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ALLIANCE DATA SYSTEMS CORPORATION INDEX

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended June 30, 2004

OR

For the transition period from                               to                              

Commission File Number: 001-15749

ALLIANCE DATA SYSTEMS CORPORATION
(Exact Name of Registrant as Specified in its Charter)

        Indicate by check mark whether the registrant (i) has filed all reports required to be filed 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 (ii) has been subject to such filing requirements for the past 90 days. Yes ý    No o

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý    No o

        As of July 30, 2004, 80,856,567 shares of the registrant's common stock, par value $0.01 per share, were outstanding.

ALLIANCE DATA SYSTEMS CORPORATION

INDEX

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PART I

Item 1. Financial Statements

ALLIANCE DATA SYSTEMS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

See accompanying notes to unaudited condensed consolidated financial statements.

3

ALLIANCE DATA SYSTEMS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share amounts)

See accompanying notes to unaudited condensed consolidated financial statements.

4

ALLIANCE DATA SYSTEMS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

5

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, 2003.

        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 with the current year presentation. Such reclassifications have no impact on previously reported net income.

2. SHARES USED IN COMPUTING NET INCOME PER SHARE

        The computation of the number of shares used in calculating basic and diluted net income per share is as follows:

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3. INTANGIBLE ASSETS

        Intangible assets consist of the following:

4. DEBT

        Debt consists of the following:

        The Company amended its Credit Facility (364-Day) by and among the Company, the guarantors from time to time party thereto, the banks from time to time party thereto, and Harris Trust and Savings Bank, as Administrative Agent, as of April 8, 2004, to extend for an additional 364 days the terms of the previous Credit Facility (364-Day) dated as of April 10, 2003, by and among the same parties. As of June 30, 2004, no amounts have been drawn against the Credit Facility (364-Day).

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        Certificates of deposit during the six months ended June 30, 2004 decreased as a result of normal seasonal trends and the sale of receivables to the securitization trusts.

        As of June 30, 2004, the certificates of deposit had effective annual fixed rates ranging from 1.6% to 3.3%, and the credit facilities had an average interest rate of 3.1%.

5. DEFERRED REVENUE

        A reconciliation of deferred revenue for the AIR MILES® Reward Program is as follows (in thousands):

6. INCOME TAXES

        For the three and six months ended June 30, 2004, the Company has utilized an effective tax rate of 37.7% 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 2004 based on all known variables.

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7. COMPREHENSIVE INCOME

        The components of comprehensive income, net of tax effect, are as follows:

(1)

Reclassifications into earnings arise from interest rate swaps, a foreign currency hedge, and amortization of amounts recorded in connection with the adoption of Statement of Financial Accounting Standards ("SFAS") No. 133.

(2)

Primarily related to the impact of changes in the Canadian currency exchange rate.

8. SEGMENT INFORMATION

        Consistent with prior periods, the Company classifies its businesses into three segments: Transaction Services, Credit Services and Marketing Services.

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(1)

See "Use of Non-GAAP Financial Measures" set forth in Item 2. "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of our use of EBITDA and a reconciliation to net income, the most directly comparable GAAP financial measure.

9. STOCK COMPENSATION

        At June 30, 2004, the Company had three stock-based employee compensation plans. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees", and related Interpretations. No stock-based employee compensation cost is reflected in net income for stock options, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and net income per share if the

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Company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation.

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10. RESTATEMENT

        Subsequent to the issuance of its condensed consolidated financial statements for the three months and six months ended June 30, 2003, the Company determined that the translation of the Company's Canadian subsidiary's financial statements was not in accordance with SFAS No. 52, "Foreign Currency Translation". The Company had been using historical exchange rates in the translation of deferred revenue and goodwill instead of the correct current period exchange rates. As a result, the financial statements presented for three months and six months ended June 30, 2003, have been restated. A summary of the significant effects of the restatement is as follows:

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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 notes thereto included in our Annual Report filed on Form 10-K for the year ended December 31, 2003.

        The accompanying management's discussion and analysis of financial condition and results of operations gives effect to the restatement of the results of operations for the three and six months ended June 30, 2003 as discussed in Note 10 to the unaudited condensed consolidated financial statements.

Year to Date in Review Highlights

        Our year to date 2004 results of operations were largely impacted by new and renewed agreements with significant clients and two capital market transactions. During the first six months of 2004, we signed or renewed agreements with several significant clients and sponsors:

•

In January 2004, we signed a long-term renewal with BMO Bank of Montreal MasterCard, a top-five client and founding sponsor in the AIR MILES Reward Program.



•

In January 2004, we entered into an agreement with Stage Stores, Inc. to purchase the Peebles' private label credit card portfolio.



•

In January 2004, we signed a long-term renewal with Shell Canada Limited, a top-ten client and significant, high-frequency sponsor in the AIR MILES Reward Program.



•

In January 2004, we signed a long-term renewal whereby Air Canada will continue as a rewards supplier in the AIR MILES Reward Program.



•

In February 2004, we commenced a five-year agreement to start a private label credit card program with Design Within Reach.



•

In March 2004, we signed a long-term, exclusive agreement with BMO Bank of Montreal and WestJet to introduce a tri-branded MasterCard.



•

In May 2004, we signed a long-term renewal with The Buckle, Inc. to provide private label credit card and marketing services.



•

In May 2004, we signed a multi-year agreement with Alimentation Couche-Tard Inc. to provide payment processing services to Circle K convenience stores across the United States.



•

In June 2004, we signed a long-term agreement with Little Switzerland, Inc. to provide private label credit card and marketing services.

Additionally, in the first six months of 2004, we completed two significant capital market transactions:

•

In April 2004, we amended our Credit Facility (364-Day) to extend for an additional 364 days the terms of the previous Credit Facility (364-Day).



•

In May 2004, we completed the sale of $500.0 million in asset backed notes for our securitization trusts.

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 on Form 10-K for the year ended December 31, 2003.

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Use of Non-GAAP Financial Measures

        EBITDA is a non-GAAP financial measure equal to net income, the most directly comparable GAAP financial measure, plus depreciation and amortization, fair value loss on interest rate derivative, interest expense, other debt-related expenses and provision for income taxes. Operating EBITDA is a non-GAAP financial measure equal to EBITDA adjusted for the changes in deferred revenue and the change in redemption settlement assets. We have presented EBITDA and operating EBITDA because we use them to monitor compliance with the financial covenants in our credit agreements, such as debt-to-operating EBITDA and operating EBITDA to interest expense ratios. We also use EBITDA and operating 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. Therefore, we believe that EBITDA and operating EBITDA provide useful information to our investors regarding our performance and overall results of operations. We also present EBITDA margin, which is EBITDA divided by revenue. 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, 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 EBITDA and operating EBITDA measures presented in this 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. The following sets forth a reconciliation of net income to EBITDA and operating EBITDA:

Note:  Operating EBITDA is affected by fluctuations in foreign exchange rates and transfers of cash to redemption settlement assets.

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Results of Operations

Three months ended June 30, 2003 compared to the three months ended June 30, 2004

        Revenue.    Total revenue increased $49.4 million, or 19.7%, to $300.5 million for the three months ended June 30, 2004 from $251.0 million for the comparable period in 2003. The increase was due to a 12.7% increase in Transaction Services revenue, a 24.5% increase in Credit Services revenue and an 18.9% increase in Marketing Services revenue as follows:

•

Transaction Services.  Transaction Services revenue increased $19.2 million, or 12.7%, primarily due to an increase in the number of statements generated. The increase in the number of statements generated is attributable to our utility and private label clients. Statements generated increased by 17.3%, while revenue per statement remained consistent. The increase in statements is primarily from the addition of new clients in both utility—CBSI (acquired in September 2003) and Orcom (acquired in December 2003) and private label—Stage Stores (signed in September 2003) and Peebles (signed January 2004) and core growth in existing

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clients. Additional growth in transaction services revenue came from an increase in core transactions processed of 32.1% as our petroleum clients experienced higher transaction volume due to higher gas prices. Higher gas prices drive more frequent visits by consumers to our petroleum clients.

•

Credit Services.  Credit Services revenue increased $24.0 million, or 24.5%, primarily due to a 27.8% increase in finance charges, net. Finance charges, net increased $17.6 million primarily as a result of a 17.6% increase in average securitized accounts receivable and a 40 basis point improvement in net charge-offs compared to the same period in 2003.



•

Marketing Services.  Marketing Services revenue increased $13.4 million, or 18.9%, primarily due to an $11.5 million increase in redemption revenue related to a 27.2% increase in the redemption of AIR MILES reward miles. Deferred revenue-redemption is impacted by both the number of AIR MILES reward miles issued and redeemed, as well as foreign currency movements. Excluding foreign currency movement, deferred revenue redemption increased $5.0 million, reflecting the greater number of AIR MILES reward miles issued in the period than redeemed. Foreign currency reduced deferred revenue-redemption by $7.3 million for the three months ended June 30, 2004.

        Operating Expenses.    Total operating expenses, excluding depreciation and amortization, increased $33.9 million, or 17.2%, to $231.5 million during the three months ended June 30, 2004 from $197.6 million during the comparable period in 2003. Total EBITDA margin increased to 23.0% for the three months ended June 30, 2004 from 21.3% for the comparable period in 2003, primarily due to increased margins for Transaction Services and Credit Services, partially offset by a decreased margin for Marketing Services.

•

Transaction Services.  Transaction Services operating expenses, excluding depreciation and amortization, increased $15.8 million, or 12.4%, to $143.0 million for the three months ended June 30, 2004 from $127.2 million for the comparable period in 2003, and EBITDA margin increased to 16.2% for the three months ended June 30, 2004 from 15.9% during the comparable period in 2003. The increase in EBITDA margin was primarily the result of an increase in revenue driven by a 17.3% increase in the segment's key driver, statements generated.



•

Credit Services.  Credit Services operating expenses, excluding depreciation and amortization, increased $11.4 million, or 13.7%, to $94.6 million for the three months ended June 30, 2004 from $83.2 million for the comparable period in 2003, and EBITDA margin increased to 22.5% for the three months ended June 30, 2004 from 15.1% for the comparable period in 2003. The increased EBITDA margin is the result of favorable revenue trends from increased receivable balances and lower net charge-offs.



•

Marketing Services.  Marketing Services operating expenses, excluding depreciation and amortization, increased $14.1 million, or 25.1%, to $70.3 million for the three months ended June 30, 2004 from $56.2 million for the comparable period in 2003, and EBITDA margin decreased to 16.6% for the three months ended June 30, 2004 from 20.6% for the comparable period in 2003. EBITDA margin decreased due to increased marketing expenses for AIR MILES sponsor programs compared to the prior period and a higher mix of lower margin redemption revenue during the current quarter.



•

Depreciation and Amortization.  Depreciation and amortization increased $3.5 million, or 18.9%, to $22.0 million for the three months ended June 30, 2004 from $18.5 million for the comparable period in 2003 due to an increase in depreciation and other amortization of $1.9 million related to the start-up of a new product offering in our Transaction Services segment and a $1.6 million increase in the amortization of purchased intangibles.

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        Operating Income.    Operating income increased $12.0 million, or 34.2%, to $47.0 million for the three months ended June 30, 2004 from $35.0 million during the comparable period in 2003. Operating income increased due to the revenue and expense factors discussed above.

        Interest Expense.    Interest expense decreased $5.4 million, or 76.1%, to $1.7 million for the three months ended June 30, 2004 from $7.1 million for the comparable period in 2003 as interest expense in 2003 was impacted by a loss on the termination of a cross currency interest rate swap. The interest rate swap was terminated with the refinancing of the prior credit facilities and repayment of the associated term debt.

        Taxes.    Income tax expense increased $8.3 million to $17.0 million for the three months ended June 30, 2004 from $8.7 million in 2003 due to an increase in income before income taxes. Our effective tax rate of 37.7% in 2004 improved from the 38.2% effective rate in 2003.

Six months ended June 30, 2003 compared to the six months ended June 30, 2004