form10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
     
 
FORM 10-Q

(Mark One)
 
R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the quarterly period ended June 30, 2013
   
OR
 
£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the transition period from          to          

Commission File Number: 001-15749
 
     
 
ALLIANCE DATA SYSTEMS CORPORATION
(Exact name of registrant as specified in its charter)

Delaware
31-1429215
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)

7500 Dallas Parkway, Suite 700
Plano, Texas 75024
(Address of principal executive office, including zip code)

(214) 494-3000
(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 R     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 R     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.

 
Large accelerated filer R     
Accelerated filer  £     
 
Non-accelerated filer £ (Do not check if a smaller reporting company)
Smaller reporting company £

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes £     No R

As of August 1, 2013, 48,742,778 shares of common stock were outstanding.
 


 
 
 
 
 
ALLIANCE DATA SYSTEMS CORPORATION
 
INDEX
 
 
 
 
 
Page
Number
 
Part I:  FINANCIAL INFORMATION
 
Financial Statements (unaudited)
 
 
3
 
4
 
5
 
6
 
7
Item 2.
27
Item 3.
40
Item 4.
40
 
Part II:  OTHER INFORMATION
 
Item 1.
42
Item 1A.
42
Item 2.
42
Item 3.
42
Item 4.
42
Item 5.
42
Item 6.
43
44


 
2

 

PART I
 
 
Item 1. Financial Statements.
 
ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
 
 
   
June 30,
2013
 
December 31,
2012
 
   
(In thousands, except per share amounts)
 
ASSETS
Cash and cash equivalents
 
$
749,821
 
$
893,352
 
Trade receivables, less allowance for doubtful accounts ($4,339 and $3,919 at June 30, 2013 and December 31, 2012, respectively)
   
337,458
   
370,110
 
Credit card receivables:
             
Credit card receivables – restricted for securitization investors
   
6,074,037
   
6,597,120
 
Other credit card receivables
   
1,156,553
   
852,512
 
Total credit card receivables
   
7,230,590
   
7,449,632
 
Allowance for loan loss
   
(448,396
)
 
(481,958
)
Credit card receivables, net
   
6,782,194
   
6,967,674
 
Deferred tax asset, net
   
223,870
   
237,268
 
Other current assets
   
455,399
   
171,049
 
Redemption settlement assets, restricted
   
509,230
   
492,690
 
Total current assets
   
9,057,972
   
9,132,143
 
Property and equipment, net
   
265,534
   
253,028
 
Deferred tax asset, net
   
28,876
   
30,027
 
Cash collateral, restricted
   
47,501
   
65,160
 
Intangible assets, net
   
520,831
   
582,874
 
Goodwill
   
1,736,054
   
1,751,053
 
Other non-current assets
   
210,544
   
185,854
 
Total assets
 
$
11,867,312
 
$
12,000,139
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Accounts payable
 
$
241,437
 
$
215,470
 
Accrued expenses
   
243,882
   
274,625
 
Deposits
   
1,106,452
   
1,092,753
 
Asset-backed securities debt – owed to securitization investors
   
660,000
   
1,474,054
 
Current debt
   
1,131,374
   
803,269
 
Other current liabilities
   
133,298
   
117,283
 
Deferred revenue
   
968,517
   
1,055,323
 
Total current liabilities
   
4,484,960
   
5,032,777
 
Deferred revenue
   
173,610
   
193,738
 
Deferred tax liability, net
   
268,202
   
277,354
 
Deposits
   
1,148,914
   
1,135,658
 
Asset-backed securities debt – owed to securitization investors
   
3,351,916
   
2,656,916
 
Long-term and other debt
   
1,724,670
   
2,051,570
 
Other liabilities
   
134,192
   
123,639
 
Total liabilities
   
11,286,464
   
11,471,652
 
Commitments and contingencies
             
Stockholders’ equity:
             
Common stock, $0.01 par value; authorized, 200,000 shares; issued, 95,376 shares and 94,963 shares at June 30, 2013 and December 31, 2012, respectively
   
954
   
950
 
Additional paid-in capital
   
1,466,331
   
1,454,230
 
Treasury stock, at cost, 46,635 shares and 45,360 shares at June 30, 2013 and December 31, 2012, respectively
   
(2,666,066
)
 
(2,458,092
)
Retained earnings
   
1,798,679
   
1,553,260
 
Accumulated other comprehensive loss
   
(19,050
)
 
(21,861
)
Total stockholders’ equity
   
580,848
   
528,487
 
Total liabilities and stockholders’ equity
 
$
11,867,312
 
$
12,000,139
 
 
See accompanying notes to unaudited condensed consolidated financial statements.

 
3

 
ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME
 
 
   
Three Months Ended
June 30,
 
Six Months Ended
 June 30,
 
   
2013
 
2012
 
2013
 
2012
 
   
(In thousands, except per share amounts)
 
Revenues
                     
Transaction
 
$
79,573
 
$
77,502
 
$
161,921
 
$
160,246
 
Redemption
   
138,342
   
159,185
   
298,354
   
347,651
 
Finance charges, net
   
462,739
   
377,794
   
940,143
   
754,109
 
Database marketing fees and direct marketing services
   
309,495
   
219,530
   
605,101
   
433,126
 
Other revenue
   
37,943
   
32,474
   
76,010
   
62,922
 
Total revenue
   
1,028,092
   
866,485
   
2,081,529
   
1,758,054
 
Operating expenses
                 
Cost of operations (exclusive of depreciation and amortization disclosed separately below)
   
619,285
   
506,455
   
1,239,707
   
1,033,360
 
Provision for loan loss
   
57,796
   
52,552
   
124,444
   
101,879
 
General and administrative
   
28,255
   
27,532
   
50,547
   
51,531
 
Depreciation and other amortization
   
20,446
   
18,496
   
40,006
   
36,100
 
Amortization of purchased intangibles
   
33,130
   
20,907
   
66,420
   
42,022
 
Total operating expenses
   
758,912
   
625,942
   
1,521,124
   
1,264,892
 
Operating income
   
269,180
   
240,543
   
560,405
   
493,162
 
Interest expense
             
Securitization funding costs
   
24,694
   
22,518
   
49,179
   
44,847
 
Interest expense on deposits
   
7,002
   
6,003
   
14,009
   
11,966
 
Interest expense on long-term and other debt, net
   
51,770
   
44,546
   
102,822
   
81,906
 
Total interest expense, net
   
83,466
   
73,067
   
166,010
   
138,719
 
Income before income tax
 
$
185,714
 
$
167,476
 
$
394,395
 
$
354,443
 
Provision for income taxes
   
69,274
   
63,655
   
148,976
   
135,393
 
Net income
 
$
116,440
 
$
103,821
 
$
245,419
 
$
219,050
 
                           
Basic income per share
 
$
2.37
 
$
2.07
 
$
4.96
 
$
4.37
 
Diluted income per share
 
$
1.71
 
$
1.63
 
$
3.62
 
$
3.49
 
                           
Weighted average shares:
             
Basic
   
49,123
   
50,161
   
49,444
   
50,157
 
Diluted
   
68,167
   
63,731
   
67,746
   
62,790
 
                           

 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
4


ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
 
   
Three Months Ended
June 30,
 
Six Months Ended
 June 30,
 
   
2013
 
2012
 
2013
 
2012
 
   
(In thousands)
 
                       
Net income
 
$
116,440
 
$
103,821
 
$
245,419
 
$
219,050
 
Other comprehensive income, net of tax
                         
Net unrealized gain (loss) on securities available-for-sale, net of tax benefits of $(928), $(90), $(1,080) and $(116) for the three and six months ended June 30, 2013 and 2012, respectively
   
(6,550
 
352
   
(5,454
)
 
1,836
 
Foreign currency translation adjustments
   
4,938
   
1,406
   
8,265
   
(1,660
Other comprehensive (loss) income
   
(1,612
 
1,758
   
2,811
   
176
 
Total comprehensive income, net of tax
 
$
114,828
 
$
105,579
 
$
248,230
 
$
219,226
 
                           

 
See accompanying notes to unaudited condensed consolidated financial statements.

 
5


ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
   
Six Months Ended
June 30,
 
   
2013
 
2012
 
   
(In thousands)
 
CASH FLOWS FROM OPERATING ACTIVITIES:
 
Net income                                                                                                                      
 
$
245,419
 
$
219,050
 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
Depreciation and amortization                                                                                                                   
   
106,426
   
78,122
 
Deferred income taxes                                                                                                                   
   
1,594
   
68,865
 
Provision for loan loss                                                                                                                   
   
124,444
   
101,879
 
Non-cash stock compensation                                                                                                                   
   
28,015
   
25,186
 
Fair value gain on interest-rate derivatives                                                                                                                   
   
(8,511
)
 
(15,184
)
Amortization of discount on debt                                                                                                                   
   
45,102
   
40,050
 
Change in operating assets and liabilities, net of acquisitions:
 
Change in trade accounts receivable                                                                                                                   
   
(5,223
 
(43,872
Change in other assets                                                                                                                   
   
(20,307
 
26,684
 
Change in accounts payable and accrued expenses                                                                                                                   
   
11,510
   
(8,570
Change in deferred revenue                                                                                                                   
   
(37,269
 
(39,323
Change in other liabilities                                                                                                                   
   
36,546
   
(19,638
)
Excess tax benefits from stock-based compensation                                                                                                                      
   
(10,103
)
 
(13,564
)
Other                                                                                                                      
   
12,822
   
(2,247
)
Net cash provided by operating activities
   
530,465
   
417,438
 
   
CASH FLOWS FROM INVESTING ACTIVITIES:
 
Change in redemption settlement assets                                                                                                                      
   
(47,671
 
41,440
 
Change in restricted cash                                                                                                                      
   
(271,132
)
 
(438,665
Change in credit card receivables                                                                                                                      
   
83,403
   
(61,375
Purchase of credit card portfolios                                                                                                                      
   
(37,061
)
 
(122,237
)
Change in cash collateral, restricted                                                                                                                      
   
18,450
   
37,735
 
Capital expenditures                                                                                                                      
   
(58,995
)
 
(55,541
)
Purchases of marketable securities                                                                                                                      
   
(18,339
)
 
(4,719
)
Maturities/sales of marketable securities                                                                                                                      
   
1,002
   
968
 
Other                                                                                                                      
   
(1,383
)
 
(10,587
)
Net cash used in investing activities
   
(331,726
)
 
(612,981
)
   
CASH FLOWS FROM FINANCING ACTIVITIES:
 
Borrowings under debt agreements                                                                                                                      
   
   
699,500
 
Repayments of borrowings                                                                                                                      
   
(43,887
)
 
(494,691
)
Issuances of deposits                                                                                                                      
   
732,754
   
659,227
 
Repayments of deposits                                                                                                                      
   
(705,799
)
 
(360,050
)
Borrowings from asset-backed securities                                                                                                                      
   
1,268,285
   
897,038
 
Repayments/maturities of asset-backed securities                                                                                                                      
   
(1,387,339
)
 
(719,558
)
Payment of capital lease obligations                                                                                                                      
   
(11
)
 
(11
)
Payment of deferred financing costs                                                                                                                      
   
(5,971
)
 
(25,624
)
Excess tax benefits from stock-based compensation                                                                                                                      
   
10,103
   
13,564
 
Proceeds from issuance of common stock                                                                                                                      
   
5,534
   
11,411
 
Purchase of treasury shares                                                                                                                      
   
(207,974
)
 
(59,032
)
Net cash (used in) provided by financing activities
   
(334,305
 
621,774
 
   
Effect of exchange rate changes on cash and cash equivalents
   
(7,965
)
 
(245
)
Change in cash and cash equivalents
   
(143,531
 
425,986
 
Cash and cash equivalents at beginning of period
   
893,352
   
216,213
 
Cash and cash equivalents at end of period                                                                                                                
 
$
749,821
 
$
642,199
 
   
SUPPLEMENTAL CASH FLOW INFORMATION:
 
Interest paid                                                                                                                      
 
$
111,633
 
$
99,257
 
Income taxes paid, net                                                                                                                      
 
$
95,108
 
$
98,243
 
 
 
See accompanying notes to unaudited condensed consolidated financial statements.


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
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, 2012, filed with the SEC on February 28, 2013.
 
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.
 
Recently Issued Accounting Standards
 
In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2013-02, “Reporting Amounts Reclassified Out of Accumulated Other Comprehensive Income,” which expands the disclosure requirements for items reclassified from accumulated other comprehensive income to net income by requiring the total changes of each component of other comprehensive income to be disaggregated and separately presenting current period reclassification adjustments from the remainder of other comprehensive income for the period. ASU 2013-02 is effective for interim and annual periods beginning after December 15, 2012 and requires prospective application. ASU 2013-02 had no impact on the Company’s financial condition, results of operations or cash flows, but did add certain disclosure requirements. The related disclosures are presented in Note 9, “Accumulated Other Comprehensive Income.”
 
 
2. 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:
 
   
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
   
2013
   
2012
 
2013
   
2012
 
       
(In thousands, except per share amounts)
     
Numerator:
                         
Net income
 
$
116,440
   
$
103,821
 
$
245,419
   
$
219,050
 
Denominator:
                     
Weighted average shares, basic
   
49,123
     
50,161
   
49,444
     
50,157
 
Weighted average effect of dilutive securities:
               
Shares from assumed conversion of convertible senior notes
   
10,611
     
8,435
   
10,372
     
8,051
 
Shares from assumed conversion of convertible note warrants
   
7,818
     
4,399
   
7,336
     
3,844
 
Net effect of dilutive stock options and unvested restricted stock units
 
615
     
736
   
594
     
738
 
Denominator for diluted calculations
   
68,167
     
63,731
   
67,746
     
62,790
 
                               
Basic net income per share
 
$
2.37
   
$
2.07
 
$
4.96
   
$
4.37
 
Diluted net income per share
 
$
1.71
   
$
1.63
 
$
3.62
   
$
3.49
 

 
7

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
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 for cash.
 
Concurrently with the issuance of its convertible senior notes, the Company entered into hedge transactions that are generally expected to offset the potential dilution of the shares from assumed conversion of convertible senior notes.
 
The Company is also party to prepaid forward contracts to purchase 1,857,400 shares of its common stock 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.
 
 
3. CREDIT CARD RECEIVABLES
 
The Company’s credit card receivables are the only portfolio segment or class of financing receivables. Quantitative information about the components of total credit card receivables is presented in the table below:
 
   
June 30,
2013
 
December 31,
2012
 
   
(In thousands)
 
Principal receivables
 
$
6,866,955
 
$
7,097,951
 
Billed and accrued finance charges
   
282,724
   
291,476
 
Other receivables
   
80,911
   
60,205
 
Total credit card receivables
   
7,230,590
   
7,449,632
 
Less credit card receivables – restricted for securitization investors
   
6,074,037
   
6,597,120
 
Other credit card receivables
 
$
1,156,553
 
$
852,512
 
 
Allowance for Loan Loss
 
The Company maintains an allowance for loan loss at a level that is appropriate to absorb probable losses inherent in credit card receivables. The allowance for loan loss covers forecasted uncollectible principal as well as unpaid interest and fees. The allowance for loan loss is evaluated monthly for appropriateness.
 
In estimating the allowance for principal loan losses, management utilizes a migration analysis of delinquent and current credit card receivables. 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 allowance is maintained through an adjustment to the provision for loan loss. Charge-offs of principal amounts, net of recoveries are deducted from the allowance. In estimating the allowance for uncollectible unpaid interest and fees, the Company utilizes historical charge-off trends, analyzing actual charge-offs for the prior three months. The allowance is maintained through an adjustment to finance charges, net. In evaluating the allowance for loan loss for both principal and unpaid interest and fees, management also considers factors that may impact loan loss experience, including seasoning, loan volume and amounts, seasonality, payment rates and forecasting uncertainties.
 
Net charge-offs include the principal amount of losses from credit cardholders unwilling or unable to pay their account balances, as well as bankrupt and deceased credit cardholders, less recoveries and exclude charged-off interest, fees and fraud losses. Charged-off interest and fees reduce finance charges, net while fraud losses are recorded as an expense. Credit card receivables, including unpaid interest and fees, are charged-off at the end of the month during which an account becomes 180 days contractually past due, except in the case of customer bankruptcies or death. Credit card receivables, including unpaid interest and fees, associated with customer bankruptcies or death are charged-off at the end of each month subsequent to 60 days after the receipt of notification of the bankruptcy or death, but in any case, not later than the 180-day contractual time frame. The Company records the actual charge-offs for unpaid interest and fees as a reduction to finance charges, net. Actual charge-offs for unpaid interest and fees were $55.0 million and $44.3 million for the three months ended June 30, 2013 and 2012, respectively, and $113.7 million and $93.2 million for the six months ended June 30, 2013 and 2012, respectively.

 
8

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
The following table presents the Company’s allowance for loan loss for the periods indicated:
 
   
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
   
2013
 
2012
 
2013
 
2012
 
   
(In thousands)
 
Balance at beginning of period
 
$
471,016
 
$
447,483
 
$
481,958
 
$
468,321
 
Provision for loan loss
   
57,796
   
52,552
   
124,444
   
101,879
 
Recoveries
   
27,163
   
23,864
   
57,948
   
52,714
 
Principal charge-offs
   
(107,579
)
 
(91,378
)
 
(215,954
)
 
(190,393
)
Balance at end of period
 
$
448,396
 
$
432,521
 
$
448,396
 
$
432,521
 
 
Delinquencies
 
A credit card account is contractually delinquent if the Company does not receive the minimum payment by the specified due date on the cardholder’s statement. It is the Company’s policy to continue to accrue interest and fee income on all credit card accounts beyond 90 days, except in limited circumstances, until the credit card account balance and all related interest and other fees are paid or charged off, typically at 180 days delinquent. When an account becomes delinquent, a message is printed on the credit 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 becoming further delinquent. 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 the Company is unable to make a collection after exhausting all in-house collection efforts, the Company may engage collection agencies and outside attorneys to continue those efforts.
 
The following table presents the delinquency trends of the Company’s credit card portfolio:
 
   
June 30,
2013
   
% of
Total
   
December 31,
2012
   
% of
Total
 
           
(In thousands, except percentages)
         
Receivables outstanding – principal
 
$
6,866,955
     
100.0
%
 
$
7,097,951
     
100.0
%
Principal receivables balances contractually delinquent:
                               
31 to 60 days
   
98,208
     
1.5
%
   
100,479
     
1.4
%
61 to 90 days
   
62,331
     
0.9
     
62,546
     
0.9
 
91 or more days
   
105,003
     
1.5
     
120,163
     
1.7
 
Total
 
$
265,542
     
3.9
%
 
$
283,188
     
4.0
%
 
Modified Credit Card Receivables
 
The Company holds certain credit card receivables for which the terms have been modified. The Company’s modified credit card receivables include credit card receivables for which temporary hardship concessions have been granted and credit card receivables in permanent workout programs. These modified credit card receivables include concessions consisting primarily of a reduced minimum payment and an interest rate reduction. The temporary programs’ concessions remain in place for a period no longer than twelve months, while the permanent programs remain in place through the payoff of the credit card receivables if the credit cardholder complies with the terms of the program. These concessions do not include the forgiveness of unpaid principal, but may involve the reversal of certain unpaid interest or fee assessments. In the case of the temporary programs, at the end of the concession period, credit card receivable terms revert to standard rates. These arrangements are automatically terminated if the customer fails to make payments in accordance with the terms of the program, at which time their account reverts back to its original terms.
 
Credit card receivables for which temporary hardship and permanent concessions were granted are both considered troubled debt restructurings and are collectively evaluated for impairment. Modified credit card receivables are evaluated at their present value with impairment measured as the difference between the credit card receivable balance and the discounted present value of cash flows expected to be collected. Consistent with the Company’s measurement of impairment of modified credit card receivables on a pooled basis, the discount rate used for credit card receivables is the average current annual percentage rate the Company applies to non-impaired credit card receivables, which approximates what would have been applied to the pool of modified credit card receivables prior to impairment. In assessing the appropriate allowance for loan loss, these modified credit card receivables are included in the general pool of credit cards with the allowance determined under the contingent loss model of Accounting Standards Codification (“ASC”) 450-20, “Loss Contingencies.” If the Company applied accounting under ASC 310-40, “Troubled Debt Restructurings by Creditors,” to the modified credit card receivables in these programs, there would not be a material difference in the allowance for loan loss.

 
9

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
The Company had $116.4 million and $117.0 million, respectively, as a recorded investment in impaired credit card receivables with an associated allowance for loan loss of $36.4 million and $39.7 million, respectively, as of June 30, 2013 and December 31, 2012. These modified credit card receivables represented less than 3% of the Company’s total credit card receivables as of June 30, 2013 and December 31, 2012, respectively.
 
The average recorded investment in the impaired credit card receivables was $117.5 million and $111.8 million for the three months ended June 30, 2013 and 2012, respectively, and $117.5 million and $115.6 million for the six months ended June 30, 2013 and 2012, respectively.
 
Interest income on these modified credit card receivables is accounted for in the same manner as other accruing credit card receivables. Cash collections on these modified credit card receivables are allocated according to the same payment hierarchy methodology applied to credit card receivables that are not in such programs. The Company recognized $3.2 million and $2.9 million for the three months ended June 30, 2013 and 2012, respectively, and $6.3 million and $6.1 million for the six months ended June 30, 2013 and 2012, respectively, in interest income associated with modified credit card receivables during the period that such credit card receivables were impaired.
 
The following tables provide information on credit card receivables that are considered troubled debt restructurings as described above, which entered into a modification program during the specified periods:
 
   
Three Months Ended June 30, 2013
   
Six Months Ended June 30, 2013
 
   
Number of
Restructurings
 
Pre-modification Outstanding Balance
 
Post-modification
Outstanding Balance
   
Number of
Restructurings
 
Pre-modification Outstanding Balance
 
Post-modification
Outstanding Balance
 
     
(Dollars in thousands)
 
Troubled debt restructurings – credit card receivables
   
35,100
 
$
32,135
 
$
32,120
     
72,895
 
$
66,101
 
$
66,062
 
                                         
 
   
Three Months Ended June 30, 2012
   
Six Months Ended June 30, 2012
 
   
Number of
Restructurings
 
Pre-modification Outstanding Balance
 
Post-modification Outstanding Balance
   
Number of
Restructurings
 
Pre-modification Outstanding Balance
 
Post-modification
Outstanding Balance
 
     
(Dollars in thousands)
 
Troubled debt restructurings – credit card receivables
   
28,499
 
$
25,917
 
$
25,839
     
60,039
 
$
54,155
 
$
54,068
 
                                         
 
The tables below summarize troubled debt restructurings that have defaulted in the specified periods where the default occurred within 12 months of their modification date:
 
   
Three Months Ended
June 30, 2013
   
Six Months Ended
June 30, 2013 
 
   
Number of
Restructurings
   
Outstanding
Balance
   
Number of
Restructurings
   
Outstanding
Balance
 
   
(Dollars in thousands)
 
Troubled debt restructurings that subsequently defaulted – credit card receivables
   
15,698
   
$
14,938
     
31,193
   
$
29,421
 
                                 

   
Three Months Ended
June 30, 2012 
   
Six Months Ended
June 30, 2012 
 
   
Number of
Restructurings
   
Outstanding
Balance
   
Number of
Restructurings
   
Outstanding
Balance
 
   
(Dollars in thousands)
 
Troubled debt restructurings that subsequently defaulted – credit card receivables
   
13,187
   
$
12,699
     
29,207
   
$
28,161
 
                                 
 
 
10

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
Age of Credit Card Receivables
 
The following tables set forth, as of June 30, 2013 and 2012, the number of active credit card accounts with balances and the related principal balances outstanding, based upon the age of the active credit card accounts from origination:
 
   
June 30, 2013
 
Age of Accounts Since Origination
 
Number of
Active Accounts
with Balances
 
Percentage of
Active Accounts
with Balances
   
Principal
Receivables
Outstanding
 
Percentage of
Principal
Receivables
Outstanding
 
   
(In thousands, except percentages)
 
0-12 Months
   
4,162
   
26.3
%
 
$
1,567,355
   
22.8
%
13-24 Months
   
2,132
   
13.5
     
868,822
   
12.7
 
25-36 Months
   
1,492
   
9.4
     
656,544
   
9.6
 
37-48 Months
   
1,188
   
7.5
     
570,969
   
8.3
 
49-60 Months
   
939
   
5.9
     
481,828
   
7.0
 
Over 60 Months
   
5,920
   
37.4
     
2,721,437
   
39.6
 
Total
   
15,833
   
100.0
%
 
$
6,866,955
   
100.0
%
 
 
   
June 30, 2012
 
Age of Accounts Since Origination
 
Number of
Active Accounts
with Balances
 
Percentage of
Active Accounts
with Balances
   
Principal
Receivables
Outstanding
 
Percentage of
Principal
Receivables
Outstanding
 
   
(In thousands, except percentages)
 
0-12 Months
   
3,469
   
26.5
%
 
$
1,198,107
   
22.0
%
13-24 Months
   
1,728
   
13.2
     
660,098
   
12.1
 
25-36 Months
   
1,335
   
10.2
     
605,357
   
11.1
 
37-48 Months
   
1,023
   
7.8
     
504,946
   
9.2
 
49-60 Months
   
851
   
6.5
     
396,614
   
7.3
 
Over 60 Months
   
4,683
   
35.8
     
2,086,155
   
38.3
 
Total
   
13,089
   
100.0
%
 
$
5,451,277
   
100.0
%
 
Credit Quality
 
The Company uses proprietary scoring models developed specifically for the purpose of monitoring the Company’s obligor credit quality. The proprietary scoring models are used as a tool in the underwriting process and for making credit decisions. The proprietary scoring models are based on historical data and require various assumptions about future performance. Information regarding customer performance is factored into these proprietary scoring models to determine the probability of an account becoming 90 or more days past due at any time within the next 12 months. Obligor credit quality is monitored at least monthly during the life of an account. The following table reflects composition of the Company’s credit card receivables by obligor credit quality as of June 30, 2013 and 2012:
 
   
June 30, 2013
   
June 30, 2012
 
Probability of an Account Becoming 90 or More Days Past
Due or Becoming Charged-off (within the next 12 months)
 
Total Principal
Receivables
Outstanding
 
Percentage of
Principal
Receivables
Outstanding
   
Total Principal
Receivables
Outstanding
 
Percentage of
Principal
Receivables
Outstanding
 
         
(In thousands, except percentages)
       
No Score
 
$
143,497
   
2.1
%
 
$
112,731
   
2.1
%
27.1% and higher
   
304,557
   
4.4
     
232,278
   
4.2
 
17.1% - 27.0%
   
618,805
   
9.0
     
478,551
   
8.8
 
12.6% - 17.0%
   
718,748
   
10.5
     
551,539
   
10.1
 
3.7% - 12.5%
   
2,782,404
   
40.5
     
2,197,155
   
40.3
 
1.9% - 3.6%
   
1,483,852
   
21.6
     
1,236,673
   
22.7
 
Lower than 1.9%
   
815,092
   
11.9
     
642,350
   
11.8
 
Total
 
$
6,866,955
   
100.0
%
 
$
5,451,277
   
100.0
%
 
 
11

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
Credit Card Portfolio Acquisition
 
In March 2013, the Company acquired the existing private label credit card portfolio of Barneys New York. The purchase price was $37.1 million, which is subject to customary purchase price adjustments, and consisted of $35.3 million of credit card receivables and $1.8 million of intangible assets that are included in the June 30, 2013 unaudited condensed consolidated balance sheet.
 
Securitized Credit Card Receivables
 
The Company regularly securitizes its credit card receivables through its credit card securitization trusts. As of June 30, 2013, these trusts consisted of World Financial Network Credit Card Master Trust, World Financial Network Credit Card Master Note Trust (“Master Trust I”) and World Financial Network Credit Card Master Trust III (“Master Trust III”) (collectively, the “WFN Trusts”), and World Financial Capital Credit Card Master Note Trust (the “WFC Trust”). The Company continues to own and service the accounts that generate credit card receivables held by the WFN Trusts and the WFC Trust. In its capacity as a servicer, each of the respective banks earns a fee from the WFN Trusts and the WFC Trust to service and administer the credit card receivables, collect payments, and charge-off uncollectible receivables. These fees are eliminated and therefore are not reflected in the unaudited condensed consolidated statements of income for the three and six months ended June 30, 2013 and 2012.
 
The WFN Trusts and the WFC Trust are variable interest entities (“VIEs”), and the Company is deemed to be the primary beneficiary for the WFN Trusts and the WFC Trust, as it is the servicer for each of the trusts and is a holder of the residual interest. The Company, through its involvement in the activities of the trusts, has the power to direct the activities that most significantly impact the economic performance of the trust, and the obligation (or right) to absorb losses (or receive benefits) of the trust that could potentially be significant. The assets of these consolidated VIEs include certain credit card receivables that 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.
 
The tables below present quantitative information about the components of total securitized credit card receivables, delinquencies and net charge-offs:
 
   
June 30,
2013
 
December 31,
2012
 
   
(In thousands)
 
Total credit card receivables – restricted for securitization investors
 
$
6,074,037
 
$
6,597,120
 
Principal amount of credit card receivables – restricted for securitization investors, 90 days or more past due
 
$
92,031
 
$
112,203
 


   
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
   
2013
 
2012
 
2013
 
2012
 
   
(In thousands)
 
Net charge-offs of securitized principal
 
$
74,595
 
$
60,640
 
$
148,689
 
$
123,445
 
 
 
12

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

4. 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. There were no realized gains or losses from the sale of investment securities for the three and six months ended June 30, 2013 and 2012. The principal components of redemption settlement assets, which are carried at fair value, are as follows:
 
   
June 30, 2013
   
December 31, 2012
 
   
Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
   
Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
 
   
(In thousands)
 
Cash and cash equivalents
 
$
31,650
 
$
 
$
 
$
31,650
   
$
40,266
 
$
 
$
 
$
40,266
 
Government bonds
   
   
   
   
     
5,064
   
53
   
   
5,117
 
Corporate bonds
   
470,761
   
7,881
   
(1,062
)
 
477,580
     
436,846
   
10,560
   
(99
)
 
447,307
 
Total
 
$
502,411
 
$
7,881
 
$
(1,062
)
$
509,230
   
$
482,176
 
$
10,613
 
$
(99
)
$
492,690
 
 
The following tables show the gross unrealized losses and fair value for those investments that were in an unrealized loss position as of June 30, 2013 and December 31, 2012, aggregated by investment category and the length of time that individual securities have been in a continuous loss position:
 
   
Less than 12 months
 
June 30, 2013
12 Months or Greater
 
Total
 
   
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
   
(In thousands)
 
Corporate bonds
 
$
95,059
 
$
(1,062
)
$
 
$
 
$
95,059
 
$
(1,062
)
Total
 
$
95,059
 
$
(1,062
)
$
 
$
 
$
95,059
 
$
(1,062
)

   
Less than 12 months
 
December 31, 2012
12 Months or Greater
 
Total
 
   
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
   
(In thousands)
 
Corporate bonds
 
$
36,518
 
$
(99
)
$
 
$
 
$
36,518
 
$
(99
)
Total
 
$
36,518
 
$
(99
)
$
 
$
 
$
36,518
 
$
(99
)
 
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 June 30, 2013, the Company does not consider the investments to be other-than-temporarily impaired.
 
The amortized cost and estimated fair value of the securities at June 30, 2013 by contractual maturity are as follows:
 
   
Amortized
Cost
 
Estimated
Fair Value
 
   
(In thousands)
 
Due in one year or less
 
$
106,162
 
$
106,783
 
Due after one year through five years
   
396,249
   
402,447
 
Total
 
$
502,411
 
$
509,230
 
 
 
13

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

5. INTANGIBLE ASSETS AND GOODWILL
 
Intangible Assets
 
Intangible assets consist of the following:
 
   
June 30, 2013
   
   
Gross
Assets
 
Accumulated
Amortization
 
Net
 
Amortization Life and Method
   
(In thousands)
   
Finite Lived Assets
               
Customer contracts and lists
 
$
440,200
 
$
(155,851
)
$
284,349
 
3-12 years—straight line
Premium on purchased credit card portfolios
   
239,561
   
(126,177
)
 
113,384
 
5-10 years—straight line, accelerated
Customer database
   
161,700
   
(112,468
)
 
49,232
 
4-10 years—straight line
Collector database
   
66,543
   
(60,859
)
 
5,684
 
30 years—15% declining balance
Tradenames
   
59,039
   
(13,027
)
 
46,012
 
4-15 years—straight line
Purchased data lists
   
15,988
   
(10,340
)
 
5,648
 
1-5 years—straight line, accelerated
Favorable lease
   
3,291
   
(202
)
 
3,089
 
10 years—straight line
Noncompete agreements
   
1,300
   
(217
)
 
1,083
 
3 years—straight line
   
$
987,622
 
$
(479,141
)
$
508,481
   
Indefinite Lived Assets
                     
Tradenames
   
12,350
   
   
12,350
 
Indefinite life
Total intangible assets
 
$
999,972
 
$
(479,141
)
$
520,831
   
 
 
   
December 31, 2012
   
   
Gross
Assets
 
Accumulated
Amortization
 
Net
 
Amortization Life and Method
   
(In thousands)
   
Finite Lived Assets
               
Customer contracts and lists
 
$
440,200
 
$
(124,351
)
$
315,849
 
3-12 years—straight line
Premium on purchased credit card portfolios
   
237,800
   
(108,227
)
 
129,573
 
5-10 years—straight line, accelerated
Customer database
   
161,700
   
(102,706
)
 
58,994
 
4-10 years—straight line
Collector database
   
70,550
   
(63,980
)
 
6,570
 
30 years—15% declining balance
Tradenames
   
59,102
   
(10,139
)
 
48,963
 
4-15 years—straight line
Purchased data lists
   
14,540
   
(8,527
)
 
6,013
 
1-5 years—straight line, accelerated
Favorable lease
   
3,291
   
(29
)
 
3,262
 
10 years—straight line
Noncompete agreements
   
1,300
   
   
1,300
 
3 years—straight line
   
$
988,483
 
$
(417,959
)
$
570,524
   
Indefinite Lived Assets
                     
Tradenames
   
12,350
   
   
12,350
 
Indefinite life
Total intangible assets
 
$
1,000,833
 
$
(417,959
)
$
582,874
   
 
Goodwill
 
The changes in the carrying amount of goodwill for the six months ended June 30, 2013 are as follows:
 
   
LoyaltyOne®
 
Epsilon®
 
Private Label
Services and
Credit
 
Corporate/
Other
 
Total
 
   
(In thousands)
 
December 31, 2012
 
$
248,070
 
$
1,241,251
 
$
261,732
 
$
 
$
1,751,053
 
Effects of foreign currency translation
   
(13,446
)
 
(1,553
)
 
   
   
(14,999
)
June 30, 2013
 
$
234,624
 
$
1,239,698
 
$
261,732
 
$
 
$
1,736,054
 
 
 
14

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

6. DEBT
 
Debt consists of the following:
 
Description
 
June 30,
2013
   
December 31,
2012
   
Maturity
 
Interest Rate
 
   
(Dollars in thousands)
           
Long-term and other debt:
                     
2011 credit facility
 
$
   
$
   
May 2016
 
 
2011 term loan
   
874,453
     
885,928
   
May 2016 or May 2017
 
(1)
 
Convertible senior notes due 2013
   
767,265
     
768,831
   
August 2013
 
1.75%
 
Convertible senior notes due 2014
   
318,207
     
304,333
   
May 2014
 
4.75%
 
Senior notes due 2017
   
396,117
     
395,734
   
December 2017
 
5.250%
 
Senior notes due 2020
   
500,000
     
500,000
   
April 2020
 
6.375%
 
Capital lease obligations and other debt
   
2
     
13
   
July 2013
 
7.10%
 
Total long-term and other debt
   
2,856,044
     
2,854,839
           
Less: current portion
   
(1,131,374
)
   
(803,269
)
         
Long-term portion
 
$
1,724,670
   
$
2,051,570
           
                       
Deposits:
                     
Certificates of deposit
 
$
1,936,058
   
$
1,974,158
   
Various – July 2013 – May 2020
 
0.15% to 5.25%
 
Money market deposits
   
319,308
     
254,253
   
On demand
 
0.01% to 0.22%
 
Total deposits
   
2,255,366
     
2,228,411
           
Less: current portion
   
(1,106,452
)
   
(1,092,753
)
         
Long-term portion
 
$
1,148,914
   
$
1,135,658
           
                       
Asset-backed securities debt – owed to securitization investors:
                         
Fixed rate asset-backed term note securities
 
$
3,246,916
   
$
2,403,555
   
Various – July 2013 – June 2019
 
0.91% to 6.75%
 
Floating rate asset-backed term note securities
   
     
545,700
   
 
 
Conduit asset-backed securities
   
765,000
     
1,181,715
   
Various – September 2013 – May 2015
 
1.19% to 1.72%
 
Total asset-backed securities – owed to securitization investors
   
4,011,916
     
4,130,970
           
Less: current portion
   
(660,000
)
   
(1,474,054
)
         
Long-term portion
 
$
3,351,916
   
$
2,656,916
           
                             
 
(1)
At June 30, 2013, the weighted average interest rate for the 2011 Term Loan was 2.20%.
 
At June 30, 2013, the Company was in compliance with its covenants.
 
Credit Agreements
 
At June 30, 2013, the Company, as borrower, and ADS Alliance Data Systems, Inc., ADS Foreign Holdings, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Data Management, LLC, Comenity LLC, Comenity Servicing LLC and Alliance Data FHC, Inc., as guarantors, were party to a credit agreement (the “2011 Credit Agreement”) that provided for a $903.1 million term loan (the “2011 Term Loan”) subject to certain principal repayments and a $917.5 million revolving line of credit (the “2011 Credit Facility”).
 
Total availability under the 2011 Credit Facility at June 30, 2013 was $917.5 million.
 
In July 2013, the Company, as borrower, and ADS Alliance Data Systems, Inc., ADS Foreign Holdings, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Data Management, LLC, Comenity LLC, Comenity Servicing LLC and Aspen Marketing Services, LLC, as guarantors, entered into a credit agreement with various agents and lenders dated July 10, 2013 (the “2013 Credit Agreement”), replacing the 2011 Credit Agreement, which was concurrently terminated. Wells Fargo Bank, N.A. is the administrative agent and letter of credit issuer under the 2013 Credit Agreement. The 2013 Credit Agreement provides for a $1,142.5 million term loan with certain principal repayments and a $1,142.5 million revolving line of credit with a U.S. $65.0 million sublimit for Canadian dollar borrowings and a $65.0 million sublimit for swing line loans. The 2013 Credit Agreement includes an uncommitted accordion feature of up to $500.0 million (in certain circumstances, up to $615.0 million) in the aggregate allowing for future incremental borrowings, subject to certain conditions.
 
The loans under the 2013 Credit Agreement are scheduled to mature on July 10, 2018. The 2013 Term Loan provides for aggregate principal payments of 2.5% of the initial term loan amount in each of the first and second year and 5% of the initial term loan amount in each of the third, fourth, and fifth year, payable in equal quarterly installments beginning on September 30, 2013. The 2013 Credit Agreement is unsecured.

 
15

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
Advances under the 2013 Credit Agreement are in the form of either U.S. dollar-denominated or Canadian dollar-denominated base rate loans or U.S. dollar-denominated eurodollar loans. The interest rate for base rate loans denominated in U.S. dollars fluctuates and is equal to the highest of (i) Wells Fargo’s prime rate (ii) the Federal funds rate plus 0.5% and (iii) the London Interbank Offered Rate (“LIBOR”) as defined in the 2013 Credit Agreement plus 1.0%, in each case plus a margin of 0.25% to 1.0% based upon the Company’s total leverage ratio as defined in the 2013 Credit Agreement. The interest rate for base rate loans denominated in Canadian dollars fluctuates and is equal to the higher of (i) Wells Fargo’s prime rate for Canadian dollar loans and (ii) the Canadian Dollar Offered Rate (“CDOR”) plus 1.0%, in each case plus a margin of 0.25% to 1.0% based upon the Company’s total leverage ratio as defined in the 2013 Credit Agreement. The interest rate for 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 1.25% to 2.0% based on the Company’s total leverage ratio as defined in the 2013 Credit Agreement.
 
The 2013 Credit Agreement contains the usual and customary negative covenants for transactions of this type, including, but not limited to, restrictions on the Company’s ability and in certain instances, its subsidiaries’ ability to consolidate or merge; substantially change the nature of its business; sell, lease, or otherwise transfer any substantial part of its assets; create or incur indebtedness; create liens; pay dividends; and make acquisitions. The negative covenants are subject to certain exceptions as specified in the 2013 Credit Agreement. The 2013 Credit Agreement also requires the Company to satisfy certain financial covenants, including a maximum total leverage ratio as determined in accordance with the 2013 Credit Agreement and a minimum ratio of consolidated operating EBITDA to consolidated interest expense as determined in accordance with the 2013 Credit Agreement. The 2013 Credit Agreement also includes customary events of default.
 
Convertible Senior Notes
 
At June 30, 2013, the Company had outstanding $1.12 billion of convertible senior notes, consisting of $772.6 million that matured on August 1, 2013 and $345.0 million scheduled to mature on May 15, 2014. The table below summarizes the carrying value of the components of the convertible senior notes:
 
   
June 30,
2013
 
December 31,
2012
 
   
(In millions)
 
Carrying amount of equity component
 
$
368.7
 
$
368.7
 
               
Principal amount of liability component
 
$
1,117.6
 
$
1,150.0
 
Unamortized discount
   
(32.1
)
 
(76.8
)
Net carrying value of liability component
 
$
1,085.5
 
$
1,073.2
 
               
If-converted value of common stock
 
$
3,094.6
 
$
2,534.4
 
 
The discount on the liability component will be amortized as interest expense over the remaining life of the convertible senior notes which, at June 30, 2013, is a weighted average period of 0.3 years.
 
Interest expense on the convertible senior notes recognized in the Company’s unaudited condensed consolidated statements of income for the three and six months ended June 30, 2013 and 2012 is as follows:
 
   
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
   
2013
 
2012
 
2013
 
2012
 
   
(In thousands, except percentages)
 
Interest expense calculated on contractual interest rate
 
$
7,471
 
$
7,618
 
$
14,999
 
$
15,237
 
Amortization of discount on liability component
   
22,669
   
20,300
   
44,719
   
40,050
 
Total interest expense on convertible senior notes
 
$
30,140
 
$
27,918
 
$
59,718
 
$
55,287
 
                           
Effective interest rate (annualized)
   
11.0
%
 
11.0
%
 
11.0
%
 
11.0
%
 
 
16

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
Both the convertible senior notes due 2013 (the “Convertible Senior Notes due 2013”) and the convertible senior notes due 2014 (the “Convertible Senior Notes due 2014”) are convertible at the option of the holder based on the condition that the common stock trading price exceeded 130% of the applicable conversion price. Pursuant to the indenture governing the Convertible Senior Notes due 2013, the Company provided notice that it intends to satisfy conversions occurring on or after April 2, 2013 by paying solely cash. Through June 30, 2013, $32.5 million of the convertible senior notes were surrendered for conversion and, in each case, either have been or will be settled in cash following the completion of the applicable cash settlement averaging period.
 
On August 1, 2013, the Company settled in cash the $772.6 million of Convertible Senior Notes due 2013, of which $772.5 million was surrendered for conversion for $1,790.3 million, with the remaining principal paid at maturity. The Company received $1,017.7 million of cash from the counterparties in settlement of the related convertible note hedge transactions.
 
Senior Notes Due 2017
 
In November 2012, the Company issued and sold $400 million aggregate principal amount of 5.250% senior notes due December 1, 2017 (the “Senior Notes due 2017”) at an issue price of 98.912% of the aggregate principal amount. The unamortized discount was $3.9 million and $4.3 million at June 30, 2013 and December 31, 2012, respectively. The discount is being amortized using the effective interest method over the remaining life of the Senior Notes due 2017 which, at June 30, 2013, is a period of 4.4 years at an effective annual interest rate of 5.5%.
 
Deposits
 
As of June 30, 2013, Comenity Bank and Comenity Capital Bank had issued $319.3 million in money market deposits. Money market deposits are redeemable on demand by the customer and, as such, have no scheduled maturity date.
 
Asset-backed Securities – Owed to Securitization Investors
 
Asset-backed Term Notes
 
In February 2013, Master Trust I issued $500.0 million of asset-backed term securities to investors, which will mature in February 2018. The offering consisted of $375.0 million of Class A Series 2013-A asset-backed notes with a fixed interest rate of 1.61% per year and an aggregate of $125.0 million of subordinated classes of the asset-backed term notes that were retained by the Company and are eliminated from the unaudited condensed consolidated financial statements.
 
In April 2013, $500.0 million of floating rate Series 2006-A asset-backed term notes matured and was repaid by the Company.
 
In May 2013, Master Trust I issued $657.9 million of asset-backed term securities to investors, which will mature in May 2016. The offering consisted of $500.0 million of Class A Series 2013-B asset-backed notes with a fixed interest rate of 0.91% per year and an aggregate of $157.9 million of subordinated classes of the asset-backed term notes that were retained by the Company and are eliminated from the unaudited condensed consolidated financial statements.
 
In July 2013, the Series 2009-D asset-backed term notes matured and were repaid by the Company. Pursuant to the indenture supplement applicable to these securities, as of June 30, 2013, the Company collected $245.0 million of principal payments made by its credit cardholders during the accumulation period. The cash is restricted to the securitization investors and is reflected in other current assets in the Company’s unaudited condensed consolidated balance sheet as of June 30, 2013.
 
Conduit Facilities
 
The Company has access to committed undrawn capacity through three conduit facilities to support the funding of its credit card receivables through Master Trust I, Master Trust III and the WFC Trust. As of June 30, 2013, total capacity under the conduit facilities was $2.0 billion, of which $0.8 billion had been drawn and was included in asset-backed securities debt in the unaudited condensed consolidated balance sheet. Borrowings outstanding under each facility bear interest at a margin above LIBOR or the asset-backed commercial paper costs of each individual conduit provider. The conduits have varying maturities from September 2013 to May 2015 with variable interest rates ranging from 1.19% to 1.72% as of June 30, 2013.
 
In May 2013, the Company renewed its 2009-VFN conduit facility under World Financial Capital Master Note Trust, extending the maturity to May 31, 2015 and increasing the total capacity from $375.0 million to $450.0 million.

 
17

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
Derivative Instruments
 
As part of its interest rate risk management program, the Company may enter into derivative contracts with institutions that are established dealers to manage its exposure to changes in interest rates for certain obligations.
 
The credit card securitization trusts entered into certain interest rate derivative instruments that involved the receipt of variable rate amounts from counterparties in exchange for the Company making fixed rate payments over the life of the agreement without the exchange of the underlying notional amount. These interest rate derivative instruments were not designated as hedges. Such instruments were not speculative and were used to manage interest rate risk, but did not meet the specific hedge accounting requirements of ASC 815, “Derivatives and Hedging.”
 
Gains on derivative instruments of $2.2 million and $8.2 million for the three months ended June 30, 2013 and 2012, respectively, and $8.5 million and $15.2 million for the six months ended June 30, 2013 and 2012, respectively, were recognized in securitization funding costs within the unaudited condensed consolidated statements of income.
 
The Company’s outstanding interest rate derivative instruments matured in April 2013. The Company was not a party to any derivative instruments as of June 30, 2013.
 
The following tables identify the notional amount, fair value and classification of the Company’s outstanding interest rate derivatives at December 31, 2012 in the unaudited condensed consolidated balance sheets:
 
   
December 31, 2012
 
   
Notional Amount
 
Weighted Average
Years to Maturity
 
   
(Dollars in thousands)
 
Interest rate derivatives not designated as hedging instruments
 
$
545,700
   
0.51
 
 

 
 
December 31, 2012
 
 
Balance Sheet Location
 
Fair Value
 
 
(In thousands)
 
Interest rate derivatives not designated as hedging instruments
Other assets
 
$
4
 
Interest rate derivatives not designated as hedging instruments
Other current liabilities
 
$
8,515
 
 
 
7. 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 fees received is deferred. Amounts for revenue related to the redemption element and service element are recorded in redemption revenue and transaction revenue, respectively, in the unaudited condensed consolidated statements of income.
 
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.

 
18

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
A reconciliation of deferred revenue for the AIR MILES Reward Program is as follows:
 
   
Deferred Revenue
 
   
Service
 
Redemption
 
Total
 
   
(In thousands)
 
December 31, 2012
 
$
380,013
 
$
869,048
 
$
1,249,061
 
Cash proceeds
   
97,097
   
251,384
   
348,481
 
Revenue recognized
   
(106,288
)
 
(279,647
)
 
(385,935
)
Other
   
 
 
138
   
138
 
Effects of foreign currency translation
   
(21,268
)
 
(48,350
)
 
(69,618
)
June 30, 2013
 
$
349,554
 
$
792,573
 
$
1,142,127
 
Amounts recognized in the unaudited condensed consolidated balance sheets:
                   
Current liabilities
 
$
175,944
 
$
792,573
 
$
968,517
 
Non-current liabilities
 
$
173,610
 
$
 
$
173,610
 
 
 
8. STOCKHOLDERS’ EQUITY
 
Stock Repurchase Program
 
On January 2, 2013, the Company’s Board of Directors authorized a stock repurchase program to acquire up to $400.0 million of the Company’s outstanding common stock from January 2, 2013 through December 31, 2013, subject to any restrictions pursuant to the terms of the Company’s credit agreements, indentures, applicable securities laws or otherwise.
 
For the six months ended June 30, 2013, the Company acquired a total of 1,274,904 shares of its common stock for $208.0 million. As of June 30, 2013, the Company has $192.0 million available under the stock repurchase program.
 
Stock Compensation Expense
 
Total stock-based compensation expense recognized in the Company’s unaudited condensed consolidated statements of income for the three and six months ended June 30, 2013 and 2012 is as follows:
 
   
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
   
2013
 
2012
 
2013
 
2012
 
   
(In thousands)
 
Cost of operations
 
$
10,600
 
$
7,954
 
$
19,542
 
$
15,521
 
General and administrative
   
4,391
   
4,926
   
8,473
   
9,665
 
Total
 
$
14,991
 
$
12,880
 
$
28,015
 
$
25,186
 
 
During the six months ended June 30, 2013, the Company awarded 257,212 performance-based restricted stock units with a weighted average grant date fair value per share of $152.05 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 earnings before taxes for the period from January 1, 2013 to December 31, 2013 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 21, 2014, an additional 33% of the award on February 23, 2015 and the final 34% of the award on February 22, 2016, provided that the participant is employed by the Company on each such vesting date.
 
During the six months ended June 30, 2013, the Company awarded 75,282 service-based restricted stock units with a weighted average grant date fair value per share of $154.21 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.

 
19

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

9. ACCUMULATED OTHER COMPREHENSIVE INCOME
 
The changes in each component of accumulated comprehensive income (loss), net of tax effects, are as follows:
 
Three Months Ended June 30, 2013
 
Net Unrealized
Gains (Losses)
on Securities
   
Foreign
Currency
Translation
Adjustments (1)
   
Accumulated
Other
Comprehensive
Income (Loss)
 
   
(In thousands)
 
Balance as of March 31, 2013
 
$
11,417
   
$
(28,855
)
 
$
(17,438
)
Changes in other comprehensive income (loss)
   
(6,550
)
   
4,938
     
(1,612
)
Balance as of June 30, 2013
 
$
4,867
   
$
(23,917
)
 
$
(19,050
)


Three Months Ended June 30, 2012
 
Net Unrealized
Gains (Losses)
on Securities
   
Foreign
Currency
Translation
Adjustments (1)
   
Accumulated
Other
Comprehensive
Income (Loss)
 
   
(In thousands)
 
Balance as of March 31, 2012
 
$
8,437
   
$
(33,075
)
 
$
(24,638
)
Changes in other comprehensive income (loss)
   
352
     
1,406
     
1,758
 
Balance as of June 30, 2012
 
$
8,789
   
$
(31,669
)
 
$
(22,880
)


Six Months Ended June 30, 2013
 
Net Unrealized
Gains (Losses)
on Securities
   
Foreign
Currency
Translation
Adjustments (1)
   
Accumulated
Other
Comprehensive
Income (Loss)
 
   
(In thousands)
 
Balance as of December 31, 2012
 
$
10,321
   
$
(32,182
)
 
$
(21,861
)
Changes in other comprehensive income (loss)
   
(5,454
)
   
8,265
     
2,811
 
Balance as of June 30, 2013
 
$
4,867
   
$
(23,917
)
 
$
(19,050
)


Six Months Ended June 30, 2012
 
Net Unrealized
Gains (Losses)
on Securities
   
Foreign
Currency
Translation
Adjustments (1)
   
Accumulated
Other
Comprehensive
Income (Loss)
 
   
(In thousands)
 
Balance as of December 31, 2011
 
$
6,953
   
$
(30,009
)
 
$
(23,056
)
Changes in other comprehensive income (loss)
   
1,836
     
(1,660
)
   
176
 
Balance as of June 30, 2012
 
$
8,789
   
$
(31,669
)
 
$
(22,880
)
                             
 
(1)
Primarily related to the impact of changes in the Canadian currency exchange rate.
 
A de minimis amount was reclassified out of accumulated other comprehensive income (loss) for the six months ended June 30, 2013.
 
 
10. 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.

 
20

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
Fair Value of Financial Instruments The estimated fair values of the Company’s financial instruments are as follows:
 
   
June 30, 2013
 
December 31, 2012
 
   
Carrying
Amount
 
Fair
Value
 
Carrying
Amount
 
Fair
Value
 
   
(In thousands)
 
Financial assets
                 
Cash and cash equivalents
 
$
749,821
 
$
749,821
 
$
893,352
 
$
893,352
 
Trade receivables, net
   
337,458
   
337,458
   
370,110
   
370,110
 
Credit card receivables, net
   
6,782,194
   
6,782,194
   
6,967,674
   
6,967,674
 
Redemption settlement assets, restricted
   
509,230
   
509,230
   
492,690
   
492,690
 
Cash collateral, restricted
   
47,501
   
47,501
   
65,160
   
65,160
 
Other investments
   
377,734
   
377,734
   
91,972
   
91,972
 
Derivative instruments
   
   
   
4
   
4
 
Financial liabilities
                         
Accounts payable
   
241,437
   
241,437
   
215,470
   
215,470
 
Deposits
   
2,255,366
   
2,282,483
   
2,228,411
   
2,255,089
 
Asset-backed securities debt – owed to securitization investors
   
4,011,916
   
4,045,421
   
4,130,970
   
4,225,745
 
Long-term and other debt
   
2,856,044
   
4,915,377
   
2,854,839
   
4,358,379
 
Derivative instruments
   
   
   
8,515
   
8,515
 
 
Fair Value of Assets and Liabilities Held at June 30, 2013 and December 31, 2012
 
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 and the relatively liquid nature of these assets and liabilities.
 
Credit card receivables, net — The carrying amount of credit card receivables, net approximates fair value due to the short maturity and average interest rates that approximate current market origination rates.
 
Redemption settlement assets, restricted — Redemption settlement assets, restricted consists of cash and cash equivalents and marketable securities. The 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 based on discounted cash flow models. The Company uses a valuation model that calculates the present value of estimated cash flows for each asset. The fair value is based on the term of the underlying securities and a discount rate. 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.
 
Other investments — Other investments consist primarily of restricted cash and marketable securities. The fair value is based on quoted market prices for the same or similar securities.
 
As of June 30, 2013, the Company’s other investments consisted of $318.4 million of restricted cash and $59.3 million of marketable securities. The Company had a cost basis in its marketable securities of $62.4 million with unrealized losses of $3.2 million and unrealized gains of $0.1 million. Of the $3.2 million unrealized losses, $2.7 million has been unrealized for less than twelve months and $0.5 million has been unrealized for twelve months or greater.
 
As of December 31, 2012, the Company’s other investments consisted of $47.1 million of restricted cash and $44.9 million of marketable securities. The Company had a cost basis in its marketable securities of $45.1 million with unrealized losses of $0.4 million and unrealized gains of $0.2 million. Of the $0.4 million unrealized losses, $0.3 million had been unrealized for less than twelve months and $0.1 million had been unrealized for twelve months or greater.

 
21

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
The amortized cost and estimated fair value of the marketable securities at June 30, 2013 by contractual maturity are as follows:
 
   
Amortized
Cost
   
Estimated Fair Value
 
   
(In thousands)
 
Due in one year or less
 
$
6,637
   
$
6,540
 
Due after five years through ten years
   
4,955
     
4,527
 
Due after ten years
   
50,856
     
48,281
 
Total
 
$
62,448
   
$
59,348
 
 
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. There were no realized gains or losses from the sale of other investments for the three and six months ended June 30, 2013 and 2012.
 
As of June 30, 2013, the Company does not consider the investments to be other-than-temporarily impaired.
 
Deposits — The fair value is estimated based on the current observable market rates available to the Company for similar deposits with similar remaining maturities.
 
Asset-backed securities debt – owed to securitization investors — The fair value is estimated based on the current observable market rates available to the Company for similar debt instruments with similar remaining maturities or quoted market prices for the same transaction.
 
Long-term and other debt — The fair value is estimated based on the current observable market rates available to the Company for similar debt instruments with similar remaining maturities or quoted market prices for the same transaction.
 
Derivative 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.
 
Financial Assets and Financial Liabilities Fair Value Hierarchy
 
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 where 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.

 
22

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
The following tables provide information for the assets and liabilities carried at fair value measured on a recurring basis as of June 30, 2013 and December 31, 2012:
 
       
Fair Value Measurements at
June 30, 2013 Using
 
   
Balance at
June 30,
2013
 
Level 1
 
Level 2
 
Level 3
 
   
(In thousands)
 
Corporate bonds (1) 
 
477,580
 
 
477,580
 
 
Cash collateral, restricted
   
47,501
   
1,550
   
   
45,951
 
Other investments (2) 
   
377,734
   
323,319
   
54,415
   
 
Total assets measured at fair value
 
$
902,815
 
$
324,869
 
$
531,995
 
$
45,951
 
 
 
       
Fair Value Measurements at
December 31, 2012 Using
 
   
Balance at
December 31,
2012
 
Level 1
 
Level 2
 
Level 3
 
   
(In thousands)
 
Government bonds (1) 
 
$
5,117
 
$
 
$
5,117
 
$
 
Corporate bonds (1) 
   
447,307
   
6,165
   
441,142
   
 
Cash collateral, restricted
   
65,160
   
2,500
   
   
62,660
 
Other investments (2) 
   
91,972
   
51,951
   
40,021
   
 
Derivative instruments (3) 
   
4
   
   
4
   
 
Total assets measured at fair value
 
$
609,560
 
$
60,616
 
$
486,284
 
$
62,660
 
                           
Derivative instruments (4) 
 
$
8,515
 
$
 
$
8,515
 
$
 
Total liabilities measured at fair value
 
$
8,515
 
$
 
$
8,515
 
$
 
                               
 
(1)
Amounts are included in redemption settlement assets in the unaudited condensed consolidated balance sheets.
 
(2)
Amounts are included in other current assets and other assets in the unaudited condensed consolidated balance sheets.
 
(3)
Amount is included in other assets in the unaudited condensed consolidated balance sheets.
 
(4)
Amount is included in other current liabilities in the unaudited condensed consolidated balance sheets.
 
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 June 30, 2013 and 2012:
 
   
Cash Collateral, Restricted
 
   
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
   
2013
 
2012
 
2013
 
2012
 
   
(In thousands)
 
Balance at beginning of period
 
$
63,140
 
$
141,866
 
$
62,660
 
$
158,727
 
Total gains (realized or unrealized):
                         
Included in earnings
   
311
   
2,330
   
791
   
4,019
 
Purchases
   
   
   
   
 
Sales
   
   
   
   
 
Issuances
   
   
   
   
 
Settlements
   
(17,500
)
 
(21,801
)
 
(17,500
)
 
(40,351
)
Transfers in or out of Level 3
   
   
   
   
 —
 
Balance at end of period
 
$
45,951
 
$
122,395
 
$
45,951
 
$
122,395
 
                           
Gains for the period included in earnings related to assets still held at end of period
 
$
311
 
$
2,330
 
$
791
 
$
4,019
 
 
There were no transfers between Levels 1 and 2 within the fair value hierarchy for the three and six months ended June 30, 2013 and 2012.

 
23

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
The spread deposits included in cash collateral, restricted are recorded at their fair value based on discounted cash flow models, utilizing the respective term of each instrument which ranged from 1 to 40 months, with a weighted average term of 17 months. The unobservable input used to calculate the fair value was the discount rate of 3.2%, which was based on an interest rate curve that is observable in the market as adjusted for a credit spread. Significant increases (decreases) in the term or the discount rate would result in a lower (higher) fair value.
 
For the three and six months ended June 30, 2013 and 2012, gains included in earnings attributable to cash collateral, restricted are included in interest in the unaudited condensed consolidated statements of income.
 
Financial Instruments Disclosed but Not Carried at Fair Value
 
The following table provides assets and liabilities disclosed but not carried at fair value as of June 30, 2013 and December 31, 2012:
 
   
Fair Value Measurements at
June 30, 2013
 
   
Total
 
Level 1
 
Level 2
 
Level 3
 
   
(In thousands)
 
Cash and cash equivalents
 
$
749,821
 
$
749,821
 
$
 
$
 
Credit card receivables, net
   
6,782,194
   
   
   
6,782,194
 
Total assets
 
$
7,532,015
 
$
749,821
 
$
 
$
6,782,194
 
                           
Deposits
 
$
2,282,483
 
$
 
$
2,282,483
 
$
 
Asset-backed securities debt - owed to securitization investors
   
4,045,421
   
   
4,045,421
   
 
Long-term and other debt
   
4,915,377
   
   
4,915,377
   
 
Total liabilities
 
$
11,243,281
 
$
 
$
11,243,281
 
$
 
 
 
   
Fair Value Measurements at
December 31, 2012
 
   
Total
 
Level 1
 
Level 2
 
Level 3
 
   
(In thousands)
 
Cash and cash equivalents
 
$
893,352
 
$
893,352
 
$
 
$
 
Credit card receivables, net
   
6,967,674
   
   
   
6,967,674
 
Total assets
 
$
7,861,026
 
$
893,352
 
$
 
$
6,967,674
 
                           
Deposits 
 
$
2,255,089
 
$
 
$
2,255,089
 
$
 
Asset-backed securities debt - owed to securitization investors 
   
4,225,745
   
   
4,225,745
   
 
Long-term and other debt
   
4,358,379
   
   
4,358,379
   
 
Total liabilities
 
$
10,839,213
 
$
 
$
10,839,213
 
$
 
 
 
11. INCOME TAXES
 
For the three and six months ended June 30, 2013, the Company utilized an effective tax rate of 37.3% and 37.8%, respectively, to calculate its provision for income taxes. For the three and six months ended June 30, 2012, the Company utilized an effective tax rate of 38.0% and 38.2%, 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 2013 based on all known variables is 38.1%.
 
 
12. SEGMENT INFORMATION
 
Operating segments are defined by ASC 280, “Segment Reporting,” as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is the President and Chief Executive Officer. The operating segments are reviewed separately because each operating segment represents a strategic business unit that generally offers different products and serves different markets.

 
24

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
The Company operates in the following reportable segments: LoyaltyOne, Epsilon, and Private Label Services and Credit. Segment operations consist of the following:
 
 
LoyaltyOne includes the Company’s Canadian AIR MILES Reward Program;
 
 
Epsilon provides end-to-end, 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.
 
Corporate and all other immaterial businesses are reported collectively as an “all other” category labeled “Corporate/Other.” 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.
 
Three Months Ended June 30, 2013
 
LoyaltyOne
 
Epsilon
 
Private Label
Services and Credit
 
Corporate/ Other
 
Eliminations
 
Total
 
   
(In thousands)
 
Revenues
 
$
220,137
 
$
331,841
 
$
479,875
 
$
 
$
(3,761
)
$
1,028,092
 
Adjusted EBITDA (1) 
   
66,175
   
63,593
   
231,844
   
(23,865
)
 
   
337,747
 
Stock compensation expense
   
2,800
   
4,742
   
3,059
   
4,390
   
   
14,991
 
Depreciation and amortization
   
4,337
   
34,708
   
13,162
   
1,369
   
   
53,576
 
Operating income (loss)
   
59,038
   
24,143
   
215,623
   
(29,624
)
 
   
269,180
 
Interest expense, net
   
(139
)
 
(23
)
 
31,173
   
52,455
   
   
83,466
 
Income (loss) before income taxes
   
59,177
   
24,166
   
184,450
   
(82,079
)
 
   
185,714
 


Three Months Ended June 30, 2012
 
LoyaltyOne
 
Epsilon
 
Private Label
Services and Credit
 
Corporate/ Other
 
Eliminations
 
Total
 
   
(In thousands)
 
Revenues
 
$
229,562
 
$
235,476
 
$
402,497
 
$
 
$
(1,050
)
$
866,485
 
Adjusted EBITDA (1) 
   
60,574
   
48,779
   
206,078
   
(22,605
)
 
   
292,826
 
Stock compensation expense
   
2,248
   
3,439
   
2,267
   
4,926
   
   
12,880
 
Depreciation and amortization
   
4,967
   
24,844
   
8,822
   
770
   
   
39,403
 
Operating income (loss)
   
53,359
   
20,496
   
194,989
   
(28,301
)
 
   
240,543
 
Interest expense, net
   
(202
)
 
(19
)
 
27,876
   
45,412
   
   
73,067
 
Income (loss) before income taxes
   
53,561
   
20,515
   
167,113
   
(73,713
)
 
   
167,476
 


Six Months Ended June 30, 2013
 
LoyaltyOne
 
Epsilon
 
Private Label
Services and Credit
 
Corporate/ Other
 
Eliminations
 
Total
 
   
(In thousands)
 
Revenues
 
$
461,044
 
$
649,754
 
$
977,223
 
$
 
$
(6,492
)
$
2,081,529
 
Adjusted EBITDA (1) 
   
128,778
   
118,010
   
490,135
   
(42,077
)
 
   
694,846
 
Stock compensation expense
   
5,219
   
8,729
   
5,595
   
8,472
   
   
28,015
 
Depreciation and amortization
   
8,659
   
68,928
   
26,496
   
2,343
   
   
106,426
 
Operating income (loss)
   
114,900
   
40,353
   
458,044
   
(52,892
)
 
   
560,405
 
Interest expense, net
   
(420
)
 
(39
)
 
62,227
   
104,242
   
   
166,010
 
Income (loss) before income taxes
   
115,320
   
40,392
   
395,817
   
(157,134
)
 
   
394,395
 


 
25

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)
 
Six Months Ended June 30, 2012
 
LoyaltyOne
 
Epsilon
 
Private Label
Services and Credit
 
Corporate/ Other
 
Eliminations
 
Total
 
   
(In thousands)
 
Revenues
 
$
487,359
 
$
463,408
 
$
809,843
 
$
292
 
$
(2,848
)
$
1,758,054
 
Adjusted EBITDA (1) 
   
118,966
   
88,601
   
430,480
   
(41,577
)
 
   
596,470
 
Stock compensation expense
   
4,369
   
7,050
   
4,102
   
9,665
   
   
25,186
 
Depreciation and amortization
   
10,086
   
49,222
   
17,347
   
1,467
   
   
78,122
 
Operating income (loss)
   
104,511
   
32,329
   
409,031
   
(52,709
)
 
   
493,162
 
Interest expense, net
   
(362
)
 
(37
)
 
54,320
   
84,798
   
   
138,719
 
Income (loss) before income taxes
   
104,873
   
32,366
   
354,711
   
(137,507
)
 
   
354,443
 
                                         
 
(1)
Adjusted EBITDA is a non-GAAP financial measure equal to net income, the most directly comparable GAAP financial measure, plus stock compensation expense, provision for income taxes, interest expense, net, depreciation and other amortization and amortization of purchased intangibles. Adjusted EBITDA is presented in accordance with ASC 280, “Segment Reporting,” as it is the primary performance metric utilized to assess performance of the segment.

 
26

 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
                    
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 on Form 10-K for the year ended December 31, 2012, filed with the Securities and Exchange Commission, or SEC, on February 28, 2013.
 
Year in Review Highlights
 
For the six months ended June 30, 2013, revenue increased 18.4% to $2.1 billion and adjusted EBITDA increased 16.5% to $694.8 million as compared to the prior year period. See below for discussion of operating results for each of our three segments.
 
LoyaltyOne®
 
Revenue decreased 5.4% to $461.0 million and adjusted EBITDA increased 8.2% to $128.8 million for the six months ended June 30, 2013 as compared to the same period in 2012.
 
The LoyaltyOne segment generates revenue primarily from our coalition loyalty program in Canada and, as such, the segment can be impacted by changes in the foreign currency exchange rate between the U.S. dollar and the Canadian dollar. A weaker Canadian dollar negatively impacted the results of operations for the six months ended June 30, 2013, as the average foreign currency exchange rate was $0.98 as compared to $0.99 in the prior year period, which lowered revenue and adjusted EBITDA by $4.6 million and $1.4 million, respectively.
 
AIR MILES® reward miles redeemed during the six months ended June 30, 2013 decreased 10.4% compared to the same period in the prior year with higher collector redemptions in the prior year attributable to the introduction of a five-year expiry policy.
 
The number of AIR MILES reward miles issued impacts the number of future AIR MILES reward miles available to be redeemed. This can also impact our future revenue recognized with respect to the number of AIR MILES reward miles redeemed and the amount of breakage for those AIR MILES reward miles expected to go unredeemed. AIR MILES reward miles issued during the six months ended June 30, 2013 decreased 4.0% compared to the same period in the prior year due to weakness in consumer credit card spending coupled with reduced promotional activity by our gas and grocer sponsors. Timing of sponsor promotional activities can impact issuance growth in a particular quarter; however, we still anticipate low- to mid-single digit year-over-year issuance growth for 2013.
 
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 fees is deferred. With the adoption of Financial Accounting Standards Board, or FASB, Accounting Standards Update, or ASU, 2009-13, “Multiple-Deliverable Revenue Arrangements,” the residual method is no longer utilized to allocate proceeds to the service element for new sponsor agreements entered into or existing sponsor agreements that are materially modified after January 1, 2011. For these agreements, we measure the service element at its estimated selling price. In the first quarter of 2013, we renewed our agreements with Bank of Montreal and Amex Bank of Canada, two of our top five sponsors. We believe there will be a shift in the allocation of deferred revenue between the multiple elements impacting the classification of revenue between transaction and redemption; however, these amounts were not material for the six months ended June 30, 2013.
 
During the six months ended June 30, 2013, LoyaltyOne also signed new multi-year agreements with Eastlink, a privately-held Canadian telecommunications company; with Irving Oil, a regional energy and marketing company; and with Staples Canada, Inc., Canada’s largest supplier of office supplies, technology, office furniture and business services, to participate as sponsors in the AIR MILES Reward Program.
 
AIR MILES Cash, an instant reward option added to the AIR MILES Reward Program in March 2012, continues to expand with over 1.5 million collectors enrolled at June 30, 2013. We expect approximately 10 percent of AIR MILES reward miles issued during 2013 will be under this option.
 
Further, CBSM-Companhia Brasileira De Servicos De Marketing, operator of Brazil’s dotz coalition loyalty program, or dotz, in which we have a 37% ownership, has approximately 8.2 million collectors enrolled at June 30, 2013, as compared to approximately 2.9 million collectors enrolled at June 30, 2012. We anticipate that dotz will enter into four additional Brazilian markets by the end of 2013.

 
27

 
Epsilon®
 
Revenue increased 40.2% to $649.8 million and adjusted EBITDA increased 33.2% to $118.0 million for the six months ended June 30, 2013 as compared to the same period in 2012. These increases were driven by the acquisition of the Hyper Marketing group of companies, or HMI, in November 2012 as well as strength in the telecommunications vertical.
 
During the six months ended June 30, 2013, Epsilon announced a new multi-year agreement with Road Scholar, a not-for-profit organization providing adults with educational travel opportunities worldwide, to provide database marketing services. We also signed multi-year renewal and expansion agreements with AT&T to continue to provide data and agency services, and with Kroger, one of the world’s largest retailers, to continue to provide permission-based email marketing deployment and to provide strategic, creative and analytic services. Finally, we renewed multi-year agreements with Guthy-Renker, one of the world’s largest direct marketing companies, to continue to provide database, data and permission-based email marketing services, and Carlson Rezidor Hotel Group, one of the world’s largest hotel groups, to continue to provide email marketing services.
 
Private Label Services and Credit
 
Revenue increased 20.7% to $977.2 million and adjusted EBITDA increased 13.9% to $490.1 million for the six months ended June 30, 2013 as compared to the same period in 2012.
 
For the six months ended June 30, 2013, average credit card receivables increased 29.1% as compared to the same period in the prior year as a result of increased credit sales, recent client signings and recent credit card portfolio acquisitions. Credit sales increased 30.2% for the six months ended June 30, 2013 due to strong core credit cardholder spending, recent new client signings and recent credit card portfolio acquisitions.
 
Delinquency rates were 3.9% of principal credit card receivables at both June 30, 2013 and 2012. The principal net charge-off rate was 4.5% for the six months ended June 30, 2013 as compared to 5.1% in the prior year period.
 
In March 2013, we purchased the existing private label credit card portfolio of Barneys New York for a purchase price of $37.1 million, subject to customary purchase price adjustments.
 
During the six months ended June 30, 2013, we signed new multi-year agreements to provide private label credit card services to El Dorado Furniture, a multi-channel furniture retailer, Aspen Dental, a provider of dental services, and TigerDirect, a computer and electronics retailer. We also signed new multi-year agreements to provide co-brand credit card services to Ohio University Alumni Association and Caesars Entertainment Corporation.
 
Additionally, we announced a multi-year renewal and expansion agreement with Orchard Brands, a leading multi-channel retailer of apparel and home products, to continue providing private label credit card services, and we renewed a multi-year agreement to continue providing co-brand credit card services to Gander Mountain, a leading multi-channel retailer of outdoor lifestyle products and services.
 
Critical Accounting Policies and Estimates
 
There have been no material changes 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 Annual Report filed on Form 10-K for the fiscal year ended December 31, 2012.
 
Recent Accounting Pronouncements
 
See “Recently Issued Accounting Standards” under Note 1, “Summary of Significant Accounting Policies,” of the Notes to Unaudited Condensed Consolidated Financial Statements for a discussion of certain accounting standards that have been issued during 2013.
 
Use of Non-GAAP Financial Measures
 
Adjusted EBITDA is a non-GAAP financial measure equal to net income, the most directly comparable financial measure based on accounting principles generally accepted in the United States of America, or GAAP, plus stock compensation expense, provision for income taxes, interest expense, net, 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.

 
28


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, 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 measure 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.
 
   
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
   
2013
 
2012
 
2013
 
2012
 
   
(In thousands)
 
Net income
 
$
116,440
 
$
103,821
 
$
245,419
 
$
219,050
 
Stock compensation expense
   
14,991
   
12,880
   
28,015
   
25,186
 
Provision for income taxes
   
69,274
   
63,655
   
148,976
   
135,393
 
Interest expense, net
   
83,466
   
73,067
   
166,010
   
138,719
 
Depreciation and other amortization
   
20,446
   
18,496
   
40,006
   
36,100
 
Amortization of purchased intangibles
   
33,130
   
20,907
   
66,420
   
42,022
 
Adjusted EBITDA
 
$
337,747
 
$
292,826
 
$
694,846
 
$
596,470
 
 
 
29


Results of Operations
 
Three months ended June 30, 2013 compared to the three months ended June 30, 2012
 
   
Three Months Ended
June 30,
   
Change
 
   
2013
   
2012
   
$
   
%
 
   
(In thousands, except percentages)
 
Revenue:
                       
LoyaltyOne
 
$
220,137
   
$
229,562
   
$
(9,425
)  
(4.1
)%
Epsilon
   
331,841
     
235,476
     
96,365
   
40.9
 
Private Label Services and Credit
   
479,875
     
402,497
     
77,378
   
19.2
 
Corporate/Other
   
     
     
   
nm
*
Eliminations
   
(3,761
   
(1,050
)    
(2,711
)  
nm
*
Total
 
$
1,028,092
   
$
866,485
   
$
161,607
   
18.7
%
Adjusted EBITDA (1):
                             
LoyaltyOne
 
$
66,175
   
$
60,574
   
$
5,601
   
9.2
%
Epsilon
   
63,593
     
48,779
     
14,814
   
30.4
 
Private Label Services and Credit
   
231,844
     
206,078
     
25,766
   
12.5
 
Corporate/Other
   
(23,865
   
(22,605
)    
(1,260
)  
5.6
 
Eliminations
   
     
     
   
 
Total
 
$
337,747
   
$
292,826
   
$
44,921
   
15.3
%
Stock compensation expense:
                             
LoyaltyOne
 
$
2,800
   
$
2,248
   
$
552
   
24.6
%
Epsilon
   
4,742
     
3,439
     
1,303
   
37.9
 
Private Label Services and Credit
   
3,059
     
2,267
     
792
   
34.9
 
Corporate/Other
   
4,390
     
4,926
     
(536
)  
(10.9
)
Total
 
$
14,991
   
$
12,880
   
$
2,111
   
16.4
%
Depreciation and amortization:
                             
LoyaltyOne
 
$
4,337
   
$
4,967
   
$
(630
)  
(12.7
)%
Epsilon
   
34,708
     
24,844
     
9,864
   
39.7
 
Private Label Services and Credit
   
13,162
     
8,822
     
4,340
   
49.2
 
Corporate/Other
   
1,369
     
770
     
599
   
77.8
 
Total
 
$
53,576
   
$
39,403
   
$
14,173
   
36.0
%
Operating income:
                             
LoyaltyOne
 
$
59,038
   
$
53,359
   
$
5,679
   
10.6
%
Epsilon
   
24,143
     
20,496
     
3,647
   
17.8
 
Private Label Services and Credit
   
215,623
     
194,989
     
20,634
   
10.6
 
Corporate/Other
   
(29,624
   
(28,301
)    
(1,323
)  
4.7
 
Eliminations
   
     
     
   
 
Total
 
$
269,180
   
$
240,543
   
$
28,637
   
11.9
%
Adjusted EBITDA margin (2):
                             
LoyaltyOne
   
30.1
%    
26.4
%    
3.7
%      
Epsilon
   
19.2
     
20.7
     
(1.5
)      
Private Label Services and Credit
   
48.3
     
51.2
     
(2.9
)      
Total
   
32.9
%    
33.8
%    
(0.9
)%      
Segment operating data:
                             
Private label statements generated
   
47,309
     
38,851
     
8,458
   
21.8
 %
Credit sales
 
$
3,691,780
   
$
2,869,999
   
$
821,781
   
28.6
 %
Average credit card receivables
 
$
6,964,945
   
$
5,467,489
   
$
1,497,456
   
27.4
 %
AIR MILES reward miles issued
   
1,251,857
     
1,316,309
     
(64,452
)  
(4.9
)%
AIR MILES reward miles redeemed
   
933,964
     
1,024,738
     
(90,774
)  
(8.9
)%
                                   
 
(1)
Adjusted EBITDA is equal to net income, plus stock compensation expense, provision for income taxes, interest expense, net, depreciation and other amortization, and amortization of purchased intangibles. For a reconciliation of adjusted EBITDA to net income, the most directly comparable GAAP financial measure, see “Use of Non-GAAP Financial Measures” included in this report.
 
(2)
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.
 
*
not meaningful
 
 
30

 
Consolidated Operating Results:
 
Revenue. Total revenue increased $161.6 million, or 18.7%, to $1.0 billion for the three months ended June 30, 2013 from $866.5 million for the three months ended June 30, 2012. The net increase was due to the following:
 
 
Transaction. Revenue increased $2.1 million, or 2.7%, to $79.6 million for the three months ended June 30, 2013. AIR MILES reward miles issuance fees, for which we provide marketing and administrative services, increased $10.6 million and other servicing fees charged to our credit cardholders increased $8.0 million, offset by a decrease of $15.9 million in merchant fees, which are transaction fees charged to the retailer, due to increased royalty payments associated with the signing of new clients.
 
 
Redemption. Revenue decreased $20.8 million, or 13.1%, to $138.3 million for the three months ended June 30, 2013 due to an 8.9% decrease in AIR MILES reward miles redeemed. The introduction of a five-year expiry policy for the AIR MILES Reward Program stimulated redemption activity in the first half of 2012.
 
 
Finance charges, net. Revenue increased $84.9 million, or 22.5%, to $462.7 million for the three months ended June 30, 2013. This increase was driven by a 27.4% increase in average credit card receivables, which have increased approximately $1.5 billion through a combination of growth in our existing credit card receivables and recent credit card portfolio acquisitions. This was offset in part by a 110 basis point decline in gross yield primarily due to the onboarding of new credit card portfolios.
 
 
Database marketing fees and direct marketing. Revenue increased $90.0 million, or 41.0%, to $309.5 million for the three months ended June 30, 2013. The increase in revenue was driven by our acquisition of HMI, which added $74.8 million, as well as an increase in revenue of $17.1 million due to demand in the telecommunications vertical within the Epsilon segment.
 
 
Other revenue. Revenue increased $5.5 million, or 16.8%, to $37.9 million for the three months ended June 30, 2013 due to additional consulting services provided by Epsilon.
 
Cost of operations. Cost of operations increased $112.8 million, or 22.3%, to $619.3 million for the three months ended June 30, 2013 from $506.5 million for the three months ended June 30, 2012. The net increase was due to the following:
 
 
Within the LoyaltyOne segment, cost of operations decreased $14.5 million due to a $9.5 million decrease in fulfillment costs for the AIR MILES Reward Program associated with the decline in AIR MILES reward miles redeemed. In addition, marketing expenses decreased $4.3 million due to a decline in costs associated with the promotion of AIR MILES Cash from 2012 and a decline in losses associated with international expansion efforts of $2.7 million. These decreases were partially offset by an increase in payroll and benefits of $2.1 million.
 
 
Within the Epsilon segment, cost of operations increased $82.9 million due to the HMI acquisition, which added $65.7 million, as well as an increase in direct marketing costs associated with the increase in revenue.
 
 
Within the Private Label Services and Credit segment, cost of operations increased by $47.2 million. Payroll and benefits increased $19.9 million due to an increase in the number of associates to support growth, and marketing expenses increased $8.9 million due to the increase in credit sales. Other operating expenses increased by $12.4 million, as credit card processing expenses were higher due to an increase in the number of statements generated, and data processing costs increased due to growth in volumes.
 
Provision for loan loss. Provision for loan loss increased $5.2 million, or 10.0%, to $57.8 million for the three months ended June 30, 2013 as compared to $52.6 million for the three months ended June 30, 2012. The increase in the provision was a result of the growth in credit card receivables, offset in part by improved credit quality. The net charge-off rate improved 30 basis points to 4.6% for the three months ended June 30, 2013 as compared to 4.9% for the three months ended June 30, 2012.
 
General and administrative. General and administrative expenses increased $0.7 million, or 2.6%, to $28.3 million for the three months ended June 30, 2013 as compared to $27.5 million for the three months ended June 30, 2012 due to higher professional fees and consulting costs, offset in part by lower payroll and benefit costs.

 
31

 
Depreciation and other amortization. Depreciation and other amortization increased $2.0 million, or 10.5%, to $20.4 million for the three months ended June 30, 2013, as compared to $18.5 million for the three months ended June 30, 2012, due to additional assets placed into service resulting from both the HMI acquisition and recent capital expenditures.
 
Amortization of purchased intangibles. Amortization of purchased intangibles increased $12.2 million, or 58.5%, to $33.1 million for the three months ended June 30, 2013 as compared to $20.9 million for the three months ended June 30, 2012. The increase relates to $8.4 million of additional amortization associated with the intangible assets from both the HMI acquisition and recent credit card portfolio acquisitions.
 
Interest expense. Total interest expense, net increased $10.4 million, or 14.2%, to $83.5 million for the three months ended June 30, 2013 as compared to $73.1 million for the three months ended June 30, 2012 due to the following:
 
 
Securitization funding costs. Securitization funding costs increased $2.2 million due to greater borrowings for the three months ended June 30, 2013 as compared to the three months ended June 30, 2012. These increases were offset by lower average interest rates.
 
 
Interest expense on deposits. Interest expense on deposits increased $1.0 million as increases from higher borrowings were offset by lower average interest rates.
 
 
Interest expense on long-term and other debt, net. Interest expense on long-term and other debt, net increased $7.2 million due to an increase of $5.3 million resulting from the 2012 issuances of senior notes. In addition, the amortization of imputed interest associated with the convertible senior notes increased $2.4 million as compared to the same period in 2012.
 
Taxes. Income tax expense increased $5.6 million to $69.3 million for the three months ended June 30, 2013 from $63.7 million for the comparable period in 2012 due primarily to an increase in taxable income, offset in part by a decline in the effective tax rate. The effective tax rate for the three months ended June 30, 2013 declined to 37.3% as compared to 38.0% for the three months ended June 30, 2012 due to a favorable outcome related to certain tax matters.
 
Segment Revenue and Adjusted EBITDA:
 
Revenue. Total revenue increased $161.6 million, or 18.7%, to $1.0 billion for the three months ended June 30, 2013 from $866.5 million for the three months ended June 30, 2012. The net increase was due to the following:
 
 
LoyaltyOne. Revenue decreased $9.4 million, or 4.1%, to $220.1 million for the three months ended June 30, 2013. Redemption revenue decreased $20.8 million, or 13.1%, due to an 8.9% decline in the number of AIR MILES reward miles redeemed. AIR MILES reward miles issuance fees, for which we provide marketing and administrative services, increased $10.6 million.
 
 
Epsilon. Revenue increased $96.4 million, or 40.9%, to $331.8 million for the three months ended June 30, 2013. The acquisition of HMI contributed $75.1 million to revenue. In addition, revenue increased $21.0 million, or 25.2%, due to increased demand in the telecommunications vertical.
 
 
Private Label Services and Credit. Revenue increased $77.4 million, or 19.2%, to $479.9 million for the three months ended June 30, 2013. Finance charges and late fees increased by $84.9 million, driven by a 27.4% increase in average credit card receivables due to recent credit card portfolio acquisitions and strong credit cardholder spending. Transaction revenue decreased $7.6 million due to lower merchant fees resulting from increased royalty payments associated with the signing of new clients, offset by an increase in other servicing fees.
 
Adjusted EBITDA. Adjusted EBITDA increased $44.9 million, or 15.3%, to $337.7 million for the three months ended June 30, 2013 from $292.8 million for the three months ended June 30, 2012. The net increase was due to the following:
 
 
LoyaltyOne. Adjusted EBITDA increased $5.6 million, or 9.2%, to $66.2 million for the three months ended June 30, 2013, and adjusted EBITDA margin also increased to 30.1% for the three months ended June 30, 2013 from 26.4% for the same period in the prior year. Adjusted EBITDA was positively impacted by a reduction in operating expenses, including a decline in marketing expenses due to the promotional activity in 2012 associated with the introduction of AIR MILES Cash, as well as a decline in expenses associated with international activities.

 
32

 
 
Epsilon. Adjusted EBITDA increased $14.8 million, or 30.4%, to $63.6 million for the three months ended June 30, 2013. Adjusted EDITDA was positively impacted by both the growth in revenue, including the acquisition of HMI, which added $9.7 million to adjusted EBITDA, and the implementation of cost-saving initiatives and operational efficiencies by Epsilon in the second half of 2012. Adjusted EBITDA margin decreased to 19.2% for the three months ended June 30, 2013 from 20.7% for the same period in the prior year. The negative impact to adjusted EBITDA margin was due to a shift in revenue mix attributable to the HMI acquisition.
 
 
Private Label Services and Credit. Adjusted EBITDA increased $25.8 million, or 12.5%, to $231.8 million for the three months ended June 30, 2013. Adjusted EBITDA was positively impacted by the increase in finance charges, net, offset in part by both an increase in operating expenses due to increased volumes and an increase in the provision for loan loss due to the increase in credit card receivables.
 
 
Corporate/Other. Adjusted EBITDA decreased $1.3 million to a loss of $23.9 million for the three months ended June 30, 2013 related to higher professional fees and consulting costs.

 
33


Results of Operations
 
Six months ended June 30, 2013 compared to the six months ended June 30, 2012
 
   
Six Months Ended
June 30,
   
Change
 
   
2013
   
2012
   
$
   
%
 
   
(In thousands, except percentages)
 
Revenue:
                       
LoyaltyOne
 
$
461,044
   
$
487,359
   
$
(26,315
)  
(5.4
)%
Epsilon
   
649,754
     
463,408
     
186,346
   
40.2
 
Private Label Services and Credit
   
977,223
     
809,843
     
167,380
   
20.7
 
Corporate/Other
   
     
292
     
(292
)  
nm
*
Eliminations
   
(6,492
)    
(2,848
)    
(3,644
)  
nm
*
Total
 
$
2,081,529
   
$
1,758,054
   
$
323,475
   
18.4
%
Adjusted EBITDA (1):
                             
LoyaltyOne
 
$
128,778
   
$
118,966
   
$
9,812
   
8.2
%
Epsilon
   
118,010
     
88,601
     
29,409
   
33.2
 
Private Label Services and Credit
   
490,135
     
430,480
     
59,655
   
13.9
 
Corporate/Other
   
(42,077
)    
(41,577
)    
(500
)  
1.2
 
Eliminations
   
     
     
   
 
Total
 
$
694,846
   
$
596,470
   
$
98,376
   
16.5
%
Stock compensation expense:
                             
LoyaltyOne
 
$
5,219
   
$
4,369
   
$
850
   
19.5
%
Epsilon
   
8,729
     
7,050
     
1,679
   
23.8
 
Private Label Services and Credit
   
5,595
     
4,102
     
1,493
   
36.4
 
Corporate/Other
   
8,472
     
9,665
     
(1,193
)  
(12.3
)
Total
 
$
28,015
   
$
25,186
   
$
2,829
   
11.2
%
Depreciation and amortization:
                             
LoyaltyOne
 
$
8,659
   
$
10,086
   
$
(1,427
)  
(14.1
)%
Epsilon
   
68,928
     
49,222
     
19,706
   
40.0
 
Private Label Services and Credit
   
26,496
     
17,347
     
9,149
   
52.7
 
Corporate/Other
   
2,343
     
1,467
     
876
   
59.7
 
Total
 
$
106,426
   
$
78,122
   
$
28,304
   
36.2
%
Operating income:
                             
LoyaltyOne
 
$
114,900
   
$
104,511
   
$
10,389
   
9.9
%
Epsilon
   
40,353
     
32,329
     
8,024
   
24.8
 
Private Label Services and Credit
   
458,044
     
409,031
     
49,013
   
12.0
 
Corporate/Other
   
(52,892
)    
(52,709
)    
(183
)  
0.3
 
Eliminations
   
     
     
   
 
Total
 
$
560,405
   
$
493,162
   
$
67,243
   
13.6
%
Adjusted EBITDA margin (2):
                             
LoyaltyOne
   
27.9
%    
24.4
%    
3.5
%      
Epsilon
   
18.2
     
19.1
     
(0.9
)      
Private Label Services and Credit
   
50.2
     
53.2
     
(3.0
)      
Total
   
33.4
%    
33.9
%    
(0.5
)%      
Segment operating data:
                             
Private label statements generated
   
93,929
     
75,968
     
17,961
   
23.6
 %
Credit sales
 
$
6,787,426
   
$
5,213,548
   
$
1,573,878
   
30.2
 %
Average credit card receivables
 
$
6,964,255
   
$
5,394,502
   
$
1,569,753
   
29.1
 %
AIR MILES reward miles issued
   
2,443,380
     
2,546,152
     
(102,772
)  
(4.0
)%
AIR MILES reward miles redeemed
   
2,038,292
     
2,274,560
     
(236,268
)  
(10.4
)%
                                   
 
(1)
Adjusted EBITDA is equal to net income, plus stock compensation expense, provision for income taxes, interest expense, net, depreciation and other amortization, and amortization of purchased intangibles. For a reconciliation of adjusted EBITDA to net income, the most directly comparable GAAP financial measure, see “Use of Non-GAAP Financial Measures” included in this report.
 
(2)
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.
 
*
not meaningful
 
 
34


Consolidated Operating Results:
 
Revenue. Total revenue increased $323.5 million, or 18.4%, to $2.1 billion for the six months ended June 30, 2013 from $1.8 billion for the six months ended June 30, 2012. The net increase was due to the following:
 
 
Transaction. Revenue increased $1.7 million, or 1.0%, to $161.9 million for the six months ended June 30, 2013. AIR MILES reward miles issuance fees, for which we provide marketing and administrative services, increased $22.7 million and other servicing fees charged to our credit cardholders increased $17.9 million, offset by a decrease of $37.7 million in merchant fees, which are transaction fees charged to the retailer, due to increased royalty payments associated with the signing of new clients.
 
 
RedemptionRevenue decreased $49.3 million, or 14.2%, to $298.4 million for the six months ended June 30, 2013 due to a 10.4% decrease in AIR MILES reward miles redeemed. The introduction of a five-year expiry policy for the AIR MILES Reward Program stimulated redemption activity in the first half of 2012.
 
 
Finance charges, net. Revenue increased $186.0 million, or 24.7%, to $940.1 million for the six months ended June 30, 2013. This increase was driven by a 29.1% increase in average credit card receivables, which have increased approximately $1.6 billion through a combination of growth in our existing credit card receivables and recent credit card portfolio acquisitions. This was offset in part by a 100 basis point decline in gross yield primarily due to the onboarding of new credit card portfolios.
 
 
Database marketing fees and direct marketing. Revenue increased $172.0 million, or 39.7%, to $605.1 million for the six months ended June 30, 2013. The increase in revenue was driven by our acquisition of HMI, which added $148.6 million, as well as an increase in revenue of $29.1 million due to demand in the telecommunications vertical within the Epsilon segment.
 
 
Other revenue. Revenue increased $13.1 million, or 20.8%, to $76.0 million for the six months ended June 30, 2013 due to additional consulting services provided by Epsilon.
 
Cost of operations. Cost of operations increased $206.3 million, or 20.0%, to $1.2 billion for the six months ended June 30, 2013 from $1.0 billion for the six months ended June 30, 2012. The net increase was due to the following:
 
 
Within the LoyaltyOne segment, cost of operations decreased $35.3 million due to a $30.4 million decrease in fulfillment costs for the AIR MILES Reward Program associated with the decline in AIR MILES reward miles redeemed. In addition, marketing expenses decreased $8.2 million due to a decline in costs associated with the promotion of AIR MILES Cash from 2012 and a decline in losses associated with international expansion efforts of $5.0 million. These decreases were partially offset by an increase in payroll and benefits of $4.2 million.
 
 
Within the Epsilon segment, cost of operations increased $158.6 million due to the HMI acquisition, which added $131.4 million, as well as an increase in direct marketing costs associated with the increase in revenue.
 
 
Within the Private Label Services and Credit segment, cost of operations increased by $86.7 million. Payroll and benefits increased $35.0 million due to an increase in the number of associates to support growth, and marketing expenses increased $14.6 million due to the increase in credit sales. Other operating expenses increased by $31.0 million, as credit card processing expenses were higher due to an increase in the number of statements generated, and data processing costs increased due to growth in volumes.
 
Provision for loan loss. Provision for loan loss increased $22.6 million, or 22.2%, to $124.4 million for the six months ended June 30, 2013 as compared to $101.9 million for the six months ended June 30, 2012. The increase in the provision was a result of the growth in credit card receivables, offset in part by improved credit quality. The net charge-off rate improved 60 basis points to 4.5% for the six months ended June 30, 2013 as compared to 5.1% for the six months ended June 30, 2012.
 
General and administrative. General and administrative expenses decreased $1.0 million, or 1.9%, to $50.5 million for the six months ended June 30, 2013 as compared to $51.5 million for the six months ended June 30, 2012 due to lower payroll and benefit costs.

 
35

 
Depreciation and other amortization. Depreciation and other amortization increased $3.9 million, or 10.8%, to $40.0 million for the six months ended June 30, 2013, as compared to $36.1 million for the six months ended June 30, 2012, due to additional assets placed into service resulting from both the HMI acquisition and recent capital expenditures.
 
Amortization of purchased intangibles. Amortization of purchased intangibles increased $24.4 million, or 58.1%, to $66.4 million for the six months ended June 30, 2013 as compared to $42.0 million for the six months ended June 30, 2012. The increase relates to $16.8 million of additional amortization associated with the intangible assets from both the HMI acquisition and recent credit card portfolio acquisitions.
 
Interest expense. Total interest expense, net increased $27.3 million, or 19.7%, to $166.0 million for the six months ended June 30, 2013 as compared to $138.7 million for the six months ended June 30, 2012 due to the following:
 
 
Securitization funding costs. Securitization funding costs increased $4.3 million due to greater borrowings for the six months ended June 30, 2013 as compared to the six months ended June 30, 2012. These increases were offset by lower average interest rates.
 
 
Interest expense on deposits. Interest expense on deposits increased $2.0 million as increases from higher borrowings were offset by lower average interest rates.
 
 
Interest expense on long-term and other debt, net. Interest expense on long-term and other debt, net increased $20.9 million due to an increase of $18.2 million resulting from the 2012 issuances of senior notes. In addition, the amortization of imputed interest associated with the convertible senior notes increased $4.7 million as compared to the same period in 2012. These increases were offset by a decline in interest expense associated with our credit facility.
 
Taxes. Income tax expense increased $13.6 million to $149.0 million for the six months ended June 30, 2013 from $135.4 million for the comparable period in 2012 due primarily to an increase in taxable income, offset in part by a decline in the effective tax rate. The effective tax rate for the six months ended June 30, 2013 declined to 37.8% as compared to 38.2% for the six months ended June 30, 2012 due to a favorable outcome related to certain tax matters.
 
Segment Revenue and Adjusted EBITDA:
 
Revenue. Total revenue increased $323.5 million, or 18.4%, to $2.1 billion for the six months ended June 30, 2013 from $1.8 billion for the six months ended June 30, 2012. The net increase was due to the following:
 
 
LoyaltyOne. Revenue decreased $26.3 million, or 5.4%, to $461.0 million for the six months ended June 30, 2013. Redemption revenue decreased $49.3 million, or 14.2%, due to a 10.4% decline in the number of AIR MILES reward miles redeemed. AIR MILES reward miles issuance fees, for which we provide marketing and administrative services, increased $22.7 million.
 
 
Epsilon. Revenue increased $186.3 million, or 40.2%, to $649.8 million for the six months ended June 30, 2013. The acquisition of HMI contributed $148.9 million to revenue. In addition, revenue increased $38.1 million, or 22.9%, due to increased demand in the telecommunications vertical.
 
 
Private Label Services and Credit. Revenue increased $167.4 million, or 20.7%, to $977.2 million for the six months ended June 30, 2013. Finance charges and late fees increased by $186.0 million, driven by a 29.1% increase in average credit card receivables due to recent credit card portfolio acquisitions and strong credit cardholder spending. Transaction revenue decreased $18.7 million due to lower merchant fees resulting from increased royalty payments associated with the signing of new clients, offset by an increase in other servicing fees.
 
Adjusted EBITDA. Adjusted EBITDA increased $98.4 million, or 16.5%, to $694.8 million for the six months ended June 30, 2013 from $596.5 million for the six months ended June 30, 2012. The net increase was due to the following:
 
 
LoyaltyOne. Adjusted EBITDA increased $9.8 million, or 8.2%, to $128.8 million for the six months ended June 30, 2013, and adjusted EBITDA margin also increased to 27.9% for the six months ended June 30, 2013 from 24.4% for the same period in the prior year. Adjusted EBITDA was positively impacted by a reduction in operating expenses, including a decline in marketing expenses due to the promotional activity in 2012 associated with the introduction of AIR MILES Cash, as well as a decline in expenses associated with international activities.

 
36

 
 
Epsilon. Adjusted EBITDA increased $29.4 million, or 33.2%, to $118.0 million for the six months ended June 30, 2013. Adjusted EDITDA was positively impacted by both the growth in revenue, including the acquisition of HMI, which added $18.0 million to adjusted EBITDA, and the implementation of cost-saving initiatives and operational efficiencies by Epsilon in the second half of 2012.
 
 
Private Label Services and Credit. Adjusted EBITDA increased $59.7 million, or 13.9%, to $490.1 million for the six months ended June 30, 2013. Adjusted EBITDA was positively impacted by the increase in finance charges, net, offset in part by both an increase in operating expenses due to increased volumes and an increase in the provision for loan loss due to the increase in credit card receivables.
 
 
Corporate/Other. Adjusted EBITDA decreased $0.5 million to a loss of $42.1 million for the six months ended June 30, 2013 related to a decrease in payroll and benefits costs.
 
Asset Quality
 
Our delinquency and net charge-off rates reflect, among other factors, the credit risk of our private label credit card receivables, the success of our collection and recovery efforts, and general economic conditions.
 
Delinquencies. A credit card account is contractually delinquent when we do not receive the minimum payment by the specified due date on the cardholder’s statement. Our policy is to continue to accrue interest and fee income on all credit card accounts beyond 90 days, except in limited circumstances, until the credit card account balance and all related interest and other fees are paid or charged off, typically at 180 days delinquent. When an account becomes delinquent, a message is printed on the credit 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 becoming further delinquent. 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 collection efforts, we may engage collection agencies and outside attorneys to continue those efforts.
 
The following table presents the delinquency trends of our credit card portfolio:
 
   
June 30,
2013
   
% of
Total
   
December 31,
2012
   
% of
Total
 
   
(In thousands, except percentages)
 
Receivables outstanding – principal
 
$
6,866,955
     
100.0
%
 
$
7,097,951
     
100.0
%
Principal receivables balances contractually delinquent:
                               
31 to 60 days
   
98,208
     
1.5
%
   
100,479
     
1.4
%
61 to 90 days
   
62,331
     
0.9
     
62,546
     
0.9
 
91 or more days
   
105,003
     
1.5
     
120,163
     
1.7
 
Total
 
$
265,542
     
3.9
%
 
$
283,188
     
4.0
%
 
Net Charge-Offs. Our net charge-offs include the principal amount of losses from cardholders unwilling or unable to pay their account balances, as well as bankrupt and deceased credit cardholders, less recoveries and exclude charged-off interest, fees and fraud losses. Charged-off interest and fees reduce finance charges, net while fraud losses are recorded as an expense. Credit card receivables, including unpaid interest and fees, are charged-off at the end of the month during which an account becomes 180 days contractually past due, except in the case of customer bankruptcies or death. Credit card receivables, including unpaid interest and fees, associated with customer bankruptcies or death are charged-off at the end of each month subsequent to 60 days after the receipt of notification of the bankruptcy or death, but in any case, not later than the 180-day contractual time frame.

 
37

 
The net charge-off rate is calculated by dividing net charge-offs of principal receivables for the period by the average credit card receivables for the period. Average credit card receivables represent the average balance of the cardholder receivables at the beginning of each month in the periods indicated. The following table presents our net charge-offs for the periods indicated.
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2013
   
2012
   
2013
   
2012
 
   
(In thousands, except percentages)
 
Average credit card receivables
 
$
6,964,945
   
$
5,467,489
   
$
6,964,255
   
$
5,394,502
 
Net charge-offs of principal receivables
   
80,416
     
67,514
     
158,006
     
137,679
 
Net charge-offs as a percentage of average credit card receivables (1) 
   
4.6
%
   
4.9
%
   
4.5
%
   
5.1
%
                                   
 
(1)
We acquired the credit card receivables of The Bon-Ton Stores, Inc. and The Talbots, Inc. in July 2012 and August 2012, respectively. Under GAAP, losses associated with purchased credit card receivables are reflected in the fair value of the purchased credit card receivables and not reported as net charge-offs. For the three and six months ended June 30, 2013, the net charge-off rate would have been 4.8% and 4.7%, respectively, if losses associated with the acquired credit card receivables had been reported as net charge-offs.
 
See Note 3, “Credit Card Receivables,” of the Notes to Unaudited Condensed Consolidated Financial Statements for additional information related to the securitization of our credit card receivables.
 
Liquidity and Capital Resources
 
Operating Activities. We generated cash flow from operating activities of $530.5 million and $417.4 million for the six months ended June 30, 2013 and 2012, respectively. The increase in operating cash flows in 2013 was primarily due to increased profitability for the six months ended June 30, 2013 as compared to the six months ended June 30, 2012.
 
We utilize our cash flow from operations for ongoing business operations, repayments of revolving or other debt, acquisitions, capital expenditures and repurchases of our common stock.
 
Investing Activities. Cash used in investing activities was $331.7 million and $613.0 million for the six months ended June 30, 2013 and 2012, respectively. Significant components of investing activities are as follows:
 
 
Redemption Settlement Assets. Cash decreased $47.7 million for the six months ended June 30, 2013, as compared to a cash increase of $41.4 million for the six months ended June 30, 2012, due to the increase in funding requirements resulting from the change in our estimate of breakage in December 2012.
 
 
Restricted Cash. Cash decreased $271.1 million for the six months ended June 30, 2013 due to the principal accumulation for the repayment of $245.0 million of asset-backed securities debt that matured in July 2013. During the six months ended June 30, 2012, cash decreased $438.7 million due to the principal accumulation for the repayment of $395.0 million of asset-backed securities debt that matured in July 2012 and $34.5 million for scheduled principal repayments of other asset-based securities debt also repaid in July 2012.
 
 
Credit Card Receivables Funding. Cash increased $83.4 million for the six months ended June 30, 2013 due to typical seasonal declines in credit card receivables from December 31, 2012. During the six months ended June 30, 2012, cash decreased $61.4 million as growth in our credit card receivables outpaced the seasonal paydown from December 31, 2011.
 
 
Purchase of Credit Card Portfolios. Cash decreased $37.1 million for the six months ended June 30, 2013 due to the acquisition of the private label credit card portfolio from Barneys New York. During the six months ended June 30, 2012, cash decreased $122.2 million due to the acquisition of the private label credit card portfolios from Pier 1 Imports and Premier Designs.
 
 
Capital Expenditures. Our capital expenditures for the six months ended June 30, 2013 were $59.0 million compared to $55.5 million for the comparable period in 2012. We anticipate capital expenditures not to exceed approximately 3% of annual revenue for the foreseeable future.
 
Financing Activities. Cash used in financing activities was $334.3 million for the six months ended June 30, 2013 as compared to cash provided by financing activities of $621.8 million for the six months ended June 30, 2012. Our financing activities during the six months ended June 30, 2013 relate primarily to borrowings and repayments of deposits and asset-backed securities debt, settlements for conversions of convertible senior notes and repurchases of our common stock.

 
38

 
Liquidity Sources. In addition to cash generated from operating activities, our primary sources of liquidity include our credit card securitization program, deposits issued by Comenity Bank and Comenity Capital Bank, our credit agreement and issuances of equity securities. In addition to our efforts to renew and expand our current liquidity sources, we continue to seek new funding sources.
 
As of June 30, 2013, we had no borrowings under our revolving credit facility, with total availability at $917.5 million. Our total leverage ratio, as defined in our credit agreement, was 2.2 to 1 at June 30, 2013, as compared to the maximum covenant ratio of 3.5 to 1. The Tier 1 risk-based capital ratio, leverage ratio and total risk-based capital ratio for Comenity Capital Bank were 16.7%, 16.5% and 18.0%, respectively, at June 30, 2013. The Tier 1 risk-based capital ratio, leverage ratio and total risk-based capital ratio for Comenity Bank were 15.9%, 15.1% and 17.2%, respectively, at June 30, 2013.
 
We believe that internally generated funds and other sources of liquidity will be sufficient to meet working capital needs, capital expenditures, and other business requirements for at least the next 12 months, including the repayment of the convertible senior notes that matured on August 1, 2013 and the repayment of the convertible senior notes scheduled to mature on May 15, 2014.
 
As of June 30, 2013, we were in compliance with our covenants. See Note 6, “Debt,” of the Notes to Unaudited Condensed Consolidated Financial Statements for additional information regarding our debt.
 
Securitization Program. We sell a majority of the credit card receivables originated by Comenity Bank to WFN Credit Company, LLC, which in turn sells them to World Financial Network Credit Card Master Trust, World Financial Network Credit Card Master Note Trust and World Financial Network Credit Card Master Trust III, or collectively, the WFN Trusts, as part of our credit card securitization program, which has been in existence since January 1996. We also sell our credit card receivables originated by Comenity Capital Bank to World Financial Capital Credit Company, LLC, which in turn sells them to World Financial Capital Master Note Trust, or the WFC Trust. These securitization programs are the primary vehicle through which we finance Comenity Bank’s and Comenity Capital Bank’s credit card receivables.
 
As of June 30, 2013, the WFN Trusts and the WFC Trust had approximately $6.1 billion of securitized credit card receivables. Securitizations require credit enhancements in the form of cash, spread deposits, additional receivables and subordinated classes. 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 credit card securitization trusts.
 
Historically, we have used both public and private term asset-backed securities 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 Comenity Bank and Comenity Capital Bank. 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 as they are dependent on the asset-backed securitization markets at the time.
 
At June 30, 2013, we had $4.0 billion of asset-backed securities debt – owed to securitization investors, of which $0.7 billion is due within the next 12 months.
 
The following table shows the maturities of borrowing commitments as of June 30, 2013 for the WFN Trusts and the WFC Trust by year:
 
   
2013
   
2014
   
2015
   
2016
   
2017 &
Thereafter
   
Total
 
   
(In thousands)
 
Term notes
 
$
245,000
   
$
250,000
   
$
393,750
   
$
600,000
   
$
1,758,166
   
$
3,246,916
 
Conduit facilities (1)
   
330,000
     
1,200,000
     
450,000
     
     
     
1,980,000
 
Total (2)
 
$
575,000
   
$
1,450,000
   
$
843,750
   
$
600,000
   
$
1,758,166
   
$
5,226,916
 
                                                   
 
(1)
Amount represents borrowing capacity, not outstanding borrowings.
 
(2)
Total amounts do not include $1.1 billion of debt issued by the credit card securitization trusts, which was retained by us and has been eliminated in the unaudited condensed consolidated financial statements.
 
Early amortization events as defined within each asset-backed securitization transaction are generally driven by asset performance. We do not believe it is reasonably likely for an early amortization event to occur due to asset performance. However, if an early amortization event were declared, the trustee of the particular credit card securitization trust would retain the interest in the receivables along with the excess interest income that would otherwise be paid to our bank subsidiary until the credit card securitization investors were fully repaid. The occurrence of an early amortization event would significantly limit or negate our ability to securitize additional credit card receivables.

 
39

 
In February 2013, World Financial Network Credit Card Master Note Trust issued $500.0 million of asset-backed term securities to investors. The offering consisted of $375.0 million of Class A Series 2013-A asset-backed term notes that have a fixed interest rate of 1.61% per year and mature in February 2018. In addition, we retained an aggregate of $125.0 million of subordinated classes of the Series 2013-A asset-backed term notes that have been eliminated from our unaudited condensed consolidated financial statements.
 
In April 2013, $500.0 million of floating rate Series 2006-A asset-backed term notes matured and was repaid.
 
In May 2013, World Financial Network Credit Card Master Note Trust issued $657.9 million of asset-backed term securities to investors. The offering consisted of $500.0 million of Class A Series 2013-B asset-backed term notes that have a fixed interest rate of 0.91% per year and mature in May 2016. In addition, we retained an aggregate of $157.9 million of subordinated classes of the Series 2013-B asset-backed term notes that have been eliminated from our unaudited condensed consolidated financial statements.
 
In May 2013, we renewed our 2009-VFN conduit facility under World Financial Capital Master Note Trust, extending the maturity to May 31, 2015 and increasing the total capacity from $375.0 million to $450.0 million.
 
In July 2013, $245.0 million of fixed rate Series 2009-D asset-backed term notes matured and was repaid.
 
2013 Credit Agreement. We entered into a credit agreement dated July 10, 2013, or the 2013 Credit Agreement, which provides for a $1,142.5 million term loan subject to certain principal repayments and a $1,142.5 million revolving line of credit with a U.S. $65.0 million sublimit for Canadian dollar borrowings and a $65.0 million sublimit for swing line loans. The 2013 Credit Agreement replaced our previously existing credit agreement, which was concurrently terminated.
 
On August 1, 2013, we settled in cash, with cash on hand and borrowings under the 2013 Credit Agreement, the $772.6 million of Convertible Senior Notes due 2013, of which $772.5 million was surrendered for conversion for $1,790.3 million, with the remaining principal paid at maturity. We received $1,017.7 million of cash from the counterparties in settlement of the related convertible note hedge transactions.
 
See Note 6, “Debt,” of the Notes to Unaudited Condensed Consolidated Financial Statements for additional information regarding our debt.
 
 
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
                               
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, 2012 related to our exposure to market risk from interest rate risk, credit risk, foreign currency exchange risk and redemption reward risk.
 
 
Item 4. Controls and Procedures.
                               
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
 
As of June 30, 2013, 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 June 30, 2013 (the end of our second 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.
 
Changes in Internal Control Over Financial Reporting
 
There have been no 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.
 
In November 2012, we acquired HMI for $451.8 million, and in December 2012 we acquired Advecor, Inc., or Advecor, for $12.2 million. Because of the timing of the acquisitions, HMI and Advecor were excluded from our evaluation of and conclusion on the effectiveness of internal control over financial reporting as of June 30, 2013. We will expand our evaluation of the effectiveness of the internal controls over financial reporting to include HMI and Advecor in the fourth quarter of 2013.

 
40


 
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,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “predict,” “project,” “would” 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, 2012 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.

 
41


 
PART II
 
 
Item 1. Legal Proceedings.
                               
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.
 
 
Item 1A. Risk Factors.
                
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, 2012.
 
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
                                  
The following table presents information with respect to purchases of our common stock made during the three months ended June 30, 2013:
 
Period
   
Total Number of
Shares Purchased (1)
   
Average Price
Paid per Share
   
Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Programs
   
Approximate Dollar Value of
Shares that May Yet
Be Purchased Under
the Plans or Programs (2)
 
                       
(Dollars in millions)
 
During 2013:
                         
April 1-30
     
462,355
   
$
155.69
     
457,664
   
$
277.1
 
May 1-31
     
114,338
     
178.59
     
110,305
     
257.4
 
June 1-30
     
381,983
     
174.31
     
374,935
     
192.0
 
Total
     
958,676
   
$
165.84
     
942,904
   
$
192.0
 
                                     
 
(1)
During the period represented by the table, 15,772 shares of our common stock were purchased by the administrator of our 401(k) and Retirement Savings Plan for the benefit of the employees who participated in that portion of the plan.
 
(2)
On January 2, 2013, our Board of Directors authorized a stock repurchase program to acquire up to $400.0 million of our outstanding common stock from January 2, 2013 through December 31, 2013, subject to any restrictions pursuant to the terms of our credit agreements, indentures, applicable securities laws or otherwise.
 
 
Item 3. Defaults Upon Senior Securities.
                                 
None
 
 
Item 4. Mine Safety Disclosures.
                
Not applicable.
 
 
Item 5. Other Information.
                
(a) None
 
(b) None

 
42

 
Item 6. Exhibits.
                
(a) Exhibits:
 
EXHIBIT INDEX
 
Exhibit
No.
 
Description
 
         
3.1
 
Second Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit No. 3.1 to our Registration Statement on Form S-1 filed with the SEC on March 3, 2000, File No. 333-94623).
   
         
3.2
 
Certificate of Amendment to the Second Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit No. 3.1 to our Current Report on Form 8-K, filed with the SEC on June 7, 2013, File No. 001-15749).
   
         
3.3
 
Fourth Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit No. 3.2 to our Current Report on Form 8-K, filed with the SEC on June 7, 2013, File No. 001-15749).
   
         
4
 
Specimen Certificate for shares of Common Stock of the Registrant (incorporated by reference to Exhibit No. 4 to our Quarterly Report on Form 10-Q, filed with the SEC on August 8, 2003, File No. 001-15749).
   
         
10.1
 
Series 2013-B Indenture Supplement, dated as of May 21, 2013, between World Financial Network Credit Card Master Note Trust and Union Bank, N.A. (incorporated by reference to Exhibit No. 4.1 to the Current Report on Form 8-K filed with the SEC by WFN Credit Company, LLC, World Financial Network Credit Card Master Trust and World Financial Network Credit Card Master Note Trust on May 24, 2013, File Nos. 333-60418, 333-60418-01 and 333-113669).
   
         
*10.2
 
Third Amended and Restated Series 2009-VFN Indenture Supplement, dated as of May 24, 2013, between World Financial Capital Master Note Trust and Deutsche Bank Trust Company Americas.
   
         
10.3
 
Amended and Restated Service Agreement, dated as of June 28, 2013, between Comenity Servicing LLC and Comenity Bank (incorporated by reference to Exhibit No. 99.1 to the Current Report on Form 8-K filed with the SEC by WFN Credit Company, LLC, World Financial Network Credit Card Master Trust and World Financial Network Credit Card Master Note Trust on July 3, 2013, File Nos. 333-60418, 333-60418-01 and 333-113669).
   
         
10.4
 
Credit Agreement, dated as of July 10, 2013, by and among Alliance Data Systems Corporation, as borrower, and certain subsidiaries parties thereto, as guarantors, Wells Fargo Bank, N.A., as Administrative Agent, and various other agents and lenders (incorporated by reference to Exhibit No. 10.1 to our Current Report on Form 8-K, filed with the SEC on July 16, 2013, File No. 001-15749).
   
         
*31.1
 
Certification of Chief Executive Officer of Alliance Data Systems Corporation pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
   
         
*31.2
 
Certification of Chief Financial Officer of Alliance Data Systems Corporation pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
   
         
*32.1
 
Certification of Chief Executive Officer of Alliance Data Systems Corporation pursuant to Rule 13a-14(b) promulgated under the Securities Exchange Act of 1934, as amended, and Section 1350 of Chapter 63 of Title 18 of the United States Code.
   
         
*32.2
 
Certification of Chief Financial Officer of Alliance Data Systems Corporation pursuant to Rule 13a-14(b) promulgated under the Securities Exchange Act of 1934, as amended, and Section 1350 of Chapter 63 of Title 18 of the United States Code.
   
         
*101.INS
 
XBRL Instance Document
   
         
*101.SCH
 
XBRL Taxonomy Extension Schema Document
   
         
*101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
   
         
*101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
   
         
*101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
   
         
*101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document
   
       
 
*            Filed herewith
 +       Management contract, compensatory plan or arrangement

 
43


 
SIGNATURES
 
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
ALLIANCE DATA SYSTEMS CORPORATION
 
 

 
 
By: 
/s/  Edward J. Heffernan
 
   
Edward J. Heffernan
 
   
President and Chief Executive Officer
 
 
Date: August 5, 2013
 
 
By: 
/s/  Charles L. Horn
 
   
Charles L. Horn
 
   
Executive Vice President and Chief Financial Officer
 
 
Date: August 5, 2013
 
 

44