Is This Stock a Value Trap or a Great Chance to Buy Low?

Alliance Data Systems thinks its shares are too damn cheap. Its stock topped out at $312 in spring 2015. It hovered near $278 as recently as January of 2018. On Aug. 16, it sat at just south of $139. The decline can't be blamed on poor earnings. Earnings per share shot from $5.21 in 2009 to an all-time record $22.72 in 2018. Alliance didn't pay cash dividends until 2016. Since starting them up, at 52 cents quarterly, the rate has been increased twice. It now pays 63 cents every three months. That's 21.1% more than it did at first. An all-cash sale of ADS's Epsilon division brought in about $4.4 billion in cash recently. Management used $750 million of that to complete a tender offer on Aug. 15, 2019, which retired over 5 million shares at $148 each. That shrunk ADS's float by around 9.9%. Only about 25% of all shares were tendered under the Dutch auction terms meaning three quarters of all previous shareholders were unwilling to give up on ADS near Wednesday's price. The company's history explains why it didn't want to sell. ADS has rarely been this cheaply valued. You'd have to go back to March of 2009 to have seen it at a much lower price-to-earnings. Buyers back then got a nice ride. ADS surged from south of $23 to north of $300 over the next five years. Last Christmas Eve, ADS briefly touched below $143, at about 6.3-times trailing earnings, before bouncing quickly to $183. The decline since then appears inexplicable. While this year's earnings per share will be shy of 2018's record, most analysts see 2020 as a rebound year. That's especially likely now that there are 10% fewer shares outstanding and a further share-buyback plan still in effect. The stock's long-term average price-to-earnings has been 14.6-times. A typical yield ran about 0.9%. As of Aug. 18, 2019, ADS' multiple was just 7.1-times this year's projected EPS, and its yield is double the normalized rate. Even a partial regression-to-the-mean multiple of 12-times would justify a $283.80 target price by Dec. 31, 2020. ADS could double from here, without even being normally valued. Independent research house Morningstar agrees. The firm assigns ADS a 4-star, out of 5, buy rating. Morningstar deigns to provide year-ahead goal prices. It does, though, indicate what it thinks is present-day fair value for each stock it covers. For Alliance Data Systems, that number sits at $220, a full 60% above its current quote. Value Line's long-term view on ADS is very positive. It sees ADS increasing EPS to $33.60 not later than 2024. Their three-to-five year projected target price range runs from $240 to $365. Such compelling value would seem tempting enough to attract insider buying. Alas, that has not been the case so far. Despite the low price, there have been no insider purchases since January 2017. Those took place in the $217-$229 price range. Perhaps we'll see some buying interest now that the tender offer has been completed and restrictions on inside activity have been lifted. Option savvy traders could consider selling some Mar. 20, 2020 expiration date puts at strikes from $135 to $150. Actual bid-ask pricing for those is shown below, reflecting action with ADS trading at $138.71. Worst-case, forced-purchase prices on the three lower-priced strikes dropped to below $130 per share. ADS hasn't actually changed hands for less than $133.56 since way back in 2012. Investors who trust the numbers should find ADS tempting. There is well-defined upside, a reasonable yield and management who thought ADS was undervalued enough to spend $750 million buying shares back at $148. Is this a great chance to buy low, or a value trap? It appears to be the former, but only the passage of time can produce a definitive answer to that question. I don't have positions in ADS at the time of writing, but I may buy shares or sell puts on ADS soon.

Is This Stock a Value Trap or a Great Chance to Buy Low?

Time will tell, but investors who trust the numbers should find ADS tempting: There is well-defined upside, a reasonable yield and management who thought ADS was undervalued enough to spend big on it.

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