Description

Davis + Henderson Income Fund (DHF) is a limited-purpose trust.  The company provides cheque supply programs to Canadian financial institutions that provide retail banking services to small businesses and individuals.  Secondly, through its Filogix segment, it also provides credit lifecycle management services and technology to US and Canadian institutions. 

Resolve Business Outsourcing Income Fund (RBO) provides outsourced business solutions to other businesses.  Services include financial and administrative solutions, contact center services, and supply chain management.

Davis + Henderson acquired Resolve Business Outsource in July 2009.

*all figures in Canadian dollars.

Investment Thesis

The merger closed on July 31, 2009.  Therefore, financial statements with the combined results have not yet been filed, and consequently, I believe the market has missed the earnings power of newly combined company.  Davis + Henderson provides pro forma numbers in its offer documents but I doubt very few people have actually read the document.

The newly combined company has the following:

• Monopoly in the cheque printing business (albeit a shrinking one).
• Dominate platform in the Canadian residential mortgages (Filogix).
• Near monopoly (95% market share) in Canadian student loan administration.
• Largest provider of personal property registrations and lien searches in Canada.
• Toll booth-like earnings from providing essential, mission-critical services.
• Simple and boring businesses that are non-capital intensive, thus generating plenty of free cash flow.
• A capable management team that has a strong track record of efficiently allocating capital to businesses with wide moats.

This is a $14 stock that should generate free cash flow / share at around $2.1 - 2.3. I expect the stock to pick up once it starts filing with combined results.  Additionally, free cash flow exceeds dividends.  Which means you can get 13% yield to sit and wait for Mr Market until 2011.

Business Overview

Cheque  Supply  program

The company acts as a provider of cheque supply programs to financial institutions that provide retail banking services to businesses and individuals.  With the seven largest Canadian banks and a numerous credit unions as its customer, the company is effectively a monopoly, albeit in a slowly dying business as the world moves toward paperless money.

 Supply printed paper cheques and deposit programs (security deposit bags and personalized deposit documents).

• The end user groups are individual and small business accounts.  In Canada, individual accounts' cheque needs are serviced exclusively through the institution that holds the accounts.
• The above is true for small business accounts, except a smaller segment that is serviced by direct-selling agents and manufacturers.
• Revenue is a function of average order values and volume.

eSwitch

The company's answer to the challenge of alternative payment.  This service allows the financial institution's account holders the switching of pre-authorized debits and credits from one chequing or credit account to another and also initial set up of pre-authorized debits to credit cards.

• In addition to the customers of the cheque supply program, eSwitch has attracted several banking institutions that operate credit card accounts.
• Currently generate a very small portion of revenue.

Moat

Monopoly

• In Canada, all cheques for individual accounts, and most cheques and deposit products for small businesses of less than 10 employees are supplied through financial institutions.
• DHF deliberately focuses on financial institutions to gain a monopoly position in individual and small business cheque supplies.  It leaves the more competitive direct sales channel catering to medium to large business to other cheque suppliers including Harland Clark Corp, R.R Donnelley & Sons and The DATA group income fund.
• eSwitch is currently the only provider of pre-authorized switching services to financial institutions in Canada and has several patents pending.

Tollbooth

• earns a fee whenever cheques are ordered and zero credit risks as their customers (the banks) hold the end-user bank account.

High barrier to entry

• Customer service, ordering, data handling services related to cheque ordering are highly integrated with its customers - Canadian financial institutions.  It will be close to impossible for competitors to match, let alone exceed the level of integration and scale that DHF currently benefits from.

Risks

Cheques are threatened by alternative payment methods such as Visa and Paypal etc.  Management believes the decline to be in low, single-digit range in the near term.   I believe this poses the biggest risk to the company in two ways: 1) the rate of decline could accelerate sharply.  2) has already limited unit price growth

Filogix:

This segment provides technology and services that allow residential mortgage and consumer lenders to manage the entire credit lifecycle - from underwriting, loan origination, credit decision-making, asset-security registration , loan monitoring, repayment and security discharge.

• Lending products covered include loans, leases, mortgages, credit cards, equipment finance and lines of credit related to consumer, small and middle-market business and industrial finance customer segments.
• To compensate for the shrinking printed cheque-supply business, DHF started to diversify its business by entering into the consumer lending market.

Filogix Expert

• provides an electronic network access service in Canada to originate and manage mortgage related data utilizing  the Filogix Expert system.
• Allow over 50 residential mortgage lenders in Canada to receive mortgage application transaction data from mortgage intermediaries (mortgage brokers and in-house mortgage sales specialists of financial institutions).
• Enable mortgage originators to receive pricing, terms, conditions and funding approval from multiple lenders. 

Filogix Express

• provides an electronic underwriting platform for more than 20 lenders.
• Enables lenders to rapidly and cost effectively receive and process mortgage applications, conduct credit bureau checks, liaise with insurance companies and appraisers.

Filogix Exchange

• A browser-based, document management and archiving solution for mortgage transactions.
• Enables lenders to efficiently manage and exchange documentation and information.

Filogix Marketplace

• Provides ancillary products and services to third parties.

Cyence

• A suite of technology solutions that automates origination, customer service and collections processes in consumer, small business, commercial and industrial finance applications.

Moat:

Network effect

• My checks in the mortgage industry have indicated that numerous independent brokers and small lenders have effectively "outsourced" their data needs and are dependent on Filogix.to provide mortgage transaction data.  This in turn creates a network effect that is beneficial to the company similar to how MS Office has benefited Microsoft.  Large lenders that have the scale and resources that could otherwise sidestep the Filogix platform cannot do so because their need to transact with other players (such as a small independent broker) that rely solely on Foligix data. 
• Additionally, from the lenders' perspective, since the Filogix platform provides mission critical services, the quality and reliability of service are more important than price.  The switching cost is high because "reliability" cannot be determined ex-ante and there is no motivation for lenders to change the status quo (which is Filogix). This somewhat mitigates the company from downward pricing pressure.

Toll Booth

• Fees are based on a percentage of funded mortgage and/or transaction volume.  The company earns a fee whenever a transaction (origination/refinancing) is completed utilizing its platform and is not subject to credit risks, interest rate risks and competitive pressure (banks lowering mortgage rates to compete with each other) within the mortgage industry.

Risks

Filogix is heavily influenced by mortgage activity, which in turn is driven by the number of home sales, changes in home prices, interest rates, employment rates and the economic conditions.  If the current recession lingers, the Canadian residential market would weaken and so would revenue.

CollateralGuard + Canadian Securities Registration Systems

The company provides a fully automated reporting solution for lenders to manage their secured loans back by personal and small business property (automobiles, RV's etc).  This platform searches public record registries of personal property in Canada and permits lenders to amend, renew and discharge loan security registrations in seconds.

"The lien search and registration business of Davis + Henderson (that is, the CollateralGuard product) operates in a highly competitive industry with its main competitors being Canadian Securities Registration Systems ("CSRS") .... ........Management believes that Davis + Henderson competes favourably with respect to each of these criteria although, currently, its market share is substantially less than the market share of CSRS."

Source : 2008 DHF annual information form

"Search and Registration Services. The Company is the largest provider of personal property registrations and searches in Canada, processing approximately 3.5 million transactions annually for the Canadian financial services industry. Management believes that the Company is the dominant outsource service provider in this sector."

Source : 2008 RBO annual information form

• The above shows why DHF bought RBO.  In fact, DHF tried to buy only the CSRS segment in July 2008, but RBO declined. 

Moat

Economies of scale

• CSRS is already the largest provider in this scale business pre-merger.  By combining the two previously competing segments, NewCo can wring savings and the increased market shares and economies of scale further entrench its moat.

Toll Booth

• Earn fees whenever a search is conducted, regardless if the search will lead to a loan.

Risks

• Recession, tightening of credit or movements in interest rate or inflation can lead to lower lending activities, which would decrease the number of searches.

Student Loan Administration

The loan portfolio under administration is $15.4B, which represent 2 million student loan accounts across major Canadian banks and provincial and federal governments.

Moat

• Dominate market share (95%)
• Toll-like business: steady and lucrative cash flow.

Credit Cards & other Admin solutions

The company provides back office admin and customer care services for one large Canadian credit card issuer, and also processes 1.7 million credit card applications annually for major banks and retailers, 6.5 million non-credit card applications, 5.3 million medical/dental claims, and 4 million financial payments.

• Revenue driven by cost per transactions and the number of transactions.  The latter should be fairly stable and the trend should be slightly positive due to 1) population growth 2)  aging demographic which should lead to an increase in the number of medical claims 3) should benefit as more financial payments move "online".

Moat

High switching cost

• NewCo already has infrastructure to process these highly repetitive transactions at a lower cost due to scale.  It will cost significant time and money for the customer to switch providers or to bring the services in-house.

Risks

• The company may face downward price pressure when contracts are up for renewal as other businesses cut budgets.

Contact Center Services

• Provide outsourced call center service for financial services, retail, telecommunications and government sectors.

Moat

High switching cost

• Government contracts are sticky.  As long as required service level is maintained, government is very likely to continue with current service providers because the risks (disruption/deterioration of service would reflect negatively on the government officials) and costs of switching is high. (due diligence requires time and effort from government staff; no incentive to cut costs as budgets are predetermined; the cost savings are tax payers' money and wouldn't result into bonus for the staff)

Supply Chain Management

• Provide marketing support: process 5 million orders that include point of sale, literature and brochure fulfillment, print management and transportation solutions.
• Incentive services for consumer -based business.  process 100 million coupons, rebates, premiums, sweepstakes, games, coupon redemption and loyalty fulfillment.
• Logistic services: received, warehoused and shipped approximately 10 million client products.
• Specialty solutions: customized document imaging and textbook distribution management service for specific customers.

Competition

There are two types of competition.  1) Other service provider.  2) Customer's own internal business process capabilities.

Current Recession

I believe the ongoing recession has actually helped outsource service provider.  To provide these services internally would entail an initial fixed cost and a continuous variable cost for these businesses, as they are trying to cut costs, shrink assets, and attain higher efficiency.  Outsourcing to 3^rd party providers such as Davis + Henderson, who can provide these services at a lower cost due to their larger scale and expertise represents a superior solution and I expect this to continue.

DHF's Management

I believe DHF has a strong management team evident by the following:

They have great business senses.

• They recognize that the cheque-supply business is a shrinking business.  Even though DHF is a monopoly in this business, management recognizes the need to diversify their business in a timely manner, not when it is too late (look at the newspaper industry).
• The table below lists their revenue mix and acquisition.

The acquired targets have several common traits.

1)     Toll booth-like business model.  Earns fees whenever services are used.

2)     Provide mission-critical services that have high switching costs for users

3)     Competes based on quality and reliability rather than price.  Thus, allowing the company to differentiate itself based on efficiency and value-added.  Additionally, this helps to protect profit margins.

They stayed within their core competency.

• Their core competency is their extensive knowledge in the retail/small business banking, derived from long term operating experience in providing cheques to financial institutions with retail banking focus. 
• They could have branched out into providing services to financial institution that focuses on corporate finance, insurances, and capital markets.  I believe they did not do so because they have no experience.
• They could also have expanded into printed media and specialty printers.  And I think they stayed away because the business does not provide a sustainable competitive advantage and in fact is a low-margin, commoditized business.

The Merger

Davis + Henderson had focused on the CSRS asset and had offered to buy RBO in November 2007.  In hindsight, it was fortunate that RBO, then trading at $8, turned down the offer.  In April 2008, RBO undertook a strategic review and began to court potential suitors.  DHF offer to buy the CSRS division only and was turned down again.  With the "help" of the credit crisis, DHF had finally closed the offer with an all-stock offer equivalent to around $3.65/share, or at EV/EBITDA of 5x.

Source: Bloomberg

Valuation

Source: company reports

With great underlying business and low leverage, DHF is at least worth 12x FCF ($26 ) which would imply an upside close to 100%.  I also believe that intrinsic value is higher, based on my view on the quality of the business and forward growth rates.

Catalyst

* filing of the next quarter / annual report.

* once the market realize the earnings / FCF of the combined company

* recognize that DHF is no longer just a cheque printing business.