Tuesday, October 26, 2021

Loyalty Ventures: Form 10 Notes

Alliance Data Systems (ADS), after a few years of speculation, is spinning off their LoyaltyOne segment as Loyalty Ventures (LYLT) in an attempt to become a more pure-play private label credit card company.  The spinoff's primary business (~80% of  EBITDA) is the Canadian loyalty program "AIR MILES" where consumers ("collectors" in LYLT speak) shop at participating retailers ("sponsors") and earn points that can be redeemed for travel, cash/gift cards or other rewards.  AIR MILES collects a fee from sponsors at the time of purchase but only recognizes revenue fully when the collector redeems the reward, creating an attractive negative net working capital business.

AIR MILES is similar to the old Blue Chip Stamps business that was a Warren Buffett favorite from a generation ago. AIR MILES is an independent rewards program, it is not formally connected to an airline or hotel chain which is common in the U.S., instead they partner with retailers offering rewards on everyday recurring consumer purchases like groceries and gas. The other business under the Loyalty Ventures corporate umbrella is "BrandLoyalty", it is more of a targeted short-term promotional business that primarily caters to grocery store chains globally. I haven't seen their promotions at any grocery stores I frequent, but the campaigns BrandLoyalty runs seem analogous to the Monopoly game promotion McDonalds occasionally does to generate a short-term bump in sales.  It doesn't appear to have the same float dynamics and its results are rather lumpy.

The spinoff setup reminds me a bit of the recent one from J2 Global, Consensus Cloud Solutions (CCSI), an historically underinvested yet steady cash flowing business the parent had harvested cash from to pursue M&A in other segments.  While I continue to have my doubts about Consensus (the market clearly doesn't share my view) not being a melting ice cube, Loyalty Ventures should be a low-single digit revenue grower inline with GDP.  It is not an exciting growth story but it will produce plenty of cash that now instead of sending up to ADS corporate, can be used to deleverage (starting off with ~3x net debt), invest in the business or return to LYLT's own shareholders (no plans for a dividend).

This is a business with some baggage and requires a little leap of faith to assume it will get back to its normalized earnings.  Back in 2016, the AIR MILES segment made a pretty terrible public relations blunder (here's a local news story on it), they had previously quietly added a 5 year expiration date in 2011 to their reward miles, all historically issued miles would then at year-end 2016 unless they were redeemed.  Due to the revenue recognition dynamics, this created a windfall in 2016 as collectors rushed to redeem their miles or have them expire, either outcome is generally good for the company's financials.  But people don't like the rules changed mid-game and AIR MILES faced significant backlash (they also reportedly didn't have enough rewards/merchandise to meet demand), eventually it became a legislative issue and the company caved to pressure a month before the deadline, removing the expiration feature from the program.  The miles once again never expire, but many long time collectors redeemed their miles for unwanted rewards just to risk not losing them and they weren't allowed to return their rewards after the expiration policy was reversed.  Naturally if you had been saving miles for a dream vacation for a decade and instead had to redeem for a fancy vacuum, you'd be upset.  Management in charge during this time have since moved on, it is not the same team that will be in charge of the spin.

The AIR MILES segment was just about back to normal when covid hit which reduced the appeal of a travel awards program and due to travel restrictions, mile redemptions (and thus revenue/earnings) dropped significantly in 2020 and 2021.  In Q2 2021 business is potentially inflecting, miles created is up (+8%) and redemptions (+32%) are following, albeit against an easy comparable Q2 2020.  The company is anticipating $187MM in adjusted EBITDA in 2021, but a normalized number is probably something closer to $200-210MM, this is something of a leisure travel recovery story.

There is not a great public peer for Loyalty Ventures currently public, Aimia previously owned Aeroplan (spun from Air Canada and repurchased by the airline a couple years back for $370+MM) and AeroMexico's loyalty plan that was sold for 9x EBITDA.  The U.S. airline carriers used their loyalty programs as collateral to raise financing for themselves last year, for example United raised financing with a 12x EBITDA multiple valuation on their rewards program.  Probably not apples-to-apples.  I have no clue where LYLT will trade, but I'm going to throw a 9x multiple on it as a guess.
When issued trading was supposed to start today under the symbol LYLTV but I didn't see any trades, regular way trading is set for 11/8.  As always, I'm very open to hearing from those more knowledgeable about the situation, especially those more comfortable with the accounting and piecing out the true cash flow of this business.

Other thoughts/notes:
  • This spin seems a bit off the radar, ADS has been kind of quiet about it too, the investor deck is about as sparse on details as the Trump/DWAC one, there hasn't been an investor call made public (guessing there's one for the debt or will be one).  Most pitches for ADS (previously was a bit of a hedge fund hotel, some potential investor fatigue here) have always been focused on the card business and the loyalty segment has been a throw away afterthought.
  • The company likes to tout that 2/3rds of Canadian households have an AIR MILES account, but many collectors are probably only loosely active in the program, the top 15% of collectors make up 70% of new miles created.  This is both good and bad, collecting miles seems like a habitual exercise, it gamifies shopping, you need the power users but you also need to keep them active and happy.
  • BMO is their largest sponsor with 15% of revenue, I believe this is their primary credit card partner, their contract comes up again in 2023.
  • ADS is retaining a 19% stake in LYLT, like other recent spins, they'll divest the retained amount over the next year or so to reduce debt.  ADS calls out that 27% of their shareholders are index funds that might be forced to sell LYLT, so there could be a bit of an overhang.  The distribution ratio is 1 share of LYLT for every 2.5 shares of ADS, if LYLT is worth $50 then its about $20 of ADS's $100 stock price.
  • I don't know the full history, but LYLT pays a 1% royalty fee to Diversified Royalty Corp (DIV in Canada) for the use of the AIR MILES brand name, rather insignificant but also kind of odd.
  • LYLT invests the "float" rather conservatively, mostly cash equivalents and some corporate bonds (most miles are redeemed after 2-3 years, so the portfolio probably matches the duration).  While their miles never expire if an account is active, miles do expire if an account is abandoned and not used for two years, so there is some breakage still despite the 5-year policy being reversed.
  • It wouldn't surprise me if we see a goodwill write-down on the BrandLoyalty business, it accounts for $542MM of goodwill and is expected to generate $52MM of EBITDA, so that would value the segment at 10x EBITDA.  They acknowledge the risk in the Form 10 noting that the fair value is less than 10% above the goodwill carrying value.  Or one could spin it that if BrandLoyalty's intrinsic value is 10x, the overall company should be at least that as the AIR MILES segment is a more valuable business model.
Disclosure: I have a tiny position in ADS $100 Jan 2022 calls, basically just a FOMO trade in case LYLT takes off out of the gate similarly to CCSI (seems like one of those situations where both parent and spin will trade up), look to add LYLT directly once it starts trading.

12 comments:

  1. Thoughts on the cash flow statement from 2018-2020? I was initially under the assumption that this would be a highly cash generative business as well but the financials turned me off a bit...

    Over 3-year period... $387m cumulative op cash flow, $100m capex, $92m outflow for redemption assets, total distributions to Parent of ~$40m... One oddity -- income taxes paid were $203m (!!) which seems off by a lot...

    https://www.sec.gov/Archives/edgar/data/1870997/000110465921125953/tm2122068d12_exh99x1.htm#fCSOC1

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  2. Tacking on 1H21... op cash flow over 3.5yr period = $485m, capex of $109m, redemption assets outflow of $133m, dividends to Parent of $180m... taxes paid at $230m...

    Also, any thoughts on the RemainCo ADS? Does the extraction of Loyalty make the PLCC business more attractive?

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    1. I don't have a good answer for the cash flow statement, had similar thoughts thus why I asked for help there and the Form 10 is a little light on details *shrug*. As for ADS, the combined entity is trading for 7x earnings, SYF trades for 8x earnings, my simple thought was LYLT should trade for a higher multiple than the PLCC business, thus the gap between RemainCo ADS and SYF would widen (and then hopefully narrow).

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    2. I went back and read through a few years of transcripts, the LoyaltyOne segment isn't talked about a lot, but its usually in the context of it being a "pure cash flow business".

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  3. I've bought this one, been sold off pretty hard down here in the mid-$30s. Might be a mistake, AIR MILES issuance down 7% in Q3 versus last year, BrandLoyalty business is a disaster (grocery stores don't need to be promotional to drive people to their stores in this environment), etc.

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  4. Thanks a lot for the write-up and idea, MDC. How do you think about the deferred revenue liability here? Should it have any impact on how we think about valuation?

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    1. That's the float, they get paid up front from the sponsors and don't recognize the revenue until points are redeemed (not entirely true, but a high level simplification), so doesn't really impact the valuation other than understanding how the cash flows work and the true FCF this business generates.

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  5. Hey thanks for sharing your work I really like your posts. It's tough. I agree it definitely looks optically cheap here. Do you have any thoughts on the full year 2021 guide? Specifically it looks like an enormous sequential revenue improvement in the BrandLoyalty biz (I think from $97mm in 3q21 to $220mm in 4q21e). With only about half the float traded so far, the ADS overhang still around, and the high net debt % of TEV, I'm worried an earnings miss this early out of the gate would be pretty painful. I did like seeing ceo buy stock here though.

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    1. Thanks for your thoughts, hard to argue, its not a high conviction holding for me but still somehow interests me. The CEO did buy a little, worth mentioning that a few people I've talked to hold him in high regard, he was the CFO at ADS and was thought to be "the adult in the room" over there.

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  6. LYLT has gotten pounded- selling by ETFs who held ADS and cannot keep LYLT, tax loss selling , selling from ADS shareholders etc. At what point will other ETFs start to buy it?

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    1. It's a good question. I think some of the selling is also covid/omicron related, it is exposed to the reopening. But I do wonder if I just got the business quality wrong, ADS underinvested in the business the last few years, there was some uncertainty on who would own it, the 2016 points scandal, all probably hurt their negotiating power with sponsors longer term. Guessing there will be some heavy spend to reinvest in the business and reinvigorate it. My hand is a bit bloody from catching the knife, still holding for now but also sort of a tax loss candidate as you suggest.

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  7. FYI - the CEO has been buying the stock all the way down, with purchases as recently as yesterday. His consistent buying gives me pause to my prior bearish stance...I think the stock has been de-risked considerably down here at near $30...I need to do more work but pointing this out to the group. (Love the blog!)

    http://openinsider.com/LYLT

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