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Be Wary Of Alliance Data Systems (NYSE:ADS) And Its Returns On Capital

When researching a stock for investment, what can tell us that the company is in decline? When we see a declining return on capital employed (ROCE) in conjunction with a declining base of capital employed, that's often how a mature business shows signs of aging. Basically the company is earning less on its investments and it is also reducing its total assets. In light of that, from a first glance at Alliance Data Systems (NYSE:ADS), we've spotted some signs that it could be struggling, so let's investigate.

Return On Capital Employed (ROCE): What is it?

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. The formula for this calculation on Alliance Data Systems is:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.063 = US$847m ÷ (US$24b - US$11b) (Based on the trailing twelve months to March 2020).

So, Alliance Data Systems has an ROCE of 6.3%. In absolute terms, that's a low return and it also under-performs the IT industry average of 9.8%.

Check out our latest analysis for Alliance Data Systems

roce
roce

Above you can see how the current ROCE for Alliance Data Systems compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Alliance Data Systems here for free.

How Are Returns Trending?

In terms of Alliance Data Systems' historical ROCE movements, the trend doesn't inspire confidence. To be more specific, the ROCE was 8.6% five years ago, but since then it has dropped noticeably. Meanwhile, capital employed in the business has stayed roughly the flat over the period. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on Alliance Data Systems becoming one if things continue as they have.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 44%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. What this means is that in reality, a rather large portion of the business is being funded by the likes of the company's suppliers or short-term creditors, which can bring some risks of its own.

The Bottom Line

In summary, it's unfortunate that Alliance Data Systems is generating lower returns from the same amount of capital. Unsurprisingly then, the stock has dived 83% over the last five years, so investors are recognizing these changes and don't like the company's prospects. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.

If you'd like to know more about Alliance Data Systems, we've spotted 5 warning signs, and 1 of them is a bit concerning.

While Alliance Data Systems may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.

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