BFH

Business Context and Reporting Period

This summary covers the Form 10-Q for Alliance Data Systems Corporation (ADSC) for the quarterly period ended March 31, 2008. The Company operates in four primary segments: Loyalty Services, Epsilon Marketing Services, Private Label Services, and Private Label Credit. During the quarter, the Company classified its merchant and utility services businesses as discontinued operations, committing to a disposition plan. A significant corporate event was the termination of a proposed merger with affiliates of The Blackstone Group L.P. in April 2008, following a dispute over regulatory approvals.

Key Financial Metrics

Note: Net Income includes a loss from discontinued operations of $13.4 million. Operating cash flow was negatively impacted by a $102.7 million increase in merchant settlement activity (float).

Material Changes vs. Prior Period

• Revenue Growth: Total revenue increased 7.1% year-over-year, driven primarily by a 30.3% increase in Loyalty Services revenue (due to higher AIR MILES redemptions and issuances) and a 17.1% increase in Epsilon Marketing Services.
• Profitability Decline: Net income decreased 13.3% to $49.3 million. This was largely due to a $13.4 million loss from discontinued operations (including a $15.0 million impairment charge) and increased operating expenses in certain segments.
• Segment Performance: Private Label Credit revenue declined 4.9% due to a decrease in securitization income and higher credit losses. Private Label Services revenue declined 3.4% following the loss of the Lane Bryant portfolio.
• Cash Flow Volatility: Operating cash flow swung from positive $28.6 million in Q1 2007 to negative $26.5 million in Q1 2008. This variance is attributed to the timing of merchant settlement activity (float) rather than operational performance; cash flow before merchant settlement activity was positive $76.2 million.

Guidance, Outlook, and Risks

• Merger Termination and Litigation: The Company terminated the merger agreement with Blackstone on April 18, 2008, citing breach of contract regarding regulatory approvals. ADSC is seeking a $170.0 million Business Interruption Fee and has commenced litigation. Blackstone has filed a counter-action seeking a declaratory judgment that no fee is owed. This litigation poses a risk of significant legal costs and management distraction.
• Discontinued Operations: The Company is actively selling its merchant services business (agreement signed with Heartland Payment Systems for ~$77.5 million) and utility services. A $15.0 million impairment charge was recorded in Q1 2008 related to these assets.
• Liquidity and Debt: The Company maintains $205.0 million in unused borrowing capacity under its credit facilities. It prepaid $150.0 million of its bridge loan in March 2008. Management expects to remain in compliance with debt covenants (Senior Debt-to-Operating EBITDA was 1.3x vs. 2.75x limit).
• Asset Quality: Net charge-offs for the private label credit portfolio increased to 6.9% (annualized) from 5.9% in the prior year, reflecting higher delinquency rates.

Investor Verification Checklist

• Merger Litigation Outcome: Verify the status of the lawsuit regarding the $170 million Business Interruption Fee and potential legal cost accruals.
• Discontinued Operations Sale: Confirm the closing of the merchant services sale to Heartland Payment Systems and the final proceeds received.
• Credit Loss Trends: Monitor the trajectory of net charge-off rates in the Private Label Credit segment, which rose to 6.9% in Q1 2008.
• Working Capital Management: Assess the volatility of operating cash flows driven by merchant settlement float timing.
• Debt Covenants: Review compliance with leverage ratios given the increase in interest expense and potential impact of litigation costs.