Business Context and Reporting Period
Company: Deluxe Corporation
Filing Type: Form 10-Q (Unaudited)
Reporting Period: Quarter and nine months ended September 30, 2004
Key Event: On June 25, 2004, Deluxe acquired New England Business Service, Inc. (NEBS) for approximately $639.6 million. NEBS is a leading provider of products and services to small businesses, including checks, forms, and apparel. The acquisition is being managed as a separate segment pending integration.
Key Financial Metrics
| Metric | Q3 2004 | Q3 2003 | 9 Months 2004 | 9 Months 2003 |
|---|---|---|---|---|
| Revenue | $484.97 million | $314.87 million | $1,103.18 million | $941.62 million |
| Gross Profit | $314.45 million | $208.90 million | $722.91 million | $619.11 million |
| Gross Margin | 64.8% | 66.3% | 65.5% | 65.7% |
| Operating Income | $100.75 million | $87.66 million | $262.39 million | $250.19 million |
| Net Income | $57.51 million | $58.18 million | $151.16 million | $153.05 million |
| Diluted EPS | $1.14 | $1.09 | $2.99 | $2.71 |
| Operating Cash Flow (9M) | $213.45 million (vs. $150.95 million in 2003) | |||
| Total Debt (Sept 30, 2004) | $1,295.67 million (vs. $594.94 million at Dec 31, 2003) | |||
| Cash & Equivalents | $13.90 million (vs. $2.97 million at Dec 31, 2003) |
Material Changes vs. Prior Period
- Revenue Growth: Revenue increased 54.0% in Q3 and 17.2% for the nine months, primarily driven by the inclusion of NEBS revenue ($176.8 million in Q3; $184.6 million for 9 months). Organic revenue from existing businesses declined due to a 7.3% drop in unit volume (Q3) and 5.1% drop (9M) caused by declining check usage and lower direct mail response rates.
- Profitability: Net income decreased slightly (1.2%) for both the quarter and nine months compared to 2003. This was largely due to higher interest expense from increased debt levels and the absence of a $7.3 million income tax reserve reversal recorded in Q3 2003. Despite lower net income, Diluted EPS increased due to share repurchases reducing the share count.
- Debt Levels: Total debt increased by $700.8 million to $1.296 billion to finance the NEBS acquisition. This included $318.6 million in short-term commercial paper and $975.6 million in long-term debt. On October 1, 2004, the company issued $600 million in long-term notes to refinance commercial paper.
- Accounting Changes: The company adopted SFAS No. 123 for stock-based compensation in 2004, resulting in an expense of $8.7 million for the nine months (compared to $0.7 million in 2003 under APB 25). Additionally, inventory accounting for a portion of the business changed from LIFO to FIFO, reducing Cost of Goods Sold by $2.2 million in Q3.
Guidance, Outlook, and Risks
- 2004 Outlook: Management expects full-year 2004 revenue to be slightly down from 2003 excluding NEBS. Diluted EPS is projected to be approximately $3.85 for the full year, with Q4 EPS between $0.83 and $0.87. Operating cash flow is expected to exceed $250 million.
- 2005 Outlook: Financial Services revenue is expected to decrease by approximately $110 million in 2005 due to the loss of a major client and continued pricing pressure. Operating margins in this segment are expected to decrease 4 to 6 percentage points.
- Cost Synergies: The company anticipates realizing cost synergies exceeding $25 million annually beginning in 2005 through the integration of NEBS, utilizing shared services and eliminating redundancies.
- Restructuring: The company recorded $2.2 million in restructuring charges in Q3 2004 related to facility closures (Dallas, Anniston) and employee reductions. An additional $20.5 million in restructuring accruals related to NEBS integration was recorded as part of the purchase price allocation.
- Risks: Key risks include the continued decline in check usage due to alternative payment methods, intense pricing pressure in the Financial Services segment, lower direct mail response rates, and the successful integration of NEBS. Credit ratings were downgraded to BBB+ (S&P) and Baa1 (Moody's) following the acquisition.
Investor Verification Checklist
- NEBS Integration: Verify the progress of integrating NEBS operations and the realization of the projected $25 million in annual cost synergies.
- Debt Servicing: Monitor the EBIT to interest expense ratio (currently 13.6x trailing four quarters) against the 3.0x covenant minimum, especially given the increased debt load and higher interest rates on new long-term notes.
- Financial Services Client Loss: Assess the impact of the lost major financial institution client on 2005 revenue and margins, as management forecasts an $110 million revenue decline in this segment.
- Check Volume Trends: Track industry-wide check usage statistics to gauge the long-term viability of the core business model against electronic payment alternatives.
- Share Repurchases: Note that the company has paused share repurchases to focus on debt reduction; verify if this strategy shifts in future quarters.