Debt Analysis Example: Deluxe Corp (DLX)
In the previous article, Debt in Business Analysis, MagicDiligence did an overview of analyzing a prospective investment's debt burden. In this article, we'll go through a Magic Formula example that covers a lot of the bases: Deluxe Corporation (DLX).
Before we begin, it's important to set a context for analyzing the debt. Is this a heavily cyclical company that suffers huge swings in revenue and profitability over short periods of time, or does it have fairly stable sales and profit margins? What is the near and medium term prospects for earnings growth? These are both important points - cyclicals and declining businesses obviously are riskier if they have worrisome debt burdens.
Deluxe's main business is printing and selling checks. This is a fairly stable business - even in poor economic times, folks still have mortgages and utility bills that they often pay with checks. A look at the financial statements confirm this: Deluxe's revenue has never experienced more than a single-digit percentage change in any of the past 5 years, and profit margins have been relatively predictable. However, checks as a payment method are also declining as online bill pay and debit cards become more popular, with check volume declining 4% annually this decade. The financials also confirm this: Deluxe's annual revenue growth since 2004 is minus 2% per year, and operating profits down 9% annually, with operating margin declining from 22% in 2004 to just under 16% today. So, while Deluxe is a fairly stable business, it's also a declining one and will continue to be.
Let's start by getting an idea of Deluxe's cash resources, as this is what's needed to service, and eventually pay off, the debt. The company has about $18 million in cash on the balance sheet. Trailing 12-month free cash flow (cash from operations - depreciation) is about $177 million. However, about $51 million of this is paid back to investors via Deluxe's hefty 6.3% dividend yield. So, if we're interested in the nice yield being maintained, this should be subtracted out of free cash flow. So, total available cash resources are about $144 million over the next year.
Total "short-term" cash resources = $144 million.
Now we move on to short-term debt liabilities. There is $75 million classified as "short-term debt" on the balance sheet, and digging into the notes we see this is a line of credit the company uses for short-term cash flow purposes (it is not revolving and thus does not cost much in interest). In addition to this, there is about $500k in capital leases due this year, so total debt to be cleared this year will be about $76 million.
Total "short-term" debt coming due = $76 million.
So far, so good, so let's move onto long-term debt. The balance sheet lumps everything together into a total $743 million of long-term debt obligations. Again, we need to dig into the "Notes" section to get the breakdown. If a large portion of this "long-term" debt is due next year, for example, we might want to consider lumping it into the "short-term" section. However, Deluxe's earliest maturation is about $280 million in 2012, with the rest due in 2014 and 2015, so we'll leave it alone for now.
However, this long-term debt (all bonds, by the way) carries interest on it. The "Notes" section shows that about $200 million of it carries a 7.4% rate, while the rest carries a low 5.1% rate. This interest adds up to about $49 million a year (from the income statement). We need to add that into our total short-term debt burden.
Total interest on debt to be paid this year = $49 million.
Add up all the debt-based payments to be made in the next 12 months and we get $125 million. We then compare this against the roughly $144 million in cash resources over the next 12 months. That's tight - the cash-to-debt ratio is about 115%. The absolute minimum MagicDiligence likes to see is 150%, and that's with a very stable business. Deluxe is experiencing declining sales and profit margins, meaning we can't be confident of the cash resource number - it may very well go down. In that case, the first action will be to cut the dividend, and the dividend is one of the few attractive qualities of an investment in Deluxe.
So, you can see why MagicDiligence holds a negative opinion on Deluxe as a Magic Formula investment - management is cutting things a little too tight given the uncertainty in future earnings levels.
This is a useful exercise to go through when debt levels look a little high when examining financial statements. Of course, a company with no debt doesn't require an exercise like this, nor does one with little debt relative to cash on the balance sheet and free cash flows. In any case, a process like this is often employed when MagicDiligence looks for Top Buy picks on the Magic Formula screen.