Price                $36.38

Shares              51.5

Market cap      1,874

Debt                 1,016

Cash                12

Ent. Value        2,878

 

·        I believe over the next 12+ months DLX offers a 25%+ return to $45, assuming it trades at a modest 10x fcf multiple + dividends.

·        Earnings will grow at a low 20s% CAGR from 2006-2009, due to a dramatic cost cutting initiative which will remove $150m of cash cost (on a base of $321m of 06 EBITDA) via purchasing synergies, layoffs, improved IT/Data center communication costs, process standardization and better systems and outsourcing.

·        With the significant earnings and fcf growth, I think DLX can get a modest 10x fcf multiple on $4.42 of 09 fcf, the first full year of fully implemented cost saves.

·        There is a dynamic new management team installed over the last six months, led by new CEO Lee Schram, most recently a senior lieutenant to Mark Hurd at NCRfor 22 years.  From 2003-2005, Lee grew operating margins at NCR’s retail solutions business (a commoditized, declining business not dissimilar to DLX) from -8% to 4% via top line growth and cost saves.  A new CFO from a division of TYCO with turnaround experience and a new CIO have also been added.  Lee was offered a spot with Mark Hurd at HPQ, turned it down, and moved his family from Dayton to Minneapolis for the opportunity to manage DLX.  This is a similar attack plan from Hurd at HPQ – a lot of blocking and tackling, attention to costs, accountability and renewed focus on growing the core.   

·        Recently, the industry dynamics improved when M&F Worldwide (the number 3 check printer with ~30% share) announced an acquisition of John Harland (the number 2 check printer with ~30% share), essentially moving the industry from a oligopoly to a duopoly structure.  This ought to improve DLX’s competitive win rate and industry pricing, which in addition to volume declines have been the major industry headwind.

·        There are no significant bank customer contracts up for renewal in the next 12-18 months.  DLX has now lapped all contract losses (and the dramatic decremental margins which result from such losses), and in fact should actually accelerate volumes per customer this year as they roll into several new contracts.

·        The business is not overlevered at 3.2x Debt/TTM EBITDA and 5.8x EBITDA/Interest., and only 2.9x ‘07 Debt/EBITDA and 6.4x EBITDA/Interest.  There’s one near term debt maturity, the 3.5% notes due 10/07, which DLX will pay 1/2 through cash flow and 1/2 through refinancing.

·        The management team is required to buy between 2x-5x of their salary in stock over time, but have been blocked from doing so until after last quarter (the majority of the senior management team bought stock at ~ $30/share after last q). 

·        The Company is followed by only two smaller analysts (Davidson and CJS) and will likely ramp its coverage in the coming months.

 

Deluxe Segment Data			FY 12/06		FY 12/07		FY 12/08	FY 12/09
Sales
Small Business Services			969.3		988.5		1028.0	1069.2
y/y growth			4.0%		2.0%		4.0%	4.0%
Financial Services			458.0		415.4		378.0	344.0
y/y growth			-14.8%		-9.3%		-9.0%	-9.0%
Direct Checks			212.2		199.2		184.2	170.4
y/y growth			-13.9%		-6.1%		-7.5%	-7.5%
Total Sales			1639.5		1603.1		1590.3	1583.6
y/y growth			-4.5%		-2.2%		-0.8%	-0.4%
Total EBITDA ex saves			321.7		299.1		277.6	262.9
			-22.2%		-7.0%		-7.2%	-5.3%
Total EBITDA w/saves			321.7		351.1		386.6	371.9
Margin			20%		22%		24%	23%
Growth			-22%		9%		10%	-3.8%
Total D&A			85.5		70.0		52.8	38.9
Total Operating Income w/saves			236.2		281.2		333.8	333.1
margin			14.4%		17.5%		21.0%	21.0%
EPS			$        2.33		$         2.94		$       3.87	$        4.26
% Growth Year-to-Year			-26.0%		26.1%		31.4%	10.2%
Shares Outstanding - FD			51.2		51.8		47.2	42.7
Total Cap Ex			40.9		40.0		39.8	35.0
Plus: Amortization of Contract Acquisition Costs			36.6		33.0		30.0	27.0
Less: Contract Acquisition Costs (upfront)			-17.1		-20.0		-24.0	-24.0
FCF			183.5		195.5		201.5	188.9
FCF / Share			$        3.58		$         3.77		$       4.27	$        4.42

  

·        Small Business segment (SBS).  (2006: 60% of total revs, 49% of ebitda).  This is the intended growth engine of DLX, which I think can keep the overall topline of the company relatively flat and offset continued secular declines in check volumes and pricing.  SBS sells stationary, business forms, holiday cards, envelopes, packaging supplies and business checks to small business customers in the US.     SBS sells at least one product to 6m small businesses in the US out of a targeted universe of 24m businesses.  Business check volumes only decline 1-2% per year relative to personal checks at 4-5% per year, because they are used as a simple accounting system by many businesses.  In addition, the dynamics of the business check market are slightly more positive than the consumer market due to subtle nuances such as consumers preferring to transact via credit card to accumulate miles, while businesses prefer to keep float between purchase and settlement via check.  Checks are only approximately 50% of SBS total revenue.  DLX thinks they can grow this segment MSD annually, and has grown the topline 4.8%, 4.2% and 5.1% last 3qs, while EBITDA margins ramped from 12.4%, 15.7% and 16.6%.  They recently acquired Johnson Printing, a 20m revenue customized digital printing business which will add 2% of revenue growth to next year’s topline (offset by the sale of a non core packaging business).  According to management, the industry growth rate of small business is 3-4% and high “churn” leads to a larger order growth rate (when a business opens the customer must order reprints, new business cards, etc).    Management’s new strategy for this segment is as follows:

o       Grow wallet share within the 6m customer base.  DLX estimates that it only captures 15% of customers spend on products within its portfolio, such that the crosselling opportunity to existing customers is large.  For example, some customers know DLX as only a check supplier, some only as a supplier of invoices, some only as a supplier of tax forms.  Deluxe has spent money to consolidate systems and sales forces in recent quarters, which will give more visibility to its sales force.  This should be relatively low hanging fruit; DLX’s acquisition of New England Business Services (“NEBS”) in 2004 was never integrated, such that up until recently NEBS and DLX salespeople have been competing against each other.

o       Rationalize SKUs.  DLX has over 25 brands in small business which they will get to 3-4; this will save costs and facilitate the selling process.

o       DLX “Business Advantage” program.  DLX will leverage its relationship with its 8,000 bank clients to generate referrals to SBS.  When a bank receives a new small business customer, the bank refers that customer to DLX so that customer can have more of their needs met (forms, stationary, packaging supplies) and the bank captures a referral fee (a win/win proposition for all parties involved).  The company believes it grew its small business customer base by 20% this year, half of that via this referral program.    

o       Crossell Johnson Printing products.  This is a new acquisition which will allow customers to create personalized stationary on the Web, with little DLX interaction.  

o       Attack the 19m businesses they don’t touch currently.  DLX intends to reach these customers the Business Advantage program and an increased focus on catalog marketing. 

 

This segment is 50% of total company EBITDA, so if it can grow it will offset the declines in EBITDA across the other two segments.  After 09, overall company EBITDA will continue to decline low single digits, but the base EBITDA is so dramatically higher in 09 (25% greater than 06) due to cost saves that the order of magnitude of business decline is less rapid than today.     

 

·        Financial Services (FS).  (2006: $458m/1640m in revs (28% of total), $86m/322m in ebitda (27% of total)).  This is the Company’s core check business which sells checks directly to bank customer account holders.  Because the product is commoditized and there is significant bank buyer power, price compression is fierce.  In addition, volumes decline 4-5%/year as consumers continue the move to debit and credit transactions.   Excluding contract wins and losses, the company starts each year’s topline HSD in the hole.  That said, there are recent signs of improvement due to new management’s focus - the customer win rate this year is twice that of the two previous years.   The new strategy is to increase bank retention and pricing, by leveraging DLX’s relationship with the banks’ customers to promote customer acquisition and loyalty to the banks.  Some examples:

o       Ten banks have paid DLX to pilot a program where DLX will use targeted mailings to improve banks’ response rates on new products.  One early pilot increased a bank’s response rate on auto loans from 5% to 25%.  DLX leverages its “call center expertise” to offer these products when a customer calls in to order checks.    

o       DLX utilizes its strong bank relationships (DLX has been doing business with banks for 100 years and DLX handles the sensitive customer service function) to leverage printing capabilities and produce mailings for community bank customers. 

 

Through 2009 I am modeling -9% declines in revenue and significant annual EBITDA declines for this segment.  (Even assuming substantial ebitda declines here, this company has ~ $4.50 of fcf power).

    

·        Direct checks.  (2006: $212m/1640m in revs (13% of total), $74m/322m in ebitda (23% of total)).  This is a high margin business segment which faces less margin pressure due to its lower overhead structure than the FS channel and more fragmented customer base.  EBITDA margins in this segment have ranged from 35-36% from 2003-2006, but revenue has declined in the mid teens the last two years.  Revenues have declined faster than overall market declines, as the company has lost market share due to prior management’s decision to reduce spending on direct marketing (mailers).  Lee Schram thinks with a modest increase in marketing spend they can reduce the revenue decline to MSD, in line with the decline in personal check volumes.  In addition they think they can cross sell other add-ons like fraud protection which they are currently not doing.