LOYALTY VENTURES INC. Management report and analysis of the financial situation and operating results. (Form 10-K)
We are a leading provider of tech-enabled, data-driven consumer loyalty solutions. Our solutions are focused on helping partners achieve their strategic and financial objectives, from increased consumer basket size, shopper traffic and frequency and digital reach to enhanced program reporting and analytics. We help financial services providers, retailers 33
and other consumer-facing businesses create and increase customer loyalty across multiple touch points from traditional to digital to mobile and emerging technologies. We own and operate the AIR MILES® Reward Program,
Canada'smost recognized loyalty program, and BrandLoyalty, a leading global provider of campaign-based loyalty solutions for grocers and other high-frequency retailers.
October 13, 2021, the Board of Directors of ADS approved the previously announced Separation of its LoyaltyOnesegment, consisting of the Canadian AIR MILES® Reward Program and BrandLoyalty businesses, into an independent, publicly traded company. On November 5, 2021, the date of the Separation, 81% of the outstanding shares of Loyalty Ventureswere distributed pro rata based on the outstanding shares of ADS common stock at the close of business on the record date of October 27, 2021, with ADS retaining the remaining 19% of the outstanding shares of Loyalty Ventures. Additionally, Loyalty Venturesmade a cash distribution of $750.0 millionto ADS on November 3, 2021, as part of
the Separation. Basis of presentation Prior to the Separation, we have historically operated as part of ADS and not as a standalone company. The combined financial statements for the periods prior to the Separation date of
November 5, 2021have been derived from ADS' historical accounting records and are presented on a carve-out basis. The financial statements after the Separation date of November 5, 2021represent the consolidated financial statements of Loyalty Ventures. Our consolidated and combined financial statements and accompanying notes have been prepared in accordance with accounting principles generally accepted in the United States of America("GAAP"). All revenues and expenses as well as assets and liabilities directly associated with the business activity of the Loyalty Venturesbusiness are included in the consolidated and combined financial statements. The consolidated and combined financial statements also include allocations of certain general and administrative expenses from ADS. ADS corporate overhead costs that directly or indirectly benefited Loyalty Ventures'business were allocated through the date of the spinoff and for the years ended December 31, 2021, 2020 and 2019. The allocated amounts included in general and administrative expense within our consolidated and combined statements of income were $12.6 million, $14.3 millionand $14.8 millionfor the years ended December 31, 2021, 2020 and 2019, respectively. These allocations relate to information technology, finance, accounting, tax services, human resources, and other functional support. These allocations were determined based on management estimates on the number of employees and non-employee costs associated with the use of these functions by us and may not be indicative of the costs that we would otherwise incur on a standalone basis or had we operated independently of ADS. ADS' third-party long-term debt and the related interest expense have not been allocated for any of the periods presented as Loyalty Ventureswas not the legal obligor of such debt. Refer to Note 1, "Description of Business, Spinoffand Basis of Presentation," to our consolidated and combined financial statements for additional information on the carve-out basis of accounting. The preparation of financial statements in conformity with U.S.GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The consolidated and combined financial statements may not be indicative of future performance and do not necessarily reflect what the financial position, results of operations, and cash flows would have been had we operated as an independent, publicly traded company during the periods presented, particularly because of changes we expect to experience in the future as a result of the Separation, including changes in the financing, cash management, operations, cost structure and personnel needs of our business.
Following the declaration by the WHO in the first quarter of 2020 of COVID-19 as a global pandemic and the rapid spread of COVID-19, international, provincial, federal, state and local government or other authorities have imposed varying degrees of restrictions on social and commercial activity in an effort to improve health and safety. As the global 34
COVID-19 pandemic has continued to evolve, our priority has been and continues to be, the health and safety of our employees, with the vast majority of our employees continuing to work from home. The effects of the COVID-19 pandemic continue to negatively impact our results of operations and certain key metrics. AIR MILES reward miles issuances declined 6% due to the impact of related government restrictions and closures impacting collector spend and the nonrenewal of certain sponsor contracts in the first quarter of 2021. Redemptions increased 12% due to an increase in redemptions for travel, including the reopening of the US border for nonessential travel prior to the emergence of the omicron variant in the fourth quarter. Merchandise redemptions continue to perform well in the current environment. With respect to BrandLoyalty, the decline in revenue and adjusted EBITDA was mainly attributed to a decline in programs in market across most regions due to the impact of COVID-19 and supply chain disruptions. Shortages in production capacity in
Europedue to insufficient staff availability led to lower than estimated campaign performance and revenue decline. As a result of the ongoing impact of the COVID-19 pandemic, in the fourth quarter of 2021, we determined that it was more likely than not that the fair value of the BrandLoyalty reporting unit was below its carrying value, and performed an interim impairment test. Based on the results, we recognized a non-cash, goodwill impairment charge of $50.0 million. Despite the availability of vaccines, surges in COVID-19 cases, including variants of the strain, may adversely impact the economic recovery and our industry outlook. We continue to evaluate the nature and extent of changes to the market and economic conditions related to the COVID-19 pandemic and current and potential impact on our business and financial position. However, given the dynamic nature of this situation, we cannot reasonably estimate the impacts of COVID-19 on our future results of operations or cash flows at this time. 35
Consolidated and combined results of operations
Years Ended December 31, % Change 2021 to 2020 to 2021 2020 2019 2020 2019 (in thousands, except percentages) Revenues Redemption, net
$ 444,395 $ 473,067 $ 637,321(6) % (26) % Services 269,073 264,050 367,647 2 (28) Other 21,839 27,689 28,163 (21) (2) Total revenue 735,307 764,806 1,033,131 (4) (26) Operating expenses Cost of operations (exclusive of depreciation and amortization disclosed separately below) 573,246 587,615 847,552 (2) (31) General and administrative 20,011 14,315 14,823 40 (3) Depreciation and other amortization 34,944 28,988 32,152 21 (10) Amortization of purchased intangibles 1,740 48,953 48,027 (96) 2 Goodwill impairment 50,000 - - nm * nm * Total operating expenses 679,941 679,871 942,554 - (28) Operating income 55,366 84,935 90,577 (35) (6) Gain on sale of a business - (10,876) - nm * nm * Interest expense (income), net 5,534 (834) 2,335 (764) (136) Income before income taxes and (income) loss from investment in unconsolidated subsidiaries 49,832 96,645 88,242 (48) 10 Provision for income taxes 52,175 21,324 11,331 145 88 (Income) loss from investment in unconsolidated subsidiaries - related party, net of tax (4,067) 246 1,681 (1,753) (85) Net income $ 1,724 $ 75,075 $ 75,230(98) % - % Key Operating Metrics (in millions): AIR MILES reward miles issued 4,670.2 4,963.8 5,511.1 (6) % (10) % AIR MILES reward miles redeemed 3,507.3 3,127.8 4,415.7 12 % (29) % Supplemental Information: Average CAD to USD foreign currency exchange rate 0.80 0.75 0.75 7 % (1) % Average EUR to USD foreign currency exchange rate 1.18 1.14 1.12 4 % 2 % * not meaningful
Revenue. Total revenue decreased
$29.5 million, or 4%, to $735.3 millionfor the year ended December 31, 2021from $764.8 millionfor the year ended December 31, 2020. The net decrease in revenue was due to the following:
Redemption. Redemption income is recognized when the
customer exchanges for a reward. Revenues have gone down
? our campaign-based loyalty programs have decreased
programs in the market in most regions due to the impact of COVID-19 and supply
chain disturbances. In response to COVID-19, some of our customers have delayed
their campaign-based loyalty programs.
Services. Service revenues are associated with the overall management of the
? loyalty programs and is generally recognized over time. Revenues have increased
million, or 2%, to
the favorable impact of foreign currency exchange rates. 36 Table of Contents
Other. Other income includes investment income and other ancillary income
? won. Revenues have gone down
excess inventory in our BrandLoyalty segment.
Cost of operations. Cost of operations decreased
$14.4 million, or 2%, to $573.2 millionfor the year ended December 31, 2021as compared to $587.6 millionfor the year ended December 31, 2020. The decline in the cost of operations was a result of a decrease in the cost of redemptions of $27.4 millionresulting from the decrease in redemption revenue noted above, offset in part by $13.2 millionin costs associated with the Separation. General and administrative. General and administrative expenses increased $5.7 million, or 40%, to $20.0 millionfor the year ended December 31, 2021, as compared to $14.3 millionfor the year ended December 31, 2020, due to an increase in payroll and benefits and $4.5 millionin certain costs associated with the Separation, of which $4.0 millionrepresented the write-off of an indemnification asset established as part of the Tax Matters Agreement. Depreciation and other amortization. Depreciation and other amortization increased $6.0 million, or 21%, to $34.9 millionfor the year ended December 31, 2021, as compared to $29.0 millionfor the year ended December 31, 2020due to additional capitalized software assets placed into service for digital investments for the AIR MILES Reward Program segment. Amortization of purchased intangibles. Amortization of purchased intangibles decreased $47.2 million, or 96%, to $1.7 millionfor the year ended December 31, 2021, as compared to $49.0 millionfor the year ended December 31, 2020, due to the fully amortized customer contracts in our BrandLoyalty segment. Goodwillimpairment. As a result of the ongoing impact of the COVID-19 pandemic, in the fourth quarter of 2021, we determined that it was more likely than not that the fair value of the BrandLoyalty reporting unit was below its carrying value, and performed an interim impairment test. Based on the results, we recognized a non-cash, goodwill impairment charge of $50.0 million. Gain on sale of a business. In January 2020, ADS sold Precima, a provider of retail strategy and customer data applications, resulting in a pre-tax gain of $10.9 million. Interest expense (income), net. Total interest expense, net increased $6.4 millionto $5.5 millionfor the year ended December 31, 2021as compared to interest income of $(0.8) millionfor the year ended December 31, 2020. The increase in interest expense is associated with our $675.0 millionin senior secured credit agreement entered in connection with the Separation in November 2021. Taxes. Provision for income taxes increased $30.9 million, or 145%, to $52.2 millionfor the year ended December 31, 2021from $21.3 millionfor the year ended December 31, 2020. The provision for income taxes for 2021 was negatively impacted by certain transactions associated with the Separation, including Canadian withholding taxes associated with payments to the former parent, non-deductible U.S.expenses and goodwill impairment. (Income) loss from unconsolidated subsidiaries-related party. The income from unconsolidated subsidiary - related party was $4.1 millionfor the year ended December 31, 2021as compared to a loss of $0.2 millionfor the year ended December 31, 2020. Our investment in our unconsolidated subsidiary, Comenity Canada, L.P., was sold to an affiliate of ADS in August 2021for $4.1 millionand we recognized a gain on sale of unconsolidated subsidiary of $4.1 million.
Refer to Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations," included in of our registration statement on Form 10, filed with
SECon October 13, 2021, for a discussion of our 2020 results compared to 2019, which discussion is incorporated by reference herein. 37
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 (income) loss from investment in unconsolidated subsidiaries - related party, provision for income taxes, interest expense (income), net, depreciation and other amortization, the amortization of purchased intangibles, and stock compensation expense. Adjusted EBITDA excludes the gain on the sale of Precima in 2020, strategic transaction costs, which represent costs for professional services and other costs associated with strategic initiatives, including the spinoff and amounts associated with the Tax Matters and Employee Matters agreement, goodwill impairment, and restructuring and other charges for actions taken in 2019. These costs, as well as stock compensation expense, were not included in the measurement of segment adjusted EBITDA as the chief operating decision maker did not factor these expenses for purposes of assessing segment performance and decision making with respect to resource allocations. 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, and we believe it provides useful information to our investors regarding our performance and overall results of operations. 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 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. Adjusted EBITDA is not intended to be a performance measure that should be regarded as an alternative to, or more meaningful than, 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.
Adjusted EBITDA presented herein 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.
38 Table of Contents Years Ended December 31, 2021 2020 2019 (in thousands) Net income
$ 1,724 $ 75,075 $ 75,230(Income) loss from investment in unconsolidated subsidiaries - related party, net of tax (4,067) 246
Provision for income taxes 52,175 21,324
Interest expense (income), net 5,534 (834)
Depreciation and other amortization 34,944 28,988
Amortization of purchased intangibles 1,740 48,953
Stock compensation expense 6,259 7,017
Gain on sale of a business, net of strategic transaction costs (1) - (7,816)
Goodwill impairment 50,000 -
Strategic transaction costs (2) 17,682 329
Restructuring and other charges (3) - 108
50,780 Adjusted EBITDA
$ 165,991 $ 173,390 $ 231,593
(1) Represents the gain on the sale of Precima in
transaction costs. Precima has been included in our AIR MILES reward program
segment. See note 5, “Disposal”, of the notes to the consolidated and combined financial statements
Financial statements for the year ended
(2) Represents costs associated with strategic initiatives, including costs
related to the separation, which included consent fees, amounts
related to social and fiscal agreements, and professional
(3) Represents costs associated with restructuring or other exit activities for
measures taken in 2019. See Note 13, “Restructuring and other charges”, of the
Notes to the consolidated and combined financial statements for the year ended
December 31, 2021for additional information. Years Ended December 31, % Change 2021 2020 2019 2021 to 2020 2020 to 2019 (in thousands, except percentages) Revenue: AIR MILES Reward Program $ 284,744 $ 277,121 $ 384,0213 % (28) % BrandLoyalty 450,609 487,685 649,110 (8) (25) Eliminations (46) - - nm * nm * Total $ 735,307 $ 764,806 $ 1,033,131(4) % (26) % Adjusted EBITDA: AIR MILES Reward Program $ 147,798 $ 144,025 $ 165,1683 % (13) % BrandLoyalty 32,112 42,161 79,376 (24) (47) Corporate/Other (13,919) (12,796) (12,951) 9 (1) Total $ 165,991 $ 173,390 $ 231,593(4) % (25) % * not meaningful
Revenue. Total revenue decreased
$29.5 million, or 4%, to $735.3 millionfor the year ended December 31, 2021from $764.8 millionfor the year ended December 31, 2020. The net decrease was due to the following:
AIR MILES reward program. Revenues have increased
? million for the year ended
favorable exchange rates. The sale of Precima in
$1.9 milliondecrease in revenue. 39 Table of Contents
Brand loyalty. Revenues have gone down
? year ended
most regions due to the impact of COVID-19 and the associated supply chain
Adjusted EBITDA. Adjusted EBITDA decreased
AIR MILES reward program. Adjusted EBITDA increased
reductions impacted by COVID 19, such as employee occupancy and engagement
? costs. For the year ended
Separation have been excluded from Adjusted EBITDA. For the year ended December
31, 2020, the
costs, has been excluded from Adjusted EBITDA.
Brand loyalty. Adjusted EBITDA decreased
for the year ended
? as discussed above. For the year ended
impairment of goodwill and costs of
have been excluded from Adjusted EBITDA.
Business/Other. Adjusted EBITDA decreased
the year has ended
The separation has been excluded from Adjusted EBITDA.
Refer to Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations," included in of our registration statement on Form 10, filed with
SECon October 13, 2021, for a discussion of our 2020 results compared to 2019, which discussion is incorporated by reference herein.
Cash and capital resources
Historically, our primary source of liquidity has been cash generated from operating activities. We expanded this source with our new credit facility and may expand these sources with future issuances of debt or equity securities. Our primary uses of cash are for ongoing business operations, repayment of our debt, capital expenditures and investments. We believe that internally generated funds and other sources of liquidity discussed below will be sufficient to meet working capital needs, capital expenditures, and other business requirements for at least the next 12 months. We believe we will meet known or reasonably likely future cash requirements through the combination of cash generated from operating activities, available cash balances and available borrowings through the issuance of third-party debt. If these sources of liquidity need to be augmented, additional cash requirements would likely be financed through the issuance of debt or equity securities? however, there can be no assurances that we will be able to obtain additional debt or equity financing on acceptable terms in the future. In addition, the continued volatility in the financial and capital markets due to COVID-19 may limit our access to, or increase our cost of, capital or make capital unavailable on terms acceptable to us or at all.
Our ability to fund our operating requirements will depend on our future ability to continue to generate positive operating cash flow and obtain debt or equity financing on acceptable terms.
Cash activity for the years ended
Operating Activities. We generated cash flow from operating activities of
$179.6 million, $216.3 million, and $105.7 millionfor the years ended December 31, 2021, 2020, and 2019, respectively. The decrease in operating cash flows in 2021 of $36.7 millionwas impacted by lower profitability and a decrease of working capital. In 2020, operating 40
cash flow increased
Investing Activities. Cash used in investing activities was
$65.3 million, $65.7 millionand $53.0 millionfor the years ended December 31, 2021, 2020 and 2019, respectively. Significant components of investing activities are as follows:
Redemption settlement assets, restricted. The money used from the redemption
settlement assets, restricted was
? million for the years ended
The increase in cash flow used is attributable to an increase in investments,
AIR MILES reward miles issued were greater than AIR MILES reward miles redeemed.
Capital expenditure. Cash paid for capital expenditures was
? and 2019, respectively. In 2022, we plan to invest a
digital platforms, while enhancing our data and analytics capabilities to
we can better serve our customers.
Proceeds from disposal of interests in non-consolidated subsidiaries – related
? Party. In 2021, we sold our investment in
million. In 2019, we sold our investment in
LP (“ICOM”) to a subsidiary of ADS for
Investments in unconsolidated subsidiaries – related party. We made investments
in unconsolidated subsidiaries – related party of
? million, for the years ended
to ICOM of
Distributions from investments in an unconsolidated subsidiary – related party. We
? received distributions from Comenity Canada LP of
Financing Activities. Cash used in financing activities was
$216.2 million, $2.6 million, and $42.9 millionfor the years ended December 31, 2021, 2020 and 2019, respectively. In connection with the Separation with ADS, we entered into a senior secured credit facility in the amount of $675.0 millionand paid $22.9 millionin debt issuance costs. In connection with the Separation, we made a distribution to ADS of $750.0 million, and ADS made a contribution of $5.6 million. In the first quarter of 2021, we also paid a dividend of $124.2 millionto ADS, of which $4.2 millionwas withheld for taxes. In 2019, a capital contribution of $288.7 millionreceived from ADS was used to repay existing amounts under BrandLoyalty's credit agreement and amounts owed under certain note payable agreements to subsidiaries of ADS.
In addition, cash used in financing transactions reflecting transactions with ADS were
November 3, 2021, Loyalty Venturesentered into a senior secured credit agreement that provides a $175.0 millionterm loan A facility, a $500.0 millionterm loan B facility, which was issued at 98.0% of the aggregate principal amount, and a revolving credit facility in the maximum amount of $150.0 million, collectively the Credit Agreement. The term loan A and revolving credit facility will mature November 3, 2026. The term loan B will mature November 3, 41
2027. The proceeds from the term loans were used to finance a portion
Loyalty Ventureswill be required to make quarterly principal amortization payments in equal installments in an aggregate amount of 7.5% per annum of the initial aggregate principal amount of each of the term loan A and term loan B. Commencing with the fiscal year ending December 31, 2022, the Credit Agreement requires, on an annual basis, the prepayment of the term loan B with either 0%, 25% or 50% of Excess Cash Flow, depending on the Consolidated Secured Leverage Ratio, as defined in the Credit Agreement. The Credit Agreement contains customary representations and warranties and affirmative and negative covenants. These covenants, among other things, limit additional indebtedness, additional liens, sales of assets, mergers and consolidations, distributions and other restricted payments, and transactions with affiliates. As of December 31, 2021, we had $175.0 millionand $500.0 millionoutstanding under the term loan A and B facility, respectively. Availability under the revolving credit facility was $137.5 million, with no borrowings but with $12.5 millionin letters of credit outstanding. Our consolidated total leverage ratio, as defined in our Credit Agreement, was under 4 to 1 at December 31, 2021, as compared to the maximum covenant ratio of 5 to 1.
Brand Loyalty Credit Agreement
April 2020, BrandLoyalty entered into a new credit agreement that provided for a committed revolving line of credit of €30.0 million, an uncommitted revolving line of credit of €30.0 million, and an accordion feature permitting BrandLoyalty to request an increase in either the committed or uncommitted line of credit up to €80.0 million in aggregate. In the first quarter of 2021, BrandLoyalty and certain of its subsidiaries, as borrowers and guarantors, amended its credit agreement to extend the maturity date by one year from April 3, 2023to April 3, 2024. During 2021, no amounts were outstanding under the BrandLoyalty credit agreement, which was terminated in connection with entering into the Credit Agreement.
See Note 15, “Debt”, in the Notes to the Consolidated and Combined Financial Statements for additional information regarding our debt.
In the normal course of business, we enter into various contractual obligations that may require future cash payments. Our future cash payments associated with our contractual obligations and commitments to make future payments by type and period as of
December 31, 2021are summarized below: 2022 2023 2024 2025 2026 Thereafter Total (in thousands) Long-term debt(1) $ 82,619 $ 82,619 $ 82,619 $ 82,619 $ 190,829 $ 333,333 $ 854,638Operating leases 15,073 14,250 13,369 12,841 12,429 77,427 145,389
ASC 740 obligations(2) - - - - - - - Purchase obligations(3) 158,389 39,409 32,956 8,065 7,678 - 246,497 Total
$ 256,081 $ 136,278 $ 128,944 $ 103,525 $ 210,936 $ 410,760 $ 1,246,524
(1) Long-term debt represents our estimated debt service obligations, including
both principal and interest. Interest was based on interest rates
(2) Accounting Standards Codification (“ASC”) 740, “Income Taxes”, obligations do not
not reflect unrecognized tax benefits of
$19.8 million, of which the timing remains uncertain. 42 Table of Contents
(3) Purchase obligations are defined as an agreement to purchase goods or
enforceable and legally binding services and specifying all
significant terms, including the following: fixed or minimum quantities to be
bought; fixed, minimum or variable price provisions; and approximate
time of the transaction. The purchase obligation amounts disclosed above
represent estimates of the minimum for which we are obligated and the time
period during which the cash outflows will take place. Purchase orders and authorizations
for purchase that do not imply any firm commitment from either party are excluded
from the table above. Purchase obligations include inventory or reward
purchase commitments, referral commitments under our AIR MILES reward program,
minimum royalty guarantees under license agreements, minimum payments
under support and maintenance contracts and purchase agreements of other
goods and services.
We believe that we will have access to sufficient resources to meet these commitments.
Discussion of critical accounting estimates
Our discussion and analysis of our financial condition and results of operations is based upon our consolidated and combined financial statements, which have been prepared in accordance with accounting policies that are described in the Notes to Consolidated and Combined Financial Statements for the year ended
December 31, 2021. The preparation of the consolidated and combined financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We continually evaluate our judgments and estimates in determination of our financial condition and operating results. Estimates are based on information available as of the date of the financial statements and, accordingly, actual results could differ from these estimates, sometimes materially. Critical accounting estimates are defined as those that are both most important to the portrayal of our financial condition and operating results and require management's most subjective judgments. The primary critical accounting estimates are described below.
AIR MILES Reward Program. The AIR MILES Reward Program collects fees, or consideration, from its sponsors based on the number of AIR MILES reward miles issued and, in limited circumstances, the number of AIR MILES reward miles redeemed. Total consideration from the issuance of AIR MILES reward miles is allocated to three performance obligations: redemption, service, and brand. As the standalone selling price is not directly observable, we estimate the standalone selling price for each performance obligation using either the adjusted market assessment or cost plus a margin approach. The transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. The estimated standalone selling price for the redemption and the service performance obligations are based on cost plus a reasonable margin. The estimated standalone selling price of the brand performance obligation is determined using a relief from royalty approach. Accordingly, management determines the estimated standalone selling price by considering multiple inputs and methods, including discounted cash flows and available market data in consideration of applicable margins and royalty rates to utilize. The margins and royalty rates used in the determination of the fair value have remained relatively consistent for the years ended
December 31, 2021, 2020, and 2019. The number of AIR MILES reward miles issued and redeemed are factored into the estimates, as management estimates the standalone selling prices and volumes over the term of the respective agreements in order to determine the allocation of consideration to each performance obligation delivered. The redemption performance obligation incorporates the expected number of AIR MILES reward miles to be redeemed, and therefore, the amount of redemption revenue recognized is subject to management's estimate of breakage, or those AIR MILES reward miles estimated to be unredeemed by the collector base. Our AIR MILES reward miles do not expire with the exception of cases of inactivity, which occurs when a collector account has had no transactional activity for 24 consecutive months. Additionally, the estimated life of an AIR MILES reward mile impacts the timing of revenue recognition.
The breakage and lifespan of an AIR MILES reward mile is based on management’s estimate after reviewing and analyzing various historical trends, including collector behavior, as well as account-related factors. a subscriber and the level of commitment which should be indicative of the likelihood of future redemptions. We use a statistical model
to analyze our breakage estimate and update the model at least annually. We also analyze vintage analysis, current run rates and other pertinent factors, such as the impact of macroeconomic factors and changes in the program structure. For the years ended
December 31, 2021, 2020 and 2019, our estimated breakage rate remained 20%. Our cumulative redemption rate, which represents program to date redemptions divided by program to date issuance, is 69% as of December 31, 2021. We expect the ultimate redemption rate will approximate 80% based on our historical redemption patterns, statistical regression models, and consideration of enacted program changes, as applicable. For the years ended December 31, 2021, 2020 and 2019, our estimated life of an AIR MILES reward mile remained 38 months. We estimate that a change to the estimated life of an AIR MILES reward mile of one month would impact revenue by approximately $4 million. Any future changes in collector behavior could result in further changes in our estimates of breakage or life of an AIR MILES reward mile. As of December 31, 2021, we had $1,022.0 millionin deferred revenue related to the AIR MILES Reward Program that will be recognized in the future. Further information is provided in Note 3, "Revenue," of the Notes to Consolidated and Combined Financial Statements for the year ended December 31, 2021.
We test goodwill for impairment annually or when events and circumstances change that indicate the carrying amount may not be recoverable.
For the 2021 annual impairment test, we performed a quantitative analysis for the AIR MILES Reward Program and BrandLoyalty reporting units under ADS. The fair value of the reporting units was estimated using a discounted cash flow analysis based on management's estimates of forecasted cash flows, with those cash flows discounted to present value using rates commensurate with the risks associated with those cash flows. The valuation includes assumptions related to revenue growth and profit performance, capital expenditures, the discount rate and other assumptions that are judgmental in nature. Changes in these estimates and assumptions could materially affect the results of our tests for goodwill impairment. As of the annual impairment test, goodwill for the AIR MILES Reward Program and the BrandLoyalty reporting units was
$198.5 millionand $527.1 million, respectively, and it was determined there was no impairment of goodwill on these reporting units, as the fair value of each of the AIR MILES Reward Program and BrandLoyalty reporting unit exceeded its carrying value by more than 190% and less than 10%, respectively. Due to the continued impact of the COVID-19 pandemic, including supply chain disruptions in the fourth quarter of 2021 negatively impacting program performance and issuing revised downward guidance in December 2021, we believed it was more likely than not that the fair value of the BrandLoyalty reporting unit was less than its carrying value, and performed an interim impairment test on the BrandLoyalty reporting unit as of December 31, 2021. To determine the fair value of the BrandLoyalty reporting unit, we utilized an income approach and discounted cash flow model. The most significant estimates and assumptions inherent in the discounted cash flow model were the forecasted revenue growth rate, forecasted margin, the discount rate and the terminal growth rate. These assumptions are unobservable inputs classified as Level 3 under the fair value hierarchy of ASC 820, "Fair Value Measurement." The projections for revenue and gross margin are based on a multiyear forecast, which reflects a recovery from the COVID-19 pandemic during the forecast period and normalization of supply chain constraints. The discount rate was based on an estimated weighted average cost of capital and a specific risk premium for the BrandLoyalty reporting unit. The components of weighted average cost of capital, which includes the cost of equity and debt, and the specific risk premium, requires judgment by management to estimate. Based on the results of the interim goodwill impairment test, we recorded an impairment charge of $50.0 million, which reduced the goodwill balance of the BrandLoyalty reporting unit by approximately 10%. The goodwill balances as of December 31, 2021for the AIR MILES Reward Program and BrandLoyalty reporting units were $194.8 millionand $455.2 million, respectively. See Note 11, "Intangible Assets and Goodwill," of the Notes to Consolidated and Combined Financial Statements for additional information. 44
As with all assumptions, there is an inherent level of uncertainty and actual results, to the extent they differ from those assumptions, could have a material impact on fair value. For example, a reduction in customer demand would impact our assumed growth rate resulting in a reduced fair value. The loss of a major customer or program could have a significant impact on the future cash flows of the reporting unit(s). Potential events or circumstances could have a negative effect on the estimated fair value. In addition, the COVID-19 pandemic and continuing uncertainty in the macroeconomic environment and future deterioration in the economy could adversely impact our reporting units and result in an additional goodwill impairment charge that could be material.
Allowance for inventory obsolescence
We use certain estimates and judgments to value inventory. Inventory is stated at the lower of cost or net realizable value. We review our inventories for excess or obsolete products. Based on an analysis of historical usage, management's evaluation of estimated future demand, market conditions, and alternative uses for possible excess or obsolete inventory, carrying values are adjusted. The carrying value is reduced regularly to reflect the age and current anticipated product demand. If actual demand differs from the estimates, additional reductions would be necessary in the period such determination is made. Excess and obsolete inventory is periodically disposed of through sale to third parties, scrapping, or other means. A 10% increase or decrease in our estimate of allowance for obsolescence at
December 31, 2021would impact our cost of operations by approximately $1.4 million.
We account for uncertain tax positions in accordance with ASC 740, "Income Taxes." The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. As such, we are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of, and guidance surrounding, income tax laws and regulations change over time. Changes in our subjective assumptions and judgments can materially affect amounts recognized in the consolidated and combined balance sheets and statements of income. See Note 21, "Income Taxes," of the Notes to Consolidated and Combined Financial Statements for additional detail on our uncertain tax positions and further information regarding ASC 740.
Recently issued and adopted accounting standards
See "Recently Issued Accounting Standards" under Note 2, "Summary of Significant Accounting Policies," of the Notes to Consolidated and Combined Financial Statements for the year ended
December 31, 2021for a discussion of certain accounting standards that we have recently adopted and certain accounting standards that we have not yet been required to adopt and may be applicable to our future financial condition, results of operations or cash flows.
Item 7A. Quantitative and qualitative information on market risk.
Market risk is the risk of loss resulting from adverse changes in market prices and rates. Our primary market risks include currency risk and interest rate risk.
Risk of change
We are exposed to fluctuations in the exchange rate between primarily the
U.S.and the Canadian dollar and between the U.S.dollar and the Euro. For the year ended December 31, 2021, an additional 10% decrease in the strength of the Canadian dollar versus the U.S.dollar and the Euro versus the U.S.dollar would have resulted in an additional decrease in pre-tax income of approximately $12.3 millionand $4.3 million, respectively. Conversely, a corresponding increase in the strength of the Canadian dollar or the Euro versus the U.S.dollar would result in a comparable increase to pre-tax income in these periods.
Interest rate risk
We have variable-rate debt under the Credit Agreement entered into in
November 2021, more fully described in Note 15, "Debt," of the Notes to Consolidated and Combined Financial Statements and are subject to interest rate risk in 45
connection with amounts outstanding under the Credit Agreement. Our interest expense, net was
$5.5 millionfor 2021. Our Credit Agreement allows for the Londoninterbank offered rate (LIBOR) to be phased out and replaced with the Secured Overnight Financing Rate and therefore we do not anticipate a material impact by the expected upcoming LIBOR transition. To manage our risk from market interest rates, we actively monitor interest rates and other interest sensitive components to minimize the impact that changes in interest rates have on the fair value of assets, net income and cash flow. The approach we use to quantify interest rate risk is a sensitivity analysis, which we believe best reflects the risk inherent in our business. This approach calculates the impact on pre-tax income from an instantaneous and sustained increase or decrease in interest rates of 1%. In 2021, a 1% increase or decrease in interest rates on our variable-rate debt, which was outstanding for approximately two months, would have resulted in a change to our interest expense of approximately $1.1 million. Our use of this methodology to quantify the market risk of financial instruments should not be construed as an endorsement of its accuracy or the appropriateness of the related assumptions.
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