Magic Formula Stock Review: Deluxe Corp (DLX)
Deluxe Corporation (DLX) is a provider of customized printed products to small businesses, banks, and consumers. The company is organized into 3 business units, distinguished mainly by the target customer. The Small Businesses Services unit, accounting for about 58% of sales, targets (you guessed it) small businesses by providing business checks, forms, marketing fliers, stationary, business cards, and so forth. Brands here include Deluxe, Safeguard, McBee, and RapidForms. Financial Services (29%) targets large banks and other financial concerns, providing checks, gift cards, and fraud protection services. Direct Checks (13%) targets consumers with similar products. Deluxe is one of the largest printed product providers in the U.S. and Canada (it's only two geographies), servicing over 6 million small businesses and 7,000 financial institutions. Check products account for nearly 65% of sales, other printed items about 25%, and services filling out the remainder.
Deluxe fails all of the main investment tests - growth, competitive moat, and financial strength - and as such I recommend that Magic Formula investors look elsewhere. Printed checks are in secular decline. In 2007, checks accounted for just 35% of all non-cash payments, well down from 45% in 2004, according to the Federal Reserve. Check volume has been declining about 4% annually this decade as an increasing number of consumers and businesses elect to pay their bills with credit/debit cards, and through online transactions. This leaves only cost cutting, market share gains, and acquisitions as growth avenues for Deluxe. Management has been trying to execute on all 3, cutting SG&A spending and closing a number of acquisitions to try and establish an Internet presence. However, revenue has declined at an annualized 4% since 2005, and there is little to suggest this trend will reverse itself.
Printed products are hardly a wide moat business, either. In check printing, Deluxe faces competition from large players like Harland-Clarke, as well as smaller printers both local and Internet-based, not to mention software programs that can print checks. Checks are losing the battle against new, electronic payment methods like credit/debit cards and online bill pay. Small business forms and stationary are likewise highly competitive. The corner office can elect to use the local print shop for it's needs, or head to Staples (SPLS), OfficeMax (OMX), or Office Depot (ODP). Deluxe does hold several 3-4 year contracts with large financial institutions, but with the turmoil in that industry, the company faces the risk of these customers being bought up by non-customers, or disappearing altogether. Otherwise, there are no switching costs, regulatory barriers, or unique assets, and scale does not really provide a major advantage. Also, printing is a business with low barriers to entry, meaning new competitors pop up all the time. Clearly, durable competitive advantages are not in force here.
Deluxe also has seen declining profitability and less than stellar financial health, completing the bleak investment picture. Gross margin has declined from 66% in 2003 to about 61% currently. Operating margin is even more pronounced, falling from nearly 26% to just above 15% in that same period. Deluxe earns about 26% less in operating earnings today than it did 5 years ago. Worse, financial health is pretty weak, a big no-no in a declining industry. The paltry $18 million in cash on the balance sheet is dwarfed by nearly $900 million in debt - nearly 30% higher than the company's market capitalization! Interest coverage ratio is tight at just 4 times. If revenue and profitability continue to decline, Deluxe could have trouble meeting the first $300 million maturity in 2012. In any case, with today's credit market it's a bad time to rely on debt to finance operations.
The positives here are few and far between. The dividend is pretty meaty at 8.5%, and looks safe as payout is just 27% of free cash flow (dividend cuts usually happen at 60% or higher). As management has focused on cost cutting and divesting non-strategic businesses, MFI return on capital has risen to a solid figure above 70%. Free cash generation continues to be pretty strong at over 12% of sales.
But even these positives have contingencies. The dividend may be high, but it was cut over 40% in 2006 and is not sustainable for a long period of time given the declining industry and high debt load. Most perplexing to me is management's stated strategy of using cash to pursue growth acquisitions. Deluxe's business is print products, and it is extremely unlikely to be successful in the highly competitive and nascent Internet business services space. Management should be doing what Earthlink (ELNK) and USA Mobility (USMO) are doing in similarly declining industries; run a lean business, pay out all free cash flow to shareholders, and run off the company's assets. I find little to like about Deluxe. Look elsewhere for your next Magic Formula stock pick.