Alliance Data Navigates the Rapids

  As a rising star in the processing arena, Alliance Data competes with giants like GE and First Data. Is there room for a mid-size player when scale seems to be a necessity?
  American consumers' tastes have changed over the last 10 years and retailers have changed with them. Discounters have usurped the full-price department stores. Specialty retailers have gone national, taking the place of many local shops.
  Big chains have come to mean scale, which translates into bargains. The trade-off has been a loss of the personal touch. So a few retailers have built a space for themselves with a more customer-friendly approach.
  Merchant acquirers and private-label card processors have evolved too. The mantra for many today is faster, better, cheaper. Scale allows large acquirers to lower prices and grab market share.
  But some merchants are demanding the personal touch too. That need has created an opening for an agile processor to use a one-on-one approach with its merchants to build a space for itself. Dallas-based Alliance Data Systems Corp. has found such a niche by emphasizing marketing and customer relationships as essential components of traditional credit card processing.
  Alliance Data's three major business lines are private-label card issuing and processing, bank card merchant processing, and loyalty programs.
  ADS doesn't sign up the huge department-store chains though it does have plenty of national shops as private-label clients. Meanwhile, it is leveraging its processing strengths to enter non-traditional markets.
  Alliance specializes in specialty stores, primarily those in soft goods. Its center is the women's apparel chain Limited Brands Inc. and its affiliates Victoria's Secret, Express, Bath & Body Works and Henri Bendel. Other clients include Crate & Barrel, Pottery Barn, Restoration Hardware, Ann Taylor, J. Crew, Dress Barn and Abercrombie & Fitch.
  The mid- to upscale nature of Alliance's retailers reduces its risk. A typical cardholder has a credit score from Fair, Isaac and Co. above 700 and maintains a card balance of $250.
  Alliance was forged out of the combination of the card division of Limited Brands and the front-end transaction authorization group at J.C. Penney Co., called BSI Business Services Inc. New York investor Welsh, Carson, Anderson & Stowe merged the two in 1996 and over the next few years brought in some other interesting elements.
  An online loyalty and stored-value firm was added in 1998. In 1999, Alliance bought the network-services business of SPS Payment Systems Inc., a subsidiary of Associates First Capital Corp. The SPS addition offered processing scale and about 180 clients. In 1998, Alliance bought the Air Miles Reward program connected to Air Canada.
  Alliance executives concede that the company's hybrid nature makes it hard to get your hands around the firm. The plus side is that Alliance offers an eclectic mix of services, an advantage as the electronic transaction industry evolves.
  Alliance's three divisions overlap but don't always interlock. The transactions group provides the traditional back-office card processing tasks including statements, payment handling and call centers.
  The credit division builds on that to provide customer loyalty and marketing programs for Alliance's private-label card clients. The Air Miles unit is a cash-generating machine that also brings expertise in the marketing and loyalty arena.
  Targets
  In 2002, the transactions unit had revenues of $538 million, credit services generated $342 million, and the Air Miles marketing group saw $237 million, according to preliminary numbers from Edward Heffernan, chief financial officer. Alliance was expected to release its final 2002 results shortly after this issue of CCM went to press.
  Alliance reported 2002 profits of $26.2 million on revenues of $871.5 million, a 12% rise. As further evidence of Alliance's tricky make-up, the firm's total revenue is less than the sum of its three parts because the accountants subtract inter-segment income earned by one division from another. For the most part, that's the back-office work the transaction division provides for the private-label credit division.
  And there's another confusing, but logical, wrinkle. The Air Miles group each year must defer some revenue to account for the estimated three-plus years that consumers wait before redeeming points. Last year Alliance posted nearly $350 million in deferred revenue.
  In 2001, ADS went public and garnered about $161 million.
  But the company is still tied to its origins. Welsh Carson owns nearly 59%, while The Limited holds 19.7%. The Limited and its affiliates accounted for 17.2% of Alliance's 2001 consolidated revenues.
  Alliance provides some processing services for about 300 retailers. But its core is its private-label card services for 53 retailers that use its loyalty and marketing expertise, says Heffernan.
  That 53 is a solid chunk of the 220 retailers in North America that Alliance estimates would benefit from its full-service private-label package that includes database marketing, Heffernan says.
  "About 100 (retailers) have (private-label) programs today. We have about half," Heffernan says. "We need to sign two or three clients a year to reach double-digit growth."
  Sales in the private-label card group have risen an average of 16.4% in the last three years. In 2002, the $4.9 billion in sales represented a 21.6% growth rate.
  One negative last year was the 27% drop in transactions processed, according to figures from Heffernan. But he says Alliance wanted to "prune" low-margin accounts from its portfolio. One loss was Equiva Services LLC, a marketing alliance between gas retailers Shell and Texaco that accounted for 8.2% of the 2001 revenue for Alliance's transaction division. Alliance also lost the statement business of Charming Shoppes Inc. for a decline of about one million statements a month.
  Still, the transaction division saw 7% revenue growth in 2002. Michael A. Beltz, transaction services president, says that some accounts may be moderately profitable but don't fit Alliance's strategy.
  The objective is to have deep relationships with several hundred clients as opposed to handling processing for thousands of clients, says Beltz.
  "If we can't build a strong relationship, it doesn't make sense to continue with the client," he says. "We just processed transactions (for the lost accounts). That's processing as a commodity."
  That space is already highly competitive with giants like First Data Corp., Total System Services Inc. (TSYS) and National Processing Co., says Jeffery Baker, a senior research analyst with U.S. Bancorp Piper Jaffray.
  "Competing with First Data on price is suicide. Why do it?" says Baker.
  Instead, Alliance offers the "full nine yards," of service, he says.
  That's where the credit group comes in. The idea is to be the best with customized loyalty programs, faster approvals, top customer service and gentle treatment of accounts past due.
  Again, giants surround Alliance. GE Consumer Finance is tops, with receivables north of $28 billion. Household Retail Services USA has receivables near $14.9 billion. Citi Commerce Solutions is the private-label division of $116.6 billion Citigroup Inc.
  In contrast, ADS holds receivables of about $2.8 billion through its World Financial Network National Bank. Nearly all of that has been securitized.
  But Alliance seems to hold its own against the big guys. Last August, ADS extended its contracts with The Limited and its affiliates for seven years. New clients added last year included Restoration and Pottery Barn. This January, ADS re-signed Brylane Inc. to a 10-year deal. Brylane operates multiple catalogs offering special-size apparel, value prices and home furnishings.
  Ivan M. Szeftel, president of the credit-services group, says Alliance will compete on price for a retailer's private-label business if another issuer is pitching a cobranded deal with MasterCard International or Visa U.S.A. Alliance earns returns from the management fee it charges retailers along with the excess spread in its securitized portfolio.
  "Our discount fee is generally in the 1.6% to 1.7% range, higher on some occasions and often significantly lower," says Szeftel. "That's no higher or lower than MasterCard and Visa."
  Two Alliance features are Smart Statements and Quick Credit. Smart Statements categorizes consumers by analyzing their past purchasing behavior. "It enables retailers to talk differently to different consumers," says Szeftel. "The jeans customer gets a jeans statement and the sweater customer gets the sweater statement."
  Sometimes customer service means being creative. Traditionally, a discount coupon was inserted in a monthly statement. Alliance made the coupon a tear-off from the top of the statement itself. Szeftel says that increased the coupon response rate by 50%.
  Quick Credit allows the retailer's clerk to swipe an existing card an applicant holds, input five numeric bits of information about the consumer, and receive a credit granting decision in less than a minute, says Szeftel. The information typically includes ZIP code, Social Security number, street address and telephone number.
  This feature helps address the age-old tug of war between retailers and store card processors over granting credit. Usually retailers would prefer that standards are somewhat easy for the applicant while the third-party issuer wants to guard against credit risk. Szeftel says that hasn't been a problem.
  "Our approval rates are at or above historic numbers that retailers run themselves," says Szeftel. "Subprime is not a market we target."
  Alliance has done a decent job in fending off delinquencies and chargeoffs. In 2001, chargeoffs reached 8.4% of managed receivables then fell to 7.8% last year, according to preliminary results. Szeftel predicts they will be below 7.5% this year. Delinquencies were at 6.3% of managed receivables in 2002 compared to 6.4% in 2001.
  The low-risk space may not be glamorous but it can be attractive for investors, says analyst Baker. "They are a stable, kind of boring, processor," Baker says. "I'd love to see faster growth. But the last thing they want to do is cut lending standards."
  Alliance has been seeking to safely raise its growth and has expanded into the utilities market, uncharted territory for processors. The theory remains to bundle the marketing skills of Szeftel's credit group with Beltz's meat-and-potatoes transaction division.
  In the late 1990s some states were deregulating their local utilities in hopes of creating a competitive market. Alliance determined that many power generators would outsource their back-office processing business. The deregulation move slowed after a power shortage debacle in California led to outraged customers and utilities in bankruptcy court.
  But the concept of outsourcing billing and customer service remains viable, and that is translating into strong growth for Alliance. It has signed Georgia Natural Gas, Puget Sound Energy, Potomac Electric Power and several others.
  Utility billing can be complex with an array of cost structures for business and consumers, discount programs, a host of charges for the time of day that power is used and myriad other variations. But Alliance claims its expertise has cut exceptions, or billing questions and disputes, by 54% at Georgia Gas. It claims a five-fold increase in service levels at the utility's call centers.
  The knotty nature of utility billing means more work, and higher charges than a typical private-label program. Alliance earns $2 to $2.50 per private-label statement, while a utility bill can mean $2 to $2.80 in fees, says Heffernan. Some oil retailers generate as little as 80 cents per statement, he says.
  Revenues from utilities rose from $60 million in 2001 to $80 million last year, Heffernan says. The goal for 2003 is $120 million.
  Another new market is unbanked or under-banked consumers, who represent about 32.9 million U.S. households, according to a report last October by Celent Communications. While that group could be high-risk, Alliance's initial foray into the space will be a virtually no-risk prepaid card product.
  In February, Alliance announced two contracts with 7-Eleven Inc. the Dallas-based convenience-store chain with 5,800 U.S. and Canadian locations. Alliance will service the prepaid 7-Eleven magnetic-stripe Convenience Card under a three-year deal.
  And under a six-year agreement ADS will provide stored-value and loyalty-marketing services for 7-Eleven's Vcom kiosks, a touch-screen automated teller machine that allows for check cashing and the purchase of money orders and money transfers. 7-Eleven plans to install a Vcom in 1,000 of its stores by the end of May and possibly in another 2,500 by the end of the year.
  In the second quarter, consumers will be able to use the Vcom to access several major Web sites and select a limited number of items, says Jay Giesen, 7-Eleven's vice president and general manager. "You may get six bouquet offers around Mother's Day," he says. Eventually, 7-Eleven hopes to expand its Convenience Card into a cobranded card that could be used outside its doors.
  Alliance fit 7-Eleven because it had similar technology and a similar mindset on the future of stored-value cards, says Giesen. "They had lots of ideas where the market may go. They are committed to stay on top of the technology," he says. Heffernan likens the two 7-Eleven contracts with Alliance's move into the utility market several years ago.
  Alliance's third division at first glance can seem like some oddly attached appendage. But the Air Miles Rewards division is a nice fit because Alliance provides the back-office processing and loyalty programs.
  It was formed from an Air Canada mileage program and remains true to those roots. Besides Air Canada purchases, points can be earned and redeemed at about 180 retailers. Card issuers offering the program in Canada are Bank of Montreal and American Express Canada.
  In 2002, Air Miles issued 2.3 billion miles and consumers redeemed 1.3 billion. Air Miles also has a staggering market share with nearly two-thirds of the 31.4 million Canadians participating in the program.
  "It ubiquitous. It's basically money, they print money," says Matthew D. Fassnacht, an equity research analyst who formerly covered Alliance at J.P. Morgan Chase & Co. The program is so pervasive that most competitors avoid entering the market, says Fassnacht.
  Though much of the news for Alliance is positive, the company faces challenges. Its competition isn't getting any smaller. The lingering economic slowdown doesn't help sales. And the retailer shift to cobranded cards got a boost this year when Starbucks Corp. announced it would align with Visa and Bank One Corp. for a card.
  But Alliance has shown that there is a place for the firm that provides the right approach to the right merchant customer.