Deluxe Corporation — Q2 2018 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2018; unaudited. Unless otherwise noted, dollar amounts below are in millions. Deluxe provides products and services through Small Business Services, Financial Services and Direct Checks, while working to grow marketing solutions and other services (MOS) as check and forms usage declines.
Financial performance
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Revenue | $488.2 | $485.2 | $980.2 | $973.0 |
| Operating income | $82.8 | $92.8 | $170.5 | $177.8 |
| Net income | $60.2 | $59.6 | $123.5 | $116.6 |
| Diluted EPS | $1.25 | $1.22 | $2.56 | $2.38 |
| Operating margin | 17.0% | 19.1% | 17.4% | 18.3% |
Q2 revenue rose 0.6%, as service revenue increased to $128.3 million from $121.6 million while product revenue declined to $359.9 million from $363.6 million. For the first half, MOS represented 40.0% of revenue, up from 36.8%; checks fell to 42.2% from 44.6%. Orders declined 1.7% in Q2 and 4.3% for the half, while revenue per order rose 2.4% and 5.3%, respectively.
Q2 gross profit was $298.0 million, down from $305.9 million; gross margin was approximately 61.1%, versus 63.0%. Higher service-related costs, material and delivery costs, and acquisition costs contributed to pressure. The lower Q2 operating income reflected higher restructuring charges and costs, among other factors. Net income nevertheless increased slightly, aided by a lower tax provision: the effective rate was 23.9% in Q2 versus 32.9% a year earlier. The first-half rates were 24.0% and 31.4%.
Segments: Q2 Small Business Services revenue increased 4.9% to $317.7 million and operating income rose 7.6% to $58.6 million. Financial Services revenue fell 5.7% to $139.3 million and operating income fell 47.5% to $14.0 million. Direct Checks revenue declined 9.9% to $31.2 million and operating income declined 12.8% to $10.2 million.
Cash flow and liquidity: First-half operating cash flow was $146.9 million, versus $151.6 million. Investing used $117.6 million, including $90.2 million for acquisitions and $28.0 million for capital assets. Financing used $18.3 million; cash increased $9.4 million to $68.6 million. First-half operating cash flow less capital expenditures was approximately $118.9 million. Management expects full-year 2018 operating cash flow of $360–$370 million and capital spending of about $55 million.
Debt: Total debt was $766.8 million at June 30, up $57.5 million from year-end; nearly all was floating-rate revolving debt. The new $950 million revolver matures in March 2023. Net borrowing availability was $174.9 million after letters of credit. The weighted-average rate on the revolver was 3.24%; management reported compliance with covenants and expected continued compliance over the next 12 months. A one-percentage-point rate change would have affected first-half interest expense by about $3.6 million.
Material changes and notable items
- First-half earnings benefited from lower taxes under the 2017 Tax Act, pricing and cost reductions, and lower impairment charges. Gains on sales of businesses and customer lists were $11.1 million in the first half of 2018, compared with $6.8 million in 2017.
- Those benefits were partly offset by secular declines in check and forms volumes, loss of Verizon Communications as a Deluxe Rewards customer, Financial Services pricing allowances, higher restructuring costs and increased material and delivery costs. Verizon-related Rewards revenue declined $7.4 million in the first half.
- First-half net restructuring charges were $7.8 million in operating expenses; total restructuring charges, including amounts in cost of revenue, were $8.7 million. The company expects most employee reductions to be completed by year-end 2018 and most severance payments by mid-2019.
- CEO Lee Schram announced his retirement and is expected to remain through March 1, 2019. Transition and retirement costs were $1.5 million in the first half; total costs are estimated at approximately $11 million, with about $6 million expected in 2018 and $5 million in 2019.
- Acquisitions included Logomix and ColoCrossing, among others. The company also had a definitive agreement to acquire a treasury management business expected to contribute about $36 million of 2018 revenue, with closing anticipated in Q3, subject to completion of the transaction.
- The company adopted the new revenue recognition standard in 2018 using the modified retrospective method. It reduced reported first-half 2018 net income by $0.9 million compared with results without adoption; prior periods were not restated. Management did not expect a material ongoing effect.
Outlook, risks and contingencies
Management forecast 2018 revenue of $2.045–$2.065 billion and diluted EPS of $5.23–$5.35, including $0.45 per share of primarily restructuring, transaction, CEO-transition and impairment charges. It projected a full-year effective tax rate of approximately 24.5% and net cost reductions of about $55 million versus 2017. Management expects Small Business Services revenue growth of 4%–5%, Financial Services growth of 8%–9%, and Direct Checks revenue decline of about 11%. It anticipates approximately 7% year-over-year check-order declines in Financial Services, partly offset by MOS growth and acquisitions.
Management said operating cash flow and revolver availability should fund operations and planned dividends, capital spending, interest, share repurchases and likely acquisitions for at least the next 12 months. It expected to maintain the current dividend level, subject to quarterly board approval. Principal business risks include continued check and forms declines, competitive and pricing pressure, dependence on financial institution clients, data security, acquisition execution and retaining key employees. Management reported no significant change in disclosed risk factors.
Environmental accruals were $2.4 million; management did not expect significant environmental cash outlays in 2018. Recorded litigation liabilities were not material, but the company cautioned that litigation outcomes are inherently uncertain and an adverse ruling could materially affect a future period. The company was still refining certain Tax Act calculations and said revisions could affect deferred taxes, the repatriation toll charge and future effective tax rates.
Important facts for investors to verify
- Whether MOS growth, particularly in web, data-driven marketing and treasury management, can offset continuing check and forms declines.
- Financial Services’ sharp operating-income and margin decline, including the effects of customer loss, pricing allowances, restructuring and costs.
- Delivery of the $2.045–$2.065 billion revenue and $5.23–$5.35 EPS outlook, including the assumed acquisitions and estimated cost savings.
- Completion and performance of the proposed treasury management acquisition, and the related purchase accounting and integration costs.
- Debt, borrowing availability, floating-rate exposure and covenant headroom as acquisition, dividend and repurchase plans proceed.
- Cash conversion and the effect of restructuring, CEO transition costs, prepaid product discounts and Tax Act adjustments on future results.