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There are a lot of logistics that come with managing payroll in-house. You have to have your work encrypted. So, from a liability standpoint, it’s a lot nicer to have someone who shoulders that responsibility.
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It’s hard to market a business. But, with , we have an opportunity to bring in more people. It feels like we have a legit business!Deluxe Corporation (NYSE:DLX) is a company that's now been around over 100 years, primarily as a provider of checks. While this might be a dying business, the company has also successfully expanded into other business lines such as eChecks, marketing, and even FinTech. I accidentally stumbled upon the business after ordering checks for my primary checking account and realizing that the checks themselves were being ordered through another company. That company was Deluxe, so I decided to take a closer look at it after confirming that it was publicly traded.
Deluxe dominates the dying checks business. It's the leading direct-to-consumer check supplier, with roughly $5.5 million customers. Despite its still lucrative (adjusted) operating margins of roughly 34.9% (according to its most recent investor presentation), it's a business in decline that's slowly being eroded by debit and credit cards. According to the most recent data from a Federal Reserve study (as cited by Deluxe in its most recent 10-K), checks still accounted for roughly 13% of non-cash transactions, but debit, credit, and ACH transactions all exceeded the number of checks written in 2015.
The company has also adapted into more modern fields, especially over the last five years. As the checks business has fallen from 58.8% of sales in 2012 to only 46.8% in fiscal 2016, Marketing Solutions and Other Services has grown to 33.4% - versus only 18.8% five years ago. MOS is also lucrative in that much of its revenue is recurring in nature.
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The company is primarily focusing on its Small Business segment, which now accounts for 65% of sales, but maintains lower adjusted operating margins of 17.9%. Sales of business checks and forms continues to decline, but Deluxe now provides marketing on demand solutions, web design, logo & hosting services, as well as payroll services. It also takes care of security and fraud, complementing its eCheck services. Its newer services, including marketing, now account for roughly 32% of the sales in this segment, while the more niche business centered around checks and forms still make up the bulk.
Its Financial Services segment provides roughly 27% of overall sales, with checks accounting for over half of the segment's revenue, while marketing and other solutions make up most of the rest at roughly 43% of segment sales. The segment boasts 22.7% adjusted operating margins.
The final segment is Direct Checks, which comprises only about 8% of overall revenue. It also maintains the most lucrative margins, however, as previously mentioned.
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Due to the subjective and fickle nature of estimating a true cost of equity, I also decided to run a range of various equity costs, as well as their individual impact on the firm's overall weighted average cost of capital, or WACC. This range can be seen below.
The firm also has a restructuring charge embedded in its income statement for fiscal 2016. I decided to adjust the firm's ROIC, therefore, by excluding the charge.
While it appears Deluxe earns illusive economic profits (ROIC exceeding its WACC) even with the highest of equity costs, this is really only the first step, because the company also utilizes off-balance sheet financing in the form of operating leases. Next, I'd like to add these leases into the capital structure, and visualize their impact on the firm's balance sheet and its ROIC.
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The capital base obviously expands when the operating leases are added, while also pushing the firm's debt-to-equity ratio up from 0.86x to 0.91x. We now have the denominator of the ROIC equation. To arrive at the numerator, aka net operating profit after tax, or NOPAT, we need to first adjust Deluxe's operating profit to account for the leases.
Now we can take taxes into account to arrive at an estimate for its adjusted NOPAT, and divide it by the adjusted capital base.
After accounting for the leases, its ROIC is knocked down a peg or two, but the restructuring charge hasn't been stripped out yet. Below is the final ROIC number, excluding the one-time charge.
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Stripping out the charge and accounting for off-balance sheet leases gives us an adjusted return on invested capital of a touch over 15%, which is still impressive, especially when compared to the adjusted WACC figures below that also account for the leases.
Larger amounts of cheaper debt lowers not only its ROIC but also the overall cost of capital. I will conclude this section stating that the firm earns economic profits, probably due to its high margin business that dominates a niche industry, which, while might be in secular decline, has little competition. Who wants to enter the check printing business at this stage of the game and compete with Deluxe? I'd hazard a guess that very few companies (if any at all).
The lingering question that remains is whether or not the firm can continue generating these excess profits going forward, by effectively managing the secular decline in checks while also simultaneously expanding its Marketing Solutions and Other Services, or MOS, business to offset losses in the dying checks business.
Deluxe Corporation: Dedicated To Small Business (nyse:dlx)
Deluxe knows that it's probably wise to diversify its overall focus away from checks. Its MOS business has grown from just 16% of its Small Business Services revenue in 2009 to 32% of segment sales in fiscal 2016. It's guiding for 35% of segment sales in 2017. This is encouraging, but the risks remain in management's execution.
MOS was only 5% of Financial Services segment revenue in 2009, but has grown to encompass 43% of it in 2016 and is expected to equal about 55% of the segment's sales in 2017. Deluxe has aggressively expanded its treasury management solutions business, as well as data driven marketing solutions within this segment, and plans to continue to integrate its acquisitions and grow this part of the segment going forward. MOS is expected to account for 5% more, or roughly 38%, of Deluxe's overall sales in fiscal 2017, with a goal of reaching 40% in fiscal 2018. Management continues to manage the declining checks business by growing these ones, which over time should make the decline in checks more tolerable.
The firm also remains focused on small business, citing that roughly 50% of small businesses don't even have a website. Deluxe wants to illustrate to these businesses that brand awareness (and increased sales) can be driven by its digital marketing solutions, which includes web design,
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