e10vq
Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
Form 10-Q
 
     
(Mark One)    
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the Quarterly Period Ended March 31, 2007
OR
o
  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
(State or Other Jurisdiction of
Incorporation or Organization)
  31-1429215
(I.R.S. Employer
Identification No.)
 
17655 Waterview Parkway
Dallas, Texas 75252
(Address of Principal Executive Office, Including Zip Code)
 
(972) 348-5100
(Registrant’s Telephone Number, Including Area Code)
 
 
 
 
Securities registered pursuant to Section 12(b) of the Act:
 
     
Title of Each Class
 
Name of Each Exchange on Which Registered
 
Common Stock, par value $0.01 per share
  New York Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act:
None
(Title of Class)
 
 
 
 
Indicate by check mark whether the registrant: (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ
 
As of May 1, 2007, 78,699,413 shares of common stock were outstanding.
 


 

 
ALLIANCE DATA SYSTEMS CORPORATION
 
INDEX
 
             
        Page
        Number
 
  Financial Statements (unaudited)    
    Condensed Consolidated Balance Sheets as of March 31, 2007 and December 31, 2006   3
    Condensed Consolidated Statements of Income for the three months ended March 31, 2007 and 2006   4
    Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2007 and 2006   5
    Notes to Condensed Consolidated Financial Statements   6
  Management’s Discussion and Analysis of Financial Condition and Results of Operations   14
  Quantitative and Qualitative Disclosures About Market Risk   22
  Controls and Procedures   22
 
  Legal Proceedings   23
  Risk Factors   23
  Unregistered Sales of Equity Securities and Use of Proceeds   23
  Defaults Upon Senior Securities   24
  Submission of Matters to a Vote of Security Holders   24
  Other Information   24
  Exhibits   25
  26
 Certification of CEO Pursuant to Rule 13a-14(a)
 Certification of CFO Pursuant to Rule 13a-14(a)
 Certification of CEO Pursuant to Rule 13a-14(b)
 Certification of CFO Pursuant to Rule 13a-14(b)


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PART I
 
Item 1.   Financial Statements
 
ALLIANCE DATA SYSTEMS CORPORATION
 
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
 
                 
    March 31, 2007     December 31, 2006  
    (In thousands)  
 
ASSETS
Cash and cash equivalents
  $ 153,876     $ 180,075  
Due from card associations
    63,179       108,671  
Trade receivables, less allowance for doubtful accounts ($4,998 and $5,325 at March 31, 2007 and December 31, 2006, respectively)
    269,850       271,563  
Seller’s interest and credit card receivables, less allowance for doubtful accounts ($40,762 and $45,919 at March 31, 2007 and December 31, 2006, respectively)
    455,533       569,389  
Deferred tax asset, net
    88,709       88,722  
Other current assets
    115,394       91,555  
                 
Total current assets
    1,146,541       1,309,975  
Redemption settlement assets, restricted
    277,587       260,957  
Property and equipment, net
    241,951       208,327  
Due from securitizations
    288,297       325,457  
Intangible assets, net
    416,297       263,934  
Goodwill
    1,195,040       969,971  
Other non-current assets
    72,781       65,394  
                 
Total assets
  $ 3,638,494     $ 3,404,015  
                 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Accounts payable
  $ 81,700     $ 112,582  
Accrued expenses
    144,315       201,904  
Merchant settlement obligations
    154,045       188,336  
Certificates of deposit
    229,900       294,800  
Credit facilities and other debt, current
    308,040       7,902  
Other current liabilities
    60,657       72,196  
                 
Total current liabilities
    978,657       877,720  
Deferred tax liability, net
    5,143       44,234  
Deferred revenue
    664,564       651,506  
Certificates of deposit
    4,200       4,200  
Long-term and other debt
    864,625       737,475  
Other liabilities
    90,732       17,347  
                 
Total liabilities
    2,607,921       2,332,482  
Stockholders’ equity:
               
Common stock, $0.01 par value; authorized 200,000 shares; issued 87,614 shares and 86,872 shares at March 31, 2007 and December 31, 2006, respectively
    876       869  
Additional paid-in capital
    854,033       834,680  
Treasury stock, at cost (9,024 shares and 7,218 shares at March 31, 2007 and December 31, 2006, respectively)
    (409,486 )     (300,950 )
Retained earnings
    575,702       527,686  
Accumulated other comprehensive income
    9,448       9,248  
                 
Total stockholders’ equity
    1,030,573       1,071,533  
                 
Total liabilities and stockholders’ equity
  $ 3,638,494     $ 3,404,015  
                 
 
See accompanying notes to unaudited condensed consolidated financial statements.


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ALLIANCE DATA SYSTEMS CORPORATION
 
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME
 
                 
    Three Months Ended March 31,  
    2007     2006  
    (In thousands, except per share amounts)  
 
Revenues
               
Transaction
  $ 164,513     $ 160,503  
Redemption
    90,543       78,948  
Securitization income and finance charges, net
    178,362       160,879  
Database marketing fees and direct marketing fees
    96,745       57,805  
Other revenue
    18,995       19,096  
                 
Total revenue
    549,158       477,231  
Operating expenses
               
Cost of operations (exclusive of depreciation and amortization disclosed separately below)
    377,868       330,319  
General and administrative
    23,303       19,966  
Depreciation and other amortization
    20,065       15,217  
Amortization of purchased intangibles
    19,341       12,321  
                 
Total operating expenses
    440,577       377,823  
Operating income
    108,581       99,408  
Interest income
    (2,861 )     (1,752 )
Interest expense
    18,688       10,289  
                 
Income before income taxes
    92,754       90,871  
Provision for income taxes
    35,894       34,450  
                 
Net income
  $ 56,860     $ 56,421  
                 
Net income per share — basic
  $ 0.72     $ 0.70  
                 
Net income per share — diluted
  $ 0.70     $ 0.69  
                 
Weighted average shares — basic
    79,016       80,065  
                 
Weighted average shares — diluted
    81,109       81,667  
                 
 
See accompanying notes to unaudited condensed consolidated financial statements.


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ALLIANCE DATA SYSTEMS CORPORATION
 
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                 
    Three Months Ended March 31,  
    2007     2006  
    (In thousands)  
 
CASH FLOWS FROM OPERATING ACTIVITIES:
               
Net income
  $ 56,860     $ 56,421  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    39,406       27,538  
Deferred income taxes
    (2,161 )     (3,294 )
Provision for doubtful accounts
    5,204       3,557  
Non-cash stock compensation
    12,093       7,304  
Fair value gain on interest-only strip
    (7,750 )     (4,250 )
Change in operating assets and liabilities, net of acquisitions:
               
Change in trade accounts receivable
    14,158       20,057  
Change in merchant settlement activity
    11,201       14,763  
Change in other assets
    (30,626 )     (12,075 )
Change in accounts payable and accrued expenses
    (64,781 )     (32,334 )
Change in deferred revenue
    7,338       10,935  
Change in other liabilities
    (11,816 )     (19,664 )
Excess tax benefits from stock-based compensation
    (2,755 )     (4,412 )
Other
    2,245       6,230  
                 
Net cash provided by operating activities
    28,616       70,776  
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Change in redemption settlement assets
    (15,793 )     (6,156 )
Payments for acquired businesses, net of cash acquired
    (438,712 )     (36,124 )
Net decrease in seller’s interest and credit card receivables
    108,478       56,269  
Change in due from securitizations
    45,345       52,170  
Capital expenditures
    (21,871 )     (20,397 )
Other
    (329 )     404  
                 
Net cash (used in) provided by investing activities
    (322,882 )     46,166  
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Borrowings under debt agreements
    859,000       465,323  
Repayment of borrowings
    (430,000 )     (359,000 )
Certificate of deposit issuances
    60,300       20,000  
Repayments of certificates of deposits
    (125,200 )     (120,900 )
Payment of capital lease obligations
    (2,059 )     (2,093 )
Excess tax benefits from stock-based compensation
    2,755       4,412  
Proceeds from issuance of common stock
    13,041       14,544  
Purchase of treasury shares
    (108,536 )     (25,633 )
Other
    (648 )      
                 
Net cash provided by (used in) financing activities
    268,653       (3,347 )
                 
Effect of exchange rate changes on cash and cash equivalents
    (586 )     20  
                 
Change in cash and cash equivalents
    (26,199 )     113,615  
Cash and cash equivalents at beginning of period
    180,075       143,213  
                 
Cash and cash equivalents at end of period
  $ 153,876     $ 256,828  
                 
SUPPLEMENTAL CASH FLOW INFORMATION:
               
Interest paid
  $ 11,001     $ 8,081  
                 
Income taxes paid, net of refunds
  $ 17,661     $ 32,548  
                 
 
See accompanying notes to unaudited condensed consolidated financial statements.


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ALLIANCE DATA SYSTEMS CORPORATION
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
1.   BASIS OF PRESENTATION
 
The unaudited condensed consolidated financial statements included herein have been prepared by Alliance Data Systems Corporation (“ADSC” or, including its wholly owned subsidiaries, 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, 2006.
 
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 the reported amounts of assets and liabilities; and disclosure of contingent assets and liabilities at the date of the financial statements; and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
 
For purposes of comparability, certain prior period amounts, have been reclassified to conform to the current year presentation. Such reclassifications have no impact on previously reported net 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 March 31,  
    2007     2006  
    (In thousands, except per share amounts)  
 
Numerator
               
Net income available to common stockholders
  $ 56,860     $ 56,421  
                 
Denominator
               
Weighted average shares, basic
    79,016       80,065  
Weighted average effect of dilutive securities:
               
Net effect of unvested restricted stock
    606       224  
Net effect of dilutive stock options
    1,487       1,378  
                 
Denominator for diluted calculation
    81,109       81,667  
                 
Basic
               
Net income per share
  $ 0.72     $ 0.70  
                 
Diluted
               
Net income per share
  $ 0.70     $ 0.69  
                 


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ALLIANCE DATA SYSTEMS CORPORATION
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

3.   ACQUISITIONS
 
On February 1, 2007, the Company completed the acquisition of Abacus, a division of DoubleClick Inc. Abacus is a leading provider of data, data management and analytical services for the retail and catalog industry, as well as other sectors. The Abacus acquisition complements, expands and strengthens Epsilon’s core offerings and provides additional scale to its data services, strategic database services and analytics offerings.
 
The acquisition of Abacus included specified assets of DoubleClick’s data division (“Purchased Assets”) and all of the outstanding equity interests of four DoubleClick entities. The consideration consisted of approximately $435.0 million plus other incremental costs as defined in the agreement for a total of approximately $439.3 million.
 
The results of operations for Abacus have been included since the date of acquisition and are reflected in our Marketing Services segment. The goodwill resulting from the acquisition of the Purchased Assets will be deductible for tax purposes.
 
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed in the Abacus acquisition as of the date of purchase. The Company is in the process of finalizing its third-party valuation of certain intangibles, and thus, the final allocation of the purchase price is subject to refinement.
 
         
    As of
 
    February 1,
 
    2007  
    (In thousands)  
 
Current assets
  $ 22,863  
Property, plant and equipment
    13,844  
Capitalized software
    19,200  
Identifiable intangible assets
    169,560  
Goodwill
    223,135  
         
Total assets acquired
    448,602  
         
Current liabilities
    9,325  
         
Total liabilities assumed
    9,325  
         
Net assets acquired
  $ 439,277  
         
 
The following unaudited pro forma results of operations of the Company are presented as if the Abacus acquisition was completed as of the beginning of the periods being presented. The following unaudited pro forma financial information is not necessarily indicative of the actual results of operations that the Company would have experienced assuming the acquisition had been completed as of January 1, 2007 or 2006, respectively.
 
                 
    March 31,
    March 31,
 
    2007     2006  
    (In thousands)  
 
Revenues
  $ 557,606     $ 502,551  
Net income
    54,691       51,028  
Basic net income per share
  $ 0.69     $ 0.64  
Diluted net income per share
  $ 0.67     $ 0.62  


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ALLIANCE DATA SYSTEMS CORPORATION
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

4.   INTANGIBLE ASSETS AND GOODWILL
 
Intangible Assets
 
Intangible assets consist of the following:
 
                             
    March 31, 2007      
          Accumulated
           
    Gross Assets     Amortization     Net     Amortization Life and Method
    (In thousands)      
 
Finite Lived Assets
                           
Customer contracts and lists
  $ 292,337     $ (121,884 )   $ 170,453     2-20 years — straight line
Premium on purchased credit card portfolios
    72,108       (24,152 )     47,956     5-10 years — straight line, accelerated
Collector database
    60,585       (45,922 )     14,663     30 years — 15% declining balance
Customer databases
    161,408       (3,827 )     157,581     4-10 years — straight line
Noncompete agreements
    2,160       (656 )     1,504     2-5 years — straight line
Favorable lease
    1,000       (409 )     591     4 years — straight line
Tradenames
    11,251       (247 )     11,004     4-10 years — straight line
Purchased data lists
    810       (615 )     195     1 year — accelerated basis
                             
    $ 601,659     $ (197,712 )   $ 403,947      
Indefinite Lived Assets
                           
Tradenames
    12,350             12,350     Indefinite life
                             
Total intangible assets
  $ 614,009     $ (197,712 )   $ 416,297      
                             
 
                             
    December 31, 2006      
          Accumulated
           
    Gross Assets     Amortization     Net     Amortization Life and Method
    (In thousands)      
 
Finite Lived Assets
                           
Customer contracts and lists
  $ 292,272     $ (111,486 )   $ 180,786     2-20 years — straight line
Premium on purchased credit card portfolios     72,108       (21,861 )     50,247     5-10 years — straight
line, accelerated
Collector database
    60,067       (44,916 )     15,151     30 years — 15% declining balance
Customer databases
    2,900       (181 )     2,719     4 years — straight line
Noncompete agreements
    1,800       (458 )     1,342     2-5 years — straight line
Favorable lease
    1,000       (341 )     659     4 years — straight line
Tradenames
    550       (34 )     516     4 years — straight line
Purchased data lists
    449       (285 )     164     1 year — accelerated basis
                             
    $ 431,146     $ (179,562 )   $ 251,584      
Indefinite Lived Assets
                           
Tradenames
    12,350             12,350     Indefinite life
                             
Total intangible assets
  $ 443,496     $ (179,562 )   $ 263,934      
                             


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ALLIANCE DATA SYSTEMS CORPORATION
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

4.   INTANGIBLE ASSETS AND GOODWILL — (Continued)
 
As a result of the Abacus acquisition, the Company acquired $158.5 million of customer relationships and related databases with a weighted average life of nine years, tradenames of $10.7 million with a weighted average life of 10 years and non-compete agreements of $0.4 million with a weighted average life of 1.5 years.
 
Goodwill
 
The changes in the carrying amount of goodwill for the three months ended March 31, 2007 are as follows:
 
                                 
    Marketing
    Credit
    Transaction
       
    Services     Services     Services     Total  
    (In thousands)  
 
Beginning balance
  $ 635,025     $     $ 334,946     $ 969,971  
Goodwill acquired during the period
    223,135                   223,135  
Effects of foreign currency translation
    1,839             90       1,929  
Other, primarily final purchase price adjustments
    5                   5  
                                 
Ending balance
  $ 860,004     $     $ 335,036     $ 1,195,040  
                                 
 
5.   DEBT
 
Debt consists of the following:
 
                 
    March 31,
    December 31,
 
    2007     2006  
    (In thousands)  
 
Certificates of deposit
  $ 234,100     $ 299,000  
Senior notes
    500,000       500,000  
Credit facilities
    654,000       225,000  
Other
    18,665       20,377  
                 
      1,406,765       1,044,377  
Less: current portion
    (537,940 )     (302,702 )
                 
Long-term portion
  $ 868,825     $ 741,675  
                 
 
As of March 31, 2007, the certificates of deposit had effective annual fixed rates ranging from 4.3% to 6.0%, and the credit facilities had a weighted average interest rate of 6.2%.
 
Credit Facilities
 
At the beginning of fiscal year 2007, the Company maintained one consolidated credit agreement that provides for a $540.0 million revolving credit facility with a U.S. $50.0 million sublimit for Canadian dollar borrowings and a $50.0 million sublimit for swing line loans (the “consolidated credit facility”). Additionally, the consolidated credit facility includes an uncommitted accordion feature of up to $210.0 million in the aggregate allowing for future incremental borrowings, subject to certain conditions. The consolidated credit facility is unsecured. Each of ADS Alliance Data Systems, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Marketing Services, LLC and Epsilon Data Management, LLC are guarantors under the consolidated credit facility.
 
On March 30, 2007, the Company amended the consolidated credit facility to extend the lending commitments which were scheduled to terminate on September 29, 2011 to March 30, 2012. In addition, the


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ALLIANCE DATA SYSTEMS CORPORATION
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

5.   DEBT — (Continued)
 
amendment adjusts the Senior Leverage Ratio applicable to the various levels set forth in the consolidated credit facility and the margin applicable to Eurodollar loans to those reflected below.
 
Advances under the consolidated credit facility are in the form of either base rate loans or eurodollar loans and may be denominated in U.S. dollars or Canadian dollars. The interest rate for base rate loans denominated in U.S. dollars fluctuates and is equal to the higher of (1) the Bank of Montreal’s prime rate and (2) the Federal funds rate plus 0.5%, in either case with no additional margin. The interest rate for base rate loans denominated in Canadian dollars fluctuates and is equal to the higher of (1) the Bank of Montreal’s prime rate for Canadian dollar loans and (2) the CDOR rate plus 1%, in either case with no additional margin. The interest rate for eurodollar loans denominated in U.S. or Canadian dollars fluctuates based on the rate at which deposits of U.S. dollars or Canadian dollars, respectively, in the London interbank market are quoted plus a margin of 0.4% to 0.8% based upon the Company’s Senior Leverage Ratio as defined in the consolidated credit facility.
 
Among other fees, the Company pays a facility fee of 0.1% to 0.2% per annum (due quarterly) on the aggregate commitments under the consolidated credit facility, whether used or unused, based upon the Company’s Senior Leverage Ratio as defined in the consolidated credit facility. The Company will also pay fees with respect to any letters of credit issued under the consolidated credit facility.
 
The consolidated credit facility includes usual and customary negative covenants for credit agreements 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, transfer or dispose of assets; create or incur indebtedness; create liens; pay dividends and repurchase stock; and make investments. The negative covenants are subject to certain exceptions, as specified in the consolidated credit facility. The consolidated credit facility also requires the Company to satisfy certain financial covenants, including maximum ratios of Total Capitalization and Senior Leverage as determined in accordance with the consolidated credit facility and a minimum ratio of Consolidated Operating EBITDA to Consolidated Interest Expense as determined in accordance with the consolidated credit facility.
 
The consolidated credit facility also includes customary events of default, including, among other things, payment default, covenant default, breach of representation or warranty, bankruptcy, cross-default, material ERISA events, a change of control of the Company, material money judgments and failure to maintain subsidiary guarantees.
 
On January 24, 2007, the Company entered into a credit facility, (the “bridge loan”) which provides for loans up to $400.0 million. At the closing of the bridge loan, the Company borrowed $300.0 million for general corporate purposes including the repayment of debt and the financing of permitted acquisitions. The bridge loan includes an uncommitted accordion feature of up to $100.0 million allowing for future borrowings, subject to certain conditions. The bridge loan is scheduled to mature July 24, 2007. The bridge loan is unsecured. Each of ADS Alliance Data Systems, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Marketing Services, LLC and Epsilon Data Management, LLC are guarantors under the bridge loan. The Company anticipates refinancing the bridge loan prior to July 24, 2007.
 
Advances under the bridge loan are in the form of either base rate loans or eurodollar loans. The interest rate for base rate loans fluctuates and is equal to the higher of (1) the Bank of Montreal’s prime rate and (2) the Federal funds rate plus 0.5%, in either case with no additional margin. The interest rate for eurodollar loans fluctuates based on the London interbank offered rate plus a margin of 0.6% to 1.2% based upon our Senior Leverage Ratio as defined in the bridge loan.
 
The bridge loan contains 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


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ALLIANCE DATA SYSTEMS CORPORATION
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

5.   DEBT — (Continued)
 
consolidate or merge; substantially change the nature of its business; sell, transfer or dispose of assets; create or incur indebtedness; create liens; pay dividends and repurchase stock; and make investments. The negative covenants are subject to certain exceptions, as specified in the bridge loan. The bridge loan also requires the Company to satisfy certain financial covenants, including maximum ratios of Total Capitalization and Senior Leverage as determined in accordance with the bridge loan and a minimum ratio of Consolidated Operating EBITDA to Consolidated Interest Expense as determined in accordance with the bridge loan.
 
The bridge loan must be prepaid prior to the scheduled maturity date if the Company or any of its subsidiaries issues any debt or equity securities, subject to certain exceptions.
 
The bridge loan also includes customary events of default, including, among other things, payment default, covenant default, breach of representation or warranty, bankruptcy, cross-default, material ERISA events, a change of control, material money judgments and failure to maintain subsidiary guarantees.
 
Senior Notes
 
On May 16, 2006, the Company entered into a senior note purchase agreement and issued and sold $250.0 million aggregate principal amount of 6.00% Series A Notes due May 16, 2009 and $250.0 million aggregate principal amount of 6.14% Series B Notes due May 16, 2011.
 
The Series A and Series B Notes will accrue interest on the unpaid balance thereof at the rate of 6.00% and 6.14% per annum, respectively, from May 16, 2006, payable semiannually, on May 16 and November 16 in each year, commencing with November 16, 2006, until the principal has become due and payable. The note purchase agreement includes usual and customary negative covenants and events of default for transactions of this type. The senior notes are unsecured. The payment obligations under the senior notes are guaranteed by certain of the Company’s existing and future subsidiaries, originally ADS Alliance Data Systems, Inc. Due to their status as guarantors under the consolidated credit facility and pursuant to a Joinder to Subsidiary Guaranty dated as of September 29, 2006, three additional subsidiaries of the Company became guarantors of the senior notes, including Alliance Data Foreign Holdings, Inc., Epsilon Marketing Services, LLC and Epsilon Data Management, LLC.
 
6.   DEFERRED REVENUE
 
A reconciliation of deferred revenue for the AIR MILES®Reward Program is as follows:
 
                         
    Deferred Revenue  
    Service     Redemption     Total  
    (In thousands)  
 
December 31, 2006
  $ 203,717     $ 447,789     $ 651,506  
Cash proceeds
    30,474       58,135       88,609  
Revenue recognized
    (26,784 )     (54,840 )     (81,624 )
Other
          353       353  
Effects of foreign currency translation
    1,808       3,912       5,720  
                         
March 31, 2007
  $ 209,215     $ 455,349     $ 664,564  
                         


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ALLIANCE DATA SYSTEMS CORPORATION
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

7.   INCOME TAXES
 
For the three months ended March 31, 2007, the Company has utilized an effective tax rate of 38.7% to calculate its provision for income taxes. In accordance with Accounting Principles Board (“APB”) Opinion No. 28, Interim Financial Reporting, this effective tax rate is the Company’s expected annual effective tax rate for calendar year 2007 based on all known variables.
 
On January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN No. 48”), Accounting for Uncertainty in Income Taxes. As a result of the implementation of FIN No. 48, the Company recognized approximately a $9 million increase in the liability for unrecognized tax benefits, which was accounted for as a reduction to retained earnings.
 
As of March 31, 2007, the Company has unrecognized tax benefits of approximately $75 million, of which $23 million relate to taxes and $16 million relate to potential interest and penalties. These unrecognized tax benefits, if recognized at some point in the future, would favorably impact the effective tax rate by approximately $31 million. The Company does not anticipate a significant change to the total amount of unrecognized tax benefits over the next twelve months.
 
The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits in income tax expense. For the quarter ended March 31, 2007, the Company recognized approximately $0.9 million in potential interest and penalties with respect to unrecognized tax benefits.
 
The Company files income tax returns in the United States Federal jurisdiction and in many state and foreign jurisdictions. With few exceptions, the tax returns filed by the Company are no longer subject to United States Federal or state and local income tax examinations for years before 2003 and are no longer subject to foreign income tax examinations by tax authorities for years before 2002.
 
8.   COMPREHENSIVE INCOME
 
The components of comprehensive income, net of tax effect, are as follows:
 
                 
    Three Months Ended
 
    March 31,  
    2007     2006  
    (In thousands)  
 
Net income
  $ 56,860     $ 56,421  
Unrealized gain (loss) on securities available-for-sale
    338       (81 )
Foreign currency translation adjustments
    (138 )     (505 )
                 
Total comprehensive income
  $ 57,060     $ 55,835  
                 


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ALLIANCE DATA SYSTEMS CORPORATION
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

9.   SEGMENT INFORMATION
 
Consistent with prior periods, the Company classifies its businesses into three segments: Marketing Services, Credit Services and Transaction Services.
 
                                         
    Marketing
    Credit
    Transaction
    Other/
       
    Services     Services     Services     Elimination     Total  
    (In thousands)  
 
Three months ended March 31, 2007
                                       
Revenues
  $ 232,470     $ 215,321     $ 194,315     $ (92,948 )   $ 549,158  
Adjusted EBITDA(1)
    43,939       91,046       25,095             160,080  
Depreciation and amortization
    21,716       3,455       14,235             39,406  
Stock compensation expense
    5,555       2,406       4,132             12,093  
Operating income
    16,668       85,185       6,728             108,581  
Interest expense, net
                      15,827       15,827  
Income before income taxes
    16,668       85,185       6,728       (15,827 )     92,754  
Three months ended March 31, 2006
                                       
Revenues
  $ 176,542     $ 199,131     $ 191,692     $ (90,134 )   $ 477,231  
Adjusted EBITDA(1)
    26,855       78,769       28,626             134,250  
Depreciation and amortization
    11,461       2,531       13,546             27,538  
Stock compensation expense
    3,141       1,089       3,074             7,304  
Operating income
    12,253       75,149       12,006             99,408  
Interest expense, net
                      8,537       8,537  
Income before income taxes
    12,253       75,149       12,006       (8,537 )     90,871  
 
 
(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 amortization. Adjusted EBITDA is presented in accordance with Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”) as it is the primary performance metric by which senior management is evaluated.


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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 audited consolidated financial statements and related notes thereto included in our Annual Report filed on Form 10-K for the year ended December 31, 2006.
 
Quarter in Review Highlights
 
Our first quarter 2007 results included the following significant new and renewed agreements with significant clients and continued selective execution of our acquisition strategy:
 
  •  In February 2007, we announced the signing of a multi-year agreement with Newfoundland and Labrador Liquor Corporation to participate as a sponsor in our Canadian AIR MILES Reward Program.
 
  •  In February 2007, we announced the signing of a multi-year agreement with Redcats USA to provide integrated credit and marketing services including co-brand credit card services to supplement Redcats USA’s existing private label credit card programs as well as providing co-brand credit card services for a new Redcats USA client, The Sportsman’s Guide.
 
  •  In February 2007, we completed the acquisition of Abacus, a division of DoubleClick Inc. and a leading provider of data, data management and analytical services for the retail and catalog industry, as well as other sectors.
 
  •  In March 2007, we announced the signing of a multi-year agreement with Pinellas County Utilities, a municipal water utility providing water and wastewater services to more than 110,000 residential and commercial accounts, to implement a new customer information system and provide ongoing services, including application management and hosting, as well as bill print and mail 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 10-K for the fiscal year ended December 31, 2006, except as follows:
 
We account for uncertain tax positions in accordance with FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes (“FIN No. 48”) an interpretation of Statement of Financial Accounting Standards No. 109 (“SFAS No. 109”). The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. As such, we are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of, and guidance surrounding, income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in the consolidated balance sheets and statements of income. See Note 7 to the unaudited condensed consolidated financial statements, “Income Taxes” included in this report, for additional detail on our tax positions.
 
Use of Non-GAAP Financial Measures
 
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. Operating EBITDA is a non-GAAP financial measure equal to adjusted EBITDA plus the change in deferred revenue plus the change in redemption settlement assets. We have presented operating EBITDA because we use the financial measure to monitor compliance with financial covenants in our credit agreements and our senior note agreements. For the three months ended March 31, 2007, senior debt-to-operating EBITDA was 1.9x compared to a maximum ratio of 2.75x permitted in our credit facilities and in our senior note agreements. Operating EBITDA to interest expense was 10.9x compared to a minimum ratio of 3.5x permitted in our credit facilities and 3.0x permitted


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in our senior note agreements. As discussed in more detail in the liquidity section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” our credit facilities and cash flows from operations are the two main sources of funding for our acquisition strategy and for our future working capital needs and capital expenditures. As of March 31, 2007, we had borrowings of $654.0 million outstanding under the credit facilities, $500.0 million under our senior notes, and had $184.0 million in unused borrowing capacity. We were in compliance with our covenants at March 31, 2007, and we expect to be in compliance with these covenants during the year ended December 31, 2007.
 
We use adjusted EBITDA as an integral part of our internal reporting to measure the performance of our reportable segments and to evaluate the performance of our senior management. Adjusted EBITDA is considered an important indicator of the operational strength of our businesses. Adjusted EBITDA eliminates the uneven effect across all business segments of considerable amounts of non-cash depreciation of tangible assets and amortization of certain intangible assets that were recognized in business combinations. A limitation of this measure, however, is that it does not reflect the periodic costs of certain capitalized tangible and intangible assets used in generating revenues in our businesses. Management evaluates the costs of such tangible and intangible assets, the impact of related impairments, as well as asset sales through other financial measures, such as capital expenditures, investment spending and return on capital. 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 and operating EBITDA are not intended to be performance measures 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 and operating EBITDA are 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 and operating EBITDA measures presented in this Quarterly Report on Form 10-Q may not be comparable to similarly titled measures presented by other companies, and may not be identical to corresponding measures used in our various agreements.
 
                 
    Three Months Ended March 31,  
    2007     2006  
    (In thousands)  
 
Net income
  $ 56,860     $ 56,421  
Stock compensation expense
    12,093       7,304  
Provision for income taxes
    35,894       34,450  
Interest expense, net
    15,827       8,537  
Depreciation and other amortization
    20,065       15,217  
Amortization of purchased intangibles
    19,341       12,321  
                 
Adjusted EBITDA
    160,080       134,250  
Change in deferred revenue
    13,058       8,253  
Change in redemption settlement assets
    (16,630 )     (5,431 )
                 
Operating EBITDA
  $ 156,508     $ 137,072  
                 
 
 
Note:  An increase in deferred revenue has a positive impact to operating EBITDA, while an increase in redemption settlement assets has a negative impact to operating EBITDA. Changes in deferred revenue and redemption settlement assets are affected by fluctuations in foreign exchange rates. Changes in redemption settlement assets is also affected by the timing of receipts and transfers of cash.


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Results of Operations
 
Three months ended March 31, 2007 compared to the three months ended March 31, 2006
 
                                 
    Three Months Ended March 31,     Change  
    2007     2006     $     %  
    (In thousands, except percentages)  
 
Revenue:
                               
Marketing Services
  $ 232,470     $ 176,542     $ 55,928       31.7 %
Credit Services
    215,321       199,131       16,190       8.1  
Transaction Services
    194,315       191,692       2,623       1.4  
Other/Eliminations
    (92,948 )     (90,134 )     (2,814 )     3.1  
                                 
Total
  $ 549,158     $ 477,231     $ 71,927       15.1 %
                                 
Adjusted EBITDA:
                               
Marketing Services
  $ 43,939     $ 26,855     $ 17,084       63.6 %
Credit Services
    91,046       78,769       12,277       15.6  
Transaction Services
    25,095       28,626       (3,531 )     (12.3 )
                                 
Total
  $ 160,080     $ 134,250     $ 25,830       19.2 %
                                 
Stock compensation expense:
                               
Marketing Services
  $ 5,555     $ 3,141     $ 2,414       76.9 %
Credit Services
    2,406       1,089       1,317       120.9  
Transaction Services
    4,132       3,074       1,058       34.4 %
                                 
Total
  $ 12,093     $ 7,304     $ 4,789       65.6 %
                                 
Depreciation and amortization:
                               
Marketing Services
  $ 21,716     $ 11,461     $ 10,255       89.5 %
Credit Services
    3,455       2,531       924       36.5  
Transaction Services
    14,235       13,546       689       5.1  
                                 
Total
  $ 39,406     $ 27,538     $ 11,868       43.1 %
                                 
Operating expenses(1):
                               
Marketing Services
  $ 188,531     $ 149,687     $ 38,844       26.0 %
Credit Services
    124,275       120,362       3,913       3.3  
Transaction Services
    169,220       163,066       6,154       3.8  
Other/Eliminations
    (92,948 )     (90,134 )     (2,814 )     3.1  
                                 
Total
  $ 389,078     $ 342,981     $ 46,097       13.4 %
                                 
Operating income:
                               
Marketing Services
  $ 16,668     $ 12,253     $ 4,415       36.0 %
Credit Services
    85,185       75,149       10,036       13.4  
Transaction Services
    6,728       12,006       (5,278 )     (44.0 )
                                 
Total
  $ 108,581     $ 99,408     $ 9,173       9.2 %
                                 
Adjusted EBITDA margin(2):
                               
Marketing Services
    18.9 %     15.2       3.7 %        
Credit Services
    42.3       39.6       2.7          
Transaction Services
    12.9       14.9 %     (2.0 )        
                                 
Total
    29.2 %     28.1 %     1.1 %        
                                 
Segment operating data:
                               
Statements generated
    56,149       51,860       4,289       8.3 %
Credit Sales
  $ 1,586,455     $ 1,494,090     $ 92,365       6.2 %
Average managed receivables
  $ 3,916,191     $ 3,581,879     $ 334,312       9.3 %
AIR MILES reward miles issued
    942,106       856,434       85,672       10.0 %
AIR MILES reward miles redeemed
    644,329       554,311       90,018       16.2 %
 
 
(1) Operating expenses excludes depreciation, amortization and stock compensation expenses.
 
(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. For definition of adjusted EBITDA and reconciliation to net income, the most directly comparable GAAP financial measure, see “Use of Non-GAAP Financial Measures” included in this report.


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Revenue.  Total revenue increased $71.9 million, or 15.1%, to $549.2 million for the three months ended March 31, 2007 from $477.2 million for the comparable period in 2006. The increase was due to a 31.7% increase in Marketing Services revenue, an 8.1% increase in Credit Services revenue and a 1.4% increase in Transaction Services revenue as follows:
 
  •  Marketing Services.  Marketing Services revenue increased $55.9 million, or 31.7%, due to a combination of strong organic growth and acquisitions completed over the past twelve months. AIR MILES Reward Program growth was driven primarily by an increase in redemption revenue of $11.6 million related to a 16.2% increase in the redemption of AIR MILES reward miles. Issuance revenue increased $2.2 million primarily due to growth in issuances of AIR MILES reward miles in recent years from the roll-out of major national programs, combined with overall firm pricing and expanded commitments from existing sponsors. Changes in the exchange rate of the Canadian dollar had minimal impact on revenue for the AIR MILES Reward Program. Database and direct marketing fees revenue increased approximately $39.1 million due to strong organic growth and the acquisition of Epsilon businesses, DoubleClick Email Solutions, and Abacus.
 
  •  Credit Services.  Credit Services revenue increased $16.2 million, or 8.1%, primarily due to a 10.9% increase in securitization income and finance charges, net, partially offset by a decrease in merchant discount fees. Securitization income and finance charges, net increased $17.4 million primarily as a result of a 9.3% increase in average managed receivables and an increase in collected yield. Cost of funds remained flat. This growth was partially offset by the normalization of our net charge-off rate to 5.9% as compared to 4.1% in the first quarter of 2006. The first quarter of 2006 was impacted by abnormally low credit losses resulting from the enactment of bankruptcy reform legislation during the fourth quarter of 2005. In addition, we had a decrease in merchant discount fees primarily as a result of a change in mix of fees received from merchants compared to fees received from cardholders.
 
  •  Transaction Services.  Transaction Services revenue increased $2.6 million, or 1.4%, as higher revenues from growth in private label statements generated was offset by a 10.1% decrease in merchant services revenue, while performance in our Utility services was flat to the prior year.
 
Operating Expenses.  Total operating expenses, excluding depreciation, amortization and stock compensation expense, increased $46.1 million, or 13.4%, to $389.1 million during the three months ended March 31, 2007 from $343.0 million during the comparable period in 2006. Total adjusted EBITDA margin increased to 29.2% for the three months ended March 31, 2007 from 28.1% for the comparable period in 2006 due to increased margins in our Marketing and Credit Services segment, offset by a decreased margin in our Transactions Services segment.
 
  •  Marketing Services.  Marketing Services operating expenses, excluding depreciation, amortization and stock compensation expense, increased $38.8 million, or 26.0%, to $188.5 million for the three months ended March 31, 2007 from $149.7 million for the comparable period in 2006. Increases in operating expenses were primarily attributable to the acquisition of the Epsilon businesses, as discussed above. Adjusted EBITDA margin increased to 18.9% for the three months ended March 31, 2007 from 15.2% for the comparable period in 2006. The increase in adjusted EBITDA margin was due to margin expansion in our Epsilon and AIR MILES businesses, and margin contribution from relatively flat allocated corporate overhead.
 
  •  Credit Services.  Credit Services operating expenses, excluding depreciation, amortization and stock compensation expense, increased $3.9 million, or 3.3%, to $124.3 million for the three months ended March 31, 2007 from $120.4 million for the comparable period in 2006, and adjusted EBITDA margin increased to 42.3% for the three months ended March 31, 2007 from 39.6% for the same period in 2006. The increased adjusted EBITDA margin is the result of growth in our average managed receivables, higher yield, infrastructure leverage and relatively flat allocated corporate overhead.
 
  •  Transaction Services.  Transaction Services operating expenses, excluding depreciation, amortization and stock compensation expense, increased $6.2 million, or 3.8%, to $169.2 million for the three months ended March 31, 2007 from $163.0 million for the comparable period in 2006, and adjusted


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  EBITDA margin decreased to 12.9% for the three months ended March 31, 2007 from 14.9% during the comparable period in 2006. The decrease in adjusted EBITDA margin was due to accrued penalties for late system conversions on utility contracts, additional expenses due to these conversion delays and incremental expenses associated with the ramp-up of a new call center. Current expectations are that these cost overruns will continue through second quarter 2007 and decrease in the latter part of the year.
 
  •  Stock compensation expense.  Stock compensation expense increased $4.8 million, or 65.6% to $12.1 million for the three months ended March 31, 2007 from $7.3 million for the comparable period in 2006. The expense associated with restricted stock awards increased $6.2 for the three months ended March 31, 2007 from the comparable period in 2006. The increase was due in part to the true up of certain estimates, including forfeitures upon the adoption of SFAS No. 123(R), of approximately $3.1 million during 2006, and incremental expenses associated with additional issuances of restricted stock subsequent to March 31, 2006 for new hires, discretionary awards, and in connection with acquisitions. The expense related to the issuance of stock options for the three months ended March 31, 2007 decreased $1.4 million from the comparable period in 2006, as the expense associated with certain prior year awards were fully amortized in 2006. During 2006 we shifted the balance of the stock-based awards granted, increasing the number of service-based restricted stock awards and reducing the number of stock options awarded. For the full year 2007, we expect the growth in stock compensation expense to be less than 10%.
 
  •  Depreciation and Amortization.  Depreciation and amortization increased $11.9 million, or 43.1%, to $39.4 million for the three months ended March 31, 2007 from $27.5 million for the comparable period in 2006 primarily due to a $7.0 million increase in the amortization of purchased intangibles related to recent acquisitions and an increase of $4.9 million in depreciation and other amortization in part related to 2006 capital expenditures.
 
Operating Income.  Operating income increased $9.2 million, or 9.2%, to $108.6 million for the three months ended March 31, 2007 from $99.4 million during the comparable period in 2006. Operating income increased due to the revenue and expense factors discussed above.
 
Interest Income.  Interest income increased $1.1 million, or 63.3%, to $2.9 million for the three months ended March 31, 2007 from $1.8 million for the comparable period in 2006 due to higher average balances of our short term cash investments, as well as an increase in the yield earned on the short term cash investments.
 
Interest Expense.  Interest expense increased $8.4 million, or 81.6%, to $18.7 million for the three months ended March 31, 2007 from $10.3 million for the comparable period in 2006. Interest expense on core debt, which includes the credit facilities and senior notes, increased $9.1 million as a result of additional borrowings to fund our recent acquisitions and our stock repurchase program as well as an increase in interest rates from the comparable period in 2006. Interest on certificates of deposit remained relatively flat.
 
Taxes.  Income tax expense increased $1.4 million to $35.9 million for the three months ended March 31, 2007 from $34.4 million in 2006 due to an increase in taxable income. Our effective tax rate increased to 38.7% in 2007 compared to 37.9% in 2006 primarily as a result of the continued impact of the 2006 Canadian tax legislation.
 
Asset Quality
 
Our delinquency and net charge-off rates reflect, among other factors, the credit risk of our private label credit card receivables, the average age of our various private label credit card account portfolios, the success of our collection and recovery efforts, and general economic conditions. The average age of our private label credit card portfolio affects the stability of delinquency and loss rates of the portfolio. We continue to focus our resources on refining our credit underwriting standards for new accounts and on collections and post charge-off recovery efforts to minimize net losses.
 
An older private label credit card portfolio generally drives a more stable performance in the portfolio. At March 31, 2007, 58.5% of securitized accounts with balances and 61.1% of securitized receivables were for


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accounts with origination dates greater than 24 months old, which is consistent with the comparable period in 2006.
 
Delinquencies.  A credit card account is contractually delinquent if we do not receive the minimum payment by the specified due date on the cardholder’s statement. It is our policy to continue to accrue interest and fee income on all credit card accounts, except in limited circumstances, until the account balance and all related interest and other fees are charged off or paid beyond 90 days delinquent. When an account becomes delinquent, we print a message on the cardholder’s billing statement requesting payment. After an account becomes 30 days past due, a proprietary collection scoring algorithm automatically scores the risk of the account rolling to a more delinquent status. The collection system then recommends a collection strategy for the past due account based on the collection score and account balance and dictates the contact schedule and collections priority for the account. If we are unable to make a collection after exhausting all in-house efforts, we engage collection agencies and outside attorneys to continue those efforts.
 
The following table presents the delinquency trends of our managed credit card portfolio:
 
                                 
    March 31,
          December 31,
       
    2007     % of total     2006     % of total  
    (Dollars in thousands)  
 
Receivables outstanding
  $ 3,793,902       100 %   $ 4,171,262       100 %
Receivables balances contractually delinquent:
                               
31 to 60 days
    56,363       1.5 %     62,221       1.5 %
61 to 90 days
    39,835       1.0       40,929       1.0  
91 or more days
    81,733       2.2       88,078       2.1  
                                 
Total
  $ 177,931       4.7 %   $ 191,228       4.6 %
                                 
 
Net Charge-Offs.  Net charge-offs comprise the principal amount of losses from cardholders unwilling or unable to pay their account balances, as well as bankrupt and deceased cardholders, less current period recoveries. The following table presents our net charge-offs for the periods indicated on a managed basis. Average managed receivables represents the average balance of the cardholder receivables at the beginning of each month in the year indicated.
 
                 
    Three Months Ended March 31,  
    2007     2006  
    (Dollars in thousands)  
 
Average managed receivables
  $ 3,916,191     $ 3,581,879  
Net charge-offs
    57,811       37,037  
Net charge-offs as a percentage of average managed receivables (annualized)
    5.9 %     4.1 %
 
The net charge-off rate in the first quarter of 2006 was impacted by abnormally low credit losses resulting from the enactment of bankruptcy reform legislation during the fourth quarter of 2005.
 
Liquidity and Capital Resources
 
Operating Activities.  We have historically generated cash flows from operations, although that amount may vary based on fluctuations in working capital and the timing of merchant settlement activity. Our operating cash flow is seasonal, with cash utilization peaking at the end of December due to increased activity in our Credit Services segment related to holiday retail sales.
 
                 
    Three Months Ended March 31,  
    2007     2006  
    (In thousands)  
 
Cash provided by operating activities before change in merchant settlement activity
  $ 17,415     $ 56,013  
Net change in merchant settlement activity
    11,201       14,763  
                 
Cash provided by operating activities
  $ 28,616     $ 70,776  
                 


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We generated cash flow from operating activities before changes in merchant settlement activity of $17.4 million for the three months ended March 31, 2007 as compared to $56.0 million for the comparable period in 2006. The decrease in operating cash flows before changes in merchant settlement activity is related to unfavorable working capital movements. Merchant settlement activity fluctuates significantly depending on the day in which the quarter ends. We utilize our cash flow from operations for ongoing business operations, acquisitions and capital expenditures.
 
Investing Activities.  Cash used in investing activities was $322.9 million for the three months ended March 31, 2007 compared to cash provided by investing activities of $46.2 million of for the comparable period in 2006. Significant components of investing activities are as follows:
 
  •  Acquisitions.  Cash outlays, net of cash received, for acquisitions for the three months ended March 31, 2007 was $438.7 million compared to $36.1 million for the comparable period in 2006. In the first quarter of 2007, the cash outlay relates primarily to the acquisition of Abacus. In the first quarter of 2006, the cash outlay primarily relates to the acquisition of ICOM.
 
  •  Securitizations and Receivables Funding.  We generally fund all private label credit card receivables through a securitization program that provides us with both liquidity and lower borrowing costs. As of March 31, 2007, we had over $3.4 billion of securitized credit card receivables. Securitizations require credit enhancements in the form of cash, spread accounts and additional receivables. The credit enhancement is partially funded through the use of certificates of deposit issued through our subsidiary, World Financial Network National Bank. Cash flow from securitization activity was $153.8 million for the three months ended March 31, 2007 and $108.4 million for the comparable period in 2006. We intend to utilize our securitization program for the foreseeable future.
 
  •  Capital Expenditures.  Our capital expenditures for the three months ended March 31, 2007 were $21.9 million compared to $20.4 million for the comparable period in 2006. We anticipate capital expenditures to be approximately 5% of annual revenue for the foreseeable future.
 
Financing Activities.  Cash provided by financing activities was $268.7 million for the three months ended March 31, 2007 compared to cash used of $3.3 million in the comparable period in 2006. Our financing activities during the three months ended March 31, 2007 relate primarily to borrowings and repayments of debt, the repurchase of 1,805,800 shares of our common stock and the issuance and repayment of certificates of deposit.
 
Liquidity Sources.  In addition to cash generated from operating activities, we have four main sources of liquidity: securitization program, certificates of deposit issued by World Financial Network National Bank and World Financial Capital Bank, our credit facilities and issuances of equity securities. We believe that internally generated funds and existing sources of liquidity are sufficient to meet current and anticipated financing requirements during the next 12 months.
 
Securitization Program and Off-Balance Sheet Transactions.  Since January 1996, we have sold, sometimes through WFN Credit Company, LLC and WFN Funding Company II, LLC, substantially all of the credit card receivables owned by our credit card bank subsidiary, World Financial Network National Bank, to World Financial Network Credit Card Master Trust, World Financial Network Credit Card Master Note Trust, World Financial Network Credit Card Master Trust II and World Financial Network Credit Card Master Trust III, which we refer to as the WFN Trusts, as part of our securitization program. This securitization program is the primary vehicle through which we finance our private label credit card receivables.
 
As of March 31, 2007, the WFN Trusts had over $3.4 billion of securitized credit card receivables. Securitizations require credit enhancements in the form of cash, spread deposits and additional receivables. The credit enhancement is principally based on the outstanding balances of the series issued by the WFN Trusts and by the performance of the private label credit cards in the securitization trust. During the period from November to January, the WFN Trusts are required to maintain a credit enhancement level of between 6% and 10% of securitized credit card receivables. Certain of the WFN Trusts are required to maintain a level of between 4% and 9% for the remainder of the year.


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Certificates of Deposit.  We utilize certificates of deposit to finance the operating activities and fund securitization enhancement requirements of our credit card bank subsidiaries, World Financial Network National Bank and World Financial Capital Bank. World Financial Network National Bank and World Financial Capital Bank issue certificates of deposit in denominations of $100,000 in various maturities ranging between three months and two years and with effective annual fixed rates ranging from 4.3% to 6.0%. As of March 31, 2007, we had $234.1 million of certificates of deposit outstanding. Certificate of deposit borrowings are subject to regulatory capital requirements.
 
Credit Facilities.  On January 24, 2007, we entered into a credit facility which provides for loans in a maximum amount of $400.0 million, or the bridge loan. At the closing of the bridge loan, we borrowed $300.0 million for general corporate purposes including the repayment of debt and the financing of permitted acquisitions. The bridge loan includes an uncommitted accordion feature of up to $100.0 million allowing for future borrowings, subject to certain conditions. The bridge loan is scheduled to mature July 24, 2007. The bridge loan is unsecured. Each of ADS Alliance Data Systems, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Marketing Services, LLC and Epsilon Data Management, LLC are guarantors under the bridge loan. We anticipate refinancing the bridge loan prior to July 24, 2007.
 
Advances under the bridge loan are in the form of either base rate loans or eurodollar loans. The interest rate for base rate loans fluctuates and is equal to the higher of (1) the Bank of Montreal’s prime rate and (2) the Federal funds rate plus 0.5%, in either case with no additional margin. The interest rate for eurodollar loans fluctuates based on the London interbank offered rate plus a margin of 0.6% to 1.2% based upon our Senior Leverage Ratio as defined in the bridge loan. On January 24, 2007, we paid an arrangement fee of $250,000 for the bridge loan.
 
The bridge loan contains usual and customary negative covenants for transactions of this type, including, but not limited to, restrictions on our ability, and in certain instances, our subsidiaries’ ability, to consolidate or merge; substantially change the nature of our business; sell, transfer or dispose of assets; create or incur indebtedness; create liens; pay dividends and repurchase stock; and make investments. The negative covenants are subject to certain exceptions, as specified in the bridge loan. The bridge loan also requires us to satisfy certain financial covenants, including maximum ratios of Total Capitalization and Senior Leverage as determined in accordance with the bridge loan and a minimum ratio of Consolidated Operating EBITDA to Consolidated Interest Expense as determined in accordance with the bridge loan.
 
The bridge loan must be prepaid prior to the scheduled maturity date if we or any of our subsidiaries issues any debt or equity securities, subject to certain exceptions.
 
The bridge loan also includes customary events of default, including, among other things, payment default, covenant default, breach of representation or warranty, bankruptcy, cross-default, material ERISA events, a change of control, material money judgments and failure to maintain subsidiary guarantees.
 
In March 2007, we amended our Credit Agreement dated September 29, 2006. The amendment extended the lending commitments under the agreement which were scheduled to terminate on September 29, 2011 to March 30, 2012. In addition, the amendment adjusts the Senior Leverage Ratio applicable to the various levels set forth in the Pricing Schedule in Appendix I of the agreement and the margin applicable to Eurodollar loans. After giving effect to the amendment, the interest rate for Eurodollar loans denominated in U.S. or Canadian Dollars fluctuates based on the rate at which deposits of U.S. Dollars or Canadian Dollars, respectively, in the London interbank market are quoted plus a margin of 0.4% to 0.8% based upon the Senior Leverage Ratio as defined in the agreement. We paid an amendment fee equal to 0.05% of each bank’s commitment under the agreement.
 
At March 31, 2007, we had borrowings of $654.0 million outstanding under our credit facilities (with a weighted average interest rate of 6.2%), $2.0 million in letters of credit outstanding, and we had available unused borrowing capacity of approximately $184.0 million. These credit facilities limit our aggregate outstanding letters of credit to $50.0 million. Additional details regarding our credit facilities are set forth in Note 5 to the unaudited condensed consolidated financial statements, “Debt”, under the caption “Credit Facilities.”


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We utilize our credit facilities and excess cash flows from operations to support our acquisition strategy and to fund working capital and capital expenditures. We were in compliance with the covenants under our credit facilities at March 31, 2007.
 
Recent Accounting Pronouncements
 
In September 2006, FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 establishes a new definition of fair value as well as a fair value hierarchy that prioritizes the information used to develop the assumptions, and requires new disclosures of assets and liabilities measured at fair value based on their level in the hierarchy. The standard is effective for fiscal years beginning after November 15, 2007. We are currently in the process of evaluating the effect that the adoption of SFAS No. 157 will have on our consolidated financial position, results of operations and cash flows.
 
In February 2007, FASB issued Statement of Financial Accounting Standards No. 159, “Establishing the Fair Value Option for Financial Assets and Liabilities”, (“SFAS No. 159”) to permit all entities to choose to elect to measure eligible financial instruments at fair value. SFAS No. 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS No. 157. An entity is prohibited from retrospectively applying SFAS No. 159, unless it chooses early adoption. We are currently in the process of evaluating the effect that the adoption of SFAS No. 159 will have on our consolidated financial position, results of operations and cash flows.
 
Item 3.   Quantitative and Qualitative Disclosures About Market Risk
 
Market Risk
 
There has been no material change from our Annual Report on Form 10-K for the year ended December 31, 2006 related to our exposure to market risk from off-balance sheet risk, interest rate risk, credit risk, foreign currency exchange risk and redemption reward risk.
 
Item 4.   Controls and Procedures
 
Evaluation
 
As of March 31, 2007, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that as of March 31, 2007, 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.
 
Our evaluation of and conclusion on the effectiveness of internal control over financial reporting as of December 31, 2006 did not include the internal controls of ICOM, DoubleClick Email Solutions, CPC or Abacus because of the timing of these acquisitions, which were completed in February 2006, April 2006, October 2006, and February 2007, respectively. As of December 31, 2006, these entities constituted $254.5 million of total assets, $96.4 million of revenues and $6.5 million of net income for the year then ended. In 2007, we will expand our evaluation of the effectiveness of the internal controls over financial reporting to include ICOM, DoubleClick Email Solutions, and CPC.
 
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.


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FORWARD-LOOKING STATEMENTS
 
This Form 10-Q and the documents incorporated by reference herein contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements may use words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “predict,” “project” and similar expressions as they relate to us or our management. When we make forward-looking statements, we are basing them on our management’s beliefs and assumptions, using information currently available to us. Although we believe that the expectations reflected in the forward-looking statements are reasonable, these forward-looking statements are subject to risks, uncertainties and assumptions, including those discussed in the “Risk Factors” section in our Annual Report on Form 10-K for the year ended December 31, 2006.
 
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.
 
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 affect on our business or financial condition, including claims and lawsuits alleging breaches of 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, 2006.
 
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds.
 
During 2005 and 2006 our Board of Directors authorized three stock repurchase programs to acquire up to an aggregate of $900.0 million of our outstanding common stock through December 2008, as more fully described in the footnote to the table below. As of March 31, 2007, we had repurchased 8,605,552 shares of our common stock for approximately $403.3 million under these programs. The following table presents information with respect to those purchases of our common stock made during the three months ended March 31, 2007:
 
                                 
                Total Number of
    Approximate Dollar
 
                Shares Purchased as
    Value of Shares
 
                Part of Publicly
    That May Yet be
 
    Total Number of
    Average Price
    Announced Plans or
    Purchased Under the
 
Period
  Shares Purchased(1)     Paid per Share     Programs     Plans or Programs(2)(3)  
                      (In millions)  
 
During 2007:
                               
January
    4,584     $ 66.59           $ 605.2  
February
    889,980       62.04       884,300       550.3  
March
    942,006       58.31       921,500       496.7  
                                 
Total
    1,836,570     $ 60.14       1,805,800     $ 496.7  
                                 
 
 
(1) During the period represented by the table, 30,770 shares of our common stock were purchased by the administrator of our 401(k) and Retirement Saving Plan for the benefit of the employees who participated in that portion of the plan.


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(2) On June 9, 2005, we announced that our Board of Directors authorized a stock repurchase program to acquire up to $80.0 million of our outstanding common stock through June 2006. As of the expiration of the program, we acquired the full amount available under this program. On October 27, 2005, we announced that our Board of Directors authorized a second stock repurchase program to acquire up to an additional $220.0 million of our outstanding common stock through October 2006. On October 3, 2006, we announced that our Board of Directors authorized a third stock repurchase program to acquire up to an additional $600.0 million of our outstanding common stock through December 2008, in addition to any amount remaining available at the expiration of the second stock repurchase program. As of March 31, 2007, we had repurchased 8,605,522 shares of our common stock for approximately $403.3 million under these programs.
 
(3) Debt covenants in our credit facilities restrict the amount of funds that we have available for repurchases of our common stock in any calendar year. The limitation for each calendar year was $200.0 million beginning with 2006, increasing to $250.0 million in 2007 and $300.0 million in 2008, conditioned on certain increases in our Consolidated Operating EBITDA as defined in the credit facilities.
 
Item 3.   Defaults Upon Senior Securities.
 
None
 
Item 4.   Submission of Matters to a Vote of Security Holders.
 
None
 
Item 5.   Other Information.
 
(a) None
 
(b) None


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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   Second Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit No. 3.2 to our Registration Statement on Form S-1 filed with the SEC on March 3, 2000, File No. 333-94623).
  3 .3   First Amendment to the Second Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit No. 3.3 to our Registration Statement on Form S-1 filed with the SEC on May 4, 2001, File No. 333-94623).
  3 .4   Second Amendment to the Second Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit No. 3.4 to our Annual Report on Form 10-K, filed with the SEC on April 1, 2002, 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   Credit Agreement, dated as of January 24, 2007, by and among Alliance Data Systems Corporation, certain subsidiaries parties thereto as Guarantors, the Banks from time to time parties thereto, and Bank of Montreal, as Administrative Agent (incorporated by reference to Exhibit No. 10.1 to our Current Report on Form 8-K filed with the SEC on January 25, 2007, File No. 001-15749).
  10 .2   First Amendment to Credit Agreement, dated as of March 30, 2007, by and among Alliance Data Systems Corporation and certain subsidiaries parties thereto as Guarantors, Bank of Montreal, as Administrative Agent and various other agents and banks (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on March 30, 2007, 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.
 
 
* Filed herewith


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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
ALLIANCE DATA SYSTEMS CORPORATION
 
  By: 
/s/  Edward J. Heffernan
Edward J. Heffernan
Executive Vice President and
Chief Financial Officer
(Principal Financial Officer)
 
Date: May 7, 2007
 
  By: 
/s/  Michael D. Kubic
Michael D. Kubic
Senior Vice President and Corporate Controller
(Principal Accounting Officer)
 
Date: May 7, 2007


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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   Second Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit No. 3.2 to our Registration Statement on Form S-1 filed with the SEC on March 3, 2000, File No. 333-94623).
  3 .3   First Amendment to the Second Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit No. 3.3 to our Registration Statement on Form S-1 filed with the SEC on May 4, 2001, File No. 333-94623).
  3 .4   Second Amendment to the Second Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit No. 3.4 to our Annual Report on Form 10-K, filed with the SEC on April 1, 2002, 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   Credit Agreement, dated as of January 24, 2007, by and among Alliance Data Systems Corporation, certain subsidiaries parties thereto as Guarantors, the Banks from time to time parties thereto, and Bank of Montreal, as Administrative Agent (incorporated by reference to Exhibit No. 10.1 to our Current Report on Form 8-K filed with the SEC on January 25, 2007, File No. 001-15749).
  10 .2   First Amendment to Credit Agreement, dated as of March 30, 2007, by and among Alliance Data Systems Corporation and certain subsidiaries parties thereto as Guarantors, Bank of Montreal, as Administrative Agent and various other agents and banks (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on March 30, 2007, 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.
 
 
* Filed herewith