Look for Deluxe to Follow Intuit's Business Successes

Hunter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Deluxe (NYSE: DLX) had a closing price of $42.35 on August 1. Based upon the financial metrics that I will discuss in this report, I believe Deluxe is currently undervalued and deserves consideration for possible investment.

Company overview

Deluxe operates in the “Business Services” sector and it provides printed materials, forms and checks, and marketing solutions for small businesses and financial institutions. The company is comprised of three segments:

  1. Small Business Services (63%)
  2. Financial Services (23%)
  3. Direct Checks (14%)

To all three segments, Deluxe offers three main services:

  1. Checks (59%)
  2. Forms, accessories, and other products (22%)
  3. Marketing Solutions and other services (19%)

Current Environment

The past several years have seen slight revenue declines for Checks, which stem from that segment’s correlation to the US economy. As our recessed economy sluggishly drags on and high unemployment persists, the demand for checks is diminished. This does, however, present a future growth opportunity if and when the US economy improves (so should the demand for checks).

In the meantime, Deluxe is counteracting these revenue declines with even greater increases in Marketing Solutions, and this is fueling top-line revenue growth for the firm. Checks has been the main revenue stream, and will continue to be in the near future, however, Deluxe is intent upon growing its Marketing Solutions services through offering a greater mix of solutions as well as strategic acquisitions of small- to mid-sized companies (most recently: OrangeSoda).

Based on what we have seen from Deluxe in the past, I wouldn't bet against this trend continuing. Take a look at what Intuit (NASDAQ: INTU) has been able to do in the last several years. Intuit, the $20 billion behemoth in this space, has completely transformed the business from simple business services online to a host of full products with the ability to cross-sell. Would I be the first to speculate that Intuit makes a bid for Deluxe? Or that Deluxe goes on an acquisition spree to rival Intuit? In either scenario, shares of Deluxe are attractive. If you are an Intuit shareholder, then you are familiar with this scenario taking place over the last couple of years.

For all the intrinsic value that Intuit has been able to acquire and develop in the business, the market has richly rewarded the stock price.  Note the ratio analysis above for Intuit versus the software industry.  Typically a price to earnings multiple as high as 24 is only warranted for a company with extremely high growth, or exceptional long term potential.  This is the markets way of saying it loves Intuit.

Analysis

Using basic fundamental analysis, we can see evidence of Deluxe’s financial soundness and growth potential. Some of the initial attractive attributes of Deluxe are relatively high margins and strong and steady cash flow.

  • Operating Margin: 19.8%
  • Net Margin: 11.3%
  • Free Cash Flow: $209 million
  • FCF/NI > 1

 

As a stand-alone statistic, free cash flow of $209 million may not mean much. However, when we observe net income of $172 million, it helps provide greater perspective. Deluxe’s free cash flow/net income ratio is 1.21 and it has consistently maintained a FCF/NI ratio greater than 1 since 2006.

While these two pieces of data regarding free cash flow are very telling, perhaps the most revealing statistics are Deluxe’s FCF yield (11.8%) and FCF/invested capital (22.3%).

Another consistency for Deluxe has been its positive earnings surprise. It has beaten analyst EPS estimates over the past 11 quarters and the average beat rate over this period has been 6.7%. The average one-week price movement for shares following its earnings announcement is +3.4%. From 2008-2012, EPS has increased from $2.00 per share to $3.33 per share, which translates to a 66.7% increase (13.62% CAGR).

Deluxe has also been very efficient operationally and has consistently maintained a negative cash conversion cycle over the last decade (-8.76 TTM). This negative CCC stems from both high receivables and inventory turnover ratios. This means that Deluxe collects money faster than it spends it and does not need to seek credit or financing to meet its financial obligations for continued operations.

Competition

The closest competitor for Deluxe is R.R. Donnelley & Sons (NASDAQ: RRD) with a similar market cap and market share. R.R. Donnelley gets a lot of attention from investors because of its strong dividend (6.6% annualized) and 'future growth prospects,' whatever that means. I may sound a little Foolish here, but why would anyone want to invest (not trade) in a company that has lost money in the last two years and sports a bad balance sheet (more liabilities than assets). If you really believe in this space and the financial transaction story, I would choose a 'best of breed' company like Deluxe.

In summation, based upon the data provided, financial performance, market history, and current economic conditions, I believe that Deluxe is a financially sound company with substantial growth potential and limited downside risk and should therefore be considered as a possible investment at its current market value.

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Hunter Orr has no position in any stocks mentioned. The Motley Fool recommends Deluxe. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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