, you have the back-to-school seasonality where everyone's coming back from vacation, and they're, like, "Yes, I'll get around to it." And some folks are a little bit late on their payments or they decide to roll it. So you tend to have seasonality on the yield itself, but as Charles said, it tends to even out on an annual basis. Robert P. Napoli - William Blair & Company L.L.C., Research Division: And on credit assumption?

We talked about it a little bit, Bob, that probably in '13, looking for maybe 20, 30 basis points change and a normalized charge-off rate. So if our charge-off rate normalized was 5% for 2012, we're looking in that 5%, 3% [ph] range for 2013.

I would also say that it's too early to call the ball on this one, but it does seem that I think that is certainly a very safe bet. It may be even a bit on the conservative side because we really have yet to see any upward movements in some of our key forward indicators suggesting that losses are, in fact, drifting back up to the more normalized 6% level. It will happen at some point, and whether it happens this year or 2 years from now, right now, we're not really sure. But based on delinquency flows, it looks fabulous. We're actually seeing improvements in personal bankruptcy rates, and recovery rates are staying very stable. So right now, a potential source of incremental upside would in fact be if losses in fact stayed relatively flat to 2012. And right now, it's tracking to that, but we don't mind putting in 20 or 30 bps just to be safe.

Your next question comes from the line of Carter Malloy with Stephens.

First off on dotz, I'm not sure how much you can speak to it on a public call, but appreciate all the data you guys have given us. When can we expect to see that actually on your P&L?

Well, the -- obviously, our share of the operating losses will flow through the P&L, and that's what you're seeing. In terms of the revenue, all we can say right now is we will continue to keep everyone updated on how revenue is growing because it is taken off. And our #1 goal right now, right, it's a land grab. And our #1 goal right now is to get from -- we went from 0 million to 6 million. We want to get 10 million folks enrolled and active by the end of this year, which means some big rollouts. At that point, you're going to see the numbers looking pretty big. At a certain point, Carter, we will obviously take a hard look at is there an opportunity to recognize that more in the financial statements as opposed to just a note. That's probably all I can say.

Okay, that's fair. And then on the breakage going up a little bit this year -- I'm sorry, from 28% to 27%, what are the drivers or the triggers that could make that happen again going forward?

Yes. I'll jump in and Charles can give you the -- probably the more correct answer. But essentially, when you have the run on the bank, when we announced the expiry policy, we need to reflect that in the breakage calculation, and as a result, we had to move it 1 point. As Charles mentioned, when you own the program as we do, there are a number of levers, as we have said for years, that we can pull, and those levers have already been pulled. So for example, if your breakage rate is a little bit less, then what you do is you will change your pricing accordingly and make it up in margin when folks redeem. And so to us, it really doesn't matter. We just want to make sure all the accounting is right, and we knew we had a run on the bank. That's already been taken care of through pricing mechanisms, and we feel pretty good about that. As we look forward, it's going to be real interesting. The consumer has really -- we have a bifurcated consumer in the sense of we have those who are looking really long term for that fabulous trip down to Florida when it's minus 20 degrees up there. And we have the others who want instant gratification when they go into the grocery store, and as a result, that's beginning to change the dynamics of the model a little bit. And so we need to change with it. The most important thing is to offer the consumer something that the consumer wants. And then we worry about how the pieces fit together later on. The consumer is clearly saying I want that instant rewards option. That could change the redemption model. What we will do with any change in the redemption model is that we will pull another lever that will keep us whole in terms of the margins. So bottom line of all of it is that whether breakage stays within a point or 2 of where it is now or not, it really doesn't matter from the model and the margin perspective. We'll pull another lever, as we've always said we would, to make sure that we're clean.

And second part of that question would be related to that on the pricing elasticity. How much have you guys moved it over the last few years? And do you think there's still a lot of digital headroom there or just a little bit left?

There seems to be a certain level of comfort with our consumer base. We think that the offering that we have today is a solid 20% premium in value over any other program that's out there in the marketplace when you look at not only the value of the rewards we offer but the ability to obtain those awards without, "Hey, let's have a blackout period 364 days a year." That's not helpful to anyone. We don't have those things. So as a result, we've got a very nice premium built into the program today, and as a result, we think there's a fair amount of flexibility. And again, what we would do is it really will be in reaction to how the consumer chooses to redeem his or her rewards, whether it's instant or whether it's a longer-term type approach, and we'll adjust accordingly.

Your next question comes from the line of Tim Willi with Wells Fargo.

I wanted to expand a bit on Bob's question about Private Label. I just wondered if you could talk about, in the context of retailers in Private Label, taking that a little bit more to the forefront around their mobile strategies. I'm assuming there's some tie in. You talked about the Walgreens platform, which I think is available as a mobile app. Could you just maybe talk about that and what that might mean for your incremental revenue take over time with your retailers as opposed to just the number of accounts you might have with retailers on the Private Label business?

Yes. It's a great question. I think we're going to fall under the camp of we don't really know right now the end result of all this stuff, so -- but what we can tell you is what we've seen thus far. And when it's all said and done, do we believe mobile will be an important channel for us? For sure. There's no question about it, but let's not kid ourselves. The huge amount of accounts we're going to get as people at the point of sale in the store, in places like that, that's still going to be the bulk of our business. Now in terms of incremental growth, I'd love to sit there and say that the ability to have folks opt in to all of our SMS, MMS, in geo-fencing initiatives and all the other fancy stuff that I almost understand, it -- these things are certainly on the -- from an incremental perspective, are helpful. But I will tell you one thing that actually has worked and we can put real numbers to, which has been very helpful, which is using a web-enabled phone or smartphone in the store to secure new applications. And if you know how Private Label works, it's primarily at the point of sale. What we have found is that we went after some of the clients who tend to cater towards a younger demographic, and we offered the opportunity as they walk into the store shopping, to hey, there's all sorts of signage, Call Here. You call it up on your phone through your web, and you enter a few pieces of information. It zips up. It gets scored. It comes back. You have a virtual card right there in the store before you've even gotten to the checkout. And what we have found is that has given us an incremental lift in new active accounts that has been very significant, and we've also found -- maybe because you already have your credit line before you go up to the point of sale, we're finding that their first purchase is quite a bit larger than a traditional client. So I guess, Tim, where we're coming out at is, yes, we will be participating in all the different digital opportunities that exist out there, but right now, I can tell you flat out, we're going to make a bunch of money based on this new application or this new account app with people in the store. I mean, that's the stuff you can take to the bank. It's a nice lift that we have. That's the only thing right now I can say that we feel very, very good about. The other stuff, look, we're like everyone else. We're going to see where it leads.

Great. If can just ask a quick follow-up around the balance sheet for Charles. Could you just -- is there -- if you said it, I apologize, but is there a way you can -- sort of number you can give us around sort of the average length of your funding duration? And I guess theoretically, is there possibility that if we say, some time out there within a 2- to 3-year window, if rates rose, would there actually be the potential for spread expansion on your Private Label business for a period of time?

That's exactly how it would work, Tim. So if you think about it for all funding borrowings, for about 27 months in duration. For just the term ABS, about 41 months in duration. We talked about 75% of it's fixed rate. So to your point, in a rising rate environment, you're going to have the majority of your file fixed for a long period of time. At the same time, on your cardholders' standpoint, you have a variable rate tied to prime. So if it's a normal rising rate interest environment where LIBOR's going up, treasury rate's going up, prime's going up, it will increase in the following billing cycle for your cardholder. At the same time, on the funding cost, until you're replenishing or renewing debt, you're largely fixed for a long period of time. So in a rising rate environment, you're going to get a little bit of yield expansion, and then that will just normalize over time as the -- basically the new higher rates burn in and new debt is issued.

And we will take one more question from the line of David Scharf with JMP Securities.

Wanted to just dig in a little more on the Private Label runway. Ed, I don't know if this is something -- a metric you have the top of your head. But when we look at that $7 billion, roughly $7 billion portfolio, give us a sense for what percentage of those balances reside at programs, stores in which your wallet share is maybe 15% or less? Just to give us a sense for kind of how much market share within those same programs, if we can still ride this?

Yes. I would say that you start with the sandbox and say how big is the potential world for us. We think there's about 300 retailers that fit sort of our DNA of a few hundred million to a few billion in sales, right, and they tend to focus on prime-quality type customers. They tend to focus on brand. You narrow down that world, there's about 300 or so in our target universe. There's about 150 programs. Today, we have about, say, 110 of those. And so we've got about 1/3 of the potential market. We've got well over 2/3 of the programs that are already out there. So this is our sandbox. If you think that we have roughly 1/3 of the total potential market for $7 billion of receivables, we think the total market for us is obviously 3x that or about $21 billion, and that's what we're shooting for. If you look, therefore, okay, how are we going to get there, it's going to be a combination of wallet share and as well as signing new clients. Typical for us, I would say right now that our wallet share varies depending on how long we have had the customer and the client and how much the client has put their shoulder into the program itself. Quite frankly, we're no good if the client is not sitting there pounding the table saying, "Look, this is our loyalty program. We're going to support it, and we're going to push it." Obviously, I'm not going to mention any client specifically, but overall, what we found is that it looks like our tender share is in the 20s, maybe 25%. We do have some clients that are up around 40% of their sales, so if you were to ask me what the opportunity is, it's somewhere between that 25% and 40%. So there's a good chunk that we can still get through tender share and obviously, a huge chunk we can get through further penetration of the sandbox.

Got it. So is it fair to say that maybe 20% of your portfolio resides at programs in which the -- that tender share or wallet share is well below 40%, I don't know, just as to that maybe 20% level? Just trying to get a sense for the organic wallet share opportunity assuming you never signed up another program, just on an organic growth level.

Yes I'd say it's probably less than that. I would say it's less than that.

Got it. Got it. Hey, switching to Loyalty. Charles, is there a figure for what the year-end true-up was in deferred revenue, just kind of the onetime true-up to account for the breakage assumption change?

I'll put it this way, David. If you look at it, breakage in your product redemption all fall within the same liability. So really, you won't see anything on the balance sheet per se because you defer 100% of the revenue associated with the points you issue. So what we'll do is we'll refine before we come out with our 10-K what projected change in amortization will be over the following few years, and then that's what we'll talk about. But at this time, I'm just not really prepared to talk about it. So the key takeaway is you won't see anything on the balance sheet, no P&L associated therewith. What you will have is less theoretical breakage revenue amortizing over a multi-year window that we'll look to offset with margin.

Got it. And with just closing with Epsilon, can you give a little update of just perhaps what your vertical concentration is as we look into 2013 and after the acquisition? Sort of what your concentration on the top line is along pharma, banking, auto and so forth?

Sure. I mean, obviously, the biggies that we're looking at would be -- auto would be a very large one for us. You would look at -- I would say telecom is a large one for us. Retail CPG is a very large one for us and then financial services. So I would say those 4, auto, health, telecom, retail CPG and financial services. I guess that's 5. Those would be the vast bulk of the $1.3 billion that we're expecting out of Epsilon. Outside of that, I probably am not going to rank those 5. They're all big.

Got it. Got it. Following the acquisition, are there any 10% customers now for Epsilon?

No, not for -- for Epsilon by itself, or for ADS?

No, for Epsilon.

Oh, you've got some 10% customers within Epsilon but not for ADS.

Right, right. Got it. Hey, and then just lastly on Epsilon, I -- is there any regulatory update or anything on that -- the FTC was looking into data brokers, which obviously doesn't -- it's not directly related to Epsilon since you're not selling the data. But has anything progressed since they started requesting information from a number of data miners in the fall? [indiscernible]

Yes, it's a good question. I would say the regulatory environment is as clear as mud as always, and what we're doing is we're trying to make sure that the folks who are asking a bunch of questions get what they need. So we are actually proactive in D.C. basically saying, "Hey, look, if you want to understand how all this stuff works, let us walk you through it. Let us help you understand how all these things work." It's -- you can't just sit there and say you click the switch and let's have a do not track because somebody's got to pay for the Internet. And so we have to make those linkages crystal clear. I would say that, not only for us but a number of other firms as well, there will be headline risks probably for quite some time. Right now, we're in the process of hopefully an education process in terms of how all this stuff works, and then we'll go from there. But investors, analysts, everyone should be aware that for this group of companies, ourselves included, you're going to see headlines that pop up. And all I can tell you at this point is it's -- from what we can tell, it's information gathering. There's no one pounding the table saying we're going to need to do this. We need to do that. It's more of here's another request, and it hits the headlines. But we're on top of it, and if anything changes, we'll certainly let everyone know. Okay. We're going to wrap it up. Thank you so much for your time, and we look forward to a great 2013. Bye.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.