form10q.htm


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

(Mark One)
 
R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the quarterly period ended September 30, 2012
   
OR
 
£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the transition period from          to          

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

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

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

(214) 494-3000
(Registrant’s telephone number, including area code)
 
     
 
 

 
Indicate by check mark whether the registrant: (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes R     No  £
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes R     No  £

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

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

As of October 31, 2012, 49,855,700 shares of common stock were outstanding.
 


 
 
 
 
 
ALLIANCE DATA SYSTEMS CORPORATION
 
INDEX
 
 
 
 
 
Page
Number
Part I:  FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited)
 
 
3
 
4
 
5
 
6
 
7
Item 2.
28
Item 3.
42
Item 4.
42
Part II:  OTHER INFORMATION
 
Item 1.
44
Item 1A.
44
Item 2.
44
Item 3.
44
Item 4.
44
Item 5.
44
Item 6.
45
46
 
 
2


PART I
 
Item 1.
Financial Statements.
  
ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
 
       
   
September 30,
2012
   
December 31,
2011
 
   
(In thousands, except per share amounts)
 
ASSETS
           
Cash and cash equivalents
  $ 766,317     $ 216,213  
Trade receivables, less allowance for doubtful accounts ($4,583 and $2,406 at September 30, 2012 and December 31, 2011, respectively)
    287,643       300,895  
Credit card receivables:
               
Credit card receivables – restricted for securitization investors
    5,838,099       4,886,168  
Other credit card receivables
    741,216       779,843  
Total credit card receivables
    6,579,315       5,666,011  
Allowance for loan loss
    (448,542 )     (468,321 )
Credit card receivables, net
    6,130,773       5,197,690  
Deferred tax asset, net
    183,319       252,303  
Other current assets
    155,854       121,589  
Redemption settlement assets, restricted
    495,699       515,838  
Assets of discontinued operations
          2,439  
Total current assets
    8,019,605       6,606,967  
Property and equipment, net
    224,018       195,397  
Deferred tax asset, net
    79,315       43,408  
Cash collateral, restricted
    62,205       158,727  
Intangible assets, net
    403,100       383,646  
Goodwill
    1,458,700       1,449,363  
Other non-current assets
    165,361       142,741  
Total assets
  $ 10,412,304     $ 8,980,249  
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Accounts payable
  $ 236,891     $ 149,812  
Accrued expenses
    238,489       206,621  
Deposits
    984,798       642,567  
Asset-backed securities debt – owed to securitization investors
    1,420,866       1,694,198  
Current debt
    782,706       19,834  
Other current liabilities
    104,666       105,888  
Deferred revenue
    1,031,836       1,036,251  
Total current liabilities
    4,800,252       3,855,171  
Deferred revenue
    202,254       190,185  
Deferred tax liability, net
    191,036       151,746  
Deposits
    850,854       711,208  
Asset-backed securities debt – owed to securitization investors
    2,094,250       1,566,089  
Long-term and other debt
    1,660,739       2,163,640  
Other liabilities
    120,433       166,244  
Total liabilities
    9,919,818       8,804,283  
Commitments and contingencies
               
Stockholders’ equity:
               
Common stock, $0.01 par value; authorized, 200,000 shares; issued, 94,832 shares and 94,141 shares at September 30, 2012 and December 31, 2011, respectively
    948       941  
Additional paid-in capital
    1,429,936       1,387,773  
Treasury stock, at cost, 44,847 shares and 44,311 shares at September 30, 2012 and December 31, 2011, respectively
    (2,386,054 )     (2,320,696 )
Retained earnings
    1,469,599       1,131,004  
Accumulated other comprehensive loss
    (21,943 )     (23,056 )
Total stockholders’ equity
    492,486       175,966  
Total liabilities and stockholders’ equity
  $ 10,412,304     $ 8,980,249  
 
See accompanying notes to unaudited condensed consolidated financial statements.

 
3


ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME
 
   
Three Months Ended
September 30,
 
Nine Months Ended
 September 30,
   
2012
 
2011
 
2012
 
2011
   
(In thousands, except per share amounts)
Revenues
                   
Transaction
 
$
74,904
 
$
74,712
 
$
235,150
 
$
221,352
Redemption
   
144,144
   
141,152
   
491,795
   
424,254
Finance charges, net
   
434,824
   
365,925
   
1,188,933
   
1,040,339
Database marketing fees and direct marketing services
   
225,303
   
230,350
   
658,429
   
565,324
Other revenue
   
32,317
   
32,705
   
95,239
   
74,469
Total revenue
   
911,492
   
844,844
   
2,669,546
   
2,325,738
Operating expenses
               
Cost of operations (exclusive of depreciation and amortization disclosed separately below)
   
499,455
   
476,993
   
1,532,815
   
1,312,768
Provision for loan loss
   
81,250
   
70,697
   
183,129
   
198,739
General and administrative
   
24,584
   
26,242
   
76,115
   
68,202
Depreciation and other amortization
   
18,745
   
20,304
   
54,845
   
53,908
Amortization of purchased intangibles
   
22,987
   
22,929
   
65,009
   
60,743
Total operating expenses
   
647,021
   
617,165
   
1,911,913
   
1,694,360
Operating income
   
264,471
   
227,679
   
757,633
   
631,378
Interest expense
           
Securitization funding costs
   
23,296
   
30,233
   
68,143
   
96,281
Interest expense on deposits
   
6,753
   
5,645
   
18,719
   
16,832
Interest expense on long-term and other debt, net
   
44,316
   
38,478
   
126,222
   
111,496
Total interest expense, net
   
74,365
   
74,356
   
213,084
   
224,609
Income before income tax
 
$
190,106
 
$
153,323
 
$
544,549
 
$
406,769
Provision for income taxes
   
70,561
   
59,342
   
205,954
   
157,389
Net income
 
$
119,545
 
$
93,981
 
$
338,595
 
$
249,380
                         
Basic income per share
 
$
2.39
 
$
1.86
 
$
6.76
 
$
4.89
Diluted income per share
 
$
1.84
 
$
1.60
 
$
5.33
 
$
4.35
                         
Weighted average shares
           
Basic
   
49,939
   
50,644
   
50,086
   
50,948
Diluted
   
65,038
   
58,579
   
63,539
   
57,377
                         
 
See accompanying notes to unaudited condensed consolidated financial statements.

 
4


ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
   
2012
 
2011
 
2012
 
2011
   
(In thousands)
                     
Net income
 
$
119,545
 
$
93,981
 
$
338,595
 
$
249,380
Other comprehensive income, net of tax
                       
Net unrealized gain on securities available-for-sale, net of tax expense of $142, tax expense of $111 and tax expense of $26, tax expense of $261 for the three and nine months ended September 30, 2012 and 2011, respectively
   
3,044
   
13,989
   
4,880
   
13,045
Foreign currency translation adjustments
   
(2,107
 
7,281
   
(3,767
 
3,750
Total comprehensive income, net of tax
 
$
120,482
 
$
115,251
 
$
339,708
 
$
266,175
                         
 
See accompanying notes to unaudited condensed consolidated financial statements.

 
5


ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
   
Nine Months Ended
September 30,
 
   
2012
   
2011
 
   
(In thousands)
 
CASH FLOWS FROM OPERATING ACTIVITIES:
 
Net income                                                                                                                      
 
$
338,595
   
$
249,380
 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
Depreciation and amortization                                                                                                                   
   
119,854
     
114,651
 
Deferred income taxes                                                                                                                   
   
76,356
     
(221
Provision for loan loss                                                                                                                   
   
183,129
     
198,739
 
Non-cash stock compensation                                                                                                                   
   
37,605
     
32,471
 
Fair value gain on interest-rate derivatives                                                                                                                   
   
(22,672
)
   
(23,146
)
Amortization of discount on convertible senior notes                                                                                                                   
   
60,915
     
54,574
 
Change in operating assets and liabilities, net of acquisitions:
 
Change in trade accounts receivable                                                                                                                   
   
(9,595
   
1,188
 
Change in other assets                                                                                                                   
   
20,317
     
43,402
 
Change in accounts payable and accrued expenses                                                                                                                   
   
134,848
     
44,739
 
Change in deferred revenue                                                                                                                   
   
(36,364
   
15,869
 
Change in other liabilities                                                                                                                   
   
(25,479
)
   
37,411
 
Excess tax benefits from stock-based compensation                                                                                                                      
   
(15,237
)
   
(12,103
)
Other                                                                                                                      
   
(211
)
   
5,546
 
Net cash provided by operating activities
   
862,061
     
762,500
 
   
CASH FLOWS FROM INVESTING ACTIVITIES:
 
Change in redemption settlement assets                                                                                                                      
   
41,885
     
4,353
 
Change in restricted cash                                                                                                                      
   
(43,892
)
   
98,408
 
Change in credit card receivables                                                                                                                      
   
(418,514
)
   
160,592
 
Purchase of credit card portfolios                                                                                                                      
   
(780,153
)
   
(42,696
)
Change in cash collateral, restricted                                                                                                                      
   
101,536
     
(468,690
)
Payments for acquired businesses, net of cash                                                                                                                      
   
     
(359,076
)
Capital expenditures                                                                                                                      
   
(77,340
)
   
(48,536
)
Investments in marketable securities, net                                                                                                                      
   
(1,492
   
(68,191
)
Investments in the stock of investees                                                                                                                      
   
(921
)
   
(17,974
)
Other                                                                                                                      
   
(9,666
)
   
 
Net cash used in investing activities
   
(1,188,557
)
   
(741,810
)
   
CASH FLOWS FROM FINANCING ACTIVITIES:
 
Borrowings under debt agreements                                                                                                                      
   
699,500
     
2,858,500
 
Repayments of borrowings                                                                                                                      
   
(500,428
)
   
(2,524,729
)
Issuances of deposits                                                                                                                      
   
1,185,049
     
842,505
 
Repayments of deposits                                                                                                                      
   
(703,173
)
   
(332,600
)
Borrowings from asset-backed securities                                                                                                                      
   
1,672,962
     
1,126,921
 
Repayments/maturities of asset-backed securities                                                                                                                      
   
(1,418,133
)
   
(1,703,776
)
Payment of capital lease obligations                                                                                                                      
   
(16
)
   
(3,920
)
Payment of deferred financing costs                                                                                                                      
   
(30,930
)
   
(27,366
)
Excess tax benefits from stock-based compensation                                                                                                                      
   
15,237
     
12,103
 
Proceeds from issuance of common stock                                                                                                                      
   
15,119
     
22,942
 
Purchase of treasury shares                                                                                                                      
   
(65,358
)
   
(186,320
)
Net cash provided by financing activities
   
869,829
     
84,260
 
   
Effect of exchange rate changes on cash and cash equivalents
   
6,771
     
(4,494
)
Change in cash and cash equivalents
   
550,104
     
100,456
 
Cash and cash equivalent at beginning of period
   
216,213
     
139,114
 
Cash and cash equivalents at end of period                                                                                                                
 
$
766,317
   
$
239,570
 
   
SUPPLEMENTAL CASH FLOW INFORMATION:
 
Interest paid                                                                                                                      
 
$
149,076
   
$
177,301
 
Income taxes paid, net                                                                                                                      
 
$
91,055
   
$
87,185
 
 
See accompanying notes to unaudited condensed consolidated financial statements.
 
 
6

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation
 
The unaudited condensed consolidated financial statements included herein have been prepared by Alliance Data Systems Corporation (“ADSC” or, including its wholly owned subsidiaries and its consolidated variable interest entities, the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report filed on Form 10-K for the year ended December 31, 2011, filed with the SEC on February 27, 2012.
 
The unaudited condensed consolidated financial statements included herein reflect all adjustments (consisting of normal, recurring adjustments) which are, in the opinion of management, necessary to state fairly the results for the interim periods presented. The results of operations for the interim periods presented are not necessarily indicative of the operating results to be expected for any subsequent interim period or for the fiscal year.
 
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect (1) the reported amounts of assets; (2) liabilities and disclosure of contingent assets and liabilities at the date of the financial statements; and (3) the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
 
Effective October 1, 2012, the Company’s subsidiaries World Financial Network Bank and World Financial Capital Bank changed their names to Comenity Bank and Comenity Capital Bank, respectively. These name changes have been reflected in the Notes to the Unaudited Condensed Consolidated Financial Statements.
 
Recently Issued Accounting Standards
 
In July 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2012-02, “Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment,” which amends Accounting Standards Codification (“ASC”) 350, “Intangibles – Goodwill and Other.” ASU 2012-02 provides an option to first perform a qualitative assessment in testing an indefinite-lived intangible asset for impairment. If based on the qualitative assessment, the carrying value of the asset is more likely than not greater than the fair value, then the current quantitative impairment test must be performed. ASU 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. ASU 2012-02 only impacts the process of testing indefinite-lived intangible assets, other than goodwill, for impairment. Accordingly, the adoption of the standard in 2013 will have no impact on the Company’s financial condition, results of operations or cash flows.
 
 
7

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
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
September 30,
 
Nine Months Ended
September 30,
 
   
2012
 
2011
 
2012
 
2011
 
       
(In thousands, except per share amounts)
     
Numerator:
                     
Net Income
 
$
119,545
 
$
93,981
 
$
338,595
 
$
249,380
 
Denominator:
                 
Weighted average shares, basic
   
49,939
   
50,644
   
50,086
   
50,948
 
Weighted average effect of dilutive securities:
             
Shares from assumed conversion of convertible senior notes
   
9,033
   
5,138
   
8,378
   
4,195
 
Shares from assumed conversion of convertible note warrants
   
5,263
   
1,750
   
4,317
   
1,306
 
Net effect of dilutive stock options and unvested restricted stock
   
803
   
1,047
   
758
   
928
 
Denominator for diluted calculations
   
65,038
   
58,579
   
63,539
   
57,377
 
                           
Basic net income per share
 
$
2.39
 
$
1.86
 
$
6.76
 
$
4.89
 
Diluted net income per share
 
$
1.84
 
$
1.60
 
$
5.33
 
$
4.35
 
 
The Company calculates the effect of its convertible senior notes, consisting of $805.0 million aggregate principal amount of convertible senior notes due 2013 (the “Convertible Senior Notes 2013”) and $345.0 million aggregate principal amount of convertible senior notes due 2014 (the “Convertible Senior Notes 2014”), which can be settled in cash or shares of common stock, on diluted net income per share as if they will be settled in cash as the Company has the intent to settle the convertible senior notes for cash.
 
Concurrently with the issuance of the Convertible Senior Notes 2013 and the Convertible Senior Notes 2014, the Company entered into hedge transactions that are generally expected to offset the potential dilution of the shares from assumed conversion of convertible senior notes.
 
The Company is also party to prepaid forward contracts to purchase 1,857,400 shares of its common stock that are to be delivered over a settlement period in 2014. The number of shares to be delivered under the prepaid forward contracts is used to reduce weighted-average basic and diluted shares outstanding.
 
For the three and nine months ended September 30, 2011, the Company excluded 10.3 million warrants, respectively, from the calculation of net income per share as the effect was anti-dilutive.
 
3. CREDIT CARD RECEIVABLES
 
The Company’s credit card receivables are the only portfolio segment or class of financing receivables. Quantitative information about the components of total credit card receivables is presented in the table below:
 
   
September 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Principal receivables
 
$
6,260,239
   
$
5,408,862
 
Billed and accrued finance charges
   
264,106
     
221,357
 
Other receivables
   
54,970
     
35,792
 
Total credit card receivables
   
6,579,315
     
5,666,011
 
Less credit card receivables – restricted for securitization investors
   
5,838,099
     
4,886,168
 
Other credit card receivables
 
$
741,216
   
$
779,843
 
 
 
8

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Allowance for Loan Loss
 
The Company maintains an allowance for loan loss at a level that is appropriate to absorb probable losses inherent in credit card receivables. The allowance for loan loss covers forecasted uncollectable principal as well as unpaid interest and fees. The allowance for loan loss is evaluated monthly for adequacy.
 
In estimating the allowance for principal loan losses, management utilizes a migration analysis of delinquent and current credit card receivables. Migration analysis is a technique used to estimate the likelihood that a credit card receivable will progress through the various stages of delinquency and to charge-off. The allowance is maintained through an adjustment to the provision for loan losses. Charge-offs of principal amounts, net of recoveries are deducted from the allowance.
 
Net charge-offs include the principal amount of losses from credit cardholders unwilling or unable to pay their account balances, as well as bankrupt and deceased credit cardholders, less recoveries and exclude charged-off interest, fees and fraud losses. Charged-off interest and fees reduce finance charges, net while fraud losses are recorded as an expense. Credit card receivables, including unpaid interest and fees, are charged-off at the end of the month during which an account becomes 180 days contractually past due, except in the case of customer bankruptcies or death. Credit card receivables, including unpaid interest and fees, associated with customer bankruptcies or death are charged-off at the end of each month subsequent to 60 days after the receipt of notification of the bankruptcy or death, but in any case, not later than the 180-day contractual time frame.
 
The Company records the actual charge-offs for unpaid interest and fees as a reduction to finance charges, net. Actual charge-offs for unpaid interest and fees were $44.3 million and $43.3 million for the three months ended September 30, 2012 and 2011, respectively, and $137.5 million and $147.8 million for the nine months ended September 30, 2012 and 2011, respectively. In estimating the allowance for uncollectable unpaid interest and fees, the Company utilizes historical charge-off trends, analyzing actual charge-offs for the prior three months. The allowance is maintained through an adjustment to finance charges, net.
 
In evaluating the allowance for loan loss for both principal and unpaid interest and fees, management also considers factors that may impact loan loss experience, including seasoning, loan volume and amounts, payment rates and forecasting uncertainties. The following table presents the Company’s allowance for loan loss for the periods indicated:
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands)
 
Balance at beginning of period
 
$
432,521
   
$
461,015
   
$
468,321
   
$
518,069
 
Provision for loan loss
   
81,250
     
70,697
     
183,129
     
198,739
 
Change in estimate for uncollectible unpaid interest and fees
   
     
(5,000
           
(5,000
Recoveries
   
22,088
     
20,858
     
74,802
     
68,600
 
Principal charge-offs
   
(87,309
)
   
(93,905
)
   
(277,702
)
   
(326,743
)
Other
   
(8
)
   
(5,000
)
   
(8
)
   
(5,000
Balance at end of period
 
$
448,542
   
$
448,665
   
$
448,542
   
$
448,665
 
 
Delinquencies
 
A credit card account is contractually delinquent if the Company does not receive the minimum payment by the specified due date on the cardholder’s statement. It is the Company’s policy to continue to accrue interest and fee income on all credit card accounts beyond 90 days, except in limited circumstances, until the credit card account balance and all related interest and other fees are paid or charged off, typically at 180 days delinquent. When an account becomes delinquent, a message is printed on the credit cardholder’s billing statement requesting payment. After an account becomes 30 days past due, a proprietary collection scoring algorithm automatically scores the risk of the account becoming further delinquent. The collection system then recommends a collection strategy for the past due account based on the collection score and account balance and dictates the contact schedule and collections priority for the account. If the Company is unable to make a collection after exhausting all in-house collection efforts, the Company may engage collection agencies and outside attorneys to continue those efforts.
 
 
9

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The following table presents the delinquency trends of the Company’s credit card portfolio:
 
   
September 30,
2012
   
% of
Total
   
December 31,
2011
   
% of
Total
 
           
(In thousands, except percentages)
         
Receivables outstanding – principal
 
$
6,260,239
     
100
%
 
$
5,408,862
     
100
%
Principal receivables balances contractually delinquent:
                               
31 to 60 days
   
96,159
     
1.5
%
   
78,272
     
1.4
%
61 to 90 days
   
58,626
     
0.9
     
51,709
     
1.0
 
91 or more days
   
109,602
     
1.8
     
105,626
     
2.0
 
Total
 
$
264,387
     
4.2
%
 
$
235,607
     
4.4
%
 
Modified Credit Card Receivables
 
The Company holds certain credit card receivables for which the terms have been modified. The Company’s modified credit card receivables include credit card receivables for which temporary hardship concessions have been granted and credit card receivables in permanent workout programs. These modified credit card receivables include concessions consisting primarily of a reduced minimum payment and an interest rate reduction. The temporary programs’ concessions remain in place for a period no longer than twelve months, while the permanent programs remain in place through the payoff of the credit card receivables if the credit cardholder complies with the terms of the program. These concessions do not include the forgiveness of unpaid principal, but may involve the reversal of certain unpaid interest or fee assessments. In the case of the temporary programs, at the end of the concession period, credit card receivable terms revert to standard rates. These arrangements are automatically terminated if the customer fails to make payments in accordance with the terms of the program, at which time their account reverts back to its original terms.
 
Credit card receivables for which temporary hardship and permanent concessions were granted are collectively evaluated for impairment. Modified credit card receivables are evaluated at their present value with impairment measured as the difference between the credit card receivable balance and the discounted present value of cash flows expected to be collected. Consistent with the Company’s measurement of impairment of modified credit card receivables on a pooled basis, the discount rate used for credit card receivables is the average current annual percentage rate the Company applies to non-impaired credit card receivables, which approximates what would have been applied to the pool of modified credit card receivables prior to impairment. In assessing the appropriate allowance for loan loss, these modified credit card receivables are included in the general pool of credit cards with the allowance determined under the contingent loss model of ASC 450-20, “Loss Contingencies.” If the Company applied accounting under ASC 310-40, “Troubled Debt Restructurings by Creditors,” to the modified credit card receivables in these programs, there would not be a material difference in the allowance for loan loss.
 
The Company had $113.5 million and $122.2 million, respectively, as a recorded investment in impaired credit card receivables with an associated allowance for loan loss of $41.8 million and $45.3 million, respectively, as of September 30, 2012 and December 31, 2011. These modified credit card receivables represented less than 3% of the Company’s total credit card receivables as of September 30, 2012 and December 31, 2011, respectively.
 
The average recorded investment in the impaired credit card receivables was $111.7 million and $129.0 million for the three months ended September 30, 2012 and 2011, respectively, and $114.3 million and $133.2 million for the nine months ended September 30, 2012 and 2011, respectively.
 
Interest income on these modified credit card receivables is accounted for in the same manner as other accruing credit card receivables. Cash collections on these modified credit card receivables are allocated according to the same payment hierarchy methodology applied to credit card receivables that are not in such programs. The Company recognized $3.0 million and $3.4 million for the three months ended September 30, 2012 and 2011, respectively, and $9.1 million and $10.5 million for the nine months ended September 30, 2012 and 2011, respectively, in interest income associated with modified credit card receivables during the period that such credit card receivables were impaired.
 
 
10

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The following tables provide information on credit card receivables that entered into a modification program during the specified periods:
 
   
Three Months Ended September 30, 2012
   
Nine Months Ended September 30, 2012
 
   
Number of Restructurings
   
Pre-modification Outstanding Principal Balance
   
Post-modification
Outstanding Principal Balance
   
Number of Restructurings
   
Pre-modification Outstanding Principal Balance
   
Post-modification
Outstanding Principal Balance
 
     
(Dollars in thousands)
 
Troubled debt restructurings – credit card receivables
   
35,000
   
$
31,267
   
$
31,248
     
95,039
   
$
85,422
   
$
85,316
 
                                                 
 
   
Three Months Ended September 30, 2011
   
Nine Months Ended September 30, 2011
 
   
Number of Restructurings
   
Pre-modification Outstanding Principal Balance
   
Post-modification
Outstanding Principal Balance
   
Number of Restructurings
   
Pre-modification Outstanding Principal Balance
   
Post-modification
Outstanding Principal Balance
 
     
(Dollars in thousands)
 
Troubled debt restructurings – credit card receivables
   
36,576
   
$
32,665
   
$
32,655
     
119,614
   
$
104,483
   
$
102,419
 
                                                 
 
The tables below summarize troubled debt restructurings that have defaulted in the specified periods where the default occurred within 12 months of their modification date:
 
   
Three Months Ended
September 30, 2012
   
Nine Months Ended
September 30, 2012
 
   
Number of Restructurings
   
Outstanding Balance
   
Number of Restructurings
   
Outstanding Balance
 
   
(Dollars in thousands)
 
Troubled debt restructurings, defaulted – credit card receivables
   
12,764
   
$
12,363
     
41,971
   
$
40,524
 
                                 
 
   
Three Months Ended
September 30, 2011
   
Nine Months Ended
September 30, 2011
 
   
Number of Restructurings
   
Outstanding Balance
   
Number of Restructurings
   
Outstanding Balance
 
   
(Dollars in thousands)
 
Troubled debt restructurings, defaulted – credit card receivables
   
18,538
   
$
17,850
     
56,933
   
$
56,267
 
                                 
 
 
11

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Age of Credit Card Receivables
 
The following table sets forth, as of September 30, 2012, the number of active credit card accounts with balances and the related principal balances outstanding, based upon the age of the active credit card accounts from origination:
 
Age Since Origination
 
Number of
Active Accounts
with Balances
   
Percentage of
Active Accounts
with Balances
   
Principal
Receivables
Outstanding
   
Percentage of Receivables
Outstanding
 
   
(In thousands, except percentages)
 
0-12 Months
   
3,838
     
25.7
%
 
$
1,388,049
     
22.2
%
13-24 Months
   
1,944
     
13.0
     
733,807
     
11.7
 
25-36 Months
   
1,424
     
9.5
     
621,926
     
9.9
 
37-48 Months
   
1,139
     
7.6
     
565,294
     
9.0
 
49-60 Months
   
944
     
6.3
     
436,518
     
7.0
 
Over 60 Months
   
5,668
     
37.9
     
2,514,645
     
40.2
 
Total
   
14,957
     
100.0
%
 
$
6,260,239
     
100.0
%
 
Credit Quality
 
The Company uses proprietary scoring models developed specifically for the purpose of monitoring the Company’s obligor credit quality. The proprietary scoring models are used as a tool in the underwriting process and for making credit decisions. The proprietary scoring models are based on historical data and require various assumptions about future performance. Information regarding customer performance is factored into these proprietary scoring models to determine the probability of an account becoming 90 or more days past due at any time within the next 12 months. Obligor credit quality is monitored at least monthly during the life of an account. The following table reflects composition of the Company’s credit card receivables by obligor credit quality as of September 30, 2012:
 
Probability of an Account Becoming 90 or More Days Past Due or Becoming Charged-off (within the next 12 months)
 
Total Principal
Receivables Outstanding
   
Percentage of Principal
Receivables Outstanding
 
   
(In thousands, except percentages)
 
No Score(1) 
 
$
290,008
     
4.6
%
27.1% and higher
   
257,032
     
4.1
 
17.1% - 27.0%
   
545,755
     
8.7
 
12.6% - 17.0%
   
625,436
     
10.0
 
3.7% - 12.5%
   
2,521,231
     
40.3
 
1.9% - 3.6%
   
1,322,943
     
21.1
 
Lower than 1.9%
   
697,834
     
11.2
 
Total
 
$
6,260,239
     
100.0
%
                     
 
 (1)
Included in the No Score information is The Talbots, Inc. credit card portfolio, whose accounts have yet to be converted to the Company’s credit card processing system. The conversion is expected to be completed in the first quarter of 2013.
 
Credit Card Portfolio Acquisitions
 
During the nine months ended September 30, 2012, the Company acquired the following credit card portfolios:
 
 
• 
March 2012 – Pier 1 Imports, for a total purchase price of $97.7 million, which consisted of $96.2 million of credit card receivables and $1.5 million of intangible assets;
 
 
• 
May 2012 – Premier Designs, Inc., for a total purchase price of $24.3 million, which consisted of $22.9 million of credit card receivables and $1.4 million of intangible assets;
 
 
• 
July 2012 – The Bon-Ton Stores, Inc., for a preliminary total purchase price of $494.6 million, which remains subject to customary purchase price adjustments and consists of $444.9 million of credit card receivables and $49.7 million of intangible assets; and
 
 
• 
August 2012 – The Talbots, Inc., for a preliminary total purchase price of $163.6 million, which remains subject to customary purchase price adjustments and consists of $136.5 million of credit card receivables and $27.1 million of intangible assets.
 
The credit card receivables and intangible assets associated with these portfolios are included in the September 30, 2012 unaudited condensed consolidated balance sheet.
 
 
12

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Securitized Credit Card Receivables
 
The Company regularly securitizes its credit card receivables through its credit card securitization trusts, consisting of World Financial Network Credit Card Master Trust, World Financial Network Credit Card Master Note Trust, World Financial Network Credit Card Master Note Trust II and World Financial Network Credit Card Master Trust III (collectively, the “WFN Trusts”), and World Financial Capital Credit Card Master Note Trust (the “WFC Trust”). The Company continues to own and service the accounts that generate credit card receivables held by the WFN Trusts and the WFC Trust. In its capacity as a servicer, each of the respective banks earns a fee from the WFN Trusts and the WFC Trust to service and administer the credit card receivables, collect payments, and charge-off uncollectable receivables. These fees are eliminated and therefore are not reflected in the unaudited condensed consolidated statements of income for the three and nine months ended September 30, 2012 and 2011.
 
The WFN Trusts and the WFC Trust are variable interest entities (“VIEs”) and the assets of these consolidated VIEs include certain credit card receivables that are restricted to settle the obligations of those entities and are not expected to be available to the Company or its creditors. The liabilities of the consolidated VIEs include asset-backed secured borrowings and other liabilities for which creditors or beneficial interest holders do not have recourse to the general credit of the Company.
 
The tables below present quantitative information about the components of total securitized credit card receivables, delinquencies and net charge-offs:
 
   
September 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Total credit card receivables – restricted for securitization investors
 
$
5,838,099
   
$
4,886,168
 
Principal amount of credit card receivables – restricted for securitization investors, 90 days or more past due
 
$
102,194
   
$
94,981
 
 
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
2012
   
2011
 
2012
   
2011
 
   
(In thousands)
 
Net charge-offs of securitized principal
 
$
61,441
   
$
65,993
 
$
184,886
   
$
231,919
 
                               
 
4. REDEMPTION SETTLEMENT ASSETS
 
Redemption settlement assets consist of cash and cash equivalents and securities available-for-sale and are designated for settling redemptions by collectors of the AIR MILES® Reward Program in Canada under certain contractual relationships with sponsors of the AIR MILES Reward Program. These assets are primarily denominated in Canadian dollars. Realized gains and losses from the sale of investment securities were not material. The principal components of redemption settlement assets, which are carried at fair value, are as follows:
 
   
September 30, 2012
   
December 31, 2011
 
   
Cost
   
Unrealized
Gains
   
Unrealized
Losses
   
Fair Value
   
Cost
   
Unrealized
Gains
   
Unrealized
Losses
   
Fair Value
 
   
(In thousands)
 
Cash and cash equivalents
 
$
14,420
   
$
   
$
   
$
14,420
   
$
35,465
   
$
   
$
   
$
35,465
 
Government bonds
   
5,166
     
82
     
     
5,248
     
4,948
     
152
     
     
5,100
 
Corporate bonds
   
464,745
     
11,337
     
(51
)
   
476,031
     
468,894
     
7,416
     
(1,037
)
   
475,273
 
Total
 
$
484,331
   
$
11,419
   
$
(51
)
 
$
495,699
   
$
509,307
   
$
7,568
   
$
(1,037
)
 
$
515,838
 
 
 
13

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The following tables show the gross unrealized losses and fair value for those investments that were in an unrealized loss position as of September 30, 2012 and December 31, 2011, aggregated by investment category and the length of time that individual securities have been in a continuous loss position:
 
   
Less than 12 months
   
September 30, 2012
12 Months or Greater
   
Total
 
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
 
   
(In thousands)
 
Corporate bonds
 
$
   
$
   
$
5,039
   
$
(51
)
 
$
5,039
   
$
(51
)
Total
 
$
   
$
   
$
5,039
   
$
(51
)
 
$
5,039
   
$
(51
)
 
 
   
Less than 12 months
   
December 31, 2011
12 Months or Greater
   
Total
 
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
 
   
(In thousands)
 
Corporate bonds
 
$
65,043
   
$
(444
)
 
$
18,124
   
$
(593
)
 
$
83,167
   
$
(1,037
)
Total
 
$
65,043
   
$
(444
)
 
$
18,124
   
$
(593
)
 
$
83,167
   
$
(1,037
)
 
Market values were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the security’s issuer, and the Company’s intent to sell the security and whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis. The Company typically invests in highly-rated securities with low probabilities of default and has the ability to hold the investments until maturity. As of September 30, 2012, the Company does not consider the investments to be other-than-temporarily impaired.
 
The net carrying value and estimated fair value of the securities at September 30, 2012 by contractual maturity are as follows:
 
   
Amortized
Cost
   
Estimated
Fair Value
 
   
(In thousands)
 
Due in one year or less
 
$
91,602
   
$
91,935
 
Due after one year through five years
   
392,729
     
403,764
 
Total
 
$
484,331
   
$
495,699
 
 
 
14

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
5. INTANGIBLE ASSETS AND GOODWILL
 
Intangible Assets
 
Intangible assets consist of the following:
 
   
September 30, 2012
   
   
Gross
Assets
   
Accumulated
Amortization
   
Net
 
Amortization Life and Method
   
(In thousands)
   
Finite Lived Assets
                   
Customer contracts and lists
 
$
289,500
   
$
(140,589
)
 
$
148,911
 
3 - 12 years—straight line
Premium on purchased credit card portfolios
   
234,894
     
(98,574
)
   
136,320
 
5 - 10 years—straight line, accelerated
Customer database
   
161,700
     
(97,825
)
   
63,875
 
4 - 10 years—straight line
Collector database
   
71,153
     
(64,253
)
   
6,900
 
30 years—15% declining balance
Tradenames
   
37,644
     
(9,148
)
   
28,496
 
5 - 15 years—straight line
Purchased data lists
   
21,643
     
(15,395
)
   
6,248
 
1 - 5 years—straight line, accelerated
Noncompete agreements
   
     
     
 
2 years—straight line
   
$
816,534
   
$
(425,784
)
 
$
390,750
   
Indefinite Lived Assets
                         
Tradenames
   
12,350
     
     
12,350
 
Indefinite life
Total intangible assets
 
$
828,884
   
$
(425,784
)
 
$
403,100
   
 
 
   
December 31, 2011
   
   
Gross
Assets
   
Accumulated
Amortization
   
Net
 
Amortization Life and Method
   
(In thousands)
   
Finite Lived Assets
                   
Customer contracts and lists
 
$
314,245
   
$
(140,622
)
 
$
173,623
 
3 - 12 years—straight line
Premium on purchased credit card portfolios
   
156,203
     
(82,988
)
   
73,215
 
5 - 10 years—straight line, accelerated
Customer database
   
175,377
     
(96,363
)
   
79,014
 
4 - 10 years—straight line
Collector database
   
68,652
     
(61,091
)
   
7,561
 
30 years—15% declining balance
Tradenames
   
38,155
     
(7,411
)
   
30,744
 
5 - 15 years—straight line
Purchased data lists
   
23,776
     
(16,712
)
   
7,064
 
1 - 5 years—straight line, accelerated
Noncompete agreements
   
1,045
     
(970
)
   
75
 
2 years—straight line
   
$
777,453
   
$
(406,157
)
 
$
371,296
   
Indefinite Lived Assets
                         
Tradenames
   
12,350
     
     
12,350
 
Indefinite life
Total intangible assets
 
$
789,803
   
$
(406,157
)
 
$
383,646
   
 
With the credit card portfolio acquisitions made during the nine months ended September 30, 2012, the Company acquired $79.7 million of intangible assets consisting of $42.4 million of customer relationships being amortized over a weighted average life of 5.0 years and $37.3 million of marketing relationships being amortized over a weighted average life of 6.6 years. See Note 3, “Credit Card Receivables,” of the Notes to Unaudited Condensed Consolidated Financial Statements for additional information related to the credit card portfolio acquisitions.
 
Goodwill
 
The changes in the carrying amount of goodwill for the nine months ended September 30, 2012 are as follows:
 
   
LoyaltyOne®
   
Epsilon®
   
Private Label
Services and
Credit
   
Corporate/
Other
   
Total
 
   
(In thousands)
 
December 31, 2011
 
$
241,697
   
$
945,934
   
$
261,732
   
$
   
$
1,449,363
 
Effects of foreign currency translation
   
8,394
     
943
     
     
     
9,337
 
September 30, 2012
 
$
250,091
   
$
946,877
   
$
261,732
   
$
   
$
1,458,700
 
 
 
15

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
6. DEBT
 
Debt consists of the following:
 
Description
 
September 30,
2012
   
December 31,
2011
 
Maturity
 
Interest Rate
   
(Dollars in thousands)
       
Deposits:
                     
Certificates of deposit
 
$
1,690,623
   
$
1,353,775
 
Various - October 2012 – September 2019
 
0.20% to 5.25%
Money market deposits
   
145,029
     
 
On demand
 
0.01% to 0.23%
Total deposits
   
1,835,652
     
1,353,775
       
Less: current portion
   
(984,798
)
   
(642,567
)
     
Long-term portion
 
$
850,854
   
$
711,208
       
                   
Asset-backed securities debt – owed to securitization investors:
                     
Fixed rate asset-backed term note securities
 
$
2,069,515
   
$
1,562,815
 
Various - October 2012 – March 2019
 
1.68% to 7.00%
Floating rate asset-backed term note securities
   
588,150
     
703,500
 
Various - October 2012 – April 2013
 
(1)
Conduit asset-backed securities
   
857,451
     
993,972
 
Various - May 2013 – March 2014
 
1.23% to 1.76%
Total asset-backed securities – owed to securitization investors
   
3,515,116
     
3,260,287
       
Less: current portion
   
(1,420,866
)
   
(1,694,198
)
     
Long-term portion
 
$
2,094,250
   
$
1,566,089
       
                   
Long-term and other debt:
                 
2011 credit facility
 
$
   
$
410,000
 
May 2016
 
—%
2011 term loan
   
891,666
     
782,594
 
May 2016 or May 2017
 
(2)
Senior notes due 2020
   
500,000
     
 
April 2020
 
6.38%
Convertible senior notes due 2013
   
753,999
     
711,480
 
August 2013
 
1.75%
Convertible senior notes due 2014
   
297,761
     
279,365
 
May 2014
 
4.75%
Capital lease obligations
   
19
     
35
 
July 2013
 
7.10%
Total long-term and other debt
   
2,443,445
     
2,183,474
       
Less: current portion
   
(782,706
)
   
(19,834
)
     
Long-term portion
 
$
1,660,739
   
$
2,163,640
       
                         
 
(1)
Interest rates include those for certain of the Company’s asset-backed securities – owed to securitization investors where floating rate debt is fixed through interest rate swap agreements. The interest rate for the floating rate debt is equal to the London Interbank Offered Rate plus a margin of 0.1% to 2.5%, each as defined in the respective agreements. The weighted average interest rate of the fixed rate achieved through interest rate swap agreements is 5.64% at September 30, 2012.
 
(2)
At September 30, 2012, the weighted average interest rate for the 2011 Term Loan was 2.22%.
 
At September 30, 2012, the Company was in compliance with its covenants.
 
Deposits
 
Beginning January 1, 2012, Comenity Bank and Comenity Capital Bank, subsidiaries of the Company, offered a demand deposit program through contractual arrangements with securities brokerage firms. As of September 30, 2012, Comenity Bank and Comenity Capital Bank had issued $145.0 million in money market deposits. Money market deposits are redeemable on demand by the customer and, as such, have no scheduled maturity date.
 
Credit Agreement
 
The Company, as borrower, and ADS Alliance Data Systems, Inc., ADS Foreign Holdings, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Marketing Services, LLC, Epsilon Data Management LLC, Comenity LLC and Alliance Data FHC, Inc., as guarantors, are party to a credit agreement that originally provided for a $792.5 million term loan (the “2011 Term Loan”) and a $792.5 million revolving line of credit (the “2011 Credit Facility”).
 
In March 2012, the Company entered into a second amendment (the “Second Amendment”) to its credit agreement, dated May 24, 2011 (the “Credit Agreement”), through which the Company increased its 2011 Credit Facility by $125.0 million to $917.5 million. In addition, in March 2012, the Company borrowed additional term loans in the aggregate principal amount of $125.5 million, increasing the 2011 Term Loan to $903.1 million.
 
 
16

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The Second Amendment, among other things, (i) extends the maturity date of certain term loans under the Credit Agreement from May 24, 2016 to May 24, 2017, (ii) creates a mechanism by which in the future non-extending term loan lenders may extend their term loans to May 24, 2017, (iii) reflects the additional term loans and the increase in the revolving credit commitments and (iv) provides for aggregate principal payments equal to 5% of the extended term loan amount in the additional year of the extended term loans, payable in equal quarterly installments. Total availability under the 2011 Credit Facility at September 30, 2012 was $917.5 million.
 
Senior Notes Due 2020
 
In March 2012, the Company issued and sold $500 million aggregate principal amount of 6.375% senior notes due April 1, 2020 (the “Senior Notes due 2020”). The Senior Notes due 2020 accrue interest on the principal amount at the rate of 6.375% per annum from March 29, 2012, payable semiannually in arrears, on April 1 and October 1 of each year, beginning on October 1, 2012.
 
The payment obligations under the Senior Notes due 2020 are governed by an indenture dated March 29, 2012 with Wells Fargo Bank, N.A., as trustee. The Senior Notes due 2020 are unsecured and are guaranteed on a senior unsecured basis by certain of the Company’s existing and future domestic subsidiaries that guarantee its Credit Agreement, initially ADS Alliance Data Systems, Inc., ADS Foreign Holdings, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Marketing Services, LLC, Epsilon Data Management LLC, Comenity LLC and Alliance Data FHC, Inc. The indenture includes usual and customary negative covenants and events of default for transactions of this type.
 
Convertible Senior Notes
 
The Company has outstanding $1.15 billion of convertible senior notes, consisting of $805.0 million scheduled to mature on August 1, 2013 and $345.0 million scheduled to mature on May 15, 2014. The table below summarizes the carrying value of the components of the convertible senior notes:
 
   
September 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Carrying amount of equity component
 
$
368,678
   
$
368,678
 
                 
Principal amount of liability component
 
$
1,150,000
   
$
1,150,000
 
Unamortized discount
   
(98,240
)
   
(159,155
)
Net carrying value of liability component
 
$
1,051,760
   
$
990,845
 
                 
If-converted value of common stock
 
$
2,485,284
   
$
1,818,048
 
 
The discount on the liability component will be amortized as interest expense over the remaining life of the convertible senior notes which, at September 30, 2012, is a weighted average period of 1.1 years.
 
Interest expense on the convertible senior notes recognized in the Company’s unaudited condensed consolidated statements of income for the three and nine months ended September 30, 2012 and 2011 is as follows:
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
2012
   
2011
 
2012
   
2011
 
   
(In thousands, except percentages)
 
Interest expense calculated on contractual interest rate
 
$
7,619
   
$
7,619
 
$
22,856
   
$
22,856
 
Amortization of discount on liability component
   
20,865
     
18,692
   
60,915
     
54,574
 
Total interest expense on convertible senior notes
 
$
28,484
   
$
26,311
 
$
83,771
   
$
77,430
 
                               
Effective interest rate (annualized)
   
11.0
%
   
11.0
%
 
11.0
%
   
11.0
%
 
In the third quarter of 2012, the convertible senior notes were convertible at the option of the holder based on the condition that the common stock trading price exceeded 130% of the applicable conversion price. During the third quarter, a de minimis amount were surrendered for conversion and, in each case, either have been or will be settled in cash following the completion of the applicable cash settlement averaging period.
 
 
17

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Asset-backed Securities – Owed to Securitization Investors
 
Asset-backed Term Notes
 
In April 2012, World Financial Network Credit Card Master Note Trust issued $550.0 million of term asset-backed securities to investors. The offering consisted of $412.5 million of Class A Series 2012-A asset-backed term notes that have a fixed interest rate of 3.14% per year and mature in March 2019. In addition, the Company retained an aggregate of $137.5 million of subordinated classes of the term asset-backed notes which have been eliminated from the Company’s unaudited condensed consolidated financial statements.
 
In July 2012, $395.0 million of Class A Series 2009-B asset-backed term notes with a fixed interest rate of 3.79% matured.
 
In July 2012, World Financial Network Credit Card Master Note Trust issued $433.3 million of term asset-backed securities to investors. The offering consisted of $325.0 million of Class A Series 2012-B asset-backed term notes that have a fixed interest rate of 1.76% per year and mature in July 2017. In addition, the Company retained an aggregate of $108.3 million of subordinated classes of the term asset-backed notes which have been eliminated from the Company’s unaudited condensed consolidated financial statements.
 
In July 2012, World Financial Network Credit Card Master Note Trust issued $266.7 million of term asset-backed securities to investors, which will mature in October 2018. The offering consisted of the following:
 
 
$200.0 million of Class A Series 2012-C asset-backed notes with a fixed interest rate of 2.23% per year;
 
 
$10.0 million of Class M Series 2012-C asset-backed notes with a fixed interest rate of 3.32% per year;
 
 
$12.7 million of Class B Series 2012-C asset-backed notes with a fixed interest rate of 3.57% per year;
 
 
$33.3 million of Class C Series 2012-C asset-backed notes with a fixed interest rate of 4.55% per year; and
 
 
$10.7 million of Class D Series 2012-C asset-backed notes which were retained by the Company and have been eliminated from the Company’s unaudited condensed consolidated financial statements.
 
Conduit Facilities
 
In June 2012, the Company renewed its $1.2 billion 2009-VFN conduit facility under World Financial Network Credit Card Master Note Trust, extending its maturity to March 5, 2014. Also, in June 2012, the Company renewed its 2009-VFN conduit facility under World Financial Capital Master Note Trust, extending the maturity to May 31, 2013 and increasing the total capacity from $275.0 million to $375.0 million.
 
In September 2012, the Company renewed its $330.0 million 2009-VFC1 conduit facility under World Financial Network Credit Card Master Note Trust III, extending its maturity to September 27, 2013.
 
Derivative Financial Instruments
 
As part of its interest rate risk management program, the Company may enter into derivative financial instruments with institutions that are established dealers to manage its exposure to changes in interest rates for certain obligations.
 
The credit card securitization trusts enter into derivative financial instruments, which include both interest rate swaps and an interest rate cap, to mitigate their interest rate risk on a related financial instrument or to lock the interest rate on a portion of their variable asset-backed securities debt.
 
These interest rate contracts involve the receipt of variable rate amounts from counterparties in exchange for the Company making fixed rate payments over the life of the agreement without the exchange of the underlying notional amount. These interest rate contracts are not designated as hedges. Such contracts are not speculative and are used to manage interest rate risk, but do not meet the specific hedge accounting requirements of ASC 815, “Derivatives and Hedging.”
 
 
18

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The following tables identify the notional amount, fair value and classification of the Company’s outstanding interest rate contracts at September 30, 2012 and December 31, 2011 in the unaudited condensed consolidated balance sheets:
 
   
September 30, 2012
    December 31, 2011  
   
Notional Amount
   
Weighted Average Years to Maturity
    Notional Amount    
Weighted Average Years to Maturity
 
   
(Dollars in thousands)
Interest rate contracts not designated as hedging instruments
 
$
588,150
    0.72  
$
703,500
    1.37  
                               
 
   
September 30, 2012
    December 31, 2011  
   
Balance Sheet
Location
   
Fair Value
 
  Balance Sheet
Location
   
Fair Value
 
   
(In thousands)
Interest rate contracts not designated as hedging instruments
 
Other assets
   
$
5
 
Other assets
   
$
 
Interest rate contracts not designated as hedging instruments
 
Other current liabilities
   
$
15,436
 
Other current liabilities
   
$
4,739
 
Interest rate contracts not designated as hedging instruments
 
Other liabilities
   
$
 
Other liabilities
   
$
33,364
 
                               
 
The following table summarizes activity related to and identifies the location of the Company’s outstanding interest rate contracts for the three and nine months ended September 30, 2012 and 2011 recognized in the unaudited condensed consolidated statements of income:
 
   
2012
  2011  
For the three months ended September 30,
 
Income Statement
Location
   
Gain on Derivative Contracts
 
Income Statement
Location
   
Gain on Derivative Contracts
 
   
(In thousands)
 
Interest rate contracts not designated as hedging instruments
 
Securitization
funding costs
   
$
7,488
 
Securitization
funding costs
   
$
8,543
 
                               
For the nine months ended September 30,
                             
Interest rate contracts not designated as hedging instruments
 
Securitization
funding costs
   
$
22,672
 
Securitization
funding costs
   
$
23,146
 
                               
 
The Company limits its exposure on derivatives by entering into contracts with institutions that are established dealers who maintain certain minimum credit criteria established by the Company. At September 30, 2012, the Company does not maintain any derivative contracts subject to master agreements that would require the Company to post collateral or that contain any credit-risk related contingent features. The Company has provisions in certain of the master agreements that require counterparties to post collateral to the Company when their credit ratings fall below certain thresholds. At September 30, 2012, these thresholds were not breached and no amounts were held as collateral by the Company.
 
 
19

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
7. DEFERRED REVENUE
 
Because management has determined that the earnings process is not complete at the time an AIR MILES reward mile is issued, the recognition of revenue on all fees received at issuance is deferred. The Company allocates the proceeds from the issuance of AIR MILES reward miles into two components as follows:
 
 
• 
Redemption element. The redemption element is the larger of the two components. Revenue related to the redemption element is based on the estimated fair value. For this component, revenue is recognized at the time an AIR MILES reward mile is redeemed, or for those AIR MILES reward miles that are estimated to go unredeemed by the collector base, known as “breakage,” over the estimated life of an AIR MILES reward mile, or a period of 42 months. The Company’s estimate of breakage is 28%.
 
 
• 
Service element. The service element consists of marketing and administrative services. Revenue related to the service element is determined in accordance with ASU 2009-13, “Multiple Deliverable Revenue Arrangements.” It is initially deferred and then amortized pro rata over the estimated life of an AIR MILES reward mile. With the adoption of ASU 2009-13, the residual method will no longer be utilized for new sponsor agreements entered into on or after January 1, 2011 or existing sponsor agreements that are materially modified subsequent to that date; for these agreements, the Company will measure the service element at its estimated selling price.
 
Under certain of the Company’s contracts, a portion of the proceeds is paid to the Company upon the issuance of an AIR MILES reward mile and a portion is paid at the time of redemption and therefore, the Company does not have a redemption obligation related to these contracts. Revenue is recognized at the time of redemption and is not reflected in the reconciliation of the redemption obligation detailed below. Under such contracts, the proceeds received at issuance are initially deferred as service revenue and revenue is recognized pro rata over the estimated life of an AIR MILES reward mile. Amounts for revenue related to the redemption element and service element are recorded in redemption revenue and transaction revenue, respectively, in the unaudited condensed consolidated statements of income.
 
A reconciliation of deferred revenue for the AIR MILES Reward Program is as follows:
 
   
Deferred Revenue
 
   
Service
   
Redemption
   
Total
 
   
(In thousands)
 
December 31, 2011
 
$
358,973
   
$
867,463
   
$
1,226,436
 
Cash proceeds
   
168,367
     
404,743
     
573,110
 
Revenue recognized
   
(151,492
)
   
(458,324
)
   
(609,816
)
Other
   
     
366
     
366
 
Effects of foreign currency translation
   
13,393
     
30,601
     
43,994
 
September 30, 2012
 
$
389,241
   
$
844,849
   
$
1,234,090
 
Amounts recognized in the unaudited condensed consolidated balance sheets:
                       
Current liabilities
 
$
186,987
   
$
844,849
   
$
1,031,836
 
Non-current liabilities
 
$
202,254
   
$
   
$
202,254
 
 
Effective from December 31, 2011, LoyaltyOne implemented an expiry policy, with all existing and future AIR MILES reward miles having an expiry of five years.
 
In December 2011, LoyaltyOne introduced a new program option, AIR MILES Cash, to which collectors, beginning in the first quarter of 2012, can allocate some or all of their future AIR MILES reward miles collected. Effective March 2012, AIR MILES Cash enabled collectors to instantly redeem their AIR MILES reward miles collected in this new program in-store towards purchases at participating sponsors. The implementation of AIR MILES Cash did not have a material impact to the Company.
 
 
20

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
8. STOCKHOLDERS’ EQUITY
 
Stock Repurchase Program
 
On December 13, 2011, the Company’s Board of Directors authorized a stock repurchase program to acquire up to $400.0 million of the Company’s outstanding common stock from January 1, 2012 through December 31, 2012, subject to any restrictions pursuant to the terms of the Company’s credit agreements or otherwise.
 
For the nine months ended September 30, 2012, the Company acquired a total of 536,241 shares of its common stock for $65.4 million. As of September 30, 2012, the Company has $334.6 million available under the stock repurchase program.
 
Stock Compensation Expense
 
Total stock-based compensation expense recognized in the Company’s unaudited condensed consolidated statements of income for the three and nine months ended September 30, 2012 and 2011 is as follows:
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
2012
   
2011
 
2012
   
2011
 
   
(In thousands)
 
Cost of operations
 
$
8,343
   
$
7,762
 
$
23,864
   
$
19,672
 
General and administrative
   
4,076
     
4,519
   
13,741
     
12,799
 
Total
 
$
12,419
   
$
12,281
 
$
37,605
   
$
32,471
 
 
During the nine months ended September 30, 2012, the Company awarded 328,759 performance-based restricted stock units with a weighted average grant date fair value per share of $120.00 as determined on the date of grant. The performance restriction on the awards will lapse upon determination by the Board of Directors or the Compensation Committee of the Board of Directors that the Company’s earnings before taxes for the period from January 1, 2012 to December 31, 2012 met certain pre-defined vesting criteria that permit a range from 50% to 150% of such performance-based restricted stock units to vest. Upon such determination, the restrictions will lapse with respect to 33% of the award on February 21, 2013, an additional 33% of the award on February 21, 2014 and the final 34% of the award on February 23, 2015, provided that the participant is employed by the Company on each such vesting date.
 
During the nine months ended September 30, 2012, the Company awarded 108,418 service-based restricted stock units with a weighted average grant date fair value per share of $122.10 as determined on the date of grant. Service-based restricted stock units typically vest ratably over three years provided that the participant is employed by the Company on each such vesting date.
 
9. FINANCIAL INSTRUMENTS
 
In accordance with ASC 825, “Financial Instruments,” the Company is required to disclose the fair value of financial instruments for which it is practical to estimate fair value. To obtain fair values, observable market prices are used if available. In some instances, observable market prices are not readily available and fair value is determined using present value or other techniques appropriate for a particular financial instrument. These techniques involve judgment and as a result are not necessarily indicative of the amounts the Company would realize in a current market exchange. The use of different assumptions or estimation techniques may have a material effect on the estimated fair value amounts.
 
 
21

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Fair Value of Financial Instruments  The estimated fair values of the Company’s financial instruments are as follows:
 
   
September 30, 2012
   
December 31, 2011
 
   
Carrying
Amount
   
Fair
Value
   
Carrying
Amount
   
Fair
Value
 
   
(In thousands)
 
Financial assets
                       
Cash and cash equivalents
 
$
766,317
   
$
766,317
   
$
216,213
   
$
216,213
 
Trade receivables, net
   
287,643
     
287,643
     
300,895
     
300,895
 
Credit card receivables, net
   
6,130,773
     
6,130,773
     
5,197,690
     
5,197,690
 
Redemption settlement assets, restricted
   
495,699
     
495,699
     
515,838
     
515,838
 
Cash collateral, restricted
   
62,205
     
62,205
     
158,727
     
158,727
 
Other investment securities
   
72,185
     
72,185
     
26,772
     
26,772
 
Derivative financial instruments
   
5
     
5
     
     
 
Financial liabilities
                               
Accounts payable
   
236,891
     
236,891
     
149,812
     
149,812
 
Deposits
   
1,835,652
     
1,856,060
     
1,353,775
     
1,372,670
 
Asset-backed securities debt – owed to securitization investors
   
3,515,116
     
3,602,686
     
3,260,287
     
3,302,687
 
Long-term and other debt
   
2,443,445
     
3,934,937
     
2,183,474
     
3,071,661
 
Derivative financial instruments
   
15,436
     
15,436
     
38,103
     
38,103
 
 
Fair Value of Assets and Liabilities Held at September 30, 2012 and December 31, 2011
 
The following techniques and assumptions were used by the Company in estimating fair values of financial instruments as disclosed herein:
 
Cash and cash equivalents, trade receivables, net and accounts payable The carrying amount approximates fair value due to the short maturity and the relatively liquid nature of these assets and liabilities.
 
Credit card receivables, net — The carrying amount of credit card receivables, net approximates fair value due to the short maturity, and the average interest rates approximate current market origination rates.
 
Redemption settlement assets, restricted — Redemption settlement assets, restricted consists of cash and cash equivalents and marketable securities. The fair value for securities is based on quoted market prices for the same or similar securities.
 
Cash collateral, restricted — The spread deposits are recorded at their fair value based on discounted cash flow models. The Company uses a valuation model that calculates the present value of estimated cash flows for each asset. The fair value is based on the term of the underlying securities and a discount rate. The carrying amount of excess funding deposits approximates its fair value due to the relatively short maturity period and average interest rates, which approximate current market rates.
 
Other investment securities — Other investment securities consist primarily of restricted cash and marketable securities. The fair value is based on quoted market prices for the same or similar securities.
 
Deposits — The fair value is estimated based on the current observable market rates available to the Company for similar deposits with similar remaining maturities.
 
Asset-backed securities debt – owed to securitization investors — The fair value is estimated based on the current observable market rates available to the Company for similar debt instruments with similar remaining maturities or quoted market prices for the same transaction.
 
Long-term and other debt — The fair value is estimated based on the current observable market rates available to the Company for similar debt instruments with similar remaining maturities or quoted market prices for the same transaction.
 
Derivative financial instruments —The valuation of these instruments is determined using a discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and option volatility.
 
 
22

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Financial Assets and Financial Liabilities Fair Value Hierarchy
 
ASC 825 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include:
 
 
Level 1, defined as observable inputs such as quoted prices in active markets;
 
 
Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and
 
 
Level 3, defined as unobservable inputs where little or no market data exists, therefore requiring an entity to develop its own assumptions.
 
Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial instruments also include those for which the determination of fair value requires significant management judgment or estimation. The use of different techniques to determine fair value of these financial instruments could result in different estimates of fair value at the reporting date.
 
The following table provides information for the assets and liabilities carried at fair value measured on a recurring basis as of September 30, 2012 and December 31, 2011:
 
   
Fair Value Measurements Using Inputs Considered as
 
   
Level 1
   
Level 2
   
Level 3
 
   
September 30,
2012
   
December 31,
2011
   
September 30,
2012
   
December 31,
2011
   
September 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Government bonds(1) 
  $     $     $ 5,248     $ 5,100     $     $  
Corporate bonds(1) 
    6,200       21,346       469,831       453,927              
Cash collateral, restricted
                            62,205       158,727  
Other investment securities(2)
    49,094       3,043       23,091       23,729              
Derivative financial instruments(3)
                5                    
Total assets measured at fair value
  $ 55,294     $ 24,389     $ 498,175     $ 482,756     $ 62,205     $ 158,727  
                                                 
Derivative financial instruments(3)
  $     $     $ 15,436     $ 38,103     $     $  
Total liabilities measured at fair value
  $     $     $ 15,436     $ 38,103     $     $  
                                                   
 
(1)
Amounts are included in redemption settlement assets in the unaudited condensed consolidated balance sheets.
 
(2)
Amounts are included in other current assets and other non-current assets in the unaudited condensed consolidated balance sheets.
 
(3)
Amounts are included in other assets, other current liabilities and other liabilities in the unaudited condensed consolidated balance sheets.
 
 
23

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The following tables summarize the changes in fair value of the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as defined in ASC 825 as of September 30, 2012 and 2011:
 
   
Cash Collateral, Restricted
 
   
(In thousands)
 
June 30, 2012
 
$
122,395
 
Total gains (realized or unrealized):
       
Included in earnings
   
995
 
Purchases
   
1,287
 
Settlements
   
(62,472
)
Transfers in or out of Level 3
   
 
September 30, 2012
 
$
62,205
 
         
Gains for the period included in earnings related to assets still held at September 30, 2012
 
$
995
 
 
 
   
Cash Collateral, Restricted
 
   
(In thousands)
 
December 31, 2011
 
$
158,727
 
Total gains (realized or unrealized):
       
Included in earnings
   
5,014
 
Purchases
   
1,287
 
Settlements
   
(102,823
)
Transfers in or out of Level 3
   
 
September 30, 2012
 
$
62,205
 
         
Gains for the period included in earnings related to assets still held at September 30, 2012
 
$
5,014
 
 
 
   
Cash Collateral, Restricted
 
   
(In thousands)
 
June 30, 2011
 
$
175,826
 
Total losses (realized or unrealized):
       
Included in earnings
   
(311
)
Purchases
   
11,656
 
Settlements
   
(29,457
)
Transfers in or out of Level 3
   
 
September 30, 2011
 
$
157,714
 
         
Losses for the period included in earnings related to assets still held at September 30, 2011
 
$
(311
)
 
 
24

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
   
Cash Collateral, Restricted
 
   
(In thousands)
 
December 31, 2010
 
$
185,754
 
Total gains (realized or unrealized):
       
Included in earnings
   
147
 
Purchases
   
13,947
 
Settlements
   
(42,134
)
Transfers in or out of Level 3
   
 
September 30, 2011
 
$
157,714
 
         
Gains for the period included in earnings related to assets still held at September 30, 2011
 
$
147
 
 
The spread deposits included in cash collateral, restricted are recorded at their fair value based on discounted cash flow models, utilizing the respective term of each instrument which ranged from 7 to 49 months, with a weighted average term of 21 months. The unobservable input used to calculate the fair value was the discount rate of 3.2%, which was based on an interest rate curve that is observable in the market as adjusted for a credit spread. Significant increases (decreases) in the term or the discount rate would result in a lower (higher) fair value.
 
For the three and nine months ended September 30, 2012 and 2011, gains and losses included in earnings attributable to cash collateral, restricted are included in interest in the unaudited condensed consolidated statements of income.
 
Financial Instruments Disclosed but Not Carried at Fair Value
 
The following table provides assets and liabilities disclosed but not carried at fair value as of September 30, 2012:
 
   
Fair Value Measurements at
September 30, 2012
 
   
Total
   
Level 1
   
Level 2
   
Level 3
 
   
(In thousands)
 
Cash and cash equivalents
 
$
766,317
   
$
766,317
   
$
   
$
 
Credit card receivables, net
   
6,130,773
     
     
     
6,130,773
 
Total assets
 
$
6,897,090
   
$
766,317
   
$
   
$
6,130,773
 
                                 
Deposits
 
$
1,856,060
   
$
   
$
1,856,060
   
$
 
Asset-backed securities debt - owed to securitization investors
   
3,602,686
     
     
3,602,686
     
 
Long-term and other debt
   
3,934,937
     
     
3,934,937
     
 
Total liabilities
 
$
9,393,683
   
$
   
$
9,393,683
   
$
 
 
10. INCOME TAXES
 
For the three and nine months ended September 30, 2012, the Company utilized an effective tax rate of 37.1% and 37.8%, respectively, to calculate its provision for income taxes. For the three and nine months ended September 30, 2011, the Company utilized an effective tax rate of 38.7%, in each case, to calculate its provision for income taxes. In accordance with ASC 740-270, “Income Taxes — Interim Reporting,” the Company’s expected annual effective tax rate for calendar year 2012 based on all known variables is 38.1%.
 
 
25

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

11. SEGMENT INFORMATION
 
The Company operates in three reportable segments: LoyaltyOne, Epsilon and Private Label Services and Credit.
 
 
LoyaltyOne includes the Company’s Canadian AIR MILES Reward Program;
 
 
Epsilon provides integrated direct marketing solutions that combine database marketing technology and analytics with a broad range of direct marketing services; and 
 
 
Private Label Services and Credit provides risk management solutions, account origination, funding, transaction processing, customer care and collections services for the Company's private label retail credit card programs.
 
Effective December 31, 2011, interest expense, net was allocated to each of the respective segments. All prior year segment information has been restated to conform to the current year presentation.
 
Additionally, corporate and all other immaterial businesses are reported collectively as an “all other” category labeled “Corporate/Other.” Income taxes are not allocated to the segments in the computation of segment operating profit for internal evaluation purposes and have also been included in “Corporate/Other.” Total assets are not allocated to the segments.
 
Three Months Ended September 30, 2012
 
LoyaltyOne
   
Epsilon
   
Private Label
Services and Credit
   
Corporate/ Other
   
Eliminations
   
Total
 
   
(In thousands)
 
Revenues
 
$
215,654
   
$
240,820
   
$
455,939
   
$
80
   
$
(1,001
)
 
$
911,492
 
Adjusted EBITDA(1) 
   
60,334
     
64,244
     
214,476
     
(20,432
)
   
     
318,622
 
Stock compensation expense
   
2,408
     
3,549
     
2,386
     
4,076
     
     
12,419
 
Depreciation and amortization
   
4,834
     
24,821
     
11,267
     
810
     
     
41,732
 
Operating income (loss)
   
53,092
     
35,874
     
200,823
     
(25,318
)
   
     
264,471
 
Interest expense, net
   
(533
)
   
(10
)
   
29,217
     
45,691
     
     
74,365
 
Income (loss) before income taxes
   
53,625
     
35,884
     
171,606
     
(71,009
)
   
     
190,106
 

Three Months Ended September 30, 2011
 
LoyaltyOne
   
Epsilon
   
Private Label
Services and Credit
   
Corporate/ Other
   
Eliminations
   
Total
 
   
(In thousands)
 
Revenues
 
$
209,634
   
$
248,405
   
$
389,051
   
$
211
   
$
(2,457
)
 
$
844,844
 
Adjusted EBITDA(1) 
   
59,920
     
58,528
     
187,712
     
(21,513
)
   
(1,454
)
   
283,193
 
Stock compensation expense
   
2,047
     
3,617
     
2,098
     
4,519
     
     
12,281
 
Depreciation and amortization
   
5,130
     
24,899
     
8,950
     
4,254
     
     
43,233
 
Operating income (loss)
   
52,743
     
30,012
     
176,664
     
(30,286
)
   
(1,454
)
   
227,679
 
Interest expense, net
   
(151
)
   
(19
)
   
35,708
     
40,272
     
(1,454
)
   
74,356
 
Income (loss) before income taxes
   
52,894
     
30,031
     
140,956
     
(70,558
)
   
     
153,323
 
 
 
Nine Months Ended September 30, 2012
 
LoyaltyOne
   
Epsilon
   
Private Label
Services and Credit
   
Corporate/ Other
   
Eliminations
   
Total
 
   
(In thousands)
 
Revenues
 
$
703,013
   
$
704,228
   
$
1,265,782
   
$
372
   
$
(3,849
)
 
$
2,669,546
 
Adjusted EBITDA(1) 
   
179,300
     
152,845
     
644,956
     
(62,009
)
   
     
915,092
 
Stock compensation expense
   
6,777
     
10,599
     
6,488
     
13,741
     
     
37,605
 
Depreciation and amortization
   
14,920
     
74,043
     
28,614
     
2,277
     
     
119,854
 
Operating income (loss)
   
157,603
     
68,203
     
609,854
     
(78,027
)
   
     
757,633
 
Interest expense, net
   
(895
)
   
(47
)
   
83,537
     
130,489
     
     
213,084
 
Income (loss) before income taxes
   
158,498
     
68,250
     
526,317
     
(208,516
)
   
     
544,549
 
 
 
26

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Nine Months Ended September 30, 2011
 
LoyaltyOne
   
Epsilon
   
Private Label
Services and Credit
   
Corporate/ Other
   
Eliminations
   
Total
 
   
(In thousands)
 
Revenues
 
$
630,470
   
$
592,545
   
$
1,108,679
   
$
924
   
$
(6,880
)
 
$
2,325,738
 
Adjusted EBITDA(1) 
   
171,114
     
131,518
     
534,713
     
(54,483
)
   
(4,362
)
   
778,500
 
Stock compensation expense
   
5,379
     
8,765
     
5,528
     
12,799
     
     
32,471
 
Depreciation and amortization
   
15,564
     
65,519
     
26,818
     
6,750
     
     
114,651
 
Operating income (loss)
   
150,171
     
57,234
     
502,367
     
(74,032
)
   
(4,362
)
   
631,378
 
Interest expense, net
   
(223
)
   
(55
)
   
108,372
     
120,877
     
(4,362
)
   
224,609
 
Income (loss) before income taxes
   
150,394
     
57,289
     
393,995
     
(194,909
)
   
     
406,769
 
         
 
(1)
Adjusted EBITDA is a non-GAAP financial measure equal to net income, the most directly comparable GAAP financial measure, plus stock compensation expense, provision for income taxes, interest expense, net, depreciation and other amortization and amortization of purchased intangibles. Adjusted EBITDA is presented in accordance with ASC 280, “Segment Reporting,” as it is the primary performance metric utilized to access performance of the segment.
 
12. DISCONTINUED OPERATIONS
 
In November 2009, the Company terminated operations of its credit program for web and catalog retailer VENUE. This has been treated as a discontinued operation under ASC 205-20, “Presentation of Financial Statements — Discontinued Operations.” The underlying assets of the discontinued operation for the periods presented in the unaudited condensed consolidated balance sheets are as follows:
 
   
September 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Assets:
           
Credit card receivables, net
 
$
   
$
2,439
 
Assets of discontinued operations
 
$
   
$
2,439
 
 
13. SUBSEQUENT EVENT
 
In October 2012, World Financial Network Credit Card Master Note Trust issued $466.7 million of term asset-backed securities to investors, which will mature in June 2019. The offering consisted of the following:
 
 
$350.0 million of Class A Series 2012-D asset-backed notes with a fixed interest rate of 2.15% per year;
 
 
$17.5 million of Class M Series 2012-D asset-backed notes with a fixed interest rate of 3.09% per year;
 
 
$22.2 million of Class B Series 2012-D asset-backed notes with a fixed interest rate of 3.34% per year; and 
 
 
$77.0 million of Class C and Class D Series 2012-D asset-backed notes which were retained by the Company and have been eliminated from the Company's unaudited condensed consolidated financial statements.
 
 
27

 
Item 2.
 
The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and related notes thereto presented in this quarterly report and the consolidated financial statements and related notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011, filed with the Securities and Exchange Commission, or SEC, on February 27, 2012.
 
Year in Review Highlights
 
For the nine months ended September 30, 2012, revenue increased 14.8% to $2.7 billion and adjusted EBITDA increased 17.5% to $915.1 million as compared to the prior year period. See below for discussion of operating results for each of our three segments.
 
LoyaltyOne®
 
Revenue increased 11.5% to $703.0 million and adjusted EBITDA increased 4.8% to $179.3 million for the nine months ended September 30, 2012 as compared to the same period in 2011.
 
The LoyaltyOne segment generates revenue primarily from our coalition loyalty program in Canada and, as such, the segment can be impacted by changes in the foreign currency exchange rate between the U.S. dollar and the Canadian dollar. A weaker Canadian dollar negatively impacted the results of operations for the nine months ended September 30, 2012, as the average foreign currency exchange rate was $1.00 as compared to $1.02 in the prior year period, which lowered revenue and adjusted EBITDA by $17.4 million and $4.9 million, respectively.
 
AIR MILES® reward miles redeemed during the nine months ended September 30, 2012 increased 18.1% compared to the same period in the prior year due to higher collector redemptions. As expected, the introduction of a five-year expiry policy for the AIR MILES Reward Program in December 2011 stimulated redemption activity during the first half of 2012. Redemption activity moderated during the third quarter of 2012 and we believe it will continue to moderate for the remainder of 2012.
 
The number of AIR MILES reward miles issued impacts the number of future AIR MILES reward miles available to be redeemed. This can also impact our future revenue recognized with respect to the number of AIR MILES reward miles redeemed and the amount of breakage for those AIR MILES reward miles expected to go unredeemed. AIR MILES reward miles issued during the nine months ended September 30, 2012 increased 5.8% compared to the same period in the prior year due to positive growth in consumer credit card spending and increased promotional activity in the gas and grocer sectors. We expect mid-single digit year-over-year issuance growth for the remainder of 2012.
 
In December 2011, we introduced a new program option to issue AIR MILES reward miles called AIR MILES Cash, to which collectors, beginning in the first quarter of 2012, can allocate some or all of their future AIR MILES reward miles collected. Effective March 2012, AIR MILES Cash enabled collectors to instantly redeem their AIR MILES reward miles collected in this new program in-store towards purchases at participating sponsors. We launched our fifth participating redemption sponsor in June 2012 and currently have approximately 850,000 collectors in the program. AIR MILES reward mile issuance in AIR MILES Cash continues to meet our expectations; however, such issuances are not a material part of total AIR MILES reward mile issuances. We plan to expand the program to as many as seven sponsors by the end of 2012, with a focus on high-frequency retail sponsors. The timing of the expansion is somewhat dependent on our sponsors as it requires point-of-sale programming changes on their part. The implementation of AIR MILES Cash did not have a material impact for the nine months ended September 30, 2012 nor is it expected to have a material impact for the remainder of 2012.
 
During the nine months ended September 30, 2012, LoyaltyOne announced a new agreement with Michaels of Canada to issue AIR MILES reward miles across multiple Canadian provinces. We also announced a new multi-year agreement with Toys “R” Us, Canada to issue AIR MILES reward miles in all Toys “R” Us and Babies “R” Us locations across Canada.
 
Further, CBSM-Companhia Brasileira De Servicos De Marketing, operator of Brazil’s dotz coalition loyalty program, or dotz, in which we have a 37% ownership, continues to roll-out its coalition loyalty program into additional regions. We announced the rollout of dotz into the Sao Paulo State interior in April 2012 and into Fortaleza in July 2012. We anticipate that dotz will enter into two additional Brazilian markets by the end of 2012. In June 2012, we acquired an additional 8% ownership interest in Direxions Global Solutions Private Ltd., a leading loyalty, CRM solutions and data analytics provider in India, bringing our total ownership interest to 34%. We expect to incur losses of approximately $15 million associated with these international initiatives in 2012.

 
28

 
Epsilon®
 
Revenue increased 18.8% to $704.2 million and adjusted EBITDA increased 16.2% to $152.8 million for the nine months ended September 30, 2012 as compared to the same period in 2011. These increases were driven by the acquisition of Aspen Marketing Holdings, Inc., or Aspen, in May 2011 as well as growth in marketing technology with the expansion of services to existing clients and new client signings for the nine months ended September 30, 2012. In the third quarter of 2012, Epsilon’s revenue decreased 3.1% due to weakness in the pharmaceutical vertical and a decline in the direct marketing of customer acquisition production programs from one of our top clients. We expect continued softness in the pharmaceutical vertical in the fourth quarter and anticipate that revenue will be flat.  However, we expect continued double-digit growth in adjusted EBITDA in the fourth quarter, with expansion in our adjusted EBITDA margin.
 
During the nine months ended September 30, 2012, Epsilon announced a new multi-year agreement with Guideposts, a leading publisher of inspirational magazines and digital content, to provide comprehensive database marketing services. Additionally, Epsilon announced the expansion of its relationship with Jaguar Land Rover for global customer relationship management and marketing services. Epsilon announced a new multi-year agreement with Northwestern Mutual Life Insurance Company to manage and deploy their permission-based email newsletters and email marketing initiatives. Epsilon also announced that The Container Store, a leading retailer of storage and organization products, has enlisted Epsilon for comprehensive data and database marketing services. Epsilon also announced a new multi-year agreement with Canadian Tire Corporation, one of Canada’s largest general and sporting goods retailers, to host the electronic platform for Canadian Tire Corporation’s customer rewards program.
 
In addition, Epsilon also announced a multi-year renewal agreement with Brookstone, a nationwide specialty retailer of consumer products, to continue to host and manage Brookstone’s customer database and continue to provide list processing and list rental fulfillment. Patagonia, a leading designer of sport-related apparel and accessories, has renewed its long-standing partnership with Epsilon where Epsilon will continue to provide comprehensive database marketing services.
 
Private Label Services and Credit
 
Revenue increased 14.2% to $1.3 billion and adjusted EBITDA increased 20.6% to $645.0 million for the nine months ended September 30, 2012 as compared to the same period in 2011.
 
For the nine months ended September 30, 2012, average credit card receivables increased 15.2% as compared to the same period in the prior year as a result of increased credit sales and stabilized payment rates. Credit sales increased 26.2% for the nine months ended September 30, 2012 due to strong core credit cardholder spending, recent new client signings and recent credit card portfolio acquisitions.
 
Delinquency rates improved to 4.2% of principal receivables at September 30, 2012, down from 4.9% at September 30, 2011. The principal net charge-off rate was 4.8% for the nine months ended September 30, 2012 as compared to 7.0% in the prior year period.
 
In March 2012, we acquired the existing credit card portfolio of Pier 1 Imports for a total purchase price of $97.7 million. In May 2012, we acquired the existing private label credit card portfolio of Premier Designs, Inc for a total purchase price of $24.3 million. In July 2012, we purchased the existing private label credit card portfolio of The Bon-Ton Stores, Inc. for a preliminary purchase price of $494.6 million, which is subject to customary purchase price adjustments. We do not expect the acquisition of the credit card portfolio to provide any accretion to earnings per share in 2012, but it is expected to be accretive to 2013. In September 2012, we acquired the existing private label credit card portfolio of The Talbots, Inc. for a preliminary purchase price of $163.6 million, which is subject to customary purchase price adjustments.
 
During the nine months ended September 30, 2012, we also announced the signing of multi-year renewal agreements to continue providing private label credit card services to Samuels Jewelers, Inc., a leading retailer of diamonds and fine jewelry; Stage Stores, Inc., a leading retailer of brand name apparel; and Gordmans Stores, Inc., a national department store retailer. We also signed long-term extension agreements with Reed Jewelers, a leading multichannel jewelry retailer; The Buckle, Inc., a leading multichannel retailer of private label and brand name apparel, accessories and footwear; Gardner-White Furniture, a Michigan-based multichannel retailer of home furnishings and electronics; and Little Switzerland, Inc., a leading multi-channel retailer of duty-free merchandise, providing for the continuation of credit, loyalty and multi-channel marketing services.
 
Additionally, we signed new multi-year agreements to provide private label credit card services for Westgate Resorts, a premier operator of time share and destination accommodations; True Value, a leading cooperative of retail locations offering home improvement, hardware products and garden supplies; and Ideal Image, a leader among laser hair removal centers. We also signed a new multi-year agreement to create and manage a new private label credit card program for Blue Nile, Inc., a leading online retailer of diamonds and fine jewelry.
 
Effective October 1, 2012, our subsidiaries, World Financial Network Bank and World Financial Capital Bank, changed their names to Comenity Bank and Comenity Capital Bank, respectively.

 
29

 
Critical Accounting Policies and Estimates
 
There have been no material changes to our critical accounting policies and estimates from the information provided in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included in our Annual Report filed on Form 10-K for the fiscal year ended December 31, 2011.
 
Recent Accounting Pronouncements
 
See “Recently Issued Accounting Standards” under Note 1, “Summary of Significant Accounting Policies,” of the Notes to Unaudited Condensed Consolidated Financial Statements for a discussion of certain accounting standards that have been issued during 2012.
 
Use of Non-GAAP Financial Measures
 
Adjusted EBITDA is a non-GAAP financial measure equal to net income, the most directly comparable financial measure based on accounting principles generally accepted in the United States of America, or GAAP, plus stock compensation expense, provision for income taxes, interest expense, net, depreciation and other amortization and amortization of purchased intangibles.
 
We use adjusted EBITDA as an integral part of our internal reporting to measure the performance of our reportable segments and to evaluate the performance of our senior management. Adjusted EBITDA is considered an important indicator of the operational strength of our businesses. Adjusted EBITDA eliminates the uneven effect across all business segments of considerable amounts of non-cash depreciation of tangible assets and amortization of certain intangible assets that were recognized in business combinations. A limitation of this measure, however, is that it does not reflect the periodic costs of certain capitalized tangible and intangible assets used in generating revenues in our businesses. Management evaluates the costs of such tangible and intangible assets, as well as asset sales through other financial measures, such as capital expenditures, investment spending and return on capital and therefore the effects are excluded from adjusted EBITDA. Adjusted EBITDA also eliminates the non-cash effect of stock compensation expense. Stock compensation expense is not included in the measurement of segment adjusted EBITDA provided to the chief operating decision maker for purposes of assessing segment performance and decision making with respect to resource allocations. Therefore, we believe that adjusted EBITDA provides useful information to our investors regarding our performance and overall results of operations. Adjusted EBITDA is not intended to be a performance measure that should be regarded as an alternative to, or more meaningful than, either operating income or net income as an indicator of operating performance or to cash flows from operating activities as a measure of liquidity. In addition, adjusted EBITDA is not intended to represent funds available for dividends, reinvestment or other discretionary uses, and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with GAAP.
 
The adjusted EBITDA measure presented in this Quarterly Report on Form 10-Q may not be comparable to similarly titled measures presented by other companies, and may not be identical to corresponding measures used in our various agreements.
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
   
   
2012
   
2011
   
2012
   
2011
   
   
(In thousands)
   
Net income
 
$
119,545
   
$
93,981
   
$
338,595
   
$
249,380
   
Stock compensation expense
   
12,419
     
12,281
     
37,605
     
32,471
   
Provision for income taxes
   
70,561
     
59,342
     
205,954
     
157,389
   
Interest expense, net
   
74,365
     
74,356
     
213,084
     
224,609
   
Depreciation and other amortization
   
18,745
     
20,304
     
54,845
     
53,908
   
Amortization of purchased intangibles
   
22,987
     
22,929
     
65,009
     
60,743
   
Adjusted EBITDA
 
$
318,622
   
$
283,193
   
$
915,092
   
$
778,500
   
           
 
 
30


Results of Operations
 
Three months ended September 30, 2012 compared to the three months ended September 30, 2011
 
 
Three Months Ended
September 30,
   
Change
 
 
2012
   
2011
   
$
   
%
 
 
(In thousands, except percentages)
 
Revenue:
                     
LoyaltyOne
$
215,654
   
$
209,634
   
$
6,020
     
2.9
%
Epsilon
 
240,820
     
248,405
     
(7,585
   
(3.1
Private Label Services and Credit
 
455,939
     
389,051
     
66,888
     
17.2
 
Corporate/Other
 
80
     
211
     
(131
)
   
(62.1
)
Eliminations
 
(1,001
)
   
(2,457
   
1,456
   
nm
*
Total
$
911,492
   
$
844,844
   
$
66,648
     
7.9
%
Adjusted EBITDA(1):
                             
LoyaltyOne
$
60,334
   
$
59,920
   
$
414
     
0.7
%
Epsilon
 
64,244
     
58,528
     
5,716
     
9.8
 
Private Label Services and Credit
 
214,476
     
187,712
     
26,764
     
14.3
 
Corporate/Other
 
(20,432
)
   
(21,513
)
   
1,081
 
   
(5.0
Eliminations
 
     
(1,454
   
1,454
   
nm
*
Total
$
318,622
   
$
283,193
   
$
35,429
     
12.5
%
Stock compensation expense:
                             
LoyaltyOne
$
2,408
   
$
2,047
   
$
361
     
17.6
%
Epsilon
 
3,549
     
3,617
     
(68
   
(1.9
Private Label Services and Credit
 
2,386
     
2,098
     
288
     
13.7
 
Corporate/Other
 
4,076
     
4,519
     
(443
)
   
(9.8
)
Total
$
12,419
   
$
12,281
   
$
138
     
1.1
%
Depreciation and amortization:
                             
LoyaltyOne
$
4,834
   
$
5,130
   
$
(296
)
   
(5.8
)%
Epsilon
 
24,821
     
24,899
     
(78
   
(0.3
Private Label Services and Credit
 
11,267
     
8,950
     
2,317
 
   
25.9
 
Corporate/Other
 
810
     
4,254
     
(3,444
)
   
(81.0
)
Total
$
41,732
   
$
43,233
   
$
(1,501
   
(3.5
)%
Operating income:
                             
LoyaltyOne
$
53,092
   
$
52,743
   
$
349
     
0.7
%
Epsilon
 
35,874
     
30,012
     
5,862
     
19.5
 
Private Label Services and Credit
 
200,823
     
176,664
     
24,159
     
13.7
 
Corporate/Other
 
(25,318
)
   
(30,286
)
   
4,968
 
   
(16.4
Eliminations
 
     
(1,454
   
1,454
   
nm
*
Total
$
264,471
   
$
227,679
   
$
36,792
     
16.2
%
Adjusted EBITDA margin(2):
                             
LoyaltyOne
 
28.0
%
   
28.6
%
   
(0.6
)%
       
Epsilon
 
26.7
     
23.6
     
3.1
 
       
Private Label Services and Credit
 
47.0
     
48.2
     
(1.2
       
Total
   35.0      33.5      1.5        
Segment operating data:
                             
Private label statements generated
 
43,050
     
35,286
     
7,764
     
22.0
%
Credit sales
$
3,149,420
   
$
2,245,718
   
$
903,702
     
40.2
%
Average credit card receivables
$
6,121,431
   
$
4,859,421
   
$
1,262,010
     
26.0
%
AIR MILES reward miles issued
 
1,212,523
     
1,222,633
     
(10,110
   
(0.8
)%
AIR MILES reward miles redeemed
 
885,647
     
869,802
     
15,845
     
1.8
%
                                   
 
(1)
Adjusted EBITDA is equal to net income, plus stock compensation expense, provision for income taxes, interest expense, net, depreciation and other amortization, and amortization of purchased intangibles. For a reconciliation of adjusted EBITDA to net income, the most directly comparable GAAP financial measure, see “Use of Non-GAAP Financial Measures” included in this report.
 
(2)
Adjusted EBITDA margin is adjusted EBITDA divided by revenue. Management uses adjusted EBITDA margin to analyze the operating performance of the segments and the impact revenue growth has on operating expenses.
 
*
not meaningful

 
31

 
Consolidated Operating Results:
 
Revenue. Total revenue increased $66.6 million, or 7.9%, to $911.5 million for the three months ended September 30, 2012 from $844.8 million for the three months ended September 30, 2011. The net increase was due to the following:
 
 
Transaction. Revenue increased $0.2 million, or 0.3%, to $74.9 million for the three months ended September 30, 2012. Transaction revenue was positively impacted by an increase of $5.4 million in other servicing fees charged to our credit cardholders and an increase of $3.3 million in AIR MILES reward miles issuance fees, for which we provide marketing and administrative services, as a result of increases in the number of AIR MILES reward miles issued over the last several quarters. These increases were offset by a decrease of $8.5 million in lower merchant fees due to increased profit sharing and royalty payments associated primarily with the signing of new clients.
 
 
Redemption. Revenue increased $3.0 million, or 2.1%, to $144.1 million for the three months ended September 30, 2012 due to a 1.8% increase in AIR MILES reward miles redeemed.
 
 
Finance charges, net. Revenue increased $68.9 million, or 18.8%, to $434.8 million for the three months ended September 30, 2012. This increase was driven by a 26.0% increase in average credit card receivables, which have increased over $1.2 billion through a combination of growth in our existing credit card receivables and recent credit card portfolio acquisitions. This was offset in part by a 170 basis point decline in gross yield, which was also impacted by the recent credit card portfolio acquisitions.
 
 
Database marketing fees and direct marketing. Revenue decreased $5.0 million, or 2.2%, to $225.3 million for the three months ended September 30, 2012. Revenue was negatively impacted by weakness in the pharmaceutical vertical as well as a decline in the direct marketing of customer acquisition production programs from one of our top clients.
 
 
Other revenue. Revenue decreased $0.4 million, or 1.2%, to $32.3 million for the three months ended September 30, 2012 due to decreases in revenue associated with strategic consulting initiatives.
 
Cost of operations. Cost of operations increased $22.5 million, or 4.7%, to $499.5 million for the three months ended September 30, 2012 from $477.0 million for the three months ended September 30, 2011. The increase was due to the following:
 
 
Within the LoyaltyOne segment, cost of operations increased $6.0 million due to a $3.8 million increase in marketing expenses due to costs associated with the promotion of AIR MILES Cash. In addition, payroll and benefit costs increased $5.1 million to support new growth initiatives, including international expansion activities. These increases in costs were offset in part by a $4.9 million decrease in fulfillment costs for the AIR MILES Reward Program.
 
 
Within the Epsilon segment, cost of operations decreased $13.4 million due to a decrease in payroll and benefits of $7.5 million and a $4.6 million decline in cost of goods sold associated with the decline in direct marketing revenue.
 
 
Within the Private Label Services and Credit segment, cost of operations increased by $29.9 million due to growth in the segment. Payroll and benefits increased $10.1 million due to an increase in the number of associates. Marketing expenses increased $5.8 million due to growth in credit sales, and credit card and other expenses increased $7.7 million due to higher volumes and growth.
 
Provision for loan loss. Provision for loan loss increased $10.6 million, or 14.9%, to $81.3 million for the three months ended September 30, 2012 as compared to $70.7 million for the three months ended September 30, 2011. The increase in the provision was a result of the growth in credit card receivables, offset in part by improved credit quality. The net charge-off rate improved 170 basis points to 4.3% for the three months ended September 30, 2012 as compared to 6.0% for the three months ended September 30, 2011. Delinquency rates improved to 4.2% of principal credit card receivables at September 30, 2012 from 4.9% at September 30, 2011.
 
General and administrative. General and administrative expenses decreased $1.7 million, or 6.3%, to $24.6 million for the three months ended September 30, 2012 as compared to $26.2 million for the three months ended September 30, 2011 due to lower professional fees and consulting costs and a decline in certain non-income based taxes. These decreases were offset in part by higher data processing costs due to technological enhancements.

 
32

 
Depreciation and other amortization. Depreciation and other amortization decreased $1.6 million, or 7.7%, to $18.7 million for the three months ended September 30, 2012, as compared to $20.3 million for the three months ended September 30, 2011, due to the acceleration of depreciation on certain assets in the third quarter of 2011, offset by additional assets placed in service in 2012.
 
Amortization of purchased intangibles. Amortization of purchased intangibles increased $0.1 million, or 0.3%, to $23.0 million for the three months ended September 30, 2012 as compared to $22.9 million for the three months ended September 30, 2011. The increase relates to additional amortization associated with the intangible assets acquired in recent credit card portfolio acquisitions, offset by certain fully amortized intangible assets.
 
Interest expense. Total interest expense, net was flat at $74.4 million for the three months ended September 30, 2012 as compared to $74.4 million for the three months ended September 30, 2011 due to the following:
 
 
Securitization funding costs. Securitization funding costs decreased $6.9 million due to a decline in average interest rates for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011, as new asset-backed securities debt issuances have been issued at lower rates than maturing debt.
 
 
Interest expense on deposits. Interest on deposits increased $1.1 million as increases from higher borrowings were offset by lower average interest rates.
 
 
Interest expense on long-term and other debt, net. Interest expense on long-term and other debt, net increased $5.8 million due in part to an increase in borrowings resulting from the issuance in the first quarter of 2012 of $500.0 million of senior notes. In addition, the amortization of imputed interest associated with the convertible senior notes increased $2.2 million as compared to the same period in 2011. These increases were offset by a decline in interest expense associated with our credit facility.
 
Taxes. Income tax expense increased $11.2 million to $70.6 million for the three months ended September 30, 2012 from $59.3 million for the comparable period in 2011 due primarily to an increase in taxable income, offset in part by a decline in the effective tax rate. The effective tax rate for the three months ended September 30, 2012 declined to 37.1% as compared to 38.7% for the three months ended September 30, 2011 as a result of the settlement of certain audits in the third quarter of 2012.
 
Segment Revenue and Adjusted EBITDA:
 
Revenue. Total revenue increased $66.6 million, or 7.9%, to $911.5 million for the three months ended September 30, 2012 from $844.8 million for the three months ended September 30, 2011. The net increase was due to the following:
 
 
LoyaltyOne. Revenue increased $6.0 million, or 2.9%, to $215.7 million for the three months ended September 30, 2012. An unfavorable Canadian foreign currency exchange rate impacted revenue by $3.2 million. Redemption revenue increased $3.0 million, or 2.1%, due to higher collector redemptions compared to the third quarter of 2011. Revenue from issuance fees, for which we provide marketing and administrative services, increased $3.3 million due to increases in the total number of AIR MILES reward miles issued over the last several quarters.
 
 
Epsilon. Revenue decreased $7.6 million, or 3.1%, to $240.8 million for the three months ended September 30, 2012. Database and digital revenue decreased $2.4 million, or 2.2%, due to weakness in the pharmaceutical vertical. In addition, agency and analytics revenue decreased $4.8 million, or 5.3%, primarily due to a decline in the direct marketing of customer acquisition production programs from one of our top clients. Data revenue also declined $0.5 million, or 0.9%, as solid performance in compiled offerings was offset by softness in transactional data.
 
 
Private Label Services and Credit. Revenue increased $66.9 million, or 17.2%, to $455.9 million for the three months ended September 30, 2012. Finance charges and late fees increased by $68.9 million, driven by a 26.0% increase in average credit card receivables due to double-digit increases in core credit cardholder spending and recent credit card portfolio acquisitions. Transaction revenue decreased $2.0 million due to lower merchant fees, offset by an increase in other servicing fees.

 
33

 
Adjusted EBITDA. For purposes of the discussion below, adjusted EBITDA is equal to net income plus stock compensation expense, provision for income taxes, interest expense, net, depreciation and other amortization and amortization of purchased intangibles. Adjusted EBITDA margin is adjusted EBITDA divided by revenue. Adjusted EBITDA increased $35.4 million, or 12.5%, to $318.6 million for the three months ended September 30, 2012 from $283.2 million for the three months ended September 30, 2011. The increase was due to the following:
 
 
LoyaltyOne. Adjusted EBITDA increased $0.4 million, or 0.7%, to $60.3 million for the three months ended September 30, 2012. Adjusted EBITDA was positively impacted by increases in revenue associated with higher redemptions and a decrease in the costs of fulfillment for the AIR MILES Reward Program. These increases were somewhat offset by increases in payroll and benefits expense and costs associated with international activities, as well as increased marketing expenses associated with the promotion of AIR MILES Cash.
 
 
Epsilon. Adjusted EBITDA increased $5.7 million, or 9.8%, to $64.2 million for the three months ended September 30, 2012. Adjusted EBITDA margin also increased to 26.7% for the three months ended September 30, 2012 from 23.6% for the same period in the prior year. Adjusted EDITDA and adjusted EBITDA margin were positively impacted by certain cost-saving initiatives and operational efficiencies implemented by Epsilon in 2012.
 
 
Private Label Services and Credit. Adjusted EBITDA increased $26.8 million, or 14.3%, to $214.5 million for the three months ended September 30, 2012. Adjusted EBITDA was positively impacted by the increase in finance charges, net and a decline in the provision for loan loss, each as described above.
 
 
Corporate/Other. Adjusted EBITDA increased $1.1 million to a loss of $20.4 million for the three months ended September 30, 2012 related to a decrease in professional fees and consulting costs as well as a decline in certain non-income based taxes, offset in part by higher data processing costs related to technological enhancements.

 
34


Results of Operations
 
Nine months ended September 30, 2012 compared to the nine months ended September 30, 2011
 
 
Nine Months Ended
September 30,
   
Change
 
 
2012
   
2011
   
$
   
%
 
 
(In thousands, except percentages)
 
Revenue:
                     
LoyaltyOne
$
703,013
   
$
630,470
   
$
72,543
     
11.5
%
Epsilon
  704,228      
592,545
     
111,683
     
18.8
 
Private Label Services and Credit
  1,265,782      
1,108,679
     
157,103
     
14.2
 
Corporate/Other
  372      
924
     
(552
)
   
(59.7
)
Eliminations
 
(3,849
)
   
(6,880
   
3,031
   
nm
*
Total
$
2,669,546
   
$
2,325,738
   
$
343,808
     
14.8
%
Adjusted EBITDA(1):
                             
LoyaltyOne
$
179,300
   
$
171,114
   
$
8,186
     
4.8
%
Epsilon
 
152,845
     
131,518
     
21,327
     
16.2
 
Private Label Services and Credit
 
644,956
     
534,713
     
110,243
     
20.6
 
Corporate/Other
 
(62,009
)
   
(54,483
)
   
(7,526
)
   
13.8
 
Eliminations
 
     
(4,362
   
4,362
   
nm
*
Total
$
915,092
   
$
778,500
   
$
136,592
     
17.5
%
Stock compensation expense:
                             
LoyaltyOne
$
6,777
   
$
5,379
   
$
1,398
     
26.0
%
Epsilon
 
10,599
     
8,765
     
1,834
     
20.9
 
Private Label Services and Credit
 
6,488
     
5,528
     
960
     
17.4
 
Corporate/Other
 
13,741
     
12,799
     
942
     
7.4
 
Total
$
37,605
   
$
32,471
   
$
5,134
     
15.8
%
Depreciation and amortization:
                             
LoyaltyOne
$
14,920
   
$
15,564
   
$
(644
)
   
(4.1
)%
Epsilon
 
74,043
     
65,519
     
8,524
     
13.0
 
Private Label Services and Credit
 
28,614
     
26,818
     
1,796
 
   
6.7
 
Corporate/Other
 
2,277
     
6,750
     
(4,473
)
   
(66.3
)
Total
$
119,854
   
$
114,651
   
$
5,203
     
4.5
%
Operating income:
                             
LoyaltyOne
$
157,603
   
$
150,171
   
$
7,432
     
4.9
%
Epsilon
 
68,203
     
57,234
     
10,969
     
19.2
 
Private Label Services and Credit
 
609,854
     
502,367
     
107,487
     
21.4
 
Corporate/Other
 
(78,027
)
   
(74,032
)
   
(3,995
)
   
5.4
 
Eliminations
 
     
(4,362
   
4,362
   
nm
*
Total
$
757,633
   
$
631,378
   
$
126,255
     
20.0
%
Adjusted EBITDA margin(2):
                             
LoyaltyOne
 
25.5
%
   
27.1
%
   
(1.6
)%
       
Epsilon
 
21.7
     
22.2
     
(0.5
)
       
Private Label Services and Credit
 
51.0
     
48.2
     
2.8
         
Total
   34.3      33.5      0.8        
Segment operating data:
                             
Private label statements generated
 
119,018
     
104,832
     
14,186
     
13.5
%
Credit sales
$
8,362,968
   
$
6,624,780
   
$
1,738,188
     
26.2
%
Average credit card receivables
$
5,636,812
   
$
4,892,198
   
$
744,614
     
15.2
%
AIR MILES reward miles issued
 
3,758,675
     
3,552,866
     
205,809
     
5.8
%
AIR MILES reward miles redeemed
 
3,160,207
     
2,675,374
     
484,833
     
18.1
%
                                   
 
(1)
Adjusted EBITDA is equal to net income, plus stock compensation expense, provision for income taxes, interest expense, net, depreciation and other amortization, and amortization of purchased intangibles. For a reconciliation of adjusted EBITDA to net income, the most directly comparable GAAP financial measure, see “Use of Non-GAAP Financial Measures” included in this report.
 
(2)
Adjusted EBITDA margin is adjusted EBITDA divided by revenue. Management uses adjusted EBITDA margin to analyze the operating performance of the segments and the impact revenue growth has on operating expenses.
 
*
not meaningful
 
 
35

 
Consolidated Operating Results:
 
Revenue. Total revenue increased $343.8 million, or 14.8%, to $2.7 billion for the nine months ended September 30, 2012 from $2.3 billion for the nine months ended September 30, 2011. The net increase was due to the following:
 
 
Transaction. Revenue increased $13.8 million, or 6.2%, to $235.2 million for the nine months ended September 30, 2012 due to an increase of $6.9 million in AIR MILES reward miles issuance fees, for which we provide marketing and administrative services, as a result of increases in the number of AIR MILES reward miles issued over the previous several quarters. Other servicing fees charged to our cardholders also increased transaction revenue by $9.5 million. These increases were offset by a decrease of $2.6 million in lower merchant fees primarily due to increased profit sharing and royalty payments associated with the signing of new clients.
 
 
Redemption. Revenue increased $67.5 million, or 15.9%, to $491.8 million for the nine months ended September 30, 2012 due to an 18.1% increase in AIR MILES reward miles redeemed. The introduction of a five-year expiry policy to the AIR MILES Reward Program in December 2011 stimulated redemption activity through the first half of 2012.
 
 
Finance charges, net. Revenue increased $148.6 million, or 14.3%, to $1.2 billion for the nine months ended September 30, 2012. This increase was driven by a 15.2% increase in average credit card receivables over the nine months ended September 30, 2012, offset in part by a 30 basis point decline in gross yield related to the recent credit card portfolio acquisitions.
 
 
Database marketing fees and direct marketing. Revenue increased $93.1 million, or 16.5%, to $658.4 million for the nine months ended September 30, 2012. The increase in revenue was driven by our acquisition of Aspen, which added $87.0 million, with the remainder of the increase driven by growth in our marketing technology business resulting from the expansion of services to existing clients as well as new client signings within our Epsilon segment.
 
 
Other revenue. Revenue increased $20.8 million, or 27.9%, to $95.2 million for the nine months ended September 30, 2012 due to increased revenue associated with strategic consulting initiatives. Of this increase, $16.2 million was attributable to our acquisition of Aspen.
 
Cost of operations. Cost of operations increased $220.0 million, or 16.8%, to $1.5 billion for the nine months ended September 30, 2012 from $1.3 billion for the nine months ended September 30, 2011. The increase resulted from growth across each of our segments, including the following:
 
 
Within the LoyaltyOne segment, cost of operations increased $65.8 million due to a $30.8 million increase in the cost of fulfillment for the AIR MILES Reward Program as a result of an 18.1% increase in the number of AIR MILES reward miles redeemed. In addition, marketing expenses increased $13.4 million due to costs associated with the launch and promotion of AIR MILES Cash, and payroll and benefit costs increased $13.0 million to support new growth initiatives, including international expansion activities.
 
 
Within the Epsilon segment, cost of operations increased $92.2 million due to the acquisition of Aspen, which added $90.5 million. Cost of operations also increased as a result of enhancements to infrastructure and security as well as a relocation of a data center to support future growth, which were mitigated by cost-saving initiatives and operational efficiencies implemented in 2012.
 
 
Within the Private Label Services and Credit segment, cost of operations increased $63.4 million due to growth in the segment. Payroll and benefits increased $24.6 million due to an increase in the number of associates, and marketing expenses increased $12.1 million due to growth in credit sales. Credit card and other expenses increased $17.7 million due to higher volumes and growth, and legal and consulting expenses also increased $4.8 million.
 
Provision for loan loss. Provision for loan loss decreased $15.6 million, or 7.9%, to $183.1 million for the nine months ended September 30, 2012 as compared to $198.7 million for the nine months ended September 30, 2011. The decrease in the provision was a result of improved credit quality, offset in part by the growth in credit card receivables. The net charge-off rate improved 220 basis points to 4.8% for the nine months ended September 30, 2012 as compared to 7.0% for the nine months ended September 30, 2011. Delinquency rates improved to 4.2% of principal credit card receivables at September 30, 2012 from 4.9% at September 30, 2011.

 
36

 
General and administrative. General and administrative expenses increased $7.9 million, or 11.6%, to $76.1 million for the nine months ended September 30, 2012 as compared to $68.2 million for the nine months ended September 30, 2011. The increase was driven by payroll and benefit costs as a result of higher medical costs and an increase in expenses for our retirement savings plans, as well as the impact of the amortization of deferred gains in 2011 associated with sale-leaseback transactions that were fully amortized in April 2011.
 
Depreciation and other amortization. Depreciation and other amortization increased $0.9 million, or 1.7%, to $54.8 million for the nine months ended September 30, 2012, as compared to $53.9 million for the nine months ended September 30, 2011, due to additional assets placed in service resulting from fixed assets acquired in the Aspen acquisition and capital expenditures. These increases were offset by the acceleration of depreciation on certain assets in the third quarter of 2011.
 
Amortization of purchased intangibles. Amortization of purchased intangibles increased $4.3 million, or 7.0%, to $65.0 million for the nine months ended September 30, 2012 as compared to $60.7 million for the nine months ended September 30, 2011. The increase relates to $9.6 million of additional amortization associated with the intangible assets acquired in the Aspen acquisition and additional amortization associated with the intangible assets from recent credit card portfolio acquisitions, offset in part by certain fully amortized intangible assets.
 
Interest expense. Total interest expense, net decreased $11.5 million, or 5.1%, to $213.1 million for the nine months ended September 30, 2012 as compared to $224.6 million for the nine months ended September 30, 2011. The decrease was due to the following:
 
 
Securitization funding costs. Securitization funding costs decreased $28.1 million due to lower average borrowings and lower interest rates for the nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011.
 
 
Interest expense on deposits. Interest on deposits increased $1.9 million as increases from higher borrowings were offset by lower average interest rates.
 
 
Interest expense on long-term and other debt, net. Interest expense on long-term and other debt, net increased $14.7 million due in part to an increase in borrowings resulting from the issuance in the first quarter of 2012 of $500.0 million of senior notes. In addition, the amortization of imputed interest associated with the convertible senior notes increased $6.3 million as compared to the same period in 2011. These increases were offset by a decline in interest expense associated with our credit facility. The increases were further offset by a decline in the amortization of debt issuance costs resulting from a $2.6 million write-off in unamortized debt costs associated with the early extinguishment of certain previous term loans in the second quarter of 2011.
  
Taxes. Income tax expense increased $48.6 million to $206.0 million for the nine months ended September 30, 2012 from $157.4 million for the comparable period in 2011 due primarily to an increase in taxable income, offset in part by a decline in the effective tax rate. The effective tax rate for the nine months ended September 30, 2012 declined to 37.8% as compared to 38.7% for the nine months ended September 30, 2011 as a result of the settlement of certain audits.
 
Segment Revenue and Adjusted EBITDA:
 
Revenue. Total revenue $343.8 million, or 14.8%, to $2.7 billion for the nine months ended September 30, 2012 from $2.3 billion for the nine months ended September 30, 2011. The net increase was due to the following:
 
 
LoyaltyOne. Revenue increased $72.5 million, or 11.5%, to $703.0 million for the nine months ended September 30, 2012. An unfavorable Canadian foreign currency exchange rate impacted revenue by $17.4 million. Redemption revenue increased $67.5 million, or 15.9%, due to higher collector redemptions compared to the nine months ended September 30, 2011. The introduction of a five-year expiry policy to the AIR MILES Reward Program on December 31, 2011 stimulated redemption activity in the first half of 2012. Revenue from issuance fees, for which we provide marketing and administrative services, increased $6.9 million due to increases in the total number of AIR MILES reward miles issued over the previous several quarters.
 
 
Epsilon. Revenue increased $111.7 million, or 18.8%, to $704.2 million for the nine months ended September 30, 2012. Aspen’s marketing services product lines added $101.5 million to revenue. In addition, marketing technology revenue increased $11.7 million, or 3.8%, due to the expansion of services to its clients. Data revenue decreased $1.5 million, or 1.1%, due to softness in consumer demographic data offerings.
 
 
Private Label Services and Credit. Revenue increased $157.1 million, or 14.2%, to $1.3 billion for the nine months ended September 30, 2012. Finance charges and late fees increased by $148.6 million, driven by a 15.2% increase in average credit card receivables due to strong credit cardholder spending, the stabilization of customer payment rates, recent new client signings and recent credit card portfolio acquisitions. In addition, transaction revenue increased $8.5 million due to other servicing fees.

 
37

 
Adjusted EBITDA. For purposes of the discussion below, adjusted EBITDA is equal to net income plus stock compensation expense, provision for income taxes, interest expense, net, depreciation and other amortization and amortization of purchased intangibles. Adjusted EBITDA margin is adjusted EBITDA divided by revenue. Adjusted EBITDA increased $136.6 million, or 17.5%, to $915.1 million for the nine months ended September 30, 2012 from $778.5 million for the nine months ended September 30, 2011. The increase was due to the following:
 
 
LoyaltyOne. Adjusted EBITDA increased $8.2 million, or 4.8%, to $179.3 million for the nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011. Adjusted EBITDA was positively impacted by the increase in AIR MILES reward miles redeemed. Adjusted EBITDA was also negatively impacted by marketing expenses associated with the launch and promotion of AIR MILES Cash and increases in costs associated with our international initiatives.
 
 
Epsilon. Adjusted EBITDA increased $21.3 million, or 16.2%, to $152.8 million for the nine months ended September 30, 2012. Adjusted EDITDA was positively impacted by Aspen and the growth in marketing technology. The positive impacts to adjusted EBITDA were somewhat offset by higher payroll and benefit costs, and costs associated with a data center relocation and incremental spending on infrastructure and security to support future growth. Adjusted EBITDA margin decreased to 21.7% for the nine months ended September 30, 2012 from 22.2% for the same period in the prior year. The negative impact to adjusted EBITDA margin was due to a shift in revenue mix attributable to the Aspen acquisition and additional costs to support future growth, as discussed above.
 
 
Private Label Services and Credit. Adjusted EBITDA increased $110.2 million, or 20.6%, to $645.0 million for the nine months ended September 30, 2012. Adjusted EBITDA was positively impacted by the increase in finance charges, net and a decline in the provision for loan loss, each as described above.
 
 
Corporate/Other. Adjusted EBITDA decreased $7.5 million to a loss of $62.0 million for the nine months ended September 30, 2012. Payroll and benefit costs increased $6.0 million as a result of higher medical costs and an increase in expenses for our retirement savings plans. In addition, in 2011, we recognized $1.2 million in the amortization of deferred gains in 2011 associated with sale-leaseback transactions that were fully amortized in April 2011.
 
Asset Quality
 
Our delinquency and net charge-off rates reflect, among other factors, the credit risk of our private label credit card receivables, the success of our collection and recovery efforts, and general economic conditions.
 
Delinquencies. A credit card account is contractually delinquent if we do not receive the minimum payment by the specified due date on the cardholder’s statement. Our policy is to continue to accrue interest and fee income on all credit card accounts beyond 90 days, except in limited circumstances, until the credit card account balance and all related interest and other fees are paid or charged off, typically at 180 days delinquent. When an account becomes delinquent, a message is printed on the cardholder’s billing statement requesting payment. After an account becomes 30 days past due, a proprietary collection scoring algorithm automatically scores the risk of the account becoming further delinquent. The collection system then recommends a collection strategy for the past due account based on the collection score and account balance and dictates the contact schedule and collections priority for the account. If we are unable to make a collection after exhausting all in-house collection efforts, we may engage collection agencies and outside attorneys to continue those efforts.

 
38

 
The following table presents the delinquency trends of our credit card portfolio:
 
   
September 30,
2012
   
% of
Total
   
December 31,
2011
   
% of
Total
 
   
(In thousands, except percentages)
 
Receivables outstanding – principal
 
$
6,260,239
     
100
%
 
$
5,408,862
     
100
%
Principal receivables balances contractually delinquent:
                               
31 to 60 days
   
96,159
     
1.5
%
   
78,272
     
1.4
%
61 to 90 days
   
58,626
     
0.9
     
51,709
     
1.0
 
91 or more days
   
109,602
     
1.8
     
105,626
     
2.0
 
Total
 
$
264,387
     
4.2
%
 
$
235,607
     
4.4
%
 
Net Charge-Offs. Our net charge-offs include the principal amount of losses from cardholders unwilling or unable to pay their account balances, as well as bankrupt and deceased credit cardholders, less recoveries and exclude charged-off interest, fees and fraud losses. Charged-off interest and fees reduce finance charges, net while fraud losses are recorded as an expense. Credit card receivables, including unpaid interest and fees, are charged-off at the end of the month during which an account becomes 180 days contractually past due, except in the case of customer bankruptcies or death. Credit card receivables, including unpaid interest and fees, associated with customer bankruptcies or death are charged-off at the end of each month subsequent to 60 days after the receipt of notification of the bankruptcy or death, but in any case, not later than the 180-day contractual time frame.
 
The net charge-off rate is calculated by dividing net charge-offs of principal receivables for the period by the average credit card receivables for the period. Average credit card receivables represent the average balance of the cardholder receivables at the beginning of each month in the periods indicated. The following table presents our net charge-offs for the periods indicated.
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
2012
   
2011
 
2012
   
2011
 
   
(In thousands, except percentages)
 
Average credit card receivables
 
$
6,121,431
   
$
4,859,421
 
$
5,636,812
   
$
4,892,198
 
Net charge-offs of principal receivables
   
65,221
     
73,047
   
202,900
     
258,143
 
Net charge-offs as a percentage of average credit card receivables(1) 
   
4.3
%
   
6.0
%
 
4.8
%
   
7.0
%
                                 
 
(1)
We acquired the credit card receivables of The Bon-Ton Stores, Inc. and The Talbots, Inc. in July 2012 and August 2012, respectively. Under GAAP, losses associated with purchased credit card receivables are reflected in the fair value of the purchased credit card receivables and not reported as net charge-offs. The net charge-off rate would have been 4.5% and 4.9% for the three and nine months ended September 30, 2012, respectively, if losses associated with the acquired credit card receivables had been reported as net charge-offs.
 
See Note 3, “Credit Card Receivables,” of the Notes to Unaudited Condensed Consolidated Financial Statements for additional information related to the securitization of our credit card receivables.
 
Liquidity and Capital Resources
 
Operating Activities. We have historically generated cash flows from operations, although that amount may vary based on fluctuations in working capital.
 
We generated cash flow from operating activities of $862.1 million and $762.5 million for the nine months ended September 30, 2012 and 2011, respectively. Operating cash flows increased $99.6 million primarily from increased profitability for the nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011.

 
39

 
Investing Activities. Cash used in investing activities was $1.2 billion and $741.8 million for the nine months ended September 30, 2012 and 2011, respectively. Significant components of investing activities are as follows:
 
 
Credit Card Receivables Funding. Cash decreased $418.5 million for the nine months ended September 30, 2012, as compared to a cash increase of $160.6 million for the nine months ended September 30, 2011, due to growth in our credit card receivables.
 
 
Purchase of Credit Card Portfolios. Cash decreased $780.2 million for the nine months ended September 30, 2012 due to the acquisition of existing private label credit card portfolios from Pier 1 Imports, Premier Designs, The Bon-Ton Stores, Inc. and The Talbots, Inc. During the nine months ended September 30, 2011, cash decreased $42.7 million due to the acquisition of an existing private label credit card portfolio from J.Jill.
 
 
Cash Collateral, Restricted. Cash increased $101.5 million for the nine months ended September 30, 2012 as compared to a cash decrease of $468.7 million for the nine months ended September 30, 2011 due to the maturing of asset-backed securities debt as the restricted cash is released upon repayment, and a decrease in excess funding deposits in 2012 as compared to 2011.
 
 
Payments for Acquired Businesses, Net of Cash. For the nine months ended September 30, 2011, we utilized cash of $359.1 million for the Aspen acquisition, which was completed on May 31, 2011. No businesses were acquired during the nine months ended September 30, 2012.
 
 
Capital Expenditures. Our capital expenditures for the nine months ended September 30, 2012 were $77.3 million compared to $48.5 million for the comparable period in 2011. We anticipate capital expenditures will not exceed 3.5% of annual revenue for 2012.
 
Financing Activities. Cash provided by financing activities was $869.8 million for the nine months ended September 30, 2012 as compared to cash provided by financing activities of $84.3 million for the nine months ended September 30, 2011. Our financing activities during the nine months ended September 30, 2012 relate primarily to borrowings and repayments of deposits and debt and repurchases of our common stock.
 
Liquidity Sources. In addition to cash generated from operating activities, our primary sources of liquidity include our credit card securitization program, deposits issued by Comenity Bank and Comenity Capital Bank, our credit agreement and issuances of equity securities. In addition to our efforts to renew and expand our current facilities, we continue to seek new sources of liquidity.
 
As of September 30, 2012, we had no borrowings under our credit facility, with total availability at $917.5 million. Our total leverage ratio, as defined in our credit agreement, was 2.1 to 1 at September 30, 2012, as compared to the maximum covenant ratio of 3.5 to 1. The Tier 1 risk-based capital ratio, leverage ratio and total risk-based capital ratio for our main bank subsidiary, Comenity Bank, were 15.5%,15.1% and 16.8%, respectively, at September 30, 2012.
 
We believe that internally generated funds and other sources of liquidity discussed above will be sufficient to meet working capital needs, capital expenditures, and other business requirements for at least the next 12 months.
 
Securitization Program. We sell a majority of the credit card receivables originated by Comenity Bank to WFN Credit Company, LLC, which in turn sells them to World Financial Network Credit Card Master Trust, World Financial Network Credit Card Master Note Trust, World Financial Network Credit Card Master Note Trust II and World Financial Network Credit Card Master Trust III, or collectively, the WFN Trusts, as part of our credit card securitization program, which has been in existence since January 1996. We also sell our credit card receivables originated by Comenity Capital Bank to World Financial Capital Credit Company, LLC, which in turn sells them to World Financial Capital Credit Card Master Note Trust, or the WFC Trust. These securitization programs are the primary vehicle through which we finance Comenity Bank’s and Comenity Capital Bank’s credit card receivables.
 
Historically, we have used both public and private term asset-backed securities transactions as well as private conduit facilities as sources of funding for our credit card receivables. Private conduit facilities have been used to accommodate seasonality needs and to bridge to completion of asset-backed securitization transactions.
 
We have secured and continue to secure the necessary commitments to fund our portfolio of securitized credit card receivables originated by Comenity Bank and Comenity Capital Bank. However, certain of these commitments are short-term in nature and subject to renewal. There is not a guarantee that these funding sources, when they mature, will be renewed on similar terms or at all as they are dependent on the asset-backed securitization markets at the time.
 
At September 30, 2012, we had $3.5 billion of asset-backed securities debt – owed to securitization investors, of which $1.4 billion is due within the next 12 months.

 
40

 
The following table shows the maturities of borrowing commitments as of September 30, 2012 for the WFN Trusts and the WFC Trust by year:
 
   
2012
   
2013
   
2014
   
2015
   
2016 & Thereafter
   
Total
 
   
(In thousands)
 
Term notes
 
$
98,076
   
$
822,339
   
$
250,000
   
$
393,750
   
$
1,093,500
   
$
2,657,665
 
Conduit facilities(1)
   
     
705,000
     
1,200,000
     
     
     
1,905,000
 
Total(2)
 
$
98,076
   
$
1,527,339
   
$
1,450,000
   
$
393,750
   
$
1,093,500
   
$
4,562,665
 
                                                   
 
(1)
Amount represents borrowing capacity, not outstanding borrowings.
 
(2)
Total amounts do not include $834.0 million of debt issued by the credit card securitization trusts, which was retained by us and has been eliminated in the unaudited condensed consolidated financial statements.
 
Early amortization events as defined within each asset-backed securitization transaction are generally driven by asset performance. We do not believe it is reasonably likely for an early amortization event to occur due to asset performance. However, if an early amortization event were declared, the trustee of the particular credit card securitization trust would retain the interest in the receivables along with the excess interest income that would otherwise be paid to our bank subsidiary until the credit card securitization investors were fully repaid. The occurrence of an early amortization event would significantly limit or negate our ability to securitize additional credit card receivables.
 
Debt
 
On March 30, 2012, we, as borrower, and ADS Alliance Data Systems, Inc., ADS Foreign Holdings, Inc., Alliance Data Foreign Holdings, Inc., Epsilon Marketing Services, LLC, Epsilon Data Management LLC, Comenity LLC and Alliance Data FHC, Inc., as guarantors, entered into a second amendment, or the Second Amendment, to our credit agreement, dated May 24, 2011, or the Credit Agreement, through which we increased our revolving line of credit, or the 2011 Credit Facility, by $125.0 million to $917.5 million and borrowed additional term loans in the aggregate principal amount of $125.5 million.
 
In March 2012, we issued and sold $500 million aggregate principal amount of 6.375% senior notes due April 1, 2020, or the Senior Notes due 2020. The Senior Notes due 2020 accrue interest on the principal amount at the rate of 6.375% per annum from March 29, 2012, payable semiannually in arrears, on April 1 and October 1 of each year, beginning on October 1, 2012. The payment obligations under the Senior Notes due 2020 are governed by an indenture dated March 29, 2012. The Senior Notes due 2020 are unsecured and are guaranteed on a senior unsecured basis by certain of our existing and future domestic subsidiaries that guarantee our Credit Agreement.
 
As of September 30, 2012, we were in compliance with our covenants.
 
See Note 6, “Debt,” of the Notes to Unaudited Condensed Consolidated Financial Statements for additional information regarding our debt.
 
In April 2012, World Financial Network Credit Card Master Note Trust issued $550.0 million of term asset-backed securities to investors. The offering consisted of $412.5 million of Class A Series 2012-A asset-backed term notes that have a fixed interest rate of 3.14% per year and mature in March 2019. In addition, we retained an aggregate of $137.5 million of subordinated classes of the term asset-backed notes which have been eliminated from our unaudited condensed consolidated financial statements.
 
In June 2012, we renewed our $1.2 billion 2009-VFN conduit facility under World Financial Network Credit Card Master Note Trust, extending its maturity to March 5, 2014. Also, in June 2012, we renewed our 2009-VFN conduit facility under World Financial Capital Master Note Trust, extending the maturity to May 31, 2013 and increasing the total capacity from $275.0 million to $375.0 million.
 
In July 2012, $395.0 million of Class A Series 2009-B asset-backed term notes with a fixed interest rate of 3.79% matured.
 
In July 2012, World Financial Network Credit Card Master Note Trust issued $433.3 million of term asset-backed securities to investors. The offering consisted of $325.0 million of Class A Series 2012-B asset-backed term notes that have a fixed interest rate of 1.76% per year and mature in July 2017. In addition, we retained an aggregate of $108.3 million of subordinated classes of the term asset-backed notes which have been eliminated from our unaudited condensed consolidated financial statements.

 
41

 
In July 2012, World Financial Network Credit Card Master Note Trust issued $266.7 million of term asset-backed securities to investors. The offering consisted of $200.0 million of Class A Series 2012-C asset-backed notes that have a fixed interest rate of 2.23% per year, $10.0 million of Class M Series 2012-C asset-backed notes that have a fixed interest rate of 3.32% per year, $12.7 million of Class B Series 2012-C asset-backed notes that have a fixed interest rate of 3.57% per year, $33.3 million of Class C Series 2012-C asset-backed notes that have a fixed interest rate of 4.55% per year, and $10.7 million of Class D Series 2012-C asset-backed notes. The Class A, Class M, Class B and Class C Series 2012-C asset-backed notes will all mature in October 2018. The Class D Series 2012-C asset-backed notes were retained by us and have been eliminated from our unaudited condensed consolidated financial statements.
 
In September 2012, we renewed our $330.0 million 2009-VFC1 conduit facility under World Financial Network Credit Card Master Note Trust III, extending its maturity to September 27, 2013.
 
In October 2012, World Financial Network Credit Card Master Note Trust issued $466.7 million of term asset-backed securities to investors. The offering consisted of $350.0 million of Class A Series 2012-D asset-backed notes that have a fixed interest rate of 2.15% per year, $17.5 million of Class M Series 2012-D asset-backed notes that have a fixed interest rate of 3.09% per year, $22.2 million of Class B Series 2012-D asset-backed notes that have a fixed interest rate of 3.34% per year, $58.3 million of Class C Series 2012-D asset-backed notes and $18.7 million of Class D Series 2012-D asset-backed notes. The Class A, Class M and Class B Series 2012-D asset-backed notes will all mature in June 2019. The Class C and Class D Series 2012-D asset-backed notes were retained by us and will be eliminated from our unaudited condensed consolidated financial statements.
 
Item 3.
                 
Market Risk
 
Market risk is the risk of loss from adverse changes in market prices and rates. Our primary market risks include interest rate risk, credit risk, foreign currency exchange rate risk and redemption reward risk.
 
There has been no material change from our Annual Report on Form 10-K for the year ended December 31, 2011 related to our exposure to market risk from interest rate risk, credit risk, foreign currency exchange risk and redemption reward risk.
 
Item 4.
                 
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
 
As of September 30, 2012, 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 September 30, 2012 (the end of our third fiscal quarter), our disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and include controls and procedures designed to ensure that information we are required to disclose in such reports is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
 
Changes in Internal Control Over Financial Reporting
 
There have been no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 
42

 
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 Item 1A. of our Annual Report on Form 10-K for the year ended December 31, 2011 and Item 1A. of Part II of this Quarterly Report.
 
If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary materially from what we projected. Any forward-looking statements contained in this quarterly report reflect our current views with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. We have no intention, and disclaim any obligation, to update or revise any forward-looking statements, whether as a result of new information, future results or otherwise, except as required by law.

 
43

 
PART II
 
Item 1.
                 
From time to time we are involved in various claims and lawsuits arising in the ordinary course of our business that we believe will not have a material adverse effect on our business or financial condition, including claims and lawsuits alleging breaches of our contractual obligations.
 
Item 1A.
         
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, 2011 or our Quarterly Report on Form 10-Q for the quarter ended June 30, 2012.
 
         
On December 13, 2011, our Board of Directors authorized a stock repurchase program to acquire up to $400.0 million of our outstanding common stock from January 1, 2012 through December 31, 2012, subject to any restrictions pursuant to the terms of our credit agreements or otherwise.
 
The following table presents information with respect to purchases of our common stock made during the three months ended September 30, 2012:
 
Period
 
Total Number of Shares Purchased(1)
   
Average Price Paid per Share
   
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
   
Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs(2)
 
                     
(Dollars in millions)
 
During 2012:
                       
July 1-31
   
53,893
   
$
126.93
     
50,000
   
$
334.6
 
August 1-31
   
2,398
     
135.02
     
     
334.6
 
September 1-30
   
5,413
     
140.67
     
     
334.6
 
Total
   
61,704
   
$
128.45
     
50,000
   
$
334.6
 
                                   
 
(1)
During the period represented by the table, 8,603 shares of our common stock were purchased by the administrator of our 401(k) and Retirement Savings Plan for the benefit of the employees who participated in that portion of the plan; and 3,101 already outstanding shares of our common stock were delivered by attestation to us by participants in our equity plans to satisfy the exercise price and/or withholding taxes associated with the exercise of options as authorized under the terms of such plans.
 
(2)
On December 13, 2011, our Board of Directors authorized a stock repurchase program to acquire up to $400.0 million of our outstanding common stock from January 1, 2012 through December 31, 2012, subject to any restrictions pursuant to the terms of our credit agreements or otherwise.
 
         
None
 
    
Not applicable.
 
    
(a) None
 
(b) None

 
44

 
Item 6.
    
(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
 
Third Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit No. 3.1 to our Current Report on Form 8-K, filed with the SEC on December 19, 2011, File No. 001-15749).
     
4
 
Specimen Certificate for shares of Common Stock of the Registrant (incorporated by reference to Exhibit No. 4 to our Quarterly Report on Form 10-Q, filed with the SEC on August 8, 2003, File No. 001-15749).
     
10.1
 
Series 2012-B Indenture Supplement, dated as of July 19, 2012, between World Financial Network Credit Card Master Note Trust and Union Bank, N.A. (incorporated by reference to Exhibit No. 4.1 to the Current Report on Form 8-K filed with the SEC by WFN Credit Company, LLC, World Financial Network Credit Card Master Trust and World Financial Network Credit Card Master Note Trust on July 23, 2012, File Nos. 333-60418, 333-60418-01 and 333-113669).
     
10.2
 
Series 2012-C Indenture Supplement, dated as of July 19, 2012, between World Financial Network Credit Card Master Note Trust and Union Bank, N.A. (incorporated by reference to Exhibit No. 4.2 to the Current Report on Form 8-K filed with the SEC by WFN Credit Company, LLC, World Financial Network Credit Card Master Trust and World Financial Network Credit Card Master Note Trust on July 23, 2012, File Nos. 333-60418, 333-60418-01 and 333-113669).
     
*10.3
 
Second Amended and Restated Series 2009-VFN Indenture Supplement, dated as of June 1, 2012, between World Financial Capital Master Note Trust and U.S. Bank National Association.
     
*10.4
 
Third Amended and Restated Series 2009-VFN Indenture Supplement, dated as of June 13, 2012, between World Financial Network Credit Card Master Note Trust and The Bank of New York Mellon Trust Company, N.A.
     
*10.5
 
Amended and Restated Series 2009-VFC1 Supplement, dated as of September 28, 2012, among WFN Credit Company, LLC, World Financial Network Bank and Deutsche Bank Trust Company Americas.
     
10.6
 
Series 2012-D Indenture Supplement, dated as of October 5, 2012, between World Financial Network Credit Card Master Note Trust and Union Bank, N.A. (incorporated by reference to Exhibit No. 4.1 to the Current Report on Form 8-K filed with the SEC by WFN Credit Company, LLC, World Financial Network Credit Card Master Trust and World Financial Network Credit Card Master Note Trust on October 10, 2012, File Nos. 333-60418, 333-60418-01 and 333-113669).
     
*31.1
 
Certification of Chief Executive Officer of Alliance Data Systems Corporation pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
     
*31.2
 
Certification of Chief Financial Officer of Alliance Data Systems Corporation pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
     
*32.1
 
Certification of Chief Executive Officer of Alliance Data Systems Corporation pursuant to Rule 13a-14(b) promulgated under the Securities Exchange Act of 1934, as amended, and Section 1350 of Chapter 63 of Title 18 of the United States Code.
     
*32.2
 
Certification of Chief Financial Officer of Alliance Data Systems Corporation pursuant to Rule 13a-14(b) promulgated under the Securities Exchange Act of 1934, as amended, and Section 1350 of Chapter 63 of Title 18 of the United States Code.
     
*101.INS
 
XBRL Instance Document
     
*101.SCH
 
XBRL Taxonomy Extension Schema Document
     
*101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
     
*101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
     
*101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
     
*101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document
         
 
Filed herewith
+
Management contract, compensatory plan or arrangement

 
45

 
SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
ALLIANCE DATA SYSTEMS CORPORATION
 
 
 
By: 
/s/  Edward J. Heffernan
 
   
Edward J. Heffernan
 
   
President and Chief Executive Officer
 
 
Date: November 5, 2012
 
 
By: 
/s/  Charles L. Horn
 
   
Charles L. Horn
 
   
Executive Vice President and Chief Financial Officer
 
 
Date: November 5, 2012
 
46