DELUXE CORP quarterly report, Q2 FY2017

Deluxe Corporation — Q2 2017 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2017. Deluxe provides checks, forms, marketing solutions, web services and financial technology through Small Business Services, Financial Services and Direct Checks. The unaudited interim results may not indicate full-year performance.

Financial performance

Metric	Q2 2017	Q2 2016	Six months 2017	Six months 2016
Revenue	$485.2 million	$450.6 million	$973.0 million	$909.9 million
Operating income	$93.3 million	$90.9 million	$178.8 million	$183.6 million
Net income	$59.6 million	$58.4 million	$116.6 million	$116.5 million
Diluted EPS	$1.22	$1.18	$2.38	$2.36

Q2 revenue rose 7.7%; six-month revenue rose 6.9%. Acquisitions contributed approximately $46.7 million in Q2 and $84.6 million in the first half; price increases also helped. Orders declined 6.2% in Q2 and 4.6% in the first half, while revenue per order increased.
Q2 gross margin was approximately 63.1%, versus 64.5% a year earlier; operating margin was 19.2%, versus 20.2%. For the first half, operating margin was 18.4%, versus 20.2%.
First-half operating income declined despite higher revenue, reflecting $8.3 million of asset impairment charges, higher acquired-business amortization and expenses, and other cost pressures. Net income was nearly unchanged; the effective tax rate fell to 31.4% from 33.0%.
Segment trends: Q2 Small Business Services revenue grew 5.1% and operating income 12.0%; Financial Services revenue grew 18.9% but operating income fell 7.8%; Direct Checks revenue and operating income each declined 9.5%.
Operating cash flow for the first half was $151.6 million, up from $128.3 million. Investing used $96.1 million, including $77.6 million for acquisitions; financing used $98.4 million. Cash and cash equivalents ended at $34.8 million, down from $76.6 million at year-end.
Total debt was $720.5 million, down $38.2 million from December 31, 2016. Revolver borrowings were $406.0 million and term-loan borrowings $313.5 million; net available revolver capacity was $108.6 million. Debt is predominantly floating-rate and facilities mature in February 2019. Shareholders’ equity was $949.0 million.

Changes, outlook and management commentary

Management cited price increases, cost-reduction actions, acquisition contributions and a $6.8 million gain from sales of two businesses as first-half earnings supports. Offsets included declining check and forms volumes, an $8.3 million impairment, investments in growth, increased legal costs, higher material and delivery costs, and the prior-year environmental-liability benefit.
2017 guidance: revenue of $1.955–$1.975 billion; diluted EPS of $5.04–$5.14, including $0.16 per share for impairment, restructuring and acquisition transaction costs; operating cash flow of $335–$345 million; and an effective tax rate of approximately 32.5%. Management expects approximately $45 million of net cost reductions versus 2016.
Management expects 2017 revenue growth in Small Business Services and Financial Services, but approximately 9% revenue decline in Direct Checks. Financial Services outlook includes an expected $9 million loss of Deluxe Rewards revenue following the loss of Verizon as a customer, as well as continuing check-order declines and pricing pressure.
Planned 2017 capital spending is approximately $45 million and contract acquisition payments approximately $27 million. Management expects cash from operations and revolver availability to fund operations, dividends, investment and debt service for the next 12 months; it anticipates maintaining the current dividend level, subject to quarterly board approval.
Acquisitions included Panthur and RDM Corporation during the first half. In July 2017, after quarter-end, Deluxe acquired Digital Pacific for approximately $41 million, funded with cash and revolver borrowings. The company continues to target marketing solutions and other services while legacy check and forms usage declines.

Risks, contingencies and unusual items

Key disclosed business risks include secular declines in checks and forms, competition, financial-institution client factors, data security, acquisitions and economic conditions. Management reported no significant change in these risks during the first half.
The $8.3 million impairment related to a small-business distributor sold in Q2. The company also recorded a $6.8 million aggregate net gain on business sales; those sales did not materially affect revenue, according to management.
Environmental remediation accruals were $2.8 million; management did not expect significant net environmental cash outlays in 2017. Recorded legal liabilities were not material, but the filing notes adverse litigation outcomes could have a material effect in the period incurred.
The credit agreement includes financial and other covenants; Deluxe reported compliance at June 30 and expected continued compliance over the next 12 months. A 1-percentage-point change in weighted-average interest rates would have changed first-half interest expense by approximately $3.8 million.
Management concluded disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter.

Investor verification priorities

Assess how much reported growth and future guidance depend on acquisitions, pricing, and the sustainability of cost savings versus underlying order volumes.
Track Financial Services profitability and margins, including acquisition-related amortization, pricing allowances, legal costs and the Verizon-related Rewards revenue loss.
Review cash conversion, acquisition spending, planned repurchases and dividends alongside the company’s floating-rate debt, 2019 maturities and available revolver capacity.
Monitor execution of the $45 million cost-reduction target and the assumptions underlying 2017 revenue, EPS and cash-flow guidance.
Verify the final purchase accounting for RDM and the financial contribution and funding impact of the July Digital Pacific acquisition.