Deluxe Corporation CASE In the late summer of 2002, Rajat Singh, a managing director at Hudson Bancorp, was reflecting on the financial policies of Deluxe Corporation, the largest printer of paper checks in the United States. Earlier in the year, Deluxe had retired all of its long-term debt, and the company had not had a major bond issue in more than 10 years. Simultaneously, the company had been pursuing an aggressive program of share repurchases, the latest of which was nearly complete. So far, those actions had proven successful; investors had responded well to the share repurchases, and the company’s stock was at its highest level in nearly 10 years. But Singh, who had been retained by Deluxe’s board of direc- tors to provide guidance on the company’s financial strategy, saw dangers looming for Deluxe that would require the company’s managers to do more. Deluxe Corporation was the dominant player in the highly concentrated and com- petitive check- printing printing industry. Deluxe’s sales and earnings growth, however, had been in a slow decline as the company struggled to fight a relentless wave of tech- nological change. Since the advent of online payment methods and the rising popu- larity of credit and debit cards, consumers’ usage of paper checks had fallen steadily. In response, Deluxe’s chair and chief executive officer (CEO), Lawrence J. Mosner, had h ad led a major restructuring of the firm whereby he rationalized its operations, reduced its labor force, and divested several noncore businesses. Singh sensed that those measures would only carry the company so far and that the board was looking for other alternatives. Singh surmised that there would eventually be a tipping point at which the demand for paper checks would fall precipitously. In this challenging operating envi- ronment, Singh was convinced that Deluxe would need continued financial flexibility to fend off the eventual disintegration of its core business. Singh had alread y told the board that the company had probably gone as far as it could with share repurchases. The Th e time for a new round of debt financing was at hand. The board had asked Singh for a detailed plan in five days, and had insisted that, as part of the plan, he undertake a complete assessment of the firm’s overall debt policy, focusing primarily on the appropriate mix of debt and equity. In the not-too-distant future, Deluxe’s financial and strategic choices would be severely constrained, and Singh believed it was essential that the company’s financial policies afford it the necessary funding and flexibility to steer a path to survivability. Modest Beginnings Deluxe Corporation was founded in 1915 by a chicken-farmer-turned-printer in a oneroom print shop in St. Paul, Minnesota. Then known as Deluxe Check Printers, the company was a pioneer in the emerging check printing business, and specialized in imprinting personalized information on checks and checkbooks. Deluxe became a publicly traded company in 1965, and traded on the New York Stock Exchange in 1980 under the name Deluxe Corporation. The company was the largest provider of checks in the United States, serving customers through more than 10,000 financial institutions.
Deluxe processed more than 100 million check orders each year — nearly half of the U.S. market. American consumers wrote more than 42 billion checks annu- ally, although check usage had declined in recent years. Between 1975 and 1995, the peak years of check usage in the United States, Deluxe Corporation’s revenues grew at a compound an nual rate of 12%. This rate, how- ever, had declined over the past decade as checks lost share to the electronic forms of payment, such as ATMs, credit cards, debit cards, and Internet bill-paying systems. As those new forms of payment created a highly fragmented payment industry, check printing itself remained highly concentrated, with only a few firms controlling 90% of the market. Deluxe competed primarily with two other companies, John Harland and Clarke American, a subsidiary of U.K.-based Novar (Figure 1). With a proliferation of alternative payment systems, the check-printing business faced an ann ual decline of 1% – 3% in check demand, a trend that most industry analysts expected to continue.
Recent Financial Performance With the prospect of a precipitous decline in demand for paper checks emerging in the late 1990s, Deluxe undertook a major reorganization during which it divested nonstrategic businesses and dramatically reduced the number of its employees and facilities. The company went from 62 printing plants to 13, reduced its labor force from 15,000 to 7,000, outsourced information technology functions, improved manufactur- ing efficiencies, and divested nearly 20 separate businesses. The resulting reductions in operating expenses helped reverse Deluxe’s earnings slump in 1998, despite the continued softening in revenue growth. In 2000, Deluxe announced a major strategic shift with the spinoff of its technologyrelated subsidiaries, eFunds and iDLX Technology Partners, in an initial public offering. The subsidiary eFunds provided electronic-payment products and services (e.g., electronic transaction processing, electronic funds transfer, and payment pro- tection services) to the financial and retail industries; iDLX offered technology-related consulting services to financial services companies. Deluxe’s CEO, Mosner, believed that Deluxe offered more value to shareholders as a pure-play company. While he admitted that the eventual demise of the paper-check business was a certainty, he insisted that there were still growth opportunities for the company: We don’t want to abandon the core business too soon. Instead, you mine all you can out of the core business before [moving on]. We have a very good business, a very solid business with high levels of profitability. We feel we can generate revenues and profits on our core business not only today but over the next five years.
With the spinoff of eFunds and iDLX, management abandoned its plan for Deluxe to offer products and services targeting the electronic-transfer market and refocused on its
core business. Repositioning the firm as a pure-play check-printing co mpany made sense to investors, and the company’s stock price rose on the news. Following the spinoff, Mosner reorganized Deluxe’s remaining paper -payments segment around three primary business units. Financial Services sold checks to consumers through financial institutions, with institutional clients typically en tering into three-tofive-year supplier contracts. Direct Checks sold to consumers through direct mail and the Internet. The Business Services segment sold checks, forms, and relat ed products through financial institutions and directly to small businesses, targeting firms with no more than 20 employees. See Figure 2 for data on Deluxe’s 2001 sales by segment.
According to some analysts, the Business Services segment ultimately held the most promise for Deluxe because it could allow the company to bundle or cross-sell a variety of products and services to the growing small-business sector. Rather than simply grow its number of individual customers, as it had done in the past with its check business, Business Services could generate growth in the number of products or services it sold per customer. Furthermore, there were several regional companies active in this sector that had the potential to be strategic partners for Deluxe. By year-end 2001, the market had responded favorably to the spinoff and restructuring efforts —the firm’s share price had grown by more than 65% over the year, outperforming the S&P 500 Index, which had fallen nearly 20%. Over the preceding decade, however, the firm’s share price growth had lagged the broad market indexes. Exhibit 1 gives a 10-year summary of the financial characteristics of the firm, including share prices and data on comparable market performance. From 1998 to 2001, Deluxe Corporation’s compound annual rate of sales growth was 4.0%, which reflected the growing maturity of the market for paper checks in the United States. Consistent with the perceived maturity of the market segment, Deluxe’s 2001 price earnings ratio (P/E) of 11.0 hovered well below the broader market’s P/E of 29.5. Concerns about revenue growth and declining demand for printed checks were echoed in the comments of analysts who followed the firm. Despite a positive assessment of the firm’s recent ability to improve margins, one analyst covering Deluxe was guarded: We remain cautious concerning Deluxe’s long-term prospects for earnings growth, until the company can improve profitability in its core [Financial S ervices] check-printing segment. At present, this seems like a tough proposition, given a relatively mature market, intense price competition, the growth in electronic payments, and consolidation in the banking sector. Rajat Singh knew that Deluxe’s board members had many of the same concerns, but also knew that they believed the analyst community had taken a shortsighted view of the company’s potential. In fact, Deluxe’s most recent annual report stated, ―While the check printing industry is mature, our existing leadership position in the market place contributes to our financial strength.‖ The U.S. Federal Reserve Board’s 2001 Bank
Payment Study indicated that checks still remained consumers’ most preferred method of noncash payment, representing 60% of all retail no ncash payments. The company’s management believed that it was well positioned to extract value from this business and to explore noncheck offerings that would closely leverage Deluxe’s core competencies. Exhibits 2 and 3 give the latest years’ income statements and balance sheets for Deluxe Corporation.
Current and Future Financing Against this backdrop, Singh assessed the current and future financing requirements of the firm. From time to time, Deluxe required additional financing for such general corporate purposes as working capital, capital asset purchases, possible acquisitions, repayment of outstanding debts, dividend payments, and repurchasing the firm’s securities. To meet those short-term financing needs, Deluxe could draw upon the fol- lowing debt instruments: Commercial paper: Deluxe maintained a $300-million commercial-paper program, • which carried a credit rating of A1/P1. ―The risk of a downgrade of Deluxe’s short-term credit rating is low,‖ Singh thought. ―If for an y reason, they were unable to access the commercial paper markets, they would rely on their line of credit for liquidity.‖ Deluxe had $150 million in commercial paper outstanding, at a weighted-average interest rate of 1.85%. Line of credit: Deluxe also had $350 million available under a committed line of • credit, which would expire in August 2002, and $50 million under an uncommitted line of credit. During 2001, the company drew no amounts on its committed line of credit. The average amount drawn on the uncommitted line during 2001 was $1.3 million, at a weighted-average interest rate of 4.26%. At year-end, no amount was outstanding on this line of credit. Medium-term notes: Deluxe had a shelf registration5 for the issuance of up to • $300 million in medium-term notes. No such notes had been issued or were outstanding. In February 2001, Deluxe paid off $100 million of its 8.55% long-term unsecured and unsubordinated notes, which it had issued in 1991. In January 2001, the company’s board of directors approved a stock -repurchase program, which authorized the repurchase of up to 14 million shares of Deluxe common stock, or about 19% of total shares outstanding. By year-end, the company had spent about $350 million to repurchase 11.3 million shares. This program followed a share -repurchase program initiated in 1999, which called for the repurchase of 10 million shares, or about 12.5% of the firm’s shares outstanding at the time. Deluxe funded these repurchases with cash from operations and from issuances of commer- cial paper. Exhibit 1 summarizes the firm’s share repurchase activity in recent years. Singh believed the board would continue to pursue an aggressive program of share repurchases.
In addition to possible buybacks and strategic acquisitions, Singh reviewed other possible demands on the firm’s resources. He believed that cash dividends would be held constant for the foreseeable future. He also believed that capital expenditures would be about equal to depreciation for the next few years. Although sales might grow, working capital turns should decline, resulting in a reduction in net working capital in the first year, followed by increases later on. Both of those effects reflected the tight asset management under the new CEO. Exhibit 4 gives a five-year forecast of Deluxe’s income statement and balance sheet. This forecast was consistent with the lower end of analysts’ projections for revenue growth and realization of the benefits of Deluxe’s recent restructuring. The forecast assumed that the existing debt would be refinanced with similar debt, but did not assume major share repurchases. The forecast would need to be revised to reflect the impact of any recommended changes in financial policy. Considerations in Assessing Financial Policy In addition to assessing Deluxe’s internal financing requirements, Singh recognized that his policy recommendations would play an important role in shaping the perceptions of the firm by bond-rating agencies and investors.
Bond Rating Deluxe’s senior debt, which had matured in February 2001, had been rated A by Standard & Poor’s and A1 by Moody’s. (Exhibit 5 presents the bond-rating defini- tions for this and other rating categories.) A/A1 were investment-grade ratings, as were the next lower rating grades, BBB/Baa. Below that, however, we re noninvest- ment-grade ratings (BB/Ba), which were often referred to as high yield or junk debt. Some large institutional investors (for example, pension funds and charitable trusts) were barred from investing in noninvestment-grade debt, and many individual investors shunned it as well. For that reason, the yields on noninvestment-grade debt over U.S. Treasury securities (i.e., spreads) were typically considerably higher than the spreads for investment -grade issues. For pertinent data on the rating categories, see Figures 3 and 4.
The ability to issue noninvestment-grade debt depended, to a much greater degree than did investment-grade debt, on the strength of the economy and on favorable credit market conditions. On that issue, Rajat Singh said: You don’t pay much of a penalty in yield as you go from A to BBB. There’s a range over which the risk you take for more leverage is de minimus. But you pay a big penalty as you go from BBB to BB. The penalty is not only in the form of higher costs, but also in the form of possible damage to the Deluxe brand. We don’t want the brand to be sullied by an association with junk debt.
For those reasons, Singh sought to preserve an investment-grade rating for Deluxe. But where in the investment-grade range should Deluxe be positioned? Exhibit 6 gives the financial ratios associated with the various rating categories.
While the rating agencies looked closely at a number of indicators of credit quality, Deluxe’s managers paid particular attention to the ratio of earnings bef ore interest and taxes (EBIT) to interest expense. Exhibit 7 illustrates Deluxe’s EBIT-coverage ratios for the past 10 years. Singh’s recommendations for the compa ny would require the selection of an appropriate target bond rating. Thereafter, Singh would have to recom- mend to the board the minimum and maximum amounts of debt that Deluxe could carry to achieve the desired rating. Flexibility Singh was aware that choosing a target debt level based on an analysis of industry peers might not fully capture the flexibility that Deluxe would need to meet its own possible future adversities. Singh said: Flexibility is how much debt you can issue before you lose the investment-grade bond rating. I want flexibility, and yet I want to take advantage of the fact that, with more debt, you have lower cost of capital. I am very comfortable with Deluxe’s strategy and internal financial forecasts for its business; if anything, I believe the forecasts probably underestimate, rather than overestimate, its cash flows. But let’s suppose that a two-sigma adverse outcome would be an EBIT close to $200 million —I can’t imagine in the worst of times an EBIT less than that. Accordingly, Singh’s final decision on the target bond rating would have to be one that maintained reasonable reserves against Deluxe’s worst-case scenario.
Cost of Capital Consistent with management’s emphasis on value creation, Singh b elieved that choosing a financial policy that minimized the cost of capital was important. He understood that exploitation of debt tax shields could create value for shareholders — up to a reasonable limit, but beyond that limit, the costs of financial distress would become material and would cause the cost of capital to rise. Singh relied on Hudson Bancorp’s estimates of the pretax cost of debt and cost of equity by rating category (see Exhibit 8).
The cost of debt was estimated by averaging the current yield-to-maturity of bonds within each rating category. The cost of equity (Ke) was estimated by using the capital asset pricing model (CAPM). The cost of equity was computed for each firm by using its beta and other capital market data. The individual estimates of Ke were then averaged within each bond-rating category. Singh reflected on the relatively flat trend in the cost of equity within the investment-grade range, and he understood that changes in leverage within the investment-grade range were not regarded as material to investors. Nonetheless, it remained for Singh to determine which rating category provided the lowest cost of capital. Current Capital-Market Conditions Any policy recommendations would need to acknowledge the feasibility of implementing those policies today as well as in the future. Exhibit 9 presents information about
current yields in the U.S. debt markets. The current situation in the debt markets was favorable as the U.S. economy continued its expansion. The equity markets seemed to be pausing after a phenomenal advance in prices. The outlook for interest rates was stable, although any sign of inflation might cause the Federal Reserve to lift interest rates. Major changes in taxes and regulations were in abeyance, at least until the outcome of the next round of presidential elections. Conclusion Rajat Singh leafed through the analyses and financial data he had gathered for his presentation to Deluxe Corporation’s board of directors. Foremost in his mind were the words of the company’s chief financial officer, Douglas Treff, who h ad said to a group of securities analysts barely a week earlier: Let me anticipate a question which many of you are pondering. What now? Our board of directors and the management team are committed to maximizing shareholder value. Our past actions have demonstrated that commitment. We have spun off a business, eFunds, at the end of 2000, to unleash the value of two different types of companies. Over the past 18 months, we have returned more than $600 million to shareholders through cash dividends and share repurchases. Therefore, be assured that we are evaluating options that will continue to create value for our fellow shareholders.7 Clearly, Singh’s plan would have to afford Deluxe low costs and continued access to capital under a variety of operating scenarios in order for the firm to pursue what- ever options it was considering. This would require him to test the possible effects of downside scenarios on the company’s coverage and capitalization ratios under alternative debt policies. He reflected on the competing goals of value creation, flexibil- ity, and bond rating. He aimed to recommend a financial policy that would balance those goals and provide guidance to the board of directors and the financial staff regarding the firm’s target mix of capital. With so many competing factors to weigh, Singh believed that it was unlikely that his plan would be perfect. But then he remembered one of his mentor’s favorite sayings: ―If you wait until you have a 9 9% solution, you’ll never act; go with an 80% solution.‖
