Ignoring the stock price of a company, what are the underlying trends that tell us a business is past the growth phase? When we see a declining return on capital employed (ROCE) in conjunction with a declining base of capital employed, that’s often how a mature business shows signs of aging. Ultimately this means that the company is earning less per dollar invested and on top of that, it’s shrinking its base of capital employed. So after glancing at the trends within Alliance Data Systems (NYSE:ADS), we weren’t too hopeful.
Understanding Return On Capital Employed (ROCE)
If you haven’t worked with ROCE before, it measures the ‘return’ (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for Alliance Data Systems:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
0.061 = US$698m ÷ (US$23b – US$11b) (Based on the trailing twelve months to June 2020).
Thus, Alliance Data Systems has an ROCE of 6.1%. Ultimately, that’s a low return and it under-performs the IT industry average of 10%.
Above you can see how the current ROCE for Alliance Data Systems compares to its prior returns on capital, but there’s only so much you can tell from the past. If you’d like, you can check out the forecasts from the analysts covering Alliance Data Systems here for free.
What The Trend Of ROCE Can Tell Us
In terms of Alliance Data Systems’ historical ROCE movements, the trend doesn’t inspire confidence. To be more specific, the ROCE was 8.2% five years ago, but since then it has dropped noticeably. On top of that, it’s worth noting that the amount of capital employed within the business has remained relatively steady. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. So because these trends aren’t typically conducive to creating a multi-bagger, we wouldn’t hold our breath on Alliance Data Systems becoming one if things continue as they have.On a side note, Alliance Data Systems’ current liabilities have increased over the last five years to 50% of total assets, effectively distorting the ROCE to some degree. If current liabilities hadn’t increased as much as they did, the ROCE could actually be even lower. And with current liabilities at these levels, suppliers or short-term creditors are effectively funding a large part of the business, which can introduce some risks.
What We Can Learn From Alliance Data Systems’ ROCE
In the end, the trend of lower returns on the same amount of capital isn’t typically an indication that we’re looking at a growth stock. We expect this has contributed to the stock plummeting 83% during the last five years. Unless these trends revert to a more positive trajectory, we would look elsewhere.
On a final note, we found 5 warning signs for Alliance Data Systems (1 is potentially serious) you should be aware of.
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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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