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. Simulta-
neously, 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 companys stock was at its
highest level in nearly 10 years. But Singh, who had been retained by Deluxes board of
direc- tors to provide guidance on the companys financial strategy, saw dangers looming
for Deluxe that would require the companys managers to do more.
Deluxe Corporation was the dominant player in the highly concentrated and com- petitive
check-printing industry. Deluxes 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, Deluxes chair
and chief executive officer (CEO), Lawrence J. Mosner, had 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 already told the board that the
company had probably gone as far as it could with share repurchases. The 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 firms overall debt policy, focusing primarily on the appropriate mix of debt and
equity. In the not-too-distant future, Deluxes financial and strategic choices would be
severely constrained, and Singh believed it was essential that the companys 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 one-
room 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 yearnearly 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
Corporations revenues grew at a compound annual 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 annual 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 non-
strategic 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 Deluxes earnings slump in 1998, despite the
continued softening in revenue growth.
In 2000, Deluxe announced a major strategic shift with the spinoff of its technology-
related 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. Deluxes 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 dont 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 company made sense
to investors, and the companys stock price rose on the news.
Following the spinoff, Mosner reorganized Deluxes remaining paper-payments seg-
ment around three primary business units. Financial Services sold checks to consumers
through financial institutions, with institutional clients typically entering into three-to-
five-year supplier contracts. Direct Checks sold to consumers through direct mail and the
Internet. The Business Services segment sold checks, forms, and related products through
financial institutions and directly to small businesses, targeting firms with no more than
20 employees. See Figure 2 for data on Deluxes 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
effortsthe firms 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 firms 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
Corporations 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, Deluxes 2001 price earnings ratio (P/E) of
11.0 hovered well below the broader markets 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
firms recent ability to improve margins, one analyst covering Deluxe was guarded:
We remain cautious concerning Deluxes long-term prospects for earnings growth, until
the company can improve profitability in its core [Financial Services] 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 Deluxes board members had many of the same concerns, but also
knew that they believed the analyst community had taken a shortsighted view of the
companys potential. In fact, Deluxes 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 Boards 2001 Bank
Payment Study indicated that checks still remained consumers most preferred method of
noncash payment, representing 60% of all retail noncash payments. The companys
management believed that it was well positioned to extract value from this business and
to explore noncheck offerings that would closely leverage Deluxes 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 firms secu-
rities. 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 Deluxes short-term
credit rating is low, Singh thought. If for any 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 companys 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 firms shares outstanding at the time. Deluxe funded these repurchases with
cash from operations and from issuances of commer- cial paper. Exhibit 1 summarizes
the firms 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 firms 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 Deluxes 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 Deluxes 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 Deluxes 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
Deluxes senior debt, which had matured in February 2001, had been rated A by Standard
& Poors and A1 by Moodys. (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, were 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 dont pay much of a penalty in yield as you go from A to BBB. Theres 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 dont 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,
Deluxes managers paid particular attention to the ratio of earnings before interest and
taxes (EBIT) to interest expense. Exhibit 7 illustrates Deluxes EBIT-coverage ratios for
the past 10 years. Singhs recommendations for the company 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 Deluxes strategy and internal
financial forecasts for its business; if anything, I believe the forecasts probably underesti-
mate, rather than overestimate, its cash flows. But lets suppose that a two-sigma adverse
outcome would be an EBIT close to $200 millionI cant imagine in the worst of times
an EBIT less than that.
Accordingly, Singhs final decision on the target bond rating would have to be one that
maintained reasonable reserves against Deluxes worst-case scenario.
Cost of Capital
Consistent with managements emphasis on value creation, Singh believed 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 Bancorps 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 imple-
menting 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 Corporations board of directors. Foremost in his mind were the
words of the companys chief financial officer, Douglas Treff, who had 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, Singhs 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 companys coverage and capitalization ratios under alter-
native 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
firms 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
mentors favorite sayings: If you wait until you have a 99% solution, youll never act;
go with an 80% solution.