UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
OR
Commission File Number: 001-15749
ALLIANCE DATA SYSTEMS CORPORATION
(Exact Name of Registrant as Specified in its Charter)
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
17655 Waterview Parkway
Dallas, Texas 75252
(Address of Principal Executive Office, Including Zip Code)
(972) 348-5100
(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 ¨ 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.
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 May 5, 2010, 53,350,522 shares of common stock were outstanding.
INDEX
Financial Statements (unaudited)
Condensed Consolidated Balance Sheets as of March 31, 2010 and December 31, 2009
Condensed Consolidated Statements of Income for the three months ended March 31, 2010 and 2009
Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2010 and 2009
Notes to Condensed Consolidated Financial Statements
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Quantitative and Qualitative Disclosures About Market Risk
Controls and Procedures
Legal Proceedings
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
(Removed and Reserved)
Other Information
Exhibits
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PART I
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
Cash and cash equivalents
Trade receivables, less allowance for doubtful accounts ($6,670 and $6,736 at March 31, 2010 and December 31, 2009, respectively)
Seller’s interest
Credit card receivables:
Credit card receivables—restricted for securitization investors
Other credit card receivables
Total credit card receivables
Allowance for doubtful accounts
Credit card receivables, net
Deferred tax asset, net
Other current assets
Redemption settlement assets, restricted
Assets of discontinued operations
Total current assets
Property and equipment, net
Due from securitizations
Cash collateral, restricted
Intangible assets, net
Goodwill
Other non-current assets
Total assets
Accounts payable
Accrued expenses
Certificates of deposit
Asset-backed securities debt—owed to securitization investors
Current debt
Other current liabilities
Deferred revenue
Total current liabilities
Deferred tax liability, net
Long-term and other debt
Other liabilities
Total liabilities
Stockholders’ equity:
Common stock, $0.01 par value; authorized 200,000 shares; issued 91,919 shares and 91,121 shares at March 31, 2010 and December 31, 2009, respectively
Additional paid-in capital
Treasury stock, at cost (39,191 and 38,922 shares at March 31, 2010 and December 31, 2009, respectively)
Retained earnings
Accumulated other comprehensive loss
Total stockholders’ (deficit) equity
Total liabilities and stockholders’ equity
See accompanying notes to unaudited condensed consolidated financial statements.
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UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except
per share amounts)
Revenues
Transaction
Redemption
Securitization income
Finance charges, net
Database marketing fees and direct marketing services
Other revenue
Total revenue
Operating expenses
Cost of operations
General and administrative
Provision for loan loss
Depreciation and other amortization
Amortization of purchased intangibles
Merger reimbursements
Total operating expenses
Operating income
Interest expense:
Securitization funding costs
Interest expense on certificates of deposit
Interest expense on long-term and other debt, net
Total interest expense, net
Income from continuing operations before income taxes
Provision for income taxes
Income from continuing operations
Loss from discontinued operations, net of taxes
Net income
Basic income (loss) per share:
Loss from discontinued operations
Net income per share
Diluted income (loss) per share:
Weighted average shares:
Basic
Diluted
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UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization
Deferred income taxes
Provision for doubtful accounts
Non-cash stock compensation
Fair value loss on interest-only strip
Fair value loss on interest rate derivatives
Amortization of discount on convertible senior notes
Loss on the sale of assets
Change in operating assets and liabilities, net of acquisitions:
Change in trade accounts receivable
Change in merchant settlement activity
Change in other assets
Change in accounts payable and accrued expenses
Change in deferred revenue
Change in other liabilities
Excess tax benefits from stock-based compensation
Other
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES:
Change in redemption settlement assets
Change in seller’s interest
Change in credit card receivables
Change in cash collateral, restricted
Change in restricted cash
Change in due from securitizations
Capital expenditures
Proceeds from the sale of assets
Net cash provided by (used in) investing activities
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under debt agreements
Repayment of borrowings
Issuances of certificates of deposit
Repayments of certificates of deposit
Proceeds from asset-backed securities
Maturities of asset-backed securities
Payment of capital lease obligations
Payment of deferred financing costs
Proceeds from issuance of common stock
Purchase of treasury shares
Net cash (used in) provided by financing activities
Effect of exchange rate changes on cash and cash equivalents
Change in cash and cash equivalents
Cash effect on adoption of ASC 860 and ASC 810
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
SUPPLEMENTAL CASH FLOW INFORMATION:
Interest paid
Income taxes (refund) paid, net
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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 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.
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.
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, World Financial Network Credit Card Master Note Trust, World Financial Network Credit Card Master Note Trust II and World Financial Network Credit Card Master Trust III (collectively, the “WFN Trusts”) and World Financial Capital Credit Card Master Note Trust (the “WFC Trust”) 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 will be required
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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
to be consolidated on the balance 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 are reported 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 new requirements for disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances and settlements related to Level 3 measurements. ASU 2010-06 also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. ASU 2010-06 is effective
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for interim and annual periods beginning after December 15, 2009, except for the requirement to provide the Level 3 disclosures about purchases, sales, issuances and settlements, which will be effective for interim and annual periods beginning after December 15, 2010. The adoption of ASU 2010-06 impacted disclosures only and did 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:
Numerator
Denominator
Weighted average shares, basic
Weighted average effect of dilutive securities:
Shares from assumed conversion of convertible senior notes
Net effect of dilutive stock options and unvested restricted stock
Denominator for diluted calculation
Income from continuing operations per share
Loss from discontinued operations per share
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. At March 31, 2010 and 2009, the Company excluded 17.5 million warrants and 10.3 million warrants, respectively, 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.
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5. 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. Retained interests in the WFN Trusts and the WFC Trust have been reclassified, derecognized or eliminated in the unaudited condensed consolidated balance sheets with the adoption of ASC 860 and ASC 810.
The tables below present quantitative information about the components of total credit card receivables, delinquencies and net charge-offs:
Principal receivables
Billed and accrued finance charges
Other receivables
Less credit card receivables—restricted for securitization investors
Principal amount of credit card receivables 90 days or more past due
Net charge-offs
The tables below present quantitative information about the components of total securitized credit card receivables, delinquencies and net charge-offs:
Total credit card receivables—restricted for securitization investors
Principal amount of credit card receivables—restricted for securitization investors 90 days or more past due
Net securitized charge-offs
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The table below summarizes certain cash flows received from and paid to the securitization trusts:
Proceeds from collections reinvested in previous credit card receivables securitizations
Proceeds from new securitizations
Proceeds from collections reinvested in revolving period transfers
Servicing fees received(1)
The Company continues to own and service the accounts that generate credit card receivables held by the WFN Trusts and the WFC Trust. WFNNB and WFCB receive annual servicing fees from the trusts based on a percentage of the monthly investor principal balance outstanding. The fee income to WFNNB and WFCB is eliminated with the fee expense at the respective trusts.
6. 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:
Government bonds
Corporate bonds(1)
Total
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 sheets as of March 31, 2010.
The following tables show the gross unrealized losses and fair value for those investments that were in an unrealized loss position as of March 31, 2010 and December 31, 2009, aggregated by investment category and the length of time that individual securities have been in a continuous loss position:
Corporate bonds
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(In thousands)
Market values were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the security’s issuer, and the Company’s intent to sell the security and whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis. The Company typically invests in highly-rated securities with low probabilities of default and has the ability to hold the investments until maturity. As of March 31, 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 March 31, 2010 by contractual maturity are as follows:
Due in one year or less
Due after one year through five years
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7. INTANGIBLE ASSETS AND GOODWILL
Intangible Assets
Intangible assets consist of the following:
Finite Lived Assets
Customer contracts and lists
Premium on purchased credit card portfolios
Collector database
Customer database
Noncompete agreements
Tradenames
Purchased data lists
Indefinite Lived Assets
Total intangible assets
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The changes in the carrying amount of goodwill for the three months ended March 31, 2010 are as follows:
December 31, 2009
Effects of foreign currency translation
March 31, 2010
8. DEBT
Debt consists of the following:
Description
Long-term and other debt:
Credit facility
Senior notes
Term loan
Convertible senior notes due 2013
Convertible senior notes due 2014
Capital lease obligations and other debt
Less: current portion
Long-term portion
Certificates of deposit:
Asset-backed securities debt—owed to securitization investors:(4)
Fixed rate asset-backed securities
Floating rate asset-backed securities
Conduit asset-backed securities
Total asset-backed securities—owed to securitization investors
The Company maintains a $750 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 in U.S. dollars is the higher of (a) the Bank of Montreal’s prime rate and (b) the Federal funds rate plus 0.5%. The interest rate for base loans in Canadian dollars is the higher of (a) the Bank of Montreal’s prime rate and (b) the CDOR rate plus
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Advances under the term loan agreement (the “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 London Interbank Offered Rate (“LIBOR”) as defined in the 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 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 Term Loan. The weighted average interest rate at March 31, 2010 was 3.23%.
The Company has other minor borrowings, primarily capital leases, with varying interest rates and maturities.
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.
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 4.57% at March 31, 2010.
At March 31, 2010, the Company was in compliance with its financial covenants.
Convertible Senior Notes
The table below summarizes the carrying value of the components of the convertible senior notes:
Carrying amount of equity component
Principal amount of liability component
Unamortized discount
Net carrying value of liability component
If-converted value of common stock
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 3.6 years.
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Interest expense on the convertible senior notes recognized in the Company’s unaudited condensed consolidated statements of income for the three months ended March 31, 2010 and 2009 is as follows:
Interest expense calculated on contractual interest rate
Amortization of discount on liability component
Total interest expense on convertible senior notes
Effective interest rate (annualized)
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 WFNNB, WFCB or their affiliates, including ADSC, 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.
Securitizations
In March 2010, World Financial Network Credit Card Master Note Trust 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 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.
During the first quarter of 2010, the Company renewed its 2009-VFC1 conduit facility, extending the maturity to September 30, 2011.
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The following table shows the maturities of borrowing commitments as of March 31, 2010 for the WFN Trusts and the WFC Trust by year:
Public notes
Private conduits(1)
Total(2)
Amount represents borrowing capacity, not outstanding borrowings.
With the consolidation of the WFN Trusts and the WFC Trust, $539.0 million of debt issued by the trusts and retained by the Company has been eliminated in the unaudited condensed consolidated financial statements.
Derivative Financial Instruments
The credit card securitization trusts have entered into derivative financial instruments, such as interest rate swaps or interest rate caps, to mitigate their interest rate risk on a related financial instrument or to lock the interest rate on a portion of its asset-backed variable 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.
As part of its interest rate risk management program, the Company may enter into derivative financial instruments, such as interest rate swap agreements or interest rate cap agreements, with institutions that are established dealers and manage its exposure to changes in fair value of certain asset-backed security obligations attributable to changes in LIBOR. 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 are not designated for hedge accounting and do not meet the strict 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 March 31, 2010 in the unaudited condensed consolidated balance sheets:
Interest rate contracts not designated as hedging instruments
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The following table identifies the classification of the Company’s outstanding interest rate contracts for the three months ended March 31, 2010 in the unaudited condensed consolidated statements of income:
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 March 31, 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 March 31, 2010, these thresholds were not breached and no amounts were held as collateral by the Company.
9. 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.
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A reconciliation of deferred revenue for the AIR MILES Reward Program is as follows:
Cash proceeds
Revenue recognized
Amounts recognized in the unaudited condensed consolidated balance sheets:
Current liabilities
Non-current liabilities
10. STOCKHOLDERS’ EQUITY
Stock Repurchase Programs
On January 27, 2010, the Company’s Board of Directors authorized a new stock repurchase program to acquire up to $275.1 million of the Company’s common stock through December 2010, subject to any restrictions pursuant to the terms of the Company’s credit agreements or otherwise.
For the three months ended March 31, 2010, the Company acquired a total of 268,500 shares of its common stock for $14.5 million.
Stock Compensation Expense
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 reserves 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.
Total stock-based compensation expense recognized in the Company’s unaudited condensed consolidated statements of income for the three months ended March 31, 2010 and 2009 is as follows:
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There was no stock-based compensation expense related to discontinued operations for the three months ended March 31, 2010. For the three months ended March 31, 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 three months ended March 31, 2010, the Company awarded 476,096 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 three months ended March 31, 2010, the Company awarded 128,516 service-based restricted stock units with a weighted average grant date fair value per share of $57.49 as determined on the date of grant. Service-based restricted stock units typically vest ratably over three years provided that the participant is employed by the Company on each such vesting date.
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.
11. COMPREHENSIVE INCOME
The components of comprehensive income, net of tax effect, are as follows:
Adoption of ASC 860 and ASC 810(1)
Unrealized (loss) gain on securities available-for-sale
Foreign currency translation adjustments(2)
Total comprehensive income, net of tax
These amounts related to retained interests in the WFN Trusts and the WFC Trust 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.
Primarily related to the impact of changes in the Canadian currency exchange rate.
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12. 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 Instruments—The estimated fair values of the Company’s financial instruments are as follows:
Financial assets
Trade receivables, net
Financial liabilities
Derivative financial instruments
Fair Value of Assets and Liabilities Held at March 31, 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. 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.
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Long-term and other debt—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 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 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;
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.
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The following tables provide the assets carried at fair value measured on a recurring basis as of March 31, 2010 and December 31, 2009:
Government bonds(1)
Other available-for-sale securities(2)
Total assets measured at fair value
Derivative financial instruments(3)
Total liabilities measured at fair value
Amounts are included in redemption settlement assets in the unaudited condensed consolidated balance sheets.
Amounts are included in other current and non-current assets in the unaudited condensed consolidated balance sheets.
Amounts are included in other current liabilities and other liabilities in the unaudited condensed consolidated balance sheets.
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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 March 31, 2010 and 2009:
Adoption of ASC 860 and ASC 810
Total gains (realized or unrealized)
Included in earnings
Included in other comprehensive income
Purchases, issuances and settlements
Transfers in or out of Level 3
Gains for the period included in earnings attributable to the change in unrealized gains or losses related to assets still held at March 31, 2010
December 31, 2008
Total (losses) gains (realized or unrealized)
March 31, 2009
Losses for the period included in earnings attributable to the change in unrealized gains or losses related to assets still held at March 31, 2009
For the three months ended March 31, 2010 and 2009, gains included in earnings attributable to cash collateral, restricted are included in revenue under finance charges, net in the unaudited condensed consolidated statements of income. For the three months ended March 31, 2009, 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 months ended March 31, 2010, the Company had no impairments related to these assets.
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13. INCOME TAXES
For the three months ended March 31, 2010 and 2009, the Company utilized an effective tax rate of 38.2% and 38.8%, respectively, 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%.
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.
14. SEGMENT INFORMATION
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.” 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 operation have been classified as discontinued operations. See Note 15, “Discontinued Operations,” for additional information.
Three Months Ended March 31, 2010
Adjusted EBITDA(1)
Stock compensation expense
Operating income (loss)
Interest expense, net
Income (loss) from continuing operations before income taxes
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Three Months Ended March 31, 2009
Merger and other costs(2)
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, loss on the sale of assets, 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.
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.
15. 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:
Assets:
The following table summarizes the operating results of the discontinued operations:
Revenue
Loss before provision for income taxes
Benefit from income taxes
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16. 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 three months ended March 31, 2010 as follows:
elimination of $74 million in redemption settlement assets for those interests retained in the WFN Trust,
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.
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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.
Quarter in Review Highlights
Our results for the first three 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.
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.
Beginning with this Quarterly Report on Form 10-Q, 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 effective January 1, 2010. Additionally, with the consolidation of World Financial Network Credit Card Master Trust, World Financial Network Credit Card Master Note Trust, World Financial Network Credit Card Master Note Trust II and World Financial Network Credit Card Master Trust III, 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. The provision for loan loss represents management’s estimate of probable net loan losses inherent in the credit card portfolio.
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Management evaluates the allowance monthly for adequacy. The allowance is maintained through an adjustment to the provision for loan loss. In estimating losses inherent in the credit card portfolio, we use an approach that utilizes a migration analysis of delinquent and current credit card receivables. A 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 new requirements for disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances and settlements related to Level 3 measurements. ASU 2010-06 also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for the requirement to provide the Level 3 disclosures about purchases, sales, issuances and settlements, which will be effective for interim and annual periods beginning after December 15, 2010. The adoption of ASU 2010-06 impacted disclosures only and did not have a material impact on our consolidated financial statements.
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 are reported 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
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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.
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, loss on the sale of assets, 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.
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.
Merger and other costs(1)
Adjusted EBITDA
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.
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Results of Continuing Operations
Three months ended March 31, 2010 compared to the three months ended March 31, 2009
Revenue:
LoyaltyOne
Epsilon
Private Label Services and Credit
Corporate/Other
Eliminations
Adjusted EBITDA(1):
Stock compensation expense:
Depreciation and amortization:
Operating income from continuing operations:
Adjusted EBITDA margin(2):
Segment operating data:
Private Label statements generated
Credit sales
Average receivables
AIR MILES reward miles issued
AIR MILES reward miles redeemed
Adjusted EBITDA is equal to income from continuing operations, plus stock compensation expense, provision for income taxes, interest expense, net, loss on the sale of assets, merger and other costs, depreciation and amortization.
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. For a definition of adjusted EBITDA and a reconciliation to net income, the most directly comparable GAAP financial measure, see “Use of Non-GAAP Financial Measures” included in this report.
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Revenue. Total revenue increased $184.1 million, or 38.4%, to $663.5 million for the three months ended March 31, 2010 from $479.5 million for the comparable period in 2009. The increase was due to the following:
LoyaltyOne. Revenue increased $39.0 million, or 24.3%, to $199.7 million for the three months ended March 31, 2010 due to a favorable foreign currency exchange rate and growth in our AIR MILES reward miles redeemed. The average foreign currency exchange rate for the current year period increased to $0.96 as compared to $0.80 in the prior year period, which favorably impacted revenue by $30.9 million. In local currency (Canadian dollars), revenue increased approximately CAD $7.0 million, or 3.5%. Redemption revenue in local currency increased approximately CAD $5.0 million, or 3.6%, whereas AIR MILES reward miles redeemed increased 13.5%. This was a result of weak, lower margin issuances over the last two years due to the prolonged economic recession in Canada. This decline has negatively impacted the breakage pool, which has yet to return to historical levels. In addition, the amortization of deferred profit related to the conversion of certain split-fee to non-split fee programs has declined as the AIR MILES reward miles acquired have been redeemed. We believe the decline in local currency redemption revenue will recover as issuances and sponsor mix return to historical levels. AIR MILES reward miles issued grew 5.2%, and as 2010 progresses, we expect AIR MILES reward miles issued to continue to return to a growth rate of 7% – 8%, consistent with historical growth periods.
Epsilon. Revenue increased $8.7 million, or 7.4%, to $126.3 million for the three months ended March 31, 2010. Revenue from the segment’s largest service offerings (marketing database services, analytical services and digital communications) increased 10.2% as compared to the three months ended March 31, 2009 due to additional client signings. Proprietary data services revenue increased as its large catalog coalition database achieved solid growth with the retail sector beginning to show signs of improvement. This growth was offset by declines in the segment’s agency business.
Private Label Services and Credit. Revenue increased $150.0 million, or 79.3%, to $339.2 million for the three months ended March 31, 2010. On a conformed presentation, adjusting 2009 revenue for securitization funding costs and credit losses which totaled $127.4 million, revenue increased $22.6 million, or 7.1%. The increase was a result of continued positive trends in portfolio growth of 22.3% and credit sales growth of 19.7%. The increase was in part mitigated by a slight decline in gross yield, which was 23.6% for the current period a compared to 25.3% for the prior period. Gross yields dipped temporarily in February 2010 upon the implementation of the Credit Card Accountability and Responsibility and Disclosure Act of 2009. However, the March 2010 implementation of new cardholder terms returned gross yields to historic levels, where they are anticipated to remain.
Corporate/Other. Revenue decreased $11.3 million to $0.8 million for the three months ended March 31, 2010 primarily due to a decline of $11.6 million in transition services revenue from agreements associated with the acquirers of our merchant services and utility services businesses, which were no longer in place in 2010.
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, loss on sale of assets, merger and other costs, depreciation and amortization. Adjusted EBITDA increased $51.1 million, or 33.7%, to $203.0 million for the three months ended March 31, 2010 from $151.8 million for the comparable period in 2009. The increase was due to the following:
LoyaltyOne. Adjusted EBITDA decreased $1.3 million, or 2.4%, to $53.6 million and adjusted EBITDA margin decreased to 26.8% for the three months ended March 31, 2010 compared to 34.2% in the same period in 2009. The decrease in adjusted EBITDA was driven primarily by a foreign exchange gain of $5.0 million in 2009, lower margins on AIR MILES reward miles redeemed discussed above and additional severance and coalition expenses.
Epsilon. Adjusted EBITDA increased $5.1 million, or 23.3%, to $27.3 million and adjusted EBITDA margin increased to 21.6% for the three months ended March 31, 2010 compared to 18.8% in the same
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period in 2009. The increase in adjusted EBITDA was driven by its large catalog coalition database. In 2009, our catalog business suffered as catalogers pared marketing budgets. In the first quarter of 2010, it achieved solid revenue growth. Additionally, our marketing database services grew $1.4 million due to additional client signings, as large multinational companies are directing a portion of their marketing spend to Epsilon due to the quantifiable benefits of transactional-based ROI micro-targeted marketing.
Private Label Services and Credit. Adjusted EBITDA increased $52.3 million, or 59.8%, to $139.8 million for the three months ended March 31, 2010 but adjusted EBITDA margin decreased to 41.2% for the three months ended March 31, 2010 compared to 46.2% in the same period in 2009. On a conformed presentation, adjusting 2009 for funding costs of $94.0 million due to the adoption of ASC 860 and ASC 810, adjusted EBITDA increased $18.8 million, or 15.5%, and adjusted EBITDA margin increased to 41.2% from 38.2%. Adjusted EBITDA and adjusted EBITDA margin were positively impacted by the increases in revenue attributable to portfolio growth and sales growth as previously described.
Corporate/Other. Adjusted EBITDA decreased $3.3 million to a loss of $15.9 million for the three months ended March 31, 2010 primarily related to the elimination of the transition services agreements and severance expense associated with the departure of certain associates.
Stock compensation expense. Stock compensation expense decreased $7.4 million, or 40.9%, to $10.6 million for the three months ended March 31, 2010. The decrease was driven by $7.0 million incurred in the comparable prior year period related to certain performance-based restricted stock unit awards that are no longer expected to vest, thus no expense was incurred in 2010.
Depreciation and Amortization. Depreciation and amortization increased $4.9 million, or 16.6%, to $34.2 million for the three months ended March 31, 2010 due to a $1.3 million increase in depreciation and other amortization and a $3.6 million increase in amortization of purchased intangibles, primarily as a result of the intangible assets acquired in the October 2009 acquisition of the Charming Shoppes credit card program.
Merger and other costs. We incurred no merger and other costs in 2010. During the three months ended March 31, 2009, we incurred approximately $3.5 million in severance costs for certain employees offset in part by a reimbursement of $0.6 million of costs associated with our proposed merger with an affiliate of The Blackstone Group. We do not anticipate any future costs associated with the proposed merger.
Operating Income. Operating income increased $56.6 million, or 55.7%, to $158.2 million for the three months ended March 31, 2010 from $101.6 million for the comparable period in 2009. Operating income increased due to the revenue and expense factors discussed above.
Securitization Funding Costs. Securitization funding costs were $41.6 million for the three months ended March 31, 2010. In 2009, these costs were netted against securitization income and totaled $33.5 million. In 2010, with the consolidation of the credit card securitization trusts, these costs are now reflected below as an operating expense. We incurred $39.4 million in interest on our asset-backed securities debt from increased borrowings due to growth in the portfolio, while interest rates remained relatively stable, and the amortization of securitized fees.
Interest Expense on Certificates of Deposit. Interest expense on certificates of deposit increased $1.8 million to $7.5 million for the three months ended March 31, 2010 from $5.7 million for the comparable period in 2009 due to higher average balances offset in part by a decline in interest rates.
Interest Expense on Long-Term and Other Debt, net. Interest expense on long-term and other debt, net increased $8.0 million, or 31.4%, to $33.6 million for the three months ended March 31, 2010 from $25.5 million for the comparable period in 2009. The increase resulted in part from additional interest expense of $5.5 million
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associated with our convertible senior notes. Our line of credit increased $1.0 million as a result of higher average balances, while interest rates remained relatively flat during the three months ended March 31, 2010 than during the comparable period in 2009.
Taxes. Income tax expense increased $1.6 million to $28.8 million for the three months ended March 31, 2010 from $27.3 million for the comparable period in 2009 due to an increase in taxable income, partially offset by a decrease in our effective tax rate to 38.2% for the three months ended March 31, 2010 from 38.8% for the comparable period in 2009.
Loss from Discontinued Operations. We incurred no loss from discontinued operations in 2010. Loss from discontinued operations, net of taxes, of $15.2 million in the three months ended March 31, 2009 related to the sale of the remaining portion of our utility services business.
Asset Quality
Our delinquency and net charge-off rates reflect, among other factors, the credit risk of our private label credit card receivables, the average age of our various private label credit card account portfolios, the success of our collection and recovery efforts, and general economic conditions. The average age of our private label credit card portfolio affects the stability of delinquency and loss rates of the portfolio. We continue to focus resources on refining our credit underwriting standards for new accounts and on collections and post charge-off recovery efforts to minimize net losses.
An older private label credit card portfolio generally drives a more stable performance in the portfolio. At March 31, 2010, 63.3% of our accounts with balances and 63.6% of receivables were for accounts with origination dates greater than 24 months old. At March 31, 2009, 63.3% of our accounts with balances and 63.4% of receivables were for accounts with origination dates greater than 24 months old.
Delinquencies. A credit card account is contractually delinquent if we do not receive the minimum payment by the specified due date on the cardholder’s statement. When an account becomes delinquent, we print a message on the cardholder’s billing statement requesting payment. After an account becomes 30 days past due, a proprietary collection scoring algorithm automatically scores the risk of the account rolling to a more delinquent status. The collection system then recommends a collection strategy for the past due account based on the collection score and account balance and dictates the contact schedule and collections priority for the account. If we are unable to make a collection after exhausting all in-house efforts, we engage collection agencies and outside attorneys to continue those efforts.
The following table presents the delinquency trends of our credit card portfolio:
Receivables outstanding—principal
Principal receivables balances contractually delinquent:
31 to 60 days
61 to 90 days
91 or more days
Net Charge-Offs. Net charge-offs comprise the principal amount of losses from cardholders unwilling or unable to pay their account balances, as well as bankrupt and deceased cardholders, less current period recoveries. The following table presents our net charge-offs for the periods indicated. Average receivables
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represents the average balance of the cardholder receivables at the beginning of each month in the periods indicated.
Net charge-offs as a percentage of average receivables (annualized)
Liquidity and Capital Resources
Operating Activities. We have historically generated cash flows from operations, although that amount may vary based on fluctuations in working capital and the timing of merchant settlement activity. Our operating cash flow is seasonal, with cash utilization peaking at the end of December due to increased activity in our Private Label Services and Credit segment related to holiday retail sales.
We generated cash flow from operating activities of $206.6 million and $71.1 million for the three months ended March 31, 2010 and 2009, respectively. The increase in operating cash flows was due to increased profitability, including non-cash charges to income such as an increase in the provision for doubtful accounts as a result of the consolidation of the credit card securitization trusts. We also generated positive operating cash flow from increases in working capital, including the timing of payments of accounts payable and accrued expenses. Also impacting cash flow from operations was amounts due from trusts. In 2009, the amounts due from the trusts were included in other assets and resulted in a use of cash as amounts increased during the period. In 2010, with the consolidation of the securitization trusts upon the adoption of ASC 860 and ASC 810, amounts due from the securitization trusts were eliminated. We utilize our cash flow from operations for ongoing business operations, acquisitions and capital expenditures.
Investing Activities. Cash provided by investing activities was $443.1 million for the three months ended March 31, 2010. Cash used by investing activities was $119.1 million for the three months ended March 31, 2009. Significant components of investing activities are as follows:
Credit Card Receivables Funding. Cash increased $397.5 million due to a decline in receivables from the seasonal pay down of our credit card receivables.
Capital Expenditures. Our capital expenditures for the three months ended March 31, 2010 were $15.4 million compared to $10.9 million for the comparable period in 2009. We anticipate capital expenditures to be approximately 3% of annual revenue for the foreseeable future.
Financing Activities. Cash used in financing activities was $723.2 million for the three months ended March 31, 2010 as compared to cash provided by financing activities of $214.6 million for the three months ended March 31, 2009. Our financing activities during the three months ended March 31, 2010 relate primarily to borrowings and repayments of debt, the issuance and repayment of certificates of deposit and repurchases of common stock.
Adoption of ASC 860 and ASC 810. The consolidation of the WFN Trusts and the WFC Trust resulted in $81.6 million in cash and cash equivalents as of January 1, 2010, which is shown separately from operating, financing and investing activities.
Liquidity Sources. In addition to cash generated from operating activities, our primary sources of liquidity include our securitization program, certificates of deposit issued by World Financial Network National Bank, or WFNNB, and World Financial Capital Bank, or WFCB, our credit facility and issuances of equity securities.
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In addition to our efforts to renew and expand our current facilities, we continue to seek new sources of liquidity. We have also expanded our brokered certificates of deposit to supplement liquidity for our credit card receivables.
We believe that internally generated funds and other sources of liquidity discussed above will be sufficient to meet working capital needs, capital expenditures, and other business requirements for at least the next 12 months.
Securitization Program.Since January 1996, we have sold a majority of the credit card receivables originated by WFNNB to WFN Credit Company, LLC and WFN Funding Company II, LLC, which in turn sold them to the WFN Trusts as part of our securitization program. In September 2008, we initiated a securitization program for the credit card receivables originated by WFCB, selling them to World Financial Capital Credit Company, LLC which in turn sold them to the WFC Trust. These securitization programs are the primary vehicle through which we finance WFNNB’s and WFCB’s credit card receivables.
At March 31, 2010, we had $3.2 billion of asset-backed securities debt — owed to securitization investors, of which $696.9 million is due within the next 12 months.
Historically, we have used both public and private asset-backed securities term transactions as well as private conduit facilities as sources of funding for our credit card receivables. Private conduit facilities have been used to accommodate seasonality needs and to bridge to completion of asset-backed securitization transactions.
We have secured and continue to secure the necessary commitments to fund our portfolio of securitized credit card receivables originated by WFNNB and WFCB. However, certain of these commitments are short-term in nature and subject to renewal. There is not a guarantee that these funding sources, when they mature, will be renewed on similar terms or at all based on recent unsuitable volumes and pricing levels in the asset-backed securitization markets.
As of March 31, 2010, the WFN Trusts and the WFC Trust had approximately $4.3 billion of securitized credit card receivables. Securitizations require credit enhancements in the form of cash, spread deposits and additional receivables. The credit enhancement is principally based on the outstanding balances of the series issued by the WFN Trusts and the WFC Trust and by the performance of the private label credit cards in these securitization trusts.
In March 2010, World Financial Network Credit Card Master Note Trust 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 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 us. 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.
During the first quarter of 2010, we renewed our 2009-VFC1 conduit facility, extending the maturity to September 30, 2011.
Debt
See Note 8, “Debt,” of the Notes to Unaudited Condensed Consolidated Financial Statements for more information related to our debt.
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Market Risk
Market risk is the risk of loss from adverse changes in market prices and rates. Our primary market risks include interest rate risk, credit risk, foreign currency exchange rate risk and redemption reward risk.
There has been no material change from our Annual Report on Form 10-K for the year ended December 31, 2009 related to our exposure to market risk from interest rate risk, credit risk, foreign currency exchange risk and redemption reward risk.
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
As of March 31, 2010, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that as of March 31, 2010 (the end of our first fiscal quarter), our disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and include controls and procedures designed to ensure that information we are required to disclose in such reports is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
During the first quarter of 2010, LoyaltyOne completed a system conversion of its order management system. There have been no other changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
FORWARD-LOOKING STATEMENTS
This Form 10-Q and the documents incorporated by reference herein contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements may use words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “predict,” “project” and similar expressions as they relate to us or our management. When we make forward-looking statements, we are basing them on our management’s beliefs and assumptions, using information currently available to us. Although we believe that the expectations reflected in the forward-looking statements are reasonable, these forward-looking statements are subject to risks, uncertainties and assumptions, including those discussed in the “Risk Factors” section in Item 1A. of our Annual Report on Form 10-K for the year ended December 31, 2009 and Item 1A. of Part II of this Quarterly Report.
If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we projected. Any forward-looking statements contained in this quarterly report reflect our current views with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. We have no intention, and disclaim any obligation, to update or revise any forward-looking statements, whether as a result of new information, future results or otherwise, except as required by law.
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PART II
From time to time we are involved in various claims and lawsuits arising in the ordinary course of our business that we believe will not have a material adverse effect on our business or financial condition, including claims and lawsuits alleging breaches of our contractual obligations.
Other than as set forth below, there have been no material changes to the Risk Factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009.
If we are unable to securitize our credit card receivables due to changes in the market, we would not be able to fund new credit card receivables, which would have a negative impact on our operations and earnings.
Our ability to continue to securitize our receivables will depend upon the conditions in the securities market at the time. There has been uncertainty in the securitization market recently over existing Federal Deposit Insurance Corporation, or FDIC, guidance regarding standards for legal isolation of the transferred assets. The FDIC has adopted a “safe harbor” rule stating that, if certain conditions are met, the FDIC will not use its repudiation power to reclaim, recover or recharacterize as property of an FDIC insured institution any financial assets transferred by that institution in connection with a securitization transaction. WFNNB and WFCB have structured the issuance of their asset-backed securities with the intention that the transfers of the securitized credit card receivables by WFNNB and WFCB would have the benefit of this safe harbor rule. Except as described below, the protection of the FDIC safe harbor rule only extends to securitizations that satisfy the conditions for sale accounting treatment (other than the legal isolation condition, since the safe harbor rule was meant to help satisfy that condition). As a result of accounting changes effective as of January 1, 2010, the transfers of receivables by WFNNB and WFCB ceased to satisfy the conditions for sale accounting treatment. The FDIC has adopted an amendment to the safe harbor rule stating that for transfers of financial assets made on or before September 30, 2010, or, with respect to revolving securitization trusts, for securitizations in which the related beneficial interests were issued on or before September 30, 2010, the protection of the safe harbor rule will continue to apply for the life of the securitization transaction notwithstanding the fact the transaction does not satisfy all conditions for sale accounting treatment under the new accounting rules, provided that the securitization satisfied the conditions (other than the legal isolation condition) for sale accounting treatment under generally accepted accounting principles in effect for reporting periods prior to November 15, 2009, and the other conditions of the safe harbor rule are satisfied. As a result, the accounting changes will not affect the availability of the safe harbor rule for securitization transactions issued by the securitization trusts prior to September 30, 2010. On December 15, 2009, the FDIC issued an Advance Notice of Proposed Rulemaking, which describes the possible future terms of the legal isolation standard. The form that this rule will ultimately take is uncertain at this time, but it may impact our ability and/or desire to issue asset-backed securities in the future.
On April 7, 2010, the SEC proposed revised rules for asset-backed securities offerings that, if adopted, would substantially change the disclosure, reporting and offering process for public and private offerings of asset-backed securities, including those offered under our securitization program. The proposed rules, if adopted in their current form, would, among other things, impose as a condition for the shelf registration of asset-backed securities a requirement that the sponsor of the asset-backed securities offering hold a minimum of 5% of the nominal amount of each of the tranches sold or transferred to investors (or, in the case of revolving master trusts, an originator’s interest of a minimum of 5% of the nominal amount of the securitization exposures) and not hedge those holdings. Issuers of publicly offered asset-backed securities would be required to disclose more information regarding the underlying assets and to file a computer program that demonstrates the effect of the transaction’s waterfall of distributions. In addition, the proposals would alter the safe-harbor standards for the private placement of asset-backed securities to impose informational requirements similar to those that would apply to registered public offerings of such securities.
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On January 27, 2010, our Board of Directors authorized a new stock repurchase program to acquire up to $275.1 million of our outstanding common stock, from February 5, 2010 through December 31, 2010, subject to any restrictions under the terms of our credit agreement or otherwise.
The following table presents information with respect to those purchases of our common stock made during the three months ended March 31, 2010:
Period
During 2010:
January 1-31
February 1-28
March 1-31
During the period represented by the table, 8,103 shares of our common stock were purchased by the administrator of our 401(k) and Retirement Saving Plan for the benefit of the employees who participated in that portion of the plan.
None
(a) None
(b) None
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(a) Exhibits:
EXHIBIT INDEX
Exhibit No.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: May 7, 2010
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