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Edited Transcript of ADS earnings conference call or presentation 20-Apr-17 12:30pm GMT

Thomson Reuters StreetEvents

Q1 2017 Alliance Data Systems Corp Earnings Call

DALLAS May 3, 2017 (Thomson StreetEvents) -- Edited Transcript of Alliance Data Systems Corp earnings conference call or presentation Thursday, April 20, 2017 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Charles L. Horn

Alliance Data Systems Corporation - CFO and EVP

* Edward J. Heffernan

Alliance Data Systems Corporation - CEO, President and Director

* Edward Sebor

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Conference Call Participants

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* Andrew William Jeffrey

SunTrust Robinson Humphrey, Inc., Research Division - Director

* Ashish Sabadra

Deutsche Bank AG, Research Division - Research Analyst

* Darrin David Peller

Barclays PLC, Research Division - MD

* David Mark Togut

Evercore ISI, Research Division - Senior MD and Fundamental Research Analyst

* David Michael Scharf

JMP Securities LLC, Research Division - MD and Senior Research Analyst

* Eric Edmund Wasserstrom

Guggenheim Securities, LLC, Research Division - MD and Senior Equity Analyst

* Georgios Mihalos

Cowen and Company, LLC, Research Division - Director and Senior Research Analyst

* Jason Scott Deleeuw

Piper Jaffray Companies, Research Division - VP and Senior Research Analyst

* Moshe Katri

Wedbush Securities Inc., Research Division - MD

* Ramsey Clark El-Assal

Jefferies LLC, Research Division - Equity Analyst

* Timothy W. Willi

Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the Alliance Data Systems First Quarter 2017 Earnings Conference Call. (Operator Instructions) In order to view the company's presentation on their website, please remember to turn off your pop-up blocker on your computer.

It is now my pleasure to introduce your host, Mr. Edward Sebor of FTI Consulting. Sir, the floor is yours.

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Edward Sebor, [2]

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Thank you, operator. By now, you should have received a copy of the company's first quarter 2017 earnings release. If you haven't, please call FTI Consulting at (212) 850-5721.

On the call today, we have Ed Heffernan, President and Chief Executive Officer of Alliance Data; and Charles Horn, Chief Financial Officer of Alliance Data.

Before we begin, I would like to remind you that some of the comments made on today's call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and the uncertainties described in the company's earnings release and other filings with the SEC. Alliance Data has no obligation to update the information presented on the call.

Also on today's call, our speakers will reference certain non-GAAP financial measures, which we believe will provide useful information for investors. Reconciliation of those measures to GAAP will be posted on the Investor Relations website at www.alliancedata.com.

With that, I'd like to turn the call over to Ed Heffernan. Ed?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [3]

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Great. Thanks, Ed. We're going to follow a similar format that we did the last quarter that people seemed to like, which was focusing on a shorter commentary period and more questions.

And so with that, we're just going to jump right in here. I'm going to have Charles go ahead and walk through the first quarter results, and then I'll talk about trends and our full year outlook. So Charles, go ahead.

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [4]

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Sure. Thanks, Ed. Let's start with Slide #3. And if you look at our start to 2017, it was better than expected with revenue up 12% to $1.88 billion and core EPS up 2% to $3.91. Both exceeded guidance for the first quarter, which is a very good start.

Adjusted EBITDA net was flat at $440 million compared to the first quarter of 2016. A $72 million reserve build at Card Services and a $17 million decrease in adjusted EBITDA at AIR MILES due to the breakage reset at the end of 2016 dampened the growth rate for the quarter.

As delinquency trends moderate over the course of 2017, consistent with the wedge, the quarterly reserve build will moderate, while the year-over-year hole in AIR MILES adjusted EBITDA should close as program changes are implemented over the course of 2017.

Starting the year, we knew we need to deliver on 3 major assertions. First, that Epsilon could return to positive revenue and adjusted EBITDA growth and that we could stabilize the Technology Platform offering. We would say we're on track, especially in view of this very strong Q1.

Second, that credit normalization will conclude by the end of 2017. We'd say check as we're definitely tracking to the wedge on Slide 11.

Third, that we can retool the AIR MILES model to replace lost EBITDA from the breakage reset. We'd say that's still in process, but we do expect EBITDA margins to increase appreciably, especially in the back half of 2017.

Turning to capital allocation. We were active with our repurchase program during the first quarter, spending $415 million of the $500 million board authorization to acquire 1.7 million shares.

Let's go to the next slide and talk about LoyaltyOne. We'll start with AIR MILES, and AIR MILES revenue decreased 6% to $181 million for the first quarter of 2017. The decrease was largely due to a 4% decline in AIR MILES redeemed, which was expected given the elevated redemption activity in 2016. The burn rate, which are miles redeemed divided by miles issued, was still elevated during the first quarter of '17 due to a backlog that carried over from 2016, but we expect it to normalize at about a 78% burn rate for full year 2017.

AIR MILES adjusted EBITDA decreased 32% to $35 million or a 20% EBITDA margin. The decrease was primarily due to the lower breakage rate entering 2017. As you recall, it's now 20% versus historically, it was 26%, and that knocks about $0.01, or one penny, off profitability per mile redeemed. This is the hole we've talked about before. We are focused primarily on lowering the cost per mile redeemed by negotiating better vendor pricing, and we started to see results in March.

From a collector standpoint, our active collector statistics overall are down from last year but on par with 2015 levels. Our promotions in market, such as a recently completed cruise promotion where every mile earned during the qualifying period was an entry into one of 1,300 cruise packages, are stimulating issuance per transaction, which is positive news.

BrandLoyalty revenue and adjusted EBITDA decreased 6% to $152 million and 14% to $24 million, respectively, compared to the first quarter of 2016. The declines were largely due to program timing between years as well as unfavorable FX rates being a 3-point drag on both.

There's really nothing new to report on the North American expansion effort at this time, but there are several high potentials for 2017.

Let's flip to the next slide and discuss Epsilon.

It's the first quarter in some time that I actually enjoy talking about the Epsilon results as we started the year very strongly with revenue up 7%, adjusted EBITDA up 5%, a very nice flow-through of the top line growth to adjusted EBITDA. And there was a better balance of revenue growth in the key product categories than we have seen in some time. Epsilon Agency, auto and CRM were all up double digits with the CRM/Direct up a robust 47%. Data and affiliate product offerings increased in the low single-digit range. Technology Platform, which is about 25% of Epsilon's revenue, decreased 7%, which was a sequential improvement to the minus 13% in Q1 of '16 -- Q4 of '16, sorry. This offering turned quickly in 2016 as growth rates went from plus 5% growth in Q1 to flat in Q2 to minus 4% in Q3 and then minus 13% in Q4. The change in 2016 was due to the loss of a few key clients midyear. Importantly, the client base has since been very stable. Lastly, Conversant Agency was down 28% compared to the first quarter of 2016. This offering has been a consistent drag now for about 9 quarters but has now reached a level where, at less than 5% of Epsilon's revenue, it appears to be stabilizing.

Let's turn to Slide 6 and talk about Card Services.

Revenue increased 22% to slightly over $1 billion for the first quarter of 2017, driven by strong gross yields, which increased 80 bps compared to the first quarter of 2016.

Operating expenses increased only 3% to $316 million for the first quarter and, expressed as a percentage of average card receivables, declined 120 basis points compared to the first quarter of 2016. That is a very strong start to the year in terms of expense leveraging.

Adjusted EBITDA net increased 8% to $331 million for the first quarter of 2017 despite a $72 million build in allowance for the loan losses. And as we talked about before, that number should drop in Q2 and Q3.

Credit sales increased 6% to $6.6 billion for the first quarter, aided by tender share gains of about 100 basis points. Over 1/3 of credit sales for the quarter were through digital channels, reflecting the changing retail landscape. Web mobile applications increased 13%, while traditional channel applications such as in-store increased 6% during the quarter. Web mobile applications now account for over 30% of all applications.

Recognizing the shift to digital sales, we recently introduced a frictionless mobile acquisition capability, which reduces the application process to only a few keystrokes, reducing the abandonment rate to over 95%. These capabilities will allow us to continue to add e-tailers, such as Wayfair as clients.

Lastly, to clarify the topic of rising interest rates, yes, it benefits Card Services' net interest margin. The APR we charge is variable rate tied to prime rate. An increase in prime rate will reset the APR to the cardholder within 2 billing cycles. Conversely, funding costs, which are about 70% fixed rate, will reset over a 2-year period.

Now with that, I will turn it over to Ed.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [5]

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Great. Thanks, Charles. If you will turn to Slide 8, just a quick summary of the first quarter of 2017.

As we mentioned, on a consolidated basis, top line was up 12%, and we had a couple of points of growth on our core EPS.

Against guidance, the guidance was less than that for -- and was looking for high-single-digit top line and flat quarter. So a little bit better than guidance, which is always a good way to start the year.

What I think was a nice change as we began 2017 was we're beginning to see balance, a return to the model. Obviously, Card Services continued to have a very strong performance, but now we had Epsilon produce one of its best quarters since 2015, and it looks like a lot of the initiatives we took in -- we put in place the last 15 months finally beginning to take root. So that was positive there.

And then finally, on the LoyaltyOne, which is the final piece to add balance to the company, we all knew that we had a hole to dig out of in the first part of the year. We are on track to return back to a nice, healthy margin in the back half. And then BrandLoyalty, that jumps up and down by quarter depending upon when the big grocers want to launch their campaigns. This year looks more like it's going to be back half as opposed to front half. But those things are beginning to spool up as we had hoped for. And so as we exit the second quarter and into the back half, you should have a third engine also contributing very nicely, and that would restore the full balance that we've been lacking in the last year or 2. So that's where we stand right now.

If you move to sort of the full your outlook by business, Epsilon, as we talked about, very strong start to the year. And the full year guidance, we're going to keep unchanged at this point, which is $2.24 billion, up 4%, and $0.5 billion of EBITDA, up 4%. So given the start to the year, we think this is a reasonable target to set for the year.

Furthermore, on the piece of Epsilon that went south on us last year, which was the big Technology Platform business, about 1/4 of Epsilon/Conversant, the move that we've been trying to make is changing the model such that the pricing is more competitive with some of the SaaS-based solutions out there, where someone could bring it in-house and then hire a bunch of analysts or come to us. We think with our initiatives at the India office, we have the pricing under control. And we're beginning to see some momentum on the pipeline in terms of selling a more standardized product into the market. So our goal is to move from sort of that negative comp to basically flat by the end of the year, which will obviously raise the overall growth rate at Epi.

Turning to LoyaltyOne. Again, similar to Epsilon, full year guidance remains unchanged. In Canada, we expect the $760 million in revs and about $180 million in EBITDA. That's versus a couple of hundred million in EBITDA prior year. That's the hole that Charles talked about where -- that we need to fill in, in order to make up for the breakage change that was made.

We expect this model to be fully retooled by the third quarter, and I expect to see 25% margins return starting no later than the third quarter compared to sort of the 20% this quarter. We're making good progress on what we need to do there.

Overall, issuance, as we expected also, would be a little bit light until we get through some of the lingering noise from the Q4 change in law up in Canada. What we are beginning to see is the activity level is beginning to return on our collector side, and what we really need now is for the sponsors to really put their shoulder into the big promotional activities that account for a large chunk of the mile issued up there.

And then, as we talked about, BrandLoyalty, the big programs will be launching in the back half.

All right, Card Services, Slide 10. We still expect to see a very nice receivable growth of roughly 15%, almost $2.5 billion of growth. The pipeline remains robust, and we certainly expect to sign another $2 billion vintage, meaning signing a number of clients such that as they move from startup into full run rate, after about 3 years, all these clients combined will add about $2 billion of portfolio growth. Growth yields, certainly stable, and we expect an ongoing benefit from operating leverage.

Credit normalization, which is, of course, the big thing everyone was concerned about over the last year or so, is very nicely on track. It's obviously nice to see that Q1 came in precisely where the wedge said it would come in, which was 50 basis points over last year. So that big hurdle is done.

And right now, we're looking at Q2 to Q4, the gap looks like it's going to narrow as we expected.

So we have, at this point, very good visibility into pretty much the rest of the year in terms of the delinquency flows, and it's -- everything we're seeing now, it's no longer a guessing game of 2 years ago. This is now in the gun sights, and we can see it happening as we speak.

So the gap is going to close, and that essentially means that loss rates will follow. And that gives us a very high level of confidence that the '18 loss rate is going to be flat to '17. So good news there.

On the principal loss rate side, we won't go into all the stuff about denominator effects and timing and all that other stuff. Suffice to say the guidance that we gave on the prior call remains consistent, which is we're going to have a [6] handle on the losses in the first half, and I expect that to drop 100 basis points or so as we -- as we're in the back half. And so we think we're in good shape with the losses.

And then finally, full year guidance, double-digit revenue growth. And importantly, I think the one tweak we've made is we expect 10% growth on adjusted EBITDA. And again, it's kind of a funny term to use in the card business, but adjusted EBITDA for us does include all the expenses associated with losses as well as all the expenses associated with funding. We just happen to call that EBITDA to keep it consistent. What that also indicates is we had an 8% to 10% range to start the year. We're now firming it up at the high end. And so even if loss rates or other variables jump around a little bit here or there, we feel very comfortable that the higher end of the range is achievable this year, which is good news.

Finally, you'll see the fabulous delinquency wedge and tracking very nicely. And I will look forward to retiring this chart sometime in October when it is no longer relevant and then talk solely about no need to build up those big reserves for '18 because we're going to be flat to '17, and that will, of course, drive the slingshot.

Okay, finishing up. 2017 outlook, full year consolidated guidance remains the same, $7.7 billion on revs and core EPS roughly 10%, $18.50. In terms of how it should flow out, guidance was high single and flat in Q1. We came in a little better on plus 12%, plus 2%. Q2, we still want to keep it at mid-single and flat until we see the LoyaltyOne businesses, being AIR MILES and BrandLoyalty, kick into full gear by Q3. And then by Q3, you're going to have the LoyaltyOne businesses, along with Epsilon, continuing to produce, as well as lower loss rates start the acceleration process and start moving us into mid-teens earnings growth. And then by Q4, you're right in the teeth of it, and we'll be looking at low teens top line, mid-teens core EPS. And then the fun begins as we move into '18. And right now, the visibility on the slingshot of very significant acceleration into the back half and into 2018 remains right on track. I would say the only change is that it's -- we have much better visibility as each month goes by, and it's certainly increasing our confidence each month that ticks by.

So that's sort of where we are. It was a good quarter for Cards. It was a very good quarter for Epsilon. And then the businesses in LoyaltyOne are tracking to add to the balance in the back half. And that being said, we should be in good shape this year and very good shape going into '18.

And we'll keep it short and sweet. That's it. We'll open up for questions, please.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And your first question comes from the line of David Togut with Evercore ISI.

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David Mark Togut, Evercore ISI, Research Division - Senior MD and Fundamental Research Analyst [2]

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Nice to see the continued growth in tender share in Card. My question really focuses on operating expense discipline. You closed out 2016 with 1,000 associates in India. What are your plans to continue to build out the India office and low-cost locations generally? And what impact should that have on margins over the next year or so?

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [3]

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Yes, it's a great question, David. Again, that's primarily focused around the Epsilon division. We're not doing any offshoring with Card Services. You're right, we ended last year at about 1,000 associates in India. We're now up to about 1,300, I believe. The target will be to continue to grow that within the Epsilon division. I would not expect to see any EBITDA margin expansion. Right at the moment from it, what it does allow us to do, David, is be more price competitive on that core Tech Platform offering that we have, where, as Ed talked about, we've seen some pressure coming through from some SaaS products and cloud based. So what I'm looking for is to allow us to really grow the top line, sustain EBITDA margins but not necessarily be incremental to EBITDA margins until at a future date.

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David Mark Togut, Evercore ISI, Research Division - Senior MD and Fundamental Research Analyst [4]

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Got it. Just as a quick follow-up, the rewards propositions on traditional Visa and MasterCards continue to increase. I recognize this is more at the mass affluent end of the market, which is not necessarily your core in Private Label. But can you just talk about what you're seeing in your demographic in Visa and MasterCard as a sort of a competitor for the Private Label business and how you think about tweaking the value proposition to your consumers?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [5]

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Sure. I'll take that one, David. It's no question on the general-purpose cards. We know that the reward portion are getting more robust than they have in the past. From our perspective, again, we view the Private Label product as a specific loyalty product for an individual brand and not necessarily catering to the mass spend. And so the ability for us, I think, to keep at the sort of current level of rewards, I think, is reasonable. Where we're getting the juice, so to speak, is our ability to target the offers much more precisely than we have in the past. So in the past, if we were out there offering 1/3 of the base 10% off and 1/3 20% off, et cetera, et cetera, based upon their buying behavior, what we can do now is we can essentially go down to personalize targeting, which allows us to be much more efficient with the marketing dollars and get a higher lift. So as long as we continue to have the ability to target a lot better than sort of a general-purpose card, we should be -- I think our reward structure is about where it should be.

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Operator [6]

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Your next question comes from the line of Darrin Peller with Barclays.

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Darrin David Peller, Barclays PLC, Research Division - MD [7]

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Just a quick follow-up on the private -- on the Card Services business. The growth that you're calling for, it does account for any weakness there might be on the -- certain types of retailers that you guys have as clients, I mean, in terms of same-store sales growth. Can you remind also which buckets it's coming from? I know there's not a lot coming from portfolio acquisitions. And then just a quick follow-up on the provisions side. It did come in higher than we thought. Can you give us a little guidance? In other words, there's a nice cushion now, it looks like, versus charge-offs. I think you ended up with the reserves around 6.5% or 6.6% maybe. Where should we be versus charge-offs by the end of the year?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [8]

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Sure, I'll take the first and Charles can take the second. In terms of retailer sales, for sure I -- or the sort of traditional customer that we have out there, our traditional client, probably is looking at negative comps, as they were during holiday season, as opposed to a more traditional plus 3%. And recall that if they do plus 3% because of our tender share gains, we get our first 8% to 10% of growth just from that. Now if they're looking at minus 2%, we'll still get our tender share gains. But rather than getting up to plus 8%, we'll probably do like plus 3%. That essentially means that if we want to see our 15% growth in the file, we're going to have to have good performance out of the more recent signings, and we are seeing that, as well as continuing to sign a $2 billion-type vintage to keep those numbers up. Essentially, we're going to have to put more in the funnel in terms of number of clients to get the same level of growth that we had before. And that's effectively what we're looking at right now.

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [9]

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On the reserve side, Darrin, the reserve was 6.6% reservable AR at 12 -- sorry, at March 31. What I would expect is the provision build, that reserve build, which was $72 million in Q1, should drop probably below $50 million in Q2, below $50 million Q3. Q4, it's really going to come down to growth and whether we see any type of bulk acquisition coming through. So I think your question's right. Based on the trends we're seeing, should it be lower than 6.6% at year-end? I'd say based on trends now, that would be an accurate assumption.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [10]

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Yes, and just to finish up, Darrin, on the question about the organic growth, all the growth we're talking about here, the plus 15%, is organic, which is a combo of the core clients plus the spool-up of the recent signings over the past 3 years. There's no large portfolio acquisition or even modest portfolio acquisition put in there.

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Darrin David Peller, Barclays PLC, Research Division - MD [11]

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All right, that's helpful. And just a quick follow-up, guys, on the AIR MILES side of the business. Just to be clear, I mean, are you actually seeing sponsors willing to come back and provide more in the way of promotions again? I mean, I know that it was a little bit of sour spot for some of them last -- at the end of last year. You're saying collectors are now looking like they're coming in again. I guess to compensate for what's probably going to be a slightly lower reward percentage in terms of the cost to redeem a reward helping your margins, I just want to make sponsors are all on board for that, and the program should still be very much intact.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [12]

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Yes, I mean, it's -- look, no one had a lot of fun in Q4, I'll tell you that. It -- with -- the change in law up there threw everything into -- everyone into a tizzy. And right now, the noise has fortunately abated. What we're looking at is the number of -- the volume levels to the call centers and to the online reward redemptions and everything else has stabilized. It's come back virtually all the way back to where it was pre-noise, if I could call it. And so I think from that perspective, that's good. We are comfortable with the sponsors. There was a lot of noise. But right now, most of the -- or in fact, all of the sponsors have basically said, hey, enough already, let's get back to driving sales. So everyone is looking forward at this point. We don't expect to see any fallout from the sponsor side. The big questions right now and what we're doing is to get the 11 million collectors fired up again, and that's why we're spending a lot of money on sort of a relaunch and lots of marketing in terms of the benefits of the program. And we expect sponsors who have been on the sidelines for the last quarter or so to start putting their marketing dollars into the big promotional programs really starting in Q2. If I looked at issuance level, I would say this would be the bottom in terms of the growth rate. I would expect to see about halfway back to flat in Q2, and I would expect to see healthy positive growth in issuance Q3, Q4. That seems to be how the promotional spend is beginning to fall out this year.

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [13]

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And Darrin, the only thing I'd add on the cost-to-mile, the reason we're attacking the cost-to-mile is it does not reduce the value proposition to the collector. So if we can go through and negotiate better pricing for the same product, we basically fill the hole and the lost EBITDA without affecting the experience of the consumer, which is really the reason why we're attacking it in that approach.

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Operator [14]

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Your next question comes from the line of David Scharf with JMP Securities.

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David Michael Scharf, JMP Securities LLC, Research Division - MD and Senior Research Analyst [15]

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First is, and I know this is sort of a difficult topic to discuss in much detail on this call. But can you remind us, as it relates to big AIR MILES sponsors, what sort of the forward 24-month calendar looks like for renewals? And curious whether or not the events of the last year are likely to impact some of the pricing discussions you have as it relates to the value of those miles to your sponsor.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [16]

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Sure. No, it's not uncomfortable. It's a reasonable question. I'd say obviously, we're not going to talk about specific names, but we have a handful of renewals that we're looking to get done this year. We've got 2 of the 4 done so far, which is good news. We have certainly had our heads filled with a number of comments about what are we going to do about getting this brand going again. And I think where we're coming out, it's going to be less about any type of pricing pressure. I think we're going to be okay on that perspective. What it is going -- where it's going to show up, David, is we've agreed to fund some fairly robust spend in the first half of this year to reengage the collectors. So a lot of the marketing dollars that normally wouldn't need to be spent to get people fired up again, we're going to take -- we're going to shoulder that, and that's what's reflected in guidance.

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David Michael Scharf, JMP Securities LLC, Research Division - MD and Senior Research Analyst [17]

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Got it. Got it. And as a follow-up, just switching to the Card business, you partially addressed this in the discussion of retailer sales. Can you give us a sense for the 6% credit sales growth, how that tracked relative to your expectations, and whether there's any type of rule of thumb we ought to be thinking about for the relationship between credit sales growth, tender share and, ultimately, the mid-teens portfolio growth assumption?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [18]

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Yes, I mean, you're going to have -- I don't think there's a good rule of thumb. I think over the long haul, things seem to -- growth rate should be roughly in line with each other, but it's going to vary year by year. You're going to have years where credit sales growth is higher than portfolio growth and vice versa. I think the 6% in terms of sales versus the 15% or whatever we did in the portfolio is -- you're not going to see that big of a discrepancy going forward. My guess is you're going to start seeing the credit sales, we think, is probably going to be back maybe 8%, 9% in second quarter and will be double digit Q3, Q4 based on what we're looking at in terms of trends and in terms of comps. And then you're going to see the portfolio, right, will start trending in that sort of mid-teens level. So they're going to -- the gap should close this year. They'll never be 1-to-1. But look for the credit sales number to move from 6% to sort of 8% to 9% and then probably 11% or 12% in the back half.

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Operator [19]

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Your next question comes from the line of Tim Willi with Wells Fargo.

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Timothy W. Willi, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [20]

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I had 2 questions. So first one on Epsilon. Could you just talk a little bit around your, I guess, industry exposure? You highlighted auto being strong. But it seems like every day, there are more stories about have auto sales peaks, funding being cut off for borrowing, et cetera. Just, I guess, how you think about auto and your discussions with that vertical, but just any other industry verticals you would highlight as potentially strengthening or didn't have as great of a quarter but could bounce back. Just anything along those lines.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [21]

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Sure. Yes, one of the interesting things, obviously, if auto sales fall off a cliff, we'll certainly be impacted because there'll tend to be sort of across-the-board cut. However, if auto sales sort of level out at, what do we have, about $17 million or so a year, that's actually just fine because what will happen is the OEMs and the dealers will certainly be very focused on reaching any and all incremental buyer out there. A lot of the work that we do with the dealerships, which really drives the auto vertical, doesn't necessarily have to do with just the new car sales. It has to do with the communication of ongoing services. So as you know, dealers make a bunch of money on the services side. And so a lot of our work is predicting when someone needs that oil change or someone needs the new tires and things like that. And those are the communications that will be ongoing regardless of where new sales are. And then if new sales soften a bit, that means that the sort of one-to-one personalized marketing becomes more and more important. So the long-winded way of saying, Tim, that I think from the auto vertical itself, we are looking at another record year in terms of growth there, and it's mainly due to the dealerships signing up for the data-driven, personalized marketing that we're doing in communications. So I think unless auto sales fall off a cliff, we should be in pretty good shape. Otherwise, the other verticals look to be fairly healthy.

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Timothy W. Willi, Wells Fargo Securities, LLC, Research Division - MD and Senior Analyst [22]

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Great. And my follow-up on Card, you referenced what you're seeing in the digital channels both in terms of spend and applications. And then you also, I think, mentioned Wayfair as a new customer. I'm just curious, as online has obviously evolved and maybe hit an inflection point around consumers' shopping behaviors, has that at all expanded what you view as your addressable market of potential customers versus how you might have thought about your addressable market of retailers a couple of years ago?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [23]

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Yes. I mean, it's a good question. I think you're seeing some of the splintering of the retail space, much like we saw in TV when cable channels came along 1,000 years ago and splintered it, and now it's being splintered even more. So the name brands that used to need the floor space in a big department store don't need that anymore. They can have their own e-commerce site. And so our game plan going forward is you may not get the huge sales growth from signing a big brand or a big department store, but we can scoop up those individualized brands as they develop their own e-commerce sites. So our focus is going to be very, very heavily on helping our existing customers grow their online presence and their ability to more precisely target the customer as well as look at some of these newer e-commerce players.

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Operator [24]

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Your next question comes from the line of George Mihalos with Cowen.

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Georgios Mihalos, Cowen and Company, LLC, Research Division - Director and Senior Research Analyst [25]

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Wanted to start off with the first quarter being as strong as it's been and, obviously, several catalysts in the back half, faster Card Services growth, better growth in Loyalty. What keeps you at this juncture from increasing the guidance? What could sort of worry you in terms of eating into this buffer that you've built in?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [26]

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Too many years of doing this, I guess, is probably a good starting point. I think what we traditionally do, George, is we'll take a look at everything on the July call. And on the July call, if we see a continuation of what we expect to see, which is Card Services being strong and actually loss rates, or the wedge closing and loss rates beginning to head downward again into the 5s, that will be check the box #1. If we see Epsilon continuing to deliver solid mid-single or higher growth rate, then check the box #2. What we still need to check the box on is making sure we get all of our margin back at LoyaltyOne in the Canadian business. And we won't know that probably -- we're on track -- we're tracking to it, but we'll have a much better sense in July. So July is where we sort of say, okay, here's what we thought, here's where we are and what's it mean for the rest of the year and for '18. So all we can say is it's a good start, but we'll talk again in July.

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Georgios Mihalos, Cowen and Company, LLC, Research Division - Director and Senior Research Analyst [27]

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Okay, that's very helpful. And then just as it relates to Epsilon, Charles, I know you're talking about revenue growth and EBITDA growth sort of converging at the 4% range for the full year. In the first quarter, revenue sort of outpaced EBITDA by 2 points. Just curious what drove that, if there's any anomaly there and why that would reverse over the course of the year.

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [28]

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I'll tell you what I look at most, George, is what did payroll do. What did the fully burdened cost of payroll do? And it was up less than 6% in Q1 versus 7%. You always have some other operating expenses if you're onboarding new programs, such as the rollout of some new auto programs we have in place where you get some other expenses behind the scene ahead of it. But what you're really trying to do with the Epsilon model is always make sure that the revenue growth rate is better than the payroll growth rate, and we definitely did that in the first quarter. And I think that's really the trend we'll look to continue at the back half of the year. Like we said, we had a couple of new programs within the auto we're rolling out. We incur quite a bit of costs up front before they come functional, and that's part of the pressure why you didn't see a 1-for-1 flow-through. But really, it's the comparison of revenue to payroll that's relevant to us.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [29]

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Yes. And I think, just to follow up from Charles comment, look, we are not immune to the commentary that is out there regarding guidance we give on the Epsilon/Conversant businesses and being disappointed the last couple of years. So while we think we're in good shape and it's been a very nice start for Epsilon/Conversant and it looks like the visibility is there, we want to be very disciplined in our guide as the year flows out. We want to basically let the results get 2, 3 quarters in where we can finally say, okay, we're beginning to really reestablish the credibility that we -- that frankly, I think, we lost some in the last couple of years.

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Operator [30]

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Your next question comes from the line of Eric Wasserstrom with Guggenheim Securities.

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Eric Edmund Wasserstrom, Guggenheim Securities, LLC, Research Division - MD and Senior Equity Analyst [31]

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I know we've touched on this a couple of times, but I just want to circle back to the issue of the health of retailers, because several have not just indicated same-store sales comps but are looking to restructure balance sheets and maybe doing some of the things that signal the beginning of a broader decline. So can you just remind us how you deal with a potentially stressed partner and how that process works if they end up having to go into a bankruptcy process?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [32]

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Sure. To quote our fabulous President of Card Services, retail is not dead. Retail itself continues to grow, albeit a bit more modestly than it has in the past. But the overall category itself isn't dead. 85% of sales are still taking place in the store. What's happening is you're having a reallocation of where -- of who is getting those sales. And as we talked about, with the splintering of sort of department stores into their individual brands, creating their own e-commerce sites, to the Amazons of the world and the Wayfairs of the world and everything else, you're seeing a redistribution take place, which is causing an upheaval. So on an aggregate basis, the pie is still growing. On an individual basis, it remains to be seen who the winners and losers are going to be. That being said, to your point, you're dead on. There are a number of clients of ours who are being stressed right now. And traditionally, what happens in the past, as you mentioned, is that there's some type of prepackaged bankruptcy or something like that, that takes place. Really, the last thing that they want to do is shut down the sales pipeline. For us, to remember, we don't lose money if a retailer goes bankrupt. What we do lose, however, is we don't have that growth the following -- we don't have that portfolio the following year. That just collects out. So from our perspective, the fewer that show stress, the better off we are. The more that shows stress, that just means we're going to have to pedal the bike a little bit harder with a couple of more names in the pipeline than we had before, which, I think, is our go-forward approach, frankly, is we're going to need to sign another 2, 3 names a year above what we used to in the past to make up for that weakness. Fortunately, a lot of the marketing dollars continue to flow over to the data-driven marketing that we do. So you've got a push-pull going on.

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [33]

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Yes, the only thing I would add, and I think this is a very important piece, historically, when we've had a retailer just basically go out of business, go into liquidation, the loss rates in that portfolio are no different than the overall portfolio experience. So to Ed's point, you lose the opportunity. They can't go into the store and spend. But [if the] cardholder does not in and of itself say I'm going to walk away from this account. I'm going to charge it off and run the risk of basically cross-defaulting on different credit card. So our experience in the loss rates are very similar to what the overall portfolio experience is.

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Eric Edmund Wasserstrom, Guggenheim Securities, LLC, Research Division - MD and Senior Equity Analyst [34]

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You anticipated my next question. And is there anyone in your portfolio, not by name, but are there any retailers that you're particularly concerned about at the moment and engaging in discussion on their outlook?

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [35]

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I'd say there's none in particular. We had 2 small retailers go into liquidation, but they're very small portfolios, really aren't affecting us. In terms of any material client, there's none that are giving us any pause at this point.

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Operator [36]

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Your next question comes from the line of Moshe Katri with Wedbush Securities.

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Moshe Katri, Wedbush Securities Inc., Research Division - MD [37]

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Guys, good performance on Epsilon. One of the things that I remember that we kind of struggled with besides the cost structure was actually re-competes for -- especially with a couple of clients last year. Where are we on that front? And are there more large re-competes for Epsilon this year?

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [38]

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I'd say, Moshe, I think that the 3 clients we lost last year midyear definitely affected us. They did shift to a little bit different model than what we were providing for them. That's part of what Ed talked about, how we had to shift to a little bit more of a packaged product to lower the costs, lower pricing. What you have seen us do is as we've had renewals since then, we have come down a little bit on the pricing. We have to offset it by lower operating costs, primarily in payroll, with our off-shoring to India. So we'd say that base is stable. As Ed talked about before, we're expecting it to basically return to flat growth year-over-year probably as early as Q3. So we think that we've addressed the salient issues with the technology platforms. We've not seen any further client attrition. And we think the changes we've made have really put this back in place frankly to return it to a growth offering versus where it declined over the last 3 quarters.

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Moshe Katri, Wedbush Securities Inc., Research Division - MD [39]

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All right. And then given where we are on the cost structure of Epsilon, are you at this point feeling that you're competitive in this market? Because that was also an issue last year, especially in terms of pricing.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [40]

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Yes, absolutely. We're now at the point where pricing -- we are out there selling, and the pricing levels that we're at are deemed very competitive by the chief marketing officers versus an alternative like a SaaS-based and hiring 100 analysts. So we're there. We've got the packaged solution in the pipe, and now it's execution. So we've got a labor force structure for Epsilon/Conversant which basically calls for, in total, stable headcount in the United States and then somewhat growing at our India office. But most of the surgery is over at this point.

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Operator [41]

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Your next question comes from the line of Ramsey El-Assal of Jefferies.

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Ramsey Clark El-Assal, Jefferies LLC, Research Division - Equity Analyst [42]

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(inaudible) question is on the Tech Platform side. Also, of your Epsilon business. How material is the difference in economics that you guys capture for the SaaS implementation versus the fully outsourced model? And do you have any visibility as to how that mix is evolving with your new kind of more nimble offerings?

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [43]

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I'd say, Ramsey, it's a little bit early. We're just now introducing the packaged offering to the market. I would expect that -- the EBITDA margins to be fairly consistent with the full service, maybe down a little bit. But it's too early for us to really know what the answer is going to be there.

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Ramsey Clark El-Assal, Jefferies LLC, Research Division - Equity Analyst [44]

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Okay. Could you give us a little more granularity on the cadence of BrandLoyalty revenue this year? Do you have visibility as to whether there will be a quarter later in the year where that business just really pops like it has in the past? Or is it something wherein it's just going to fall at some point, and you're just not -- quite have that kind of visibility to it yet?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [45]

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Q3, Q4.

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [46]

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Yes.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [47]

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Both will be strong.

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [48]

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And Q4 is always the strongest for BrandLoyalty.

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Operator [49]

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Your next question comes from the line of Jason Deleeuw with Piper Jaffray.

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Jason Scott Deleeuw, Piper Jaffray Companies, Research Division - VP and Senior Research Analyst [50]

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Just hoping to get a little bit more color on the OpEx leverage in Card Services, just kind of the drivers there. And can we expect this to be a sustainable level?

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [51]

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Obviously, Q1, it was extremely good. I don't expect it to be quite that good for the full year. As Ed talked about, probably 20, 30 basis points versus a very strong start to the year. I'd say it's coming from pretty much all angles. So it's the growth in the portfolio. Obviously, it's the influence of co-brand that we put in there over the last few years, which has a little bit lower OpEx. But it gets into the way we do collection activities, whether we source within our own operations or we allow people to work from home. I would say there's really no one silver bullet. It's a combination of different factors that are really allowing us to drive that operating leverage.

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Jason Scott Deleeuw, Piper Jaffray Companies, Research Division - VP and Senior Research Analyst [52]

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Great. And then just following up on the other discussion around how retail, the landscape is evolving, more e-commerce, maybe different players, maybe a bigger addressable market for you guys. Is that just simply a Card Services, Private Label offering? Or is that also open up opportunities for Epsilon? Like how do you think about those opportunities as the retail space continues to evolve?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [53]

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Yes, it's a good question, Ed (sic) [Jason]. The biggest opportunity within the Epsilon/Conversant family is actually over on the Conversant side, the CRM product, which, as you know, is when we're out there, we use all the data from the SKU level information and the various demographic, psychographic information about the customers. And we can reach out and touch you across device multiple times every single day and do it in a very targeted, personalized basis because we do have the ability to identify your own unique device. And so from a retailer perspective, that is becoming sort of -- it's almost table stakes at this point that they have to participate in that. And that's something that is one of the reasons where CRM this quarter grew what, Charles, 40%?

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [54]

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47%.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [55]

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47%. Retail is going to be a huge growth driver for that as the retailers are shifting towards identifying their customers and offering them a different deal depending upon who they are. It's almost like pricing airline seats -- everyone has a different price -- and then also using sort of that anonymized profile to then go out and prospect and find new customers. So the net result of all of it is that the way marketing was done in the past has changing -- in the retail space, it's changing even faster, which fortunately means that our type of product is pretty attractive.

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Operator [56]

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Your next question comes from the line of Andrew Jeffrey with SunTrust.

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Andrew William Jeffrey, SunTrust Robinson Humphrey, Inc., Research Division - Director [57]

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Lots of talk about retailer health and same-store sales and changing consumer behavior. Ed, can you just address how big that you think the TAM is for Card Services, how penetrated you are, and whether the market has changed in a meaningful way, either having expanded or contracted, over the years?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [58]

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Sure. I think -- and clearly, I don't think you'll find anyone out there who thinks we need more stores. I think we've all realized that we've been -- it's a bit overbuilt and needs to come down to reality. But again, the overall market for retail is a growing market. Again, not quite as fast as it used to be, but it is growing. You just have different players shifting. In terms of the TAM, from our perspective, we believe that we are roughly halfway through what we believe is our comfortable sandbox. So if you think of $15 billion, $16 billion portfolio as roughly half penetrated, that would be about right. I think we're probably -- the last cut I saw, if you included e-commerce -- sorry, pure e-commerce players, would be -- we think, overall, our sandbox is about a $35 billion portfolio. And so the delta between where we are today and where we're going surprisingly is not filled by a bunch of folks who have an existing program. A lot of these folks are just now beginning to shift their dollars away from the traditional marketing spend channels and into -- really getting into the personalized one-to-one, data-driven, targeted marketing. And we all think that everyone has already done all that, and the answer is they haven't. It's a trend that's well underway, but there's a long, long way to go. And based on our pipeline, we feel comfortable that our sandbox is certainly not shrinking and perhaps growing just a little bit more. If you think about some of the folks that weren't in our sandbox had these massive $5 billion, $6 billion, $8 billion files, which frankly were too big for us, but if those are some of these massive department stores where you have the name brands within those stores now cutting out on their own to become e-commerce players, they're much smaller and more bite-sized, and we excel at bite-sized.

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Andrew William Jeffrey, SunTrust Robinson Humphrey, Inc., Research Division - Director [59]

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Okay, that's helpful. And then when you look at -- I think you said about 47% CRM revenue growth in the first quarter?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [60]

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Yes.

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Andrew William Jeffrey, SunTrust Robinson Humphrey, Inc., Research Division - Director [61]

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That's pretty encouraging. Can you talk a little bit about the pipeline and how much of continued growth in that business is coming from existing customers taking share within their marketing budgets versus new customer signing?

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [62]

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Sure. You're going down the right area, which is the way that CRM signings work is almost like a vintage, where in the first year, you'll sign a group, and maybe they do $50 million of revenue first year, $75 million second year, $100 million third year, we are definitely benefiting. At the same time, though, we are definitely benefiting from new clients. Last year, we added about 33 new clients to CRM. This year, it could be an estimate as high as 50. So it's the combination of both the ability to leverage a new client for 3 to 4 years to get revenue growth, plus we're continuing to onboard more clients as people see -- companies see the value of the proposition we bring.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [63]

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Yes, it's a pretty cool business in the sense of much like the card business, it's -- you have clients that spool up over 2- to 3-year period. So you can -- you build these vintages, and so you can have pretty good visibility into the next year or 2 based upon the number of client signings. But for sure, existing clients are spending more, and the market for new clients is getting deeper.

All right, one more.

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Operator [64]

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Our final question comes from the line of Ashish Sabadra with Deutsche Bank.

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Ashish Sabadra, Deutsche Bank AG, Research Division - Research Analyst [65]

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A quick question on gross yield expansion. I understand you benefit from higher interest rate, but we saw some pretty solid growth there. I was just wondering what drove that. And how should we think about it through the rest of the year?

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [66]

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The way we look at it, Ashish, we knew that we had a little pressure early in 2016 that we played through starting this year at 25.5% gross yields. It's consistent with the average we had last year. So we would tell you there could be a little positivity to it based upon, obviously, any changes with the Fed raising rates and so forth could pass a little bit through to gross yield. The thing that always creates noise within your gross yields is if you do find a bulk file and you acquire it, it puts temporary pressure. So there's a lot of moving parts. But we would say stay at steady state. 25.5% feels good for the year. It could up maybe 10, 20 basis points given further interest rate increases coming through. But really, it goes back to mid-2015. If you remember, we've put some changes in place that were cardholder friendly. We had to burn through those issues and the temporary pressure it put. And we would tell you at this point, we're past that.

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Ashish Sabadra, Deutsche Bank AG, Research Division - Research Analyst [67]

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No, that's great. Maybe one quick follow-up would be just the free cash flow expectations for this year. And how do you think about the capital allocation through the rest of the year?

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [68]

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Yes, Charles can hit the free cash flow. I think from an allocation, I'm good on the spending side of it. Certainly, we instituted a dividend, which is couple $100 million. Then you've got buyback. We've had authorization for $500 million. Obviously, we have the opportunity to go back to the well if we so choose. So at a minimum, that gets you to $700 million. There's probably $400 million or so we're setting aside for growth, the capital required to grow the $2.5 billion. If I'm doing my math right, about $1.1 billion or so. And then that leaves a little room for either maybe a tuck-in deal if there's something attractive by the end of the year. We're not going to do anything until we're sure that all 3 businesses are -- have executed and are all contributing and the balance has been restored. So that would be one thing. It wouldn't be until late in the year. Or we could certainly go back to the well for additional buyback if we so choose. So I think that would chew up. The goal is to basically get through the free cash flow but try to keep the leverage multiple under 3, which is what we traditionally do. So Charles?

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Charles L. Horn, Alliance Data Systems Corporation - CFO and EVP [69]

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No, nothing to add to that.

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Edward J. Heffernan, Alliance Data Systems Corporation - CEO, President and Director [70]

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So that should do it.

All right. Well, thank you, everyone. And we kept it exactly to an hour, and we'll talk to you again in a few months. Bye.

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Operator [71]

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This concludes today's conference call. You may now disconnect.