Now with the inversion of the yield curve, markets are becoming more sure of an impending recession, and as a consequence, there’s a flight to value. Finding that extraordinary bargain may be hard these days, but there will always be some special-situation issues that are overlooked. One such bargain, in our humble opinion, is Deluxe Corporation (DLX). Once a provider of checks and forms, it is now repositioning as a provider of web and online marketing services targeted at small businesses and financial services. Although the repositioning was driven by an acquisition strategy of questionable success, write-downs on which have been a transient headwind for earnings, it nonetheless leaves Deluxe gaining more than 30% of their revenue from marketing solutions and web services alone. With their presence in these markets, I believe that they stand to benefit from the incoming sole proprietor and online business revolution, which given their valuation makes them a great GARP investment.
Drop-shipping and the Entrepreneurial Revolution
As jobs are becoming disrupted and the US public, leveraged with student and car loans, seek to make money wherever they can in an increasingly gig-oriented economy, the value of risky, personal entrepreneurial initiatives has gone up. While before, small businesses and sole proprietorships selling niche products or services found it difficult to economise on customer acquisition, now with the possibility of small incremental expenditures on digital marketing ad campaigns supported by social media platforms like Facebook (FB), a business of any size can effectively generate leads in a manageable quantity.
According to the various gurus in the digital marketing space, getting a positive spread between lifetime value (LTV) of a customer and customer acquisition costs (CAC) only really takes a reasonably crafted product and a good understanding of the people in your niche market. Indeed, the success in generating a positive ROI on advertising dollars has made running digital marketing businesses very profitable. Both small services, such as Poland-based WebUp, and larger services such as Deluxe’s Marketing Suite and Alex Becker’s Market Hero, have sprung up everywhere. This is an obvious consequence of the value that you still get as an advertiser by exposing your product on platforms where people spend an increasing amount of their time, with these platforms accruing huge demand-side benefits such as better profiling of convertible customers.
A consequence of the ease of creating the LTV-CAC spread in niche markets has been the Shopify (SHOP) drop-shipping revolution, evident from Shopify’s massive sales growth, whereby entrepreneurs will sell all sorts of niche products like wolf mugs and cat socks on Shopify eCommerce stores. Drop-shipping is the logistical principle whereby orders are taken before the supplies to produce the product are sourced, allowing for entrepreneurs to dip their toe in the market to gauge demand without having to commit a lot of capital.
Digital marketing is a critical component of the drop-shipping revolution, partially because it’s eliminated indivisibilities in ad expenditure and allows entrepreneurs running even the smallest of businesses to scale their business; however, they want to suit any market. Just as critically, digital marketing gives advertisers a lot of options to target profiles with a high degree of specificity through tailored campaigns. Incremental investment in these campaigns allows sellers to iterate their customer profile as they get more data on which customers are turning out to be the most impressionable. Digital marketing, together with drop-shipping, allows almost any entrepreneur to implement a very lean business model and the value in these low risk businesses could become a substantial stimulant of a small business revolution driven by ordinary, enterprising people.
Making money on ad dollars isn’t as simple as it sounds though. Defining and understanding the niche for your products can be difficult as well as choosing how to reach it effectively. This is the way Deluxe delivers value with its marketing suite through the provision of concierge or DIY digital marketing services that help you manage all your options. Its various services, like SEO, social media, and email marketing services as well as logo, landing page, and web-page design, can be tacked on to the basic service for additional subscription fees providing massive scope of advertising methods for clients. With the concierge service, you also have a campaign manager who can help you manage your options and run a campaign that is designed to market your product to your niche who will take initiative with choices regarding how to generate leads and where to hunt for them. Working with someone experienced in this area can be very helpful in keeping down CAC, especially when they are well versed in how to run ads with as high an impression threshold as possible, impressions being the metric by which social media platforms bill advertisers. With the various marketing avenues and other web services that Deluxe provides, it is positioned as a provider of a service that will become increasingly important as businesses, ranging from consulting to consumer goods businesses both small and large, continue to leverage increasingly valuable social media platforms to make digital marketing the epicentre of their sales-to-cash generation strategy.
Cash Generative and Trusted by Creditors
So I’ve tried to make the case that digital marketing companies are a valuable vendor to corporations of many sizes and types, but the question is why would an investor be interested in Deluxe Corporation, which is in the tricky process of moving from one very different business to another? Fundamentally, special situations like a repositioning can yield extraordinarily high returns due to the uncertainties, but in the case of Deluxe Corporation, certain characteristics of the business lend itself to a thesis that the repositioning is less risky than what the market may believe.
Even though its check business is terminal, due to the fact that the use of checks is in structural decline, checks is still a highly cash generative business. Because of the cash contribution of the checks business, which still accounts for a plurality of revenue, DLX is able to achieve an outstanding overall cash conversion margin of 17.7% of sales. This cash generation has been important for maintaining the financial health of the business as well as financing the acquisitions involved in Deluxe’s repositioning.
The high degree of cash conversion also opens up DLX’s debt capacity substantially, and this is evident in the high degree of bank trust placed in the business. In January, Deluxe’s total facility commitment reached $1.15 billion, which is already half the book value of the business’ total assets and the company’s current market cap (10-K Outlook for 2019). Further evidence of the bank’s confidence lies in the fact that a large part of the debt is variable rate, an indenture detail that the bank must have been comfortable saddling onto Deluxe (10-K Capital Resources). The availability of funds from operations and also from creditors is important as Deluxe continues to navigate after its pivot and attempt to solidify its position in the digital marketing segment.
Additionally, the acquired data-management technologies that position Deluxe as vendors for the oncoming small business revolution are already being applied to financial services customers, one of Deluxe’s biggest and oldest markets. Treasury management, security management and data driven marketing services provided to the financial clients are growing healthily, with the most recent earnings release showing a 9.8% increase in revenue from this segment. This segment is the largest and a growing source of cash that can continue to support Deluxe in its transition, as well as sustain its debt.
As the small business digital marketing service picks up speed, creditors can expect that the possibility of financial stress from the debt load will be reduced even further. With the Deluxe Marketing Suite business model being highly oriented around subscription based services that lock in clients for at least a year of payments, as the marketing suite customer base grows, the cash generative power of the business will likewise grow with great efficiency.
For the valuation, we’ll be using an expectations-based DCF approach, whereby we will establish, based on market forecasts and past performance, what the expectations are for the company’s future performance.
We will assume that interest rates on the company debt will continue to be at 3.8%. We will also use an implied equity premium figure of 5.5%, as well as a Beta of 1.39 for the main CAPM inputs. We will assume the risk-free rate as the yield on 5-year US government bonds. The cash and accounting tax rate will be assumed the same at 21%, the TCJA corporate tax rate. We will assume that the market’s collective model is incorporating the consensus forecasts of sales growth and operating profit (EBIT margin) for Deluxe. For the business’ capital intensity, we are using the historical incremental investment rates in working capital and in fixed capital net of historical depreciation. Using their total non-operating assets as well as their contractual obligations net of the over-funded balance of pension plans, we get the following valuation.
|Incremental fixed-capital investment||2305.993||2359.03||2413.2882||2468.79381||2525.576068|
|Working capital investment||13835.96||14154.18||14479.729||14812.7629||15153.45641|
|PV of FCF||245565.7||234924.3||224744.07||215004.99||205687.9473|
|Total PV of FCF||245565.7||480490||705234.02||920239.01||1125926.957|
|PV of Residual Value||3759235||3596332||3440488.7||3291398.26||3148768.545|
|SHAREHOLDER VALUE (Billion)||3.058291||3.130313||3.1992147||3.26513027||3.328189503|
In order to justify the price, instead of the business’ revenues growing at all, it would have to decline by 30%, followed by no revenue growth in perpetuity. Assuming that a growth appreciation period of only 1 year is reasonable at the forecast 2.3% sales growth rate, the business would already be trading at a 33% discount.
Expectations for Deluxe seem unreasonably low. Given the current growth market of financial services and the potential onset of a small business revolution, a decline in revenue at all doesn’t seem very likely, yet a substantial one of 30% seems to be priced in.
Naturally, this supposed undervaluation could be an illusion of our model. DCF models are always rather sensitive, and the dynamics of their terminal value assumptions compound the sensitivity problem. Even though as substantial a discount as this one is usually not entirely a consequence of a faulty model or sensitive assumptions, it still could be.
But it could also be that DLX is indeed an overlooked opportunity. Due to recent write-downs on acquisitions, there is contraction below the operating line, meaning that P/E based screeners are not likely to pick Deluxe up as a potential value opportunity. Additionally, it’s classified by big data services like CapIQ as being part of the declining checks and forms industry. The fact that it’s also a rather small company by market cap and revenues may also preclude it from being investigated by larger market actors. As such, Deluxe could very well be an untapped opportunity, still with substantial upside, waiting to be snatched up by the more nimble, individual investors who are able to stomach the risk of failed execution in the repositioning process with the onus of debt, as well as a continued trend of value destruction through acquisitions.
Disclosure: I am/we are long DLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.