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

August 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.

Year in Review Highlights

For the six months ended June 30, 2014, revenue increased 20.0% to $2.5 billion and adjusted EBITDA, net increased 5.5% to $666.5 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 48.5% to $684.6 million and adjusted EBITDA, net increased 10.7% to $142.5 million for the six months ended June 30, 2014 as compared to the same period in 2013, primarily due to the BrandLoyalty acquisition, which added $248.3 million and $24.0 million to revenue and adjusted EBITDA, net, respectively. A weaker Canadian dollar negatively impacted results of operations for the six months ended June 30, 2014, as the average foreign currency exchange rate was $0.91 as compared to $0.98 in the prior year period, which lowered revenue and adjusted EBITDA, net by $33.8 million and $9.2 million, respectively.

On January 2, 2014, we acquired a 60% ownership interest in BrandLoyalty, a Netherlands-based, data-driven loyalty marketer that 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.

For the AIR MILES Reward Program, AIR MILES reward miles issued and AIR MILES reward miles redeemed are two key drivers and indicators of success. 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 six months ended June 30, 2014 decreased 2.0% compared to the same period in the prior year, as the merger of two of our top grocery sponsors and newly enacted regulations related to prescription drug purchases negatively impacted our AIR MILES reward miles issued. For the year, we still expect AIR MILES reward miles issuance growth in the single-digit range, driven by increased promotional activity by our sponsors and new initiatives within AIR MILES Cash. AIR MILES reward miles redeemed during the six months ended June 30, 2014 increased 2.8% compared to the same period in the prior year due to increased redemptions through the AIR MILES Cash program option. For the six months ended June 30, 2014, AIR MILES Cash represented approximately 14% of the AIR MILES reward miles issued, compared to 11% in the prior year period.

During the six months ended June 30, 2014, LoyaltyOne signed a cross-Canada, long-term agreement with Sobeys, a national grocery retailer in Canada who acquired Canada Safeway in late 2013, to continue its participation and expand its Sobeys-owned banners as sponsors in the AIR MILES Reward Program. We also signed new multi-year agreements with Kent Building Supplies, a Canadian home improvement products retailer, and Moneris Solutions Corporation, a Canadian credit and debit card processor, to participate as sponsors in the AIR MILES Reward Program. Finally, we signed a new multi-year consulting agreement with Loblaw Companies Limited to develop and execute merchandising and marketing strategies.

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The Company has an approximate 37% ownership in CBSM-Companhia Brasileira De Servicos De Marketing, operator of Brazil's dotz coalition loyalty program, which operates in 10 markets and has more than 12 million collectors enrolled as of June 30, 2014. We expect dotz to expand to 13 markets by the end of 2014. Dotz did not have a significant impact to our results of operations for the three and six months ended June 30, 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 8.4% to $704.6 million and adjusted EBITDA, net increased 4.1% to $122.9 million for the six months ended June 30, 2014 as compared to the same period in 2013. Revenue growth was positive in all major product offerings, with marketing technology increasing 12.4%, agency increasing 7.7% and our data products increasing 1.4% 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 six months ended June 30, 2014, Epsilon announced new multi-year agreements with ANN INC., operator of leading women's specialty retail fashion brands, to provide a customer relationship management database solution, and FordDirect, a joint venture between Ford Motor Company and its franchised dealers, to build and host a customer relationship management database and provide database marketing services. Additionally, we announced new multi-year agreements with Ebates Inc. to provide email marketing services and UncommonGoods to provide database marketing services.

Private Label Services and Credit

Revenue increased 14.5% to $1.1 billion and adjusted EBITDA, net increased 6.3% to $453.9 million for the six months ended June 30, 2014 as compared to the same period in 2013.

For the six months ended June 30, 2014, average credit card and loan receivables increased 16.3% as compared to the same period in the prior year as a result of increased credit sales. Credit sales increased 19.5% for the six months ended June 30, 2014 due to strong core cardholder spending and new client signings.

Delinquency rates increased slightly to 4.0% of principal receivables at June 30, 2014, up from 3.9% at June 30, 2013. The principal net charge-off rate for the six months ended June 30, 2014 was 4.6%, as compared to 4.5% in the prior year period.

During the six months ended June 30, 2014, we announced new multi-year agreements to provide private label credit card services to Overstock.com, JD Williams, International Diamond Distributors and Venus. We also announced multi-year renewal agreements with Bealls and Burkes Outlet and Eddie Bauer to continue providing private label credit card services and multi-year renewal agreements with HSN and with ANN INC. brands, Ann Taylor and LOFT, to continue providing private label and co-brand credit card services.

Additionally, we announced new multi-year agreements to provide co-brand credit card services to American Kennel Club, Orbitz, DSW Inc. and Virgin America. We also announced a new multi-year agreement with Good Sam Enterprises to provide co-brand credit card services and to acquire the existing co-brand credit card portfolio at a future date.

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 Issued Accounting Standards" and "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 issued and adopted during 2014.

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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.

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 intangible assets, including 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, 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. In addition to the above, adjusted EBITDA, net also excludes the interest associated with financing our credit card and loan receivables, which represents securitization funding costs and interest on deposits, and the percentage of the adjusted EBITDA attributable to the non-controlling interest. 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 Six Months Ended June 30, June 30, 2014 2013 2014 2013 (In thousands) Net income $ 139,189$ 116,440$ 274,936$ 245,419 Stock compensation expense 15,873 14,991 31,497 28,015 Provision for income taxes 80,419 69,274 158,717 148,976 Interest expense, net 62,932 83,466 130,679 166,010 Depreciation and other amortization 25,973 20,446 51,485 40,006



Amortization of purchased intangibles 48,322 33,130 96,883 66,420 Adjusted EBITDA

372,708 337,747 744,197 694,846 Less: Securitization funding costs 22,300 24,694 45,211 49,179 Less: Interest expense on deposits 8,228 7,002 16,462 14,009 Less: Adjusted EBITDA attributable to non-controlling interest 10,214 - 16,003 - Adjusted EBITDA, net $ 331,966$ 306,051$ 666,521$ 631,658 33



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