Earnings of Alliance Data Systems Corporation (NYSE: ADS) improved to $2.79 per share in the third quarter from $0.81 per share in the second quarter of 2020. The earnings recovery was mainly attributable to an improvement in credit sales and lower provisions for loan losses. Earnings will likely continue to increase in the coming quarters as credit card and loan receivables will likely grow as economic activity picks up. Further, ADS has strategic investment plans that will likely drive earnings in the coming quarters. Overall, I’m expecting ADS to report earnings of around $7.07 per share in 2020 and $12.15 per share in 2021. The June 2021 target price suggests a high upside from the current market price; hence, I’m adopting a bullish rating on ADS.

Expansion Plans, Economic Recovery to Drive Revenues

ADS’s total revenue recovered in the third quarter to $1,051 million from $979 million in the second quarter. The improvement was mostly attributable to a 28% increase in credit sales in the third quarter, on a linked-quarter basis, as retailers continued reopening and consumer spend improved, according to details given in the third quarter’s investor presentation. The card gross yield improved as the impact of COVID‐related customer relief on fees was mitigated, which undermined the decline of average card receivables during the quarter, thereby lifting credit sales. The following chart from the presentation shows how credit sales rose sequentially despite the decline in average credit card receivables.

Alliance Data Systems Credit Sales History

I’m expecting revenues from card services to continue to improve because the recovery of economic activity will likely drive up credit card receivables. Further, ADS is in the process of offering its new proprietary credit card, called Comenity, which is likely to incrementally increase card receivables in the coming quarters, as mentioned in the presentation. Further, ADS has recently launched two new partnerships in the beauty supplies segment that will support card and loan receivables growth in the coming quarters.

ADS also plans to close the acquisition of Bread, a point of sale technology platform, in the fourth quarter of 2020. However, Bread will take three years to be accretive to income, as mentioned in the presentation.

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The LoyaltyOne segment, which handles air miles and rewards, is another important driver of total revenue as it made up around 18% of revenues in the third quarter. I’m expecting revenue from this segment to continue to improve in the coming quarters as air traveling will likely speed up a few months after a COVID-19 vaccine first becomes available. I’m expecting air travel to return to normal by the second half of 2021.

Mostly due to the expected improvement in card and loan receivables and air miles activity, I’m expecting revenue to increase by around 5% year-over-year in 2021. I’m expecting yields to not affect revenues next year because interest rates will likely remain stable. Further, I’m not expecting COVID-19 relief programs to affect yield in 2021.

Provisions Likely to Decline Sequentially

ADS’s earnings improved in the third quarter due to a plunge in provisions for loan losses to $208 million from $250 million in the second quarter of 2020. I’m expecting the provision expense to decline sequentially in the coming quarters but stay above normal. The company has already built significant loan loss reserves earlier this year that will help cover some of the loan losses in the coming quarters. The provisions for loan losses made up 9.1% (annualized) of total loans in the first nine months of 2020, as opposed to an average of 5.9% in the years 2016 to 2019. The management mentioned in the third quarter’s conference call that it expects average net loss rate pressure to be maintained in 2021. Considering these factors, I’m expecting ADS to report provisions for loan losses of $1.2 billion in 2021, representing 7.0% of total loans, down from an expected 8.3% of total loans in 2020.

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ADS’s credit risk has substantially declined in the third quarter as the economy has reopened. As mentioned in the third quarter’s conference call, COVID-19 related relief programs represented just 3% of total card receivables in the third quarter, down from 10% in the second quarter.

Expecting Earnings to Surge by 72% Next Year

Due to the expected recovery in card receivables and sequential decline in provisions for loan losses, I’m expecting earnings to improve in the fourth quarter of 2020 compared to the third quarter. However, the non-interest expense will likely limit the earnings growth in the fourth quarter. ADS’s plans to invest in strategic initiatives, including the new card offering, will likely drive expenses. Moreover, the management plans to ramp up marketing expenditure in the fourth quarter, as mentioned in the conference call. Considering these factors, I’m expecting ADS to report earnings of $2.84 per share in the fourth quarter, which will take full-year earnings to $7.07 per share.

For 2021, I’m expecting the 5% revenue growth to drive earnings. Further, lower provisions for loan losses will likely support earnings growth. Excluding provisions, I’m expecting margins to remain mostly stable because the interest rates are likely to be maintained at the current level. Further, I’m expecting marketing and administrative expenses and investments to increase in tandem with revenues. Considering these factors, I’m expecting earnings to increase by 72% year-over-year in 2021 to $12.15 per share. The following table summarizes my estimates for income statement items.

Alliance Data Systems Income Forecast

ADS Offering a Low Dividend Yield of 1.5%

After the slash in dividend earlier this year, ADS’s current quarterly dividend suggests a dividend yield of just 1.5% based on the closing price of $57.37 for November 3, 2020. However, there is room for an increase in dividends because of the expected increase in earnings. Further, ADS’s combined banks had a common equity tier I ratio of 18.8% in the third quarter, as mentioned in the presentation, which is far above the regulatory requirement of 6.5%.

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However, investors are cautioned that ADS is far from a dividend stock. The sharp cut in dividends earlier this year shows that the management prefers earnings growth over dividend consistency. Further, even if ADS reverts to its previous quarterly dividend level of $0.63 per share, it will provide a dividend yield of only 4.4%.

Considering ADS’s history and for the sake of prudence, I’m assuming that ADS will maintain its quarterly dividend at the current level of $0.21 per share through 2021.

Target Price for Next Year Suggests a High Upside

The price-to-book multiple (“P/B”) is the most appropriate way to value ADS because the company belongs to the financial sector. ADS is currently trading at a P/B ratio of 2.07x, as shown in the chart below.

ChartData by YCharts

Using my earnings and dividend estimates, I have arrived at a forecast book value of $33.3 per share for June 2021. Multiplying this book value per share with the P/B multiple of 2.07 gives a target price of $69.1 for the mid of next year. This price target implies a 20% upside from the current market price. The following table shows the sensitivity of the target price to the P/B ratio.

Alliance Data Systems Valuation Sensitivity

Based on the high upside, I’m adopting a bullish rating on ADS. I like the company because its earnings are set to sharply recover from the COVID-19 pandemic in the coming quarters.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article is not financial advice. Investors are expected to consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.

Via SeekingAlpha.com