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ALLIANCE DATA SYSTEMS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

May 5, 2014

The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and related notes thereto presented in this quarterly report and the consolidated financial statements and related notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the Securities and Exchange Commission, or SEC, on February 28, 2014.

Quarter in Review Highlights

For the three months ended March 31, 2014, revenue increased 17.0% to $1.2 billion and adjusted EBITDA, net increased 2.7% to $334.6 million as compared to the prior year period.

LoyaltyOne®

LoyaltyOne generates revenue primarily from our coalition loyalty program in Canada, the AIR MILES Reward Program, and our recent acquisition of a 60% ownership interest in BrandLoyalty Group B.V., or BrandLoyalty. Revenue increased 36.6% to $329.0 million and adjusted EBITDA, net increased 4.1% to $65.2 million for the three months ended March 31, 2014 as compared to the same period in 2013, primarily due to the BrandLoyalty acquisition, which added $111.9 million and $8.7 million to revenue and adjusted EBITDA, net, respectively. A weaker Canadian dollar negatively impacted results of operations for the three months ended March 31, 2014, as the average foreign currency exchange rate was $0.91 as compared to $0.99 in the prior year period, which lowered revenue and adjusted EBITDA, net by $18.9 million and $5.2 million, respectively.

On January 2, 2014, we acquired a 60% ownership interest in BrandLoyalty Group B.V., a Netherlands-based, data-driven loyalty marketer. BrandLoyalty designs, organizes, implements and evaluates innovative and tailor-made loyalty programs for food retailers worldwide. The acquisition expands our presence across Europe, Asia and Latin America. See Note 3, "Acquisition," of the Notes to Unaudited Condensed Consolidated Financial Statements for more information.

AIR MILES reward miles issued and AIR MILES reward miles redeemed are two key drivers and indicators of success of the AIR MILES Reward Program. 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 remain unredeemed.

For those sponsor contracts not yet subject to Accounting Standards Update, or ASU, 2009-13, "Multiple-Deliverable Revenue Arrangements," the allocation of the fees received from AIR MILES reward miles issued is allocated to the redemption element based on the fair value of the redemption element, and the service element is determined based on the residual method. For sponsor contracts subject to ASU 2009-13, we determine the selling price for all of the deliverables in the arrangement, and use the relative selling price method to allocate the arrangement consideration among the deliverables. Proceeds from the issuance of AIR MILES reward miles under these contracts are allocated to three elements: the redemption element, the service element and the brand element, based on the relative selling price method. Revenue for the redemption element is recognized at the time an AIR MILES reward mile is redeemed. For the service element, revenue is recognized over the estimated life of an AIR MILES reward mile. Revenue attributable to the brand element is recognized at the time an AIR MILES reward mile is issued.

AIR MILES reward miles issued during the three months ended March 31, 2014 decreased 3.7% compared to the same period in the prior year due to weak consumer credit card spending and limited sponsor promotional activity. AIR MILES reward miles redeemed during the three months ended March 31, 2014 decreased 4.4% compared to the same period in the prior year due in part to reduced demand for domestic travel as a result of inclement weather.

AIR MILES Cash, an instant reward option added to the AIR MILES Reward Program in March 2012, continues to expand with over 2.1 million collectors. We currently have 11 participating sponsors that can process instant redemptions of AIR MILES reward miles collected in the AIR MILES Cash program option. For the three months ended March 31, 2014, AIR MILES Cash represented approximately 13% of the AIR MILES reward miles issued, compared to 10% in the prior year period.

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CBSM-Companhia Brasileira De Servicos De Marketing, operator of Brazil's dotz coalition loyalty program, or dotz, in which we have an approximate 37% ownership, has approximately 11.9 million collectors enrolled at March 31, 2014, as compared to approximately 7.2 million collectors enrolled at March 31, 2013. In February 2014, CBSM-Companhia Brasileira De Servicos De Marketing signed a multi-year renewal agreement with Banco do Brasil as a sponsor for dotz. We expect dotz to enter into four additional markets in Brazil during 2014. Dotz did not have a significant impact to our results of operations for the three months ended March 31, 2014 and 2013, respectively, and is not expected to have an impact to our results of operations for the remainder of 2014.

Epsilon®

Revenue increased 9.3% to $347.5 million and adjusted EBITDA, net increased 1.4% to $55.2 million for the three months ended March 31, 2014 as compared to the same period in 2013. Revenue growth was strong in all major product offerings, with marketing technology increasing 11.2%, agency increasing 9.0% and our data products increasing 5.5% percent. This growth was dampened in part by an increase in operating costs with the onboarding of new clients, higher health care costs and severance associated with the integration of HMI.

During the three months ended March 31, 2014, Epsilon announced new multi-year agreements with Ebates Inc., operator of consumer shopping rewards programs, to provide email marketing services, and UncommonGoods, a privately-held online marketplace, to provide database marketing services.

Private Label Services and Credit

Revenue increased 13.0% to $561.8 million and adjusted EBITDA, net increased 7.4% to $243.5 million for the three months ended March 31, 2014 as compared to the same period in 2013.

For the three months ended March 31, 2014, average credit card and loan receivables increased 15.2% as compared to the same period in the prior year as a result of increased credit sales. Credit sales increased 16.8% for the three months ended March 31, 2014 due to cardholder growth and strong core cardholder spending.

Delinquency rates increased slightly to 3.9% of principal receivables at March 31, 2014, up from 3.8% at March 31, 2013. The principal net charge-off rate was 4.8% for the three months ended March 31, 2014 as compared to 4.5% in the prior year period.

During the three months ended March 31, 2014, we announced the signing of a new multi-year agreement with Venus, a multi-channel women's retailer, to provide private label credit card services. We also announced the signing of a new multi-year agreement with airline Virgin America to provide co-brand credit card services. Additionally, we announced the renewal of a multi-year agreement to continue providing co-brand and private label credit card services to HSN, a lifestyle and entertainment retailer.

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, 2013.

Recent Accounting Pronouncements

See "Recently Adopted Accounting Standards" under Note 1, "Summary of Significant Accounting Policies," of the Notes to Unaudited Condensed Consolidated Financial Statements for a discussion of certain accounting standards that have been adopted during 2014.

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. Adjusted EBITDA, net is also a non-GAAP financial measure equal to adjusted EBITDA less securitization funding costs, interest expense on deposits and adjusted EBITDA attributable to the non-controlling interest.

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We use adjusted EBITDA and adjusted EBITDA, net 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 and adjusted EBITDA, net are each 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, net provided to the chief operating decision maker for purposes of assessing segment performance and decision making with respect to resource allocations. In addition to the above, Adjusted EBITDA, net also excludes the percentage of the adjusted EBITDA attributable to the non-controlling interest, and the interest associated with servicing on credit card and loan receivables, or securitization funding costs and interest on deposits. We believe that adjusted EBITDA and adjusted EBITDA, net provide useful information to our investors regarding our performance and overall results of operations. Adjusted EBITDA, and adjusted EBITDA, net are not intended to be performance measures that should be regarded as an alternative to, or more meaningful than, either operating income or net income as indicators of operating performance or to cash flows from operating activities as a measure of liquidity. In addition, adjusted EBITDA and adjusted EBITDA, net are 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 and adjusted EBITDA, net measures 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 March 31, 2014 2013 (In thousands) Net income $ 135,747$ 128,979 Stock compensation expense 15,624 13,024 Provision for income taxes 78,298 79,702 Interest expense, net 67,747 82,544 Depreciation and other amortization 25,512 19,560 Amortization of purchased intangibles 48,561 33,290 Adjusted EBITDA 371,489 357,099 Less: Securitization funding costs 22,911 24,485 Less: Interest expense on deposits 8,234 7,007 Less: Adjusted EBITDA attributable to non-controlling interest 5,789 - Adjusted EBITDA, net $ 334,555$ 325,607 30



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