form_10q.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 June 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 £     No R
 
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 August 1, 2012, 49,906,953 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.
27
Item 3.
41
Item 4.
41
Part II:  OTHER INFORMATION
Item 1.
42
Item 1A.
42
Item 2.
42
Item 3.
42
Item 4.
43
Item 5.
43
Item 6.
44
45


 
2


PART I
 
Item 1. Financial Statements.
 
ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
 
   
June 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
ASSETS
 
Cash and cash equivalents
 
$
642,199
   
$
216,213
 
Trade receivables, less allowance for doubtful accounts ($4,718 and $2,406 at June 30, 2012 and December 31, 2011, respectively)
   
319,292
     
300,895
 
Credit card receivables:
               
Credit card receivables – restricted for securitization investors
   
4,891,816
     
4,886,168
 
Other credit card receivables
   
818,885
     
779,843
 
Total credit card receivables
   
5,710,701
     
5,666,011
 
Allowance for loan loss
   
(432,521
)
   
(468,321
)
Credit card receivables, net
   
5,278,180
     
5,197,690
 
Deferred tax asset, net
   
208,022
     
252,303
 
Other current assets
   
553,541
     
121,589
 
Redemption settlement assets, restricted
   
476,234
     
515,838
 
Assets of discontinued operations
   
     
2,439
 
Total current assets
   
7,477,468
     
6,606,967
 
Property and equipment, net
   
218,938
     
195,397
 
Deferred tax asset, net
   
54,974
     
43,408
 
Cash collateral, restricted
   
124,895
     
158,727
 
Intangible assets, net
   
347,601
     
383,646
 
Goodwill
   
1,450,284
     
1,449,363
 
Other non-current assets
   
152,754
     
142,741
 
Total assets
 
$
9,826,914
   
$
8,980,249
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
Accounts payable
 
$
169,938
   
$
149,812
 
Accrued expenses
   
160,983
     
206,621
 
Deposits
   
809,547
     
642,567
 
Asset-backed securities debt – owed to securitization investors
   
1,634,517
     
1,694,198
 
Current debt
   
22,972
     
19,834
 
Other current liabilities
   
106,202
     
105,888
 
Deferred revenue
   
994,526
     
1,036,251
 
Total current liabilities
   
3,898,685
     
3,855,171
 
Deferred revenue
   
196,634
     
190,185
 
Deferred tax liability, net
   
187,246
     
151,746
 
Deposits
   
843,405
     
711,208
 
Asset-backed securities debt – owed to securitization investors
   
1,803,250
     
1,566,089
 
Long-term and other debt
   
2,405,350
     
2,163,640
 
Other liabilities
   
131,352
     
166,244
 
Total liabilities
   
9,465,922
     
8,804,283
 
Commitments and contingencies
               
Stockholders’ equity:
               
Common stock, $0.01 par value; authorized, 200,000 shares; issued, 94,752 shares and 94,141 shares at June 30, 2012 and December 31, 2011, respectively
   
948
     
941
 
Additional paid-in capital
   
1,412,598
     
1,387,773
 
Treasury stock, at cost, 44,797 shares and 44,311 shares at June 30, 2012 and December 31, 2011, respectively
   
(2,379,728
)
   
(2,320,696
)
Retained earnings
   
1,350,054
     
1,131,004
 
Accumulated other comprehensive loss
   
(22,880
)
   
(23,056
)
Total stockholders’ equity
   
360,992
     
175,966
 
Total liabilities and stockholders’ equity
 
$
9,826,914
   
$
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
June 30,
 
Six Months Ended
 June 30,
 
   
2012
 
2011
 
2012
 
2011
 
   
(In thousands, except per share amounts)
 
Revenues
                     
Transaction
 
$
77,502
 
$
69,869
 
$
160,246
 
$
146,640
 
Redemption
   
159,185
   
133,342
   
347,651
   
283,102
 
Finance charges, net
   
377,794
   
332,272
   
754,109
   
674,414
 
Database marketing fees and direct marketing services
   
219,530
   
182,264
   
433,126
   
334,974
 
Other revenue
   
32,474
   
22,711
   
62,922
   
41,764
 
Total revenue
   
866,485
   
740,458
   
1,758,054
   
1,480,894
 
Operating expenses
                 
Cost of operations (exclusive of depreciation and amortization disclosed separately below)
   
506,455
   
431,250
   
1,033,360
   
835,775
 
Provision for loan loss
   
52,552
   
60,376
   
101,879
   
128,042
 
General and administrative
   
27,532
   
21,021
   
51,531
   
41,960
 
Depreciation and other amortization
   
18,496
   
16,850
   
36,100
   
33,604
 
Amortization of purchased intangibles
   
20,907
   
19,170
   
42,022
   
37,814
 
Total operating expenses
   
625,942
   
548,667
   
1,264,892
   
1,077,195
 
Operating income
   
240,543
   
191,791
   
493,162
   
403,699
 
Interest expense
             
Securitization funding costs
   
22,518
   
35,062
   
44,847
   
66,048
 
Interest expense on deposits
   
6,003
   
5,494
   
11,966
   
11,187
 
Interest expense on long-term and other debt, net
   
44,546
   
38,238
   
81,906
   
73,018
 
Total interest expense, net
   
73,067
   
78,794
   
138,719
   
150,253
 
Income before income tax
 
$
167,476
 
$
112,997
 
$
354,443
 
$
253,446
 
Provision for income taxes
   
63,655
   
43,974
   
135,393
   
98,047
 
Net income
 
$
103,821
 
$
69,023
 
$
219,050
 
$
155,399
 
                           
Basic income per share
 
$
2.07
 
$
1.35
 
$
4.37
 
$
3.04
 
Diluted income per share
 
$
1.63
 
$
1.19
 
$
3.49
 
$
2.74
 
                           
Weighted average shares
             
Basic
   
50,161
   
51,070
   
50,157
   
51,099
 
Diluted
   
63,731
   
58,145
   
62,790
   
56,778
 
                           
 
See accompanying notes to unaudited condensed consolidated financial statements.

 
4


ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME
 
   
Three Months Ended
June 30,
   
Six Months Ended
 June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands)
 
                             
Net income
 
$
103,821
   
$
69,023
   
$
219,050
   
$
155,399
 
Other comprehensive income, net of tax
                               
Net unrealized gain (loss) on securities available-for-sale, net of tax benefit of $(90), tax expense of $146 and tax benefit of $(116), tax expense of $150 for the three and six months ended June 30, 2012 and 2011, respectively
   
352
     
3,484
     
1,836
     
(944
Foreign currency translation adjustments
   
1,406
     
(387
   
(1,660
   
(3,531
Total comprehensive income, net of tax
 
$
105,579
   
$
72,120
   
$
219,226
   
$
150,924
 
                                 
 
See accompanying notes to unaudited condensed consolidated financial statements.

 
5


ALLIANCE DATA SYSTEMS CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
   
Six Months Ended
June 30,
 
   
2012
   
2011
 
   
(In thousands)
 
CASH FLOWS FROM OPERATING ACTIVITIES:
 
Net income                                                                                                                      
 
$
219,050
   
$
155,399
 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
Depreciation and amortization                                                                                                                   
   
78,122
     
71,418
 
Deferred income taxes                                                                                                                   
   
68,865
     
9,960
 
Provision for loan loss                                                                                                                   
   
101,879
     
128,042
 
Non-cash stock compensation                                                                                                                   
   
25,186
     
20,190
 
Fair value gain on interest-rate derivatives                                                                                                                   
   
(15,184
)
   
(14,603
)
Amortization of discount on convertible senior notes                                                                                                                   
   
40,050
     
35,882
 
Change in operating assets and liabilities, net of acquisitions:
 
Change in trade accounts receivable                                                                                                                   
   
(43,872
)
   
(19,321
)
Change in other assets                                                                                                                   
   
26,684
     
10,941
 
Change in accounts payable and accrued expenses                                                                                                                   
   
(8,570
)
   
(21,599
)
Change in deferred revenue                                                                                                                   
   
(39,323
)
   
5,113
 
Change in other liabilities                                                                                                                   
   
(19,638
)
   
36,253
 
Excess tax benefits from stock-based compensation                                                                                                                      
   
(13,564
)
   
(11,590
)
Other                                                                                                                      
   
(2,247
)
   
1,782
 
Net cash provided by operating activities
   
417,438
     
407,867
 
   
CASH FLOWS FROM INVESTING ACTIVITIES:
 
Change in redemption settlement assets                                                                                                                      
   
41,440
     
15,513
 
Change in restricted cash                                                                                                                      
   
(438,665
)
   
16,842
 
Change in credit card receivables                                                                                                                      
   
(61,375
)
   
270,586
 
Purchase of credit card portfolios                                                                                                                      
   
(122,237
)
   
(42,696
)
Change in cash collateral, restricted                                                                                                                      
   
37,735
     
(131,172
)
Payments for acquired businesses, net of cash                                                                                                                      
   
     
(359,076
)
Capital expenditures                                                                                                                      
   
(55,541
)
   
(33,935
)
Investments in the stock of investees                                                                                                                      
   
(921
)
   
(13,591
)
Other                                                                                                                      
   
(13,417
)
   
222
 
Net cash used in investing activities
   
(612,981
)
   
(277,307
)
   
CASH FLOWS FROM FINANCING ACTIVITIES:
 
Borrowings under debt agreements                                                                                                                      
   
699,500
     
2,336,500
 
Repayments of borrowings                                                                                                                      
   
(494,691
)
   
(1,876,776
)
Issuances of deposits                                                                                                                      
   
659,227
     
138,061
 
Repayments of deposits                                                                                                                      
   
(360,050
)
   
(169,480
)
Borrowings from asset-backed securities                                                                                                                      
   
897,038
     
636,500
 
Repayments/maturities of asset-backed securities                                                                                                                      
   
(719,558
)
   
(989,757
)
Payment of capital lease obligations                                                                                                                      
   
(11
)
   
(3,791
)
Payment of deferred financing costs                                                                                                                      
   
(25,624
)
   
(24,564
)
Excess tax benefits from stock-based compensation                                                                                                                      
   
13,564
     
11,590
 
Proceeds from issuance of common stock                                                                                                                      
   
11,411
     
20,533
 
Purchase of treasury shares                                                                                                                      
   
(59,032
)
   
(116,661
)
Net cash provided by (used in) financing activities
   
621,774
     
(37,845
)
   
Effect of exchange rate changes on cash and cash equivalents
   
(245
)
   
992
 
Change in cash and cash equivalents
   
425,986
     
93,707
 
Cash and cash equivalent at beginning of period
   
216,213
     
139,114
 
Cash and cash equivalents at end of period                                                                                                                
 
$
642,199
   
$
232,821
 
   
SUPPLEMENTAL CASH FLOW INFORMATION:
 
Interest paid                                                                                                                      
 
$
99,257
   
$
118,971
 
Income taxes paid, net                                                                                                                      
 
$
98,243
   
$
58,371
 
 
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.
 
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
June 30,
   
Six Months Ended
June 30,
 
   
2012
 
2011
   
2012
 
2011
 
       
(In thousands, except per share amounts)
     
Numerator:
                       
Net Income
 
$
103,821
 
$
69,023
   
$
219,050
 
$
155,399
 
Denominator:
                   
Weighted average shares, basic
   
50,161
   
51,070
     
50,157
   
51,099
 
Weighted average effect of dilutive securities:
               
Shares from assumed conversion of convertible senior notes
   
8,435
   
4,659
     
8,051
   
3,724
 
Shares from assumed conversion of convertible note warrants
   
4,399
   
1,537
     
3,844
   
1,085
 
Net effect of dilutive stock options and unvested restricted stock
   
736
   
879
     
738
   
870
 
Denominator for diluted calculations
   
63,731
   
58,145
     
62,790
   
56,778
 
                             
Basic net income per share
 
$
2.07
 
$
1.35
   
$
4.37
 
$
3.04
 
Diluted net income per share
 
$
1.63
 
$
1.19
   
$
3.49
 
$
2.74
 
 
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.

 
7

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
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 six months ended June 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:
 
   
June 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Principal receivables
 
$
5,451,277
   
$
5,408,862
 
Billed and accrued finance charges
   
222,735
     
221,357
 
Other receivables
   
36,689
     
35,792
 
Total credit card receivables
   
5,710,701
     
5,666,011
 
Less credit card receivables – restricted for securitization investors
   
4,891,816
     
4,886,168
 
Other credit card receivables
 
$
818,885
   
$
779,843
 
 
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 $48.3 million for the three months ended June 30, 2012 and 2011, respectively, and $93.2 million and $104.5 million for the six months ended June 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.

 
8

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
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
June 30,
   
Six Months Ended
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands)
 
Balance at beginning of period
 
$
447,483
   
$
489,620
   
$
468,321
   
$
518,069
 
Provision for loan loss
   
52,552
     
60,376
     
101,879
     
128,042
 
Recoveries
   
23,864
     
21,876
     
52,714
     
47,742
 
Principal charge-offs
   
(91,378
)
   
(108,942
)
   
(190,393
)
   
(232,838
)
Other
   
     
(1,915
)
   
     
 
Balance at end of period
 
$
432,521
   
$
461,015
   
$
432,521
   
$
461,015
 
 
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 will engage collection agencies and outside attorneys to continue those efforts.
 
The following table presents the delinquency trends of the Company’s credit card portfolio:
 
   
June 30,
2012
   
% of
Total
   
December 31,
2011
   
% of
Total
 
           
(In thousands, except percentages)
         
Receivables outstanding – principal
 
$
5,451,277
     
100
%
 
$
5,408,862
     
100
%
Principal receivables balances contractually delinquent:
                               
31 to 60 days
   
77,212
     
1.4
%
   
78,272
     
1.4
%
61 to 90 days
   
49,842
     
0.9
     
51,709
     
1.0
 
91 or more days
   
87,346
     
1.6
     
105,626
     
2.0
 
Total
 
$
214,400
     
3.9
%
 
$
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 Accounting Standards Codification (“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 significant difference in the allowance for loan loss.

 
9

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The Company had $107.9 million and $122.2 million, respectively, as a recorded investment in impaired credit card receivables with an associated allowance for loan loss of $40.7 million and $45.3 million, respectively, as of June 30, 2012 and December 31, 2011. These modified credit card receivables represented less than 3% of the Company’s total credit card receivables at each of June 30, 2012 and December 31, 2011.
 
The average recorded investment in the impaired credit card receivables was $111.8 million and $135.0 million for the three months ended June 30, 2012 and 2011, respectively, and $115.6 million and $135.3 million for the six months ended June 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 $2.9 million and $3.5 million for the three months ended June 30, 2012 and 2011, respectively, and $6.1 million and $7.1 million for the six months ended June 30, 2012 and 2011, respectively, in interest income associated with modified credit card receivables during the period that such credit card receivables were impaired.
 
The following tables provide information on credit card receivables that entered into a modification program during the specified periods:
 
   
Three Months Ended June 30, 2012
   
Six Months Ended June 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
   
28,499
   
$
25,917
   
$
25,839
     
60,039
   
$
54,155
   
$
54,068
 
                                                 
 
 
   
Three Months Ended June 30, 2011
   
Six Months Ended June 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
   
38,966
   
$
34,389
   
$
34,381
     
83,038
   
$
71,818
   
$
69,764
 
                                                 
 
 
10

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
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
June 30, 2012
   
Six Months Ended
June 30, 2012
 
   
Number of Restructurings
   
Outstanding Balance
   
Number of Restructurings
   
Outstanding Balance
 
   
(Dollars in thousands)
 
Troubled debt restructurings, defaulted – credit card receivables
   
13,187
   
$
12,699
     
29,207
   
$
28,161
 
                                 
 
 
   
Three Months Ended
June 30, 2011
   
Six Months Ended
June 30, 2011
 
   
Number of Restructurings
   
Outstanding Balance
   
Number of Restructurings
   
Outstanding Balance
 
   
(Dollars in thousands)
 
Troubled debt restructurings, defaulted – credit card receivables
   
19,595
   
$
19,414
     
38,395
   
$
38,417
 
                                 
 
Age of Credit Card Receivables
 
The following table sets forth, as of June 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
   
3,469
     
26.5
%
 
$
1,198,107
     
22.0
%
13-24 Months
   
1,728
     
13.2
     
660,098
     
12.1
 
25-36 Months
   
1,335
     
10.2
     
605,357
     
11.1
 
37-48 Months
   
1,023
     
7.8
     
504,946
     
9.2
 
49-60 Months
   
851
     
6.5
     
396,614
     
7.3
 
Over 60 Months
   
4,683
     
35.8
     
2,086,155
     
38.3
 
Total
   
13,089
     
100.0
%
 
$
5,451,277
     
100.0
%
 
 
11

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Credit Quality
 
The Company uses proprietary scoring models developed specifically for the purpose of monitoring the Company’s obligor credit quality. The proprietary scoring model is used as a tool in the underwriting process and for making credit decisions. The proprietary scoring model is based on historical data and requires 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 June 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
 
$
112,731
     
2.1
%
27.1% and higher
   
232,278
     
4.2
 
17.1% - 27.0%
   
478,551
     
8.8
 
12.6% - 17.0%
   
551,539
     
10.1
 
3.7% - 12.5%
   
2,197,155
     
40.3
 
1.9% - 3.6%
   
1,236,673
     
22.7
 
Lower than 1.9%
   
642,350
     
11.8
 
Total
 
$
5,451,277
     
100.0
%
 
Portfolio Acquisitions
 
In March 2012, World Financial Network Bank (“WFNB”) acquired the existing private label credit card portfolio of Pier 1 Imports. The total purchase price was $97.7 million, which consisted of $96.2 million of credit card receivables and $1.5 million of intangible assets that are included in the unaudited condensed consolidated balance sheets as of June 30, 2012.
 
In May 2012, World Financial Capital Bank (“WFCB”) acquired the existing private label credit card portfolio of Premier Designs, Inc. The preliminary total purchase price, which is subject to customary purchase price adjustments, was $24.5 million and consisted of $22.8 million of credit card receivables and $1.7 million of intangible assets that are included in the unaudited condensed consolidated balance sheets as of June 30, 2012.
 
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 six months ended June 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.

 
12

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
The tables below present quantitative information about the components of total securitized credit card receivables, delinquencies and net charge-offs:
 
   
June 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Total credit card receivables – restricted for securitization investors
 
$
4,891,816
   
$
4,886,168
 
Principal amount of credit card receivables – restricted for securitization investors, 90 days or more past due
 
$
78,104
   
$
94,981
 
 
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands)
 
Net charge-offs of securitized principal
 
$
60,640
   
$
78,623
   
$
123,445
   
$
165,926
 
                                 
 
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:
 
   
June 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
 
$
6,379
   
$
   
$
   
$
6,379
   
$
35,465
   
$
   
$
   
$
35,465
 
Government bonds
   
4,954
     
104
     
     
5,058
     
4,948
     
152
     
     
5,100
 
Corporate bonds
   
456,346
     
8,869
     
(418
)
   
464,797
     
468,894
     
7,416
     
(1,037
)
   
475,273
 
Total
 
$
467,679
   
$
8,973
   
$
(418
)
 
$
476,234
   
$
509,307
   
$
7,568
   
$
(1,037
)
 
$
515,838
 
 
The following tables show the gross unrealized losses and fair value for those investments that were in an unrealized loss position as of June 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
   
June 30, 2012
12 Months or Greater
   
Total
 
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
 
   
(In thousands)
 
Government bonds
 
$
   
$
   
$
   
$
   
$
   
$
 
Corporate bonds
   
     
     
4,507
     
(418
)
   
4,507
     
(418
)
Total
 
$
   
$
   
$
4,507
   
$
(418
)
 
$
4,507
   
$
(418
)
 
 
   
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)
 
Government bonds
 
$
   
$
   
$
   
$
   
$
   
$
 
Corporate bonds
   
65,043
     
(444
)
   
18,124
     
(593
)
   
83,167
     
(1,037
)
Total
 
$
65,043
   
$
(444
)
 
$
18,124
   
$
(593
)
 
$
83,167
   
$
(1,037
)
 

 
13

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
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 June 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 June 30, 2012 by contractual maturity are as follows:
 
   
Amortized
Cost
   
Estimated
Fair Value
 
   
(In thousands)
 
Due in one year or less
 
$
93,723
   
$
93,831
 
Due after one year through five years
   
373,956
     
382,403
 
Total
 
$
467,679
   
$
476,234
 
       
 
5. INTANGIBLE ASSETS AND GOODWILL
 
Intangible Assets
 
Intangible assets consist of the following:
 
   
June 30, 2012
   
   
Gross
Assets
   
Accumulated
Amortization
   
Net
 
Amortization Life and Method
   
(In thousands)
   
Finite Lived Assets
                   
Customer contracts and lists
 
$
314,245
   
$
(157,096
)
 
$
157,149
 
3-12 years—straight line
Premium on purchased credit card portfolios
   
159,395
     
(92,462
)
   
66,933
 
5-10 years—straight line, accelerated
Customer database
   
175,429
     
(106,600
)
   
68,829
 
4-10 years—straight line
Collector database
   
68,854
     
(61,896
)
   
6,958
 
30 years—15% declining balance
Tradenames
   
38,162
     
(8,922
)
   
29,240
 
5-15 years—straight line
Purchased data lists
   
20,639
     
(14,497
)
   
6,142
 
1-5 years—straight line, accelerated
Noncompete agreements
   
300
     
(300
)
   
 
2 years—straight line
   
$
777,024
   
$
(441,773
)
 
$
335,251
   
Indefinite Lived Assets
                         
Tradenames
   
12,350
     
     
12,350
 
Indefinite life
Total intangible assets
 
$
789,374
   
$
(441,773
)
 
$
347,601
   
 
 
   
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
   

 
14

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Goodwill
 
The changes in the carrying amount of goodwill for the six months ended June 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
   
680
     
241
     
     
     
921
 
June 30, 2012
 
$
242,377
   
$
946,175
   
$
261,732
   
$
   
$
1,450,284
 
 
6. DEBT
 
Debt consists of the following:
 
Description
 
June 30,
2012
   
December 31,
2011
 
Maturity
 
Interest Rate
   
(Dollars in thousands)
       
                   
Deposits:
                     
Certificates of deposit
 
$
1,514,944
   
$
1,353,775
 
Various - July 2012 – April 2019
 
0.20% to 5.25%
Money market deposits
   
138,008
     
 
On demand
 
0.01% to 0.26%
Total deposits
   
1,652,952
     
1,353,775
       
Less: current portion
   
(809,547
)
   
(642,567
)
     
Long-term portion
 
$
843,405
   
$
711,208
       
                   
Asset-backed securities debt – owed to securitization investors:
                     
Fixed rate asset-backed term note securities
 
$
1,929,415
   
$
1,562,815
 
Various - July 2012 – March 2019
 
1.68% to 7.00%
Floating rate asset-backed term note securities
   
645,825
     
703,500
 
Various - July 2012 – April 2013
 
(1)
Conduit asset-backed securities
   
862,527
     
993,972
 
Various - September 2012 – March 2014
 
1.20% to 1.70%
Total asset-backed securities – owed to securitization investors
   
3,437,767
     
3,260,287
       
Less: current portion
   
(1,634,517
)
   
(1,694,198
)
     
Long-term portion
 
$
1,803,250
   
$
1,566,089
       
                   
Long-term and other debt:
                 
2011 credit facility
 
$
   
$
410,000
 
May 2016
 
—%
2011 term loan
   
897,403
     
782,594
 
May 2016 or May 2017
 
(2)
Senior notes due 2020
   
500,000
     
 
April 2020
 
6.38%
Convertible senior notes due 2013
   
739,484
     
711,480
 
August 2013
 
1.75%
Convertible senior notes due 2014
   
291,411
     
279,365
 
May 2014
 
4.75%
Capital lease obligations
   
24
     
35
 
July 2013
 
7.10%
Total long-term and other debt
   
2,428,322
     
2,183,474
       
Less: current portion
   
(22,972
)
   
(19,834
)
     
Long-term portion
 
$
2,405,350
   
$
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 (“LIBOR”) 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 5.70% at June 30, 2012.
 
(2)
At June 30, 2012, the weighted average interest rate for the 2011 Term Loan was 2.25%.
 
At June 30, 2012, the Company was in compliance with its covenants.
 
Deposits
 
Beginning January 1, 2012, World Financial Network Bank and World Financial Capital Bank, subsidiaries of the Company, offered a demand deposit program through contractual arrangements with securities brokerage firms. As of June 30, 2012, WFNB and WFCB had issued $138.0 million in money market deposits. Money market deposits are redeemable on demand by the customer and, as such, have no scheduled maturity date.

 
15

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
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, is 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.
 
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 June 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:
 
   
June 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
   
(119,105
)
   
(159,155
)
Net carrying value of liability component
 
$
1,030,895
   
$
990,845
 
                 
If-converted value of common stock
 
$
2,363,602
   
$
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 June 30, 2012, is a weighted average period of 1.3 years.

 
16

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Interest expense on the convertible senior notes recognized in the Company’s unaudited condensed consolidated statements of income for the three and six months ended June 30, 2012 and 2011 is as follows:
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands, except percentages)
 
Interest expense calculated on contractual interest rate
 
$
7,618
   
$
7,618
   
$
15,237
   
$
15,237
 
Amortization of discount on liability component
   
20,300
     
18,187
     
40,050
     
35,882
 
Total interest expense on convertible senior notes
 
$
27,918
   
$
25,805
   
$
55,287
   
$
51,119
 
                                 
Effective interest rate (annualized)
   
11.0
%
   
11.0
%
   
11.0
%
   
11.0
%
 
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 August 2009, World Financial Network Credit Card Master Note Trust issued $395.0 million of Class A Series 2009-B asset-backed term notes that have a fixed interest rate of 3.79% per year and mature in July 2012. Pursuant to the indenture supplement applicable to these securities, as of June 30, 2012, the Company has collected $395.0 million of principal payments made by its credit cardholders during the accumulation period. The cash is restricted to the securitization investors and is reflected in other current assets in the Company’s unaudited condensed consolidated financial statements as of June 30, 2012.
 
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.
 
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 and manage its exposure to changes in fair value of certain obligations attributable to changes in LIBOR.
 
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.”

 
17

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 June 30, 2012 and December 31, 2011 in the unaudited condensed consolidated balance sheets:
 
   
June 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
 
$
645,825
   
0.92
   
703,500
   
1.37
 
 

 
   
June 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
   
$
8
   
Other assets
   
$
 
Interest rate contracts not designated as hedging instruments
 
Other current liabilities
   
$
22,927
   
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 six months ended June 30, 2012 and 2011 recognized in the unaudited condensed consolidated statements of income:
 
   
2012
 
2011
 
For the three months ended June 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
   
$
8,172
   
Securitization
funding costs
   
$
4,711
 
                               
For the six months ended June 30,
                             
Interest rate contracts not designated as hedging instruments
 
Securitization
funding costs
   
$
15,184
   
Securitization
funding costs
   
$
14,603
 
 
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 June 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 June 30, 2012, these thresholds were not breached and no amounts were held as collateral by the Company.

 
18

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 Accounting Standards Update (“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
   
113,589
     
269,083
     
382,672
 
Revenue recognized
   
(99,323
)
   
(323,062
)
   
(422,385
)
Other
   
     
385
     
385
 
Effects of foreign currency translation
   
907
     
3,145
     
4,052
 
June 30, 2012
 
$
374,146
   
$
817,014
   
$
1,191,160
 
Amounts recognized in the unaudited condensed consolidated balance sheets:
                       
Current liabilities
 
$
177,512
   
$
817,014
   
$
994,526
 
Non-current liabilities
 
$
196,634
   
$
   
$
196,634
 
 
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.

 
19

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 six months ended June 30, 2012, the Company acquired a total of 486,241 shares of its common stock for $59.0 million. As of June 30, 2012, the Company has $341.0 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 six months ended June 30, 2012 and 2011 is as follows:
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands)
 
Cost of operations
 
$
7,954
   
$
6,007
   
$
15,521
   
$
11,910
 
General and administrative
   
4,926
     
5,099
     
9,665
     
8,280
 
Total
 
$
12,880
   
$
11,106
   
$
25,186
   
$
20,190
 
 
During the six months ended June 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 six months ended June 30, 2012, the Company awarded 94,626 service-based restricted stock units with a weighted average grant date fair value per share of $120.16 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.

 
20

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:
 
   
June 30, 2012
   
December 31, 2011
 
   
Carrying
Amount
   
Fair
Value
   
Carrying
Amount
   
Fair
Value
 
   
(In thousands)
 
Financial assets
                       
Cash and cash equivalents
 
$
642,199
   
$
642,199
   
$
216,213
   
$
216,213
 
Trade receivables, net
   
319,292
     
319,292
     
300,895
     
300,895
 
Credit card receivables, net
   
5,278,180
     
5,278,180
     
5,197,690
     
5,197,690
 
Redemption settlement assets, restricted
   
476,234
     
476,234
     
515,838
     
515,838
 
Cash collateral, restricted
   
124,895
     
124,895
     
158,727
     
158,727
 
Other investment securities
   
469,215
     
469,215
     
26,772
     
26,772
 
Derivative financial instruments
   
8
     
8
     
     
 
Financial liabilities
                               
Accounts payable
   
169,938
     
169,938
     
149,812
     
149,812
 
Deposits
   
1,652,952
     
1,670,748
     
1,353,775
     
1,372,670
 
Asset-backed securities debt – owed to securitization investors
   
3,437,767
     
3,502,028
     
3,260,287
     
3,302,687
 
Long-term and other debt
   
2,428,322
     
3,779,796
     
2,183,474
     
3,071,661
 
Derivative financial instruments
   
22,927
     
22,927
     
38,103
     
38,103
 
 
Fair Value of Assets and Liabilities Held at June 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 of 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 of the same transaction.

 
21

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
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.
 
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 June 30, 2012 and December 31, 2011:
 
   
Fair Value Measurements Using Inputs Considered as
 
   
Level 1
   
Level 2
   
Level 3
 
     
June 30,
2012
     
December 31,
2011
     
June 30,
2012
     
December 31,
2011
     
June 30,
2012
     
December 31,
2011
 
   
(In thousands)
 
Government bonds (1) 
 
$
   
$
   
$
5,058
   
$
5,100
   
$
   
$
 
Corporate bonds (1) 
   
14,158
     
21,346
     
450,639
     
453,927
     
     
 
Cash collateral, restricted
   
2,500
     
     
     
     
122,395
     
158,727
 
Other investment securities (2)
   
443,793
     
3,043
     
25,422
     
23,729
     
     
 
Derivative financial instruments (3)
   
     
     
8
     
     
     
 
Total assets measured at fair value
 
$
460,451
   
$
24,389
   
$
481,127
   
$
482,756
   
$
122,395
   
$
158,727
 
                                                 
Derivative financial instruments (3)
 
$
   
$
   
$
22,927
   
$
38,103
   
$
   
$
 
Total liabilities measured at fair value
 
$
   
$
   
$
22,927
   
$
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.

 
22

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 June 30, 2012 and 2011:
 
   
Cash Collateral, Restricted
 
   
(In thousands)
 
March 31, 2012
 
$
141,866
 
Total gains (realized or unrealized):
       
Included in earnings
   
2,330
 
Purchases
   
 
Settlements
   
(21,801
)
Transfers in or out of Level 3
   
 
June 30, 2012
 
$
122,395
 
         
Gains for the period included in earnings related to assets still held at June 30, 2012
 
$
2,330
 
 
 
   
Cash Collateral, Restricted
 
   
(In thousands)
 
December 31, 2011
 
$
158,727
 
Total gains (realized or unrealized):
       
Included in earnings
   
4,019
 
Purchases
   
 
Settlements
   
(40,351
)
Transfers in or out of Level 3
   
 
June 30, 2012
 
$
122,395
 
         
Gains for the period included in earnings related to assets still held at June 30, 2012
 
$
4,019
 
 
 
   
Cash Collateral, Restricted
 
   
(In thousands)
 
March 31, 2011
 
$
179,333
 
Total gains (realized or unrealized):
       
Included in earnings
   
126
 
Purchases
   
 
Settlements
   
(3,633
)
Transfers in or out of Level 3
   
 
June 30, 2011
 
$
175,826
 
         
Gains for the period included in earnings related to assets still held at June 30, 2011
 
$
126
 
 
 
23

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
   
458
 
Purchases
   
2,291
 
Settlements
   
(12,677
)
Transfers in or out of Level 3
   
 
June 30, 2011
 
$
175,826
 
         
Gains for the period included in earnings related to assets still held at June 30, 2011
 
$
458
 
 
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 1 to 52 months, with a weighted average term of 14 months. The unobservable input used to calculate the fair value was the discount rate of 3.3%, 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 six months ended June 30, 2012 and 2011, gains 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 June 30, 2012:
 
   
Fair Value Measurements at
June 30, 2012
 
   
Total
   
Level 1
   
Level 2
   
Level 3
 
   
(In thousands)
 
Cash and cash equivalents
 
$
642,199
   
$
642,199
   
$
   
$
 
Credit card receivables, net
   
5,278,180
     
     
     
5,278,180
 
Total assets
 
$
5,920,379
   
$
642,199
   
$
   
$
5,278,180
 
                                 
Deposits 
 
$
1,670,748
   
$
   
$
1,670,748
   
$
 
Asset-backed securities debt - owed to securitization investors 
   
3,502,028
     
     
3,502,028
     
 
Long-term and other debt 
   
3,779,796
     
     
3,779,796
     
 
Total liabilities
 
$
8,952,572
   
$
   
$
8,952,572
   
$
 
 
10. INCOME TAXES
 
For the three and six months ended June 30, 2012, the Company utilized an effective tax rate of 38.0% and 38.2%, respectively, to calculate its provision for income taxes. For the three and six months ended June 30, 2011, the Company utilized an effective tax rate of 38.9% and 38.7%, respectively, 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 38.4%.

 
24

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 June 30, 2012
 
LoyaltyOne
   
Epsilon
   
Private Label Services and Credit
   
Corporate/ Other
   
Eliminations
   
Total
 
   
(In thousands)
 
Revenues
 
$
229,562
   
$
235,476
   
$
402,497
   
$
   
$
(1,050
)
 
$
866,485
 
Adjusted EBITDA (1) 
   
60,574
     
48,779
     
206,078
     
(22,605
)
   
     
292,826
 
Stock compensation expense
   
2,248
     
3,439
     
2,267
     
4,926
     
     
12,880
 
Depreciation and amortization
   
4,967
     
24,844
     
8,822
     
770
     
     
39,403
 
Operating income (loss)
   
53,359
     
20,496
     
194,989
     
(28,301
)
   
     
240,543
 
Interest expense, net
   
(202
)
   
(19
)
   
27,876
     
45,412
     
     
73,067
 
Income (loss) before income taxes
   
53,561
     
20,515
     
167,113
     
(73,713
)
   
     
167,476
 
 
 
Three Months Ended June 30, 2011
 
LoyaltyOne
   
Epsilon
   
Private Label Services and Credit
   
Corporate/ Other
   
Eliminations
   
Total
 
   
(In thousands)
 
Revenues
 
$
203,162
   
$
188,456
   
$
350,718
   
$
356
   
$
(2,234
)
 
$
740,458
 
Adjusted EBITDA (1) 
   
52,943
     
39,324
     
163,671
     
(15,567
)
   
(1,454
)
   
238,917
 
Stock compensation expense
   
1,365
     
2,855
     
1,786
     
5,100
     
     
11,106
 
Depreciation and amortization
   
5,251
     
20,721
     
8,858
     
1,190
     
     
36,020
 
Operating income (loss)
   
46,327
     
15,748
     
153,027
     
(21,857
)
   
(1,454
)
   
191,791
 
Interest expense, net
   
(94
)
   
(21
)
   
36,047
     
44,316
     
(1,454
)
   
78,794
 
Income (loss) before income taxes
   
46,421
     
15,769
     
116,980
     
(66,173
)
   
     
112,997
 
 
 
Six Months Ended June 30, 2012
 
LoyaltyOne
   
Epsilon
   
Private Label Services and Credit
   
Corporate/ Other
   
Eliminations
   
Total
 
   
(In thousands)
 
Revenues
 
$
487,359
   
$
463,408
   
$
809,843
   
$
292
   
$
(2,848
)
 
$
1,758,054
 
Adjusted EBITDA (1) 
   
118,966
     
88,601
     
430,480
     
(41,577
)
   
     
596,470
 
Stock compensation expense
   
4,369
     
7,050
     
4,102
     
9,665
     
     
25,186
 
Depreciation and amortization
   
10,086
     
49,222
     
17,347
     
1,467
     
     
78,122
 
Operating income (loss)
   
104,511
     
32,329
     
409,031
     
(52,709
)
   
     
493,162
 
Interest expense, net
   
(362
)
   
(37
)
   
54,320
     
84,798
     
     
138,719
 
Income (loss) before income taxes
   
104,873
     
32,366
     
354,711
     
(137,507
)
   
     
354,443
 
 
 
25

ALLIANCE DATA SYSTEMS CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
Six Months Ended June 30, 2011
 
LoyaltyOne
   
Epsilon
   
Private Label Services and Credit
   
Corporate/ Other
   
Eliminations
   
Total
 
   
(In thousands)
 
Revenues
 
$
420,836
   
$
344,140
   
$
719,628
   
$
713
   
$
(4,423
)
 
$
1,480,894
 
Adjusted EBITDA (1) 
   
111,194
     
72,990
     
347,001
     
(32,970
)
   
(2,908
)
   
495,307
 
Stock compensation expense
   
3,332
     
5,148
     
3,430
     
8,280
     
     
20,190
 
Depreciation and amortization
   
10,434
     
40,620
     
17,868
     
2,496
     
     
71,418
 
Operating income (loss)
   
97,428
     
27,222
     
325,703
     
(43,746
)
   
(2,908
)
   
403,699
 
Interest expense, net
   
(72
)
   
(36
)
   
72,664
     
80,605
     
(2,908
)
   
150,253
 
Income (loss) before income taxes
   
97,500
     
27,258
     
253,039
     
(124,351
)
   
     
253,446
 
         
 
(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:
 
   
June 30,
2012
   
December 31,
2011
 
   
(In thousands)
 
Assets:
           
Credit card receivables, net
 
$
   
$
2,439
 
Assets of discontinued operations
 
$
   
$
2,439
 
 
13. SUBSEQUENT EVENTS
 
Portfolio Acquisition
 
In July 2012, the Company purchased the existing private label credit card portfolio of The Bon-Ton Stores, Inc. Total consideration paid was approximately $500 million, subject to customary purchase price adjustments.
 
Asset-backed Securities – Owed to Securitization Investors
 
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 will be 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. 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 will be eliminated from the Company’s unaudited condensed consolidated financial statements.
 
The Class A, Class M, Class B and Class C Series 2012-C asset-backed notes will all mature in October 2018.

 
26

 
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and related notes thereto presented in this quarterly report and the consolidated financial statements and related notes thereto included in our Annual Report filed 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 six months ended June 30, 2012, revenue increased 18.7% to $1.8 billion and adjusted EBITDA increased 20.4% to $596.5 million as compared to the prior year period as each of our three segments achieved solid operating results.
 
LoyaltyOne®
 
Revenue increased 15.8% to $487.4 million and adjusted EBITDA increased 7.0% to $119.0 million for the six months ended June 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 quarter as the average foreign currency exchange rate for the six months ended June 30, 2012 was $0.99 as compared to $1.02 in the prior year period, which lowered revenue and adjusted EBITDA by $14.6 million and $4.0 million, respectively.
 
AIR MILES® reward miles redeemed during the six months ended June 30, 2012 increased 26.0% 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 quarter of 2012 and remained somewhat elevated during the second quarter of 2012. We believe redemption activity 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 six months ended June 30, 2012 increased 9.3% 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 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 have approximately 600,000 collectors in the program and launched our fifth participating redemption sponsor in June 2012. 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. During the remainder of 2012, we plan to increase the number of redemption sponsors as well as increase the number of locations where AIR MILES Cash redemptions are accepted. The implementation of AIR MILES Cash did not have a significant impact for the six months ended June 30, 2012 nor is it expected to have a significant impact for the remainder of 2012.
 
During the six months ended June 30, 2012, LoyaltyOne 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, is continuing 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 the expansion of the dotz program 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 our international initiatives in 2012.
 
 
27

 
Epsilon®
 
Revenue increased 34.7% to $463.4 million and adjusted EBITDA increased 21.4% to $88.6 million for the six months ended June 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 and growth in marketing technology with the expansion of services to existing clients and new client signings.
 
During the six months ended June 30, 2012, 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. In addition, Epsilon 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. 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.
 
We anticipate that Epsilon’s revenue growth will experience some temporary softness in the second half of 2012, particularly in the third quarter of 2012, due to weakness in the pharmaceutical sector. However, we expect that adjusted EBITDA will continue double-digit growth, with expansion in our adjusted EBITDA margin.
 
Private Label Services and Credit
 
Revenue increased 12.5% to $809.8 million and adjusted EBITDA increased 24.1% to $430.5 million for the six months ended June 30, 2012 as compared to the same period in 2011.
 
For the six months ended June 30, 2012, average credit card receivables increased 9.9% as compared to the same period in the prior year as a result of increased credit sales and stabilized payment rates. Credit sales increased 19.1% for the six months ended June 30, 2012 due to strong credit cardholder spending and recent new client signings.
 
Delinquency rates improved to 3.9% of principal receivables at June 30, 2012, down from 4.5% at June 30, 2011. The principal net charge-off rate was 5.1% for the six months ended June 30, 2012 as compared to 7.5% in the prior year period. Based on current trends, we anticipate a 150-180 basis point improvement in the principal net charge-off rate for the full year 2012 as compared to 2011.
 
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 preliminary purchase price of $24.5 million, which is subject to customary purchase price adjustments. In July 2012, we purchased the existing private label credit card portfolio of The Bon-Ton Stores, Inc. Total consideration paid was approximately $500 million, subject to customary purchase price adjustments. We do not expect the acquisition of the portfolio to provide any accretion to earnings per share in 2012, but it is expected to be accretive to 2013.
 
During the six months ended June 30, 2012, we also announced the signing of multi-year renewal agreements to continue providing private label credit card services to Reed Jewelers, a leading multichannel jewelry retailer; The Buckle Inc., a leading multichannel retailer of private label and brand name apparel, accessories and footwear; and to Gardner-White Furniture, a Michigan-based multichannel retailer of home furnishings and electronics. In addition, we signed a multi-year renewal agreement to continue managing the private label credit card program for Little Switzerland, Inc., a leading multi-channel retailer of duty-free merchandise. We 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.
 
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.

 
28

 
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
June 30,
   
Six Months Ended
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands)
 
Net income
 
$
103,821
   
$
69,023
   
$
219,050
   
$
155,399
 
Stock compensation expense
   
12,880
     
11,106
     
25,186
     
20,190
 
Provision for income taxes
   
63,655
     
43,974
     
135,393
     
98,047
 
Interest expense, net
   
73,067
     
78,794
     
138,719
     
150,253
 
Depreciation and other amortization
   
18,496
     
16,850
     
36,100
     
33,604
 
Amortization of purchased intangibles
   
20,907
     
19,170
     
42,022
     
37,814
 
Adjusted EBITDA
 
$
292,826
   
$
238,917
   
$
596,470
   
$
495,307
 
 
 
29


Results of Operations
 
Three months ended June 30, 2012 compared to the three months ended June 30, 2011
 
 
Three Months Ended
June 30,
   
Change
 
 
2012
   
2011
   
$
   
%
 
 
(In thousands, except percentages)
 
Revenue:
                     
LoyaltyOne
$
229,562
   
$
203,162
   
$
26,400
     
13.0
 %
Epsilon
 
235,476
     
188,456
     
47,020
     
25.0
 
Private Label Services and Credit
 
402,497
     
350,718
     
51,779
     
14.8
 
Corporate/Other
 
     
356
     
(356
)
   
(100.0
)
Eliminations
 
(1,050
)
   
(2,234
   
1,184
   
nm
*
Total
$
866,485
   
$
740,458
   
$
126,027
     
17.0
 %
Adjusted EBITDA (1):
                             
LoyaltyOne
$
60,574
   
$
52,943
   
$
7,631
     
14.4
 %
Epsilon
 
48,779
     
39,324
     
9,455
     
24.0
 
Private Label Services and Credit
 
206,078
     
163,671
     
42,407
     
25.9
 
Corporate/Other
 
(22,605
)
   
(15,567
)
   
(7,038
)
   
45.2
 
Eliminations
 
     
(1,454
   
1,454
   
nm
*
Total
$
292,826
   
$
238,917
   
$
53,909
     
22.6
 %
Stock compensation expense:
                             
LoyaltyOne
$
2,248
   
$
1,365
   
$
883
     
64.7
 %
Epsilon
 
3,439
     
2,855
     
584
     
20.5
 
Private Label Services and Credit
 
2,267
     
1,786
     
481
     
26.9
 
Corporate/Other
 
4,926
     
5,100
     
(174
)
   
(3.4
)
Total
$
12,880
   
$
11,106
   
$
1,774
     
16.0
 %
Depreciation and amortization:
                             
LoyaltyOne
$
4,967
   
$
5,251
   
$
(284
)
   
(5.4
)%
Epsilon
 
24,844
     
20,721
     
4,123
     
19.9
 
Private Label Services and Credit
 
8,822
     
8,858
     
(36
)
   
(0.4
)
Corporate/Other
 
770
     
1,190
     
(420
)
   
(35.3
)
Total
$
39,403
   
$
36,020
   
$
3,383
     
9.4
 %
Operating income:
                             
LoyaltyOne
$
53,359
   
$
46,327
   
$
7,032
     
15.2
 %
Epsilon
 
20,496
     
15,748
     
4,748
     
30.1
 
Private Label Services and Credit
 
194,989
     
153,027
     
41,962
     
27.4
 
Corporate/Other
 
(28,301
)
   
(21,857
)
   
(6,444
)
   
29.5
 
Eliminations
 
     
(1,454
   
1,454
   
nm
*
Total
$
240,543
   
$
191,791
   
$
48,752
     
25.4
 %
Adjusted EBITDA margin (2):
                             
LoyaltyOne
 
26.4
%
   
26.1
%
   
0.3
 %
       
Epsilon
 
20.7
     
20.9
     
(0.2
)
       
Private Label Services and Credit
 
51.2
     
46.7
     
4.5
         
Total
 
33.8
%
   
32.3
%
   
1.5
 %
       
Segment operating data:
                             
Private label statements generated
 
38,851
     
34,800
     
4,051
     
11.6
 %
Credit sales
$
2,869,999
   
$
2,425,363
   
$
444,636
     
18.3
 %
Average credit card receivables
$
5,467,489
   
$
4,848,715
   
$
618,774
     
12.8
 %
AIR MILES reward miles issued
 
1,316,309
     
1,219,695
     
96,614
     
7.9
 %
AIR MILES reward miles redeemed
 
1,024,738
     
816,927
     
207,811
     
25.4
 %
                                   
 
(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

 
30

 
Consolidated Operating Results:
 
Revenue. Total revenue increased $126.0 million, or 17.0%, to $866.5 million for the three months ended June 30, 2012 from $740.5 million for the three months ended June 30, 2011. The net increase was due to the following:
 
 
Transaction. Revenue increased $7.6 million, or 10.9%, to $77.5 million for the three months ended June 30, 2012. Transaction revenue was positively impacted by an increase of $3.7 million in other servicing fees charged to our credit cardholders, an increase of $2.6 million in higher merchant fees due to increased credit sales at certain retailers, and an increase of $1.3 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.
 
 
Redemption. Revenue increased $25.8 million, or 19.4%, to $159.2 million for the three months ended June 30, 2012 due to a 25.4% increase in AIR MILES reward miles redeemed. The introduction of a five-year expiry policy to the AIR MILES Reward Program in December 2011 continued to stimulate redemption activity during the second quarter of 2012, although at moderated levels from the first quarter of 2012.
 
 
Finance charges, net. Revenue increased $45.5 million, or 13.7%, to $377.8 million for the three months ended June 30, 2012. This increase was driven by an improvement in our gross yield of 20 basis points and a 12.8% increase in average credit card receivables as customer payment rates stabilized on a year-over-year basis and credit cardholder spending remained strong.
 
 
Database marketing fees and direct marketing. Revenue increased $37.3 million, or 20.4%, to $219.5 million for the three months ended June 30, 2012. The increase in revenue was driven by our acquisition of Aspen, which added $33.2 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 $9.8 million, or 43.0%, to $32.5 million for the three months ended June 30, 2012 due to Aspen, which added $8.1 million in revenue associated with strategic consulting initiatives.
 
Cost of operations. Cost of operations increased $75.2 million, or 17.4%, to $506.5 million for the three months ended June 30, 2012 as compared to the three months ended June 30, 2011. The increase resulted from growth across each of our segments, including the following:
 
 
Within the LoyaltyOne segment, cost of operations increased $19.7 million due to a $9.1 million increase in the cost of fulfillment for the AIR MILES Reward Program as a result of the increase in the number of AIR MILES reward miles redeemed. In addition, marketing expenses increased $3.9 million due to costs associated with the promotion of AIR MILES Cash, and payroll and benefit costs increased $3.3 million to support new growth initiatives, including international expansion activities.
 
 
Within the Epsilon segment, cost of operations increased $38.1 million due to the acquisition of Aspen, which added $35.2 million. Cost of operations also increased as a result of enhancements to infrastructure and security.
 
 
Within the Private Label Services and Credit segment, cost of operations increased by $17.7 million, with payroll and benefits increasing $7.1 million due to an increase in the number of associates to support current and future growth. Marketing expenses increased $2.9 million, in part due to growth in credit sales, other credit card expenses increased $3.0 million due to higher volumes and legal and consulting fees also increased $2.3 million.
 
Provision for loan loss. Provision for loan loss decreased $7.8 million, or 13.0%, to $52.6 million for the three months ended June 30, 2012 as compared to $60.4 million for the three months ended June 30, 2011. The provision for loan loss was impacted by a decline in the net charge-off rate of credit card receivables. The net charge-off rate improved 230 basis points to 4.9% for the three months ended June 30, 2012 as compared to 7.2% for the three months ended June 30, 2011. Delinquency rates improved to 3.9% of principal credit card receivables at June 30, 2012 from 4.5% at June 30, 2011. The decrease in the provision for loan loss was partially offset by the 12.8% increase in average credit card receivables.

 
31

 
General and administrative. General and administrative expenses increased $6.5 million, or 31.0%, to $27.5 million for the three months ended June 30, 2012 as compared to $21.0 million for the three months ended June 30, 2011. The increase was driven by payroll and benefit costs associated with higher medical costs and an increase in expenses for our retirement savings plans.
 
Depreciation and other amortization. Depreciation and other amortization increased $1.6 million, or 9.8%, to $18.5 million for the three months ended June 30, 2012 as compared to $16.9 million for the three months ended June 30, 2011 due to additional assets placed in service resulting from fixed assets acquired in the Aspen acquisition and capital expenditures.
 
Amortization of purchased intangibles. Amortization of purchased intangibles increased $1.7 million, or 9.1%, to $20.9 million for the three months ended June 30, 2012 as compared to $19.2 million for the three months ended June 30, 2011. The increase relates to $3.8 million of additional amortization associated with the intangible assets acquired in the Aspen acquisition, offset in part by certain fully amortized intangible assets.
 
Interest expense. Total interest expense, net decreased $5.7 million, or 7.3%, to $73.1 million for the three months ended June 30, 2012 as compared to $78.8 million for the three months ended June 30, 2011. The decrease was due to the following:
 
 
Securitization funding costs. Securitization funding costs decreased $12.5 million due to a decline in average interest rates for the three months ended June 30, 2012 as compared to the three months ended June 30, 2011. In addition, we also incurred a net benefit of $3.5 million resulting from a change in the valuation of our derivative financial instruments.
 
 
Interest expense on deposits. Interest on deposits increased $0.5 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 $6.3 million due, in part, to an increase in borrowings resulting from the issuance in the first quarter of 2012 of the $500.0 million senior notes due in 2020. In addition, the amortization of imputed interest associated with the convertible senior notes increased $2.1 million as compared to the same period in 2011. These increases were offset by a decline in interest expense associated with our line of credit. The increases were further offset by a decline in the amortization of debt issuance costs as in the second quarter of 2011 we wrote off $2.6 million in unamortized debt costs associated with the early extinguishment of certain previous term loans.
 
Taxes. Income tax expense increased $19.7 million to $63.7 million for the three months ended June 30, 2012 from $44.0 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 June 30, 2012 declined to 38.0% as compared to 38.9% for the three months ended June 30, 2011, as the result of the settlement of certain tax audits in April 2012.
 
Segment Revenue and Adjusted EBITDA:
 
Revenue. Total revenue increased $126.0 million, or 17.0%, to $866.5 million for the three months ended June 30, 2012 from $740.5 million for the three months ended June 30, 2011. The net increase was due to the following:
 
 
LoyaltyOne. Revenue increased $26.4 million, or 13.0%, to $229.6 million for the three months ended June 30, 2012. An unfavorable Canadian foreign currency exchange rate impacted revenue by $10.1 million. Redemption revenue increased $25.8 million, or 19.4%, due to higher collector redemptions compared to the second quarter of 2011. The introduction of a five-year expiry policy to the AIR MILES Reward Program on December 31, 2011 continued to stimulate redemption activity during the quarter. Revenue from issuance fees, for which we provide marketing and administrative services, increased $1.3 million due to increases in the total number of AIR MILES reward miles issued over the last several quarters.
 
 
Epsilon. Revenue increased $47.0 million, or 25.0%, to $235.5 million for the three months ended June 30, 2012. Aspen’s marketing services product lines added $41.0 million to revenue. In addition, marketing technology revenue continues to build from past client signings and the expansion of services to existing clients, growing $7.0 million, or 6.9%. These increases were offset by a 2.0% decrease in data revenue, as solid growth in Abacus transactional data was offset by softness in consumer demographic data offerings.

 
32

 
 
Private Label Services and Credit. Revenue increased $51.8 million, or 14.8%, to $402.5 million for the three months ended June 30, 2012. Finance charges and late fees increased by $45.5 million, driven by an increase in our gross yield of 20 basis points and a 12.8% increase in average credit card receivables due to strong credit cardholder spending and the stabilization of customer payment rates. Transaction revenue increased $6.3 million due in part to an increase in merchant fees and other servicing fees.
 
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 increased $53.9 million, or 22.6%, to $292.8 million for the three months ended June 30, 2012 from $238.9 million for the three months ended June 30, 2011. The increase was due to the following:
 
 
LoyaltyOne. Adjusted EBITDA increased $7.6 million, or 14.4%, to $60.6 million for the three months ended June 30, 2012. Adjusted EBITDA was positively impacted by increases in revenue associated with higher redemptions. These increases were somewhat offset by increases in the cost of fulfillment for those AIR MILES reward miles redeemed. Adjusted EBITDA was also negatively impacted by marketing expenses associated with the promotion of AIR MILES Cash and increases in costs associated with our international initiatives.
 
 
Epsilon. Adjusted EBITDA increased $9.5 million, or 24.0%, to $48.8 million for the three months ended June 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 costs associated with a data center relocation and enhancements to infrastructure and security to support future growth.
 
 
Private Label Services and Credit. Adjusted EBITDA increased $42.4 million, or 25.9%, to $206.1 million for the three months ended June 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. The net charge-off rate for the three months ended June 30, 2012 was 4.9% as compared to 7.2% in the same period in 2011. Delinquency rates also improved to 3.9% of principal credit card receivables at June 30, 2012 from 4.5% at June 30, 2011.
 
 
Corporate/Other. Adjusted EBITDA decreased $7.0 million to a loss of $22.6 million for the three months ended June 30, 2012 related to increases in payroll and benefit costs associated with higher medical costs and an increase in expenses for our retirement savings plans.

 
33


Results of Operations
 
Six months ended June 30, 2012 compared to the six months ended June 30, 2011
 
 
Six Months Ended
June 30,
   
Change
 
 
2012
   
2011
   
$
   
%
 
 
(In thousands, except percentages)
 
Revenue:
                     
LoyaltyOne
$
487,359
   
$
420,836
   
$
66,523
     
15.8
%
Epsilon
 
463,408
     
344,140
     
119,268
     
34.7
 
Private Label Services and Credit
 
809,843
     
719,628
     
90,215
     
12.5
 
Corporate/Other
 
292
     
713
     
(421
)
   
(59.0
)
Eliminations
 
(2,848
)
   
(4,423
   
1,575
   
nm
*
Total
$
1,758,054
   
$
1,480,894
   
$
277,160
     
18.7
%
Adjusted EBITDA (1):
                             
LoyaltyOne
$
118,966
   
$
111,194
   
$
7,772
     
7.0
%
Epsilon
 
88,601
     
72,990
     
15,611
     
21.4
 
Private Label Services and Credit
 
430,480
     
347,001
     
83,479
     
24.1
 
Corporate/Other
 
(41,577
)
   
(32,970
)
   
(8,607
)
   
26.1
 
Eliminations
 
     
(2,908
   
2,908
   
nm
*
Total
$
596,470
   
$
495,307
   
$
101,163
     
20.4
%
Stock compensation expense:
                             
LoyaltyOne
$
4,369
   
$
3,332
   
$
1,037
     
31.1
%
Epsilon
 
7,050
     
5,148
     
1,902
     
36.9
 
Private Label Services and Credit
 
4,102
     
3,430
     
672
     
19.6
 
Corporate/Other
 
9,665
     
8,280
     
1,385
     
16.7
 
Total
$
25,186
   
$
20,190
   
$
4,996
     
24.7
%
Depreciation and amortization:
                             
LoyaltyOne
$
10,086
   
$
10,434
   
$
(348
)
   
(3.3
)%
Epsilon
 
49,222
     
40,620
     
8,602
     
21.2
 
Private Label Services and Credit
 
17,347
     
17,868
     
(521
)
   
(2.9
)
Corporate/Other
 
1,467
     
2,496
     
(1,029
)
   
(41.2
)
Total
$
78,122
   
$
71,418
   
$
6,704
     
9.4
%
Operating income:
                             
LoyaltyOne
$
104,511
   
$
97,428
   
$
7,083
     
7.3
%
Epsilon
 
32,329
     
27,222
     
5,107
     
18.8
 
Private Label Services and Credit
 
409,031
     
325,703
     
83,328
     
25.6
 
Corporate/Other
 
(52,709
)
   
(43,746
)
   
(8,963
)
   
20.5
 
Eliminations
 
     
(2,908
   
2,908
   
nm
*
Total
$
493,162
   
$
403,699
   
$
89,463
     
22.2
%
Adjusted EBITDA margin (2):
                             
LoyaltyOne
 
24.4
%
   
26.4
%
   
(2.0
)%
       
Epsilon
 
19.1
     
21.2
     
(2.1
)
       
Private Label Services and Credit
 
53.2
     
48.2
     
5.0
         
Total
 
33.9
%
   
33.4
%
   
0.5
 %
       
Segment operating data:
                             
Private label statements generated
 
75,968
     
69,546
     
6,422
     
9.2
%
Credit sales
$
5,213,548
   
$
4,379,062
   
$
834,486
     
19.1
%
Average credit card receivables
$
5,394,502
   
$
4,908,587
   
$
485,915
     
9.9
%
AIR MILES reward miles issued
 
2,546,152
     
2,330,233
     
215,919
     
9.3
%
AIR MILES reward miles redeemed
 
2,274,560
     
1,805,572
     
468,988
     
26.0
%
                                   
 
(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
 
 
34

 
Consolidated Operating Results:
 
Revenue. Total revenue increased $277.2 million, or 18.7%, to $1.8 billion for the six months ended June 30, 2012 from $1.5 billion for the six months ended June 30, 2011. The net increase was due to the following:
 
 
Transaction. Revenue increased $13.6 million, or 9.3%, to $160.2 million for the six months ended June 30, 2012 due to an increase of $3.6 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 past year, and higher merchant fees of $5.9 million. Other servicing fees charged to our cardholders also increased transaction revenue by $4.1 million.
 
 
Redemption. Revenue increased $64.5 million, or 22.8%, to $347.7 million for the six months ended June 30, 2012 due to a 26.0% 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 six months ended June 30, 2012.
 
 
Finance charges, net. Revenue increased $79.7 million, or 11.8%, to $754.1 million for the six months ended June 30, 2012. This increase was driven by an improvement in our gross yield of 50 basis points and a 9.9% increase in average credit card receivables as customer payment rates stabilized on a year-over-year basis and credit cardholder spending remained strong.
 
 
Database marketing fees and direct marketing. Revenue increased $98.2 million, or 29.3%, to $433.1 million for the six months ended June 30, 2012. The increase in revenue was driven by our acquisition of Aspen, which added $88.8 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 $21.2 million, or 50.7%, to $62.9 million for the six months ended June 30, 2012 due to Aspen, which added $19.3 million in revenue associated with strategic consulting initiatives.
 
Cost of operations. Cost of operations increased $197.6 million, or 23.6%, to $1.0 billion for the six months ended June 30, 2012 as compared to the six months ended June 30, 2011. The increase resulted from growth across each of our segments, including the following:
 
 
Within the LoyaltyOne segment, cost of operations increased $59.8 million due to a $35.7 million increase in the cost of fulfillment for the AIR MILES Reward Program as a result of a 26.0% increase in the number of AIR MILES reward miles redeemed. In addition, marketing expenses increased $9.6 million due to costs associated with the launch and promotion of AIR MILES Cash, and payroll and benefit costs increased $7.8 million to support new growth initiatives. Cost of operations also increased as a result of additional international expansion activities.
 
 
Within the Epsilon segment, cost of operations increased $105.6 million due to the acquisition of Aspen, which added $93.5 million. Cost of operations also increased as a result of increased payroll and benefit costs, enhancements to infrastructure and security as well as a relocation of a data center to support future growth.
 
 
Within the Private Label Services and Credit segment, cost of operations increased by $33.6 million, with payroll and benefits increasing $14.5 million due to an increase in the number of associates to support current and future growth. Marketing expenses increased $6.3 million, in part due to growth in credit sales, other credit card expenses increased $6.9 million due to higher volumes and legal and consulting also increased $3.8 million.
 
Provision for loan loss. Provision for loan loss decreased $26.2 million, or 20.4%, to $101.9 million for the six months ended June 30, 2012 as compared to $128.0 million for the six months ended June 30, 2011. The provision for loan loss was impacted by a decline in the net charge-off rate of credit card receivables. The net charge-off rate improved 240 basis points to 5.1% for the six months ended June 30, 2012 as compared to 7.5% for the six months ended June 30, 2011. Delinquency rates improved to 3.9% of principal credit card receivables at June 30, 2012 from 4.5% at June 30, 2011. The decrease in the provision for loan loss was partially offset by the 9.9% increase in average credit card receivables.

 
35

 
General and administrative. General and administrative expenses increased $9.6 million, or 22.8%, to $51.5 million for the six months ended June 30, 2012 as compared to $42.0 million for the six months ended June 30, 2011. The increase was driven by payroll, benefit and consulting 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 $2.5 million, or 7.4%, to $36.1 million for the six months ended June 30, 2012 as compared to $33.6 million for the six months ended June 30, 2011 due to additional assets placed in service resulting from fixed assets acquired in the Aspen acquisition and capital expenditures.
 
Amortization of purchased intangibles. Amortization of purchased intangibles increased $4.2 million, or 11.1%, to $42.0 million for the six months ended June 30, 2012 as compared to $37.8 million for the six months ended June 30, 2011. The increase relates to $9.6 million of additional amortization associated with the intangible assets acquired in the Aspen acquisition, offset in part by certain fully amortized intangible assets.
 
Interest expense. Total interest expense, net decreased $11.5 million, or 7.7%, to $138.7 million for the six months ended June 30, 2012 as compared to $150.3 million for the six months ended June 30, 2011. The decrease was due to the following:
 
 
Securitization funding costs. Securitization funding costs decreased $21.2 million due to lower average borrowings and lower interest rates for the six months ended June 30, 2012 as compared to the six months ended June 30, 2011.
 
 
Interest expense on deposits. Interest on deposits increased $0.8 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 $8.9 million due, in part, to an increase in borrowings resulting from the issuance in the first quarter of 2012 of senior notes due in 2020. In addition, the amortization of imputed interest associated with the convertible senior notes increased $4.2 million as compared to the same period in 2011. These increases were offset by a decline in interest expense associated with our line of credit. The increases were further offset by a decline in the amortization of debt issuance costs as in the second quarter of 2011 we wrote off $2.6 million in unamortized debt costs associated with the early extinguishment of certain previous term loans.
 
Taxes. Income tax expense increased $37.3 million to $135.4 million for the six months ended June 30, 2012 from $98.0 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 six months ended June 30, 2012 declined to 38.2% as compared to 38.7% for the six months ended June 30, 2011, as the result of the settlement of certain tax audits in April 2012.
 
Segment Revenue and Adjusted EBITDA:
 
Revenue. Total revenue increased $277.2 million, or 18.7%, to $1.8 billion for the six months ended June 30, 2012 from $1.5 billion for the six months ended June 30, 2011. The net increase was due to the following:
 
 
LoyaltyOne. Revenue increased $66.5 million, or 15.8%, to $487.4 million for the six months ended June 30, 2012. An unfavorable Canadian foreign currency exchange rate impacted revenue by $14.6 million. Redemption revenue increased $64.5 million, or 22.8%, due to higher collector redemptions compared to the six month ended June 30, 2011. The introduction of a five-year expiry policy to the AIR MILES Reward Program on December 31, 2011 stimulated redemption activity. Revenue from issuance fees, for which we provide marketing and administrative services, increased $3.6 million due to increases in the total number of AIR MILES reward miles issued over the past year.
 
 
Epsilon. Revenue increased $119.3 million, or 34.7%, to $463.4 million for the six months ended June 30, 2012. Aspen’s marketing services product lines added $106.2 million to revenue. In addition, marketing technology revenue continues to build from past client signings and the expansion of services to existing clients, growing $14.0 million, or 7.1%. Data revenue remained relatively flat as solid growth in transactional data was offset by softness in consumer demographic data offerings.

 
36

 
 
Private Label Services and Credit. Revenue increased $90.2 million, or 12.5%, to $809.8 million for the six months ended June 30, 2012. Finance charges and late fees increased by $79.7 million, driven by an increase in our gross yield of 50 basis points and a 9.9% increase in average credit card receivables due to strong credit cardholder spending and the stabilization of customer payment rates. Transaction revenue increased $10.5 million due in part to higher merchant fees.
 
 
Corporate/Other. Revenue decreased by $0.4 million to $0.3 million for the six months ended June 30, 2012 as a result of the transfer of certain sublease agreements.
 
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 $101.2 million, or 20.4%, to $596.5 million for the six months ended June 30, 2012 from $495.3 million for the six months ended June 30, 2011. The increase was due to the following:
 
 
LoyaltyOne. Adjusted EBITDA increased $7.8 million, or 7.0%, to $119.0 million for the six months ended June 30, 2012 as compared to the six months ended June 30, 2011. Adjusted EBITDA was positively impacted by increases in revenue associated with higher redemptions. These increases were somewhat offset by increases in the cost of fulfillment for those 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 $15.6 million, or 21.4%, to $88.6 million for the six months ended June 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 19.1% for the six months ended June 30, 2012 from 21.2% 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 $83.5 million, or 24.1%, to $430.5 million for the six months ended June 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. The net charge-off rate for the six months ended June 30, 2012 was 5.1% as compared to 7.5% in the same period in 2011. Delinquency rates also improved to 3.9% of principal credit card receivables at June 30, 2012 from 4.5% at June 30, 2011.
 
 
Corporate/Other. Adjusted EBITDA decreased $8.6 million to a loss of $41.6 million for the six months ended June 30, 2012. Payroll and benefit costs increased $5.4 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 engage collection agencies and outside attorneys to continue those efforts.
 
 
37

 
The following table presents the delinquency trends of our credit card portfolio:
 
   
June 30,
2012
   
% of
Total
   
December 31,
2011
   
% of
Total
 
   
(In thousands, except percentages)
 
Receivables outstanding – principal
 
$
5,451,277
     
100
%
 
$
5,408,862
     
100
%
Principal receivables balances contractually delinquent:
                               
31 to 60 days
   
77,212
     
1.4
%
   
78,272
     
1.4
%
61 to 90 days
   
49,842
     
0.9
     
51,709
     
1.0
 
91 or more days
   
87,346
     
1.6
     
105,626
     
2.0
 
Total
 
$
214,400
     
3.9
%
 
$
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
June 30,
   
Six Months Ended
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(In thousands, except percentages)
 
Average credit card receivables
 
$
5,467,489
   
$
4,848,715
   
$
5,394,502
   
$
4,908,587
 
Net charge-offs of principal receivables
   
67,514
     
87,066
     
137,679
     
185,096
 
Net charge-offs as a percentage of average credit card receivables
   
4.9
%
   
7.2
%
   
5.1
%
   
7.5
%
 
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 $417.4 million and $407.9 million for the six months ended June 30, 2012 and 2011, respectively. Operating cash flows increased $9.5 million as cash flows from increased profitability were offset by a decrease in cash flows associated with higher working capital balances for the six months ended June 30, 2012 as compared to the six months ended June 30, 2011.
 
Investing Activities. Cash used in investing activities was $613.0 million and $277.3 million for the six months ended June 30, 2012 and 2011, respectively. Significant components of investing activities are as follows:
 
 
Restricted Cash. Cash decreased $438.7 million for the six months ended June 30, 2012, as compared to a cash increase of $16.8 million for the six months ended June 30, 2011, due to the principal accumulation for the repayment of asset-backed securities debt maturing in July 2012.
 
 
Credit Card Receivables Funding. Cash decreased $61.4 million for the six months ended June 30, 2012, as compared to a cash increase of $270.6 million for the six months ended June 30, 2011, due to growth in our credit card receivables.
 
 
Purchase of Credit Card Portfolios. Cash decreased $122.2 million for the six months ended June 30, 2012 due to the acquisition of existing private label credit card portfolios from Pier 1 Imports and Premier Designs. During the six months ended June 30, 2011, cash decreased $42.7 million due to the acquisition of an existing private label credit card portfolio from J.Jill.
 
 
38

 
 
Cash Collateral, Restricted. Cash increased $37.7 million for the six months ended June 30, 2012 as compared to a cash decrease of $131.2 million for the six months ended June 30, 2011 due to the maturing of asset-backed securities as the restricted cash is released upon repayment.
 
 
Payments for Acquired Businesses, Net of Cash. For the six months ended June 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 six months ended June 30, 2012.
 
 
Capital Expenditures. Our capital expenditures for the six months ended June 30, 2012 were $55.5 million compared to $33.9 million for the comparable period in 2011. We anticipate capital expenditures not to exceed approximately 3.5% of annual revenue for 2012.
 
Financing Activities. Cash provided by financing activities was $621.8 million for the six months ended June 30, 2012, as compared to cash used by financing activities of $37.8 million for the six months ended June 30, 2011. Our financing activities during the six months ended June 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 World Financial Network Bank, or WFNB, and World Financial Capital Bank, or WFCB, 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 June 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 2.2 to 1 at June 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, WFNB, were 15.7%, 16.0% and 17.0%, respectively, at June 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 WFNB 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 WFCB 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 WFNB’s and WFCB’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 WFNB and WFCB. 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 June 30, 2012, we had $3.4 billion of asset-backed securities debt – owed to securitization investors, of which $1.6 billion is due within the next 12 months.

 
39

 
The following table shows the maturities of borrowing commitments as of June 30, 2012 for the WFN Trusts and the WFC Trust by year:
 
   
2012
   
2013
   
2014
   
2015
   
2016 & Thereafter
   
Total
 
   
(In thousands)
 
Term notes
 
$
596,651
   
$
822,339
   
$
250,000
   
$
393,750
   
$
512,500
   
$
2,575,240
 
Conduit facilities (1)
   
330,000
     
375,000
     
1,200,000
     
     
     
1,905,000
 
Total (2)
 
$
926,651
   
$
1,197,339
   
$
1,450,000
   
$
393,750
   
$
512,500
   
$
4,480,240
 
                                                   
 
(1)
Amount represents borrowing capacity, not outstanding borrowings.
 
(2)
Total amounts do not include $804.2 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 June 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 public, 7-year, fixed-rate, 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.
 
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, 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 will be eliminated from our unaudited condensed consolidated financial statements.
 
 
40

 
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 will be eliminated from our unaudited condensed consolidated financial statements.
 
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 
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. Controls and Procedures.
 
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
 
As of June 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 June 30, 2012 (the end of our second 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.
 
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.

 
41

 
PART II
 
Item 1. Legal Proceedings.
 
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. Risk Factors.
 
There have been no other material changes to the Risk Factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011 except as follows:
 
Failure to safeguard our databases and consumer privacy could affect our reputation among our clients and their customers, and may expose us to legal claims.
 
Although we have extensive physical and cyber security and associated procedures, our databases have in the past been and in the future may be subject to unauthorized access. In such instances of unauthorized access, the integrity of our databases have in the past been and may in the future be affected. Security and privacy concerns may cause consumers to resist providing the personal data necessary to support our profiling capability. The use of our loyalty, marketing services or credit card programs could decline if any compromise of physical or cyber security occurred. In addition, any unauthorized release of customer information or any public perception that we released consumer information without authorization, could subject us to legal claims from customers, consumers or regulatory enforcement actions and adversely affect our client relationships.
 
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
   
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 June 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:
                       
April 1-30
   
1,909
   
$
126.71
     
   
$
397.5
 
May 1-31
   
284,072
     
122.97
     
279,524
     
363.1
 
June 1-30
   
186,450
     
122.06
     
181,717
     
341.0
 
Total
   
472,431
   
$
122.63
     
461,241
   
$
341.0
 
                                   
 
(1)
During the period represented by the table, 11,190 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.
 
(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.
 
 
Item 3. Defaults Upon Senior Securities.
   
None

 
42

 
Item 4. Mine Safety Disclosures.
 
Not applicable.
 
 
Item 5. Other Information.
   
(a) None
 
(b) None

 
43

 
Item 6. Exhibits.
   
(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-A Indenture Supplement, dated as of April 12, 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 April 16, 2012, File Nos. 333-60418, 333-60418-01 and 333-113669).
     
10.2
 
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).
     
10.3
 
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).
     
*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
**
 
Furnished herewith
+
 
Management contract, compensatory plan or arrangement

 
44

 
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: August 6, 2012
 
 
By: 
/s/  Charles L. Horn
 
   
Charles L. Horn
 
   
Executive Vice President and Chief Financial Officer
 
 
Date: August 6, 2012
 
 
45