Description

Deluxe Corporation (DLX) is a 100+ year-old mid-cap provider of checks, forms, marketing solutions, accessories and other products and services to ~4.4 million small business customers and ~5,600 financial institutions. The company is cheap today, with a EBIT/TEV yield of 9.4%, which puts it in the cheapest 10% of the relatively liquid market (~$2bn market cap and reasonable liquidity).

Why is it so cheap?

The reason relates to its core business of checks, which are being rendered obsolete by technology, and represent a market in terminal decline. We can already hear the cries of anguish from the VIC crowd: “Paper checks, Jamal?! You cannot be serious!”

Bear Case

Indeed, check usage has been in secular decline since the mid-1990s, yet checks are DLX’s bread and butter, representing 43% of revenues. Competition is rife: Debit and credit cards, and ACH payments (where vendors pull funds directly from checking accounts) have rapidly expanded market share for non-cash payment transactions. PayPal and Venmo are ascendant, as are cryptocurrencies.

A recent Federal Reserve study (released 12/16, see link below) estimates that the number of checks written declined at an annual rate of 8.8% between 2009 and 2012, and at 4.8% between 2012 and 2015: https://www.federalreserve.gov/newsevents/press/other/2016-payments-study-20161222.pdf

The macro trends are certainly reflected in DLX’s business. Revenues for DLX’s Direct Check segment, a direct-to-consumer check supplier, declined by 7% in 2016, and by 8% in 2017. DLX expects the Direct Checks segment to decline an additional ~11% in 2018! Ouch!

Despite the dire backdrop for DLX’s core market for checks, we find that if you dig a little deeper, you will find a stable, high quality business that has evolved from being a check producer to a marketing and web advisor to small businesses and financial institutions, with solid growth prospects across a variety of new product and service areas.

The Business

Taking a step back, while it is true that Checks are in secular decline, DLX’s overall business is still growing. Here are DLX’s Total Revenue growth rates for the past 5 years: 2013: 4.6%, 2014: 5.6%, 2015: 5.9%, 2016: 4.3%, 2017: 6.3%. That’s a 5-year geometric CAGR of 5.3%. That is not flashy growth, but it’s not bad either. DLX manages this feat of growing against the check headwinds by compensating with a high growth Marketing Solutions segment, fueled by acquisitions (more on this later), that in 2018 may be a bigger contributor to revenues than checks.

DLX organizes its product and service offerings into four categories: 1) Checks, 2) Marketing solutions and Other Services (MOS), 3) Forms, and 4) Accessories and other products. For categories, we’re going to focus on #1, and #2, since these two big muscle movements account for >80% of the overall business. #3 and #4 are mostly associated with the Small Business Services segment, which we will cover later.

Checks – 43% of Revenues

Notwithstanding the shrinking market for checks outlined above, DLX continues to be one of the largest providers of checks in the U.S. Checks can provide a basis for a relationship with a small business or financial institution, and based on that relationship, DLX can then offer additional products and services. We find it quite striking that DLX grew its revenues over the past few years at mid-single digit rates, even with significant exposure to a shrinking check market.

It is notable that Checks revenues have steadily declined as a percentage of the business. Here are the last 5-years of Checks revenues as a percentage of total revenues: 2013: 55.8%, 2014: 52.0%, 2015: 49.3%, 2016: 46.8%, 2017: 43.3%.

Thus, the financial impact of a shrinking Checks market is reduced as it becomes a smaller component of revenues; Checks are a financial headwind that is becoming easier to overcome. So how much are Checks actually shrinking for DLX? When we apply these percentages to total revenues over the past 5 years, we get the following absolute percentage declines for Checks: 2013: -0.7%, 2014: -1.6%, 2015: 0.4%, 2016: -1.0%, 2017: -1.6%; this is a 5-year CAGR of -0.9%. While DLX still has significant exposure to a declining core market, this slightly negative growth is a far cry from the Fed data that suggested mid- to high-single digit annual declines.

Indeed, DLX’s Check exposure is concentrated in the consumer Direct Checks segment (80% of Direct Checks revenues are Checks) discussed above, but that is only 7% of the overall business. DLX is moving away from these consumers, and towards small business and financial institutions, where the check business is easier to retain and where DLX can sell other high growth products and services.

Marketing Solutions & Other Services (MOS) – 39% of Revenues

While Checks are shrinking, DLX’s Marketing Solutions & Other Services (MOS) segment is growing quite rapidly, largely based on successful acquisitions (more on this later). In the past DLX appealed to small business and financial institutions as a provider of business checks and printed forms, but today the offering has become much broader. Customers now rely on DLX as a kind of outsourced sales & marketing and web consultant/contractor.

Marketing products include digital printing and web-to-print (W2P) products such as business cards, postcards, brochures, greeting cards, retail packaging, print marketing, and promotional goods and apparel. Web offerings include logo and site design, hosting, domain name services, search engine optimization, and email and social media marketing programs.

In the fourth quarter of 2017, MOS revenues were up 15% YoY. DLX’s CEO recently said the company is targeting an overall MOS to total company revenue mix of 60% by year-end 2020. This implies that Total Revenues could accelerate in the coming years, as the high-growth MOS category becomes predominant in the business. DLX’s CEO has said that he expects MOS revenues to exceed check revenue for the first time in 2018.

Business Segments

DLX’s business consists of three segments: 1) Small business services, 2) Financial services and 3) Direct checks.

Small Business Services

DLS derives ~63% of its revenues from small business customers. As discussed above, DLX is increasingly positioning itself as a consultant/contractor or business partner, who can help small businesses brand, market and sell their products and services.

In discussing categories above, we covered Checks and MOS, but the other categories -- Forms, and Accessories and other products – are best thought of as a component of the Small Business Services segment.

Traditionally, DLX has provided small businesses with checks, and it is also a leading provider of printed business forms. These are things like deposit tickets, billing forms, work orders, job proposals, purchase orders, invoices, personnel forms, and computer forms compatible with accounting software packages. Forms, however, have the same problem checks do, in that they are paper, and are being displaced by technology. As with Checks, growth in Forms is slightly negative. Here are the last 3-years of growth rates for Forms: 2015: -2.6%, 2016: -0.2%, and 2017: -1.8%.

Checks and Forms/Accessories make up two thirds of Small Business Services, but the other third, in the MOS category, has some very high growth areas.

Small Business Marketing – This relates to things like marketing-on-demand solutions, such as email marketing and social media campaigns and analytics, W2P (web-to-print) services, and packaging. This is ~21% of the segment, and it is growing at ~10%.

Web Services – This relates to things like marketing on demand solutions, such as the Deluxe Marketing Suite, which provides customers with the ability to build and launch a web site using templates, with custom domain and business email, ongoing management of your online presence, and a team of DLX representatives who provide support. DLX is also growing its Payroll services offering. This represents ~11% of the segment, but these recurring revenues are growing at rates in the low 20% range.

When you consider the double-digit growth in MOS, and the flat or negative growth in other categories, the Small Business Services segment is growing its top line at approximately 4%-5% per year.

Financial Services

The real growth for DLX is coming from its Financial Services segment, which represents ~29% of DLX revenues. DLX does business with a variety of banks, credit unions, and financial services companies. Building on the checking relationship, DLX also offers a suite of software and cloud-based products and services.

Retail Banking – As they do with Small Business, DLX wants to partner with Retail Banking clients by helping them identify and acquire new customers through data-driven marketing, which assists retail banking clients in marketing their depository and lending products. Data Driven Marketing is ~26% of Financial Services, and these revenues, which are 90% recurring, are growing at 30%-40% rates.

Commercial Banking – Similarly, DLX offers treasury management solutions that allow for payment acceptance of multiple payment types, reconciliation, exception resolution, and invoice matching. This automates a big piece of payment processing for banks, and reduces their staffing needs. Last year, Treasury Management Solutions were ~19% of Financial Services revenues. This category, consisting of 70% recurring revenues, is growing at rates the company reports are in excess of 60%. Wow.

Steady Diet of Acquisitions

The company estimates that its acquisition activity contributes substantially to the company’s revenue growth. Much of the success of the higher growth MOS categories discussed above relates to DLX’s success in identifying tuck-in acquisitions that strengthen the portfolio and drive revenue growth.

Below are DLX’s acquisition budgets over the past 3 years, and their contribution to Total Revenues:

2015: $212 million – 8.9%

2016: $270 million – 6.4%

2017: $139 million – 9.3%

Note that without giving effect to acquisitions, DLX organic revenue grow is actually flat to negative. The company believes it is at an inflection point, where due to new MOS products and services and recurring revenue streams, organic growth should tip positive going forward. In particular, there are strong opportunities in Financial Services, where data-driven marketing and treasury management have good organic prospects augmented by additional acquisitions.

Disciplined Managers

Management has been focused on various cost reductions, mostly targeting SG&A (e.g., sales and marketing, call center/fulfillment activities), but also in cost of revenues (e.g., sourcing third party goods and services). The management team committed to and delivered on $50 million of cost reductions in 2016, and on another $45 million during 2017. They are calling for another $50 million in 2018.

The dividend has grown at a 3.7% CAGR over the past 5 years. The team has delivered 8 consecutive years of revenue growth, and 9 years of operating cash flow growth; over the past 5 years, they have achieved a revenue growth CAGR of 5.4%.

DLX has been a net repurchase of stock in each of the past 4 years. Stock repurchases for 2017 were $65 million, and including the dividend DLX returned $123 million to shareholders in 2017.

Long-Term Returns

When assessing the ability of DLX management to continue to deliver on their vision, we can look to the company’s results over time. When looking at fundamental metrics that indicate quality in a business, we look to long-term (8-year) geometric returns.

Return on Assets

ROA is Net Income (before Extraordinary Items) / Total Assets. DLX has an 8-year ROA of 12.0%, which places it in the 84th percentile of our tradeable universe (~>$2bn Mkt Cap). Here are DLX’s last 8 years of ROA (most recent first): 11.6%, 11.2%, 12.5%, 12.6%, 12.6%, 12.8%, 11.6%, 11.3%. Consider that these steady, stable returns were generated as DLX grew both Net Income and Total Assets in each of the past 8 years.

Strong Returns on Capital

For Return on Capital, we use EBIT(1-Tax Rate)/(BV Debt + BV Equity – Cash). DLX has an 8-year ROC of 16.0%, which places it in the 81st percentile of our tradeable universe. Here are DLX’s last 8 years of ROC (most recent first): 14.9%, 14.9%, 16.8%, 17.7%, 16.6%, 16.7%, 15.4%, 15.1%.

Strong Cash Flows Over a Long Period

DLX has generated $1.87 billion in Free Cash Flow over the past 8 years, representing 85% of the firm’s Total Assets of $2.21 billion. When scaling 8-year cumulative FCF versus Assets in this way, we find DLX is in the 88th percentile of firms in our tradeable universe.

Looking over our universe, this represents a better outcome than notable cash generators such as Microsoft, Johnson & Johnson, Oracle, Nike, and Caterpillar, all of which have generated less cash flow over time versus their assets when compared to DLX. By the way, all of these companies are also more expensive (have lower EBIT/EV yields) today than DLX.

Extreme Margin Stability

We calculate margin stability using a sharpe ratio-type approach, which divides long-term average gross margins by their standard deviation. Here are the DLX’s gross margins for each of the past 8 years: 62.2%, 64.0%, 64.1%, 63.8%, 64.7%, 65.6%, 65.4%, 64.6%. This series is more stable than is true for 93% of our tradeable universe. These high margins and their stability suggest the firm has some pricing power across its markets.

Other Signs of Recent Operating Momentum and Financial Strength

We look at a variety of metrics to assess the financial health of a business. Here are some highlights of our analysis. The company generated Free Cash Flow in excess of Net Income, and thus is not using accruals, which would be a red flag for us. The company paid down debt in 2017. The company’s ROA increased in 2017, versus 2016, as did Free Cash Flow. Asset Turnover (Sales/Assets) also increased in 2017 versus 2016. These collectively paint a picture of a financially healthy business.

Valuation

We use an adjusted EBIT figure that reclassifies certain expenses/gains on the income statement. This would include such items as Merger Expense, Disposal of Assets, Write-Downs, Impairment of Goodwill or Intangibles, and other items we characterize as Abnormal. DLX is cheap, with a EBIT/TEV yield of 9.4%, which is cheaper than 90% of the market we consider investable. Is this too cheap for a business with DLX’s growth prospects and favorable long-term track record? We think it is.

Summary

If investors can get past the admittedly significant exposure to old-fashioned checks and forms which are in decline, DLX is a hidden value gem that is rapidly transforming itself into a growth engine for its small business and financial institution customers.

In conclusion, we’ll quote Warren Buffett, who wrote about his purchase of Berkshire in his 2014 shareholder letter:

“I purchased…shares of Berkshire in December 1962...The stock was selling for $7.50…Buying the stock at that price was like picking up a discarded cigar butt that had one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free.”

DLX is a little ugly, and a little soggy, but we think at the right price it may have at least one free puff left in it.

Catalyst

-Continued stability in core check business

-Continued success of MOS, and moderately aggressive acquisitive growth

-Growth in Small Business, including payroll services

-Growth in Financial Services segment (Data-Driven Marketing, Treasury Management)